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: finance

  • 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

  • Money and beauty

    I’ve told versions of this story before, but I was reminded of it again today.

    When I was in grad school studying both architecture and real estate, I used to walk back and forth across campus and jump between two very different kinds of academic experiences. On the one side of campus, it was taboo to talk about money. And on the other end, the only important thing to talk about was money. (I am exaggerating in both cases, but I think only slightly.)

    Given that I was studying and genuinely interested in both, this always felt like a weird false dichotomy. I mean, why not care about, you know, multiple things? But that’s generally not the way it was. Talking about money tainted the purity of design. And talking about things like design and beauty felt out of place and less serious in a room where cap rates were being debated and serious financial models were being honed.

    This is not to say that nobody was thinking across disciplines. I was in a joint program, after all. I can also remember attending a lunch & learn where a student asked a seasoned real estate executive what he should study in addition to finance. The response he got was something along the lines of, “the furthest thing from finance. Study something that will give you a different perspective on real estate.”

    I remember this really resonating with me — probably because I was searching for breadcrumbs to make me feel like less of an outsider at Wharton. Still, this came across as a unique perspective at the time.

    Knowing how money stuff works is absolutely fundamental. (We need to teach more of it in schools to young people.) And as a developer, it all starts with managing risk, executing (i.e. doing what we said we would do), and being an honest steward of other people’s money. Don’t do this, and you likely won’t be a developer for very long.

    But then, what else? What unique insights can we bring to the assumptions that feed a finely honed model? Fast forward to today and this is now the basis for how the Globizen team aims to look at real estate opportunities. We want to cover all ends of campus. And that means we are more than okay talking about unserious things like design and beauty.

  • Eight centuries of global real interest rates

    Levered assets, such as real estate, tend to have prices that are correlated with interest rates. Lower rates usually translate into higher asset prices. We are living through this kind of environment right now. And so it is generally valuable to have a view on where rates might go next.

    To do that, it can be helpful to look back at history. And a lot of the time, that look goes as far back as the second half of the 20th century. I wasn’t buying real estate in the 1970s and 1980s, but I am often reminded — by people older than me — that this was a period of high inflation and high interest rates.

    But what about an even longer period of time?

    Paul Schmelzing (visiting researcher at the Bank of England) has a pioneering working paper that was published last year which looks at global interest rates over a 707 year time horizon. His research spans the period of 1311 to 2018 and uses archives and many other sources to try and reconstruct annual rates across the world’s advanced economies.

    Below are two charts from the paper that I found interesting. The first represents the data that was used to weight long-term debt yields across the various advanced economies. My how things change when you take a long enough view. It also shows the share of advanced economy real GDP that is captured by the study (it’s about ~80% — the red line below).

    The second chart shows the headline global real rate from 1317 to 2018. And what Schmelzing discovers is that even when you look across many different monetary and fiscal regimes, real interest rates have never really ever been stable. In fact, when you look as far back as the 14th century, real interest rates have on average declined about 0.6 to 1.6 basis points per year.

    So part of his argument is that what we are seeing today maybe isn’t all that strange; it’s actually expected. For a copy of the full working paper, click here.

    Images: Bank of England

  • How to model a wealth tax

    I just came across this post by Paul Graham called, “modeling a wealth tax.” It’s from last year, but it recently resurfaced. In it, he paints a scenario. Let’s say you’re a successful entrepreneur in your twenties (i.e. you make some money) and then you live for another 60 years. How much of your stock would the government take with various wealth taxes?

    With a 1% wealth tax, it means that you would get to keep 99% of your stock each year. But assuming the wealth tax gets applied every year, you would be left with 0.99^60, which equals 0.547. Put more simply, a 1% wealth tax would mean that over the course of the 60 years after you built your company, you would be giving the government 45% of your stock.

    How did this number get so big?

    The reason wealth taxes have such dramatic effects is that they’re applied over and over to the same money. Income tax happens every year, but only to that year’s income. Whereas if you live for 60 years after acquiring some asset, a wealth tax will tax that same asset 60 times. A wealth tax compounds.

