Residential Real Estate

Hello,

Lately, I have been receiving an increasing number of requests for a copy of an "air rights" article I wrote in 2003 which was circulated in the Winter of 2004, entitled "MONEY FROM THIN AIR - DEVELOPING URBAN AIR RIGHTS".

With the latest announcement [see Crain's Chicago Business, July 5, 2006] that Toronto-based Brookfield Asset Management Inc. has paid $27.5 million for the "air rights" associated with 300 S. Riverside Plaza, Chicago, Illinois, where a 1.1 million square foot office tower is about to go on the market, interest in understanding the transfer, ownership and development of "air rights" is bound to increase.

If you are interested in learning more about the subject of "air rights" transfer, ownership and development, hopefully you will find the attached article instructive. Please feel free to request the full article, with footnotes and case citations, via email.

The fundamentals of air rights transfer, ownership and development as described in this article remain useful today, notwithstanding that zoning district classifications under the Chicago Zoning Ordinance were modified effective August 1, 2004 (except as to Downtown Districts, which were modified effective November 1, 2004) [making references in this article to specific zoning districts and FAR requirements in need of reexamination].

"Air rights" are, of course, NOT a uniquely "Chicago" phenomena. The specifics of each applicable zoning ordinance must always be taken into consideration when planning to sell, acquire or develop an "air rights" interest.

Enjoy!

Kymn



MONEY FROM THIN AIR
*Developing Urban Air Rights

Prime commercial land is limited. Prices per square foot can be astronomical. Demand for efficiency to maximize return is growing. No wonder developers and property owners are looking to the sky, with varying degrees of success, to capture all the value they can from each urban parcel.

Owners and developers, and people in general, are conditioned to think of potential development sites as flat surfaces with essentially two dimensions: north/south and east/west. They see only the surface of the land, and envision the building they will construct for the particular purpose they have in mind; a bank, a drugstore, a restaurant, a strip mall, a parking garage, an office building. If the parcel is larger than they need, they may envision subdividing the parcel to make two or more lots. In most cases, however, they think primarily in terms of land coverage for the type of building they need. They visualize only the two dimensional space depicted on their Site Plan or Plat of Survey.

In 30 out of 50 states , including all Mid-Western states, the "Rectangular Survey System" is in effect. The Rectangular Survey System was adopted in 1785 to meet the needs of the Federal Government as it faced the challenge of dividing vast areas of undeveloped land lying west of the original 13 colonies. The system, developed under the direction of Thomas Jefferson, essentially divides the United States into rectangles, measured in relation to lines known as Meridians and Base Lines .

Development lots are instinctively viewed as the two-dimensional surface of land visually representing a potential development parcel. Descriptions of a parcel typically refer to "a parcel of land X feet by Y feet" located in relation to an intersection or other identifiable landmark.

Once a parcel is "developed", or designated for development, by construction of improvements on the land, it is natural to think of the parcel as being unavailable for further development (unless the existing improvements are to be demolished).

Classic examples of this are single story commercial buildings at prime commercial locations, a multi-deck parking garage or mid-rise building in a downtown development area, railroad tracks or spurs cutting across valuable urban land and, in some cases, roadways and alleys.

Each of these situations represent, potentially, underutilization of valuable real estate. Finding a way to develop the "air" above these existing or planned improvements maximizes the economic utility of these parcels and can be like creating "money from thin air."

The practice of finding ways to utilize the "space above" is often referred to as "air rights development". Air rights development requires thinking in three dimensions, and requires serious design consideration and legal planning but, when land values are at a premium and zoning permits, the economic return may be dramatic.

Though often overlooked, virtually all of Chicago's downtown business district is a "city in the air". People tend to think of streets and street level entrances to buildings in the downtown Chicago "loop" as being at "ground level". This is simply not the case. Most of what is thought of in the Chicago Loop as being at "ground level" is located 12 to 22 feet above the earth's surface . This explains the vast network of "lower" streets and passageways in downtown Chicago, such as "Lower Wacker Drive", "Lower Dearborn Street", "Lower State Street", etc. which most people seldom traverse. It also explains why, in 1992, the Chicago Loop business district was virtually shut down by "the Great Loop Flood of '92", but few people got wet or even saw any water as office and retail buildings were closed and workers were sent home because of "flooding".

The point of these observations is to reveal that "development of air rights" is not new. It is also not ". . . some exotic legal manipulation of doubtful efficacy dreamed up by big city lawyers for use only in big cities" . Development of so-called "air rights" is little more than efficient use of a limited resource when use becomes economically feasible and beneficial.

