School of Architecture, Carleton University, Ottawa, Canada
City Organization and Planning:
Study of Enterprise of the City --
Urban Economics, Design and Real Estate Development and the Sustainability of the City
Over Investment in Real Estate
We know that value of real estate is largely dependent on density. The higher the density, the greater the value of land, as a general rule. In Ottawa, Canada in 2007, sites for construction of residential condominiums in downtown Ottawa generally sell for $10 to $15 per sq. ft. of FSI (Floor Space Index). So a one acre, downtown site (43,560 sq. ft.) with an FSI of 12 and a price of $10 per sq. ft. of built-up space might sell for more than $5.2 million or $120 per sq. ft. of land area.
A site that only had a FSI of 8.0 would probably sell for less- $80 per sq. ft. of land or around $3.5 million. Obviously, a site that is further from the city centre will, all else being equal, sell for less as the rent gradient falls as you move further from the city centre. This happens in most cities because: a) there are more services at the city centre, b) there are more transportation links at the city centre, c) there are more cultural and job opportunities at the city centre, d) higher building heights and greater densities are usually allowed at the city centre, e) there is more demand and a finite supply of land which drives up site prices at the city centre which in turn requires greater heights of buildings to take best advantage of a scarce resource (land) and to put the land to its highest and best use, which is the sine qua non of good planning.
The 'all else being equal' condition implies that crime rates, vandalism and other urban ills don't over run the city core and that the core is not a sea of mono cultured commercial office buildings that empty out at night. The above assumes that enlightened planning policies are in place that encourages mixed use and multi use of the city centre.
But there is another dimension to the value of real estate; it is not just dependent on density and location with respect to the city centre. Real estate value is also dependent on the passage of time- for example, the time to lease up a new Commercial Office (CO) tower or to sell through all the residential units in a new condo. So even if a city had no height limits or density restrictions, a developer would not necessarily build a larger building than he or she could expect to sell or lease up in a reasonable time period.
Value of Real Estate = a function of (demand, supply, population growth, dwelling occupancy rate, density, FSI, height limits, location with respect to the core, interest rates, economic growth, rents, crime rates, planning policies, time to lease up or sell through, inflation rates, employment growth, unemployment, etc.)
Now this equation is practically useless in terms of making decisions about the appropriate density for a given site and its highest and best use- there are too many variables and many of them are dependent variables (that is dependent on others within the equation).
Perhaps we can simplify the equation by identifying the independent variables. Maybe we could say that:
Value of Real Estate = a function of (density and the inverse of time);
since density subsumes to some degree, demand, supply, population growth and dwelling occupancy rates and time subsumes interest rates, time to lease up or sell through, inflation, unemployment, employment, rents, crime rates and so forth.
This is undoubtedly simplifying matters but it is probably a good first approximation for the value of any site- if you know what density you can develop and you know how long it will take you to lease up or sell through a project, you can probably come up with a good idea of the return on a given project (its IRR, Internal rate of Return).
Let's look at a typical suburban site that is 1.25 acres and has a FSI of 1.0. This site will thus allow a CO building to be built that is 54,450 sq. ft. If it has a floor plate of 18,150 sq. ft. (pretty typical for a suburban office building), it will be a three storey building surrounded by a sea of parking. In the attached spreadsheet (Immediate Lease-Up Spreadsheet), you can see that the IRR for this project over a 20 year period is 11.2% per annum, assuming that the building is 100% leased on the day it is completed.
Now if it takes five years to lease up the building (Five Year Lease-Up Spreadsheet), you can see that the IRR has fallen to 10.6% p.a. and if it take 20 years (20 Year Lease-Up Spreadsheet), the IRR falls again to 9.3% p.a. In the 'worst case' scenario where net rents are just enough to cover mortgage costs (i.e., there is zero NOI, Net Operating Income) for the entire 20 year period, IRR falls to 8.3% (Zero NOI Spreadsheet).
