Why do investors tend to be averse to investing in undeveloped land? What are the advantages and disadvantages of investing in raw land? What are some of the factors that need to be taken into consideration when assessing whether an undeveloped parcel is a good investment? Jim McAlister IV, CEO of Rockspring Capital, takes us through the paces in this Q&A excerpted from a podcast interview he recently did with Real Assets Adviser. Listen to the podcast by going to this link: https://bit.ly/2rzqJqo

Investors tend to be averse to investing in undeveloped land. Why the hesitation?

Investing in land requires a much higher level of expertise than investing in income properties. When you’re investing in properties that have a cash flow, such as an office building or shopping center, it’s very easy to determine what that asset is worth. Essentially, what are you willing to pay for that cash flow? They are sold on cap rates and it’s hard to screw up. With land, what’s a piece of land worth? Well it doesn’t produce any income, generally speaking, and so it’s only worth what an end user or developer is willing to pay for it at a certain period of time. So if you’re not a complete expert in land investing you can get absolutely burned. There is good reason why novices should not be playing in the land market.

Let’s talk about the people who do understand the land market and are investing. What is the number one motivation for buying undeveloped land, or the chief strategy behind it?

Most people who buy undeveloped land are developers, not investors, and they are going to buy the land right when they are ready to build. There are others whom I call quasi-investors — developers who are not immediately building as they are waiting for the area to mature a little bit. In our case, we look for undeveloped sites that are undervalued. If you’re an expert, you can find really good buys, especially when you have a little stress going on from the seller. We then get the property completely developed horizontally, so that it’s ready for the developer to develop vertically.

What is the real advantage to buying undeveloped land for an investor?

If you’re a true expert and know what other people don’t know, you can make a much higher rate of return buying an undervalued piece of land versus buying an income-producing asset. You just don’t see income-producing assets selling drastically below what they should be selling for because it’s just a cash flow, and there is a giant group of investors that are willing to pounce on anything. For instance, if I own an office building that is trading on a four cap and I make an incremental change to what I’m willing to sell the property for, like reducing it by 5 percent, I’ll have 15 buyers within a week. Land doesn’t work that way. If you’re an expert, you can see the future potential of a property that no one else sees, thus purchasing it at a cheaper price because of less competition. That’s the advantage.

Let’s talk about central business districts, which is where a lot of investors put their money. Central business districts are often devoid of undeveloped land. Where are undeveloped parcels they generally found?

In urban areas there are a lot of what we call “covered land plays.” Those are areas that are transitioning, creating situations where an original property’s use might be transformed into something else in the near future. For example, maybe it’s an area that is a great part of town, but it was developed out for industrial, say 60 years ago, and is no longer the highest and best use for that land because land values in that submarket are changing. A lot of times folks like us will buy an income-producing asset, such as an industrial building or class C or D apartment complex, and hold onto it for a couple of years. We would take that cash flow and wait for the area to continue transitioning, then sell it to a high-end residential developer for a completely different land price.

Would you be buying that property and then tearing down the warehouse, or is that something that is done prior to the purchase? Secondly, what about zoning? Does the buyer handle rezoning, or does that rezoning have to happen prior to the sale?

Firstly, while we’re waiting for the area to mature, we want that tenant to pay rent, essentially producing income for us while we hold the asset. The last thing we want to do is kick them out before we have a buyer. Also, we don’t buy commercial buildings with long-term leases as we want to have flexibility when exiting the property. Secondly, we operate in Texas, and most of the state does not have zoning — except Travis County and some suburbs of Houston — so zoning is not a big issue.

But that is not the case in most of the rest of the United States where zoning is enforced and you have to apply for zoning changes. What about those situations?

In those situations, you have to understand the nature of the district you’re in. Let’s say that it’s a class C or D multifamily property and the area’s highest and best use is now high-end single-family residential. You would have to understand and know that the city wants those apartments gone as much as anyone else does. But if it’s a situation where you’re trying to change it from one thing to another and you don’t know if the city wants to go with it, then you are absolutely rolling the dice, and making a good rate of return is probably in the trash can.

What are some of the factors to be taken into consideration when assessing whether an undeveloped parcel is a good investment?

When looking at a piece of land, you have to understand the market’s dynamics and cost of development. If you have a piece of land that you know is good for single-family residential, you need to know what a developer will be willing to pay for it and assume they are able to get their utilities and do everything they need to do. Are you going to be able to get $20,000 a lot or $45,000 a lot? That tells you what and when you can buy to get the rate of return you need. If you buy something and have no clue what a developer’s willing to pay for it, it’s a total gamble and you’re probably going to lose. Also, in some areas in Texas, it might cost millions of dollars to get water to the site. In other areas in Texas, like Houston, where there is too much water, the city or the county won’t let you develop unless you have a plan for water runoff, and that might mean digging a ditch to the closest creek at a cost of $15 million. If you buy either of those properties not realizing those development factors, well then you probably grossly overpaid.

Commercial real estate, especially in the gateway markets, has become quite expensive. Have undeveloped land prices in those markets inflated by the same volume or percentage as developed properties?

Yes, that’s the case for sure.

Have undeveloped land prices in gateway markets been priced out of the range of profitability at this point?

There will always be good deals out there, especially with land. As mentioned before, a lot of people don’t know what land is worth, and someone that’s a true expert is going to secure profitable opportunities others don’t know about. When you have a market that is generally overpriced, there will be fewer opportunities, or maybe the opportunities won’t be quite as strong, but it’s a little bit much to say that there are no opportunities in any place. Also, there are bubble and burst cycles in real estate like anything else, and different parts of the cycle create opportunities for investors.