Demystifying Development Math

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The developer journey to build and finance new housing is long and complicated. Throughout this process, a developer must take into account several market and regulatory factors that impact whether or not they can successfully propose and build residential projects. And while this “math” underlying housing development decisions is critical, very few resources exist to explain that math to those outside the real estate industry. 
Demystifying the math that underpins whether a project “pencils” is an important step towards forming a shared understanding of what it will take to build an adequate supply of housing.
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The “Making It Pencil” series unpacks the steps a developer undertakes to finance and build new housing, and how those steps are impacted by policy choices and market conditions.
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Building New Housing Is Complicated And Costly.

But for many, the way that it’s built is a mystery.
By the time a housing development is under construction years of work has already taken place behind the scenes. Years of designing and engineering, securing city approvals, and committing millions of dollars are needed to make that construction and eventual new homes a reality.

What are those steps? What are the costs? And how are key development decisions made?

What Does "Making It Pencil" Mean?

Developers and housing professionals say it all the time: development projects have to “pencil”, but what does that mean?

Essentially, the project has to make financial sense in order for a developer to move forward with the creation of new housing.

Because most developers rely on a combination of bank loans and equity investment, they must be able to show that their project can both repay their loan and satisfy investor requirements.

To do that, developers calculate the cost to build new homes - for example, the total cost of lumber, architects, city fees, and taxes - and assess that against what those homes can be rented or sold for once completed.

A project “pencils” when a developer concludes that they can build new homes at a cost and sales/rental price that allows them to pay back their debt and make their equity partners a good return. If costs are too high, or anticipated revenue is too low, then the project does not pencil and will not get built.

Pencils Down: The Realities Of Building New Homes Today Limits Feasibility 

A combination of high construction costs, interest rate increases, and shifting demand in many high-cost cities means that most projects today are not penciling out.

As a consequence, places like California are continuing to fall behind on housing supply goals.

To avoid this, policymakers can proactively confront rising costs by considering reforms to make projects more financially feasible.
The Brief

Making It Pencil: The Math Behind Housing Development

We developed the “Making It Pencil” series to demonstrate how development decisions are made and to illuminate the challenge of building new market rate housing in today’s market.
This information will help policymakers and advocates understand the dynamic nature of the residential development market and think thoughtfully about the right approaches to increasing housing supply

To demonstrate these concepts, we created a series of case study “pro formas” - the analyses a developer undertakes to estimate total development costs relative to projected income (e.g., the monthly rents) in order to determine financial feasibility. We used this pro forma to examine development conditions in four key California markets: the East and South Bay areas of the San Francisco Bay Area, the Westside of Los Angeles, and the core neighborhoods of Sacramento.

While in reality no two housing developments are the same, this analysis allows us to see broadly how development math works and how different policy choices impact whether or not new housing gets built.
Dive deeper into development math with our latest brief
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The Simulation

Does it Pencil?

Try your hand at navigating the challenges of developing new housing by building your own project through this self-guided activity!
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6 min

Let's get started!

Follow this self-guided simulation, step into the shoes of a developer! Will your project pencil?
As we grapple with the need to construct more homes in a manner that aligns with affordability, sustainability, and other goals, understanding how homes get financed and built in the first place has never been more important.
While the specific ‘math’ is different for each type of development (e.g., subsidized affordable housing, for-sale housing, single-family development) the overarching theme is universal:
Building a baseline understanding of the challenges to housing development is essential to forming thoughtful approaches to reform.
Shaping a more affordable and equitable future. Learn more about our data-driven research & policy agenda.
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Welcome To Terner Terrace!

While there are various types of development (e.g., highrises, townhomes, accessory dwelling units), Terner Terrace is designed as a market-rate, mid-rise, rental apartment building.
Click on each icon to explore the property.
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Terner Terrace will be built in a strong East Bay market location (e.g., Uptown Oakland) and is market rate, meaning no units are subsidized or subject to affordability restrictions.
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Terner Terrace is built using a concrete podium on the ground floor and wood frame construction above, which is typical of mid-rise apartments with elevators.
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The building consists of 120 units (a mixture of studios, 1-, and 2-bedrooms), one parking space per unit, and 1,500 square feet of ground floor retail—about the size of a coffee shop.

