How to Forecast your ROI on a Land Development Project; The Entire Process

It's the process used and how well it's executed that makes sure the passing of time doesn't erode the return on the investment. Choose wisely, buy at the right price, and execute properly to make land development projects hit their targeted return, and more.

Sophia, a seasoned land developer with a reputation for excellence, approached each project with a meticulous process, ensuring its financial soundness and profitability. Standing on a piece of undeveloped land, she felt a surge of excitement mixed with determination. She started with a thorough market analysis, diving deep into recent sales data and local real estate trends. As she worked closely with her team of architects and contractors, every detail of the cost estimation was scrutinized. Sophia’s heart pounded with anticipation as she navigated zoning laws and secured permits, knowing that each step brought her vision closer to reality. Her highest and best use analysis aimed to transform the land into its most valuable form.

As the project progressed, Sophia’s excitement grew. She projected potential revenue, assessed financing options, and created compelling pro forma statements to attract investors. Combining all her research and calculations, she set the final pricing, balancing competitive rates with healthy profit margins. Launching the project, she felt a deep sense of pride and satisfaction. Her systematic approach paid off as the development quickly attracted buyers and tenants, generating the passive income she had envisioned. Sophia's reputation as a master land developer was reinforced, her meticulous planning and emotional investment ensuring the financial success and community impact of every project she undertook.

Key Factors Influencing Value

Several factors play a role in determining the highest value use for a piece of land:

Property Type: The type of property that can be built—commercial, residential, or mixed-use—affects its value significantly. Different property types meet varying market demands and profitability potential.

Buildable Area: For condo developments, factors such as allowable height and total buildable square footage based on city bylaws are critical. The density permitted by these regulations directly influences potential returns.

Zoning Codes: Specific zoning regulations extracted from city bylaws dictate what can be built on the land. Understanding these codes is essential in shaping the development possibilities and thus the land’s value.

Execution: With everything in place, targeted returns fall on the team's ability to execute well and consistently. Once this initial information is compiled, it is handed over to a financial analyst.

Financial Analysis

A financial analyst will prepare a pro forma—a detailed financial statement projecting the future income and expenses of the development project. For example, if the analysis shows that 1,000 square feet is buildable, the next step is to find comparable projects offering similar products. This helps in understanding market rates and potential revenue. However, this broad analysis needs to be refined further.

Consider zoning bylaws that might specify for a condo project:

• 60% of units can be one-bedroom
• 20% must be two-bedroom
• 20% must be three-bedroom

Some space must be allocated for commercial use

The financial analysis will include a thorough review of historical sales data for one-bedroom units, projections for new condo construction, and expected market conditions at the time of project completion. Adjustments and indexing of data based on timing and various factors ensure an accurate financial forecast.

In-Depth Market Analysis

An in-depth market analysis involves:

• Studying historical sales data for different types of units
• Estimating the construction timeline for new condos
• Projecting market conditions upon the project’s completion

Forcasting Post-SPA Costs to Determine Purchase Price

Assuming the project can achieve Site Plan Approval (SPA), the next critical step is forcasting the cost of construction and associated development charges. These costs are essential for determining the overall feasibility and profitability of the project.

Construction Costs: To forecast accurately, it's essential to understand the cost of constructing different types of units within the development. This includes knowing the market rates for construction materials and labor, as well as any additional costs associated with the specific type of development.

Development Charges: Each unit will incur development charges imposed by the local government. These charges vary depending on the location and type of development. Calculating these fees per unit helps in understanding the total financial commitment required.

Market Pricing for Units

An accurate forecast also involves understanding the market prices for different types of units on various floors. For example, a one-bedroom unit on the first floor may sell for a specific price, while similar units on higher floors may command higher prices due to better views and less noise. Two-bedroom and three-bedroom units, along with any commercial spaces, need to be priced based on market demand and historical sales data.

This detailed pricing strategy ensures that you have a clear picture of potential revenue from the project.

Selling to a Builder?

• If the decision is made not to proceed with construction, the next option is selling the approved project to a builder. To secure a good price, it's crucial to have a comprehensive understanding of all the associated costs and potential value.
• Application Fees and Carrying Costs: These include the costs incurred during the approval process, such as application fees, holding costs, and financing charges.
• Development and Consultant Fees: This involves the costs for hiring a development team, including architects, noise consultants, traffic consultants, and other specialists. Knowing the exact costs of these services is vital for accurate financial planning.

For instance, if a property is approved for 150 units, its value can be estimated based on historical comparables of similar developments.

Historical Comparables

Analyzing historical comparables involves looking at similar projects in the area that have recently sold. This analysis provides a benchmark for pricing the SPA-approved property. For example, if similar properties have sold for a certain amount per unit, you can use this data to estimate the value of your project.

Detailed Financial Projections

Using all the gathered data, a detailed financial projection can be created. This projection will outline:

• Expected revenue from unit sales.
• Total costs, including construction, development charges, and consultant fees.
• Potential profit margins.

