Here’s one of the hard truths about real estate that very few people have discussed over the last 8-10 years: real estate values don’t always go up.
Part of the reason is that, almost universally, real estate values went up after the Great Recession through 2021/2022, except for certain types of assets suffering from functional obsolescence due to new technologies and an evolving economy.
The other reason is because real estate gurus have been popping out of the woodwork since 2019/2020. They’re all over social media, hawking their courses, pitching “get rich quick” schemes, and talking unsuspecting investors and limited partners (LPs) into buying overvalued properties.
The really unpopular truth is that a lot of LP equity has evaporated over the last couple of years. Syndicators and land developers who purchased properties at inflated values, with variable debt at historically low interest rates, are struggling. They’re being forced to refinance at much higher interest rates and in an environment where cap rates are 2-3% higher than at acquisition.
I say all this to add some context - the market has quickly changed since 2022. One of the things I am seeing in the land development business as I talk with landowners is that they haven’t quite come to terms with the fact that their property isn’t worth what it was several years ago.
The value of land is influenced by a bunch of different factors, including:
- The future potential value or highest and best use
- The availability and price of debt
- The underlying market demand for the type of development
- Relative competitor supply to accommodate that demand
- The developability of the site (i.e., the presence of streams & wetlands, topography, soils, subsurface conditions, access to utilities, required off-site improvements, environmental conditions, etc.)
- Land entitlement risk – political and neighborhood unknowns, the approval process, the stringency of a municipality’s development ordinances, etc.
- Sitework and land development costs
- Vertical construction costs
- Post-construction lease rates and sale prices
Many landowners lack the experience to understand all the complexities accompanying land development. So, anecdotally, when I negotiate with owners in hopes of purchasing their property, it’s imperative that I manage expectations regarding the timing, out-of-pocket costs, and risks I deal with before closing the purchase.
Because of all these factors, there is a pretty apparent dislocation between landowners and buyers in terms of price and terms – many owners want 2021/2022 land prices but don’t want to share in the risk a land developer will inherit. And many real estate developers aren’t willing to pay top dollar given market uncertainties, the price of debt, still inflated construction prices, and a continually evolving land entitlement process.
So, we’re left with a market where some deals are still getting done, but buyers and landowners often exist in different realities. Regardless of which side of the table you sit on and who you think should be willing to budge, it’s frustrating for both parties.
Many land developers and real estate private equity groups have said they’re comfortable sitting on the sidelines while the market works towards a better equilibrium.
But where does that leave landowners - some of whom may want to sell their property today or regret not capitalizing on peak values several years ago?
Many are turning to land entitlement and even self-development to maximize property value. In this article, we’ll discuss the obvious benefits of the strategy but the inherent risks that many landowners aren’t considering.
What is land entitlement?
Before we discuss the merits/risks of land entitlement, let’s first discuss the concept.
In order to develop a piece of raw land, owners need a series of permits and approvals before they can break ground. The process of obtaining those approvals is land entitlement.
Owners must draft a site plan and any pertinent engineering construction drawings for various government agencies to review. The construction drawing review and site plan approval process is cumbersome and often differs by municipality. First, there is usually some form of pre-submittal meeting to discuss the concept/project. Then, developers must conduct any required special studies, critical pre-development tasks, and real estate due diligence before refining their site concept.
If the project requires a property rezoning, that needs to happen during land entitlement to proceed.
Once all the front-end work is complete, the landowner or developer must incorporate all their findings and due diligence into a full site submittal package.
The engineering site package typically goes through a series of review and resubmission cycles until deemed approved.
Keep in mind that in addition to an approved set of plans, land developers must also obtain a series of permits, including erosion control, driveway, encroachment agreements, and land disturbance.
Once all permits and approvals are obtained, the land is considered fully entitled and shovel-ready.
Why should owners consider a land entitlement or development exit strategy?
There is a lot to consider as a landowner:
- When is the right time to sell your land?
- How do you maximize land value?
- What kind of land developer, builder, or investor should you sell the property to?
- How do you even value your land?
There’s generally not a singular “right” answer, but it becomes even more complicated when you consider that land values may not be what they were several years ago.
However, if landowners decide to pursue a land entitlement exit strategy, a couple of things will work to their benefit.
Lower land cost basis
Property owners can acquire their land in various ways. Maybe the property has been passed down across generations, and they’ve inherited it. They could have purchased the property years ago at a much lower price. Or they bought it as an investment property, got busy, and haven’t done anything with it.
There is an essential lesson in understanding how someone came to own a property. Depending on the circumstances, their cost basis in a property is frequently much lower than if they recently purchased the property.
They also aren’t incurring carrying costs through continued ownership and debt service other than property taxes, insurance, and potentially some minor maintenance costs.
That gives owners a lot of flexibility that a land developer wouldn’t otherwise have.
An owner with a low-cost basis can entitle and sell the project at an attractive price. They can capture the upside in the increased property value without having to sell the project at top market value to cover their land acquisition and entitlement expenses.
Many homebuilders and real estate developers want to avoid the land entitlement process altogether. They’re happy purchasing a property with an already approved project and falling in on an existing plan, assuming it meets their acquisition parameters.
