By Greg Vogel
It is hard to believe mortgage interest rates are nearing 8% and the demand for land and lots is strong and getting stronger each month. With this increased demand, there continues to be a systemic scarcity of existing housing, finished lots, and shovel-ready land to build upon.
While the shortages continue, the financial markets are forcing a sea change in the way that land and land development is being financed and structured.
- Banks continue to tighten or plain stop lending – mainly affecting land developers and private builders.
- Private money lending demand is exploding, but few lenders are scaled to handle the demand.
- Lot banking is becoming a preference for both private and public builders.
- High interest rates and cap rates have decimated the build-to-rent and multifamily financial feasibility.
Given the demand and underwriting economics, new land transactions are passing through feasibility at a very high ratio. As underwriting new projects occurs, builders study the competitive projects in the submarket and make rational comparisons for their new proposed projects. If they have an active project in that submarket, there is real-time data to project more clearly. But even with clarity, there is a long gap in time between the current market findings and the state of the market in 24 months when the project opens – let alone the 24-48 months to sell through.
Underwriting from raw land acquisition through the full buildout of a project has dozens of tasks, barriers and, variances to navigate, and potential windfalls to capture.
The questions builders should always be asking:
- What is everything that could go wrong?
- How can we minimize or eliminate those items under our control?
- What must happen to perform to the expected financial returns, and is that realistic?
- What things can we do to enhance and outperform our projections?
One of the variables under the builders’ control is financial structuring. Basic financial metrics that pass underwriting standards for a new project require an 18-20 percent gross margin and an unlevered 18-20 percent IRR. These two metrics of IRR and Gross Margin are not always aligned. For example, gross margin can suffer by taking on a higher interest cost in lot banking but will increase IRR due to positive leverage as the rate charged for lot banking is less than the hurdle rate of return projected.
As stated above, the average conventional 100-140 lot subdivision might take 4 to 5 years to take a project from raw land to the last home closing. This time could be cut in half if the “project” started with fully finished lots ready for a building permit. If finished lots can be found, a premium will be paid, gross margin suffers, but risk is reduced, which would rationalize accepting a lower IRR.
On the other end of the spectrum, buying less than fully entitled or unentitled land on a quick close for cash is taking a high risk with the potential windfall for a high IRR and very high gross margins. Public builders would rarely consider this, leaving a lane for local private builders and developers to take these risks and be rewarded with outsized returns.
Overpaying for ready-to-go finished lots and cost busts on land development are the biggest enemies of gross margin. Delays in land development, slower than projected home sales, and slow cycle times are the main enemy of IRR.
Getting from raw land to finished lots on time and at budget is where the highest risk lies in both cost and time. The elimination or reduction of the risk of cost and time is where land developers have played a role over the decades. Depending on the market, the population of land developers has become an endangered species. Many were wiped out and or aged out in 2007.
Many did not recover or return after the GFC. Why? It is a risky business that was and should be very rewarding. Due to basic math and competition with homebuilders, developers have been squeezed out of acceptable returns – “there is no room” for a developer. Leaving this risk to now be embedded in the overall project returns builders require.
So what has happened to keep the wheels of progress rolling to serve the homebuilder’s needs to reduce risk and enhance returns? The 4 items below are a few strategies we are engaged in on a increasing frequency.
- Paper Developers – One step removed from playing the actual horizontal land developer is to tie up, entitle and exit. This reduces the risk to the builder (in time and better ability to quantify development cost). It also reduces the “carry” for both the builder and the paper developer. This results in splitting the risk of land entitlement and land development.
- Lot Bankers – This strategy is being utilized in mammoth proportions as it reduces homebuilder equity and mitigates overall risk – Public builders who were averse and privates alike are running like a herd toward lot banking, which has now been fully institutionalized for public and large private builders. There are also local and regional players banking small to medium sized builders. A current favored strategy is taking existing finished lots in active projects off the hands of private builders to gain liquidity and pay down debt.
- Joint Ventures – Financial partners that will provide 80-90 percent of the equity with the potential to enhance bank financing availability and at better terms. This is primarily a private builder strategy.
- Private Money Lending – As banks have tightened or halted lending – private money is more expensive but will lend higher up the stack with less or no recourse.
In many cases, there will be an ideal combination of several or all of these for the private builders to survive and for public builders to improve their scorecards and reduce risk.
In the end, risk has its price. Slicing and dicing the elements of risk is providing new and unique, lasting strategies and opportunities for those who utilize or provide them.
Greg Vogel is founder and CEO of Land Advisors Organization, the nation’s largest brokerage focused specifically on land. He can be reached at GVogel@LandAdvisors.com.