Recreational complexes, pristine pools, golf courses, scenic lakes and hiking trails, sports parks, ball courts, tot lots, and a dog spa. No, this is not a luxury resort. It is a modern-day, master-planned community attracting hundreds of U.S. homebuyers.
Many of today’s successful master-planned communities include an array of amenities. They often contain new schools and areas for entertainment, in addition to retail and business districts. Master plans typically offer a range of residential product types, from large homes with big backyards to smaller townhomes or apartments with efficient living spaces. A well-designed master plan can create a sense of community.
Master plans are appealing from a consumer standpoint, but is it an attractive investment as well? What does it take to build a master-planned community and is it a worthwhile investment?
NEW HOUSING DEMAND
The homebuilding industry is on fire. As of January 2021, home prices were up 11 percent year-over-year, according to John Burns Real Estate Consulting (JBREC), and the U.S. Census Bureau reports new home sales are up 18.8 percent. The reasons for the meteoric rise in demand for new homes can be attributed to historically low interest rates, a tidal wave of aging millennials ready to purchase a family home and a remarkably short supply of housing stock nationwide, among other factors. These trends were already in motion leading up to 2020, but the onset of the COVID-19 pandemic threw gas on the flames and ignited a new rise in demand for newly constructed homes. In the past decade, California and other expensive coastal markets have been experiencing an exodus as people have been opting for locations with a lower cost of living. The pandemic accelerated this migration trend as many people have more flexibility in where they work.
The pandemic also put more emphasis on the preference for suburban homes as people have taken a closer look at their living environment. Homebuyers are more focused on health and wellness, seeking homes that offer more functional interior and exterior space. As their needs and priorities have changed, homebuyers now require homes that provide designated spaces for work, education, exercise and other activities. The Q3 NAHB Home Building Geography Index reported that single-family and multifamily construction continues to outperform in lower-cost markets like suburbs and exurbs, reaffirming these trends.
New master-planned communities are typically located away from urban cores in more spacious secondary and tertiary markets and are a major part of this homebuyer activity. JBREC’s 50 top-selling master-planned developments collectively sold 37,305 new homes in 2020, setting a new record with a 31 percent increase over 2019.
THE PLAY FOR INVESTORS
Investing in and developing a master-planned community can bring a high degree of upside potential. Homes within these communities typically garner about a 10 percent pricing premium over other homes.
Creating a master plan is a complex process and is not for the faint of heart. Resources such as developable raw land and capital are scarce, and some developments can take up to a decade to entitle, let alone build out and complete. However, this complexity can provide an assortment of opportunities for investors and developers. As multiphase projects, master-planned communities are designed to offer multiple product types and sizes that attract a variety of merchant builders that specialize in certain segments. The array of product also appeals to diverse groups of buyers looking for homes that suit their budget and lifestyle.
Compared to other institutional-quality real estate assets, an investor can participate at various stages of development with a relatively small amount of equity capital ($15 million to $150 million), depending on their tolerance for risk and investment timeframes.
HOW IT WORKS
Simply stated, the creation of a master-planned community typically starts with a developer acquiring a large portion of unimproved land (i.e., hundreds or even thousands of acres). Sometimes this land is raw dirt, a farm or an underutilized property. The developer works with multiple government entities, local stakeholders and financial partners to develop and entitle plans for the new community. The developer then segments the community into smaller subdivisions and sells them to merchant builders who create smaller residential neighborhoods, and then sell homes directly to consumers.
From an investment standpoint, there are several points of opportunity for investors with varying degrees of risk appetite to jump in. Consider the three primary phases of development: entitlement, development and construction.
Entitlement plays entail navigating the political process to get land approved for a proposed use. It is the riskiest and can be the most lucrative portion of the development process, especially in markets with tougher entitlement and regulatory requirements such as California. Investors in this space should be more focused on the equity multiple than internal rate of return because garnering these entitlements is almost as much of an art as it is a science.
Once entitlements are secured, the developer can begin moving dirt. The development phase includes site grading and installing major infrastructure such as roads and traffic signals, water lines, sewer and power in addition to sidewalks, parks and clubhouse amenities. This phase is much more of a private equity type of investment as the timing is shorter (12 months to 24 months per phase), with target returns in the 18 percent-plus IRR range.
The final construction is the point at which an institutional player can invest by providing up to 95 percent of the equity a builder needs to complete the homes. Return expectations here should be more than 15 percent.
Another strategy is investing in part of a community at its mid-point of development, when a percentage of the homes and the amenities are already constructed and most infrastructure is installed. An example is the mid-life investment one company made in a master-planned community in Austin, Texas. The project consists of 6,550 total homes, 2,500 of which have already been developed with the community infrastructure and amenities. That organization, in tandem with its investment partner, is developing and building the remaining 4,050 homes.
UNDERSTANDING THE VALUE OF LAND
Land values can and do vary substantially from market to market and even street corner to street corner. Many inputs go into deriving land value, which ultimately affects the entire outcome of project development.
Land is always the shock absorber and its price is a derivative of other development inputs. To arrive at a residual land value, development costs, construction costs, indirect (“soft”) costs, builder profit and development fees are all subtracted from the ultimate sale price of a home. As any of these inputs fluctuate, the value of the raw land goes up or down accordingly.
Few understand the true value of the single-family for-sale home market. The aggregate value of U.S. homes is $34 trillion, according to Zillow. This staggering number is almost equal to the combined 2018 GDPs of the United States and China.
Despite the extraordinarily large size of these numbers, surprisingly little institutional capital is invested in the residential for-sale arena (absent of mortgages). A lack of intellect is not what holds investors back, but a lack of knowledge and experience in a complex business. Master-planned communities offer many benefits for both investors and homebuyers. For those considering entering the space, finding an experienced partner that understands every phase of development is critical to successfully navigating the process.
Chris Bley is co-president and chief investment officer IHP Capital Partners.