Land Development Returns
For those of you in the land development side (converting raw unentitled/entitled land into finished lots with infrastructure to sell to private/public homebuilders), what are the return hurdles you're typically looking for?
I know every deal is different but I want to get your perspective on minimum return hurdles on an unlevered basis. Or what do you guys usually look for?
This is purely for my own edification. Thanks in advance.
Side note - am I wrong to assume that most land developers don't care about IRR since the projects are so drawn out.
Based on the most helpful WSO content, here are some insights on return hurdles in land development:
Unlevered IRR:
Levered IRR:
Yield-on-Cost:
Deal-Specific Considerations:
IRR Hurdles in JV Development Deals:
Regarding the assumption that most land developers don't care about IRR due to the drawn-out nature of projects, it is not entirely accurate. While the timeline can affect the focus on IRR, it remains an important metric for evaluating the overall return and feasibility of a project.
For more detailed discussions and examples, you can refer to the following WSO threads: - https://www.wallstreetoasis.com/forum/real-estate/trying-to-understand-…</a">Trying to understand the concept of IRR - https://www.wallstreetoasis.com/forum/real-estate/trying-to-understand-…</a">Is there an ideal spread between Unlevered and Levered IRRs?
These threads provide valuable insights into how IRR and other return metrics are used in real estate development.
Sources: Is there an ideal spread between Unlevered and Levered IRRs?, Rough mental return calculations?, Trying to understand the concept of IRR, From Real Estate Finance to Founder of Development Company - Q&A, Real Estate Private Equity Technical Qs
Don't have a ton of knowledge in the space - I work for a developer that does a variety of things and I'm specifically on the multifamily side. That being said we have a land dev side and it seems that they are just targeting a profit margin on the lots when they sell them off. If I remember right I would say 15% net profit margin. We aren't some massive land developer, we're very active in just our local market, so this could be way different than what some large land developers are doing. And like I said, I'm just sharing what I have briefly overheard in conversation.
I appreciate it - thank you.
I think that it’s important to note that in most instances, horizontal developers try to de-risk their deals as much as possible. Not a unique concept to investors…
Place a deposit, but it doesn’t go hard until entitlements are received. Schedule closing, but defer until they have a buyer and tie the closing date to permitting. Most of the risk is in pursuit costs and DD.
On a purely speculative land deal where a closing follows a traditional 30/30 or 60/30 timeline, the return expectations would be much higher than 15%. I’m thinking that returns would be at least 30% or higher for speculative deals.
I am not sure how unnecessary this comment may end up being in situations where the risk for the developer is significantly less risky (typically a land bank scenario w/ a lot servicing agreement or if a developer has a separate agreement apart from the acquisition to develop the land) is where you will see a 15% return. and metrics like IRR really start to matter.
There isn't one land developer that I know of that has been in this business for the long haul that will do a deal any less than 25% margin. If you're underwriting to a 15% margin you'll be out on your ass before you know it. Land is extremely risky and a deal hardly even comes in on budget - for a variety of reasons.
Interesting. 15% feels really light unless you’re delaying closing and money going hard until you have an end buyer lined up.
At a multifamily/condo developer, not specifically land flipping but we look at land sales a lot if trouble raising capital for a build-out option.
Typically 15% - 20% levered margin. Im in a supply constrained market where municipal zoning knowledge and good city relationships is highly valued. IRRs can be 20% to 80%+ so not really meaningful number, just depending on the timeline. Acquiring site, getting approvals, and getting the site shovel ready can be quick if we know the area well and there are precedent/comparable rezonings in the area so city can usually move more quickly.
If you're talking about an actual, full cycle land develop - land acquisition, entitlements, construction, lot sales - then you're looking for a minimum 25% margin. I typically target 30%. Net investor IRR targets of say 20% - 25%. Those with a commercial background may feel that's high, but consider land development is extremely risky. There's deals constantly blowing up, even in the best of market conditions.
For example, imagine you found a home run land deal (minimal sitework required, water and sewer to the property, perfect drainage to an onsite outfall, etc.) in 2018. You spend 2018 and most of 2019 entitling it. You spend the rest of 2019 and 2020 in construction. You deliver in the hottest residential market we've seen in a decade and your building partners are chewing through the lots because sales are amazing. What you thought was going to be a 5 - 6 year sell out period is looking like a 2 - 3 year period, your home run turned into a grand slam. Then all of a sudden you get rug pulled by rates and you find out the market and submarket were more rate sensitive than people thought. Builders slow down and renegotiate their take downs and all of a sudden your timeline gets kicked out to more like 7 - 8 years. It happens - a lot.
Although what's more common is a blown budget. It's all civil site work and so if your geotechnical had an unfortunate bore and you find out actually it isn't clay in that part of the project it's rocky sand - have fun with that. Or you get caught by a sudden rise in construction costs, even though you locked in your lot sales two years ago. So on and so forth.
