Zoning in Relation to Commercial Real Estate Investment and Development
Zoning is the process of segmenting land into zones, each of which permits and prohibits specific land uses. Zoning also regulates elements like the height, density, and design of buildings in certain areas. Understanding zoning as it relates to commercial property is essential for commercial real estate investors and developers, as failing to abide by zoning regulations can be expensive, time consuming, and potentially disastrous.
In most cases, areas are zoned for one specific property type; i.e. single-family residential, multifamily residential, retail, industrial, or agricultural, to name a few. However, overlaps often occur, especially in high-density urban areas.
In this article, we’ll review:
The basics of commercial zoning: We explain the difference between residential and commercial zoning, and zoning considerations for each individual type of commercial property, including multifamily, retail, office, industrial, agricultural, and more.
Negotiating and adjusting commercial zoning ordinances: Rezoning petitions, conditional use permits, and variances are all ways that developers sidestep zoning regulations in order to move their projects forward. We explain each, as well as detailing potential land use pitfalls like exaction clauses, easements, and restrictive covenants.
Commercial zoning in relation to commercial real estate loans: We’ll delve into why zoning information is so important to commercial mortgage lenders, and why it’s especially important for commercial construction loans.
The Basics of Commercial Zoning
Unlike residential zoning, which governs the design and structure of single-family homes, commercial zoning ordinances regulate commercial structures, such as apartment buildings, shopping centers, office parks, and industrial facilities. Due to this, factors such as parking, building safety, access requirements, and other factors become significantly more important.
Residential Zoning vs. Commercial Zoning Regulations
When most people think of zoning ordinances, they think of rules for single-family homes in residential neighborhoods. These type of zoning regulations typically govern design essentials such as building paint and color, layouts, setbacks, and design. Commercial zoning usually includes all of these elements, as well as other zoning rules specific to commercial structures, including:
Floor area ratio: Floor area ratio, or FAR, compares the square footage of a parcel of land with the square footage of a building itself. FAR counts vertically and horizontally; if they were both located on the same sized parcel, a 1-story, 3,000 sq. ft. building would have the same FAR as a 3-story building with 1,000 sq. ft. on each floor.
Lot coverage: Like FAR, lot coverage compares the square footage of a land parcel to the size of a building(s) footprint. Unlike FAR, however, lot coverage does not factor in height/density; on the same sized parcel, a 10-story building and a 1-story building with the same building footprint would have the same lot coverage. Lot coverage is generally expressed as a percentage, and is mainly used for industrial properties.
Parking ratio: Parking ratio compares the number of parking spaces for a commercial property with the property’s gross leasable area (GLA). It is usually represented as the number of parking spaces per 1,000 sq. ft. Cities and counties generally set a minimum ratio for different types of buildings; office buildings may need a minimum parking ratio of 5, while an industrial facility may only need a parking ratio of 2 to comply. Parking ratios also must comply with the Americans with Disabilities Act (ADA) regulations, by having a certain number of handicapped parking spots.
Exits and fire escapes: Exits and fire escapes are essential safety features in any building, and, while exact requirements vary between municipalities, larger and taller commercial structures must generally invest significantly more time, money and planning efforts into ensuring that safety features comply with local zoning regulations.
Specific Zoning Considerations for Individual Commercial Property Types
While it’s important for investors and developers to understand the broad strokes of general residential and commercial zoning rules, each individual commercial property type has it’s own specific considerations, as detailed below:
Many neighborhoods are classified as either single-family or multifamily zones. In general, multifamily zones permit both single-family homes and multifamily properties, while single-family zones permit only single-family properties. For multifamily zones, density and height restrictions are common. Some multifamily zones only allow duplexes, triplexes, or quadplexes, while others permit significantly larger apartment buildings. However, in many municipalities, apartment buildings with 5+ units are considered commercial properties, as the apartment buildings themselves are profit-generating businesses.
While commercial and residential properties often mix, areas zoned for industrial use are typically more segregated, and further away from urban areas. Technically, most industrial zones do not allow for commercial businesses, however, exceptions are often made. For instance, business owners or developers looking to build a retail property (such as a gas station) in an industrial zone can often seek special permission to do so, usually through an ancillary use permit. In general, industrial zoning regulations often differ between light industrial zoning and heavy industrial zoning.
Light Industrial: Light industrial property uses include packaging, certain types of manufacturing, and distribution facilities. As these uses do not typically produce a significant amount of noise and environmental pollution, light industrial zones are generally located closer to commercial and residential zones than their heavy industrial counterparts.
