At the end of last year, I wrote this post arguing that development value has shifted from land to the build. And in it, I argued that it's no longer viable to be a high-density land developer in Toronto. The practice of buying land, rezoning it for a higher-and-better use, and then selling it for a margin, is over — at least for the time being.

It's also not easy to find value in the execution of new builds, but it's a better place to be looking. Because today, as we underwrite new development sites, we are seeing land prices (on a per buildable square foot) that are similar to what they were back in 2017 when we were assembling the land for Junction House. Meaning that, in some cases, land prices have been nearly flat over this 8 year period. This is despite a total inflation rate of approximately 25% and an average annual decline in the value of money of 2.86%.

This is not all that surprising, though. Land should, in theory, be the residual claimant in a development pro forma; so it should be one of the first things to reset during a market downturn. However, in the past, I have referred to land prices as being sticky in the face of changing cost structures, such as development charge increases and/or new inclusionary zoning policies. So which is it, Brandon?

Well, one way I think about this is that land prices tend to be sticky in the short term. Nobody wants to immediately take a loss. And as long as prices/rents continue to exhibit strong growth, there's a chance that these new costs will get absorbed into somebody's pro forma and that land prices won't need to adjust downward. But turn off demand and reverse price/rent growth, and now there's no other option but for land prices to come down.

This is what we've been seeing in Toronto since 2022.

Cover photo by Adam Vradenburg on Unsplash

Generally speaking, the value of a piece of land depends on what you can do with it. If the highest-and-best use is agriculture, then it might be worth $X. But if the highest-and-best use is a supertall skyscraper, then it's going to be worth a lot more than $X.

This is why the land component is typically thought of as the residual claimant in a development pro forma. Start with what you can build, forecast your revenues and expenses, and then see what is left over and can be attributed to the land. This is, at least in theory, how the mechanics should work.

An interesting thought exercise, though, is to consider how different developers might value the exact same piece of land.

One obvious scenario is that a developer could just get their forecasts wrong. For instance, maybe they understate their costs, which then leads them to believe that they can pay more for the land. In this case, an error makes them the highest bidder.

In a rising market, there will also be developers who believe that they can almost certainly collect higher revenues in the future. In this case, the most bullish developer often becomes the highest bidder for land. And as long as the market continues to rise, they might not be wrong.

But things change in a slower or flat market.

Now the market isn't there to save you if you happen to overpay for land. It's a less forgiving environment. But it's also a market where you really benefit from conservative underwriting and solid execution. Now it's these groups who are the high bidders.

And I know that some/many developers prefer it this way.

Jeremiah Shamess of Colliers made the claim this week that land values in some areas of the Toronto region are down 25%. He then shared a chart from Alan Leela showing how various factors have increased or decreased land values since 2020.

Broadly speaking, a revenue increase and/or more development density should increase land values; whereas something like inclusionary zoning, which is a cost to the project, should decrease land values. Indeed, this is one of the arguments in favor of inclusionary zoning: "Don't worry about the additional cost to the project because landowners will simply pay for it through reduced land prices."

In theory, all of this is correct.

Land is (or should be) the residual claimant in a development pro forma. Start with your revenue, subtract your costs, and then see what is left over for the land. (Though keep in mind that what is left over for the land could be $0 or even a negative number.)

But as I have argued before in the context of inclusionary zoning, I don't think things always play out so neatly in the market. Put differently, if the cost impact of inclusionary zoning is something like $44 psf, I don't think all landowners suddenly drop their prices accordingly -- especially in a rising market where developers are competing fiercely for land.

They don't care about your residual value model. Many or most will just hang on to their number and wait for someone to pay it.

So what I am saying with all of this is that, yeah, there are factors that put either downward or upward pressure on land values. But how it all actually plays out in the market tends to depend on the macro environment and what else is going on at the time. And right now we are at a point in the cycle where there is clearly downward pressure on land values.

