Finance for Real Estate Development

Finance for Real Estate Development

by Charles Long

ISBN: 9780874201574

Publisher Urban Land Institute

Published in Business & Investing/Real Estate, Business & Investing/Finance

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Sample Chapter


The Development Process

Real estate development requires diverse disciplines and activities to convert an idea into a completed project. The work up to completion must be paid for with invested time and capital supported by the property's finished development value, which results from either income or sales. Construction costs are the largest component of project costs, followed by land, architecture and engineering, legal, financial, environmental, management, marketing, and communications. Each discipline involves a different array of staff, contractors, and consultants who have different skills and roles. All these disciplines cannot function coherently without the skill of the real estate developer, who coordinates the different activities to create value. One of the most important skills that a developer brings to this process is the ability to obtain and manage appropriate equity and debt financing to fund these activities in a timely and cost-effective manner.

This chapter starts with a brief overview of real estate as a sector of the economy, its dependence on capital markets, and its dynamic nature. The chapter then describes the development process, its tasks, the overarching questions that a developer must address, the skills necessary to be a successful developer, and the role of finance in the development process. It concludes with an overview of the main sectors of real estate and their customer risk and absorption profiles.

Real Estate Overview

In 2007, private construction activity for commercial and residential real estate development in the United States totaled approximately $700 billion, according to the Bureau of Labor Statistics. With the addition of a reasonable estimate of 40 percent of this figure to account for land, design, financing, and other development costs, the real estate development sector contributed about 7 percent to gross domestic product (GDP) (Figure 1–1). Of this activity, about 71 percent was residential; the other 29 percent was nonresidential, including retail, office, industrial, lodging, education, and health care.

In addition to its contribution to ongoing economic activity, commercial real estate is an important investment category for major investors in their allocation of portfolio assets. Commercial real estate has a relatively low total capitalization compared with U.S. stocks, according to the CME Group (figure 1–2). When combined with residential real estate, however, the value of U.S. real estate exceeds that of U.S. stocks and is approximately equal to that of the U.S. bond market.

Commercial real estate has grown in importance as an investment asset class over the past several decades, in part owing to new laws and new investment vehicles. The Tax Reform Act of 1986 substantially reduced tax rates for all taxpayers and eliminated accelerated depreciation for real estate, thus making real estate less of a tax shelter and more of an income-producing asset. (This change is discussed further in chapters 5 and 10.) The Act also broadened the investment scope of real estate investment trusts (REITs), making them development and management entities instead of merely lenders. These publicly traded investment vehicles made real estate investments accessible to many more investors. Then, in the early 1990s, following a disastrous real estate recession, the financial markets developed commercial mortgage-backed securities (CMBS), which sold securities backed by pools of real estate loans — resulting in substantially enhanced access to debt for the real estate sector. (Chapter 5 provides more detail on the effects of these two changes.) Private equity funds, backed by institutional money and high-net worth investors, also entered the landscape in the 1990s, often focusing on opportunistic investments. These changes together substantially transformed the real estate industry and increased the capital available for real estate investment, ultimately resulting in a far more sophisticated investment landscape with a broader set of participants and vehicles.

As these changes propagated through the industry, real estate competed more effectively with other asset classes for capital and attracted the interest of more investors. In the early 2000s, real estate performed better than equities and fixed-income securities, largely because it was perceived as low risk; that is, as "always going up." Figure 1–3 compares the performance of bonds, stocks, commercial real estate, and residential real estate for the period from 2004 to 2010. Early in this period, real estate — both commercial and residential — outperformed both the equity and the fixed-income sectors; but in 2008, stocks and real estate collapsed and capital flowed out of real estate and stocks and into the safe haven of bonds. Then, while stocks recovered, real estate lagged as investors realized how much its performance correlates with jobs and capital availability.