Heavy Industrial: Heavy industrial property uses include chemical manufacturing, mining, power production. As a result, heavy industrial zoning regulations specifically take into account factors like noise pollution, smoke, smell, waste, and other, similar elements that could have a negative impact on the surrounding environment.
Airports: Are generally considered heavy industrial properties, but often are subject to somewhat different rules and regulations due to the amount of land required and the additional noise generated by their operations.
Retail zoning may not generally be as challenging as industrial zoning, but specific types of businesses often have to abide by certain restrictions. This is not necessarily of massive importance to a commercial real estate investor or developer, but it is still something to be cognizant of, especially when determining what kind of tenants may be renting out a particular commercial property. While rules vary by state and by municipality, restrictions are generally placed upon bars and liquor stores, as well as businesses involved in the adult entertainment sector. For instance, in Texas, establishments that serve alcohol must be at least 300 feet away from schools and churches. In addition, while not technically “zoning” in the traditional sense, all private businesses that serve the public must abide by the Americans with Disabilities Act (ADA), which ensures that the business can reasonably be used by disabled individuals.
Agricultural zoning generally restricts an area to agricultural production and associated activities. Most commercial developers rarely interact with agricultural zones, with the exception of areas close to growing cities or suburbs that may be prime candidates for redevelopment into industrial or single-family residential properties.
A variety of regulations prevent the alteration or demolition of certain historic buildings, particularly those within designated historic zones. On the federal level, the National Register of Historic Places has a definitive list of historic structures throughout the U.S., but it’s typically local and state regulations that actually impact development. For example, in California, any building more than 50 years that possess some degree of architectural or historic significance may be classified as a potential historic resource. And, on the local level, the city of Los Angeles uses Historic Protection Overlay Zones (HPOZs) in order to prevent the demolition of historic structures. However, historic buildings aren’t always a bad thing for development-- especially since the federal government’s Historic Tax Credit (HTC) program allows developers to claim a 20% tax credit against qualified rehab expenses for income producing historic buildings. In addition, various state tax credit programs also encourage the rehab of historic structures, and can be combined with the federal HTC program to maximum investment yield.
Negotiating and Adjusting Commercial Zoning Ordinances
Now, we’ll discuss the most common ways that investors “get around” commercial zoning restrictions, including rezoning petitions, zoning variances, conditional use permits, and more. We’ll also touch on subdividing commercial properties, planned use developments, and
Rezoning Commercial Property
If a landowner or developer wishes to, say, build a commercial property in a residential neighborhood, they may attempt to petition the government to rezone the area to allow for commercial property. However, rezoning is generally a slow process, and zoning changes are not typically made specifically for developers. In fact, governments will generally only make direct changes to zoning regulations, when an area has itself undergone significant change. For instance, if residential and commercial properties are being developed close to a former industrial area with a lot of unused buildings, a city may decide to rezone that area in hopes that it will encourage sustainable re-development.
Accessory and Ancillary Use Codes
Accessory and ancillary use codes both impact commercial property development, albeit in different ways. Accessory use codes determine what “accessory” elements a property may have; examples include swimming pools, playgrounds, solar power collectors, fuel tanks, storage areas, and other similar structures. In general, these are mostly of concern for multifamily developments but may impact larger office parks or corporate campuses Ancillary use codes permit specific uses of property that may not be in reflect the exact zoning codes but align with the needs of local businesses or the local community. To use a previous example, a gas station located in an industrial zone does not directly reflect zoning ordinances, but is nonetheless needed by workers traveling in and out of the area.
Commercial Zoning Variances and Conditional Use Permits
In most cases, the most effective way for a commercial property investor to circumvent zoning regulations is through a zoning variance. A zoning variance is a request for a certain zoning requirement or requirement(s) to be waived for a specific property. In most cases, a developer will have to apply through the correct channels, often through a city or county government website or zoning office. They will then have to attend a zoning hearing where they argue that the current zoning regulations make it difficult to make the best use of their property and that their intended use will not negatively impact the surrounding community. It’s generally recommended that an owner/developer consult with an experienced real estate attorney to help guide them through the process.
Variances are most likely to be granted to allow physical changes to a property-- such as permitting an office building to be 7 or 8 stories in an area that typically only permits 5-story developments. In rarer cases, variances are granted to permit the development of a property with a different use than was originally intended for that zone. However, in many cases, a conditional use permit (CUP) can be a significantly more effective way to do this.
A conditional use permit (CUP) allows a property to violate an area’s zoning regulations, provided that it creates an overall benefit to the community as a whole. CUPs are often used to allow retail or commercial businesses and schools in residential zones. Much like the process to obtain a zoning variance, getting a conditional use permit typically involves a developer communicating with the local zoning board and drafting a CUP request, which should generally be created with the help of an attorney. Then, the owner/developer will usually need to go before the local zoning board or city to argue that their intended use for the property will help, rather than harm the surrounding community.
