How much should a builder pay for land? The residual method, step by step

The short answer

A builder can pay whatever is left of the home price after the build cost, the site work, the fees, the selling costs, overhead and the profit target. That residual, times the lot count, is the land basis the deal supports. For 80 homes selling at $425,000, with the costs in the example below and a 12% profit target, it comes to $48,250 a lot, or $3.86 million for the land.

Residual land value, explained

There are two ways to price land. One looks sideways, at what similar land sold for. The other looks forward, at what you can build on it, and works back. Builders lean on the second, because two tracts with the same acreage can hold very different numbers of homes at very different costs.

The forward method is called residual land value, or the land residual, because the land gets what's left. Every other input has a price you can look up or bid: lumber, labor, engineering, fees, commissions, even the return an investor expects. The land is the one input whose value depends on all the others, so it's solved for last.

Appraisers use the same idea under the name land residual technique, and developers who sell finished lots run it from the other end, starting from what a builder will pay for a lot.

How to calculate land basis, step by step

1. Start with the home price

Use what comparable new homes nearby closed for, after incentives and closing-cost help. List prices run high, and resales describe a different product. If the community will mix plans, use the blended average. This is the input to get right: in the example below, a price 5% lower cuts the land value by a third.

2. Count the lots

The lot count in a listing is usually the gross acres times a density. The real count comes after floodplain, wetlands, buffers, easements, open space, streets and ponds are out, and it's often lower. The lots per acre guide walks through it, and the lot yield calculator does the math.

3. Take out the costs that scale with the price

Selling and closing costs (commissions, closing-cost help to buyers, marketing), overhead (your company's general and administrative cost, spread across the homes it builds), financing on the land and construction loans, and your target profit. Builders usually carry these as shares of the price. In the example they add up to 23%: 6% selling, 5% overhead and financing, and 12% profit.

4. Take out the build cost

The direct cost of the house: materials, labor and the trades. Use your cost for the plans you'd build there, with the options you expect buyers to pick.

5. Take out the site work and fees

Everything it takes to turn raw land into a finished lot, divided by the lot count: clearing and grading, streets and curbs, water and sewer mains, stormwater ponds and amenities, then impact fees, tap fees, permits, engineering and legal. Include offsite work such as a turn lane or a sewer extension. Listings rarely mention it, and it's where budgets break.

6. What's left is the land

Subtract steps 3 to 5 from the price and you have the land value per lot. Multiply by the lot count for the land basis, and divide by the gross acres for the price per acre.

7. Check it against the asking price and the market

Put the seller's price in and see what margin it leaves you. Then hold your finished lot cost, the land plus site work and fees, against what builders have paid for finished lots nearby. If your finished lot costs more than lots trade for, a developer can probably deliver lots cheaper than you can.

A worked example, line by line

80 homes on a 32-acre tract, selling at an average of $425,000.

At $48,250 a lot the land basis is $3,860,000, or $120,625 an acre. The finished lot, the land plus $55,000 of site work and $14,000 of fees, costs $117,250.

The seller is asking $4.5 million, which is $56,250 a lot. At that price your profit drops from 12% of the price to 10.1%, about $8,000 less on every home.

Raw land, paper lots and finished lots

Land changes hands at three stages, and a price per lot means something different at each one.

Raw land is the tract as the owner holds it, often zoned for something else. Paper lots are entitled: the zoning is in place and the plat or plan is approved, but nothing is built. Finished lots have the streets, utilities and stormwater in, and they're ready for a foundation.

The residual method gives you a raw land value. To compare it with a developer's finished lot price, add your site work and fees back. In the example, $48,250 of land plus $69,000 of site work and fees makes a $117,250 finished lot. If a developer will sell you finished lots for less, buying lots beats developing them, before you even count the time and risk you'd skip. Paper lots sit in between: the seller has carried the rezoning and engineering risk, so they cost more than raw land and less than finished lots.

The lot-to-price check

A quick check builders use is the finished lot cost as a share of the home price. The long-standing rule of thumb puts it at about 20% to 25%. It's a sanity check rather than a method, because the share runs higher where land is scarce and at lower price points, and lower for large, expensive homes.

In the example the finished lot is 27.6% of the price. That doesn't kill the deal. It says the land, the site work or both are running high for a $425,000 home, and it's worth a second look at the site budget before you counter.

What moves the number

Because the land is the residual, it absorbs every error upstream, and it absorbs them at a multiple. In the example the land is 11.4% of the price, so a 5% miss on the price is a third of the land value.

It works in both directions. A builder who's right about the price can pay more than a competitor who isn't, and one who's wrong about it overpays by far more than the error. It's why land teams spend so much time on what homes nearby actually closed for.

Time and carrying cost

The method above is static. It assumes you buy, build and sell in one go. Real deals take years, and every month between buying the land and the last closing costs interest, property tax and insurance on the land and the unsold lots.

There are two simple ways to account for it. Raise the financing share until it covers the interest over the whole sellout, or take the land value the residual gives you and discount it back to today. A rezoning adds months before the first home starts: with $2 million of land carried at 8% a year, each month costs about $13,333. The rezoning timeline checker works out how many months to plan for.

A takedown schedule, where you buy lots in batches as you need them, moves much of that carrying cost to the seller or a land banker. That's why lots on a takedown usually cost more per lot than the same land bought at once.

Fees and taxes that vary by state

Impact fees and the transfer tax on the deed are set by state law, and they differ across Georgia, the Carolinas, Alabama and Tennessee. Georgia and South Carolina have impact fee acts, North Carolina mostly allows water and sewer system development fees, Alabama leaves fees to local acts, and Tennessee counties use a school facilities tax on new homes instead of impact fees. The state table on the calculator page has each state's rules and transfer tax.

Mistakes that inflate a land number

• Pricing the homes off resales or list prices instead of new-home closings after incentives.
• Using the listing's lot count before anyone has laid the site out.
• Leaving offsite work out of the site budget: turn lanes, sewer extensions, pump stations.
• Counting financing twice, once as a share of the price and again as interest inside the build cost.
• Comparing a price per acre with another tract's without checking how much of each can hold lots.
• Using last year's impact and tap fees. Counties and utilities raise them often.

Terms

Land basis

What the land under each home costs a builder. It has nothing to do with tax basis.

Residual land value

What land is worth once every other cost and the required profit are taken out of what the finished product will sell for.

Land residual technique

The appraisal name for the same method.

Raw land

Land before entitlements or site work.

Paper lot

An entitled lot that hasn't been developed: the zoning and plat are approved, but nothing is built.

Finished lot

A lot with streets, utilities and stormwater in and fees paid, ready for a house.

Site work

Grading, streets, utilities, stormwater and amenities. Also called horizontal development.

Takedown

Buying lots in batches on a schedule. The seller or a land banker carries the rest until you take them.

Land banker

An investor who buys land or lots and holds them for a builder, who has an option to buy them on a schedule.

Absorption

How fast homes sell, usually in homes a month. It sets how long you carry the land.