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. Last Updated: 07/27/2016

Setting the Right Price for Each Patch of Land

The principle of what anything should cost in a free economic market is straightforward and simple: It should cost the amount equal to the economic benefits it can deliver to its owner. As everywhere, in the case of land in Russia, that means the cost should reflect the benefits from the uses to which the land can be put.

Of course, any given piece of land may have many different possible uses; its maximum value will be indicated by the most profitable way in which the land can be used. Acting to suppress value of a particular parcel can be lack of demand, the absence of infrastructure to support valuable uses and unnecessary restrictions on its use.

Starting from distant and deserted land parcels, the usefulness of land is increased by the presence of a greater number of people. That is why land in downtown areas is always worth more than land in outlying country areas.

Once the presence of greater numbers of people have created demand for increasingly valuable uses of a land parcel, other factors work to increase or decrease what land should cost. They include the presence of infrastructure that can support more profitable uses and lawful restrictions on its use.

Infrastructure needed to support high-value uses like retail stores, hotels and business offices include good roads, effective drainage and sewage disposal systems, and the supply of adequate electricity, water and gas (or heat). Value can also be enhanced by some prudent restrictions on land use, like those that assure pleasant appearance (architectural controls), safe operation (construction permits) and an orderly flow of traffic and people (planning restrictions). At the same time, unnecessary restrictions, like detailed zoning that restricts the realization of market demand, can destroy land value when they unnecessarily limit its use.

Based on the infrastructure that exists to serve a parcel of land and the restrictions that apply to its use, the second part of achieving maximum value comes from the marketing process used to sell it. We have observed already the sale by the state of large numbers of other assets (privatization of enterprises) and most observers consider that it was not particularly effective in achieving maximum value. To justify the sale of the land assets of Russia for the benefit of its people, represented by their elected government, the privatization process must be carried out in the way that achieves optimum realizable value for each parcel.

Experience in competitive market economies shows that the highest prices are achieved when the sale process is competitive, open and includes the greatest number of potential purchasers. To achieve this for land parcels in cities across Russia, the process must include the following steps:

1. Create the conditions necessary to maximize each parcel's usefulness in the market (i.e. enhance available infrastructure -- or at least the plan for it -- and reduce restrictions on development and use of the parcels).

2. Provide complete information about the conditions of the parcel and its permitted uses for distribution to potential buyers.

3. Widely advertise the availability of the land parcels for sale -- and make the information about the parcels easily available to the greatest possible number of potential buyers.

4. Allow sufficient time for buyers to analyze and understand for themselves the most profitable use of the land for them. This is the step that invokes the power of the free market to capture maximum value.

5. For the conduct of the sale, set an open and transparent process for competition between buyers. This can be an open or sealed bidding process or a direct negotiation. In any case, it should be supervised and managed by an independent and objective professional service firm to ensure its transparency and maximum use of global experience.

6. Ensure that after the sale, the buyers have maximum control and freedom over the uses and disposition of their land parcels.

For any sale process of an asset, a fundamental question is what the initial asking price should be. This is no less true for land parcels, as any seller wants to ensure that he asks a price at or above the maximum achievable, but not too far above -- so as not to destroy the credibility of his desire to sell and drive away capable buyers.

As we have observed in previous privatization of assets, the level of asking price cannot be left to the seller itself, as the state lacks the necessary familiarity with the factors that drive value and its measurement within free and competitive markets. In markets where there are no existing sales from market activity -- like most of Russia -- appraisers measure land value by its relationship to the total value of the most profitable project that may be built on the parcel.

There are several techniques for doing this, including:

- Allocation -- using markets similar to the subject to compare the percentage of known land values to known total project values that are similar to the subject; and

- Residual analysis by subtracting the estimated economic benefits of three of the four basic factors of production (labor, capital and management) from the total estimated value of the optimum project, resulting in estimation of the residual benefits attributable to the fourth factor of production, the land.

In the end, the price of land should be the highest price supported by the optimal use of the parcel as determined by an open and competitive, well-organized marketing process. Hopefully, for this process of privatization, real estate professionals will be able to help Russia get it right this time.

Gerald Gaige is the partner at Arthur Andersen responsible for the Real Estate Consulting practice and for the Valuation Services Group in Russia and the other CIS countries.