Land loans are generally regarded as the riskiest type of real estate lending. Here are the FDICIA regulatory maximums for the various types of construction and development loans:
Why? Because land values evaporate in a severe downturn. From an interview with Bob Voit, a legendary Southern California real estate investor posted on Lansner on Real Estate:
Bob: …You could build a case that many real estate assets have zero value today that were worth millions a couple of years ago.
Us: Why?
Bob: It’s because, let’s say you have a beautiful site to build a high-rise office building on in downtown wherever. The combination of market forces, which would include construction costs, lack of availability of financing and the lack of available tenants that support your rental rate. What makes the development of an office structure economically unfeasible. If it’s unfeasible, nobody wants to buy it. Whoever may want to buy it can’t get the money.
Us: You’re talking basically of a collapse.
Bob: A relative collapse in temporary values. The same thing happened 20 years ago. Then market forces readjust, and off we go again.
An example shows how this is possible. Here is a breakeven analysis on a development project:
Now let’s suppose, for the reasons Bob talked about, the completed asset is worth 10% less. Here are the new numbers:
There goes the equity, the lender is now at 100% LTV. Same example, but suppose the completed asset is worth 28.6% less:
The land value is now $0. How likely is it asset values will fall 28.6%? Very possible, as discussed here.
But, of course, you don’t see many signs offering land for free. The reason the land value is zero is because the construction cost equals the end asset value. Build it for less, or find an end use worth more, and there’s still value there. Unfortunately, although construction costs are down, they’re not down that much, and the end values of all types of real estate tend to move down together. So, as Bob says, you wait for the market to readjust. Here are a couple of alternative uses for the land in the meantime:
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