Obviously, most private investors would not construct a project where there is no operating cashflow for a 20 year period (i.e., no cash on cash return). Their equity would remain locked in to the project and it would be producing no income for them. However, in the example I am using here, the growth in the value of the building over 20 years and the 'wealth' effect from having your tenants pay down the mortgage over that time combine to produce an 8.3% annual return. For a large sophisticated pension fund or an insurance company or REIT (Real Estate Investment Trust) with low cost of capital, this may be an acceptable way to 'run the railroad' but for most private investors, this is reminiscent of the 1980s when real estate developers hoped that inflation would bail them out- they hoped that even if they had negative cash on cash returns, the value of their portfolio would increase faster that their losses and that they would be able to sell their buildings before they ran out of cash.
This is the "Tarzan" strategy- you hope that when you swing to the top, there is another vine just waiting there to take you home to Jane. Essentially, they had two strategies for survival- a) they can sell their buildings for ever increasing amounts (the 'greater fool' theory) or b) they can refinance their buildings to pull cash out when needed by finding a complicit appraiser willing to give their buildings ever higher valuations and banks or other lenders and funders willing to loan against these higher appraisals.
This resulted in a huge bubble in Japan at the end of the 1980s where the value of real estate in the precincts of Tokyo exceeded the value of all the real estate in the continental US; obviously, a correction was going to take place and it did. The impact on the national economy of Japan was felt for the next 15 years and the Japanese are just now (in 2006/07) really over the effects. Canada and the US also suffered but to a lesser extent. Nevertheless, the real estate recession here was really a six or seven year affair. Those that don't remember their history are doomed to repeat it.
If we assume that there is no net operating income and real estate inflation is -1.25% instead of +1.25%, the IRR drops to 5.6% p.a. (Zero NOI and Negative Inflation Spreadsheet).
We certainly have a commonsense notion of what over-investment in real estate means in a residential context. Bill Gates, Michael Dell and Michael Cowpland (founder of Corel and co-founder of Mitel) have all built enormous homes that costs in the tens of millions of dollars. They are not the first generation of entrepreneurs to do this. In Ottawa, the lumber barons did the same thing 100+ years ago as they profited from the enormous wealth that flowed from Canada's forests.
Now all three entrepreneurs have argued with their respective tax assessors (with varying degrees of success) that despite the outlandish costs of their mansions, the FMV (Fair Market Value) is much lower and, therefore, their tax assessments should be based on market value and not cost and hence their realty taxes (property taxes) should be much lower.
Clearly, they have over invested in their properties but I don't think that matters much to them. But it certainly could matter to you and me. This is similar to the notion of progression or regression in real estate. If you buy the smallest and least expensive home on a block of mega homes, you are likely to benefit from progression- the value of your home will be pulled up by the others around you. Unfortunately, the reverse is true. If you build a monster home in amongst a neighborhood of small bungalows, you are going to experience regression, you will not get the value out of your monster home when you sell it.
Almost certainly, the forces at work in terms of reducing the IRR of a CO project when it takes longer to lease up or the rental rates are lower than you would have hoped for or real estate inflation is less than you expected, will have a larger impact on projects that depend on sales- for example, the length of time it takes to sell through a condo project or a residential or industrial sub-division. I will leave those calculations for another time though. The bottom line- we want to address the density deficit in most North American cities by building taller buildings that take up more of the site but not at any cost. Remember that by addressing the density deficit and making neighborhoods more mixed use and multi use, we can address, at least in part, the affordability question (higher density and lower square footage per capita may make housing and office costs relatively more affordable) and we can make our cities more sustainable if people can walk to their jobs or to a store and, generally, make fewer car trips and use public transit more effectively.
But having said this, building vertically is expensive and, after a certain point, counter productive (beyond a certain height the area of the floor plate that is taken up by elevators exceeds the entire floor plate). So over investment in real estate is counter productive and does not lead to greater levels of environmental sustainability. Think about money as representing a given amount of goods and services; for that amount of goods and services to be produced, there is an energy component and a certain level of environmental impact which is unavoidable. Therefore, throwing away money by over building is, by definition, leading us away from higher levels of sustainability. So we want to density and we want to build more neighborhoods that are mixed use and multi use but we also want to optimize the level of investment and its IRR which will also have the happy effect of (hopefully) reducing environmental impacts.
Copyright. Dr. Bruce M. Firestone, Ottawa, Canada. 2007.