Is investment in raw land considered a low risk, moderate or high risk investment?Retirement Plans
This would be land close to a fast growing area in a top growth area in the us. This land is purchased alongside our residential land so is considered extension of residential until sold. At that time, no tax should have to be paid on the sale if it is less than $500000 for a couple. (per current tax law)
Travis' comments are correct. Raw land should be contemplated with great care and only be considered in addition to a core portfolio of liquid assets (various types of stocks, bonds, alternative investments). REITs are a much more liquid way to invest in real estate. Your comment about tax implications should be run past a tax specialist - you have an exemption on your primary residence of 500K (if married) if you've retained property as your primary residence for at least 2 years (out of the past 5 years) before selling. I'm not sure how your raw land would be taxed if you continue to reside in your primary residence and decide to sell this raw land to e.g. a developer --I don't believe you can utilize the same exemption twice.
Raw land is generally considered to be a higher risk investment because it has greater liquidity risk. An investment is considered to be liquid if it can be converted into cash, in a reasonable period of time, at a reasonable price, and at a reasonable cost. Real estate may have been considered reasonably liquid a few years ago, but not so much today. Raw land's lack of liquidity is.exacerbated by the fact that only a small sub-set of real estate investors are comfortable investing in raw land, so the potential market of investors is less robust. But, with higher expected risk, comes higher expectations for returns; you just have to be comfortable with the risks.
Generally, raw land is considered to be a high-risk investment. Ultimately, when you buy an investment - especially one that is illiquid - it is important to consider your ultimate goal for the investment. In this case - how are you going to make money on it?
Typically, land makes money in 1 of 2 ways. Either it appreciates - and you sell it for a profit - or it generates income (such as timberland - or land which is already developed, like a strip mall or office building).
Based upon it being residential raw land and your comments about capital gains exclusion, I'll assume your purpose for considering its purshase would be price appreciation. Price appreciation can occur naturally over time, or can be caused by something you do to the land - such as developing it.
If you intend to increase its value by developing the land - (horizontal development, such as cutting down and selling the trees, putting in water lines, septic or sewer, etc) and then selling it to a developer - you may be in for lots of unexpected costs such as engineer's reports, zoning permits, etc. All of that comes before vertical development - such as building a house on it. I would check these costs, and your tax strategy with a tax professional before assuming that any capital gain on this type of appreciation can be excluded; the tax calculations may be a bit more complex than you are assuming.
If your intent is merely to hold the land and assume that it will appreciate over time, I would first check out the historical appreciation of property in your area BEFORE 1995 or so. The reason that I say this is because about 1995, real estate values entered into the "Real Estate Bubble" that we are all so familiar with. All the "Real Estate Crash" really did was bring these values back to where they WOULD HAVE BEEN - IF that bubble never existed in the first place. This is called "reversion to the mean." It is highly unlikely that we will see price appreciation in residential real estate anywhere near what we saw after 1995 because the market dynamics have changed significantly. A realistic expectation for raw land appreciation would likely be somewhere in the 3-4% range - unless a local market dynamic - such as a new plant opening - were to change that.
So many people are assuming that since prices have fallen - they are likely to rise again back to where they were. Unfortunately, the data does not support that assumption. The price appreciation of real estate from 1995 to 2006 was fueled by unsustainable lending practices and massive fraud on the part of investment banks. We are not likely to see that particular mix again any time soon.
So... in short... I would consider this to be a high risk investment - a risk made much, much higher if you are considering financing it.
Some things to consider about the riskiness of an investment in raw land:
A value investor would tell you that the riskiness of an investment is first and foremost a function of the price paid. If you pay too much for ANY investment--be it a stock, a bond, or a tract of land--you put yourself at risk or long-term or permanent loss.
With leverage comes risk. If you pay cash for the land and pay a reasonable price, then your biggest risk is that of opportunity cost (i.e. the risk that you could have gotten better returns elsewhere). But if you mortgage the property, you put yourself at risk of financial distress if your income were to take a short-term hit and you were unable to service the mortgage. The use of leverage can take a relatively low-risk asset and turn it into a high-risk asset.
It's debatable whether raw land qualifies as an "investment" at all unless you intend to generate revenues from it via farming or ranching rights or intend to build an income-producing property on it. If you are buying land hoping for nothing more than capital appreciation, you have officially become a land speculator. There is nothing inherently wrong with that, but investing and speculating do require different mindsets and a different attitude towards risk.
You are fortunate to live in an area where price appreciation has continued to be robust. Farm land is still an area that continues to see price appreciation and if you are in an area that continues to see employment growth, then you may continue to benefit from prospective real estate development.
While an investment in raw land is generally considered a high risk for the reasons noted above (lack of liquidity, no income, uncertain development), your question brings into focus the value of diversification.
If the investment in land were your only investment, then your portfolio risk would compound the individual asset risks noted. But if you consider the investment in raw land to be akin to an investment in "alternative" assets such as those utilized by pension funds and endowments, then you are bringing the overall risk of your total portfolio down. In this context, then the investment is lowering your overall risk.
Obviously, to what extent this is a high or low or medium risk for you and your portfolio depends on the total allocation into land compared to your entire portfolio.
One thing to consider: REITS do offer a way to at least receive income while awaiting price appreciation. And if you sell off the land and it's not sheltered by the primary residence exclusion you referenced, you may want to consider the tax-deferred advantages of a 1031 Exchange into a REIT.