Lead Story… If you read real estate industry headlines these days, you would be mistaken for thinking that property prices in California are doing anything other than rising. It seems as though every day (with the possible exceptions of malls and class A apartments), there is a story of some sort about a new high being set in a product type or region in either rents or sale prices. This has been particularly true on the residential side of late where even talks of a slowdown are more about a decelerating rate of appreciation that an outright decline. However, there is something interesting going on behind the scenes that flies below the radar of most people who are not a part of the real estate industry: despite the increase in residential asset prices and rents, the residual value of residential land is often not increasing and in many cases is actually falling.
How is this even possible? To start, one must first recognize that land is priced as a derivative – an asset having a value derived from something else. Financial derivatives can get quite complex but the one used to price land is simple:
Land Value = Revenue (from sale of structure to be built) – Cost of Improving Land – Permits and Impact Fees – Construction Cost of Structure – Builder Profit.
The value of land is derived from the five factors noted above and tends to be substantially more volatile than the variables themselves since increases in revenue or cost flow straight through to the underlying land value. If revenues rise and costs fall, the value of land goes up substantially. On the other side, if costs rise and revenues fall, the residual value of land quickly vanishes and can even go negative.
I put together a quick chart summarizing the residual value of a lot that a $1MM home will be constructed on in order to illustrate this increased volatility. In the example below, 10% revenue inflation yields an increase in land value of 28.6%. By the same token, an increase in cost (and builder margin) of 10% results in a decrease in land value of 18.6%.
|Base Case||10% Revenue Increase||10% Cost Inflation|
|Revenue From Home Sale||$1,000,000||$1,100,000||$1,000,000|
|Permits and Impact Fees||(100,000)||(100,000)||(110,000)|
|Builder Profit 15%||(150,000)||(150,000)||(165,000)|
|Residual Land Value||$350,000||$450,000||$285,000|
|% Increase (Decrease) From Base||28.6%||(18.6%)|
The residential housing market stabilized in California around 2012 – 2013. Since that time, home values and finished lot values have continued to outpace inflation, often by a substantial margin. So why has the value of unimproved residential land failed to keep pace? There are two primary reasons:
- Construction and development costs have also soared during the above-referenced time period as economic growth and protectionist trade measures have pushed the cost of raw materials higher and a crippling construction worker shortage has pushed the cost of labor up as well (and caused timing delays).
- Cities – which are restricted in how they can raise revenue due to Prop 13 have taken the opportunity provided by rising home values to push already-astronomical impact fees even higher.
The end result is that increases in costs and fees have offset the revenue increases that merchant builders of both homes and apartment projects have realized, leaving underlying land values to tread water or worse. We’ve heard this critique in recent months from builders, developers, capital partners and brokers operating in California. Perhaps an even larger looming issue is that there are signs that merchant builders are losing their ability to pass cost increases on to buyers as affordability of both ownership and rentals has become strained. If costs continue to go up, this will inevitably lead to fully approved projects being shelved, meaning that values of existing units will likely remain high despite rising interest rates, simply because household formation will continue to outpace new supply.
All of this calls into question the very rationale of investing in land in the first place. Traditionally, land development is the most lucrative but also the most risky corner of real estate development. In other words, its possible make massive returns if the market moved in your favor but lose your ass if it moved against you due to the derivative nature of the asset. However, in this cycle, the best case scenario appears to be that rising values of completed home and apartments keep a developer at break-even land residual as costs rise just as fast. In addition, municipalities view impact fees in a market where home and apartment values are on the rise as a honey pot and continue to increase them aggressively. The downside is that municipalities are not about to cut their fees once revenues top out (or God forbid fall) and cost inflation shows no sign of abating. So under the best current outcome, a developer keeps their head above water and in the worst one they get wiped out. Hell of a business. Perhaps only in the perverse world of real estate development in California is it possible to be 100% correct about the direction of the market and still lose money. And then we wonder why we have an affordability crisis.
Help Wanted: Construction employment opportunities with a starting salary of $75k and benefits and no college education needed are going unfilled.
Precarious Position: The fracking revolution has made the US energy independent but most operators operate at a deficit thanks to the relatively short lifespan of wells. That deficit has been filled by cheap debt up until now but rising interest rates could mean that there is an economic disaster lurking underground.
Bubbleicious? Companies have been binging on corporate debt at incredibly low borrowing costs throughout the current economic cycle. However, rates are now rising and this high leverage could pose danger to the economy if growth slows.
Survival of the Fittest: Competition from the likes of Amazon has forced existing retailers to re-examine their business plans and innovate. The best of the group are flourishing, while the weakest competitors are dying off.
In the Right Direction: Residential construction loans are increasing in volume – but still nowhere near the prior peak.
Boomtown: Las Vegas has dethroned Seattle as the nation’s hottest housing market after the latter had held the title for nearly two years.
Hard to Pick a Side: It’s difficult for me to figure out who to root for when a legal battle pits billionaire tech VC and likely James Bond villain Vinod Khosla against the capricious and completely unaccountable bureaucrats at the California Coastal Commission.
Bubble: Goldman thinks that most crypotcurrencies won’t stop going down until they hit zero.
Covered: As veterinary bills add up more pet owners are opting for insurance to cover their four-legged family members.
Chart of the Day
This is remarkable considering growing affordability issues. According to Genworth, the US had the “most first-time homebuyers for a second quarter since 1999. First-time homebuyers accounted for 36% of single-family home sales in Q2, the highest share for a second quarter since 2000.”
Grab and Go: A couple was arrested for building a drive-through window at their mobile home to sell drugs because Florida.
Idiots: Dominoes Pizza was forced to cancel a promotion offering fans free pizza for life if they got the brand’s logo tattooed in a prominent place on their body after too many people agreed to the stunt. If you needed proof that the people around you are getting both dumber and fatter by the day, look no further.
Innocent Until Proven Guilty: A crackhead fell through the ceiling of a Mexican restaurant in California because drugs.
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