Development Option Theory

The real option theory of land development was a hot topic in the mid 2000’s, as the volatility of the real estate market peaked. Now that we have a break from the U.S. housing bubble and financial crisis, it’s worth talking about how we might decrease the volatility of the development market over time.

Urbanism by right is achieved with tools such as form-based codes, which allow walkable, compact, mixed-use, sustainable development, at the scale of the lot, block, neighbourhood, and region. Changing the law to allow urbanism by right makes walkable communities go “in the money” for several reasons, including decreased uncertainty, shortened planning and approval processes, increased flexibility, and increased long term asset value.

Snow falls on The Waters, a traditional neighborhood development in
Montgomery, Alabama, governed by the form-based SmartCode.

One of the best ways to decrease volatility is to decrease uncertainty. You change what developments pencil when you decrease the uncertainty of what is developable. Uncertainty is “beta” from the option theory perspective. As beta decreases, the required rate of return also decreases, because people don’t need to be paid so handsomely if they aren’t taking as much risk when they “buy” their option to develop.

The time value of money is less of a factor when the playing field is levelled to allow urbanism by right, because the development process is drastically shortened. If the developer isn’t owning a call option on a property as long, her interest fees decrease. The reason that form-based codes shorten the timeline is because a prerequisite is consensus on the community vision. By agreeing in advance about the sort of development that locals want, developers have both shorter plan approval times, and increased certainty about what their options are. Less emphasis is put on individual mojo and political connections that allow discretionary power over development decisions. Community NIMBYs have already spoken to what is and isn’t allowed in their back yards.

As flexibility increases, the option value increases. Form-based codes are inherently flexible, and nimble in their responsiveness to adapt to changing conditions. The mixture of compatible uses allows one building or block to respond to market demands, changing from a townhouse, to a live-work, to a storefront, and back again, all as a matter of right. Higher densities encourage more compact development patterns, allowing narrow lots that can provide a range of price points. Blocks within form-based codes are easily re-platted to move up or down the Transect, because the basics of the urban form and street grid are honoured. Conversely, in suburban bedroom communities, along strip retail, or within other auto-centric patterns, sprawl repair is expensive and time consuming. Once a developer commits to one of these uses, they’re locked in.

Increased long term asset value is enjoyed by walkable neighbourhoods, which are healthier for the economy, society, and environment. This is from myriad reasons, including increased walkscore, decreased vehicle miles traveled, increased housing value, decreased carbon emissions, decreased auto costs, increased personal fitness, decreased infrastructure cost, increased hours available, real community, and the list goes on.

All of this is captured in the intrinsic and extrinsic value of the development option. Intrinsic just marks the asset to market once the land is developed, while extrinsic is the value of the volatility around which a developer can bet or trade. Too much of the latter builds your house of cards, and bubble bursts. The extrinsic value decreases and intrinsic value increases when physical and policy planning reforms are undertaken.

A recent NY Times article discusses several market factors of the development landscape over the next two years, as we recover from recession. These include the current scarcity of construction financing, the lowering price points of residential demand along with increasing housing types to include condos, town homes, and flats, and that in many places, conversion is less expensive than new construction. All these items, with the exception of financing, find solutions within the flexibility, certainty, and timeliness of form-based codes. In fact, in places that have adopted optional form-based codes, locals indicate that most of the recessionary development is occurring under these optional form-based codes instead of under the auto-centric laws.

“One of the economic conundrums of the past year has been the great divergence in the Canadian and U.S. housing markets. While American home prices swooned in 2009, the Canadian market only stumbled before resuming its inexorable climb upward,” according to the Globe & Mail last week. Some economists say this is the result of Canada’s fiscally sound banking practices, while others argue that the Canadian housing market is 15 to 35% overvalued. If the latter is true, a careful look at the predominance of Euclidean bylaws in Canada that increase market volatility via destabilizing uncertainty is worth consideration. Indeed, western provinces are leading with bylaw reform, with 12 out of the current 14 Canadian form-based bylaw initiatives being based in the west.

–Hazel Borys

1 Comment

Filed under Development, Legal, Planning and Design

One response to “Development Option Theory

  1. Pingback: Community-Based Economic Development | PlaceShakers and NewsMakers

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