Uncertainty and land prices
But what determines the value of land? The land owner wants to sell for the highest possible price, the land buyer wants to buy for the lowest possible price, but what yardstick helps to determine the proper value of land?
Well, my theory, which I believe is pretty sound, is that the potential profit value of development is what decides how much the land will sell for. In essence, a development generates revenues that are the difference between the market value per square foot and the construction cost, times the number of square feet that can be built.
Land owners know this and will set their expectations for the price of the land they sell accordingly. It’s important to understand that, generally speaking, only the building itself generates revenue. Parking (unless it is tolled) doesn’t generate revenues, neither do trees or grass (green buffer space), etc… It’s the building that generates revenues, that is either rented or sold to people who want to use it. The rarer the land, the more land owners can negotiate a higher share of these expected revenues, the more abundant the land, the lower the share they can negotiate.
So what does that mean for urban developments? The market value is largely an input from the real estate market, it’s relatively easy to get from looking at other developments. Construction costs can also often be approximated based on local construction costs. So the big question here is how many square feet of revenue-generating floor area can you build? That will determine what the land is worth.
So we come back here to the Floor-Area Ratio. I once said that it was not a proper vector for urban regulations because there is no direct negative externality of FAR that justifies its direct regulatory control. However, I may have jumped to conclusions too soon. The point is that controlling FAR may actually help the market determine with a greater amount of certainty the total potential revenue of development on land.
For example, if the value of office space is, say 300$ per square foot (not the rent, the actual value), and the construction cost is 200$ per square foot, that’s a total revenue of 100$ per square foot. If allowed FAR is 200%, then that means that development revenue is limited to 2 square feet of revenue-generating floor area per square foot of land. So there is a ((300$/sq ft – 200$/sq ft) X 2 sq ft floor area/sq ft of land) 200$ revenue associated to each square foot of land, which is a hard cap on land value. If land owners get on average half the total revenue, then the land value would be about 100$ per square foot.
|Front setback and minimum margins reducing the area the building can cover, here, the maximum coverage is 42% of the lot, if there is a height limit, then FAR is indirectly limited (for example, if 5 stories are allowed, maximum FAR is 210%)|
…or through minimum parking requirements, then this helps clear up the uncertainty as to the amount of revenue-producing floor area that can be built on any given lot. This helps both the seller and the buyer of the land establish a potential land value, and thus helps them come to an agreement on price much faster.
But what happens when you keep zoning very strict with the expectation that you will consider requests for variances and zoning changes on a case-by-case basis?
The result is likely to be making development less likely, as land owners price their lots well over what they are currently zoned for while developers, afraid of risk, may balk at the idea of paying land a certain price that is only justified with a zoning change.
Other impacts: corruption, blackmail and administrative bottleneck
Everywhere in the world, arbitrary power is always associated with another phenomenon: corruption. Without strict guidelines, this gives the freedom to public administrators to make decisions based only on their own feelings without having to explain them to anyone. As a result, given the massive amount of money involved, developers have an incentive to do all they can to get administrators to come down on their side. I’m sure developers would prefer doing their thing without having to grease a few paws, but in the context of arbitrary urban planning, the temptation may be too great.
This may also go the other way, with either administrators or even sometimes NIMBY groups using the situation as leverage to extort favors from developers. For example, forcing developers to pay directly for the repair or replacement of local infrastructure, or forcing the developer to provide public goods like parks in exchange for building permits. This can result in much higher prices for new constructions as all the burden of providing for local infrastructure needs can be unloaded on them alone. This doesn’t mean that having developers provide certain social goods is a totally bad idea, rules that establish certain
Finally, there is one final drawback. Setting up a case-by-case review process of every project is extremely expensive in terms of labor and time. Since cities have a limited amount of planners and architects, if there is a construction boom, then the review process might get congested as the urban planning department is overwhelmed with projects to review and comment. This can lead to delays and a limit on how many projects get the green light in cities, limiting new constructions just when demand is highest for them.
All these factors coalesce into one major final negative effect: the elimination of small-scale developers who do not have the funds and expertise to deal with all these issues and of small-scale developments that do not yield the revenues to justify facing down all that process.
I think what cities need is not more control by urban planners and architects, but less… arbitrary inputs in the development process need to be reduced to a minimum. Where rules exist, they must be applied upstream, based on clear, established guidelines to reduce, or even eliminate, uncertainty. When upzoning is required to deal with higher demand (and I believe rules must have a pro-redevelopment bias), this upzoning should be gradual and affect a large area, not just spot-by-spot rezoning based on specific reqests. Even exceptional projects should ideally be realized in the context of specific rules, for instance through the purchase of “air rights” (buying unused FAR limits or height limits from lesser density developments) or incentive-based zoning (giving FAR or height bonuses for certain initiatives).
As in most things, in terms of urban development, the rule of law must be predominant, not the rule of men, in order to provide certainty and to level the playing field.