Changing Cities Through Business: Finance, Urban Centers and Real Estate Development

Finance, Urban Centers, and Real Estate Development are three different disciplines that are not normally analyzed together. Therefore, it is essential to study and understand them separately but, most importantly, how they influence each other. Given the practical nature of their focus, most individuals have a form of interaction with them daily. Even with such close interaction, we rarely analyze the real impact they have on our way of living.

We must understand each of these three disciplines individually before analyzing how they interrelate and the forces they exercise on each other.

Urban Centers

Economists define cities as ‘the spatial concentration of economic actors’ (Glaeser, Kolko and Saiz, 2021, p.8). In other words, urban areas are the physical platform where individuals interact with each other and where they can share means to satisfy their own personal and public needs. Urbanization is the space that facilitates individuals to cooperate with each other and create synergies, which with time, result in the progress of society. These physical platforms are the result of years of humans constructing and centralizing the means for development that ultimately improve their life quality. Cities have provided societies with the economies of scale with respect to the main infrastructure and resources (both tangible and intangible) needed for development. During the evolution and progress of civilization, humans have noticed the true benefits of urban centers and cities have become more desirable. According to a United Nations report, 55% of the world′s population?lives in cities (United Nations Department of Economic and Social Affairs, 2021), which means that the majority of the people in the world live in or have had contact with urban centers, and this number is projected to keep growing.

Real Estate and Real Estate Development

These urban centers are formed of smaller, public and private, components, normally in the form of vertical constructions and open areas. These smaller components?are usually proposed and developed by real estate companies or institutions trying to satisfy the demands and needs of the users of the urban center. Therefore these buildings?should be perceived as ‘products’ offered to the citizens of the urban grid. Real Estate development should be conceived as the process of adding value by?optimizing the land and creating spatial conditions that satisfy users’ physical needs through urbanization, construction or/and optimization of the current land-conditions.

Finance

Finally, because this is an economic process, financials are crucial. Numbers are important in determining which buildings will be constructed and which not. From a private perspective, if a building does not match the urban or financial criteria, it is not a good component for the city at the specific time when it is evaluated. Finance determines the feasibility of such constructions.

The Relationship

I was once speaking to a real estate developer, and from our conversation, it was clear that he did not visualize the direct relationship between these three disciplines. He argued that the feasibility of a real estate project is dependent on the project itself. Finance may be an important factor, but it is only addressed?at the beginning of the project's development when investors are looking to secure capital and investment to start the project. ‘Then you only need to take care of paying the bank the monthly agreed sum,’ he said. Personally, I believe that if the private sector (real estate developers and investment companies) saw the potential in combining Urban Infrastructure, Real Estate, and Finance, then the projects, investments, and cities would receive an exponential gain. We must therefore focus on incentivizing cooperation between these in order to create a positive-sum gain for all parties.

After analyzing these three different disciplines, we must study how they relate to and impact on each other. Specifically, we are going to address:

• How urban center′s infrastructure has a direct impact on the raw material (which is the land where construction takes place) of Real Estate development.
• The economic process of real estate and finance when analyzing the feasibility of a project is dependent on the land?where it will be constructed and by direct implication, on the urban infrastructure.
• Understanding urban infrastructure and real estate as a financial and investment asset.

Whilst there are real estate development projects in rural and natural ecosystems, this analysis will concentrate on those in urban areas?or those that are undergoing urbanization and the construction of tangible infrastructure.

Urban Infrastructure & Real Estate

To fully comprehend this matter, we must analyze and compare real-life urban examples and observe their different dynamics and the direct relationship between urban infrastructure and Real Estate. Research conducted by Bojorque and Chuquiguanga in Cuenca, Ecuador highlights this phenomenon. Since Latin American cities are still in development and have accelerated growth, this relationship is more noticeable. Their analysis of the ‘critical effect of public infrastructure on the price of urban land’ (Bojorque and Chuquiguanga, 2021), exemplifies the dynamic of the first two disciplines we are analyzing; urban centers and real estate.

As can be observed in the analysis by Bojorque and Chuquiguanga, there is a direct relationship between the prices of land versus the investment made in the urban infrastructure. This study shows that after the public investment in urban infrastructure there was a 24.4% increase in the market price of most of the properties (95%) surrounding these constructions. The research also shows that the profit expected by the owners has an ‘average of 6.35 times the investment cost’ (Bojorque and Chuquiguanga, 2021).This means that the return on investment (ROI) of these constructions in urban infrastructure exceeds the expectations of what can be considered a favorable investment according to financial valuation criteria.

