Asking Too Much From the Land

I remember standing below a 15-foot-tall retaining wall that ran the full depth and half the rear width of a roughly 14,000-square-foot residential building pad. Like the wall, most of the project it was part of was built before I was given management responsibility. Building that wall will probably cost approximately $80,000.

I couldn’t help but wonder if we had, given the extra cost, made any money on it. And, more importantly, had anyone even gone to the trouble of determining whether we would?

As developers, we are taught to approach real estate projects like any other type of investment, and rightly so. The same elements of investment apply, and truly, whether a real estate project possesses groundbreaking design elements or very simple aesthetics, the bottom line, no pun intended, is that it must achieve the desired return. In my experience, though, I’ve seen too many examples where developers do not behave rationally as they should and instead simply equate maximum revenue (or, more simply, maximum unit yield) to maximum profit.

My argument is simple: for any given parcel of land, there is an ideal financial profit, and it rarely, if ever, exists at maximum yield.

If you remember your economics courses, you will recall the concepts of marginal cost (MC) and marginal revenue (MR), marginal cost being that extra cost for one more unit of production, and marginal revenue being that extra revenue received for one more unit of production. You will also remember that profit is maximized when MC = MR. How do we apply this concept to the reality of for-sale residential real estate? If we set the x-axis of that classic MR/MC curve to the proposed parcel yield, it becomes clearer. Even though total revenue increases with yield, marginal costs will typically increase exponentially for those last few units. Squeezing in those last few lots typically requires some extraordinary engineering element or design consideration and regularly condemns developers and projects to miss or underperform the expected returns. And unfortunately, these decisions sometimes decide if the project winds up being profitable at all.

The question turns to the origins of those exponentially higher costs. In my experience, they fall into two categories: "conspicuous” and “inconspicuous.” Conspicuous costs include things such as:

● Creek crossings were created to get access to additional parts of a parcel.

● Retaining walls are built to create additional “useable” lot areas where the existing topography doesn’t naturally support it.

● Road improvements are required to obtain these higher yields. Inconspicuous causes are less tangible and can be more difficult to recognize and evaluate.

They include, for example,

● Costs indirectly associated with municipally restricted parts of the project, like disturbance limits or tree save areas.

● Increased earthwork costs on projects where the entirety or majority is designed as either lot area or restricted area, as there are fewer areas to swap and balance material

● Expensive export scenarios where excess material must be trucked off the job because there is little to no room to swap or waste topsoil and structural material

Certainly, there will be some parcels, perhaps in other parts of the country than mine, where profit is maximized at maximum yield. But, in my market, with topography, jurisdictional waters, and regulations creating unique constraints on each project, profit is maximized at some point below the absolute maximum yield. My position is simple: developers must continuously examine and estimate the financial impacts of engineering decisions while the design process runs its course.

“The same elements of investment apply, and truly, whether a real estate project possesses groundbreaking design elements or very simple aesthetics, the bottom line, no pun intended, is that it must achieve the desired return”

If a $500,000 creek crossing gets access to 10 additional lots, does that additional $50,000-per-lot expenditure create an additional return for the project? Even if the project breaks even from a pure cost perspective, it will cost the project time, and the same return generated now is better than the same return, say, six months later. If a lot is created that requires a retaining wall and costs $80,000, will the resulting home sold on that lot generate a profit of more than $80,000 and justify the wall’s inclusion in the design? If not, simply abandoning that lot is the more profitable decision.

If developing a lot incurs $40,000 in additional export costs, will that significant sum be returned? May be not.

Each of these hypotheticals demands analysis. Challenge that creek crossing that only yields ten more lots—and consider the total cost of adding them. Challenge the need for that retaining wall—does it create any value or just make the schedule longer or worse? Many engineers think they are serving their clients best by maximizing yield and, ultimately, costing them profit instead. That is not the engineer’s fault—it’s the client’s. Don’t allow them or your lack of evaluation to ask too much of the land.