    Of course, Paul also points out that giving away a portion of your assets each year doesn’t necessarily mean that you’re becoming net poorer, so long as your assets are increasing in value by more than the wealth tax rate.

    Still, these are massive numbers. A 2% wealth tax would translate, over this same 60 year time period, into the government taking 70% of your stock. A 5% wealth tax works out to 95%. For more on this, check out Paul Graham’s post.

  • What are you serving at your restaurant?

    Warren Buffet’s annual letter to Berkshire Hathaway shareholders was just published for 2020. It can be downloaded here. I have made a habit out of reading his letter every year and his overall approach has been instrumental in shaping the way I think about investing.

    What is clear to me when I look at the first page of each letter — which contains a comparison of Berkshire’s performance to that of the S&P 500 — is that he and Charlie Munger have got to be the most successful stock market investors of the last century.

    They have consistently outperformed the market. And they have done that by focusing on fundamentals, doing what others are not (i.e. being contrarians), and being incredibly patient, among other things. All of this isn’t rocket science. It’s simple, understandable, and repeatable.

    The other thing we can learn from his widely read letters is that clear and concise writing is a powerful tool. I have said this many times before, but to explain something clearly it means you need to really understand it. Things tend to get complicated when you don’t know what you’re taking about.

    And with that, here’s an excerpt from this year’s annual letter:

    In 1958, Phil Fisher wrote a superb book on investing. In it, he analogized running a public company to managing a restaurant. If you are seeking diners, he said, you can attract a clientele and prosper featuring either hamburgers served with a Coke or a French cuisine accompanied by exotic wines. But you must not, Fisher warned, capriciously switch from one to the other: Your message to potential customers must be consistent with what they will find upon entering your premises.

    At Berkshire, we have been serving hamburgers and Coke for 56 years. We cherish the clientele this fare has attracted.

    The tens of millions of other investors and speculators in the United States and elsewhere have a wide variety of equity choices to fit their tastes. They will find CEOs and market gurus with enticing ideas. If they want price targets, managed earnings and “stories,” they will not lack suitors. “Technicians” will confidently instruct them as to what some wiggles on a chart portend for a stock’s next move. The calls for action will never stop.

    Many of those investors, I should add, will do quite well. After all, ownership of stocks is very much a “positive-sum” game. Indeed, a patient and level-headed monkey, who constructs a portfolio by throwing 50 darts at a board listing all of the S&P 500, will – over time – enjoy dividends and capital gains, just as long as it never gets tempted to make changes in its original “selections.”

    Productive assets such as farms, real estate and, yes, business ownership produce wealth – lots of it. Most owners of such properties will be rewarded. All that’s required is the passage of time, an inner calm, ample diversification and a minimization of transactions and fees. Still, investors must never forget that their expenses are Wall Street’s income. And, unlike my monkey, Wall Streeters do not work for peanuts.

    When seats open up at Berkshire – and we hope they are few – we want them to be occupied by newcomers who understand and desire what we offer. After decades of management, Charlie and I remain unable to promise results. We can and do, however, pledge to treat you as partners.

    And so, too, will our successors.

  • The origins of carried interest

    In the world of finance, carried interest is the share of the profits in an investment that a manager (of said investment) earns in excess of what they may have contributed to the partnership. For example, let’s say that a manager is putting in 10% of the cash that is required for a particular project. If the project goes really well, the manager, through carried interest, could earn more than their 10% share of the profits. Put another way, it is a performance fee that is intended to incentivize and reward the manager.

    Today I learned (credit to Lucas Manuel) that the origins of carried interest go all the way back to the Middle Ages. The concept and term supposedly came about because the captains of European ships would take a share of the profit from the “carried goods” that they were transporting. This was to compensate them for the work and for the risk of sailing all over the place. Keep in mind that, just like today, any number of things could have gone wrong. Maybe you don’t make it or maybe pirates steal all of your goodies.

    There is also a compelling argument (made here) that this simple concept has been instrumental, since the Medieval Period, in improving the fortunes of many, but most notably those that weren’t born into riches and that were starting out with limited means. Carried interest allowed Medieval merchants to (1) initiate sailing ventures for which they didn’t have the requisite money and (2) earn a disproportionate amount of the profits so that they could more quickly improve their socioeconomic position.