Development Assumptions

The characteristics of our project site as well as local policies matter a lot in determining the total cost to build Terner Terrace. Let’s take a look at some of the factors that we need to be mindful of in order to get an accurate cost estimate.
Hover over each of these assumptions to learn more.
Pricing Factors
Terner Terrace
Cost Assumptions
  • Land Price
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    In theory, the market value of land—and what the developer will pay for it—is driven by what can be developed there. This is the ‘residual price’. In reality, land costs can be impacted by many other factors not related to project feasibility. For example, a land owner may not sell because they are operating a profitable business on the property.
  • Environmental review not required
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    Our project is not required to conduct a full EnvironmentalImpact Report, as generally required by the CaliforniaEnvironmental Quality Act (CEQA).
  • No demolition​
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    No existing structures existed on the site that required demolition.
  • No environmental remediation
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    The site does not require any significant remediation of contaminated soil, or other issues commonly found in urban infill locations.
Policy Assumptions​
  • No inclusionary zoning/linkage fee
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    These types of requirements or fees are used to promote the creation of affordable housing units. While they operate in different ways, they share the common goal of ensuring that a certain percentage of housing units within a development are affordable for low- and moderate-income individuals or families.
  • No offsite infrastructure improvements​
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    There is sufficient existing infrastructure (e.g., sewer connections, road capacity) to service the Terner Terrace. The project does not need to undergo significant work in order to improve capacity for services such as water,power, or wastewater.
  • No exactions
    The city is not asking for any extra requirements of the project, such as a community benefits agreement, which are sometimes exacted from a project as a condition of approval.
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The Final Price Tag

Three categories of costs are associated with any development project: hard costs, soft costs, and land costs. Now that we have all our building characteristics and assumptions, we can calculate the total cost of Terner Terrace.
Click on each component to reveal what is driving up costs.
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Land Cost
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Hard Cost
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Soft Cost
Terner Terrace
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Soft Costs are 25% of the total.
These costs are those associated with the design and implementation of the project, but not the physical construction (i.e. hard costs). Tax, title, insurance, consultants, financing are included.
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Hard Cost are 65% of the total.
All of the costs associated with the physical construction of the project. These include materials, wages, and contingencies.
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Land Costs are 10% of the total.
Includes closing costs and due diligence

Making It Pencil

With an accurate cost estimate for Terner Terrace, it’s time to get financing: the money the developer will need to build the property. Financing, and the cost of that capital, has a major impact on whether a project pencils.

To pay for the cost of building, a developer will obtain funding from two sources: debt - generally in the form of a loan from a bank - and equity - from an investor. Debt provides the majority of project financing, and equity provides the rest.

Both forms of financing require certain returns or metrics before either lenders or investors are willing to commit money.
Let’s see if our new project has what it takes to access the necessary financing to break ground.
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How much debt can you raise?

Our first financing avenue is to get a loan from our bank. Much like a traditional home mortgage, the bank will not cover the entire cost of our project.

The amount that banks are willing to lend relative to the total project cost is referred to as the loan-to-cost ratio (LTC). If the bank thinks the project will succeed, they will allow for a higher LTC. But if they have concerns, they might only provide a smaller loan to minimize their risk.
Use the slider to see how confident the bank is in our project and what gap remains to be filled with equity!
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Unfortunately, banks in our market are not lending this amount for new housing given their lack of confidence in the market. Instead, they’ve offered an LTC of 55% which is typical for projects seeking financing today.
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Good job! The bank has offered an LTC of 55% which is typical for these types of projects. In the past, banks used to offer between 70 and 80 percent, but because of today’s volatile market, banks are not willing to lend as much.
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Almost there! Thankfully, our bank has enough confidence in our project to offer a 55% LTC. Traditionally bank LTCs have gone as high as 70 to 80%. Today’s tricky market means banks are not as eager to lend.
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Check Answer
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Unfortunately, banks in our market are not lending this amount for new housing given their lack of confidence in the market. In the past, banks used to offer 75% or higher! Instead, they’ve offered an LTC of 55% which is typical for projects seeking financing today.
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Good job! The bank has offered an LTC of 55% which is typical for these types of projects. In the past, banks used to offer between 70 and 80 percent, but because of today’s volatile market, banks are not willing to lend as much.
Satisfied face
Almost there! Thankfully, our bank has enough confidence in our project to offer a 55% LTC. That seems good, but traditionally bank LTCs have gone as high as 70 to 80%. Today’s tricky market means banks are not as eager to lend as much as they used to.

The Search for Equity Funding

To finance the remaining 45% of our project, we need to find an investor!

