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Residential Lots: The Next Big Boom

Over the past two years, in a number of markets stretching across the West, from Phoenix through Las Vegas to Sacramento and Riverside, investor groups have been maneuvering to acquire finished residential lots that due to the recession ended up stranded without hope like lost pilgrims in a vast desert.

There were so many unfinished developments of one size or another that the buying spree lurched along in starts and stops through this year with another great push at the end of 2009.

Some cities have been scraped almost clean of unsold finished lots, but, again, there were so many sites slated for residential development over the past decade that it’s been hard to get to them all. Yet, the economics of investing in finished lots is so darn attractive it’s worth hunting them down.

Typically, the cost of a lot is about 25 percent of the finished house price. So, if a home sold for $800,000, it probably cost the developer $200,000 just to buy and prepare the lot, getting it graded and then hooked into water, utilities, and assorted street and drainage lines. The latter expenses usually run about $50,000.

During the past decade, builders could usually tap their lenders to the tune of $100,000 per finished lot, says Scott Clark, president of San Ramon, Calif.-based Americap Development Partners, which has been aggressively pursuing finished-lot deals since 2004, acquiring thousands across the West.

Most of the housing development volume was the result of aggressive construction practices by regional and publicly traded national builders. Now the regionals are bankrupt and out-of-business, while the nationals were punished by investors for the vast inventory of non-revenue-producing land held on their books. This was raw land and finished lots that would not be utilized in the near future because the lengthy recession had pummeled housing markets making new development very risky.

As a result, finished lots are being dumped back into the market at 50 cents on the dollar — or much, much less — by builders and banks, which took back the properties due to loan defaults.

In bigger developments, investors have been buying these lots at 30 cents on the dollar, notes Nate Nathan, president of Scottsdale, Ariz.-based Nathan & Associates. In fact, well-funded investor groups have been sweeping up these long rows of unfinished lots by the dirtful leaving individual investors with no other option than to haunt smaller projects. And that, too, has been a worthwhile use of time and resources because, as Nathan points out, customized lots are selling for 10 cents to 20 cents on the dollar.

Think of it this way, lots are being acquired below finishing costs, which if new construction proceeds means the land cost is negligible, if not zero-valued.

“I love this space,” chortles Clark. “About 80 percent of what we are doing is finished-lot investing. We are concentrating on buying at below finishing costs, leaving virtually no land cost whatsoever.”

Americap “has scraped everything in Northern California” and is starting to work the Phoenix market. It is also looking closely at Southern California, the Inland Empire (Riverside and San Bernardino, Calif.), Las Vegas, Denver and Salt Lake City.

As of the beginning of 2009, Riverside and San Bernardino counties contained almost 30,500 lots ready for construction, reported The Press-Enterprise newspaper in Riverside.

“If you take multifamily out of the equation, there is probably about 40,000 unfinished lots of standard, single-family size (40 feet by 90 feet) in the Phoenix market,” says Nathan. In November 2009, Nathan brokered the sale of 7,000 finished, partly finished and plotted lots dropped into the market by two major homebuilders.

Currently, so-called “money partners” are buying the lots and then doing off-balance-sheet, rolling options with builders. That’s because, for the publicly traded homebuilders, an extensive inventory of lots is considered bad business. “It’s what got them into trouble three years ago,” says Clark.

Americap, as an example, is acquiring a residential project in El Sobrante, Calif. The lots are being purchased at about $50,000 a pop in a community where the houses are selling for an average of $350,000.

For individual investors, the most important point to realize about finished lots is that these investments, unlike a downtrodden single-family home that can be quickly reconstructed to market veneer, generally can’t be flipped.

“In a typical cycle, we hold the finished lots for anywhere between 12 months and 36 months depending on location,” says Clark.

“Investors are underwriting to hold unfinished lots for three to four years,” Nathan confirms.

By one estimate, most cities across the American West have about a two- to three-year supply of lots. By the time house prices recover, which optimistically could be as early as 2011 or 2012, developers will need to start building again.

By then the existing overhang of finished lots would have been consumed, and because developers over this period hadn’t been buying land, they are going to suddenly wake up to the fact they need lots and at that point they will be paying a premium. At least that’s the scenario most investor groups are counting on.

“The country needs 1.2 million new units for the next 10 years just because of population growth,” says Clark. “We built about 500,000 units in 2009 and 600,000 units in 2008, so there eventually will be pent-up demand. We want to get as many of those finished lots as we can because as demand begins to rise, the need for housing will become painfully obvious. The delta (ratio of change to value of underlying asset) in this investment will be significant.”