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Commercial vs. Residential Real Estate
Part II - Developments
This is the second article of a series of five, comparing risks and benefits associated with commercial real estate (see my last blog), residential, vacant land, and (this week) real estate developments.
For the purpose of this article, we shall call a "development" the process which starts from a vacant land parcel and takes it to a finished real estate product, such as a mall, an apartment complex, a condominium building, retail stores or any combinations thereof. Permitting and building a single residential home would not qualify as a "development"; however, platting a tract of land and building multiple single family residences would.
A successful real estate development is the fruit of a long, risky, capital and labor intensive endeavor. Each one requires a customized approach; hence, no general blueprints fit all. Yet, I will attempt below to convey the general thought process and direction required to follow this long and bumpy road.
The first step is to envision the parcel's highest and best use. This process encompasses the limitations imposed by zoning ordinances, political sympathy to a given land use, market demand at the time the development will be complete, legal and engineering fees, costs of construction, and financial costs. Needless to say, at the beginning each one of these elements is at best an educated guess. When you put them all together, it becomes obvious that the final decision is based on compounded guesswork. When you add the large price tag accompanying most developments, the huge financial risk becomes all too obvious!
The second step is to put likely numbers in a pro-forma. The challenge here is not to find numbers (engineers, builders, real estate advisors will have plenty of them for you), but to find conservative yet plausible numbers...and this is an art! Here, experience and intuition will carry the day. The skeleton of a pro-forma may read as follows:
Gross Resale Value: $120,000,000
Less Cost of Sale: <$9,000,000>
Sub-Total Income: $111,000,000
Less Hard Costs*: <$35,000,000>
Less Soft Costs**: <$8,000,000>
Less Financing Cost: <$9,000,000>
Less property tax & insurance: <3,000,000>
Less Contingency 10%: <6,000,000>
Less Land Cost: <10,000,000>
Sub-Total Costs: $71,000,000
Profit: $40,000,000
(*) Hard Costs are construction costs.
(**) Soft Costs are costs of engineering, permitting, architecture, legal and design.
The third step is to audit thoroughly the validity of the pro-forma. The example above provides numbers which could be associated with an actual project. Each entry must be thoroughly scrutinized. The best results will be obtained when advisors combine professional knowledge with developmental experience. Here probably more than in any other type of real estate venture, the quality and field experience of the "brain trust" is critical. At this point in the process, developers must make a critical choice: will they go forward with construction or not? If the answer is yes, what is the exact blue print of the project?
The fourth step is securing the capital or financing necessary to carry out the development. Several ways to pay for the development costs are available, each carrying their load of benefits and drawbacks. (i) Bank financing is usually cheaper, but must be thoroughly secured; it yields a great return to the developer...Unless the project does not sell and millions of dollars in interest must be paid monthly to a bank - then, it might send the developer to the path of bankruptcy due to a potentially huge debt service. (ii) Equity partners are usually more demanding and will ask for higher shares of the profits; yet, they will give the development the stability afforded by the absence of a large debt service. (iii) Cash investment by the developer is certainly the safest choice, but few developers favor it. Why? Possibly because a true developer may have something in common with a compulsive gambler - they do not mind risking more (everything?) in order to maximize their expected returns. In this business, risking more means leveraging. Yet the most recent downturn in the economy outlines the benefits of this conservative option.
The fifth step is to put in place the audit process enabling a thorough control of the construction phase for timely performance, quality and cost. Each one of these three elements can make a drastic difference in the bottom line. Monitoring them can, more often than not, be a challenge.
The sixth step is the marketing and sale (or lease) of the project. Here again, finding the right professional help is critical: a PR firm, a marketing firm and a real estate company will almost always be part of the mix.
In short, being a real estate developer is a dangerous business where risks abound, but rewards can be amazing:
Risks abound. The most common risk factor relates to misjudging the market: "build it and they will come" is not always true. Another serious risk is political, such as the failure to get the desired concept through the permitting process; or simply, a change in the political landscape between the beginning of the process and the completion of the permitting phase. We must not forget environmental issues which can be extremely costly to mitigate. Construction costs can vary greatly from the time of the pro-forma to the time contractors must be paid..
Rewards can be amazing. With the right balance of leverage, hard work, foresight and luck, the returns can be prodigious. Take the example above: with sufficient numbers of pre-sales, lenders may require a small amount of equity in the project (say 10%, or $7 million). Then, if the actual bottom line is indeed a profit of $40 million achieved over a two to three year period, the rate of return on equity is astronomical.
In conclusion, real estate developments can quickly bring their owners to the diverging paths of wealth or bankruptcy. As a banker once put it: "my clients with the highest positive net worth are developers, and my clients with the highest negative net worth are also developers". To quote another celebrity in this field: Donald Trump is said to have told a beggar in the streets of New York, while he was going through his tough financial times, that he (the beggar) was millions of dollars ahead of him (the Donald) - and back then, he was right!
Posted by:
Olivier
Monod
Posted:
5/19/2008
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