Is Land a Good Investment?December 20, 2018 / Blog, Land Investment / 0 Comments
How Risky are Land Investments?
Land investments have risks. Of course, all investments have risks. In spite of the occasional email touting a no-risk way to get incredible returns, or enthusiasts claiming inside knowledge of a “sure thing,” seasoned investors recognize that risk and reward go hand in hand. That is certainly true for land investments.
Strategic Risk Produces Investment Returns
Market dynamics are the reason why. A thought experiment can make the point. Think of two potential investments of any kind, both of which are looking to be sold to the highest bidder. They both offer the promise of $1,000 annually. One is guaranteed by the federal government and can be cashed out at any time. The other is not guaranteed, has a lot of unknown contingencies, and has an unclear hold period.
What would you pay to make $1,000 per year in a federally guaranteed, completely liquid investment? Some would pay a lot, so much that the return on their purchase price would drop to the 2-3% range. What would you pay if it were a fairly risky venture, with a fair chance of losing money, and even a small chance of losing all your money? A lot less, I’m sure. Others would agree. So that investment instrument would sell for less. A $1,000 of profit compared to that lower price would represent a higher return.
We recognize that if we are willing to accept low rates of return, we can buy highly rated bonds or Treasury Bills with low risk and low rewards. At the other end of the scale, stocks in new companies developing new technologies offer not only the possibility of radical returns, but have high failure rates as well. Prudent investors are interested in comparing the degree of risk and the prospect for reward, the so-called risk/reward ratio.
A question I am frequently asked is, How risky are land investments? I did a quick Google search to get a sense of how others have answered that question. I was dumbfounded by some of the answers I found. While there are many well-written articles extolling the benefits of land investment, there was an equal number of warning people of their excessive risks.
My Strategies for Radically Reducing Land Investment Risk
I’m sure it will come as no surprise: I think strategic land investments provide the best risk/reward ratio of any investment vehicle. I don’t think I have a significant chance of losing money on those investments. That’s why I put my own money into them so aggressively.
Land investments come in many shapes and sizes, and some would certainly qualify as highly risky. However, I don’t consider that to be true of my own for the following reasons:
1. We buy only in growth corridors.
The growth in the Phoenix area is tremendously robust and a long-term economic trend that I’ve written about frequently. Virtually no national economists or real estate experts believe that the migration to the Phoenix area is going to stop in the decades ahead.
Further, it’s surprisingly straightforward to determine exactly where in greater Phoenix that growth is going (see our overview video to understand why).
By limiting our purchases to well-understood growth corridors, we are (all but) guaranteed that future demand for the pieces we buy will be much greater than current demand–that is, values will be much higher in the future.
2. We only buy for cash.
Probably the number one reason that some people have had a bad experience owning raw land is their use of debt to acquire it.
Debt exaggerates risk in two ways:
- First, it puts a tremendous burden on the timing of investment. The weight of these interest payments, not to mention the looming balloon payment, is exactly what throws a bad deal into distress, forcing price drops and all kinds of seller concessions. I like to buy from distressed sellers. I don’t want to be one.
- Second, the land is notoriously illiquid. That simply means that unlike a stock investment in which you can sell on demand by accepting that day’s ‘market price,’ land sales typically take careful strategizing, particularly in terms of market timing. Having debt can create an urgency to find a buyer when the market isn’t yet ripe for a good transaction. Cash owners simply don’t face that pressure.
Of course, most investors don’t have the cash resources to purchase the larger pieces. That’s why I pool my money with others to purchase. We form an LLC, contribute our cash to it, and the LLC owns the land without debt. Each investor owns a prorated share of the LLC.
3. We know the parcel characteristics that make for a low-risk purchase.
This is where the less experienced can certainly get themselves into trouble. Two pieces, seemingly similar in location, size, and topography, can have radically different outcomes in terms of future values. Subtle differences in access, zoning, water movement, deed restrictions, and the like, can have an outsized effect on developability. Ultimately, developability determines value.
We understand land uses, how cities cooperate with landowners to prepare for development (the entitlement process), and the kinds of characteristics that raise the cost of development. For a land investment to be lower in risk, it’s imperative to evaluate it in light of each of these.
In my opinion, investors that don’t have a thorough understanding of such things should steer clear of raw land, especially in the outskirts. Improved lots in the developed areas would offer much less risk since the entitlement and improvement work has already been done.
4. We don’t develop.
That’s a big one. One of the articles I mentioned earlier talked about how risky land investments are focused exclusively on the many ways development can go wrong. I completely agree with his assessment. I just don’t consider development to be a land investment.
As a land investor, I want to sell to a developer. Before I do, I’ll be holding that property for appreciation, probably for several years. During that time, I’ll interact with engineers as well as the planning and zoning department of city or county governments. We’ll arrive at an approved development plan that I can hand to my developer-buyer. I’ll have done the slow-paced, long-in-the-tooth entitlement work.
The developer will bring a completely different set of skills to the table. His world will likely include debt, a strict schedule, and a fairly tight profit margin. That’s not a world I want to occupy. The developers who are good at their jobs do very well. Nonetheless, it’s a very different game than the one I play. I don’t want their risks.
5. We pay close attention to development cycles.
We don’t have a crystal ball, and we recognize that markets can change quickly. After decades of investment activity, we know that markets are surprisingly predictable over the longer term. We try to buy as markets are coming out of their cyclic lows. When they are coming out of a crash, as they are now, we buy aggressively.
Land investors get into trouble when their investment model demands a sale within a shorter time period (say 2 years). A slight hiccup in the market can then cause major problems. People who recognize they might have to wait a couple extra years are in a much safer position.
My returns in pure land investments over the past 20+ years have been tremendous. I don’t think I got lucky. I think following those five principles will consistently give outstanding returns. Furthermore, I think my risk is surprisingly low, specifically given the returns I’ve been able to enjoy.
I’d love to share those returns with you. Call me to discuss the pieces we’re currently considering and how you might invest in our next purchase!