Potential solutions to address the issue of increased lot development costs
By GREG VOGEL
New home markets across the U.S. have recovered substantially in price and volume. Historically raw land prices have moved in tandem with an improving housing market over the past two years, and raw land prices have remained stable while finished lot prices have increased dramatically. In past real estate cycles, there was a discernible correlation between the increase in finished lot pricing with that of the underlying platted lot value increase. Currently the increase in lot finishing costs has eroded land value and its potential near-term appreciation.
At a ULI Forum, I was asked to state the one thing that keeps us up at night. My answer was, “Two hundred and fifty bucks.” I clarified my answer with the “$250 per-front-foot increase in the typical lot development cost.” I now refer to most of the trouble related to completing “as agreed” builder land transactions as the “$250 Problem.”
While $250 may appear to be a relatively small amount, on the typical 60-foot-wide lot, there has been a $15,000 increase in the cost to complete that lot. A finished lot relative to a $280,000 house would sell for approximately $65,000 ($280,000 x 23 percent). That same lot now costs $80,000, resulting under the standard formula of a $345,000 priced home.
If a builder or developer optioned land to zone, plat, and finish, it is a two to three-year journey to complete the lots. The initial purchase was approved by a land committee or capital partner based on an estimate of the cost to improve. Many development budgets are broken due to outdated cost assumptions and builders’ inability to cover the increase. While this example requires a $65,000 home price increase to maintain a desired lot to home/finished lot ratio, reality is that $65,000 could come from multiple sources including: land owner concessions; homebuilder margin compression; buyers paying more for less a reduction in cost of capital; and/or, use of special taxing districts.
The increase in the lot-to-home price ratio is due to the inelasticity of land sellers, cost increases, and inadequate proforma contingencies stressing the standard financial return formulas. Sub-market forces of builders with varied lot basis resulting from varying acquisition dates create larger deviations among competing project/products. Lower cost subdivisions have to be sold off in mass to allow for a new stair step of pricing. Jurisdictions continue to increase development standards, permits, and fees, generating additional development costs for the industry. Some strategies to address the $250 issue include:
- Design and build narrower lots and add more depth to allow a variety of product size and address jurisdictional design/density concerns with varied set-backs.
- Go further out to buy land more affordably and get ahead of the herd. Align with land bankers willing to warehouse larger unentitled parcels with relative certainty of zoning and platting.
- Buy larger lot counts to gain scale and development efficiency, or option land for future phases to your strategy.
- Add a home builder/capital partner to increase the purchase scale.
- Build behind a gate – privatized streets typically require less infrastructure. Be aware that many jurisdictions oppose gates and sub associations can increase HOA fees.
- Utilize special district bond financing for infrastructure – offset a portion of the increased infrastructure costs with a long term (25 – 30-year term) low cost of capital ultimately being assumed by the homebuyer.
- Persuade the jurisdiction to have less infrastructure, such as a sidewalk on only one side of the street and soft surface trail on the other, reducing cost and enhances the overall community look and value.
- Negotiate for guaranteed finishing costs from the lot provider and/or contractor to gain certainty in pricing.
Builders’ customary proformas utilized a 10-percent contingency on lot development costs with a preliminary plat and a five-percent contingency with final engineered, fully bid plans. Builders are utilizing a varied range of contingencies. We are finding this varied spread of contingency usage disrupting some builders from successfully contracting for new development projects.
Cost increases mean more projects failing the feasibility process. We are being required to sell the same land/lots multiple times in order to close the sale. The failing feasibility rate is resulting in a lack of production exacerbating the chronic shortage of lots in many local and national markets. Developers and their capital providers are finding less room for profit. The result has been increasing lot prices, stable to slight decline in land value and home prices rising out of reach for many first-time homebuyers.
There is some evidence that horizontal development costs are beginning to moderate, employment rates are at their lowest in 50 years, and builders have shown a willingness to absorb these increases and pass most, if not all, the increased costs to the consumer. Solving the “$250 problem” will take a myriad of approaches with all participants in the development process adjusting their expectations and sharing in the increased cost burden.
Greg Vogel is the Founder & CEO of Land Advisors Organization. He may be reached at landadvisors.com.