Landowners can take advantage of this by taking on the land entitlement risks themselves and delivering a shovel-ready project to eager buyers.
Timing flexibility
As I mentioned, the land entitlement process is long, time-consuming, and potentially risky.
To reduce that risk, developers frequently structure land contracts, allowing themselves enough time to obtain approvals before closing. This can put landowners in a bind because their property is tied up for 12+ months, waiting for a buyer to navigate the entitlement process.
If a land developer buys the property before obtaining approvals, they’ll either have to come out of pocket with cash or be forced to take on debt and the resulting interest payments. Those additional carrying costs put investors in a bind during a drawn-out entitlement process, mainly because most vacant land parcels don’t produce positive cash flow.
On the other hand, landowners have the flexibility not to be as concerned about the entitlement/permitting timeline. Instead of having their property tied up with a buyer for months or even years, the owner takes on the approval process and can sell the property to a back-end buyer for a higher price.
Land development as a strategy
Taking land entitlement one step further, owners may even consider developing the property before selling.
Managing sitework and the real estate development process is complex. Still, there is even more financial upside in selling padded lots or a build-ready site to another developer or homebuilder.
As the real estate market moves through cycles, there are times when builders look to offset more risk and only want to acquire pad-ready sites. When you add the fact that smaller local and regional builders often don’t have in-house land development teams, the back-end market for owners to sell a build-ready project is likely more substantial.
This strategy carries more risk as an owner but offers a larger buyer pool and the potential for significantly higher financial returns.
Risks to consider in land entitlement as a landowner
Because of all the recent hype around land entitlement as a strategy, it’s easy to get deluded into thinking there’s no downside.
As you contemplate alternatives to selling your land or ways to maximize its value, you’ll need to account for several risks.
Entitling a project that is actually marketable
A property is only worth what someone is willing to pay for it. As an owner, you can go through the headache of entitling a project – taking on the risk, out-of-pocket costs, and time required, only to find out there’s no buyer.
Before you decide to move forward with a project, you’ll want to consider several factors:
- Is there demand for the type of project you’re proposing?
- If it’s a commercial project, what is the prevailing submarket lease rate, and can builders justify buying the property given construction costs
- What are the new home sales prices and rental rates if it's a residential project? What can builders afford to pay for either entitled paper or padded lots?
These central questions will help inform your strategy. Once you’re in the midst of site decision and permitting, it’s essential to consider the property’s highest and best use or similarly adequate use that is marketable for sale.
Considering buyer demand based on site yield and project costs
Economic considerations as a real estate developer are pretty simple – they’ll determine what they can sell or lease the project for (homes sales, multifamily lease rates, commercial rents, etc.), and subsequently back out hard and soft costs, a reasonable percentage for financial returns, and arrive at a price they can pay for the land.
So, as a landowner, if you plan to sell an entitled project or even develop the site yourself, you’ll need to consider the same financial parameters.
Projects typically become more profitable as they achieve higher density, i.e., more homes, units, or leasable commercial space.
However, greater density often comes with higher construction costs - more grading and stormwater considerations, the potential for more substantial retaining walls, and more concrete, asphalt, etc.
So, it’s essential to weigh these factors just as a land developer would ensure that there’ll be back-end buyer demand based on the site yield and horizontal/vertical construction costs.
Cost
Navigating land entitlement isn’t cheap. You’ll need to assemble a development team of surveyors, environmental engineers, civil engineers, architects, attorneys, geotechnical engineers, site work contractors, and consultants.
You’ll continuously pay them for their services during permitting while plans aren’t guaranteed approval and the property isn’t generating any cash flow.
Land is an illiquid asset, and mistakes during entitlement can add up quickly, especially if you haven’t sequenced your real estate due diligence activities properly. It’s critically important to map out the size and timing of all your upfront entitlement costs early so you’re not caught mid-permitting and unable to continue with a project.
The size and complexity of a proposed project, municipal requirements, and site-specific due diligence investigations dictate your potential out-of-pocket soft costs.
Finding and hiring the right civil engineer can help with some early project planning.
A real estate development consultant can assist owners pursuing land entitlement
The real estate development industry is filled with service providers who provide very siloed expertise. Environmental consultants are experts in navigating environmental permitting issues, civil engineers are experts in site planning and municipal code, and surveyors can help with site mapping and plat preparation.
While all these services are critical to a project's success, they are very distinct skills. So, unless a landowner has previous development experience, the lack of broad-ranging guidance leads to blind spots. Projects get designed too expensively, essential permits get missed or aren’t appropriately sequenced, leading to time delays and redesign costs, and design happens in a vacuum without the end user in mind.
A real estate development consultant can save owners money and reduce risk – their expertise crosses traditional real estate functions to offer guidance on everything from due diligence to land entitlement and construction.
As landowners consider land entitlement as an alternative to selling their property, they might consider engaging a consultant to help manage or guide them through the process. Making site planning and cost decisions during project design is much easier than making expensive changes post-land entitlement.
Marsh & Partners offers landowners real estate consulting services to help guide their decision-making and ultimately maximize a property's value.
If you’re bogged down in the land entitlement process or trying to structure your exit strategy, it may make sense to have a quick call and brainstorm. You can book a meeting with us directly and begin making more thoughtful, calculated real estate decisions.
