To determine the intrinsic value of development land, the Highest and Best Use Analysis technique is employed.

Naturally, the intrinsic value of development land is derived from the value of the building that will be constructed on it. Based on the anticipated selling price of the building and the cost of construction, we can estimate the land’s value. However, this heavily depends on what will be built (which, in our case, is determined by the developer).

Below is an example of such an analysis (source*), reflecting different functionalities. For each different function, the costs, NOI, risks, expected growth rates, and discount rates vary.

It’s important to understand that this valuation considers the long term, as short-term cyclical fluctuations can lead to misleading decisions (see also: What Creates a Housing Bubble?).

Additionally, this analysis highlights how land prices can fluctuate significantly depending on infrastructural changes in the surrounding environment.

Finally, one more nuance emerging from this evaluation is the concept of valuing real options. For example, consider a scenario where we aim to evaluate land with the following parameters:

  • Construction cost of the building: $800,000;
  • Probability of annual NOI (Net Operating Income) being $130,000: 50%;
  • Probability of NOI being $70,000: 50%;
  • Cap Rate: 10%;
  • Discount rate: 12%.

Using the traditional method:

Expected NOI = 0.5 * 130,000 + 0.5 * 70,000 = 100,000.
Building Value = 100,000 / 10% = $1,000,000.
Land Value = (1,000,000 – 800,000) / (1 + 12%) = $178,571.

Now, let’s analyze this through the lens of a real option—suppose we have the option to buy the land but delay construction until the situation becomes clearer (e.g., awaiting election results). We can clarify what the NOI will be and then decide whether to proceed with the project.

In this case, one year later, the land will either be worth $500,000 or $0 (though in reality, land doesn’t become worthless; this is a simplified assumption).

As a result:
Land Value = (500,000 * 0.5 + 0 * 0.5) / (1 + 12%) = $223,214.

As you can see, understanding that we can buy the land and delay construction has made the land 25% more valuable to us. Further factors affecting land value could include the realization that delaying the project might allow us to choose a more suitable function (e.g., based on expected infrastructural changes).

However, a real option exists only if the land is purchased outright (with cash) rather than with obligations (though theoretically, a hybrid version could exist—for instance, allowing the developer to decide when construction begins, rather than the seller).

P.S.
Buying land with obligations has significant financial implications, especially regarding risk transmission—see Cash or Barter – Land Real Estate.

Source:
Real Estate Finance & Investments by William B. Brueggeman and Jeffrey D. Fisher.