While an ongoing housing correction has depressed residential land prices by more than 30% in some parts of the country, commercial property values are moving in the opposite direction, say experts. Such a substantial jump in commercial land values is leading some investors to plop down big dollars for large tracts in the path of future growth.
The stark contrast in land values is becoming increasingly apparent. The median cost per acre for single-family residential land took a nosedive from $98,500 at mid-year 2005 to $69,018 just 12 months later, according to a national market analysis by Chicago-based commercial brokerage Grubb & Ellis. On the commercial side, including retail, hotel, apartment and office properties, the median price per acre during that same period rose from $159,753 to $170,940. Industrial land, meanwhile, spiked from $130,009 to $165,162 per acre.
Conditions that led to the housing industry's pain — overbuilding, rampant speculation, aggressive lending and high foreclosure rates — simply aren't as prevalent in the more disciplined commercial sector.
At the same time, several major homebuilders have been taking sizable write-downs on the value of surplus land in their development pipeline. KB Home, for instance, reported in December it was taking a write-down of more than $300 million on the value of its land holdings from lost earnest money and other pre-acquisition costs incurred from abandoning land-option contracts. D.R. Horton announced its own $199 million write-down in the fourth quarter, as did luxury homebuilder Toll Brothers, which took a $115 million write-down.
Even after dumping land and options through much of 2006, the nation's 11 top public builders still have land stockpiles that are more than a year in excess of their needs, according to Carl Reichardt, senior analyst at Wachovia Securities. A report by Credit Suisse analyst Ivy Zelman last fall showed that publicly traded homebuilders invested $35.2 billion in new land and land development in 2005, up 36% from the previous year. When the final numbers are tallied for 2006, Zelman projects an additional jump of 8% in land investment and related costs.
As public home builders continue to unload land positions in 2007 to appease shareholders, some private builders, investment groups and developers are out shopping for bargains, albeit mostly in fast-growth areas of the West Coast and the South and Southwest, several land experts say. Some public builders are contracting with third parties to hold onto land.
California-based Lewis Group, a residential developer with assets exceeding $1.5 billion, has served in that role, but the lending environment doesn't encourage it now, says Doug Mull, the company's vice president of land acquisition and development. “Leverage is structured so you just don't see much wild land speculation. Most of the land banking now is done by [long-time] owners.”
Although large residential land buys have slowed to a trickle even in many of the faster-growing U.S. markets, purchasers of commercial land have been unfazed by the trend, says Dennis Smith, president of Home Builders Research Inc. in Las Vegas. “Anywhere there's job growth, you'll see commercial [land] sales holding up pretty well now,” he says.
Banking on future growth
Despite the potential risks, some investors have decided to acquire land in the path of future growth in select locations. The Adler Group, based in Miami, recently partnered with Apollo Real Estate Advisors to form the Florida Land Bank fund to focus exclusively on future retail development in the Sunshine State.
Thus far, the upstart land bank has closed on 53.5 acres of land zoned for future retail development, including 26 acres in St. Lucie and 26.5 in Bradenton for a total of $15.5 million.
Adler's strategy is based on projections that Florida, which currently has a population of approximately 18.6 million, will surpass New York as the third most populous state by 2011, buoyed by continued migration of Baby Boomers and retirees.
The fund targets commercially zoned property near future residential developments where projected income levels will be high enough to lure retailers, says Matthew Adler, the firm's executive vice president.
“We're buying that great corner that all new residents are going to pass by some day on their way to the highway.” Although developers have no problem pinpointing promising retail sites, they seldom have the financial wherewithal to wait for them to mature, says Adler.
For the Adler Group, preferred sites are typically 20 to 50 acres, but they can be as small as one acre, says Adler, noting that the property-hold period ranges from three to five years. Generally, the fund buys from a speculator or a family owner, using 50% debt on acquisitions. For example, $25 million in capital raised will generate $50 million in buying power. Apollo commits 90% of the dollars and Adler Group provides the balance.
