If you've bought land with the intention of developing it and you now think the value of that land has either gone up or down, there comes the question of what number you should plug into your development pro forma. Do you input what you paid for the land or do you input the current market value of the land? The former is probably more common than the latter, but in my view it's important to consider both scenarios.
If the value of the land has gone up, it means that you think you could turn around and sell it for that price today. And that would mean you would be making a profit without doing anymore work and without taking on any additional risk. That's an option that exists right here and right now (t = 0). What you want to get at in your pro forma, or at least understand, is the incremental profit margin from taking on the risk and brain damage of actually doing and completing the development project.
To do that, you need to consider the current market value of the land. That way you isolate your land margin from your build-out margin. The one problem with this approach is that the numbers may then tell you not to develop. In a hot market (which is not right now), it is not uncommon for land to get bid up beyond current fundamentals. There's always someone else who is willing to be more aggressive.
In this case, you may find that most of the development margin is in the land. And you will start thinking to yourself, "How can anyone afford to pay this much? It doesn't make sense." This doesn't necessarily mean that you shouldn't develop. But at least it gives you a better understanding of the risk and reward trade-off that you're about to take on. It might also tell you some things about the market.
If you've bought land with the intention of developing it and you now think the value of that land has either gone up or down, there comes the question of what number you should plug into your development pro forma. Do you input what you paid for the land or do you input the current market value of the land? The former is probably more common than the latter, but in my view it's important to consider both scenarios.
If the value of the land has gone up, it means that you think you could turn around and sell it for that price today. And that would mean you would be making a profit without doing anymore work and without taking on any additional risk. That's an option that exists right here and right now (t = 0). What you want to get at in your pro forma, or at least understand, is the incremental profit margin from taking on the risk and brain damage of actually doing and completing the development project.
To do that, you need to consider the current market value of the land. That way you isolate your land margin from your build-out margin. The one problem with this approach is that the numbers may then tell you not to develop. In a hot market (which is not right now), it is not uncommon for land to get bid up beyond current fundamentals. There's always someone else who is willing to be more aggressive.
In this case, you may find that most of the development margin is in the land. And you will start thinking to yourself, "How can anyone afford to pay this much? It doesn't make sense." This doesn't necessarily mean that you shouldn't develop. But at least it gives you a better understanding of the risk and reward trade-off that you're about to take on. It might also tell you some things about the market.
There's a narrative out there that all developers are uncreative and greedy, and if only they would start being more creative and generous, we could solve the housing affordability problem that is plaguing many (if not all) global cities. In other words, the solution to increasing the supply of low and middle incoming housing is simply a psychological reframing on the part of developers.
The problem with this mental model is that it ignores reality. Development happens on the margin. The market is competitive. It's difficult to find developable sites. And it's a challenge to make projects work. More often than not, you have to say no as a developer. No I can't buy this land. No I can't build housing here. And no the market will not support new office space here. Sorry, but no. (See cost-plus pricing.)
Development needs to give back. On the blog we usually call this city building. And that's because it implies a greater sense of civic responsibility. Developers aren't just building one-off buildings, they're building a city. I believe wholeheartedly in this. But the belief that projects can be saddled with an endless array of government fees and civic contributions is a problematic one. There are limits -- because markets have limits.
There's a narrative out there that all developers are uncreative and greedy, and if only they would start being more creative and generous, we could solve the housing affordability problem that is plaguing many (if not all) global cities. In other words, the solution to increasing the supply of low and middle incoming housing is simply a psychological reframing on the part of developers.
The problem with this mental model is that it ignores reality. Development happens on the margin. The market is competitive. It's difficult to find developable sites. And it's a challenge to make projects work. More often than not, you have to say no as a developer. No I can't buy this land. No I can't build housing here. And no the market will not support new office space here. Sorry, but no. (See cost-plus pricing.)
Development needs to give back. On the blog we usually call this city building. And that's because it implies a greater sense of civic responsibility. Developers aren't just building one-off buildings, they're building a city. I believe wholeheartedly in this. But the belief that projects can be saddled with an endless array of government fees and civic contributions is a problematic one. There are limits -- because markets have limits.