“Conducting thorough due diligence and understanding all financial aspects of the project ensures a solid foundation for investment decisions”. This comprehensive approach helps in making informed decisions, whether proceeding with construction or selling the approved project to a builder.

Interest Rates vs. Project Fundamentals

In any land development project, certain parameters are beyond our control. Chief among these are interest rates, which can fluctuate based on broader economic conditions and central bank policies. These changes can significantly impact the cost of financing and overall project feasibility.

In times of high-interest rates, discipline in project quality becomes even more critical. When financing costs are elevated, it's essential to ensure that every dollar is spent wisely and that the project is executed efficiently to minimize unnecessary expenses. By maintaining a rigorous focus on quality and cost control, developers can increase the attractiveness of their projects to potential buyers. Additionally, projects with strong fundamentals, such as well-thought-out designs, desirable locations, and experienced development teams, will always attract buyers, regardless of interest rate environments. By prioritizing quality and staying disciplined, developers can ensure their projects remain competitive and attractive to investors, even in challenging market conditions.

Controllable Parameters and Strategic Management

While we cannot control interest rates, there are several crucial aspects of a development project that we can manage effectively to mitigate risks and enhance profitability:

• Cost of Construction: By carefully planning and negotiating contracts, we can control construction costs. This involves selecting reliable contractors, sourcing materials at competitive prices, and maintaining strict project timelines.
• Development Charges: Understanding and planning for local government development charges per unit allows us to incorporate these costs into our financial projections and avoid unexpected expenses.
• Purchase Price of the Land: Negotiating the best possible purchase price for the land is crucial. This involves conducting thorough market research and leveraging negotiation tactics to secure favorable terms.
• Closing Agreements and Financing: How we finance the project and the terms of our closing agreements are within our control. By securing advantageous financing options and structuring agreements strategically, we can optimize cash flow and reduce financial risk.

Strategic Land Acquisition and Financing

A key strategy that has proven successful in managing our projects is securing land with long closing dates. For example, we might secure land in March 2022 but close the deal one year later. During this period, there are no carrying costs, and we can expedite the application process. This approach allows us to push for fast approvals while minimizing financial exposure.

Vendor Take-Back (VTB) Agreements: Another effective tactic is negotiating VTB agreements with sellers. By offering a larger upfront deposit or releasing deposits earlier, we can often secure VTBs at lower interest rates than those available in the market. This not only reduces our financing costs but also aligns the seller’s interests with ours.

For instance, consider a scenario where we secure a piece of land in March 2024 with a closing date in March 2025. During this period, we aggressively push for application approvals, ensuring that by the time we close, we are ready to move forward with development. This strategy eliminates carrying costs during the pre-approval phase and accelerates project timelines.

In addition, by negotiating a VTB at a lower rate, we effectively manage our financing costs. As one experienced developer points out, "Securing favorable financing and structuring deals strategically helps in managing cash flow and reducing overall project risk"

This approach allows us to maintain financial flexibility and focus on executing the development efficiently.

The Misconception of Simple Comparables

It’s a common misconception that anyone can succeed in land development by simply using neighbouring properties as comparables. However, unless you deeply understand the Highest and Best Use (HBU) for a specific parcel of land—not just the general area—you risk overpaying and undermining the project's feasibility.

Dangers of Superficial Comparisons

A superficial comparison can be misleading and costly. For example, if a neighbouring property sold for $40 million, it might seem logical to assume your property on the same street has a similar value. However, an uneducated developer who relies solely on this direct comparison, without conducting due diligence, can make a significant financial mistake.

Case Study: The Hidden Pitfalls

Imagine a scenario where a developer purchases land next to a property that sold for $40 million, expecting similar returns. Upon closer inspection, several issues could drastically reduce the value:

- Contamination: The adjacent land might be contaminated, requiring expensive remediation.

- Water Levels: Higher water levels on the neighbouring property can complicate construction and increase costs.

- Zoning Regulations: City bylaws may allow development on the adjacent property but restrict it on yours, significantly lowering its value.

Without thorough research, you might find that your land isn't even worth $10 million. This highlights the importance of understanding the specific boundaries and regulations from city bylaws that can make or break a development project.

Real-World Example

In one of our projects, we encountered a similar situation. For certain sections of the townhomes, we could offer basements, while in others, construction had to be above grade due to ground conditions. This discrepancy arose because certain parts of the land couldn’t be excavated beyond a metre.

Construction Cost Variances:

- Basement Construction: More expensive but increases the property's value and rental potential.

- Above-Grade Construction: Cheaper but offers less long-term value and income potential.

The ability to offer basements in some sections meant we could sell those units for a higher price and market them as more lucrative investments due to potential rental income from the basement units.

This example underscores that it’s not just about having a good location; it’s about understanding the unique characteristics and constraints of the specific parcel of land. As one experienced developer notes, "It's essential to go beyond surface-level comparisons and dive deep into the specifics of each parcel to avoid overpaying and ensure a project's profitability"

By thoroughly analyzing factors such as soil conditions, zoning regulations, and the physical characteristics of the site, developers can make informed decisions that optimize the value and return on investment of their projects.

