New urban projects yield solid returns

But only a tiny percentage of U.S. real estate dollars are now invested in neotraditional developments. or every dollar that institutions invest in traditional neighborhood developments (TNDs), an estimated $1,400 goes into conventional real estate projects. While TND investment is minuscule in relative terms, it has totaled an estimated $1.1 billion — a figure that has grown by 60 percent annually over the last five years. Cultural and economic trends indicate that TND investment will continue to grow at a rapid pace. One reason is the strong interest in “Smart Growth,” i.e. compact, mixed-use, pedestrian-oriented development (see article on page 17), and the New Urbanism. Another is that many TNDs are providing developers with strong returns on investment (see Table 1). Annual returns on most of the six projects listed range from 25 percent to 45 percent, measured by the annual increase in market value of developed property as determined by sale and resale prices. The TND returns substantially exceed the real estate investment returns reported in the National Council of Real Estate Investment Fiduciaries Property Index (just under 9 percent average annual return over the last 10 years). The TNDs also exceed the returns from common stocks (S&P 500), which have a 10-year yield of almost 16 percent. The figures come from published reports and interviews with developers. The six TNDs listed are not a representative sample (although they do comprise nearly 20 percent of all U.S. TNDs that are far enough along to be analyzed financially). All six are located in the Southeast. More study is required to obtain defensible figures for TNDs generally. Sources of institutional investment in TNDs In 1996, institutions invested an estimated $460 billion to finance real estate transactions. Outstanding cumulative institutional investment as of 1997 amounts to about $1.5 trillion, according to Real Estate Capital Markets Report/The Roulac Group. That total, broken down into categories and subcategories, is compared to the $1.1 billion in TND investments to date in Table 2. Institutional investors include banks, pension funds, insurance companies, government credit agencies, investment trusts and private investors in large properties — nearly all conventional development financing sources outside of individual equity. TND investments fall under six subcategories: 1) Corporate owners of large properties have funded some of the larger new towns. Examples include Dis-ney’s investment in Celebration (Orlando, Florida) and Weyerhaeuser’s Northwest Landing (Dupont, Washington). 2) Real Estate Investment Trusts (REITs) have made sizable investments in a handful of projects. Examples are the Columbus Realty Trust (now Post Properties) investment in Addison Circle (Dallas, Texas) and the Federal Realty investments in neighborhood centers. 3) Life insurance companies have made loans to developers. One example is Northwestern Mutual Life Insurance Company’s debt financing of Haile Village Center in Gainesville, Florida. 4) Bank and mortgage companies were a source for such projects as Amelia Park in Fernandina Beach, Florida, (First Union National Bank) and Daniel Island in Charleston, South Carolina, (National Bank of South Carolina). 5) Government credit agencies have put capital into projects such as Southlake near Orlando, Florida (Florida Housing Finance Agency). 6) Life insurance companies have contributed equity, e.g. Leucadia National Corporation (Colonial Penn holding company) financed Rosemary Beach. Upfront capital Real estate developments in general, and TNDs in particular, require substantial upfront capital. By averaging projected development costs from the financial forecasts of eight TNDs currently under development, it was determined that TND developers expect to spend, on average, $12,525 per lot for raw land, planning, permits, and infrastructure — including streets and utilities. Basic infrastructure in these projects also supports an average of 175 square feet of neighborhood commercial per housing unit (it should be noted that many of the eight developments included are designed to draw retail customers from surrounding residential areas) . Using those figures, a hypothetical TND — with plans for 500 homes and 87,500 square feet of neighborhood commercial, retail, and public buildings — requires a financing commitment of approximately $6.3 million (assuming average land costs). Phasing may reduce the initial infrastructure costs, but a substantial portion of those dollars must be expended before a single house can be sold. Today, finding this much money for a TND is very difficult. So far, most TNDs have obtained their financing from individual investors or from conventional bank loans in which repayment is guaranteed by relatively wealthy individuals. The exceptions are large corporations which have embarked on TNDs — e.g. Disney, Leucadia National and Weyerhaeuser — and REITs. Why TND investment share is so small Institutions currently concentrate on short term investments (five years maximum). Short term investments help reduce the risk of exposure to a real estate downturn. By their nature, TNDs are a longer-term investment. Although some have done well in early years, they are generally structured to yield higher returns later than conventional development. TNDs are designed to be more than the sum of their parts, and it takes many years to develop all of the elements, i.e. retail, mix of housing types and community amenities, which add to the value of neo-traditional projects. Also, TNDs generally have no market comparables nearby — therefore little data is available upon which to base house and lot values in early years of the project, delaying the time when peak yields are achieved. The exception is Rosemary Beach, only 12 miles from Seaside, where buyers have an easily understood point of reference. Rosemary, consequently, may have had the best first-year financial return of any TND to date. Conventional real estate investors have a number of tendencies which steer them away from TNDs. Investors “follow the money,” which is currently flowing to conventional development projects. They make decisions quickly and like “no brainers,” but TNDs are more complex than single use projects, requiring