Following the analysis in Latin America, where cities have an accelerated growth and this phenomenon is more noticeable, research was carried in the city of Santiago, Chile by members of the Universidad Mayor and Universidad de Chile. This is an analysis that shows the intrinsic relationship between Real Estate densification, the prices of land and public infrastructure (López-Morales, Sanhueza, Espinoza and órdenes, 2021). Based on an econometric analysis they managed to demonstrate a positive variation, not only in land value but also in finalized constructions and units sold, which was directly related to the constructed urban infrastructure in their surroundings. According to this research in Santiago, the investment made by the local public entities in the Metro line resulted in an average increase of 25.6% in the profit of the finished units sold by real estate development companies. However, it only increases the market value of the raw land by 5.5% (López-Morales, Sanhueza, Espinoza and órdenes, 2021).

Urban infrastructure may also vary depending on its location within the metropolitan area. Typically, city centers have had more investment and endowment in urban infrastructure. Since the ‘center of the cities’ is where the urban dynamic started, they have been in the place for longer and so have a greater capability to improve their facilities and infrastructure. As we start moving away from the centers, the land becomes less developed, hence there is less and less investment in their infrastructure. As we can see in graph 1, the decrease in the price of land in Recife, Brazil, depends?on the distance to the center of the city:

Graph 1 Title: Investments in urban infrastructure in Recife (Brazil) produce an evident increase in the value of the land.Source: Graph 1 Smolka, 2017

It is important to mention that in most cases urban infrastructure is constructed by public entities. Still, private institutions also may invest in this infrastructure once they understand the positive impact on the value of the raw material (land capital gain). Ciudad Reformadores in Villa Nueva, Guatemala, a development by the Real Estate Company Grupo Apolo, and a project I personally directed, is a project and business model created based on these criteria. As can be observed in figure 1 below, the land had no urban infrastructure even when it was located in the center of this city. The total extension of the land is 460,820.94 m2 and the price at that moment (2014) was US$ 35.75 per m2. Grupo Apolo constructed the main sewage system, park and boulevard, as part of stage one of Ciudad Reformadores.

All of these constructions, conceived as public urban infrastructure, were built by the private company, and then donated to the local government and Villa Nueva City. The total budget for these constructions was US$ 4.3 million. Additional to these investments, a land plot with an extension of 14,000 m2 was donated to the Institute of Technical Education of Guatemala (INTECAP), representing an opportunity cost to the company of US$ 0.5 million. In other words, Grupo Apolo invested a total amount of US$ 5.4 million in urban infrastructure that directly benefits the urban grid and civilians of Villa Nueva. Figures 2 and 3 show Ciudad Reformadores after the constructions in stage 1 of the project:

Figure 1 (2014)????????????????????????????????????????????

?Figure 2 (2020)

Source: Figures 1 and 2 are from Google Maps Pro archives

Figure 3

Source: Grupo Apolo Real Estate Development Company

After the construction of the main sewage system, park, boulevard, and donation of the land, Ciudad Reformadores had a usable area of 337,000 m2 with an average price of US$ 70 per m2. After a simple analysis, Grupo Apolo managed to create a total capital gain in the value of the land of US$ 34,430,619 million. (See table 1 for more detail)

Table 1

Source: Table 1 was self-elaborated using available information and historical financial data. ($ = US Dollars)

Through the analysis of these concrete examples, we can conclude a direct relationship between the investment in urban infrastructure and the prices of land, the raw material of real estate development, and its economic process and finances. Therefore, it is vital for real estate developers to visualize cities and urban areas as the canvas to create their art. The buildings they will construct will be a piece of art that will remain in the cities as transcendental sculptures that many generations will appreciate, and as such, a building is an addition to the metropolitan dynamic. It will have the capability to change the activity and shape the lives of its different users and the area's citizens. That is why real estate development should be closely studied and addressed from different perspectives in professional practice.

The Real Estate Development Process

Now that the relationship between urban centers (infrastructure) and real estate has been analyzed, we must now comprehend the economic process behind this business's real estate value creation. For the purpose of this analysis, a simplified overview of the stages and the process will be given. This will assume that the development is one that takes all of the steps involved until a final construction is done. It is possible that in real life, many developers take part in each stage or specialize (and profit) only in a certain part of the process described.