Many, or perhaps most, developers I know have a minimum project size that they will work on. That's why you'll hear people say, "No, that project is too small. I need at least X square feet or Y number of units." Given that smaller scale development such as laneway housing and "the missing middle" are so in vogue today, I thought I would discuss some of the reasons why scale matters.
But first, it's worth mentioning that "laneway suites," as we have structured them here in Toronto, are intended to be built by individual homeowners and not by developers. The lots can't be severed and most lots will yield less than 1,000 square feet. So this is a bit of a unique circumstance. As most of you know, I am a big supporter of this initiative.
When you get into larger developer-led projects, it's a different ball game. For one, it's hard to even find sites. And good luck if you need to deal with multiple owners as part of an assembly. Most landowners have pricing expectations that do not even remotely align with "missing middle" level densities.
But assuming you've been able to find land at a reasonable price, you still have to contend with the fact that projects have a lot of fixed costs, as well as diseconomies of scale. In other words, there are schedule, cost, and resourcing considerations that won't change no matter how big or small you go. It's still going to take this long and cost this much, and you're still going to need a set of humans to manage it through.
This can then create a situation where there's not enough margin for error. The project is simply too small to absorb any shocks, such as an unforeseen delay or an unforeseen groundwater concern that is now adding millions to your project budget. There's a lot of risk with development and it's prudent to have contingency room. That's harder to do with smaller projects.
The other problem developers run into with smaller projects is that the construction subtrades also tend to think of them as smaller projects. They have their own set of fixed costs and margins to worry about. So unless you happen to catch them with an opening in their schedule, you run the risk of them telling you they're too busy or them giving you a stinky price, which is just another way of them saying they don't want the job.
On top of all this, there's minimum project size inflation. If capital is not a constraint, there's a tendency to want to do bigger projects (see above). And because the cost of everything keeps going up, it's simultaneously getting harder and harder to make smaller projects pencil; unless you, maybe, go ultra luxury and ultra exclusive. But that's kind of the opposite goal of this whole "missing middle" movement, is it not?
Many, or perhaps most, developers I know have a minimum project size that they will work on. That's why you'll hear people say, "No, that project is too small. I need at least X square feet or Y number of units." Given that smaller scale development such as laneway housing and "the missing middle" are so in vogue today, I thought I would discuss some of the reasons why scale matters.
But first, it's worth mentioning that "laneway suites," as we have structured them here in Toronto, are intended to be built by individual homeowners and not by developers. The lots can't be severed and most lots will yield less than 1,000 square feet. So this is a bit of a unique circumstance. As most of you know, I am a big supporter of this initiative.
When you get into larger developer-led projects, it's a different ball game. For one, it's hard to even find sites. And good luck if you need to deal with multiple owners as part of an assembly. Most landowners have pricing expectations that do not even remotely align with "missing middle" level densities.
But assuming you've been able to find land at a reasonable price, you still have to contend with the fact that projects have a lot of fixed costs, as well as diseconomies of scale. In other words, there are schedule, cost, and resourcing considerations that won't change no matter how big or small you go. It's still going to take this long and cost this much, and you're still going to need a set of humans to manage it through.
This can then create a situation where there's not enough margin for error. The project is simply too small to absorb any shocks, such as an unforeseen delay or an unforeseen groundwater concern that is now adding millions to your project budget. There's a lot of risk with development and it's prudent to have contingency room. That's harder to do with smaller projects.
The other problem developers run into with smaller projects is that the construction subtrades also tend to think of them as smaller projects. They have their own set of fixed costs and margins to worry about. So unless you happen to catch them with an opening in their schedule, you run the risk of them telling you they're too busy or them giving you a stinky price, which is just another way of them saying they don't want the job.
On top of all this, there's minimum project size inflation. If capital is not a constraint, there's a tendency to want to do bigger projects (see above). And because the cost of everything keeps going up, it's simultaneously getting harder and harder to make smaller projects pencil; unless you, maybe, go ultra luxury and ultra exclusive. But that's kind of the opposite goal of this whole "missing middle" movement, is it not?