more thought. They do not want entitlement or construction risk (TNDs are a new concept and therefore often are more difficult to get approved and built). Also, the trend towards “securitization” — i.e. packaging real estate so that it can be bought and sold on Wall Street — favors standardization of product. The complexity and novelty of TNDs puts them at a disadvantage with regard to securitization. Why TND investment is growing Two rules of conventional real estate development offer encouragement to TNDs. First, institutions are expected to have at least some of their portfolio in “specialty investments,” including mixed-use properties. However, institutions require higher yields from such investments. Second, successful investors want to be on the next bandwagon — early and in a big way. To all appearances, the next bandwagon is TND. Furthermore, traditional Neighborhood Development will grow because it fulfills the needs of a growing number of people who see suburbia as dysfunctional and dislike sprawl. This market segment wants to break free from automobile dependence and seeks community. “Sample the attitudes of suburbanites today and you’ll find a growing number who think their lifestyle is becoming more difficult and less appealing,” reports ERE/Yarmouth’s Emerging Trends in Real Estate: 1998. “And for the first time they’re beginning to consider alternatives.” At the current rate of increase, the total invested in TND will rise to more than $10 billion in the next five years — a scenario that is not unrealistic given the number of projects that are planned, financed and just beginning construction. Investment in TND may, in fact, increase faster. One reason is that TND investment is a hedge against risk. The principles of investment diversification found in Harry Markowitz’s classic concept, Modern Portfolio Theory (MPT), argue against allocating all of a real estate portfolio to conventional development. By imposing constraints on conventional investment and by diversifying into TND and New Urbanism, the portfolio risk is reduced, according to MPT. Discontent with suburbia and traffic congestion and concern over use of fossil fuels may play a role in eroding the value of automobile-dependent development in the long term. In this scenario, pedestrian-oriented, mixed-use TNDs likely would appreciate. Thus, trends away from conventionally designed development mean increased value for New Urbanism. Furthermore, the multiple-use design complexity that makes financing for TND more difficult will, in the long run, mean richer, more vital communities that continually appreciate, according new urban theorists. Home Prices in TNDs Command Premiums Across the country, developers have sensed that home prices in TNDs command significant premiums over comparable units within conventional suburban developments (CSDs) in the same market area. Only recently has hard evidence been collected and analyzed by independent researchers. A study by George Washington University researchers (see the November/December, 1997 issue of New Urban News) examined Kentlands, a TND in Gaithersburg, Maryland, and found a $30,000 to $40,000 premium attributable to neotraditional design. A follow-up study will look at a half dozen TNDs around the country. Lot prices in TNDs are commanding premiums as well. According to data compiled by Montgomery Newsletter for 1993 through 1995, 99 finished lots at Kentlands sold for an average of $15.92 per square foot. A total of 601 finished lots at twelve other Gaithersburg area subdivisions sold for an average of $6.31 per square foot. That premium likely is attributable both to Kentlands’ design and its smaller average lot size. Lots at Tannin, a Duany Plater-Zyberk designed TND located 100 miles west of Seaside in Orange Beach, Alabama, now are selling for $22/square foot, while beachfront property across the highway is fetching only $7/square foot. The lots in Tannin are not on the beach. While TNDs require expenditures that developers of conventional pro-jects do not incur (village squares, community amenities, wider sidewalks, alleys), they also offer significant potential savings. In a report on traditional development, The Wall Street Journal concludes that “New Urbanism ... is turning the economics of residential development topsy-turvy.” The Journal cites “...a recent study sponsored by Ottawa-based Canada Mortgage & Housing Corp. [which] found that traditional neighborhood development costs a developer about 24 percent less per dwelling largely because smaller lots make roads and utilities less expensive for each unit.” The savings depend on TNDs achieving higher densities than CSDs. boosting liquidity, reducing risk Significant institutional investment in TNDs awaits greater securitization, risk pooling and risk segmentation. More money into REITs that specialize in New Urbanism is one avenue to securitization. Commercial mortgage backed securities (CMBS), are among the hottest investment innovations in real estate, and very little, if any, of this money is being invested in TND. New Urbanism represents a potential outlet for CMBS because TNDs include commercial and multifamily components, and the financing for these elements could be packaged and sold as CMBS. Pools of money, such as investment funds, that spread risk over many TND projects, are another vehicle that could achieve an investment rating. Securitization of TND investments would provide greater liquidity and substantially reduce perceived risk. Neotraditional projects, which may take a longer time to reach peak yields than conventional real estate development, likely are better suited for equity investment — which means investors contribute money in return for a share of profits — rather than debt financing. The interest clock on loans causes bad decisions and compromises, whereas the success of TND ultimately depends upon not compromising design principles. As some of the early TNDs mature in coming years, financial data on the trend will increase substantially. If returns continue to be positive, the data will boost the comfort level of potential investors in New Urbanism. u Robert Chapman III is the president of the TND Fund, an equity investment group for neotraditional developments, based in Durham, North Carolina. Contact: (919) 403-7654.