Valuing the Conversion Option Afforded by Form-Based Zoning Ordinances in Different Economic Environments By: W. Keener Hughen, Ph.D. Assistant Professor of Finance University of North Carolina at Charlotte 9201 University City Blvd. Charlotte, NC 28223 [email protected] (704) 687-7638 & Dustin C. Read, PhD/JD Assistant Professor of Property Management and Real Estate College of Liberal Arts and Human Sciences Virginia Tech 295 W. Campus Drive Blacksburg, VA 24061 [email protected] (540) 231-0773 Abstract: Form-based zoning ordinances often provide real estate developers with the ability to alter the mix of residential and commercial space included in their projects so long as they comply with heightened urban design requirements governing the exterior of buildings and the relationship of these structures to the public realm. The real option pricing model presented in this paper seeks to value this flexibility and assess the impact on both development decisions and developer profits in different economic environments. Focusing on the incremental value afforded by a form-based code in a single-period setting allows for the derivation of closed-form solutions in some scenarios, thereby contributing to the existing real options literature. Results generated by the model also suggest form-based codes can serve as a useful urban revitalization tool. These regulations are found to have a greater relative impact on developer profits in weaker markets and those with more volatile demand, which bodes well for their use to stimulate development in markets where it might not otherwise occur. Nonetheless, form-based codes may not encourage a greater amount of mixed-use development in comparison to other regulatory alternatives allowing for the integration of residential and commercial space at the project level. Policymakers must therefore be mindful of their objectives when evaluating the merits of this type of land use regulation. Keywords: Form-based zoning, real estate development, real options, and urban revitalization 1 Introduction Form-based zoning ordinances provide real estate developers with the ability to include a market-driven mix of residential and commercial space within their projects so long as they satisfy a series of urban design requirements put in place to ensure the external features of buildings support a community’s articulated vision (Langdon, 2006; Barry, 2008 Talen, 2013). To the extent the option to convert space from one use to another over time is valued by the private sector, these regulations are anticipated to encourage development activity in markets where it might not otherwise occur (Walters and Read, 2014). The real option pricing model presented in this paper examines this hypothesis to determine if form-based codes are a useful urban revitalization tool. Factors such as conversion costs, diminishing marginal revenues and economies of scale in construction are taken into account to estimate the impact of a stylized form-based code on development decisions and developer profits when market demand is uncertain and evolving stochastically over time. Unlike many real option models set in continuous time that focus on the impact of regulatory flexibility on the timing of real estate development, this model examines the value afforded by a form-based code in a single-period setting. This simpler setting allows for the derivation of closed-form solutions in some scenarios and greatly facilitates the sensitivity analyses. The results generated by the model suggest this type of zoning can act as a catalyst for development in markets with relatively weak and/or volatile demand. This bodes well for municipalities interested in using form-based codes to foster urban renewal. However, the flexibility afforded by form-based codes may not produce a greater amount of mixed-use development in comparison to other regulatory tools permitting the integration of residential and commercial space at the project level. Policymakers representing municipal governments should 2 be mindful of these outcomes when evaluating the potential advantages and disadvantages of implementing form-based zoning ordinances in the communities they serve. The study begins by reviewing the structure of form-based codes and discussing the appropriateness of examining them through the lens of real option theory. Key features of the model presented in this paper are outlined next, along with the numerical results generated by a set of base case parameters. Sensitivity analysis is then performed to estimate the potential impact of form-based zoning on development decisions and developer profits in the presence of different market conditions. The paper concludes with an assessment of the model’s limitations and a summary of issues in need of further investigation. Steps are taken throughout to emphasize the relevance of the research to the study of economic development, real estate and urban planning. Literature Form-based zoning represents a dramatic departure from the land use regulations that have shaped the built environment of cities throughout the United States over the course of the last century. Rather than imposing somewhat arbitrary restrictions on allowable land uses within defined geographic districts, as is typically the case with Euclidean zoning, form-based codes authorize a much more liberal mix of residential and commercial space in areas that are urban in character (Walters, 2007; Gellar, 2010). Stakeholder interests are protected throughout the process by requiring developers to act in accordance with heightened urban design standards influencing how privately-owned buildings interact with the public realm. Common features of modern form- based codes include requiring buildings to meet the street in a uniform manner to frame public areas; eliminating blank walls along pedestrian thoroughfares through the inclusion of transparent 3 windows and doors; screening parking and moving it to the rear of structures; and establishing height and width requirements for buildings and roads to improve walkability (Talen, 2009). Municipalities interested in adopting form-based codes begin by soliciting input from stakeholder groups regarding the desired physical character of a place or space (Sitkowski, 2006). Diagrams, drawings and pictures illustrating the vision for future development are then created through an iterative process, along with text describing the relationship between buildings, streets and public spaces (Rangwala, 2005; Cable, 2009; Morphis, 2010). The resulting code includes all of these elements and is prescriptive, as opposed to proscriptive, in the sense that it tells developers what they can build on a given site as opposed to what they cannot (Inniss, 2007). Controlling development activity in this manner is anticipated to combat urban sprawl and improve the quality of life enjoyed by local residents through the elimination of regulatory barriers that have historically served as obstacles to mixed-use development (Talen, 2013). Depending upon the policy objectives, form-based codes can impose mandatory design standards or voluntary ones that a real estate developer can opt into as an alternative to the existing zoning requirements. These regulations can also be structured to cover a variety of geographic scales ranging from targeted revitalization districts to a municipality as a whole (Langdon, 2006). Irrespective of these differences, most form-based codes include five common components including a regulating plan illustrating the desired location for different types of buildings and public areas; urban regulations governing size, massing and in-building use standards; street regulations controlling the width and location of thoroughfares and sidewalks; and in some instances landscaping and architectural controls imposing significant restrictions on the design of both structures and open spaces (Inniss, 2007). Codes including these components have withstood a host of legal challenges, especially when architectural requirements are implemented in a style- 4 neutral manner to influence interactions between buildings and the public realm (Sitkowski, 2006). Resilience to legal scrutiny has encouraged a growing number of municipalities to adopt form- based codes to govern real estate development in green-field locations and on infill sites. Those in favor of using form-based zoning as an urban revitalization tool contend that this type of regulation can produce a wide array of benefits for economically disadvantaged neighborhoods when it encourages the incorporation of housing into mixed-use development projects (Gonzalez & Lejona, 2009). Some notable examples include improving access to employment opportunities for the working poor; deterring crime through the integration of housing into active commercial districts; enhancing pedestrian mobility as a result of greater spatial connectivity between complimentary land uses; attracting retail amenities to low-income communities through the elimination of barriers to entry; and promoting healthier lifestyles through the provision of functional public spaces (Gellar, 2010). Municipalities can additionally benefit from an expanded tax base and a lower marginal cost of providing infrastructure when form-based codes serve as a catalyst for development in economically fragile areas (Barry, 2008). The benefits associated with form-based zoning have created substantial support among planners and economic developers working on behalf of local governments (Talen, 2005). Real estate