By. Neil Williamson, President
2019 Summer Economics Series: This summer The Free Enterprise Forum will examine a number of economic theories that impact business development, housing affordability, transportation, and quality of life in Central Virginia. In all cases these issues relate to local government policy not any one particular project
While our community continues to discuss housing affordability and “housing attainability” (a new term for me), developers have often been characterized as the profit seeking villain.
Why? Two reasons:
1. Change is hard
2. People confuse ‘profit’ with ‘exploitation’.
Merrium-Webster defines profit objectively:
I consider #5 to be the best fit for development investment. By seeking a rezoning to make the zoning map agree with the community vetted Comprehensive Plan, developers take on significant risks beyond the approval unpredictability, the time of an application and the market changes that may occur within that time all must be part of the calculation regarding the level of risk involved in the investment.
The Foundation for Economic Education (FEE) has suggested it is time to challenge the negative connotation of profit. Writing for FEE, Economist Richard Turnbull pushes back on those attempting to construe profit as exploitation. He provides 5 reasons profit is good and concludes:
However, profit also allows individuals to act. Through distributing surplus through individuals in employment and investment, profit acts as a mechanism for the well-being of individuals and families. Similarly profit provides the means for philanthropy at every level from an individual contributing to a local charity to the larger-scale activities of the philanthropist.
Suddenly, profit doesn’t seem so bad after all.
There is a story to tell about profit and the good that profit does. We have a responsibility to articulate and tell that story. What we discover is not only that profit has a function and a purpose but that as a concept it is deeply moral.
Development projects are structured so that the lenders are protected against much of the risk while equity investors and the developer take the most risk. If a project is worth 10 percent less than anticipated, the bank or mortgage holder continues to receive its mortgage payments and is generally protected from losses. A mortgage interest rate of 4.0 to 5.0 percent may be sufficient to compensate the lender for those limited risks. The developer, on the other hand, may see no return and may lose his or her entire investment. As a result, real estate development typically requires a premium return over the cost of borrowing and the returns available on less risky investments. At this time in the local market, developers typically target returns of roughly 7.0 percent of total development costs.
Important to all investment returns is the time value of money. If you have to wait five years to receive a dollar, it is worth much less than a dollar in your hand today. This is due to both the direct cost of borrowing and the opportunity cost of what you could have earned with a dollar while you were waiting. Some of the most significant costs of development are incurred during the development approval process. In a six-month approval process, a the total costs of borrowing, insurance and real estate taxes (sometimes referred to as “carry costs”) are much lower than in a drawn-out process of one to two years when the approval process is inefficient and impossible to predict. Architectural and engineering costs also mount quickly as multiple redesigns and submissions are required to secure approvals.
Undertaking a development is less risky and costly when the approvals process is quick and predictable. When the decision is inherently political and made by elected officials, it is much less predictable and more risky, impacting a developer’s willingness to pursue a project. When faced with great uncertainty about future approvals at the outset as a project is first designed, the developer may decide to forego construction of a larger building that needs a special permit and lengthy approval process in favor of a smaller project that can be built with by-right zoning that entails little risk or delay.
Much of the discussion about this report has focused on the roughly 7 percent of total development cost profit margin. Economic theory indicates that absent this level of profitability, those investment dollars will go to other types of investments with different level of risk (and rewards).
The investor group of any project will run a detailed proforma prior to dedicating funds to a project. If the project profit (AKA Return on Investment) does not pencil out, after sharpening the pencil on all the building costs, there are generally two areas for adjustment, land cost and end user cost.
- If the land owner is unable to lower the land costs to meet the market rate unit cost the project will not move forward.
- If the end user cost exceeds the market, the project should not go forward. If it does the unit will likely be overpriced and take significantly longer time to sell (additional carrying costs).
Steven Chandler, a Property Development Expert with over 40 years experience commented about developer profit last January:
Project based gross profits vary depending on the risk attached to the project. Gross profit on my projects allow for company overheads, risk margin and profit margin.
On small projects with short timeframes and “reasonable” risk profiles I use 25% return on cost as my basis. On larger projects with extended periods of time (where risk is greater) I look for better than 25% return on cost for the project…
…And by the way, property developers don’t make money on every project either. When a property developer starts a project they are looking into the future trying to assess what is going to happen with their product over time. Sometimes things don’t work out and the economy and other factors change for the worse. That’s where risk management comes in. emphasis added-nw
The Free Enterprise Forum believes profits drive progress. By providing the appropriate risk/reward balance in any project, money will be available from investors to build the next great thing.
If instead profits become out of proper balance (or worse are locally demonized as evil), investors may use their free will to place their investments elsewhere.
If we embrace the power of the capitalist profit motive, we help move our entire community forward.
Neil Williamson, President
Neil Williamson is the President of The Free Enterprise Forum, a privately funded public policy organization covering the City of Charlottesville as well as Albemarle, Greene, Fluvanna, Louisa and Nelson County.
Photo Credit: industryweek.com