Until now, we’ve focused our analysis on an existing productive asset—archetypically, a rental property. Such assets represent the bulk of real estate investment in many countries, and they are, in some sense, the primal or underlying asset of real estate. They provide productive services for long periods, evidenced by the rental income flow that they do, or could, generate. (Some assets are owner‐occupied, but that doesn’t mean they aren’t providing valuable benefits for their occupants.) The production of profitable income‐generating, “stabilized” assets is the purpose and reason for being of the real estate development industry. (“Stabilized” means that they are operating normally, at near full occupancy most of the time.)

We now shift attention to development projects, to the process of creating built assets—that is, of creating stabilized assets, like our example in the preceding chapters.

All stabilized real estate assets physically consist of two parts; these are the:

• Land that provides the location and site; and
• Structures that constitute the built space necessary to produce value.

In the United States, on average across all the existing real estate assets (including old and new buildings), about half of the total property asset value is attributable to the structure, and about half to the land. The land is neither produced nor consumed, but we must build the structure (and the structure will ultimately depreciate to zero value). We refer to the construction process that produces a built real estate asset as a real estate development project. Beginning with this chapter, and for the remainder of this book, we focus on development projects.

11.1 Time‐to‐Build Difference between Development Projects and Existing Assets

Development projects are particularly interesting and important. They represent the visible physical and economic process of creating value. They bring new real estate assets into the world. They transform financial capital into physical capital.

Real estate development projects are also capital intensive, as construction usually represents a large fraction of their total cost. Since real estate structures tend to be very long‐lived, development makes a major, long‐lasting impact on the physical and social world, for better or worse. It is important to do development projects as best we can, for environmental, social, and economic reasons.

From an economic and management perspective, there is an essential difference between a development project and an existing built real estate asset. This is the difference between when you pay for and receive the asset. With an investment in an existing asset, you pay the price and obtain the productive asset now, simultaneously. With a development project, however, there is a gap. You pay for the construction of the asset over time and obtain its value only upon its completion and stabilization.

With an existing asset, the timing of the investment decision is essentially the same as the timing of receipt of the net present value (NPV) of the investment, the value of the asset minus the cost (price) you pay for it. In other words, the investor experiences the benefit (the value of the built asset) and the cost (the price to buy it) together, at the same time. In contrast, with a development project, there is a “time‐to‐build” period between the timing of the investment decision (the commitment of the land and the investor to the construction project) and the receipt of the benefit or purpose of the investment—the productive, stabilized built asset.

When valuing a development project, we start the clock when the developer decides to invest in the project and commits the land to its construction. We define this as “Time 0” for the development. (Note that the developer may already own the site before starting the development project, but commitment of the land still incurs the opportunity cost of the land, as the opportunity to sell the land at its then market value is foregone at that time.) The project thus incurs part of the development cost (part of the cost of the investment), particularly the cost of the land, up front, at Time 0.

The project incurs much of the investment cost after Time 0. This consists of the cost of building the structure (or structures, if the project involves more than one building). It is only at the end of the construction process, which we label as “Time T,” that we have fully paid for the development (or the first phase of it) and receive the newly built asset (or its first phase).

This gap between the start of the project and the completion of construction, the “time‐to‐build” between Time 0 and Time T, complicates the computation of the NPV of the investment in the development project, compared to that of the simple purchase of an existing built asset. Part of the complication lies in the fact that it is appropriate to apply different rates of the opportunity cost of capital to the construction costs and to the built asset, because they have different levels of risk.

11.2 Lower Opportunity Cost of Capital for Construction Costs

In general, the opportunity cost of capital (OCC) appropriate for construction costs should be quite a bit less than the OCC of the built property. This is for two reasons:

• Construction costs tend to be relatively stable; and
• We can better mitigate their risks.

In short, lower volatility means lower OCC, but let’s explore this issue further.

There is typically less uncertainty about future construction costs than about future real estate values. In most countries, the “price elasticity” of supply of construction goods and services, which consists largely of labor and materials, is quite high at any time. (“Price elasticity” refers to how production changes with changes in prices. Economists define it as the percentage change in quantity divided by the percentage change in price.) This means that a small change in price will evoke a relatively large change in the quantity supplied.

High price elasticity of supply tends to keep construction prices stable. This is because, when demand for construction increases, the supply increases apace, and the resulting competition among construction suppliers keeps prices from rising much. Vice versa, when demand falls, construction firms lay off workers, stop ordering materials, and drop out of the business. This reduction in supply prevents construction prices from falling much. Cyclical variations in margins are a minor part of construction costs, and long‐term trends, such as keeping up with inflation, do not create volatility.

In contrast to construction costs, much of the value of the built asset lies in its location value, the land component, the supply of which is very constrained (inelastic). This causes real estate prices to vary considerably with changes in demand, unlike construction prices.

