Land investment in the 21st century

Real Estate Issues, Summer 1999 by MacCrate, James R

This article examines some of the ways that U.S. land investment in the 21st century will be different from what we know today. We will look ahead five to 10 years to predict which of today's practices and patterns will have changed - and how dramatically. We will also examine how these changes could affect returns and investment strategies.

Before beginning this look into the future, we describe the basic elements of risk and related strategies that are always present in land investment. We then review recent history to see how land investment has changed over the past 10-15 years. This information provides a baseline from which we can analyze expected changes in risk elements and strategies and their effects on investment returns.

BASIC ELEMENTS OF RISK AND STRATEGY

Risks

Land investment is always subject to a number of risk factors. The character of risk changes as development moves forward. The types of risk associated with land investment include:

Market risk - supply and demand fluctuations. As the window of development opportunity becomes smaller, timing becomes more important and market risk may increase. On the other hand, as the quality of information improves and as market data can be retrieved and analyzed more quickly - almost in real time - market risk may be reduced in some instances.

Governmental risk - This type of risk is becoming increasingly important as more jurisdictions regulate more aspects of the development equation more closely. Regulation by its very nature limits what the owner can do with land. Simple zoning and subdivision regulations have now been expanded in many jurisdictions to include growth impact fees, school construction contributions, affordable housing exactions, and many other potentially costly requirements.

Financial risk - The willingness of lenders to back projects and the percentage of value and interest rates at which they are prepared to lend are always important variables. Some but not all financial risk can be hedged against. The recounting of recent land investment history, in a later section, shows how fluctuations can impact markets.

Environmental risk - Some environmental risk events can be hedged or insured against by prepurchase due diligence, but some so-called "Acts of God" cannot be. Accumulated pollution from past decades and even centuries is an everpresent and significant factor in development calculations.

Operating/development risk - A land owner's investment return and profit often depend upon the expertise and reputation of the developers, builders, and contractors with whom he/she is associated. Development is a business and is thus subject to normal business risks which good management can minimize.

Strategies

As land investment moves from raw land status through the acquisition, approval, zoning, subdivision, and other regulatory approval processes, the amount and character of risk will change. The wise investor develops strategies to minimize, hedge against, and otherwise deal with these risks. At least three basic strategies can be identified, each of which presents a different risk/return profile.

The first strategy is to purchase large tracts of unsubdivided land with the intent to hold for longterm anticipated future development. Land purchases of this type are typically not conditioned on approvals. The owner who may or may not be the ultimate developer, assumes all the approval risk in the hope of increasing overall returns. Land investment surveys conducted over the past decade by Price Waterhouse LLP (now Pricewaterhouse Coopers LLP) confirm the speculative, high-risk, highreturn nature of this strategy. Survey results have shown expected returns in excess of 50 percent, in contrast to developers' anticipated median returns of less than 30 percent.

The second strategy is to purchase land that is approved for development but remains unimproved. The owner assumes the risks associated with subdividing the land and installing infrastructure. In this case market risk is of greater concern. If the market shifts or weakens the landowner may be caught with obsolete layout or too many parcels. Expected pre-taxed unleveraged returns on these types of land investments have usually ranged between 15 percent and 30 percent. Market conditions, (for example, the housing affordability index), and the short-term interest rate environment can dramatically affect return levels within this range.

The third strategy involves purchase of finished approved parcels that can be developed within one to or two years. Landowners who adopt this strategy are often, but not always, the developers of the ultimate product. Market and financing risk are therefore of greatest concern to this type of investor. Historically, expected returns for such investments have ranged from nine percent for build-to-suit projects to more than 15 percent for speculative ventures.

Whichever strategy is chosen, ongoing micromarket analysis, both economic and political, is an important part of the landowner's risk management activities. This can often take the form of market analysis, with full appraisals required only when significant micro-market changes have been noted. Even though land investment may be financed globally, the factors that determine investment risk and land value - such as political decisions, economic conditions, and buyer preferences - will always remain primarily local.