"Air rights" are part of the "bundle of rights" constituting fee simple title to real estate. The term "air rights" generally refers to the right of the owner of fee simple title of a parcel of land to use the space above the land. If this right did not exist, it would not be possible to construct improvements on the land, such as a home, fence or other structure above the surface of the land. While the ancient common law doctrine that "ownership of land extends to the periphery of the universe" has been limited to accommodate the modern world realities of air-travel, the fundamental concept that land ownership includes the right to use and occupy the airspace above the surface of the land is well established.

As one of the bundle of property rights comprising fee simple title to real estate, "air rights" may also be "unbundled" and alienated separate from other rights in the bundle. Conceptually, from a legal standpoint, the separation and transfer of so-called "air rights" is not materially different from subdividing and transferring a lot pictured in only two dimensions. Instead of subdividing and selling off, for example, "that part of Lot 1 lying east of the west 100 feet of Lot 1" as depicted on a plat of survey, the transfer of air rights subdivides and transfers a parcel based upon its vertical elevation. For example, one might subdivide and transfer "that part of Lot 1 lying above a horizontal plane located 100 feet above [some benchmark elevation].

By dividing a development parcel "vertically", it is often possible to "stack" uses in a mixed use development owned by more than one owner or developer, in the same way it is possible to subdivide and develop side-by-side a horizontal surface subdivision. In some cases, without even developing the open air above existing or planned improvements, it is possible to sell and transfer "air rights" to an adjacent property owner to allow construction of a taller building on an adjacent building site. Recognizing this potential can result in a substantial economic windfall to a property owner otherwise underutilizing a valuable development parcel.

Hypothetical Facts: Suppose you are planning to acquire a 20,000 square foot parcel in Chicago, IL zoned B6-6. Your purchase price is $4,500,000. You believe it is a perfect location for a restaurant/banquet/entertainment complex serving food and liquor, with live entertainment and dancing. You visualize a state of the art venue spread out over 2 floors, with about 19,000 square feet of usable space per floor, for a total restaurant/banquet/entertainment venue of 38,000 square feet. Fortunately, adequate parking is close by and available. Demand for offices and condominium housing is growing in the vicinity of your parcel, which you believe will further enhance the chances of success of your planned business by bringing more customers through your doors. Although you recognize development of offices and condominiums in your area is a "hot" development opportunity and might also be an excellent investment, you have no interest or experience in developing offices or condominiums and really just want to develop and open your dream restaurant/banquet/entertainment complex. You have calculated your costs of construction and operation, and believe the project is economically feasible, although you would like to find a way to cut your costs or otherwise increase your return on investment.

Consider this: The restaurant/banquet/entertainment complex you wish to construct is a permitted use in the B6-6 zoning classification under the Chicago Zoning Ordinance. Also permitted is a wide array of other business and service uses, as well as dwelling units as long as the dwelling units are not below the second floor.

The permitted floor area ratio (F.A.R.) for a parcel zoned B6-6 under the Chicago Zoning Ordinance is 12; which means that the total square footage of the building or buildings permitted on your 20,000 square foot parcel is 240,000 square feet. You are utilizing only 38,000 square feet which means, from a zoning standpoint at least, you are underutilizing your parcel to the extent of 202,000 square feet.

Suppose you were able to reconfigure your proposed project to free up 1000 to 1200 square feet per floor in return for recovering half (or more) of your total land cost. If this were possible, your restaurant/banquet/entertainment complex may be reduced in size to 36,000 square feet instead of 38,000 square feet, but your development cost for the project would be reduced $2,000,000 or more. Almost free money.

How could this work?

Scenario No. 1: With the hypothetical facts presented, it is certainly within the realm of possibilities to market and sell the "air space" above your proposed restaurant/banquet/entertainment complex for development of offices and/or condominiums. As mentioned, under the applicable zoning classification, 202,000 square feet remains available for development on your site. With prevailing land values of $225 per square foot (represented by your purchase price of $4,500,000 for a 20,000 square foot parcel), a condominium/office developer may well view your "air space parcel" as a bargain at $2,000,000 ($100 per square foot – measured in two dimensions for 20,000 square feet) since it would still enable construction of 202,000 square feet of floor area above the second floor.

Obviously, to make the "air space" usable, adequate means of access and support must be planned, which will require detailed planning for design and construction of both the ground level parcel and the "air space" parcel (which do not necessarily need to be constructed at the same time, although simultaneous construction may be more efficient and practical) and creation of legally sufficient easements of support, and easements for ingress and egress, utilities, loading and unloading, mail delivery, a street level lobby, elevators, standpipes, etc., as well as drafting of development specific covenants running with the land to promote non-interference and compatibility of use of each parcel. The necessity for easements of support, and easements (or conveyance of fee parcels) for a street level lobby, mail delivery areas, and loading and unloading areas, is the reason slight reduction in size of the proposed restaurant/banquet/entertainment complex is suggested in the premise to Scenario No. 1 – to free up space for these purposes.

