Monday, December 15, 2014

The NIMBY Cronicles Part 1, Zoning is money.

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.
Detroit bonds are riskier than New York bonds and consequently have to pay a higher Y to attract investors. It is the same with rental property. Some are riskier than others and have to pay more. The dividend the building pays is the profit. i.e. the yearly rental income minus the operating expenses. If a building shows a profit of $50,000 each year and you judge the risk to demand a 10% return, than the most you should pay for the building is $500,000. ($50,000/ 10%)

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


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