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 pro forma

  • 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

  • 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.

  • A decade of changing development pro formas

    Ten years ago when I was working on development pro formas (here in Toronto), we used to assume that we would launch condominium pre-sales, and then start working drawings once we hit somewhere around 50% sold. And for our hard costs, we would carry a modest inflation rate of say 2-3% per year.

    The thinking at the time was that construction documents are expensive, let’s not spend the money until we know that we have a good amount of sales under our belt. In Toronto, you can also use purchaser deposits toward project costs, so this is an equity efficient way of managing your cash flow.

    But then this go-to-market strategy started becoming too risky, probably around 2017-2018. Sales were happening faster and costs started increasing a lot faster, and so now everyone wanted to minimize the lag between their pre-sales (your revenue) and when they procured construction (your costs).

    So as an ideal and totally risk-averse approach, the objective was to be ready to start construction and to know what your hard costs would be before you even started selling condominiums. It didn’t matter that you were going to spend a bunch of money on technical drawings, because it was still going to be many multiples less than your cost escalation exposure if you didn’t do it. There was also a high degree of confidence that you would get the pre-sales once you did launch.

    This is how things mostly worked during the pandemic. But strategies once again changed in the second half of 2022. Pre-sales slowed and people started wondering, “wait a minute, could hard costs actually come down?” The answer turned out to be yes and, this year, most people in the industry expect them to come down even further.

    This is a good example of how quickly and dramatically things can change in development. In 2021, it was “we need lock in construction costs immediately or we might get hit with a 40% increase on glass.” Now it is, “let’s wait as long as possible because we’re in a deflationary cost environment and I’m sure it’ll be cheaper later.”

    To some extent, you can look to leading indicators like architecture billings and home pre-sales to determine what the future might look like. But it’s far from perfect. I don’t know anyone that accurately predicted what we just went through over the last number of years.

    So as a developer, you just have to do your best to stay ahead of what’s coming and manage your downside risk as best you can. In all cases, you’re going to need to be creative and nimble. Because clearly a lot can change in the span of even a single development project.

    Photo by Ben Allan on Unsplash

  • What’s land worth?

    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.

  • Are we really back to talking about “use-it-or-lose-it” zoning?

    It is very disappointing to hear that Paul Calandra — Ontario’s new Minister of Municipal Affairs and Housing — is talking about “use-it-or-lose-it” zoning policies and that mayors are coming out in support of it. This is a terrible idea.

    On the surface, it may seem like this would force/incentivize developers to build more housing sooner. But what it fails to recognize is this: just because a developer wants to build, it doesn’t mean that they are able to build.

    This current market environment is a perfect example. It is likely that the Greater Toronto Area will see dozens of new condominium launches this fall. These are developers who will be spending millions of at-risk dollars to bring their projects to the market in the hopes of pre-selling homes and then obtaining construction financing.

    However, it is highly probable that not all of these projects will actually start construction in the short-term. And if/when that happens, it will not be because these developers are just squatting on entitled land; it will be because they can’t get financing. In other words, the market isn’t there.

    This will not be a good day for anybody. So I fail to see how it makes sense to penalize developers who happen to find themselves in this unfortunate situation. It’s as if our only solution to the current housing crisis is to make it more expensive to build new housing.

    For another post that I wrote on this topic, click here.

  • 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.

  • Real estate developers are stupid

    Big Ben Myers of Bullpen Consulting doesn’t usually have strong opinions on Twitter (obviously joking), but I did see him respond to this tweet this morning:

    The assertion he is responding to is basically this: “developers are stupid because they tend to hold onto land during downturns, instead of building through them.” On some level, I think I know where this line of thinking is coming from. It’s the whole Warren Buffet philosophy of “being fearful when others are greedy, and greedy when others are fearful.”

    But what it ignores is development feasibility. Developers typically rely heavily on the availability of debt financing. First you need land financing in order to acquire the land, and then, once you have your entitlements, condominium pre-sales and/or any other requirements in place, you move onto a construction loan (which often “takes out” your land loan).

    Maybe you have deep enough pockets to fund everything with cash, but most of the time that is not the case. And so if these debt facilities are not available to you, then you are not building.

    The other part of this equation is that, during downturns, it can be harder to forecast your future revenues. What can I sell/rent this space for, and how long will it take to absorb? These are difficult questions in the best of times, but they’re even more difficult when you don’t have a lot of market activity/comparables to point to.

    All of this contributes to debt being less available, especially for smaller developers. It also makes new sites difficult to underwrite. Because as we have talked about many times before on this blog, land should be the residual claimant in a development pro forma. Revenue minus development costs equals how much you can afford to pay for land.

