by Gabe Gonzalez
Even as the fundamentals in various commercial real estate markets around the nation recover and improve, land loans continue to plague the balance sheets of banks and other lenders. Since the 2008 meltdown, capital providers have been unwilling to lend money for land transactions for two main reasons: First, land does not produce income to service a lender’s debt and secondly, the potential for immediate development may not be a strong argument for an exit strategy. On the equity side of a land transaction, a JV Partner’s equity may not have the patience to park money without any cash-on-cash returns with the hopes of hitting investment goals from a sale in the future.
Metropolitan Capital Advisors (MCA) has closed a multitude of land transactions and inherently knows what constitutes a viable land investment. The majority of these successful deals shared similar qualities that enabled our clients to obtain the required capital to achieve their investment/development goals. Below are some of the characteristics required to successfully obtain capital for land acquisition/development:
Definitive Exit Strategy
Land does not create cash flow during the hold period, and therefore, an appropriate exit strategy is needed. A JV Partner will require a 20-25% IRR on its equity before the sponsor begins to see any substantial profit participation. Land typically does not increase in value enough to generate that kind of return over a 3-5 year period unless it is purchased at depressed prices or unless there is substantial value enhancement via favorable entitlements. In order to meet investor time hurdles, a sponsor should already be under contract with homebuilders, developers, and users. A capital provider will feel more comfortable if a sponsor can show a strong level of interest in the property. (“Nothing draws a crowd like a crowd.”) Contracts in hand for lot takedowns and sales demonstrates an exit strategy, and furthermore, immediate sales gives a capital provider a benchmark to model up the investment to better estimate return of its capital and a return on its capital.
As with most real estate investments, location is critical when buying vacant land. Ideally, investors will buy vacant land that will be in the path of future development, but identifying an expanding market and predicting which areas will be in demand can prove challenging. Land owners have been left empty handed owning land that is not accessible to utilities and major thoroughfares. Many municipalities may have originally planned to expand and build additional roadways to make remote land accessible; however, those plans may not come to fruition due to the current economic environment where cities are struggling for tax revenues.
A tract of land does not necessarily have to be located at “Main & Main” to be a viable investment; however, the location of the development must be easily accessible to roadways and commercial development. If the land is located in a more rural setting, the property has to have exclusivity and uniqueness coupled with the city’s ability to fund the construction of roads in order to realize its full value potential.
MCA recently closed two (2) land transactions south of Wilmington, North Carolina. While Wilmington is not considered a major MSA, the specific location of the proposed development was attractive for future single-family housing. The community was situated near various shopping and dining centers, elementary schools, grocery stores, and hospitals, providing an ideal location for those who desired small town living with the conveniences of the big city. The location also offered natural amenities including the Intracoastal Waterway along the Atlantic Ocean and a 12-acre lake.
MCA also closed a 622-acre tract of land located in southwest Fort Worth. The sponsor realized an opportunity when the City of Fort Worth announced the construction of Southwest Parkway; a tollway from I-20 to Hwy 67. The development of the tollway will create six (6) additional hard corners on the land, thus creating a market for commercial development. The sponsor has received multiple offers from big box retailers and single-family developers who have been eager to get in on the action in this new, highly accessible growth corridor.
Strong Sponsorship and a Good Story
As with any real estate transaction, a strong sponsorship is key for land development. A strong balance sheet and clean real estate owned schedule (REO), coupled with development experience, are required to even be considered. An REO schedule that has positive global cash flow from other income producing properties can be a risk mitigant to lenders as excess proceeds can be used to cover debt service until development begins. Offering up additional unencumbered land as part of the collateral has proven to be a successful option to further enhance the credit for the proposed transaction.
Favorable Cost Basis
Purchasing a piece of land at a low cost basis is crucial to making an investment viable. Many developments incur cost overruns due to delays, an unexpected increase in the cost of materials, or city planning and infrastructure issues. Many of our clients have been successful at purchasing notes from a bank at steep discounts in order to acquire the property at a favorable basis. Banks are incentivized to sell notes at a discount to rid their balance sheets of toxic loans, thus allowing the bank to free up loan loss reserves that are required by the FDIC. MCA recently closed a transaction where the sponsor purchased a partially developed subdivision for a fraction of the principal loan amount. Like many developments in 2007, the timing of the project and poor capitalization led to its failure with only 1/5 of the property developed for single family homes.
Schmoozing with City Officials
Acquiring land with flexible zoning and entitlements allows the developer to be creative and to maximize value by designating the highest and best use of certain parcels. Having a good relationship with city planners allows flexibility during the development process and increases the chance of the zoning change to be approved. The best way to garner support from the planning office is to involve them in the process from the beginning, holding early site meetings to discuss the development on an informal basis without any costs.
In summary, a good land deal may be financeable in today’s cautious financing environment provided that the deal has the following characteristics:
- Strong sponsorship
- Value creation via entitlements
- Exit strategy via lot takedowns and contracts
- Favorable cost basis
The good news is, with the right story, LAND may not be a four letter word when it comes to capitalizing your next acquisition or development.