Factors that contribute to the cost of a home [Download PDF]

Over the past three years, developers and builders have walked away from billions of dollars in land options, often leaving landowners with projects midway through the approval process. As the inventory of entitled lots grows, the focus of most of the highly-vaunted opportunity funds and builders leaning toward an asset-light models has been on these lots.

Laurence Pelosi Landowners with property in the entitlement process face an untenable dilemma: wait for the next cycle and risk that new regulatory or environmental constraints will restrict development, or team up with a developer at today's depressed land values to complete the approval. At the same time, many developers and builders–especially those who are capital-constrained–face competition for entitled, finished lots in key markets. An opportunity exists for these two groups to complete these projects' approval and share the value created through the entitlement process. However, it will take creativity and a new paradigm of risk.

Estimates are that public builders wrote off over $3 billion in option deposits in 2006 and 2007, with further impairments expected through 2008. While not all of these were options for unentitled land and some were renegotiated, when you add the options that private builders and developers have walked away from, the total is likely in the billions, representing hundreds of thousands of lots throughout the country.

Despite the market downturn, policymakers and environmental groups push for more restricted growth. California offers numerous examples. SB 375 would profoundly alter residential land use decision-making in the interest of reducing traffic congestion and greenhouse gasses by pushing increased density and transit-oriented development. The bill would have a significant impact on development in "path of growth" locations where many builders focused over the previous years. In the San Francisco Bay Area, a coalition of builders recently shelved a proposal for 25,000 homes in San Jose's Coyote Valley after spending over five years and $17 million attempting to win approval. Finally, urban growth boundaries and restrictive growth measures continue to appear on the ballot in cities and counties throughout the state. Given that full recovery in some California markets may be two to three years away, landowners who attempt to wait out the cycle before completing entitlement of their property may find themselves out of luck.

While landowners are reluctant to enter into new option agreements at today's depressed values and developers and builders are reluctant to try to price land in today's volatile market, they should explore creative option structures to keep these projects alive so that landowners can preserve the value of their holdings and builders can guarantee an adequate lot supply coming out of this cycle. While traditional option contracts might adjust the purchase price depending on the number of units entitled and provide some profit sharing, new ventures are being crafted with fixed-lot residual percentages and "true up" mechanisms that assure each side they're mitigating risk and maximizing value. Residual percentages might be fixed by product type or price point, with finished lots hypothetically being valued at 20 to 40 percent of home prices and target absorption levels established, which can be adjusted depending on the market environment. The landowner might receive significant initial payments once the land is entitled but the balance of their value will be realized once the lots are in contract with builders, with the residual percentages providing the valuation framework and keeping the developer honest. The landowner gives up something on the front end but keeps his project moving forward and, once the market recovers, has an opportunity for significant gain beyond today's option value. The builder mitigates its downside risk but must share in the upside potential. It works.

Laurence Pelosi is an executive director with Morgan Stanley Real Estate. He may be reached via e-mail at Laurence.Pelosi@morganstanley.com.

Learn more about markets featured in this article: San Francisco, CA.