Natural Disasters

Real estate development must plan for and around natural disasters.  Over the long duration of planning, construction, and sales, nature will have a say about a project.  Where I work in Northern Nevada and Northern California the three primary types of disasters that are considered and planned for are wildland fire, floods, and earthquakes.

There is nowhere in this country that does not require an accounting for natural disasters and climate change is elevating the amount of discourse, research, and mitigation measures required as we plan.  Thankfully, we have science on our side in way that I don’t think developers did for most of the 20th century.  Drought in Las Vegas, tornadoes in Dallas, flooding in Chicago, hurricanes in Florida, and blizzards in NYC are all regular phenomena and must be part of our learning as we move ahead.

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One great positive about real estate development today is that we have a variety of experts to aid in understanding natural conditions and disaster planning when it comes to land planning and construction.  The California Environmental Quality Act (CEQA) governs the preparation of a very thorough analysis of the environmental impacts of a new development in a region.  CEQA is a bit of a cottage industry in California.  Certain consulting firms can make their living creating the voluminous and detailed reports.  Certain attorneys can make a career out of arguing about the scope and meaning of the requirements.

How many cars will use an intersection at build-out and what does that mean to air quality?  Will new lighting from development negatively impact migratory bird behaviors?  Are there any rare or threatened plant species for which the site is critical?  Will a 100-year flood wash it all away?  CEQA calls for the creation of an Environmental Impact Report (EIR) which answers all these questions for local planning authorities to consider when reviewing a project.

Where I grew up in the suburbs of Chicago it seemed that almost every spring the Des Plaines River would come out of its banks and flood the homes nearby.  There was some good modern planning around leaving flood plain as open space, parks, and playing fields when I lived there but too many homes had previously been built in the river’s path.  One of my key lessons in life is don’t live in a flood plain unless you want to be in a situation where volunteer high school football players filling sandbags will determine the fate of your property.

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In the West flash floods are more the issue vs. the slow-moving behemoths that occur in the Midwest. But even downtown Reno floods when there is simply too much water flowing out of the Sierra Nevada for the creek beds and river beds to hold.  Of course, humans haven’t helped as we converted urban river corridors to concrete chutes that allow little room to flex, but we’re learning.

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We’re in a better place than ever when it comes to studying land uses, but the problem is not going away.  Real estate development will always require some compromises as we move forward, but new projects and housing can’t be expected to fully remediate the sins of the past.

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Opposition to Development

There is much opposition to new development in this world, some of it warranted, much of it not.  This is one of the most difficult parts of the development process.  Developers like to work on a level playing field but so much of what happens when plans materialize for previously undisturbed land is highly emotional and can become a political issue.

Two of the major opposition groups to developers are environmental groups and the classic NIMBYs.  I’ve worked on development projects in the mountain resorts of Colorado and California.  It’s amazing how much local sentiment can affect the ability to create new communities in certain locations.  As far as I can tell, there is not an acre of land in the US that is not spoken for by someone or by some entity.  And as mentioned in a previous blog, every parcel of land in this country falls under some jurisdiction, whether it be a county or the federal government.

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Most developers study and understand the rights vested in land when they purchase it with an eye for future development.   Land must make sense physically.  You don’t want to have to move a mountain or fill in a lake if you don’t have to (though projects like that start to make sense in certain cities).  But after you determine the land makes sense you need to make sure the governmental entity in charge allows for the land use you would like to build.

In today’s world, most cities and towns want to grow and have a plan for that growth.  Commercial in certain locations, dense housing (apartments) in others, parks, schools, single family residences, and roads, trails, and public transportation corridors that connect it all together.   You can tell when you’re in place that’s been planned versus a place that grew up in fits and starts and doesn’t make sense.

Most developers would like to create a place that functions well for their customers and that starts with fitting into the bigger plan for the community.  But when someone sees the empty field behind their house that their kids rode dirt bikes on, or that they walked their dog in, sometimes something snaps when they find the current usage might change.

Mountain towns are infamous for the “pull up the drawbridge, we’re full” mentality.  I’ve seen it so many times.  There are many folks who have their house on the lake, near the creek, or in the dense forest, who object to anything like their very own property ever being built again.  It’s remarkable how emotional folks get in their effort to deny additional opportunities for people to live the lifestyle they so love.