Furthermore, to the extent that there is uncertainty or risk in the construction costs within a given project, these risks are largely specific to the particular project. (This is referred to as “idiosyncratic” risk.) Surprises in construction costs likely relate more to technical issues than to market or financial issues. And the contractor may provide a guaranteed price contract, relieving the developer of most of such technical risks. (Cost overruns due to change orders from the developer don’t count as price increases, because the developer is receiving greater “quantity” of construction product in return.) Because of these considerations, there is little covariance between developer’s construction costs and financial market returns in the capital markets (see Box 11.1). This means that, in their overall investment portfolios, investors could diversify away any such idiosyncratic construction cost risks that may exist. In the capital market, investors would thus not require an extra ex‐ante return premium for assets whose cash flows mimic construction costs. This makes the OCC of construction costs low.

At this point, students sometimes protest. They say, “But construction is really risky; developers need to treat construction cost with great caution!” Their first instinct is to want to apply a higher OCC rate to construction cost to reflect the high risk. How does this observation fit with the argument that the OCC for construction costs should be lower?

The explanation for this seeming contradiction lies in the fact that we are dealing with two different meanings of “risk.” Thus:

• Construction is “risky” in the sense that it is a large fraction of the total value of the project, and it is a negative element in the profit (NPV). This means that, if you underestimate construction cost by much on a percentage basis, you can drastically cut into the project profits. We certainly agree that developers need to treat construction cost with caution. The analysis needs to be careful not to underestimate the magnitude of the expense of construction when analyzing the profitability of the development project. In the NPV framework that we are here employing, this translates into “Don’t underestimate the present value of the construction cost.”
• But, such “risk,” defined as profit sensitivity to cost, is not what determines the OCC for investments in the capital market. Recall that the OCC is the discount rate that is relevant for translating future money values to present money values. The capital markets determine this rate in the manner described earlier in this section.

In an NPV (investment profit) analysis of a development project, we are working toward a present value of construction cost, starting from a projection of what that cost will be at a future date when it is time to pay for it, which is when the construction cash outflow will occur. It is in this situation that we should view both the risks and thus the OCC (discount rate) from the capital market perspective, and hence as being lower.

To demonstrate that it is correct to use a lower OCC for construction costs, consider the consequence of applying a larger discount rate to these costs. We would end up with:

• A lower present value magnitude at Time 0 of future construction cost paid at Time T;
• A smaller construction cost amount to subtract in calculating the NPV of the project as of Time 0; thus
• Making the project appear more profitable; which is
• Just the opposite of what we want to do to reflect the risk of construction!

Thus, the economic perspective that the OCC on construction costs should be relatively low actually confirms and implements the instinct to recognize the riskiness of construction costs when designing and planning a development project from an investment perspective.

Consistent with this, it is reasonable to assume a construction cost OCC rate of around 3%, for example, if the real estate OCC rate is around 7% (as we have been assuming in the previous chapters). This 3% rate is what we will assume for our illustrative simple development project.

11.3 Illustrative Example

To better understand how investments in development projects differ from investments in existing assets, let’s explore a simple example. We compare two investments:

• Rental investment: The property from the Chapter 1 case ($1000 PV pro forma with resale in 10 years);
• Development investment: A project to create that same stabilized rental property, combining land and construction costs, over a 1‐year time‐to‐build.

This illustrative development project is as simple as it could be, but contains the essential differences between investments in development and investments in existing built assets. Specifically in this case, the differences are that the development:

• Does not receive the net cash flow of the rental in Year 1 because the building is not already complete;
• Has to pay for construction at the end of Year 1, at the end of the time‐to‐build; and
• Combines two elements, land and construction, with only the land component being paid for up front at Time 0.

Apart from these differences, the example investments are identical. They have the same net cash flows over time and the same growth rates. Note, however, that the OCC for construction and built real estate differ, as discussed in the previous section. Table 11.1 summarizes the relevant parameters for the valuation of the projects. (We will use upper case to refer to the two alternatives as if they are the names of two specific, real investments: “Rental” and “Development.”)

Now let’s explore the value at Time 0 of the Development (that is, at the end of “Year 0”) that delivers a property worth $1020 after 1 year at the end of Year 1. (Recall that all values and cash flows are quoted “in arrears”—that is, as of the end of the year.) The Time 0 value of the asset the development project will produce is:

(11.1)

This differs from the $1000 value of Rental at Time 0. This is because the Development does not benefit from the net cash flow in Year 1 ($50), which has a present value at Time 0 of $50/1.07 = $47. Indeed, at Time 0, we have:

(11.2)

The Development in effect makes a “forward purchase” of the Rental property. This purchase is worth less at Time 0 than the Rental, which is an immediate purchase of the already‐productive asset. Development is worth less because it does not benefit from the net cash flow over the “time‐to‐build” period.

Now let’s consider the construction costs. What is their PV as of Time 0? We might suppose that, if paid at Time 0, these costs would be, for example, $650. But supposing construction costs also grow at 2%, the bill for Year 1 construction will be 1.02*650 = $663. To obtain the Time 0 present value of the construction costs, we need to discount them using the construction cost OCC of 3%. Thus:

(11.3)

We can thus calculate the NPV of the Development at Time 0 exclusive of land cost. It is the residual—the difference between the PV of the benefit (the forward purchase of the built asset) minus the cost (the PV of the construction cost):

(11.4)

11.4 Residual Value of Development Land

This residual value of $310 in Equation 11.4 is the economic value of the land, with two caveats. This calculation presumes that the:

• Project is the highest and best use (the so‐called “HBU”—the project that has the maximum feasible residual value) for this site; and
• Timing is “ripe” to undertake the project (it is better to build now than to wait and speculate on further growth in land value).

