Doesn’t Pencil

As I drive around Kansas City, I often, as I’m sure you do, see vacant sites and imagine wonderfully dense mixed-use developments springing up on them like mushrooms. If I had unlimited financial resources, I would plant these mixed-use mushrooms all over town, but especially in vacant lots in Kansas City, some parts of which haven’t seen any new real estate investment in decades.

Sometimes, when a parcel is actually for sale, I indulge in the exercise of some architectural artistic license and go as far as sketching out a plan, elevation and section view of what a mixed-use building could look like on that particular site. I usually don’t take the exercise very far, because I lack the capital to make such a project happen on my own, and am not plugged in enough to the local development community to take my idea to anyone with the juice to do something about it.

But I usually go as far as the first cost estimate, a SWAG as we call it, to see what we’re talking about. A million dollars? Ten million? Fifty million? It’s at this point, the first, wildly simplified cost estimate, that I realize—every time—that this development doesn’t pencil.

Pencil, when used as a verb, means for a financial pro forma to make at least some sense, that there would be a reason why someone would invest one or ten or fifty million dollars in a project: namely, a return on their investment (or at least on the equity they put into it, assuming a loan is involved). And so far, none of my little mixed-use daydreams has come close enough to “penciling” that I would consider taking it to a wealthy friend, or a friendly banker, for that next conversation. This week’s exercise was an example.

Kansas City wants to sell a parcel of unneeded land across from a small urban park. The purchaser of this land could build 15 or so housing units without even changing the current zoning, and could get the land for, I predict, next to nothing. Kansas City is not Boston or San Francisco when it comes to real estate prices.

But here’s the rub: even if the land were free, the project doesn’t pencil. The houses in the neighborhood around this park show on Zillow at around $35,000 each. No, that’s not a typo. My hypothetical mixed-use project pencils at around four and a half or five million, or around $300,000 per unit. That’s cost to build it, not what it would sell for. Add a meager 10 percent profit and you’re at $330,000 per unit, and you’d have a hard time attracting any capital with that rate of return.

Would you buy a $330,000 house, no matter how nice it was, in a neighborhood where the average sale price is a tenth of that? Of course you wouldn’t. Nobody would. No bank would create a mortgage for it, no bank would write a loan to me to build it. If I had a really rich friend who could just write a check for the whole thing, we could build it, but the development would lose 90% of its value the day it opened. Talk about depreciation! This idea “doesn’t pencil” on a grand scale.

Unlike overheated coastal markets, Kansas City doesn’t have a housing affordability crisis. The homes in this neighborhood demonstrate that quite clearly. These homes may not be of the highest quality, but there is no reason they cannot be safe, sound, and watertight. My dream of elevating the neighborhood with a nifty new development would only make sense if the new units and the current homes were near enough to each other in value that the former could elevate the latter a little without the latter devaluing the former by a lot. And that is clearly not the case here.

New construction is, under the best of circumstances, a long, difficult, challenging process with a lot of risk for the reward. Given the circumstances around this small urban park (and it’s a lovely little park, by the way), the likelihood of seeing something happen on this particular surplus parcel is, I’m sorry to say, about the same as my chance of winning the PowerBall. In which case, I am definitely building this project.

1 thought on “Doesn’t Pencil”

  1. We see the same dynamic here in Pittsburgh. It’s sad, really.

    Yet, at the same time, it totally pencils for some of the most fertile farmland in distant suburbs to be sold for big box and strip mall construction.

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