If Capital is the lifeblood of real estate, then Land is its beating heart. Land is at the core of real estate. It is the foundation of the clichéd saying “location, location, location.” In highly dense metropolises like New York and London, raw land regularly achieves astronomical values north of $1,000/SF ($43.56 million per acre). Why then is land so hard to finance? Why is such a crucial part of the real estate industry such a difficult piece of the financing equation? The answer is a mix of government regulation and the inherently speculative nature of land.
Land, Basel III, and HVCRE
The Great Recession and its fallout led to a number of major banking reforms, including Basel III. Basel III established voluntary regulations for the global banking industry, putting a focus on stress tests, assessment of market risk and adequacy of capital at banking institutions around the globe. Most of the major countries around the world have implemented these reforms. One of the more contentious Basel III regulations in the U.S. – and the one most directly tied to financing land – is what is known as High-Volatility Commercial Real Estate (HVCRE). It is the bane of many banks. In a nutshell, it makes financing land and construction projects more difficult for banks across the board. In particular, it doesn’t allow for a piece of land’s increased value over time to be contributed to a development project as equity, regardless of how long the land has been owned. This obviously has caused major issues for banks and developers over the past few years. There is a bill underway in Congress that seeks to loosen up the HVCRE language. The odds look good for the bill to pass, but for the time being the banking industry is operating under the current HVCRE guidelines.
Analyzing the Value of Land Pre-Development
Putting government regulations aside, it is fair to say that land – and what will ultimately be built upon it – is a speculative proposition. Whatever you plan to build on your land does not exist there today. You have to build it first. The market needs to remain stable while you do so. You need to build your building on budget, and the demand for your building, once it is built, needs to be there as planned. Valuing land, whether for a bank or for a joint-venture partnership, is, therefore, an exercise in demand and supply forecasting and cost estimation. I am intimately familiar with this analysis. My first job in the industry was performing residual land value analysis for development sites in major European cities (in fact, I had to learn how to do this analysis in a foreign language – Russian – but that is a whole separate story). The point of the analysis was to back into the value of a development site based on i) what you could build on that site, ii) the demand for that type of building and iii) how much it would cost to build. It’s fascinating to think through, and also highly theoretical. The market is just as much of a factor – if not more – in dictating how much the site is worth. Like most things in business, the valuation and sales prices for development sites are as much an art as a science.
The Landscape of Land & Development Financing
Having said all that, land is a vital part of real estate and how projects get financed. I have become acquainted with land and development financing over the past few years. The landscape (no pun intended) has changed since we came out of the Great Recession. At our firm, we like to joke that land is now a dirty word within the banking industry. I’ve financed a few projects where land contributions have been the primary equity contribution to the development projects. In a couple of instances, a large amount of land – grossed up to today’s value – served as both the equity and the collateral for the construction loan, such that no cash equity was required for the development. Given the banking landscape today, these were of course extremely difficult deals to structure. It takes creativity and a keen understanding of the industry to structure these deals in a manner suitable for lenders.
The author, Justin Laub, is a Senior Director in the Dallas office of Metropolitan Capital Advisors.