Subdividing Commercial Property
Some developers may attempt to fund a commercial development is by subdividing property they have purchased and selling off part of it. However, to subdivide land, property owners generally also need the permission of their local municipal zoning board. While subdividing property is more common for individuals who own large amounts of land, especially in suburban or rural areas, it can work for commercial development in more densely populated areas. However, to work, the size of the property must large be enough to reasonably be subdivided, and the developer’s intended project will still need to fit on the remaining portion of the land.
Commercial Zoning and Planned Unit Developments
A Planned Unit Development (PUD) is a type of development that has specifically been zoned to allow for both residential and commercial property uses. PUDs are most common in areas that are undergoing a certain degree of economic revitalization, and thus, municipal authorities are willing to relax typical zoning rules, at least to a certain extent.
This makes PUD-zoned areas significantly easier to develop, as owner/developers may not need to put additional time and energy into seeking variances or conditional use permits. This is especially the case for developers who want to construct commercial properties in traditionally residential areas or to create viable mixed-use developments. PUDs may sometimes receive public subsidies in addition to private development dollars, but this is somewhat rare, as residents may perceive that their tax dollars are simply encouraging corporate profits, and not working toward the public good.
In most situations, a PUD acts as a “floating zone,” which means that it is not visible on a zoning map, and instead “floats” over a specific area for the duration of the planning process. Only after the PUD is complete is the zoning map actually changed. In addition to allowing for a combination of property types, PUDs may also relax other zoning ordinances, such as setback rules or maximum building size. This can make them especially appealing to developers who feel constricted by overly strict zoning regulations.
Exaction Clauses and Commercial Property Development
Commercial zoning regulations are usually intended to help municipal governments shape development in a way that benefits residents in the long run. However, while municipalities often support real estate developers, their focus on maintaining public services could lead to unexpected development challenges. An exaction clause is a perfect example of such a challenge. An exaction clause can be triggered when a municipality believes that developing a specific property could lead to an unforeseen cost to the surrounding environment, especially to city property.
For instance, if a city believed that a new shopping center developing would significantly increase wear and tear on roads, they could attempt to charge a developer for this anticipated cost before allowing them to break ground on the property. However, exaction clauses can be challenged in court; to be held up by a judge, an exaction must result from “a substantial government interest” and that there must be a direct relationship between the exaction and that interest. In other cases, an exaction may come in the form of an easement for public use; for instance, a shopping center or industrial park may need to allow for a bike path or access road running through part of the property.
Other Restrictions: Private Easements and Restrictive Covenants
While not technically ‘zoning’ in the traditional sense, easements and restrictive covenants can have a substantial impact on how a developer may utilize a specific property. Easements, for example, allow a third-party to use a property for some specific use, and are often written into the deed of the property itself, however, they can also be implied by repeated behavior. For example, if the owner of a shopping center allowed (or did not stop) a neighboring fast food restaurant’s delivery trucks to park in shopping center parking lot, a new owner may not be able to legally stop this practice.
Like many easements, restrictive covenants are written into the deed of a commercial property, and may either last a certain number of years or indefinitely. In some cases, they may restrict the types of businesses that can be operated on the property, or they might prevent a certain part of the property from being developed. Either way, it’s essential to know exactly what restrictions a property has (or allowances that a property owner must provide) before purchasing or developing a commercial property.
Commercial Zoning in Relation to Commercial Real Estate Loans
Since zoning is essential to determining how a commercial property may be used, it’s an equally essential part of the commercial real estate lending process. Before approving a borrower for a commercial or multifamily loan, a lender will want to be certain that the intended use of the property is in alignment with any zoning ordinances that an area might have.
To do this, they typically require a borrower to pay for a zoning report, a detailed analysis of all pertinent zoning laws in the area where the property will be purchased. In fact, some states, including New Jersey, require that a borrower orders a zoning report before buying any kind of commercial property. If a building currently has a legal, non-conforming use (i.e. grandfathered-in), lenders will typically lend more conservatively due to the increased risk of future liability. Zoning reports are even more important for property rehabilitation and commercial construction loans, as these typically are significantly riskier than acquisitions re refinances, and may involve a property being used in a different way than it was previously.
In conclusion, without understanding zoning, commercial investors and developers cannot effectively do business. It’s important to realize that, while commercial zoning ordinances may seem restrictive, there are numerous ways to modify or work around them, depending on the specifics of an individual deal. In the end, the more investors understand about zoning, the more they can do to minimize risks and boost potential investment returns.