The Cycle of Development, Optimal Redevelopment, Redevelopment Goals and Benefits, and Barriers to Redevelopment

Before I review the foundations of real estate development finance and the role of public-private partnerships in redeveloping the United States, I need to show where P3s fit in the development/redevelopment cycle. I start by describing the cycle of urban development and what I call "efficient redevelopment." This is followed by a review of impediments to efficient development, and I conclude with the role of P3s to facilitate efficient redevelopment.

The Cycle of Development

That urban areas transform themselves over time is certain. Miles Colean (1953) calls this the "cycle of development." Larry S. Bourne (1967) provides a succinct review of the process, which comprises an initial period of construction followed by a period of increasing value and function, then a period of increasing maintenance costs and deterioration, perhaps leading to idling or abandonment, and then a period of redevelopment as the old structures are replaced.

Consider the normal life of a building. It is built initially to serve an investment horizon and becomes obsolete either because of economic factors (where the building is more expensive to maintain than justified by revenue streams) or functionality (where markets have changed, leaving the building unsuitable for its initial use) or both. As the structure loses value through a process called depreciation, the land on which it sits will normally gain value, especially if the urban area is growing.

Figure 1.1 illustrates this appreciation in land and depreciation in the structure assuming a new building is built with a fifty-year useful life, which is common for one- and two-floor office buildings. When its doors open, the building accounts for 80 percent of the property value and the land for the remaining 20 percent; this is a typical building-to-land relationship for commercial buildings. The building depreciates over a fifty-year period, or 1.6 percent annually, and becomes worthless (except for any scrap value) in the fiftieth year. Land, on the other hand, gains value at about the rate of growth of the urban area, compounded. If the population or employment growth rate is 2 percent annually, the land value increases at this rate (net of inflation). By the twenty-eighth year, the land is worth more than the building. Some years before and after this happens, the investors reassess their investment and, ideally, renew the site by replacing the initial structure with one consistent with the highest and best use over a new investment horizon.

For the most part, nonresidential space is not durable. Overall, the United States has about 100 billion square feet of enclosed space used for such nonresidential purposes as retail, offices, institutions, and so forth. About 70 percent of all nonresidential space is housed in buildings of one or two floors. In any given year, about 2.5 billion square feet of nonresidential space becomes idled or is replaced—2.5 percent annually.

In contrast, residential structures are quite durable. The United States has about 130 million residential units, but only 500,000 residential units—about 0.5 percent—become vacant or are replaced each year. I have estimated that the typical residential unit lasts about 170 years (Nelson 2004, 2013a). Pitkin and Myers (2008) estimate that units last 200 to 500 years. Whatever the length, planners and public officials need to understand that residential development is very durable, not because the structures themselves are built to last a long time, but because occupants will maintain the unit through repairs and rehabilitation for decades or even centuries. Most nonresidential development, in contrast, is not durable and needs to be replaced about every 20 to 40 years.

Urbanized land thus goes through a series of changes over decades and centuries. The first building on a site, for instance, might be a neighborhood grocery store. As the building ages, it becomes more expensive to maintain, so profit (revenue net of costs) goes down. In the meantime, the land value goes up. The "opportunity" cost of keeping the land in its current use goes up as profit in the current use goes down. At some point, the landowner incurs the cost of demolition and rebuilding to increase profits by going to the "highest and best" use of the land. Maybe the new structure is a low-rise retail store. In a few more decades, the next highest and best use might be a midrise office building. In theory, redevelopment of the built environment would be seamless, leading to ever higher and better uses over time, as illustrated in figure 1.2. In practice, this is rarely the case, for reasons I outline next.

Optimal Redevelopment

The first buildings to be constructed in an area are often small and built of material that is easy to dismantle. At some point, buildings become of such size and durability that they may be difficult to replace, especially if market conditions do not warrant the expense of both dismantling and rebuilding the site. The result can be what Bourne (1967) calls a "constrained" process of redevelopment. This could lead to blight as the structure becomes idled or vacant and its presence discourages reinvestment in the area, thereby delaying redevelopment beyond that which is "optimal."

In a classic paper theorizing the optimal timing of redevelopment, Donald Shoup (1970, 43) demonstrated that the optimal time for redevelopment of urban land depends on four factors:

The optimal date for development or redevelopment of urban land depends on (1) the discount rate applying in the real estate market, (2) the property tax rate, (3) the earnings in any interim use, and (4) the way in which the highest and best use of the land is expected to change in the future.

I refine Shoup's principles for application in this book. The first is the "discount rate" that is applicable to the local real estate market. Put simply, this is the rate at which future revenues net of costs ("profit") are discounted to the present to allow for a fair comparison of alternative investment choices. A high discount rate means the investor is willing to pay less for something, presumably because risks are higher.

The discount rate is akin to the capitalization rate, or "cap rate," which is the ratio between the net operating...