Brandon Donnelly

Daily insights for city builders, delivered every morning at 6 AM ET. I’m Brandon Donnelly — a Toronto-based real estate developer and founder of Globizen. I’ve been writing here since 2013.

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Tag: development land

  • How much is development land worth?

    As we have talked about many times before, the best answer to this question is that it’s worth whatever money is left in your pro forma once you’ve accounted for everything else. This is what is called the “residual claimant” in a development model. And it means you start with your revenue, you deduct all project costs, including whatever profit you and your investors need to make in order to take on the risk of the development, and then whatever is left can go to pay for the land.

    This is the most prudent way to value development land; but of course, in practice, it doesn’t always work this way. In a bull market, the correct answer to my question might be, “whatever most market participants are willing to pay.” And sometimes/oftentimes, this number will be greater than what your model is telling you, meaning you’ll need to be more aggressive on your assumptions if you too want to participate. (Not development advice.)

    Given that determining the value of land starts with revenue, one way to do a very crude gut check is to look at the relationship between land cost and revenue. This is sometimes called a land-to-revenue ratio. And historically, for new condominiums in Toronto, you wanted a ratio that was no greater than 10%. Meaning, if the most you could sell condominiums for was $1,000 psf, then the most you could afford to pay for land was $100 per buildable square foot.

    However, this is, again, a very crude rule of thumb. I would say that it’s only really interesting to look at this after the fact. Because in reality, things never work this cleanly. For one thing, there is always a cost floor. Don’t, for example, think you can buy land in Toronto for $80 pbsf and sell condominiums for $800 psf, because this will not be enough to cover all of your costs. You will lose money.

    Secondly, there are countless variables that have a huge impact on the value of development land. Things like a high required parking ratio, development charges and other city fees, inclusionary zoning, and so on. All of these items are real costs in a development model, and so they will need to be paid for somehow.

    Typically this happens by way of higher revenues (in a rising market), a lower land cost (in a sinking market), or some combination of the two. But in all of these cases, it means your land-to-revenue ratio must come down to maintain project feasibility. This is why suburban development sites typically have a lower ratio — too much loss-leading parking, among other things.

    Of course, there are also instances where the correct answer could be a land-to-revenue ratio approaching zero, or even a negative number. In this latter case, it means your projected revenues aren’t enough to cover all of your other costs, excluding land. For anyone to build, they will require some form of subsidy. And this is basically the case with every affordable housing project. They don’t pencil on their own. (For a concrete example of this, look to the US and their Low-Income Housing Tax Credits.)

    So once again, the moral of this story is that the best way to think about the value of development land is to think of it as “whatever money is left in the pro forma once you’ve accounted for everything else.” Because sometimes there will be money there, and sometimes there won’t be.

    Photo by Jannes Glas on Unsplash

  • Buy quality

    When the market is hot, it becomes more difficult to buy real estate. You end up with more buyers than sellers. And because of this, there’s a natural tendency to look further afield for opportunities. You don’t want to overpay for the obvious assets, and so you start to pioneer.

    This can work out just fine, particularly if the market remains strong. But oftentimes, when the market does turn, it is the peripheral stuff that gets hit the hardest. There is a flight to quality and pioneering gets quickly viewed as too risky.

    Here in Toronto, I am consistently being told that there are peripheral development sites that have seen their value drop to 20-25 cents on the dollar compared to the peak, and that’s if you can actually find a buyer. In many cases, the sites are now unsellable.

    This, to me, is our periodic reminder that while it’s important to search for overlooked opportunities and buy cheap, you can’t forget to also buy quality.

  • Unclear and unknowable

    Development land, as we often talk about on this blog, should be the residual claimant in a pro forma. Meaning, start with your revenue, subtract your costs and required margin, and then see how much money is leftover to pay for the land. This is, in theory, how you should value land.

    It’s also the most disciplined way to go about your underwriting. In fact, it can be beneficial to not know the asking price or broker guidance for a new site until you’ve completed this exercise. That way you won’t bias yourself.

    However, in practice, it can be difficult to do all of this. In a rising market, you might find that there’s always some other developer who is willing to be more aggressive on their assumptions, which means they will be willing to pay more for the same piece of land.

    And so if you want to be in the game, you might find yourself doing the exact opposite: starting with the land price and then trying to figure out how to make the rest of your model work. We’ve all been there.