Importance of Benchmarking For Credibility

When we publish our financial projections, it's crucial to benchmark them against standard industry reports. This practice ensures that our projections are realistic, credible, and aligned with market expectations. By comparing our figures with those from well-respected industry sources, we can validate our assumptions and make informed decisions.

Industry Reviews and Expert Consultations

We rely on several esteemed organizations to review our pro forma and ensure it meets industry norms:

- Altus Group: Reviews our financial projections against industry benchmarks to ensure accuracy and feasibility.

- Cushman Wakefield: Provides valuable market insights that help us align our projections with current trends.

- JLL Reports: Offers comprehensive data and analysis that we use to refine our financial models.

- Pelican Cost Consulting: We engage them to thoroughly review our budget. They compare our numbers with industry standards, providing a detailed analysis of where we stand. Their reports are invaluable for ensuring our numbers are accurate and competitive.

This ongoing review process has significantly improved the alignment of our internal figures with industry benchmarks.

Benchmark vs. Actual

From past experience, we know that if the industry pro forma indicates a 12% return, we can comfortably aim for a 15% return. This confidence stems from our strategic cost-saving measures:

- Commission Sales: Standard industry practice might dictate a 5% commission for all units sold. However, since we have an in-house realty team, our commissions are lower. We can retain 1% of the commission for units sold by our agents, a saving not available to other developers without an internal realty arm.

- Virtual Model Homes: Instead of incurring the high costs of building physical model homes or presentation centers, we use virtual models. This approach is significantly cheaper and provides potential buyers with an immersive experience.

Attainability, Affordability, Sustainability & Development Charges

In one of our recent projects, we are paying $120k per unit to the city in development charges. This cost represents 8-9% of the retail price per unit and is an important revenue stream to the municipality.

Development charges are a significant factor in the overall cost structure, especially for high-priced properties. However, there are exceptions, such as rental buildings, which receive HST and development charge relief to promote affordable housing.

Municipalities often strive to develop real estate that addresses three key needs: affordability, attainability, and sustainability. Affordability refers to housing options that are accessible to households earning a certain percentage of the average household income. Attainability focuses on enabling families to purchase their first home, considering factors such as mortgage payments and down payments. Sustainability encompasses environmentally friendly practices and designs that promote energy efficiency and reduce carbon emissions.

Municipalities will often lower their development charges in order to entice and attract land developers to prioritise these features in their designs which allows a project to meet target returns as well as the long-run needs of the community.

To illustrate, let’s consider a project where industry reports project a 12% return. Our rigorous benchmarking and strategic cost-saving measures, such as reduced commission rates and virtual model homes, enable us to project a 15% return confidently. The land development project aligned with the municipal real estate vision: affordability, attainability, and sustainability and thus qualified for lower development charges as well. This both shortened the time to approval and lowered the overall project costs.

Finally, The Cashflow Forcast: Project Lifecycle from Acquisition to Disposition

Planning for cash flow and understanding the investment thesis is essential for the success of any land development project. Our strategy ensures that investors are not burdened with a large upfront cost but instead, contribute funds in manageable tranches throughout the project lifecycle. This structured approach helps maintain a steady cash flow and aligns investor contributions with key project milestones.

Investment Summary

Investment Details:

- Initial Payments:

- Upon signing: $20,000

- After 6 months: $40,000

- After 12 months: $35,000

- Total Investment: $95,000

- Sale Timing: 30 months (2.5 years) after the final payment

- Sale Price for Desired IRR of 18.2%: $154,000

Cash Flow Schedule:

1. Time 0 (initial signing): -$20,000

2. Time 0.5 years (6 months): -$40,000

3. Time 1 year (12 months): -$35,000

4. Time 3.5 years (42 months after

signing): $154,000

Financial Metrics

Internal Rate of Return (IRR): 18.2%

- The IRR represents the annualized effective compounded return rate that equates the net present value (NPV) of all cash flows to zero.

Average Annual Return (ARR):

- Total Profit: $59,000

- ARR: $16,857.14 per year

- ARR Percentage: 17.74%

- ARR is calculated as the average annual profit divided by the initial investment, excluding the time value of money.

3. Return on Investment (ROI):

- ROI: 62.11%

- ROI is determined by dividing the total profit from the investment by the initial investment and expressing it as a percentage.

This investment approach provides a clear and structured cash flow plan, allowing investors to contribute incrementally:

The total investment of $95,000 is divided into three payments, reducing the initial financial burden.

The property is projected to be sold 3.5 years after the initial investment for $154,000, generating substantial returns.

The IRR of 18.2% indicates a strong annualized return, considering the timing of cash flows.

The ARR of 17.74% demonstrates a solid average annual return relative to the initial investment.

The ROI of 62.11% reflects the total profit relative to the initial investment.

These metrics provide a comprehensive overview of the investment's performance, with the IRR offering the most precise measure of efficiency over time. This structured approach ensures a steady cash flow, aligning investor contributions with key project milestones, and ultimately maximizing returns.