While sale of an "air rights parcel" will require added expense for engineering (much of which will likely be undertaken by the proposed developer of the air rights parcel) and attorneys fees to negotiate and draft a workable declaration of easements, covenants and restrictions to legally facilitate the development and use of each parcel, the economic advantage of being able to sell the air rights parcel may more than justify the added effort and development expense involved.

Scenario No. 2. Assume the same hypothetical facts as in Scenario No. 1, except that instead of being the owner of the parcel referred to in Scenario No. 1 (the "Entertainment Parcel"), you own or wish to develop a parcel adjacent to the Entertainment Parcel. Perhaps the Entertainment Parcel has already been developed with the restaurant/banquet/entertainment complex referred to in Scenario No. 1. Assume your parcel (the "High Rise Parcel") is 40,000 square feet with B6-6 zoning, and you wish to construct (or to sell your parcel to a developer to construct) a mixed-use development with first floor retail, five floors of office space and six floors of luxury condominiums. Because zoning for the High Rise Parcel allows an F.A.R. of 12, you determine a twelve-story, 480,000 square foot building is the maximum you will be able to construct on your 40,000 square foot lot

In conducting a financial analysis of your project you determine that the marginal cost of each floor would result in you generating a substantially greater return on your investment if you were able to construct additional floors of office space, condominiums or even multi-level parking in your proposed project on the High Rise Parcel. Still, you are faced with the maximum F.A.R. of 12 for the High Rise Parcel as established by the Chicago Zoning Ordinance.

Is there a solution? Perhaps.

The Chicago Zoning Ordinance defines a "Zoning Lot" as follows: "A 'zoning lot or lots' is a single tract of land located within a single block, which (at the time of filing for a building permit) is designated by its owner or developer as a tract to be used, developed, or built upon as a unit, under single ownership or control. Therefore, 'zoning lot or lots' may or may not coincide with a lot of record".

One solution is that the owner of the High Rise Parcel might acquire the "air rights" over the Entertainment Parcel (by purchasing from the owner of the Entertainment Parcel, ". . . all of the Entertainment Parcel except that part thereof lying below a horizontal plane located x feet above the Chicago City Datum") and then designate the Entertainment Parcel as part of the Zoning Lot to be developed and controlled by the developer of the High Rise Parcel. The "Zoning Lot" would then be 60,000 square feet . Because the F.A.R. remains 12, the maximum floor area on the total Zoning Lot is 720,000 square feet.

Because 38,000 square feet has been used (or is to be used) for the restaurant/banquet/entertainment complex, 682,000 square feet remains available for development on the Zoning Lot (being, in effect, the High Rise Parcel) . Therefore, instead of being able to construct only a 480,000 square foot project on the High Rise Parcel, if developed alone, the developer would now be able to construct up to an additional 202,000 square feet (for a total of 682,000 square feet) on the High Rise Parcel – or, roughly, 5 additional floors at 40,000 square feet each, because the High Rise Parcel and the Entertainment Parcel, collectively, constitute the "Zoning Lot".

* * *

Of course, if the developer does construct 682,000 square feet of floor area on the High Rise Parcel (in addition to the 38,000 square feet constructed on the Entertainment Parcel) under the foregoing Scenario No. 2, all floor area available for development of the combined Zoning Lot pursuant to the zoning ordinance will have been fully utilized. As a result, since the Zoning Lot is fully developed as a whole, no further opportunity exists to expand the square footage of improvements on the Entertainment Parcel. If the restaurant/banquet/entertainment complex fails, or is destroyed or otherwise demolished, the replacement improvements will be limited to a maximum square footage of 38,000 square feet.

To avoid this outcome, parties will sometimes negotiate an "air rights transfer" that raises the elevation of the delimiting horizontal plane and includes an express covenant running with the land that reserves potential floor area to the transferring parcel (in this case, the Entertainment Parcel).

Under Scenario No. 2, the sale of "air rights" is more akin to the sale of "development rights", but the legal principal is substantially the same as in Scenario No. 1. In each case, a property owner is selling the right to develop "the sky above" while retaining the ground level development parcel.

* * *

"Air rights" are valuable property rights that can be sold, purchased and transferred. Under the right circumstances, "air rights" may represent a substantial untapped resource with great value to those who recognize their potential. Since the transfer of these property rights may not directly impair the owner's intended use of the surface level property, they often do represent "money from thin air".

R. Kymn Harp