Equity investors in residential real estate come in various forms and can include private equity companies and pension funds.These groups need a certain return to mitigate the risk involved in the volatile real estate market, otherwise they will not invest.

Because of the length of development time and other new housing challenges, equity investors consider housing development a riskier investment compared to government treasuries or bonds. Finding an investor can be a competitive process.
Click on each profile to explore the different types of potential investors and the factors they consider.
Click on the investor profile to learn more
Private Equity companies are private capital groups who invest in real estate of all kinds, including commercial and industrial projects.
Pension Funds are groups who routinely invest in real estate as “high return” options to round out their overall member portfolios.
Insurance groups put money into a broad portfolio of investments, including residential real estate.
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What About the Developer?
Developers make money when building new projects by contributing their own money and time (i.e., “sweat equity), but are generally last in line to receive any profit. Before they receive any payouts, their loan payments must be made and the primary equity investors must receive their preferred return.

Measuring Return

How do we know if Terner Terrace can attract investors? There are a couple ways developers figure this out.

The simplest measure of how profitable a new project will be is to compare how much money Terner Terrace will make after expenses (Return on Cost) against the return of simply purchasing an existing, occupied building (Capitalization Rates).

Return on Cost (ROC) compares the cost to build and manage Terner Terrace against the revenue it will bring in from rents.

Capitalization rates measures the return one can expect by purchasing a similar property nearby.

Return on Cost

If Terner Terrace brings in less profit (ROC) than buying an existing building (Cap Rate), there’s little incentive to build something new. To put it another way, the time, expense, and risk of a new project won’t be worth it to investors if their returns are not higher than simply buying a nearby occupied apartment building.

But how much higher does our ROC need to be than Capitalization rates? Let’s find out!

What Return on Cost does Terner Terrace need to demonstrate to be viable?
Drag the slider to determine a viable percentage.
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Check Answer
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This will work! In our market, Capitalization Rates for apartment buildings are around 5%, and investors are looking for at least a one percent difference between ROC and Capitalization Rates in order to invest in projects like ours.
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A long ways to go…Capitalization rates in our market for apartment buildings are around 5%, and this ROC means that our project would not be as profitable as simply buying an existing, similar apartment building.
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Not quite! Capitalization rates in our market for apartment buildings are around 5%, and this ROC is not far enough above 5% to attract investors and account for the time and risk of building new apartments.

Determining Rents

To calculate returns, we need to know what kind of income our project will bring in. Terner Terrace, like most new developments, derives the vast majority of its income from rents charged to tenants. What will those rents be? We will use some of our consultant budget to commission a detailed market analysis to find out.

These consultants use proprietary data sources to determine the demand for new housing in the project area as well as what a developer could expect to receive in rents.
Select different one-bedroom rents to determine whether they will be enough to make our project pencil out.
Select a rent price to see how ROC is affected.
Return on Cost
This rent is affordable to a two person household making 80% of Area Median Income.

But unfortunately, setting rents at this level brings the project well below feasibility, and so the developer needs to charge much more than this to satisfy lender and investor requirements.
Return on Cost
Our market analysis says that this is roughly the going rate for new one bedroom apartments in our project area. At $3,500 a month, a one bedroom at Terner Terrace is affordable to a household making roughly $140,000 a year.

Unfortunately, because our project costs are so high, the project still does not pencil out, which means it won’t get built unless costs come down or rents are much higher.
Return on Cost
At this price, Terner Terrace pencils out!

But unfortunately, very few renters can afford $4,000 for a one bedroom (this would only be affordable to a household earning $160,000 year). Because there is no market for one bedroom units with such high rents, we won’t get financing for our project.

In Today's Market, Terner Terrace Would Not Be Built

Unfortunately, current market dynamics and development requirements combine to make our project financially infeasible. In 2019, this same project was possible, but today it would stay on the drawing board.

What’s changed? A combination of higher costs and relatively low rent growth in our area mean that Terner Terrace just doesn’t work in 2023.

Increases since 2019
  • Hard costs (increase of 12.9%)
  • Interest Rates (increase to 8.5%)
  • Rents not making up for additional costs
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Changing Policies

Policymakers can take steps to move projects like Terner Terrace closer to project feasibility. Things like impact fees, increasing allowed units, and reducing parking can save on costs and make new housing math work better.
See what happens to the project financials in three common scenarios.
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Reduce fees to 10k/unit
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Reduce parking to .25 spaces/unit
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Increase density by 25%
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Reduce hard costs by 10%
Return on cost
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