    Do good work, take on some risk, and then hopefully make a few bucks. That’s still how things work today. Supposedly David Rubenstein, cofounder of The Carlyle Group, also talks about the origins of carried interest in his recent appearance on the Tim Ferriss Show. I say supposedly because podcasts generally take too long for me and I haven’t listened to it.

  • How to get rich (and why talking about money is okay)

    I’ve written about this before on the blog, but one of my qualms about architecture school was that it was too often taboo to talk about business and money. Why? Talking about and understanding the realities of the world doesn’t have to mean that you’re compromising on good design. Constraints are often good for design innovation. Similarly, I’ve always felt that personal finance should feature more prominently in schools at an early age. It should be considered a basic life skill.

    In any event, I came across this tweet thread last night by Naval Ravikant talking about how to get rich (without getting lucky). It’s from 2018, but the lessons — and there are many — obviously haven’t changed. (For those of you who may not be familiar, Naval was the co-founder of AngelList and was an early stage investor in companies like Uber, Twitter, and Opendoor.)

    When you see a headline like this it’s perfectly normal for your bullshit radar to go off. (In fact, it is one of his points.) But this thread is not bullshit. It’s about building wealth. Owning equity instead of renting out your time. Working hard. Taking a long view. Leveraging your time and skills. Understanding compound interest. Partnering with people of integrity. Being accountable. And becoming the best at what you do because you’re pursuing genuine curiosity (among many other great points).

    Here are a couple of his tweets. But I would encourage you to have a full read.

  • The case for speculative asset bubbles (and happy new year)

    This is an interesting perspective. It is from Fred Wilson’s annual what-happened-this-past-year post:

    But here is the thing about speculative frenzies – they are generally directionally correct but off in their order of magnitude. And they finance the trend that they are directionally correct about. It may be the case that Tesla’s market capitalization is too high, but that allows Tesla to raise $10bn without diluting more than a few percentage points. And that $10bn will go towards accelerating the conversion of the auto industry from carbon-based fuel to renewable energy. And that is a good thing for society.

    When I first read this my mind immediately went to tulip mania. Was that directionally correct? Did tulip bulbs ultimately rebound and maintain their value over the long-run? I actually don’t know.

    But if you think about the dot-com bubble, that was directionally correct. Sure, infamous “companies” like Pets.com never ended up going anywhere, but the idea of tech and the internet becoming dominant was absolutely right.

    Fast forward twenty years and you can be sure that many people are now buying their pet supplies online, along with pretty much everything else. Sometimes we simply overshoot and get the timing wrong.

    This is perhaps a good thought for all of us to consider as we welcome 2021 and say goodbye to what was one weird and terrible year.

    Being directionally correct means that it’s okay for there to be bumps, mistakes, and speculative frenzies along the way. They are expected. What matters is the path forward.

    Happy new year, everyone.

  • Thinking exponentially and the rule of 72

    I came across the above Twitter thread last night before bed and I thought it was great. It’s about the importance of thinking exponentially, as opposed to linearly, when it comes to finance and investing.

    In it, the author provides a quick rule of thumb to help reframe our mind when it comes to compounding. It’s called the “rule of 72” and it works like this.

    To calculate the approximate number of years to double your money, simply take 72 and divide it by the annualized rate of return (%). For example, if you had an annualized rate of return of 10%, this rule of thumb would tell you that you’re going to need 7.2 years to double your money.

    If the annualized rate of return were to increase to 18%, it would now only take you 4 years to double your money. Of course, this rule of thumb is an approximation. It only really works within a certain band of returns.

    If the annualized rate of return were 100%, this formula would spit out 0.72 years, whereas an annualized rate of return of 100% actually means that you’re doubling your money in the span of one year.

    It’s a rule of thumb. The reality is that compound returns are incredibly powerful over the long-run, not only for finance and investing, but for life in general. Worthwhile things take time. If you’ve got the patience and discipline, the long-run curve ends up looking pretty sweet.

  • 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.