There are two ways a project can be started: you have the land and then decide on the project, or you have the idea for the project and?then need to source the land. In both of these scenarios, the land (and, by consequence, the urban area where it is located) plays a major role. For the first scenario where the developer already owns the land, he must take into consideration the market value of the property for their financial projections. Even if in the business model the land is not actually being bought, there is an opportunity cost implied; in other words, if the project does not take place, the land can still be sold or it can be part of another business transaction. If the developer acquires the land (buying or inviting the former owner to participate), the value of this asset will play an important role in the financial model. The value of the land which is affected by urban conditions and infrastructure directly impacts the financial model of the project and as a result exerts an influence on the economic process involved in the real estate development.

For both of the initial stages of the real estate economic process mentioned above, the developer must have a deeper understanding of the characteristics of the physical context. They should have studied the needs of the city in order to propose a project that creates value for both: the urban context and the future users. This integral analysis of the context (including local regulations) and real estate market will guide the developer in deciding which use or uses to incorporate in the construction. The important decision of what type of product will be offered will then be a decisive factor in the possible selling prices. Again, we see how the urban factors exercise pressure on the financial and business model.

Having decided the main factors of the real estate process (location, land plot, and uses) the developer may now sketch a more robust financial model. The process will continue with different iterations of architectural design (that should be based on financial premises more than subjective decisions). Once the architecture is starting to take shape, the different engineers involved will start to design in their different disciplines, normally as overlapping processes. This will allow the developer to start assembling a detailed budget of the project, which is another important expenditure in the financial model.

With these important factors defined: land value plus total budget, which will equal the total expenditures and the gross profitable area per specific use, we can assemble our valuation and financial models.

As may be observed, this is an oversimplification of the economic process of real estate development but it is possible to conclude that two of the three main factors in this process have a direct correlation with the urban factors. The profitability of the project will depend on many other factors, but if we better understand the main ones involved in the value creation of this business, it will be much easier to create optimal business models.

?Finance & Real Estate

Having considered the economic process involved in real estate development, it is crucial to dissect one of its essential components: Finance. As has been observed, land is an important matter in the financial evaluation of a real estate project. Since the value of land has a direct relationship with its context (urban centers), real estate investment and finance have an impact on urban infrastructure. Therefore, the valuation of these kinds of assets has its own complexity and peculiarities. Each project will have its unique considerations because there are no same two plots of land in the world. Land which is close to urban areas may share some similarities, but there will be differences seemingly insignificant as the width of the sidewalk in front of the plot or the location within the block, both of which can affect its value. As Williams mentions in his analysis of Real Estate finance, the market for this kind of assets is not organized and it is decentralized in various actors participating in the realization of the transactions (Williams, 1999, p.11).

Typically, when working on a capital budget to determine if the capital expenditure in real assets as real estate is feasible, possible cash flows are projected. These projections are directly dependent on the current and future situation of the land and consequently to the urban proximities and city where it is located. The information required to correctly evaluate the asset financially is dynamic, as it is responsive to the urban activity. In other words, future cash flows, which will later be discounted according to the weighted average cost of capital (WACC) to determine the financial criteria for investment such as the Net Present Value (NPV), have a strong relationship with the current situation and the expectations of the city, such as its urban infrastructure (and other related conditions). Consequently, the execution of the investment of real assets takes time to physically get constructed. The developer will need to take into consideration the construction of other buildings (that will be influenced by the same urban forces) and at the end will not only ‘add to the supply of developed assets and thereby reduces competitive rents’ (Williams, 1999, p.14), but will also change the urban area. The new buildings proposed and constructed will add new characteristics to the live urban dynamic of the city. This will become a life-long bilateral relationship as the urban center has and will dictate many of the future conditions of the building (even financial ones) and the building will contribute in different ways to the city.

The valuation of real assets differs from financial assets, where the market is centralized and there are fewer entities involved in the transactions. In other words, information about trading assets such as bonds and stocks in the stock market is much more visible and accessible; normally the information required to analyze these types of investment updates in real-time while the evaluation is taking place. Reducing the effort in this search and access to data results in trades that can be ‘executed quite quickly at much less cost’ (Williams, 1999, p.11).

?REITs

When discussing real estate investment and finance it is necessary to make the distinction between real assets, such as constructions and tangible properties, and financial assets, such as securities and stocks. As mentioned above, in real assets the contextual, urban, and physical conditions of the real estate play a major role in the analysis of the investment. To invest in real estate financial assets, there are options available, such as the Real Estate Investments Trusts (REITs) in advanced financial markets. The crucial difference is that the investment is for companies in the real estate industry and development. These ultimately undergo the same analysis and evaluation as mentioned above in order to decide their investments. In the end, are REITs a more dynamic, centralized, and fluent way of investing in Real Estate related assets? Either option will have a relationship, to different degrees, with the urban and contextual dynamics of the urban infrastructure.

