Excess Development Rights
This article addresses how to book a real estate acquisition in which excess development rights or surplus land exists. As real estate developments become more complex (mixed-use, condo structures, air rights) we see property acquisitions in which future development possibilities are part of the acquired assets and should be booked separately on the balance sheet, if possible.
Here are some examples we have seen over the past several years:
Properties with one or more office buildings plus surplus land to build another building, with or without existing entitlements
Parcel with under-developed density in which excess allowable density (FAR) can be sold to another party
Existing mixed-use development that has air rights which can be further developed or sold (e.g. rights to build on top of an existing parking structure that is owned by another entity)
Properly setting the cost basis for these excess development rights can have far-reaching effects on the ultimate profitability of that component of the project. It is not uncommon for the acquisitions team to over-sell the value of these opportunities while under-estimating the costs and time period it can take to convert such opportunities. A common miscalculation is to assume the excess development rights have the same value per area as the rest of the project land area, when in fact, these elements typically require additional zoning, entitlement, planning, engineering, and other efforts before they can be further developed. The cost basis can add up quickly over the course of satisfying all of these requirements.
When evaluating newly acquired excess development rights from an accounting and purchase price allocation standpoint, consider the following:
What is the range of realistic FAR that can be achieved?
What entitlement-related hurdles have to be passed before development can be realized?
How strong is market demand to support additional development?
What is the likely timeframe before development or sale is feasible? Discount the current basis to account for this holding period.
If the excess land or development rights can easily be sold or developed with few uncertainties, and at a predictable price, then simply booking a value commensurate with that sales assumption can be a reliable method. If not, then keep reading.
When calculating the value associated with these excess development rights, the most thorough approach is to build out a cash-flow schedule of all the expected expenses during the holding period and then add the expected net sales price at a date in which sale or development would be most likely. Calculate the net present value (NPV) by applying a discount rate consistent with rates of return required for similar projects in the local market. In some cases the net present value is small enough, or the development requirements too uncertain, to where it doesn’t make sense to apply any value.
Most importantly, do the work now to carve out this element of the property rather than trying to figure it out at a later time. Having to determine a proper basis allocation during the sales process invites several delays and audit inquiries at a time when you have more pressing matters to attend to.