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We cannot poison our waters and cut down all our trees and I’ve never met a developer who wants to do that.  Most understand the reason people want to live in a specific place and the goal is not to ruin that.  A major part of development expense (which ends up in the home price) is when a developer buys land with certain rights, but the plans to develop are objected to by members of the community, and local politicians and government officials don’t play by their own rules or even change them midstream.

There exists a perception of the big bad developer who would poison the environment to make a buck, but I haven’t seen it.  There is however now a whole industry motivated towards fighting development and the professionals who engage in it are no less motivated by financial gain than the developer.

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In real estate development there are many reasons and ways to determine what a parcel of land is worth.  It’s easy to figure out what a house in a neighborhood that has an abundance of sales activity is worth.  We all start with the average sales price per square foot on recently sold homes in the same neighborhood.  Adjust the per sq ft number up or down based on the level of finish (floors, counters, fixtures, etc.), amenities (pool, outdoor kitchen, 3 car garage) and precise location (backs up to permanent open space, views, away from heavy vehicular traffic).

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It’s far more imprecise when considering the value of that neighborhood’s vacant land in the state when no development improvements had begun, and houses had yet to be constructed or sold.  Appraisers are independent certified professionals who can offer an opinion of value on the land, your building, your house, or whatever else you need.  They’re most often called in when you’re securing debt on property, from a construction loan to mortgage, or even the public financing options that I discussed in the previous blog post.  Appraisers are hired by the group or institution that is doing the lending to provide some comfort that there is value in excess of the debt to be provided.

Appraisers are doing the same work as the county assessor and the underwriter for the developer who is trying to figure out what a piece of land is worth.  There are two key ways to determine value on an undeveloped land parcel.  Appraisers use discounted cash flow models or look for market comparables.  In a perfect world they have both.

A discounted cash flow is a business model that shows the cash flows, in and out, over the life of the project.  In real estate development the first big outflow will be for acquisition.  Second, you’ll see outflows to design the project and obtain county or city approvals.  Next, you’ll see outflows for construction of infrastructure and for the team to manage the process.  Finally, you’ll see marketing outflows that ideally soon generate sales, and cash inflows. 

The discounted cash flow (DCF) will take those periodic cash flows and discount them by a factor that incorporates the relative risk of the project, inflation, and bakes in the cost of the invested capital that is used to fund the costs.  DCFs are strange in that the discount rate is negotiable but should be relatively similar to projects with similar profiles and life spans.  Regardless, take all the cash flows in and out over time, apply the discount rate, and you have a present value of the project.  The appraiser is generally going to start with the developer’s model since it’s presumed the developer has a reasonable handle on the costs and the market for sales.

In almost every instance the developer wants the appraisal or valuation to come in as high as possible.  Except when you’re dealing with the county assessor, in which case you want their DCF to generate as low a present value as possible.  Adjusting costs higher or lower, adjusting sales volume and pace, and tinkering with the discount rate will all drastically change a project’s value.  Excel is the tool most everyone uses.

This just begins to touch on the art and science of valuation.  There is a lot of gray area, but it can be critically important in determining if a project will get off the ground.

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Public Land Finance

There are many ways to finance real estate development.   Owner or investor equity and bank debt are the traditional ways to fund development.  But there is another way, unknown to the general public, rather mysterious and complex, and dominated by experts in this niche industry.  Developers can unlock serious funding for public infrastructure if they can develop relationships with governmental entities that are willing to sponsor their plans and can assemble the team of attorneys, engineers, consultants, and financiers that it takes to get it done.

Public finance is a local industry.  As far as I can tell it differs from state to state and some states utilize the tool more than others.  In Colorado they have Metro Districts, in Nevada they have Special Assessment Districts, and in California they have Community Facilities Districts.  I’ve worked on several Community Facilities Districts (CFDs) but assume the mechanisms are similar in every state and also assume all 50 states have a similar tool on their books.

CFDs in California are commonly called Mello-Roos districts, named famously (or infamously) after the California legislators who sponsored the bill that created the structure.  All these districts are a way to promote development of public infrastructure while funding it with a tax assessed on the land that is developed and assumed to have a much-increased value once the roads, sewers, electric lines, stoplights, fire stations, and water tanks are completed that will benefit the land.