The partnership buys land at $4 to $6 per sq. ft. with an anticipated hold period of three to five years and a targeted sell in the $9 to $12 per sq. ft. range. “Obviously the big risk is figuring out that hold period,” he says. “This is purely speculative and we get no [ongoing] return from the property in that time.” Public and private real estate operations have expressed interest in using the fund as a resource, he adds.
While speculative investors can potentially strike gold, commercial land banking largely remains a dormant art because of dwindling inventories, rising prices and the weight of rising property taxes and other annual carrying costs, explains Doug Haney, president of valuation & advisory services for CB Richard Ellis' North American operations. “It is not a good process for most people. It is parked money. Those carry costs can add up in a hurry.”
The Tax Reform Act of 1986 dampened many of the incentives for long-term investment, says veteran land broker Whitney Kerr of St. Louis-based brokerage Colliers Turley Martin Tucker. Prior to the act's passage, investors could structure deals to take large paper losses through accelerated depreciation and then deduct those losses from their other sources of income.
The tax laws were changed to deter some speculators from buying properties only for the annual tax write-offs they generated. Except for the now-defunct Resolution Trust Corp.'s clearance sales of the early 1990s, which followed the savings and loan bust, smaller partnerships and syndicates have steered clear of buying large tracts as a result of the tax changes, Kerr notes.
Land bank open for business
Some of the more marketable tracts in the U.S. have recently been “un-banked” by the timber industry. In 2006, International Paper completed the sell-off of 5.67 million undeveloped acres in the U.S. for $6.6 billion — or just under $1,200 an acre — to reduce its debt and refocus its business.
Gobbling up vast tracts may be the ideal strategy for developers looking for specific opportunities to buy land wholesale for major projects such as ground-up communities. Privately held PEC Development of Atlanta picked up nearly 4,000 acres along the shores of the Gulf of Mexico in Baldwin County, Ala. between Mobile and Pensacola, Fla., to build a master-planned, mixed-use development.
Financed by Hearthstone, one of the nation's largest institutional real estate investors, the land purchase “will give us a place to do business for a long time,” says Paul Corley, CEO of PEC, which has two slightly smaller master-planned communities in the works totaling nearly 5,000 acres.
“When you're buying land in such sizable quantities, you are also able to do a lot of pre-planning, from roads to schools to highway access points,” says Corley. Build-out of the Alabama project will take 10 to 15 years. The tax and debt service on the land “will be our challenge going forward,” he says. To address those issues, PEC plans to sell off some non-core parcels.
Land investment in the 5,000-acre town of Mountain House in San Joaquin County, Calif. has been rife with fiscal challenges. Trimark Communities, a subsidiary of SunChase Holdings, started buying land options and seeking development approval as far back as 1990 for the property, which will be home to the first new California city to be developed in over a quarter century.
Like PEC, Trimark will recoup some of the estimated $400 million it's spent on infrastructure by selling off select pieces to developers. Roughly 2,500 acres are planned for homes, 700 acres for commercial projects and at least 750 acres for parks, ecologically protected areas and water access. The first homes opened there in 2006.
Pressures to sell piecemeal
Opportunities to latch onto such big tracts, however, are waning. The majority of prime, long-held family-ranch tracts of 100 acres or more have been sold off in recent years, says rural land expert Charles Gilliland, research economist with the Texas A&M University Real Estate Center.
Most have been carved up and sold piecemeal because developers seldom can afford to buy them en bloc. Younger family members show a continued eagerness to sell what they consider unproductive family land. “In fact, with higher land values and taxes, families aren't holding onto real estate today unless they absolutely have to,” he says.
One such tract, a nearly 25,000-acre cattle ranch in Santa Barbara County, Calif. that includes nine miles of Pacific coastland, sold last month [January] for an estimated $155 million, or a little more than $6,000 per acre.
The buyer, Los Angeles-based Coastal Resources, is controlled by an investor team that includes the Boston investment firm, Baupost Group. The group has yet to divulge plans for the largely undeveloped, agriculturally zoned property, which combines the 15,814-acre Jalama Ranch and 8,580-acre Cojo Ranch.