At the end of last year, I wrote this post arguing that development value has shifted from land to the build. And in it, I argued that it's no longer viable to be a high-density land developer in Toronto. The practice of buying land, rezoning it for a higher-and-better use, and then selling it for a margin, is over — at least for the time being.

It's also not easy to find value in the execution of new builds, but it's a better place to be looking. Because today, as we underwrite new development sites, we are seeing land prices (on a per buildable square foot) that are similar to what they were back in 2017 when we were assembling the land for Junction House. Meaning that, in some cases, land prices have been nearly flat over this 8 year period. This is despite a total inflation rate of approximately 25% and an average annual decline in the value of money of 2.86%.

This is not all that surprising, though. Land should, in theory, be the residual claimant in a development pro forma; so it should be one of the first things to reset during a market downturn. However, in the past, I have referred to land prices as being sticky in the face of changing cost structures, such as development charge increases and/or new inclusionary zoning policies. So which is it, Brandon?

Well, one way I think about this is that land prices tend to be sticky in the short term. Nobody wants to immediately take a loss. And as long as prices/rents continue to exhibit strong growth, there's a chance that these new costs will get absorbed into somebody's pro forma and that land prices won't need to adjust downward. But turn off demand and reverse price/rent growth, and now there's no other option but for land prices to come down.

This is what we've been seeing in Toronto since 2022.

Cover photo by Adam Vradenburg on Unsplash

Generally speaking, the value of a piece of land depends on what you can do with it. If the highest-and-best use is agriculture, then it might be worth $X. But if the highest-and-best use is a supertall skyscraper, then it's going to be worth a lot more than $X.

This is why the land component is typically thought of as the residual claimant in a development pro forma. Start with what you can build, forecast your revenues and expenses, and then see what is left over and can be attributed to the land. This is, at least in theory, how the mechanics should work.

An interesting thought exercise, though, is to consider how different developers might value the exact same piece of land.

One obvious scenario is that a developer could just get their forecasts wrong. For instance, maybe they understate their costs, which then leads them to believe that they can pay more for the land. In this case, an error makes them the highest bidder.

In a rising market, there will also be developers who believe that they can almost certainly collect higher revenues in the future. In this case, the most bullish developer often becomes the highest bidder for land. And as long as the market continues to rise, they might not be wrong.

But things change in a slower or flat market.

Now the market isn't there to save you if you happen to overpay for land. It's a less forgiving environment. But it's also a market where you really benefit from conservative underwriting and solid execution. Now it's these groups who are the high bidders.

And I know that some/many developers prefer it this way.

Jeremiah Shamess of Colliers made the claim this week that land values in some areas of the Toronto region are down 25%. He then shared a chart from Alan Leela showing how various factors have increased or decreased land values since 2020.

Broadly speaking, a revenue increase and/or more development density should increase land values; whereas something like inclusionary zoning, which is a cost to the project, should decrease land values. Indeed, this is one of the arguments in favor of inclusionary zoning: "Don't worry about the additional cost to the project because landowners will simply pay for it through reduced land prices."

In theory, all of this is correct.

Land is (or should be) the residual claimant in a development pro forma. Start with your revenue, subtract your costs, and then see what is left over for the land. (Though keep in mind that what is left over for the land could be $0 or even a negative number.)

But as I have argued before in the context of inclusionary zoning, I don't think things always play out so neatly in the market. Put differently, if the cost impact of inclusionary zoning is something like $44 psf, I don't think all landowners suddenly drop their prices accordingly -- especially in a rising market where developers are competing fiercely for land.

They don't care about your residual value model. Many or most will just hang on to their number and wait for someone to pay it.

So what I am saying with all of this is that, yeah, there are factors that put either downward or upward pressure on land values. But how it all actually plays out in the market tends to depend on the macro environment and what else is going on at the time. And right now we are at a point in the cycle where there is clearly downward pressure on land values.