How Big Is an Incremental Step? Let’s #DoTheMath

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This project hasn’t reduced our cost per square foot over the second option, though the smaller 1,000-square-foot units would be less expensive than the larger units in the first two options. You couldn’t do this project under current zoning for a host of reasons, but if you could design it and get it permitted, would it work as a for-sale project? Maybe… If they were really nice. But you couldn’t get financing to build it unless it also worked as a rental building. 

Rental buildings are valued based on their Net Operating Income (NOI = Revenue minus Expenses, before figuring in debt, taxes, etc.). The ratio between NOI and sales prices is called the “cap rate.” A cap rate of 6.5% would be pretty typical in our market for a building like this. Then NOI would have to be around $21.67 per square foot per year. If operating expenses are 35% of gross revenue (at typical figure), then the gross rents would need to be about $33.34 per square foot per year, which translates to a monthly rent of about $2,775 per month for a 1,000 square foot apartment. That’s pretty high for Providence, even on the upper end of quality. Maybe you could do it, but it would be quite risky.

Takeaway Lessons

Existing buildings, even pretty junky buildings, have significant value. When you lose some or all of this value through redevelopment to the next increment of intensity, it substantially increases the cost of development relative to doing nothing. It may make incremental redevelopment infeasible. A high-price, low-quality existing land use (e.g., a Dunkin Donuts with a drive-through) is very hard to redevelop even with a big building. It is basically impossible with a smaller, more incremental step: There’s too much “value” that would be destroyed doing something different. 

This is a major reason gentrification happens where it does. You need a big gap between current prices and potential prices in order for any development to happen. It’s in these rent-gap seams that development is feasible. Since that’s where development can happen, gentrification is associated with development, but in a sense it’s backwards. Development follows the gentrification opportunity; even as it sometimes helps generate the snowball of demand which propels the process. Current prices often have to fall very low to get to the point where redevelopment makes sense. 

Demolishing existing buildings throws away a lot of potential value. Structures that are more durable and flexible are very valuable for your community because they can adapt to changing demand and uses without being torn down. Buildings which can learn with time and be affordably added on to or renovated are very valuable. Keeping them is a long-term strategy to be encouraged in your community. 

The other major variable here is the expense of new construction. It’s typical to pay more than $200 per square foot in our market. At this cost per square foot, only expensive, high rent buildings can get built and the gap between current intensity and the next step has to be larger. If we could lower the cost of construction, development to the next increment would be more feasible. I plan to explore strategies we could use to lower construction costs and increase our capacity for building things in a future article. 

I come away from this analysis with a lot of questions. Strong Towns has often shared the montage of photos from the development of Brainard, Minnesota, over the decades. How did their business models work? How were properties priced? How were they financed? How big of a step in value was needed to justify each additional increment? 

We have a lot to learn from the past—not just about design, but about the business models and practices that allowed for development to the next increment of intensity.

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