Multifamily developers on the prowl
As demand for single-family homes and condos softens, some developers are turning to apartment-zoned land despite fast-rising prices, says Bruce Breslow, vice president of the land services group in CB Richard Ellis' Reno office. Lately, multifamily developers are paying premiums for properties, anywhere from $130,000 per acre for apartment land in Michigan to about $500,000 per acre in the Reno-Lake Tahoe area, Breslow says. The average sale price of non-industrial commercial land nationally, which includes apartment property, jumped from $124,000 per acre in early 2004 to $170,940 at mid-year 2006, according to Grubb & Ellis.
On the industrial front, prices and demand are equally high. “There is a huge demand for industrial product, a huge demand for tenants needing space and huge demand for investors wanting industrial investment products,” explains CBRE's Haney. “Office and retail properties are also growing in demand — albeit a little more slowly — despite residential land's woes.”
At year-end 2006, commercial land sales in the southern U.S. from the mid-Atlantic area to Texas outperformed the rest of the nation, although with some moderating in Atlanta and softening in Florida, says Brian Curry, who heads New York-based Cushman & Wakefield's valuation group in San Diego.
Cushman & Wakefield officials also have observed some industrial land that was rezoned to residential revert back to industrial use in the past year. Boston Properties, a diversified real estate investment trust, recently indicated that it may transform some of its residential properties to office sites in 2007, a move that may hasten an uptick in office construction in tight markets such as New York, according to a recent report by the National Association of Real Estate Investment Trusts.
A wakeup call
Many residential landowners are just now coming to grips with market realities, says Curry. “It was a very interesting year in 2006 to the extent that you no longer had large buyers, yet the sellers were not quite willing to concede what their property was worth yet,” he says.
Even as residential land drops in value, there is still the perception on the part of some investors that all land prices are inflated, says Nancy Muscatello, senior real estate economist for Boston-based Property & Portfolio Research, a data provider for institutional investors.
Those inflation fears may be justified. Since 1975, the land portion of the average U.S. home property has risen in value from 37% to 46%, or nearly half of the home price, says Muscatello, citing data from land researchers Morris Davis and Jonathan Healthcote.
According to the economist, in an eight-year period ending in 2005, the brick-and-mortar value of homes rose 66% while the land those homes are built on increased 142%.
Steve McLinden is a Dallas-based writer.
How to bank land and beat high taxes
You can have your land and develop it too — without incurring the huge tax bite that many owners suffer when they start making improvements to their property.
Through a little-known tax-planning strategy called “land banking,” property holders can save up to 20% on annual tax bills by setting up separate corporations that concentrate on development activity and others that focus on investment activity, says James Walker, a senior tax partner and real estate specialist with Denver-based Rothgerber Johnson & Lyons.
Historically, real estate owners were reclassified from investor status to developer status in the eyes of the Internal Revenue Service (IRS) when they began making improvements to property such as site-prep work that's designed to increase its value.
That site improvement proved to be significant when the property was sold because it produced “ordinary income,” which tops out at a 35% tax rate, instead of the far friendlier ordinary capital gains rates of 15%.
But in 1992, that interpretation started to change. A four-person joint venture in Texas used the land-banking strategy by selling its property to a separate development corporation, consisting of the same four people.
The IRS challenged the joint venture's treatment of its profit on the sale as capital gains, saying it should be taxed as ordinary income.
But in a landmark case, Bramblett vs. Commissioner, the Fifth Circuit Court ruled the venture had legally separated its investment and developer activities and should be taxed at the capital gains rate (15%). Several similar cases have since reaffirmed this tax strategy, says Walker.
Thanks to a succession of court rulings over the last decade, owners can sell a property to a separate corporation they control, which in turn handles the marketing and improvements of the land.
Although the land-banking structure is not formally penciled into the tax code, it is consistently validated by the IRS these days.
Walker, the tax specialist, estimates that only one-third of land developers eligible to employ the strategy take advantage of it. “It's important they review this with their tax advisors very early in the entitlement process to make it work.”
— Steve McLinden