Remember, in land development you generally forward sell the lots to building partners. So when you're ready to break ground you sell your lots at an agreed upon price and if the market shifts on your or something happens in construction - it's your ass. So many land developers quietly got smoked the last year or two because they locked in prices at say $60,000 / lot and then their construction costs rose from $40,000 / lot to $60,000 / lot, wiping out all profit and then some on that first phase. Have to keep going and hope for a better day where you can make it up on the project overall - later phase.
Have you ever just dont the entitlement side and then flipped the land to a builder? There is a large parcel of land going up for auction near me that's current zoned for something like 2 acres per DU, and I think we could work it to reverse that and get 2 units per acre. We're not home builders though, so we'd just be looking to entitle and flip, sounds like it's possible if you can get the land under forward sale contract.
Yes, that is a business model that has varying degrees of success depending on what market you are in, what submarket the property is in, and where we are in the residential cycle. This was a much more viable model in 2020 - early 2022 when there was a land grab with low interest rates. However, a lot of this has unraveled over the last few years and operators (at least in my market) are back in demand.
The risk with what you are proposing is that a developer or builder can get you very far along in their process with the deal and leave you out to dry at closing and you have little to no recourse. The ability to make this work is financial leverage in so far as you're willing to close on the land and develop it, but would entertain a sale of the entitled project if it makes sense. Many (most) buyers are of the mind set that if you're not a real buyer and you're just trying to flip out of the property, they can use that as leverage against you. Happens all the time.
Can you explain how the forward sale concept for land development works? Does a land developer buy the land and get the lot ready for development (utilities, etc.) and then the home builder comes in and buys the lot at a pre determined price?
Why would the home developer do it at a pre determined price? If the market moves downward, doesnt this hurt them? Or does the home developer not need to close?
I will keep this simple, but it generally goes something like this in full cycle land development:
Developer gains control of the land and secures entitlements. Sometime during the process, but before the Developer breaks ground, the Developer sells the lots to a Builder. The Builder puts down an earnest money deposit on their lot purchase and agreed to a take down schedule. This take down schedule is effectively the number of lots the Builder will close in a given period. So let's use an example to better illustrate this.
Developer acquires a property and is entitling the property for 500 lots. The Developer is going to develop the property in two phases, each 250 lots. The Developer secures entitlements and then approaches a number of Builders to buy lots in the first phase. Builder A and Builder B agree to each purchase 125 lots in the first phase with an initial take down of ten lots and then a subsequent take down schedule of five lots per month. So that's 60 lots a year which translates into a two-year take down period. Builder A and Builder B put down 15% earnest money on these lot sales.
The Developer proceeds to construction and develops the property, delivering 250 finished lots. Builder A and Builder B each make their initial take down of ten lots each, or 20 total. They then proceed to each take down five a month on schedule, or 10 a month. So the Developer will be out of finished lots in 24 months.
Now, let's assume it takes 12 months for construction. Generally what happens is once the Builders are 12 months out from being out of lots (or earlier), the Developer approaches them and asks if they'd like to roll over into the second phase. If things are going well, they generally do. So then they rinse and repeat. New lot prices are negotiated, new lot sales with new take down schedule is agreed to. The Developer breaks ground on the second 250-lot phase and delivers those lots in 12 months, just as Builder A and Builder B are selling their last homes in the first phase.
Obviously, deals are never this clean. But this is ideally how it goes and how both sides think of it on paper.
I don't understand your question. Why would the Developer agree to a set price up front? Or the Builder? If the market tanks between the contract and lot deliveries, the Builder can always walk away from the contract - but it hurts the relationship and costs them their 15% earnest money. So for example, LGI Homes did this a lot in 2022 when interest rates were going higher and everyone was concerned about builders losing market. It absolutely crushed them because the market has been good still and has normalized with builders buying down interest rates to qualify home buyers. LGI Homes lost all their lot positions and others - DR Horton, Lennar, Pulte - picked them up from the Developers. Now Developers don't want to sell LGI Homes lot positions because they lost trust. Given the nature of the business, this is a repeat business that is more like manufacturing than it is real estate investment. So you can burn bridges if you're flippant in your decision making. Like manufacturing, imagine you're a supplier and your buyer keeps turning on and off buying materials from you. That's not good for business. You'd rather have a slower, but consistent buyer.
This is sort of the market norm for land developers and builders. It allows the builders to be 'asset light' in that they effectively control lard swathes of land / lots with option contracts without having to pay up front or hold those lots on their balance sheet. They're builders so once again, think of it more like manufacturing and just-in time. You don't want to sit on widgets and that's all the finished lot is - a widget in the final product - a single family home. So it is no different than say lumber. You want to make sure you have it when you need it, but you don't want to stock pile it and have it sit there as inventory. That's bad business.
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