For homebuilders, financing a real estate transaction, oftentimes via an institutional lender, is common place in the industry. But what is land banking and why should it be considered by homebuilders?
Land banking is an off-balance sheet financing structure whereby the land banker purchases fee title to the homebuilder’s desired lots – instead of the homebuilder. Simultaneously, the homebuilder enters into an option agreement with the land banker wherein the homebuilder obtains an option to purchase the desired lots from the land banker. Such option is generally secured by a non-refundable option fee paid by the homebuilder to the land banker.
So, why would the homebuilder be willing to pursue the land bank structure if it comes at such a premium? The option agreement sets forth a rolling “takedown schedule” which has been negotiated by both the homebuilder and land banker and is the schedule by which the homebuilder must exercise its option to purchase certain lots. Such schedule is generally based on the homebuilder’s absorption schedule related to its projected retail sales. In other words, the homebuilder does not pay the purchase price for the lot until the lot is developed and the homebuilder is ready to commence construction of the home, all as forecasted in the takedown schedule.
In addition to the option agreement, the land bank structure generally involves a construction agreement, whereby the land banker pays the homebuilder, as the contractor, to develop the property.
By utilizing this structure, neither the property, nor the development costs, are shown on the homebuilder’s balance sheet and the homebuilder’s capital outlay is available for other projects during the property’s development. So, the homebuilder’s rate of return is increased, while its capital is conserved.
Land banking also mitigates market risk. If the homebuilder owns fee title to the property when the market turns, such turn could have a very negative impact on the homebuilder’s balance sheet. However, if the homebuilder only holds the option to purchase the property, the homebuilder is in a better position to walk away from the deal – only losing its option fee.
Although land banking comes at a premium to the homebuilder, it is an often-utilized structure for both private and public homebuilders. Accordingly, homebuilders might want to consider such process for an existing or future project.