AMA - Do Public Companies Want To Hold Land?

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AMA – Do Public Companies Want To Hold Land?

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AMA – Do Public Companies Want To Hold Land?

Welcome to the Real Estate Espresso podcast, your morning shot of what’s new in the world of real estate investing. I’m your host, Victor Menasce. Today is another AMA episode. That is, ask me anything. I love to answer your questions. If you have a question you think is going to be of broad interest, send it in and I’ll answer it live on the air. Send your questions to [email protected].

Today’s question comes from Steve who writes, “I’ve heard that public companies don’t like holding land on their balance sheet. Is that true? And if so, why is that?” Well Steve, this is a great question. I think we need to make a distinction between different types of land. Some land is entitled, which means it’s able to be built on. When we talk about developing land, there’s several phases we need to focus on.

Sections of Land Development

First of all, you start with raw land that might be zoned, say, agricultural, and it would need to be rezoned or annexed to be entitled for development. Once it is zoned, then you need to develop the site plan that can be divided into phases. The first one is preliminary plot and then final plot. At preliminary plot you have an approved plan, but it’s not yet shovel-ready to start the horizontal improvements. And then at final plan when everything is nailed down, then you can start installing the infrastructure consisting of the roads, utilities and all of the improvements that are necessary to get a shovel-ready property that you can actually build detached homes or commercial buildings on. Each step gets you closer to putting the shovel in the ground to start vertical construction.

Why Public Companies Avoid Keeping Undeveloped Land?

Public companies often avoid keeping undeveloped land on their balance sheet for several reasons. The first is the lack of immediate cash flow. Unlike developed properties that generate real income, vacant land does not produce revenue. Public companies are typically under pressure to show consistent earnings, and holding non-income generating assets can hurt financial performance. Another issue is a lower return on assets. Public companies tend to be evaluated on their financial metrics like return on assets or return on invested capital. Since undeveloped land doesn’t contribute to the revenue, it can negatively impact those ratios. Investors often penalize companies if it looks like they’re deploying capital inefficiently. Holding land ties up capital that could be otherwise used for development, acquisitions, returning value to shareholders, for example, stock buyback.

Other factors include volatility in valuations. Value of land can be volatile, for example, if prices of homes were to drop let’s say 10 percent, the value of land could drop by quite a bit more because land is this kind of binary thing. It’s either in demand or it’s not in demand, and that can happen over a period of several years. Unlike income generating properties, land valuations can be a lot more speculative.

Of course, land ownership also comes with ongoing costs like property taxes, maintenance, and sometimes even regulatory expenses. And since that land is not generating any income, it’s a source of negative cash flow. Most public companies are structured as real estate investment trusts. They’ve got to distribute about ninety percent of their taxable income to shareholders, and since undeveloped land doesn’t generate income, it doesn’t align particularly well with the REIT model.

So instead of holding land, companies prefer to either land bank through joint ventures or partnerships and that reduces their direct balance sheet exposure. Sometimes they prefer to buy options. Often they will want to buy rolling options so that they acquire the land in phases as they need it. They will sometimes sell land and lease it back as a way of land banking. That way their holding costs are somewhat reduced.

Public Companies that Hold Land

But public real estate companies in fact do hold land. They have strategic land reserves. Some companies, especially those in industrial and retail, might keep land for future development where it aligns with a particular strategic growth plan. And if a company has a plan to develop the land very soon, it might temporarily hold it before starting construction.

I’m going to pick on one particular company, that’s Lenar. The second largest home builder in the U.S. They’re a very capable company with a strong ability to manage every aspect of the home development process. In our recent dealings with them, Lenar was negotiating with us to purchase a development site from us in Utah with a plan to construct over a hundred townhouses. They made it clear they wanted to acquire shovel-ready lots from us and they did not want to participate in the horizontal development of the infrastructure. In the end, we did not get a deal done, their offer price was too low and would have barely covered the cost of putting in the infrastructure. It’s clear that Lenar are accustomed to buying land at rock-bottom prices. As a result, in my opinion, they’re shut out of many markets.

Last week, Lenar also completed the spin-off of its land holdings into a separate entity called Milrose Properties. That strategic move is aimed to remove those perhaps riskier land assets from the company’s balance sheet. Theoretically, that should enhance its return on equity and adopt more of an asset-light model. Now Milrose Properties holds all the land, the infrastructure and sells the finished lots back to Lenar. That arrangement allows Lenar to mitigate some of the financial risk associated with the land ownership, while still having control and securing land for future development. Now Milrose is externally managed by a third company called Kennedy Lewis Land which is a land development company with $25 billion in assets. Lenar contributed $5.8 billion in land to the Milrose spin-off which is now listed as a public company under the stock ticker… MRP.

There’s another company with a storied history that’s active in land. That’s the Howard Hughes Holdings. They focus on development and management of master-planned communities. The company holds substantial land assets that are intended for future development. They are also reported on the company’s balance sheet. But in order to optimize their capital efficiency and reduce exposure, Howard Hughes often engages in joint ventures or partnerships for specific projects. That allows the company to share the financial responsibility and the risks associated with land development. It better aligns with its strategic growth objectives while managing its balance sheet exposure. It all comes down to managing assets and managing risk.

So yes Steve, while it is true public companies prefer not to carry land on their balance sheet, there are many examples of public companies actually doing it or doing it in a very restricted manner.

I want to thank you Steve for a fabulous question and for listeners at home have an awesome rest of your day. Go make some great things happen. We’ll talk to you again tomorrow…