Building and Massing Presentation
5: Financial Feasibility of Development
This is Part 5 of 5 of the Building and Massing Presentation. 6 minutes, 53 seconds.
Dated August 5, 2022. Released to the public August 12, 2022.
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Sections of the Building & Massing Presentation:
- Current and Proposed Height Standards
- Solar Shading
- Proposed Setbacks and Massing Impacts
- Height Ratios and Unit Calculations
- Financial Feasibility of Development
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David Loya 39:07 in the full video in Financial Feasibility of Development 0:00
I want to transition into a little bit more of a new nuanced and higher level conceptual financial model that looks at the relationship between unit density and the feasibility of building these projects to begin with — because those two things are related as well. If we said, well, we want to go with four-story buildings, we want to go with the larger sites that are dedicated to the area — that’s going to inhibit the ability for developers to build units. And the units is what makes these projects pencil. So before we go off on the idea of saying “Well, let’s just have smaller building footprint and lower unit count, and we’d be happy with that.” — you have to ask the question: Is it financially feasible?
Okay, don’t panic, I’m going to explain this graphic. This shows a conceptual model for when a development pencils out.
[Note: The phrase “pencils out” or “pencils” means that the project will be profitable — that is, that the expected income is enough to cover the costs. (It refers to doing calculations with a pencil.) Clearly if the costs are too high or the income is too low – that is, if the income is not greater than the costs involved in make the building — it’s a problem, and it becomes less likely that a developer will build what is (at least initially) projected to be a money-losing project.]
And so this is going to be relative — this could this model could be applied to a single family stand-alone, it could be applied to a duplex, it could be applied to a walk up, and a mid-rise building, or a high-rise building. All of those run on the same conceptual principles, and I’m going to explain to you using this graphic.
On this axis [vertical axis] we’re looking at the cost per dwelling. So this is how much it costs to produce each dwelling unit in any of those different kinds of scenarios. On the bottom here [horizontal axis], you have density, it’s the number of units that are allowed in the code per area of land. You typically use acres in our codes. What you’re seeing in this gray line is the average cost per unit. So some units are going to be bigger and cost more, some units are going to be smaller and cost less. But that’s the average cost per unit for that building type. This orange line is always going to be higher than the average cost per unit because it’s basically taking the incremental cost of adding new units — called the marginal cost. So every time you add a new unit, you’re adding new margin to the cost of the development. And this dashed line is the market price — this is the price that you would get either for rent or for sale of the unit.
[David Loya does not mean that “you’re adding new margin to the cost of the development” – I do not think. I think he means: Every time you add a new unit, there is an incremental cost of building that unit, and you’re adding that marginal cost in order to make that next unit.”]
The marginal costs will increase as density goes up. As the marginal cost increases, it will at some point hit what is considered the market price. That market price cross — where the marginal costs crosses the market price — is referred to as the optimal density. This is the density at which the project is penciling best. It’s making the most return on the investment — it makes the most sense for the developer to do it. When you get above that market price — when the marginal cost, the cost to build a unit — gets above the market price, then you’re starting to lose returns. You’re getting diminishing returns on that marginal cost investment. If your marginal cost doesn’t get into this gray box — this is sort of the profitability zone and this is the price of land that it costs to do the development — then the project is just not going to pencil at all, it’s just you’re never going to pencil it. So that means that the development won’t be built.
David Loya 42:49 in Financial Feasibility of Development 3:45
And so the way to look at this is that the developer is always going to want to hit this optimal density point, but will accept being within this range. You know the area that we’re talking about in terms of hitting the right density count, to make sure that people actually build the units that we want them to build. These two areas are infeasible. So from a financial feasibility point, you get above the market price, or you get below the area of the land value, and the project isn’t penciling either, because you’re getting diminishing returns on the investment. And so there’s no point investing more or because the marginal cost doesn’t maximize the return on the investment to the point — or even meet the threshold criteria — for getting a return on the investment. That means that the ideal density is between where the marginal cost enters this area of land value, if you will, and where it exits the area of land value. So this is going to vary by area, it’s going to vary by market, it’s going to vary by development type. There’s lots of detail to this.
But I want us to understand this concept that there’s a Goldilocks range in density, where if we don’t set the density high enough you’re going to be in this region and the projects are going to be unfeasible. If you set the density too high — let’s say eight-story buildings are in this range where the marginal cost is never going to pencil to make that return on the investment — you’re never going to see an eight-story building built. But what you will see built is what the market can bear. And so this might be four, this might be five, might be six-story buildings.
So if we say to ourselves, as a community, we only want to have four-story buildings because we can hit our unit count that we want — unless we are absolutely positive that four-story buildings is not in this region and is instead in this region, we would be making a mistake. Because if four-story buildings are in this region, they will not be built. So that’s the main point behind this graphic. And I hope I didn’t put too many people to sleep there.
Okay, so just to recap, housing production can be met with smaller stature buildings — there’s absolutely no question about that. And the financial feasibility of projects will be impacted by the development standards: What we set in play as community amenities, what we require in terms of open space, what we require in terms of energy efficiency, and all these other things that are of great importance to us in our community, all have a financial impact on the projects. And ultimately, unless we develop a code that allows developments to pencil — to make money, to make a return on the investment — those developments will not be built.
David Loya 45:57
There’s more that I’d like to talk to you about. But I wanted to make sure that we got through some of the features on how Form-Based Code can further ameliorate some of the impacts, some of our biggest fears about what Arcata might look like in the future, if we allowed every site develop out like these glass boxes. That is not the proposal. No one has suggested that. And I understand it’s been a little vague in some ways. But the next steps as we move through this Form-Based Code process will further refine these glass boxes to give us a better understanding around how we want to grow as a community. And we’re doing that work together.
So again, my name is David Loya. I’m the Director of Community Development. I’d like to hear from you. I know the Council would love to hear from you, as with the Planning Commission. Please reach out to myself or others on my design team in our shop, and we’d be happy to speak with you. I want to remind you that we have many of these resources on our SIRP page. That’s S-I-R-P, Google that and Arcata and you’ll hit our webpage. We also have many of the videos that we produced on that webpage and on our YouTube page. We’re having upcoming engagements to work through the Form-Based Code details in greater refinement with the community and with the decision makers and we hope to see you there.
