‘Tis An Ill Wind, A Creative Response: The Transfer of Development Rights

Even the no-growth movement, which has been bedeviling the real estate industry for the past several years, carries with it some new opportunities for the canny real estate investor. These new opportunities go by a variety of names; sale of air rights, transferable development credits, and transfer of development rights (''TDR") are among the most common. By whatever name, the concept remains the same. The owner of a piece of real property can sell the unused development rights to the developer of another piece of land.

Consider this example: Jones owns a 50,000 sq. ft building. Under current zoning and development rules, Jones could tear down the existing building and build a 100,000 sq. ft building on his property. Smith owns a similar piece of property on which he could build a 100,000 sq. ft building. Smith would like to build a larger building. Smith purchases the unused development rights from Jones. Smith builds a 150,000 sq. ft building. Jones is given the “benefit” of his unused development rights in the form of a cash payment.

These TDRs are, in large part, the by-product of the enormous increase in government regulation of the real estate industry. Prior to the recent surge of government regulation, property owners had the general ability to obtain approval for the construction of almost anything that market conditions would otherwise justify. With the rise of stringent land use controls, the cost and complexity of obtaining permission to build has significantly increased the value of all development rights and has created a market of those development rights independent of the land to which they were attached.

Transfer of development rights while conceptually uncomplicated is, in practice, no place for the unsophisticated buyer.

The first problem facing the prospective buyer or seller is defining what is to be sold. Unlike the sale of real property, which can be defined, drawn, and even staked out by a good civil engineer, development rights, prior to their use, have an almost mystical quality. There is no simple solution to the definition problem. The cooperation of the city attorney and planning director in smaller municipalities will be invaluable.

Some jurisdictions, like the City of Los Angeles, have begun enacting ordinances regulating the transfer of development rights. These ordinances assist in defining the interests to be transferred. Most jurisdictions do not have such ordinances. Careful legal drafting and close cooperation between the buyer, seller, and City will be necessary to protect all of the parties’ rights.

Even after the interest to be sold is described, the process for consummating the sale may be complicated. Unlike the sale of most real property interests, which can be transferred through an escrow, this transaction requires concurrent governmental approval. The buyer and seller are, in essence, transferring a government permission to build between each other. A sale without the blessing of the government agency carries with it inordinate risks. In those cities which have enacted ordinances which permit the transfer of development rights, the ordinance will spell out the procedures. Many cities are either unfamiliar with the concept or have no formal procedures for permitting such exchanges. In such municipalities, the buyer and seller may be obligated to educate both the public as well as the pubic officials before being able to consummate the sale. Traditionally, such transfers will require a public hearing before the Planning Commission and/or City Council. In Redevelopment Agency areas, approval of the Agency Board will also be necessary.

California State law has not yet identified or codified the transfer of development rights. This opens the door for both creativity and confusion. In many cases, the pioneer in the purchase or sale of development rights will be working together with government to define the procedures while completing their transaction.

Adding to the complexity of these problems is the absence of a pricing schedule. While the purchase and sale of real property is always the subject of negotiation, the negotiations normally are "controlled" by similar sales. Since few transactions of the sale of development rights have actually been completed, it is too early for the industry to have developed a set of “comparable sales” to use as an index for such transactions. Each transaction must be, therefore, negotiated in a far less defined environment than is traditionally the case for real estate transactions.

Determining price for the buyer will be a less complicated process than for the seller. The buyer, who is purchasing the ability to build additional marketable space, can use the same return on investment standards as would be applied to any other real estate purchase. The seller, however, is selling an "extra" which is less definable and less measurable for him than for the buyer. The seller's task is complicated by the government approvals. Most approving government agencies will require the payment of a fee for approving the transaction. Those fees are also subject to negotiations. The amount of the fee paid to the government agency will reduce the amount of money that the seller can command for the sale.

The newness of the market for transfer development rights also means that the real estate brokerage community has not yet developed a simple system for bringing buyers and sellers together. Very sophisticated real estate brokers are beginning to talk to their clients about marketing surplus development rights. Despite these conversations, no listing procedure has been developed. Both buyer and seller have to seek each other out.

Lastly, title companies, lenders, accountants and lawyers have not had a stream of transactions to use as benchmarks. Traders in development rights will have to educate those parties as well.

Will the benefits justify the effort? The answer is a qualified yes. For the sophisticated real estate investor, the transfer of development rights offers a unique opportunity. For the seller, it offers a chance to maximize the value of his property by selling space he has not used and is not intending to use. For the buyer, it permits the opportunity to increase the development rights of a project less expensively and with fewer complications than traditional land use approvals would permit. For both parties, it is a process well worth the effort.

Douglas Ring is a partner in the law firm of Shea & Gould. He serves on the Los Angeles Transfer of Development Rights Evaluation Task Force.