    During this stage of the cycle, you get punished for being conservative and disciplined — you don’t win sites. But when the market turns, discipline and conservatism get rewarded handsomely. You then become thankful for the deals you didn’t do. And I’m sure that many prudent risk managers are feeling this way right now.

    It is very challenging to underwrite new sites today. Many of the assumptions that go into a pro forma are unclear and unknowable. And so the spread between what developer’s models are telling them to pay and what landowners want to sell for is often significant. That is why everyone is trying to find “creative deal structures” that can be used to close this gap.

    At some point, though, the gap will actually close; things will once again feel clear and knowable. I have absolutely no idea when that will happen, but I do know that when it does, it will then be too late from a maximum opportunity standpoint.

    Because that’s how risk works. Once the uncertainty is gone, it’s no longer a risk. And if it’s no longer a risk, then you’re not going to be paid for bearing it.

  • Land prices can be weird

    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.

  • Mid-rise development land is more expensive

    As is the case every quarter, Bullpen Research & Consulting and Batory Management have just published their latest Greater Toronto Area land insights report (for Q3-2022). The average price per buildable square foot (pbsf) in this report remains the same as in Q2 at $95.

    But once again, it’s important to keep in mind that this represents a fairly small sample size (34 land sales in the quarter versus 46 in Q2); that the range in land pricing can be significant across the GTA (here it is $24-274 pbsf); and that there can sometimes be a lag between a deal being struck and actual closing. Here is the summary data:

    Another interesting data point from the report is land price compared to building height. The average price for high-rise development land was $88 pbsf, and the average price for mid-rise development land (5-15 storeys) was $131 pbsf.

    This once again speaks to the cost differential between high-rise and mid-rise housing. The mid-rise scale is certainly a desirable form of infill, but it is also a more expensive form of housing.

  • Per buildable square foot

    Let’s say that you were comparing and thinking about buying two different pieces of development land. Both are about 25,000 square feet in size, but one is priced at $5 million and the other is priced at $50 million. If you were to calculate how much you were paying per square foot of actual dirt, you might conclude that the $5 million parcel is the cheaper one.

    But as we have discussed many times before on the blog, the value of development land depends on what you can build on top of it. So what matters more is the price per buildable square foot. And to calculate this, you simply divide the purchase price by the allowable gross floor area (GFA) on the site (or, in many cases, the GFA that you believe is likely achievable on the site).

    For example, if you could build 50,000 sf on the $5 million parcel and 500,000 sf on the $50 million parcel, both sites would have a price per buildable square foot of $100. This makes them, in theory, equal, assuming all other things are equal. That said, one could argue that 50,000 sf is maybe too small of a build, and so the $50 million lot is actually a better buy because you can hope to achieve some economies of scale.

    Of course, if you could build even more than 500,000 sf on the one lot, then your price per buildable square foot would come down even further and that would make it the more attractive site (again, assuming all other things are equal).

    There are a lot of other details to consider when evaluating a development site. Maybe the $5 million one actually has a bunch of environmental contamination that will cost you an additional $5 million to clean up ($10 million in total costs). In that case, your price per pound would actually be double the other lot, assuming the other parcel doesn’t have any contamination or other factors that might impair value.

    Permitted uses also greatly affect value, with residential often being the most valuable kind of urban density. And so this is ultimately why you need to create a full and detailed pro forma in order to properly evaluate a new development opportunity. But even before you get to that stage, you can tell a lot with just the price per buildable square foot. If you know the market, you’ll usually know right away if it’s too high or if it’s an opportunity that may be worth exploring.

  • 6-unit missing middle site for sale in Toronto

    Marty over at Laneway Housing Advisors published this listing in his newsletter today. It’s for an entitled lot at 78 Gladstone Avenue in Toronto that has been approved (by way of a minor variance) for 6 units. Five units in the front where a house currently sits and one unit at the back in a standalone laneway suite. Though it also happens to be a corner lot and so the laneway suite isn’t really “in the back”.

    It’s listed for $2.5M. And according to the description, you can build about 5,500 square feet (4,200 sf in the front with a 1,300 sf laneway suite). This ask translates into a land cost that is just over $450 per buildable square foot, which is far more than what high-density land typically trades for in the city right now. This is usually the case for smaller low-rise sites.