More recently, the Great Recession of 2007 to 2008 highlighted not only the cyclical nature of the real estate industry but also its dynamic nature. Valuation losses in many markets and for many sectors placed property values below replacement costs, thus deferring development in these markets and sectors for some time, until valuations recovered to at least replacement levels. Investors redirected their energies toward new opportunities as distressed properties became available at much lower prices.

Inherently, real estate is a dynamic industry that adjusts to changing market and capital opportunities. The history of real estate development for the last two generations underscores this dynamic characteristic. Starting in the 1950s, with the baby boom and the mobility created by the automobile, the development industry responded with innovative housing production and auto-oriented suburban retail. Although some viewed this response with disdain (think of Malvina Reynolds' lyrics — "little boxes made of ticky-tacky" — or Joni Mitchell's — "They paved paradise and put up a parking lot"), it provided needed housing and created communities that reflected the sense of freedom of a nation with wheels. Throughout the 1960s and 1970s, as urban centers lost commerce and residents, the industry corrected many of its commodity-driven practices and responded to demand for new, higher-quality forms of retailing such as shopping malls and office parks. Gradually, in the 1980s and 1990s, suburbs became fringe cities and the concepts of business parks, lifestyle centers, and place making evolved. Beginning in the late 1990s, as people yearned for identity, the industry advanced the concept of smart growth and town centers, and mixed-use development evolved. Going forward in the 2010s, the development industry will continue to respond to evolving demands with more sustainable development, more infill, more revitalization, and more mixed-use products.

The dynamism in the industry relies on the capacities of the professional developer to recognize and harness market demand, to enable the creativity and practicality of architects, contractors, marketers, and financiers to produce value from ideas. Starting with an idea and a piece of land and, perhaps, a major tenant, the developer puts money and time at risk to design a project, obtain community support, buy land, and — if financing sources can see that it will work — to construct and close out the project. The developer is the conductor of a complex, multidisciplinary process that depends on exogenous forces, especially market demand and capital availability. No other industry creates a product that involves the collaborative effort of so many disciplines in such a publicly accountable process. Real estate development is unique. In this chapter we begin learning how to do it effectively.

The Development Process and Risk

Development involves putting increasing amounts of investment capital at risk over time. As more capital is invested, the risk to that investment should be reduced by the growing certainty that the project will be successful and provide returns to investors.

Figure 1–4 diagrams the risk and cost profile of a typical real estate development project. Costs increase with time, but the risk profile is the inverse of the cost profile. Risks from unknown and uncontrollable factors are high in the early stage, when uncertainty is high because of scarce information. Risk lessens as the project proceeds through design to entitlement and financing as more information is developed, uncertainties are resolved, and — most important — risk is controlled through competent management strategies.

At the initiation of a new development project, the developer evaluates two dimensions of economic viability. First, can the project pay a return on investment if it is actually built? Second, and equally important, does the developer have sufficient capital to fund the early project costs to bring the project to a stage where it can be financed and built? This second dimension highlights the risks that the developer takes to get a project to the point at which it can demonstrate viability and thereby attract capital from outside investors and lenders.

The early costs of a development project are relatively low; they involve investigatory work, market analyses, preliminary design, navigating the approval process, cost estimating, and site analysis — costs categorized as "soft costs" and typically paid from the developer's own capital, at least until project viability has been demonstrated to a financing source and outside funding becomes available. With time, these costs can accumulate to be quite significant — reaching into millions of dollars for larger projects and hundreds of thousands for smaller projects. The risks and funding of these predevelopment costs can constitute a major challenge to the economic viability of a real estate development project, especially in areas where the entitlement process is long, costly, and uncertain.

The first significant cost that a project incurs is, typically, acquiring either the land or an option to buy the land. Knowing how to evaluate what a project can afford to pay is crucial. Land value for a project must be evaluated on the basis of the "residual" of the project's value less all development costs (including an adequate return), not on the basis of comparables or appraisals. (Chapter 3 addresses this issue in detail.)