    If the math doesn’t work and if you can’t get financing, it almost certainly doesn’t matter how much “leading” you feel like doing. You’re not building.

  • Multiple on land cost

    Following yesterday’s post about the most expensive home in Brooklyn’s Dumbo, Jed Bryne of Oak City CRE fame shot me a note asking about the typical land multiple that developers need in Canada in order to make a project feasible. In other words, if your land cost is $X, what multiple on this would your top line number need to be in order to have a project? And he mentioned that in North Carolina, he often sees multiples in the range of 3-5x the land acquisition cost.

    My initial response was that we don’t typically look at this metric. Many years ago, the rough rule of thumb for new condominiums here in Toronto used to be 10x the land price per buildable square foot. So if you were buying development land at $100 per buildable square foot (calculated as land price divided by the total gross floor area of the project), then you likely needed to sell your condominiums for somewhere around $1,000 per square foot.

    On some level this can be a useful metric, because it allows you to quickly tell if a parcel of land is too expensive. And in some situations, it might allow you to compare sites/markets. If you have two different markets and land at the same $X price pbsf, but one requires a 10x multiple to be feasible and the other a 5x multiple, then it tells you something about the cost structures of these two markets. Construction costs probably won’t vary all that much (assuming similar builds), but project timelines, development charges, and many other things sure can.

    But again, this isn’t a number that we typically care a great deal about.

    There are a lot of variables in a pro forma and the “required” multiple can change overnight. Maybe it’s 10x today, but then development charges go up by 49% and now you need an even higher multiple in order to make the project feasible. So for us, the salient land number is the price per buildable square foot. What is the price per pound of development density? And the way you determine if you have a reasonable number is by doing a residual land value calculation.

  • How to cheapen a new building

    Anyone who has ever worked on a development pro forma will know that the process generally works like this: You start with a bunch of assumptions. You assemble those assumptions in a way that will allow you to determine if the project in question is feasible. And then, you realize that almost everything is more costly than you initially thought and that the project may not actually work. Oh shit.

    In fact, a sure-fire way to know that you’re on the right track is if the numbers sort of don’t work. If the returns look too good to be true, they almost certainly are and you’re likely missing something big and meaningful. As we have talked about before on this blog, development happens on the margin. That means that you have to work at it. You have to be creative. And often you have to find ways to increase revenues and cut costs.

    The common way to find money is through something known as value engineering, which is just a fancy way of saying, “I need to cut costs, so let’s see what I can tolerate losing from this project.” That’s generally how it works. And we do it on every project. You’re trying to find high-cost items with relatively low perceived value.

    This process often gets a lot of criticism because people view it as a distasteful cheapening of a project. But the reality is that it is usually an important part of maintaining project feasibility. You may really want to use that fancy material you can only get from Switzerland, but maybe development charges were just increased and now you need to offset those new costs by finding savings somewhere else.

    This isn’t a perfect analogy, but imagine you were shopping for a new car. You might start out by wanting the fully-loaded version, but then you see the price and realize you can’t afford it. So you decide to start trimming features and add-ons until you get to a place where you feel more comfortable. I would imagine this happens with cars, and I’m not sure it’s right to point to that person after and say, “oh my god, I can’t believe you cheaped out and didn’t buy the fully-loaded version.”

    At the same time, I think it would be perfectly reasonable to argue that you don’t need to spend a lot of money to (1) care deeply about the work that you do and (2) have taste. You can’t fight the economic realities of the world, but you can care and you can be creative. And I don’t think it’s too much to advocate for these things.

  • How 20% affordable can impact development pro formas

    This Twitter thread by Richard Wittstock of Domus Homes (developer out in Vancouver) is a timely follow-on to yesterday’s post about housing supply, land-use regulations, and specific policies such as inclusionary zoning. What Richard clearly describes in his thread is the economic impact of a Community Amenity Contribution (CAC) that requires developers to provide 20% social housing.

    The thread will walk you through all of the specific numbers, but I think there are three important takeaways:

    1. Everything has a cost. It is entirely disingenuous for anyone to refer to inclusionary zoning or other similar policies as a mechanism for “no-cost” affordable housing. Even if you believe it is the right public policy approach, there is still a cost. Social housing doesn’t just appear out of thin air.
    2. In Richard’s thread, the remaining market rate condominiums end up needing to be sold for $1,750 psf in order for the entire project to pencil. This is a significant number. But in this case, it is a result of these homes needing to shoulder the cost of the social housing. It is basically saying “housing is too expensive, so let’s make it more expensive so that we can use some of the incremental proceeds to finance less expensive housing.”
    3. If the math doesn’t work, developers will not build new housing.

    P.S. Thank you Volodya Gusak for pointing out Richard’s thread to me.