Risk perception of unentitled land

Abstract

Even the most seemingly straightforward developments are not without risk. Given development's speculative nature, developers are taking a risk today that there will be future demand for their project at the time of delivery. Additionally, given the high fixed costs of development, such as land value and construction costs, developers face the risk that their projected rental revenue or asset valuation might shift unfavorably by the time of delivery. While nearly all developments face these risks, developers acquiring a parcel of land that must still go through the entitlement and permitting process are faced with a host of additional risks given the uncertainty surrounding third party approvals. As zoning is a localized set of regulations, the process and associated risks vary from market to market.

The purpose of this thesis is to understand what uncertainties are considered the riskiest by developers and how the clarity of the local zoning code can create or mitigate these risks and impact a developer's risk tolerance. Through a set of interviews with groups experienced in development in three major U.S. markets, this paper explores how developers are pricing the additional risk of acquiring unentitled land into their return requirements and if their methods suggest that they are being adequately compensated for taking on greater uncertainty. It appears that while developers do underwrite a premium for unentitled land, among different unentitled opportunities, this premium is fairly homogenous within a given market. Differences exist however between markets depending on how transparent and easily understood the approval process is.

In a city where the approval process for obtaining entitlements is clear and codified, developers feel confident in the path to construction commencement and therefore underwrite only a moderate return premium. However, in cities with ambiguous or byzantine zoning codes, uncertainty and perhaps even skepticism of the process causes developers to require a greater return premium, resulting in decreased land values, to compensate themselves for the increased risk in obtaining entitlement approvals.