Developers don’t ask for a zoning change because they have a
shining vision of the city’s future. They ask because it puts more cash in
their pockets. This is why they submit to public input, because they are asking
for free money.
It’s big money and here, I hope to explore exactly how much.
To the developer every development parcel has a highest
ultimate value.
Put simply, the highest you can pay for a plot of land is
the value of what can be built on it at its highest and best use, minus the
cost of construction.
This is not necessarily the market price. If the market
price is above this value, it is a bad investment. If the market price is equal
to this value, it is still a sound investment to some one who sees it as a long
term hold. If the market price is below this value, it gives the developer a chance
to make his profit by selling the completed building. This is as it should be;
these guys need to eat too.
This price is typically expressed in the form of dollars per
buildable square foot. That is, if a lot's price is $1 million and you can build a 20,000
sq feet building, its cost is $50 per buildable sq ft. If the lot next door also
costs $1 million but allows you to build 40,000 sq ft, despite the same price its cost is only $25 per buildable sq ft.
All these variables, save one are governed by the vagaries of
supply and demand. The highest and best use is governed by zoning.
Zoning wasn't done willy nilly. It is part of grand plan for
the city. It was made by intelligent and well meaning men and it’s still a good
plan. It sees a crescendo of population and business at the city center
tapering off the borders. It has a series of radiating lines that that allow
for moderately higher use along transportation corridors, and industrial uses
along freight corridors. Still it tapers from downtown out to the burbs.
Back in the day you bought a plot of land and built a house,
a store, an apartment building, but mortgages were tough to get and demand and
consequently value was driven solely by the end user and his financial state.
With the invention of mortgage backed securities, we
increased that pool of demand. This seemed to be a good thing, but when these
securities became a widespread investment vehicle, the demand for the
securities started to drive the real estate market. Eventually, a residential
mortgage was available to anyone with a pulse, so that more mortgages could be
created to feed the insatiable thirst for the securities.
This is when the condo was king. When a developer asked for
a zoning change it was to slap another condo on top and make more money. This
tended to build bigger units maximizing bulk but moderately impacting density.
It was easy to figure out the value of a zoning change, it was simply the price
of the additional unit minus its construction costs.
With the crash, this changed. Everything is about
apartments, at first we thought it was about renter demand, but this isn't
really the case. The same investors who were clamouring for securities are
looking for somewhere else to invest their money. The demand stems less from
people wanting to rent and more from people wanting to buy apartment buildings.
Investors judge a rental property's value by something called
the capitalization rate.
Think of an apartment building like a municipal bond.
You invest X dollars and it pays you Y percent each year. Y
percent is the Cap Rate.
But here’s the situation, the collapse made other
investments riskier or less lucrative and increased demand by REITs, pensions
and other bigger investors for rental real estate. This lowered the required
cap rate. Now it’s around 5%, so that same building showing the same profit of
$50,000 each year is worth $1,000,000.
To get the most out of this boom, the developer wants to
maximize the income.
One way is with smaller apartments, but more of them. Imagine
you can get $1500 each for two 750 sq ft apt ($2/sqft). To get the same sq ft
rate for one 1500 sq ft unit. You need $3000 a month. This jumps a threshold
that makes it more difficult to keep rented. You would need to charge less, say
$1.75/sqft ($2625) for the larger unit to stay rented.
So, smaller units rent for about 25 cents/sqft more each
month. How much could this be worth? .25
x 12mo / 5% = $60. A zoning request solely for an increase in density with no
extra floor space, adds $60 per buildable square foot to the ultimate value of
the vacant land.
Other ways to maximize profits include adding amenities, but
this is the developers choice and is not dependent on any zoning change. Two
ways that are dependent on zoning, are building more square feet, or building
taller (units with skyline views rent at a premium)
So, let’s construct a model.
Three standard city lots, initial zoning B3-2
You can build a 4 story mixed use building. 20,625 total
sqft
9 residential units + around 8000 sqft retail.
Residential units around 1400 sqft
Good retail in the area commands $20/ft/yr NNN
Retail gross rent $160,000- $2000 expenses Net income $140,000
Retail cap rate (per CBRE) 6%
Investment value of retail $2,333,333
Investment value of retail
Residential gross rent @ $1.75/sqft/mo 29400/unit/year.
$264,600 total
Costs, $24,000 taxes $6000 insurance $20,000 maintenance.
Net $214,600
Residential cap rate (per CBRE) 5%
Investment value of residential $4,292,000
Total Value $6,405,433
Construction costs (per RSMeans 4-7 fl apt) $205/ sqft
Total $4,228,125
Ultimate value of undeveloped land $2,177,308
Or $105 per buildable square foot.
Three standard city lots, new zoning B3-3
You can build a 5 story mixed use building. 28,125 total
sqft
18 residential units + around 8000 sqft retail.
Residential units around 970 sqft
Good retail in the area commands $20/ft/yr NNN
Retail gross rent $160,000- $2000 expenses Net income
$140,000
Retail cap rate (per CBRE) 6%
Investment value of retail $2,333,333
Residential gross rent @ $2.00/sqft/mo $23,400/unit/year. $ 421,200
total
Costs, $28,000 taxes $6000 insurance $22,000 maintenance.
Net $365,200
Residential cap rate 5%
Investment value of residential $7,304.000
Total Value $9,637.333
Construction costs (per RSMeans 4-7 fl apt) $205/ sqft
Total $5,765,625
Ultimate value of undeveloped land $3,871,708
Difference $1,694,400
There it is. A fairly minor zoning change on a fairly small
project represents about 1.7 million dollars in additional profits. Probably
more than they paid for the land.
If the change is to a B3-5 those numbers add up to $5.2
million, and over $6 million if you add a 25 cent bump in rents for the skyline
views on floors 6 & 7
