I had an interesting conversation the other day with local developer Tom Hickman. The subject of rising connection fees and various other RTB (right-to-build) costs came up. The RTB is not the price of vacant land. It’s as if you subtract the total cost of the building from the overall cost of the project. What you’re left with is the cost of the land PLUS all the permit fees, carrying costs, connection fees, etc.
When water & sewer fees increase, there is a general assumption by local government. The assumption being that this is a way of development paying for itself. Another popular approach, fostered by many home builders, is that this is a tax on future home-buyers. That an extra $10,000 in fees will result in $10,000 extra in the sales price.
Tom couched it in different terms, ones I had never considered:
“The developers aren’t bearing that cost. Neither are the home-builders or home-buyers. It’s the guy who owns the land before he sells it to the developer. Think about it - you’re a developer, you see a piece of land and you want to build a house. Here’s how I look at it: For simplicity, let’s assume there’s room for one unit. Assuming there is high market substitution (i.e. rentals, lower priced existing housing, etc.), and therefore good elasticity, the developer looks at the market and figures it will support a $350,000 house. Now let’s say, it costs $150,000 to build the house. That leaves $200,000. Let’s say all the site costs (permits, drawings, connection fees, etc.) cost $90,000. That leaves $110,000. To make the deal worth the risk, let’s say I need to make $50,000. That leaves $60,000. The land ends up being worth $60,000 to the developer. Why? because the deal won’t get done if I have to pay more than that. If the sewer fees go up $10,000, now that land is depreciated (in terms of development) to $50,000. “
This seemed so straightforward I was shocked I never heard it before. Is it just me, or does this make complete sense?
2 Comments
Yes, this makes sense because the most inelastic component in the whole process is the end price the consumer will pay for the house…this number also changes in the future up and down many years after the land purchase decision is made which creates even more risk and uncertainty which further drives down the initial land price the developer is willing to pay. Land sellers get more money by selling to the end user(s) but this implies small unit sales or offerings (ie one lot).
Great Points! It would be interesting to see a data set of raw land appreciations compared to RTB costs over the same period of time. I’d be curious to see what cycles or correlations exist. I only raise the issue in relation to those investors who knowingly buy land in a future growth corridor. They buy with the intention of holding for a longer period of time and making money off of future appreciation. Is there a “sweet spot” in the cycle? I’d be curious as to how someone like Wendell Wood approaches this issue.