In these conditions, $310 is what we could expect to sell the land for. So, $310 represents the market value of the land, and therefore the opportunity cost of not selling the land but instead undertaking the development project. (That is, $310 is what we’re foregoing at Time 0 by doing the development project instead of selling the land.) This land price provides expected returns sufficient to compensate for the investment risk in the project, since we have computed the $310 residual by discounting the future cash flows at their OCCs.

Under the above assumption about the land market value, what are the implications of alternative prices? If we could obtain the land for:

• Less than $310, then the project would present the investor with a positive NPV (evaluated at fair market prices), suggesting super‐normal profit for the buyer/developer (but sub‐normal profit for the land seller).
• More than $310, then (at least in the view of the landowner) the project is either not the highest and best use for this land site, or else the time is not yet “ripe” for launching the project. It would be better to wait and continue holding the land available for future development.
• Exactly the market value of $310, then NPV = 0 for the development project net of the land cost, which is the classical criterion sufficient to make the investment acceptable from the standpoint of market value. Price equal to market value indicates that an investment is fairly priced from the perspectives of both sides—that is, the investment provides just the market OCC rate of return, ex‐ante.

11.5 Investment Risk in Development Project

We can use the computed market value of the development project to estimate its investment risk. We can do this by first determining the expected return to the investment in the project when the investor pays market value. In our case, the expected profit at the completion of the construction project at the end of Year 1 is:

(11.5)

Therefore, the return on investment, at the market value (fair) price, is:

(11.6)

Assuming the project is the HBU and the land is ripe for development, this 15% must be the economic OCC for the investment in the land. (The land is what enables the development project.) This 15% OCC thus reflects the amount of investment risk that is in the project, as the capital market perceives and “cares about” (prices) such risk (as reflected in asset market values).

The development project thus has quite a bit more investment risk than an otherwise similar existing built asset, or than what the asset that is being constructed will have once it is complete:

(11.7)

To obtain a more precise estimate of the difference in risk, we should subtract the risk‐free rate from each OCC in order to estimate their risk premiums (see Section 2.5). Assuming the risk‐free rate to be 2%, just slightly less than the 3% construction cost OCC, we obtain:

(11.8)

This implies that, as far as the investment marketplace is concerned, the development project has times the amount of investment risk as an investment in an otherwise identical already existing (stabilized) built asset.

The reason development projects typically have more risk is fundamentally because of the leverage that is inherent in development projects. Mathematically, a development project is essentially equivalent to an investment in an existing stabilized asset using borrowed funds.

To illustrate this concept, suppose we could borrow money for 1 year at an interest rate of 3%. Then, at Time 0, we could borrow $643 and combine that borrowed money with $310 of our own money to purchase a 1‐year forward claim on a rental property for $953. (We have already seen that this is the value of such a forward claim on a property that is today worth $1000, including the present value of its Year 1 expected cash flow of $50, which the forward claim would not provide.) Then, in 1 year, if all goes well, we will take ownership of the rental property that we expect to then be worth $1020. We will then owe and pay back 1.03 × 643 = $663 on our loan. Thus, we will have an expected net at Year 1 of: $1020 − $663 = $357. Not coincidentally, this exactly equals the expected profit from the development project. In other words, the development project is mathematically equivalent to the forward investment in the existing property using borrowed money. That is, development is a levered position in the fully operational real estate asset.

As we know from finance theory, leverage magnifies both the risks and returns of investments. Note in particular that the development project in this example is not riskier because the development is speculative (not yet leased). The example assumes that the asset to be built will yield exactly the same operating cash flow as the existing stabilized (fully leased) building. We assume, in effect, that the development is pre‐leased. Speculative development (without pre‐leasing) would add even more risk.

The type of leverage that is in the development project is referred to as “operational leverage.” The type of leverage that would be in the purchase of a stabilized income property using borrowed money is referred to as “financial leverage.” Operational leverage is inherent in development projects. You can’t avoid it, because it is in the nature of the construction process. Financial leverage, on the other hand, is a choice made by the investor, relating to the capital structure chosen for the investment (or for the firm making the investment).

11.6 Conclusion

This chapter introduced the essential economics of real estate development projects. In particular, it compares development to investment in otherwise identical existing built property assets. We saw that the essential difference between the two is in the timing of incurring the costs and benefits of the investment. This has implications regarding the different levels of investment economic risk between the benefit (the to‐be‐built asset) and the cost (the construction).

We have seen how these considerations lead development investments to be inherently riskier than built property investments, owing to the effect of operational leverage. We have also seen how land value derives from the present value of the highest and best use development project for the site, as the residual between that value and the present value of the construction costs.

We have demonstrated these points concretely by extending the simple numerical example of the rental property presented in Chapter 1, showing how we can quantify the economic features mentioned in the preceding text.