    To help put this figure into some kind of context, Bullpen Consulting published in their latest insights report that the average high-density land price in Q4-2021 was $135 per buildable square foot in Toronto (416 area code only). Of course, averages only tell you so much. To truly evaluate the feasibility of a site like this, you’d need to create your own pro forma and do your own residual land value calculation. The value of development land depends on what you can build on it.

    If you were to do that, I suspect that you would discover at least two things: 1) you would find it challenging to make the numbers work, particularly for rental housing, and 2) you would quickly realize that this sort of “missing middle” housing isn’t, in its current form, some undiscovered bastion of housing affordability.

    Part of the problem is that these 6 units are not being delivered on an as-of-right basis. Somebody had to go out and entitle the land in order to secure these permissions. That means that time and money were spent and that the current owner is now rightly seeking a margin for their efforts. But if we collectively believe that this is an appropriate and sensible form of housing, then this should not be a necessary step in the whole process. Especially for only 6 units.

    All of this being said, we know that Toronto and many other cities around the world are taking a hard look at this issue. And that there is a groundswell of interest in allowing more housing in our low-rise communities. It’s going to be a battle — just look at how Toronto’s new garden suite policies have now been appealed by various resident’s groups. But I’m certain that we’ll get there, just like we are getting there with laneway housing and other types of ADUs.

  • Non-consensus thinking

    The venture capital industry likes to talk about the importance of investing in ideas that are and turn out to be both non-consensus and successful. The idea here is that if an idea or opportunity is already consensus, then there’s too much money flooding into that space and it becomes too difficult to make money. This is particularly true in venture capital where a select few companies usually end up generating most of the returns. This is a high risk business. Supposedly, even the best VCs end up having to write off a big portion of their deals.

    But I don’t think that this logic need only apply to venture capital. In real estate development, you are often faced with similar situations. For example, if an area is already consensus — that is, it is already considered to be highly desirable — then capital is going to naturally flow into it and land prices will be relatively high. These high land prices might be justified by the revenue side of your pro forma, or they might not be. I know many developers who avoid “core” locations simply because the land is too much and the margins are too little.

    On the other hand, if an area is non-consensus — that is, you’re not sure people will want to rent or buy new space in the area — then the land prices should reflect this. But here’s the thing. What you’re doing is trading, among other things, a lower land price for greater market risk. Because the non-consensus bet could turn out to be either successful or unsuccessful. People will either want to occupy space here or they won’t. And remember, by definition, it being non-consensus means that most people believe they won’t — or at least not at the prices you might need in order to make the math work.

    What all of this means is that if you’re right about something that most people think is wrong, then you have the opportunity to do quite well. (Though I am not suggesting that you need to follow this framework in all situations.) This is on my mind right now because it feels to me that there are certain consensus opinions emerging as a result of this pandemic. For example, opinions around the demise of office space and the demise of downtown living. If you’re a regular reader of this blog, you’ll know that I think these death-of-the-city predictions are largely bullshit.

    I could be wrong. Or I could be right.

  • Where developers won’t build even with $0 land

    Building on yesterday’s post about inclusionary zoning, below is a telling diagram from the Urban Land Institute showing which areas of Portland can support new development and which areas cannot. To create this map, ULI looked at achievable rents in each US census block to determine, quite simply, where rents will cover the cost of new development (all types of construction).

    However, in their models they are also assuming a land value of $0. And typically people want you to pay them money when you buy their land. So in all likelihood, this map is overstating the amount of blue — that being land where new development is feasible.

    But it does tell you something about developer margins. A lot of people seem to assume that the margins on new developments are so great that things like inclusionary zoning can simply be “absorbed” without impacting overall feasibility. The reality is that there are large swaths in most cities where development is never going to happen even if you were to start handing out free land.

    This map is also helpful at illustrating some of the impacts of IZ. If you assume that rents are the highest in the center of the city and that they fall off as you move outward, then the outer edge of the above blue area is going to be where development is only marginally feasible. And so any new cost imposed on development would naturally start to uniformly eat away at the blue feasible area — that is, until rents rise enough to offset it.

    Of course, this is a simplified mapping. Land usually costs money. Land values might also be highest in the center and fall off as you move outward, or there could be pockets of high-cost land. There may be more price elasticity in certain sub-markets compared to others. So the impacts of a new development cost may not play out as neatly as I outlined above.

    Regardless, there will be impacts, which is why I find this map telling even if it isn’t fully accurate or up to date. Maybe some of you will as well.

  • Acquisition price vs. current market value — which should be your land input?

    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.