Many people who like to invest in real estate say it is one of the best investments out there. Why is that? Because, they argue, they aren’t making any more of it! The amount of land in the world is fixed, right? I think that is a fact we can all accept. The occasional development of multistory buildings hardly adds to the additional inventory of real estate in the broader world.
Real estate is kind of funny though, because it tends to hold its value better if it has buildings and other improvements. This is because real estate that has been improved can usually be rented, which means an income stream is attached to it. So while the value of the underlying land might increase or decrease because of market conditions, improvements can still always be rented and provide more value over raw land.
To take this one step further, appraisals for commercial real estate are often heavily based on the income stream the rental real estate can generate. The more money you can rent an office building or apartments for, the more money someone else is willing to pay you for it when you sell.
The value of land is generally not determined by how much rental income it generates. Rather, the value is based on what other similar types of land are selling for. In other words, the value of land is more based on what people think it is worth, and not based on more scientific methods that can compare it to the income of other investments.
Because the value of land is determined by what people think it’s worth, it is subject to wide swings in value when the economy changes. When there is a recession and people feel gloomy about the future, they are not willing to pay much for land. The value of land will decline. When there is an economic boom, people get very excited about the future and can’t buy land fast enough. The value of land will increase.
How do lenders protect themselves from this uncertainty in values? First of all, land will require higher down payments than improved real estate. In other words, the buyer must have a high amount of equity invested to protect against the swings in the market. It is not uncommon for lenders to limit land loans to LTVs between 50% to 65%.
And then there will still be concerns about how and where repayment will come from. If that land is generating rent, then the land itself won’t help repay the loan. The borrower will need to use some other existing source of income. Because a land payment can be a real albatross around your neck, many lenders prefer to keep land on a shorter amortization; typically ranging from 3 years to 10 years.
Notice what a huge difference in lending standards this creates. A home residence can have an LTV of 97% and amortized over 30 years. An apartment building can have an LTV of 80% and amortized over 20 to 30 years. But, raw land might have an LTV of 65% and could be amortized over 5 years! When raw land serves no purpose but some future speculative purpose, lenders rightly hedge their bets to protect against the uncertainty.