After writing my last post about 4 Things You Learn As A Real Estate Operating Partner, we ended up having a capital partner back out of a deal we had underwritten a week before we were scheduled to go hard. Over the past few days my boss and I have been talking about what went wrong, and what the future of the land development industry holds. He thinks that maybe there is going to be a long term shift from having institutional capital back land deals to having high net worth individuals and family offices doing more of these deals.

Background

My boss has worked in the land development business for over 20 years. The first portion of his career was spent on the institutional side before he left to start his own firm that served as an operating partner for capital providers. Over the course of that time he’s seen a shift in how institutional capital goes after land deals. At the beginning of his career firms had a much stronger appetite for land deals. Since the deals were riskier than commercial deals but had tremendous upside, they almost acted as call options. However after the credit crisis there are now fewer firms willing to invest in land for several reasons. Land is illiquid, it has a longer time horizon, it’s riskier than commercial real estate, and it’s incredibly hands-on. The last point is crucial: you can buy a hotel or an office building and not have to do that much in terms of management. Land is much more management intensive and oftentimes you need to have a local team that knows how to get things done in the market to make the deal work. This is both time consuming and expensive.

In the current climate the builders have gotten so aggressive in going after land that there is now oftentimes not enough margin in deals for them to pencil for developers. It’s already almost impossible to underwrite an unlevered deal in Florida; you have to put a community development district bond on it for the deal to come close to
penciling.

Where will the capital for these deals come from?

As institutional capital shies away from land, the answer might be that the capital is going to come from individuals and families. These types of firms can internally fund the deals which means that they have a much lower cost of capital. They are willing to accept a lower return which in turn allows them to pay more. Their time horizon is longer, and oftentimes they are willing to invest in hairier deals since they don't have to take deals to get approved by an investment committee. A lot of capital providers won’t back an entity sale or something in a tertiary market because it doesn’t fit their mandate even if the potential returns (and risk) are extremely high. Family offices and individuals are more often willing to pursue those types of deals.

What does the future hold?

The housing recovery has gained steam this year as home prices have appreciated nationwide. New home construction, which was severely depressed the past 5 years, has picked up and new household formation is on the rise as well. We are going to need to bring several million new housing units online in the next 6-8 years just to meet growing demand. There is still a future for land developers because someone has to deliver those finished lots to builders. It’s quite possible though that instead of institutional-backed projects we will see family offices becoming land barons.