Saturday, March 07, 2009

Densification

You will probably hear the word “densification” thrown around on this and other local blogs from time to time. What it is, basically, is the anticipation that a piece of land will be subdivided or “densified” so as to put more dwellings in the same area. This has the effect of increasing the land’s productivity -- more rent from the same amount of land -- and more importantly has implications on how to value the land itself.

To understand densification we can look at two extreme examples, a highrise condo complex and a detached property right beside it. In the condo’s case, its units produce a certain utility, captured by the rents collected, and have certain costs, captured by the maintenance and other carrying costs. Since it is unlikely the condo will be torn down in the next (say) 50 years, we can sum the net cash flows, discount at the cost of capital, and we get the property’s net asset value.

Next the detached property. Since it is in a neighbourhood that has higher average density it is possible to sell the property to a developer who will build a dwelling of density commensurate to the neighbourhood’s density. The owner of the property, however, can choose not to sell the property and instead rent it out. From a net asset value perspective, what a property is worth is choosing a use that maximises total return. In this case it is possible the owner could maximise his profit by selling right away to a developer. It may also be possible he can wait a few years and hope the price of land increases above inflation and sell then. In the meantime he must live with lower returns from rents which will be (hopefully) compensated by higher capital gains as the land increases in value.

Undensified properties in an area that is undergoing population growth therefore need a bit more analysis when determining value. When we sum cash flows from rents we must consider all possible uses of the land, including renovations, reconstruction, or leaving it as-is. The maximum of all possible outcomes will set the price.

But how about properties where densification is a ways off? We can take somewhere like Vancouver as an interesting example of this. Many neighbourhoods in Vancouver have been densifying for the past 20 years. Witness the addition of dual suites in the past 5-10 years where before it was common only to have one and 20 years before this suites were not necessarily the norm at all. It is conceivable that in 10-20 years from now houses will become multiplexes, as they are in certain parts of the city already. We can do some quick back-of-the-envelope math to figure out what to expect. From this we can determine a “densification premium” to put on a piece of land expected to be densified.

Let’s take a 2000sqft bungalow that can rent for $1600 on today’s market. There are several options available for this property. We can rent it out as-is for a net profit of around $15K per year. We can tear it down and build a denser property, say a Vancouver Special with two basement suites that could rent for $3000 total, netting $30K per year. But the structure costs $250K to build and would forgo one year’s rent in the process. Another alternative is to wait for ten years and subdivide into a duplex, perhaps the construction costs $300K (in today’s dollars) and could be rented for $5000 total, netting $48K per year.

So which one to pick? Doing a quick net asset value calculation, option A is $270K, option B is 320K and option C is $290K. From these assumptions I would be better to rebuild the property right away and start generating revenue quickly.

The point is not the accuracy of the calculations, only that a property’s potential return can be more than what its current structure can produce. It doesn’t necessarily mean all properties should be torn down but it does mean their values will be higher than what a straight rental income equation suggests. This is the densification premium.

Premiums for densification and speculation are often confused. A densification premium is really about summing cash flows assuming the property is held in perpetuity and redeveloped as necessary to maximise return. Speculative premiums, those we have seen in many US cities and those likely present in Vancouver, are not really densification premiums at all if the net cash flows do not reasonably justify the prices.

Another point is that while future development and densification is a certainty, the existing properties must be carried by someone until they are ready for redevelopment. This means that families and investors must occupy the properties until such time as it makes sense to start densifying and have the incomes or equity to do so. It also means if densification is a ways off it has little to no impact on the property’s value. Many assuming a property will be redeveloped in the next 20 years may be extrapolating a bit too aggressively depending upon where the property is located.

A final and obvious corollary to all this is that a densification premium is on the land itself, not the structure. The potential uses of the land determine its value. The current capital asset located on the land has value as well of course. Note land values can be negative if there is no way to make a profit by owning it. In certain parts of the US, notably Detroit, this is effectively happening.

Densification premiums along with speculative premiums are already priced into the local market and then some. If we experience a full-on market crash the price bottoms for detached housing will still justifiably include some semblance of densification premiums. Condos will not be so lucky, not because they cannot be densified further but because the reconstruction costs are considerable compared to the increased density. (Construction costs do not necessarily scale linearly with density.)

What should we take away from the densification premium concept is that many properties carry a justifiable premium (or discount!) over what is justified by their current rents. This is an important point when determining value in a market downturn and estimating a property’s inherent value from an investment perspective.

5 comments:

JimTan said...
This comment has been removed by the author.
condohype said...

Why hasn't anyone commented? This is a fascinating post. We may run out of land but we won't run out of sky. Good stuff Jesse.

jesse said...

The tribe has spoken :D

ReductiMat said...

The only reason why I rarely reply here is because I hate people who post "+1" or the like and I rarely have anything else to add.

That said, great work here folks.

deedavid said...

sorry just glanced at the post, that said, densification hides an underlying problem which could be said to be one of the root causes of the various "symptoms" we are seeing in todays world.

ie, economic collapse is a symptom

over population is a cause.

densification hides the cause.

and again sorry I know this is outside of the scope, but there it is, the elephant no one wants to talk about.