Investing for the long-term

Christopher Leinberger of Arcadia Land Co., a leading new urbanist finance theorist, believes that financial returns from new urban communities lag behind conventional suburban development (CSD) in the first few years. But if done right, those new urban developments will greatly outstrip CSD in the long term, he says. (Graph 1 on the next page illustrates his point.) Conventional suburban projects lose their value in the mid- to long-term, Leinberger says, because they are built cheaply — at $35 a square foot, for example, for cinder-block and simulation stucco retail stores — and because the worth of their locations declines quickly as sprawl moves demand farther out. What was once the “100 percent” intersection becomes passé as newer strip malls are built elsewhere. Though suburban centers sometimes get a second life if they are substantially refurbished, they can still fall prey to sprawl and inexpensive construction. Urbanism, by contrast, is more durable, Leinberger says. Quality urbanism uses longer-lasting materials, since it is meant to be experienced up close as one walks past, not from a car traveling 45 miles per hour, 150 feet away — and it generates its own value of place. Three examples of quality urbanism cited by Leinberger are Country Club Plaza in Kansas City, Missouri, developed by J.C. Nichols; Coral Gables, Florida, developed by George Merrick; and Seaside, Florida, by Robert Davis. The first two are 1920s projects that continue to rank among the most valuable real estate in their markets. The third, by Leinberger’s partner in Arcadia Land, was built over the past 20 years. In the mid-1980s, Seaside lots began selling at $15,000. In the first two years, only 20 were purchased, but after Seaside achieved critical mass and shops were built, prices rose rapidly, and lots have recently fetched as much as $2 million. Seaside downtown, by itself, is now appraised at $100 million, Leinberger says, whereas the overall 80-acre parcel was worth just $1 million when Davis started the project. “There has never been a second-home project in the history of this country — maybe the world — that had that kind of appreciation,” he says. “What we are talking about is tremendous value creation if you do it right, but you have got to have a mid- to long-term outlook.” The big problem is overcoming what Leinberger calls “the gap” — the period of several years when most CSD would be expected to outpace New Urbanism in returns. The problem is that the net present value/discounted cash flow analyses used by investors cannot see beyond the 5-7 year period in which CSD hits its peak. A typical real estate project is judged against an expected return of 18 to 25 percent annually. Projects viewed as “risky” (such as mixed-use town centers) must generate returns of 18 to 35 percent in order to attract investment dollars. Whatever value is added after year seven is seen as meaningless. “This is madness,” Leinberger says. Real estate should not be viewed as a seven-year play, Leinberger argues. Instead, it should be seen as a 40-year asset class, the way Merrick and Nichols viewed it. So how does one finance New Urbanism? A developer showing up with a beautifully designed new urban town center or neighborhood is likely to have a hard time at the bank and with investors, Leinberger says. The problem is that the plan doesn’t fit into any of approximately 19 recognized single-use real estate categories. “Notice that not one of the 19 categories is New Urbanism,” he says. “What you are doing is considered wacky. The bankers and investors don’t understand it — and they do not want to spend more than five nanoseconds looking at your project.” A developer may have an easier time if he has already built a successful new urban community — a scenario that is becoming increasingly common as developers move on to their second, third, or fourth projects. In that case, it should be noted, the banker is lending more on the strength of the developer than of the project itself. Regardless of whether it is the developer’s first project, the best approach for financing New Urbanism is to reduce debt and increase equity, Leinberger says. Conventional development is financed with 75 to 80 percent debt and 20 to 25 percent equity. Leinberger recommends 35 to 50 percent equity for a new urban development (see Graph 2). This approach allows developers to spend more money up-front to build a higher-quality place without taking on a crushing burden of debt. This approach also makes bankers feel more comfortable, Leinberger says, and means less money is required from lenders. The increased equity may come from the developers and their partners, family members, foundations, the city, and other sources. Because these sources may have differing time horizons for realizing their returns, Leinberger recommends dividing equity sources into “tranches” or slices. Since conventional investors can’t see beyond year seven, “take advantage of that blindness,” he says. Short-term investors provide what Leinberger calls “first tranche” equity. Those investors should get 100 percent preferred return — preferred means they get paid prior to other equity partners — with no ownership. “Offer 13 to 15 percent with no tail. Get them out in five years.” A potential source of first-tranche equity is Fannie Mae’s American Communities Fund, which invested in the Civano development in Tucson, he says. Another source may be a local foundation interested in redeveloping a downtown. Such an organization would view 13 percent as a very good return. The first-tranche equity makes up 10 to 15 percent of a project’s capital — $1 million to $1.5 million in a $10 million development. Usually this return is cumulative; if the first-tranche investor does not get the promised return in the first five years, the investor gets a cut of later returns, to the detriment of second-tranche investors. More patient second-tranche investors represent the biggest chunk of equity — 15 to 25 percent or $1.5 million to $2.5 million of a $10 million project. The land should be part of the second tranche, Leinberger says. “If the landowner is not willing to be patient [to get paid], walk away from the deal. It will not work.” The developer’s personal equity, family investments, and funds from a local foundation may be in this tranche. Some of this slice of equity may also by obtained by making the land planner or architect a partner. In Seaside, planners Andres Duany and Elizabeth Plater-Zyberk received lots in lieu of payment. (Unfortunately, they sold too soon to take advantage of Seaside’s amazing land appreciation.) Making the architect a partner has another benefit. The designers pay more attention to costs, says Leinberger, who is a proponent of what he calls “value design. You get better design that’s cheaper.” After the first-tranche investors are paid, the second-tranche investors typically get 100 percent of the returns during years 6 to 12 — and long-term ownership of the project. The third tranche, which may amount to 10 percent of total capital, is the very long-term equity — with paybacks after year 12. This equity could take the form of a city putting up a parking garage. In addition to perhaps getting some cut of long-term profits, the city typically counts on receiving increased tax revenues. Third-tranche investors share long-term returns with second-tranche investors. No studies have proved or disproved the findings shown in Graph 1, Leinberger notes. His theories are based on a thousand financial analyses that he estimates he has completed during his real estate career and on his study of places where long-term value has been created. Leinberger is convinced that the demand for urbanism is growing — and it is not being met by conventional real estate methods. “There’s a tremendous groundswell of desire for something different, and those in conventional real estate don’t know how to provide that.” Demand for urbanism will be greatest, he says, in city downtowns, suburban downtowns, corridors connecting to downtowns, and transit-oriented developments, and on land around universities, in miscellaneous special places, and in rural towns. “Or, you can create this stuff,” he adds, referring to greenfield new urban communities such as Seaside and Celebration.