Further Study

Real Estate is the common ground between urban centers and finance. Is important to explore creative ways how to improve the two latter disciplines through the first discipline. After understanding how the three of them exert an influence on each other; the idea of investing in real estate projects that are not only financially feasible but also contribute to creating a healthier urban dynamic becomes imminent.

?Based on data analyses such as the case of Ciudad Reformadores show that investing in urban infrastructure creates interesting returns. Further study is necessary to develop a?mechanism where companies or individuals can invest through centralized financial markets in this kind of project. Even if they do not own the land, they can create the platform for different entities to invest in the construction of urban infrastructure in areas where the landowners or real estate developers are willing to pay for the capital gain their land or finalized constructions will gain. This kind of link will allow citizens that do not own land or projects to invest in infrastructure. Landowners and companies will appreciate the capital gain of expensive infrastructure that otherwise may not be constructed. Cities and their citizens will improve their urban conditions and as a consequence their life quality. Such investments are profitable and increase the wellness of the citizens and create the opportunities and conditions for humans to develop and thrive. Incorporating these three disciplines: Finance, Urban Centers and Real Estate Development will result in the sum of three that equals four. The fourth being the synergy of profitable real estate projects that actively contribute to urban centers creating ecosystems that support the progress of society and improve the quality of life of individuals.

?Urban Centers in developing economies

Further analysis of these types of synergies is especially important for urban centers in developing cities and emerging markets. Urban infrastructure is expensive and takes considerable time and coordination to get built. It is therefore important to create innovative ways of integrating the three disciples to benefit from the strengths of each other.

Conclusions

This research has shown how vital it is to underline the fact that the infrastructure in the surrounding area exerts a great influence on the value of the land in urban centers. After all, it is natural that urban and developed land will have a higher price than rural land. This greater value is not only attributed to the investment made in the different physical facilities a city offers, but also to the concentration of different resources individuals can find in urban ecosystems. In the end, cities, as Glaser highlighted in his book are ‘man's greatest invention’ (Gleaser, 2012, p.80). Only through urban dynamics have societies been able to cooperate and achieve common progress. The urban areas bring together a series of resources and facilities that support individuals to thrive and to create real value for the users, community, and country. Cities integrate the means by which people can fulfil their own purpose. Cities make ‘us richer, smarter, greener, healthier, and happier’ (Gleaser, 2012, p.30).

Real Estate developers need to understand that the formula of the business model is simple: developing projects with the essential goal of providing a better quality of life, and ecosystems that foster opportunities and serve as positive catalysts to the area where they are built. Projects need to be nurtured by their contextual conditions. If the proposed developments manage to create a correct synergy with the city and work as a complement rather than a merely isolated object, the business model and financials will benefit in direct proportion. The benefit an individual (user) perceives from the city and the real estate development project have a direct relationship with the sale price of the “square meter” (of the urban land as the raw material, or the finished product as a construction).

References / Bibliograpghy

Bojorque, J. and Chuquiguanga, C., 2021. Efecto de la infraestructura pública en el precio del suelo urbano. Caso de Cuenca, Ecuador. [Online] Scielo. Available at: <https://scielo.conicyt.cl/scielo.php?pid=S0718-36072021000100074&script=sci_arttext&tlng=es#f3> [Accessed 28 August 2021].

Glaeser, E.L. (2012). Triumph of the city: how our greatest invention makes us richer, smarter, greener, healthier and happier. London: Pan.

Glaeser, E., Kolko, J. and Saiz, A., 2021.?Consumer City. [Online] Scholar.harvard.edu. Available at: <https://scholar.harvard.edu/glaeser/publications/consumer-city> [Accessed 4 September 2021].

López-Morales, E., Sanhueza, C., Espinoza, S. and órdenes, F., 2021. Verticalización inmobiliaria y valorización de renta de suelo por infraestructura pública: un análisis econométrico del Gran Santiago, 2008-2011. [Online] Scielo. Available at: <https://www.scielo.cl/scielo.php?script=sci_arttext&pid=S0250-71612019000300113&lng=en&nrm=iso&tlng=en#aff2> [Accessed 26 August 2021].

Un.org. 2021.?68% of the world population projected to live in urban areas by 2050, says UN | UN DESA | United Nations Department of Economic and Social Affairs. [Online] Available at: <https://www.un.org/development/desa/en/news/population/2018-revision-of-world-urbanization-prospects.html> [Accessed 30 August 2021].

Williams, J., 1999. What is Real Estate Finance? Journal of Real Estate Finance and Economics, 19:1, (1999), pp.9-19.