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A developer/landowner must partner with a municipal agency that has the legal authority to levy a tax.  Municipal agencies (cities, towns, utility districts, services districts) will engage if there is some benefit to them such as a new fire truck or a new well.    It also allows them to build their empire by increasing the size of the public infrastructure they manage and the residents/customers for their services.

When the developer owns all the land, they can vote to allow a special tax to be levied on the land.  The municipality can then sell tax-exempt bonds based on the special tax they are going to collect over the next 15, 20 or 30 years.  The municipality will engage an investment bank to do their magic to figure out how much total dollar volume can be sold based on the projected tax collection.  They’ll figure out what interest rates need to be offered (lower rates mean more debt can be serviced) and how to sell the bonds to institutions and retail clients.  Of course, the bigger the issuance the bigger the commissions collected by the bank so they’re properly motivated.

The bonds are sold with many disclosures to ensure that bond buyers know the revenue sources that will pay them, what the bonds paid for or will pay for (the facilities), and how the bonds fit into the overall tax load on the properties that will pay them back.  The tax load cannot be too high relative to the value of the property.

The bonds are generally regulated by the SEC and can achieve a rating from the bond rating agencies.  However, if the bonds are being sold ahead of the development happening that will create the value that will support the bonds then you have “story bonds”, with no rating.  The buyer has to believe the seller’s story and believe they can execute on what they promise.  As a bond owner, you look forward to the day in the future when your cash flows are supported by the 1500 new families that own new houses in the brand-new subdivision rather than paid by the one developer/landowner who is in the early stages of taking a large risk in developing the land.

The public financing can significantly reduce the upfront capital investment in the project required by the owner when the bond proceeds are used to acquire the completed public infrastructure from the developer, but the tax obligations and servicing of the debt, and ultimately repaying the bond debt, remain attached to the land until they’re paid off.

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Due Diligence

Due diligence is a term common to many lines of business and industry. It simply means to do your research before making a purchase. According to the Investopedia site it became a common practice and common term with the Securities Act 0f 1933. The law was meant to ensure that investors had access to truthful and relevant financial information and disclosures when considering the purchase of publicly traded stocks and other financial instruments.

In real estate due diligence is a similar concept but can be a very lengthy and complex process, with lots of room for interpretation and errors. You’re looking for a piece of land to develop. You think you have a good idea for how to use the land that will be in demand. You’ve got some money committed for purchase and improvements based on your plan generating a return. Now the fun starts.

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The nice thing about buying land is that you can see it, feel it, walk on it, observe the activity that happens on and around it. But in 21st Century America it can often be what you cannot see that matters. There is no land that someone doesn’t own. And there are a lot of individuals and groups that have rights to land they don’t own.

In Nevada the federal government owns approximately 85% of all land. Even when land is not publicly owned it usually has some designated use in the municipality in which it exists.

The first step in your due diligence will be to figure out what you’re allowed to do with the land. Can you build residential units? Homes or apartments? Can you build commercial? Can you farm it? Does a certain percentage have to remain undisturbed? How tall can you build? Etc.

You’ll find most of the critical information about the property in a title report. The title report will list all the ownership claims to the land. It will list all the easements. The easements determine who is allowed access to the land for various uses. Is there a major utility that runs underneath your property that can’t be disturbed and occasionally needs maintenance? Does someone have the right to drive cattle across your property every spring and fall ? (I’ve seen it). Does a mining company have rights to access some valuable mineral found deep underneath your foundation? Better know now.

When you enter into contract on land the contract will usually define a due diligence period which allows some time for you to perform this research before closing on the property. The contract will usually allow for refund of the deposit if you find anything that’s detrimental to the value of the property. The seller will usually provide any relevant information they have about the land that will help facilitate a sale, but not always. It can be a nice head start but you’ll want to rely on your own team of experts. Lawyers, land planners, engineers, architects, hydrologists, geologists, biologists, and lobbyists may all be critical in determining the allowed use.

There’s plenty more to consider when purchasing land and I’ll revisit this topic in the future. Just remember to leave no stone unturned. It’s often what you don’t know that can be dangerous.

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