Exploiting Intrinsic Land Value
Profit in disguise
Let’s face it. If the potential for profit was obvious and stared you in the face every time you looked at an asset, anyone would be able to make a profit.
The first question identifying profit potential is to identify the commodity. What’s the finite resource? Think about a hamburger’s retail price which has many components (the meat, the bun, the sauces and dressings, the marketing costs and so on). But follow the key ingredient – the meat – back through the processes of distribution, processing, slaughtering and so on. What’s the commodity? It’s the cow. If the retail price of a hamburger goes up by 10 percent, the price of the cow can go up by 20–30 percent. Why? Because the cow is the finite resource.
In investment property, what’s the commodity? I hope by now you know it’s the land. Let’s say you have units selling in downtown Sydney for $500,000: the land content of those units might be 10 percent, or $50,000. If the retail value of the units goes up to $700,000 (an increase of 40 percent), the value of the land will go up, not just by 40 percent but by 100 percent or more! The rising retail price of property prices boosts the value of the base commodity – land. And there lies the hidden potential.
The business of making a profit is to spot the potential in an asset that the market is currently underselling.
The intrinsic land value triangle
Intrinsic value has three key dimensions. What is:
• Τhe property’s value today
• Its highest and best use
• Its value in the future?
When you know these three things about a piece of land, you have an edge over the market. You can begin to identify properties that may be undervalued or underutilized – often because the vendors and their advisers have not thought it through.
In property, the added value is created when the vendors don’t understand market value and you do. Or when there’s a problem with the property that the vendors can’t find a solution to and you can.
Identify present value
Identify the current market value of the property. This can be done by obtaining comparable sales evidence of recently sold properties (in the last 6 to 12 months) in the immediate vicinity of the target property. (We referred to this in Session 4.4 on valuations.)
Identify future value: residential property
The median house price has been tracked for decades and has tended to increase in value by 5–10 percent per annum over a 10 year period. With property cycles, it may peak then flatten out, but averaged over a 10 year period, the median house price will increase by around 8–9 percent in most of our capital cities (and a little bit lower in some of the secondary cities and regional areas). Land, on the other hand, has shown growth of around 20 percent per annum.
When I look at a residential asset, I generally identify the land content of that asset and forecast its growth at 15–20 percent (compounding) per annum: I’m generally within a few percentage points over a 10 year period.
Identify future value: commercial property
Basically, the true value of a commercial property is based on the ability of the tenant of that property to be able to continue to pay the rent. The future value of that property is based on the tenants being able to pay an increased amount of rent in the future. The future value of the property and its rental potential can be broken down into three components.
Opportunities in the building
• The site may be under-capitalized. Under the allowable zoning, the building may have the potential to be increased in size within the existing land area thus making the land more valuable.
• The current rent being paid by the tenant on the site could be below market value. There may be provisions in the lease (called ‘market review’) where these rents can be increased to true market value, essentially increasing the building’s value.
• Special dispensation may be obtained from the local council to increase the permitted uses for the site. For example, obtaining a hotel license, gaming license or Lotto license can positively affect the tenant’s ability to pay rent or the building’s ability to attract high turnover, high-profit tenants.
Opportunities in the surrounding infrastructure
• It may be possible to up-zone the property to increase the let-able area or permitted uses on the site. This information is obtained by looking at the current use of the site and then referring to the zoning guidelines of the municipality to determine whether the site area has been maximised. We discuss this in detail in Unit 6.5.
• Some areas going through transition (changing road traffic patterns, motorway off/on ramps and so on) may also be targeted for rezoning although there is as yet little official recognition of this. For example, when a railway station is built, there is often pressure to create a community around it in order to improve its viability: this may result in a change of zoning to higher-density residential or commercial.
• Areas that were once inhabited by mainly older residents in post-Second World War housing can be ‘gentrified’ or transformed by the influx of young upwardly mobile professionals. These changing demographics can lead to changes in commercial land use demand, based on the new population’s needs – for example cafes, pubs, movie theatres, strip shopping, locally-based entertainment and social activities.
• Changing demographics may also create areas of high population growth, which increases property demand in terms of tenancy and purchase.
• The volume of traffic carried by roads has a direct relationship to the value of the buildings passed by those roads, as does access to and exits from those buildings. It may be possible to identify undervalued property prior to the announcement or opening of a major highway or road upgrade. Where property has been purchased based on old rental levels (based in turn on old traffic volumes) and the traffic increases substantially, there may be a corresponding rise in the tenants’ income and their ability to pay the increased rent.
• Major developments may change traffic flow, entry and exit points and patterns, and hence the exposure of the property. For example, if a railway station is enlarged and reoriented, the number of commuters gaining direct exposure to surrounding shops may be significantly increased – with the potential to increase tenant turnover (and rent).
Opportunities in the tenant
• The type and quality of the tenant also have an important bearing on value. ‘Blue chip’ and government tenants are usually reliable in paying rent and vacancy during the period of the lease need not be factored in.
• If the tenant has an expanding business, it may have an increased requirement for space which can be met on site.
• The changing nature of the tenant’s business may lead to alternative uses being requested for the site, with opportunities for increased rent to be paid. For example, many plant nurseries have added cafes and licensed restaurants to their business: they have spotted an opportunity to exploit their land and ambiance to create a new profit stream.
Highest and best use
The highest and best use of a piece of land is determined by three distinct factors:
• Location – this includes access to main roads, infrastructure and other amenities that will suit particular uses (or not).
• Zoning – zoning defines the usage of a particular property, and also clusters and limits the complementary and/or competing usage of adjoining properties.
• Council requirements – this includes things like height or size restrictions on the building that can be put on a particular piece of land.
I recommend that you get into the habit of going in person to the council and chatting with the town planners about town planning, zoning, council restrictions and so on. That’s one of the few things that councils don’t charge you for! If you put your cards on the table and say, ‘Look, I’m just getting into this: can you give me an overview of this site’s zoning, what I can do, what I can’t do and so on?’ they’re very helpful. They’re so used to just citing the problems and restrictions that if you say: ‘So what can I do with this building? Have you got any ideas?’ they’re often quite happy to offer some suggestions.
Try talking to the chief town planner if you can, rather than one of the underlings (who generally think red tape first, and tell you what can’t be done: that’s their job). The chief town planner will often have been in the area a long time and can tell you everything that’s going on in the area.
Exploiting the difference between current and future value
This is where the fun really starts. Having identified the present value of a property and its potential for future value, it’s time to negotiate the purchase of the property for the present value or less.
While this does require developed negotiation skills, you should already have gathered a key tool – comparable sales evidence. In essence, your aim is to position yourself as:
• A pessimist regarding the present value of the property (backed up by lower sales evidence) when it comes to making an offer and securing a sale at a lower price
• An optimist regarding the present value of the property (backed up by higher sales evidence) when it comes to convincing the valuer in order to secure funding.
Having secured control over the asset (through an option or conditional contract to purchase), you are now in a position to begin the process of realizing the asset’s potential future value. This process will be ongoing over the life of the property until your final exit strategy is realized.