Land Banking: A Sound Approach to Residential Real Estate Pre-Development Financing

May 15, 2024

Key Takeaways

  • Traditional bank loans for land acquisition are less accessible, prompting developers to use land banking. This involves a land banker buying property and later transferring it to the developer, providing liquidity and enabling development without immediate balance sheet impact.
      • Land banking unlocks liquidity, offers operational flexibility, and shifts predevelopment market risk from developers to land bankers. It's beneficial for public companies to avoid earnings dilution and provides a long-term investment strategy with potential for significant returns.
          • Land banking requires meticulous due diligence and knowledge of legal, accounting, and tax considerations. Dechert LLP specializes in structuring these transactions. With traditional financing scarce, land banking remains attractive for private investment.

          Residential real estate developers and homebuilders are faced with a classic dilemma – feeding the development inventory acquisition pipeline while simultaneously maximizing limited cash reserves for business plan execution. Historically, developers would look to fund their acquisition and pre-development programs with first mortgage land loans, secured lines of credit, or equity joint ventures, often turning to regional banks as a preferred source of financing. In the current market, traditional bank loans have been less available for these purposes, with some smaller regional banks experiencing increased levels of distress, leaving developers scrambling to find alternate capital sources. That market dislocation has inspired a growing developer cohort to source capital using land banking technology. Given the relatively few sources for that financing and the persistent shortage of new single-family housing stock, a growing number of private credit and private equity funds have stepped into the fray and are now readying pools of pre-development capital for residential development.

          The typical land banking transaction involves the capital provider (the “land banker”) purchasing and holding undeveloped or partially entitled residential development property and then conveying it (or reconveying it) to the developer after a period of time, using a structured option. Because there are a limited number of traditional banking institutions providing capital in this space today, land bankers typically operate as private credit vehicles and are often financed by private credit and private equity funds. Typically, the developer will place a large land tract under contract with a third-party seller, and then will assign the purchaser’s contract rights to the land banker at the contract closing. Alternatively, the developer may convey to a land banker some of the development property that the developer already holds. The option requires a sizeable non-refundable up-front deposit paid to the land banker. The developer then moves forward with its pre-development activities, usually through a development or construction agreement with the land banker (who temporarily acts as owner). That may include creating subdivisions, obtaining zoning variances, horizontal improvements (e.g., utilities rough-ins, constructing roads and other common facilities), and a limited amount of vertical improvement (e.g., constructing a model home or temporary sales facility). Then, as the developer readies itself to begin vertical improvement in earnest, which may include single family homes for sale or build-to-rent product, it begins exercising that option, taking down land parcels on a pre-agreed schedule, and at pricing that covers the horizontal improvements and which provides investment returns to the land banker. Land banking transactions are usually structured to temporarily transfer land market risks to the land banker, while leaving development execution risks with the developer. Some additional points to consider when evaluating land banking technology include:

          • Unlocking Liquidity: The primary allure of land banking lies in its ability to unlock liquidity for homebuilders and other large-scale developers. By moving property inventories off the developers’ balance sheets and onto the land bankers’, the developer enhances its financial flexibility and creditworthiness. This off-balance sheet financing is particularly attractive to public companies, as it avoids earnings dilution during the period that the inventoried land is not generating income.
          • Operational Flexibility: Homebuilders retain the ability to make basic improvements while the land is banked, maintaining development flexibility. While the land banker holds title to the property, the developer can still complete its horizontal improvements. This ensures that the development proceeds continuously. When the property returns to the developer’s hands, it is at a higher value and ready to “go vertical”.
          • Shifting the Market Risk: Land banking enables homebuilders to manage property inventories and balance sheet risk simultaneously and effectively. The land banking technology permits off-balance sheet financing, temporarily shifting market risk from the developer and improving its ability to secure funding. The developer's balance sheet does not immediately reflect the land as an asset or the purchase obligation as a liability. The option price’s built-in return reflects the land banker’s risk, and the developer only pays upon electing to purchase the lots, which can be more cost-effective than traditional financing methods.
          • Longer Term Investment Strategy: Land banking is attractive because of its longer term investment horizon that can yield significant returns as land is developed horizontally, in phases, while appreciating in value. Land banking investors capitalize on that appreciation by purchasing in areas poised for growth, and if the developer has not exercised its option, then the land banker can sell the entitled land for a profit. This strategy offers stability in volatile markets, potential for significant returns for all parties, and serves as a powerful portfolio diversification tool.

          Land banking technology is a strategy benefiting both the land banker and the developer by providing liquidity, shifting market and balance sheet risks, and optimizing financial ratios. Each transaction requires meticulous due diligence, strategic structuring, and an understanding of legal, accounting, and tax implications to ensure long term success and profitability. Dechert has elite-level expertise in each of the disciplines necessary to successfully structure a land banking transaction (including fund formation, joint ventures, acquisitions and dispositions, and financings (as well as back-leverage transactions)). Given the continued lack of traditional bank financing availability, we expect land banking to continue to be attractive for private credit and private equity involvement.

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