Costs grow as the project becomes more complete, as entitlement applications are filed, as community groups are engaged in the entitlement process, and as equity and debt financing sources are pursued. By the start of construction, the risks to project success are largely confined to managing construction, reacting to unforeseen market downturns, and executing the marketing, leasing, and management plan. Of these, only market conditions are beyond the control of the development team.

Any project faces the very real risk that the market could collapse during construction, resulting in reduced leasing or sales, and project failure. During construction, there is the risk that costs and construction time could exceed projections, resulting in funding shortfalls or a higher carrying cost for capital. The developer's challenge at the beginning of a project is to identify the issues that represent future risk and to conceive of and implement competent management strategies to mitigate them. Market collapse and construction risks are easier and cheaper to mitigate if they are defined and anticipated before they happen.

In summary, the key management strategy for successful development is to continually monitor whether there is a likelihood of adequate return on investment and whether the project warrants the investment of additional time and money to proceed. The developer should resist the complacency induced by momentum, so that the discipline of monitoring key issues does not erode as more costs are incurred. The sooner an unviable project is abandoned, the smaller the loss. Many development projects are abandoned, some quite late in the process, when information about costs, markets, or entitlement conditions shows that they are not viable.

Stages of Development

Figure 1–5 shows the three stages of development and the tasks associated with each:

* The predevelopment phase, which has the highest risk of loss, consumes a relatively small 5 to 15 percent of project costs.

* The bulk of project expenditures, 80 to 90 percent, occur during construction in the development phase.

* Close-out, involving marketing, selling, leasing, and managing the project after completion, also consumes a relatively small 5 to 8 percent of project costs.

Figure 1–5 groups the tasks, showing how they evolve over the three phases from information gathering and planning into implementation. The effective implementation of construction and close-out depends on the quality of work done on the predevelopment tasks. The following subsections describe the primary focus of each of the three phases. (Chapter 4 describes in detail the management and funding of each task in the three phases.)


The predevelopment phase is when all the most important ideas behind the project concept and plan are created and refined, and the time when the most important decisions are made. Notes Dan Rosenfeld, a mixed-use developer based in Los Angeles formerly with Urban Partners, LLC, "Eighty to 90 percent of project value is created during predevelopment." During predevelopment the developer conceives the project, acquires land, designs the project, secures financing commitments, and obtains the entitlements. In other words, the tasks in this stage shape what occurs in later phases, including the strategies used to respond to changes in market and financing conditions.

The tasks in predevelopment focus, first, on designing a product that responds to the market, that can be entitled, and that can be built at a cost that allows an adequate return on investment. To accomplish this, predevelopment must necessarily address implementation steps to achieve project viability. Each task in predevelopment, then, generates an implementation strategy for later phases. Only after a high degree of certainty is achieved about project value, cost, and entitlement, can the project obtain financing commitments from lenders and investors. (Chapters 3 and 4 discuss task management and funding in more depth.)


Although the development phase involves high project costs, the success of this phase depends largely on the quality of the work done in the predevelopment phase. Notes Richard Dishnica, a developer in the San Francisco Bay Area, "Things go wrong in the development phase because somebody didn't spend the money or didn't communicate key information early enough. Things going wrong early are cheaper than [things going wrong] later." Assuming that the developer hascompetently managed the predevelopment tasks, the risks in the development stage are mostly controllable through competent management and funding of the construction process.

The following are examples of issues in the development stage:

* Unexpected site conditions: Conditions such as poor soils, hazardous waste, or archeological artifacts are discovered after the start of construction, because of inadequate site analysis. These conditions can cause expensive delays for remediation or archeological research, and may require redesign of the project, resulting in higher-than-expected costs and a threat to project viability.

* Unexpected increases in material costs: Depending on market conditions for materials, the timing of orders for construction materials such as steel or concrete may make a significant difference in costs. Monitoring material costs to capture the best pricing enables an optimal ordering strategy. If costs are escalating rapidly, early ordering may be advantageous; in a declining market, waiting may be the optimal strategy. Of course, the ordering of materials also must take into account the degree of certainty that the project will not change or be cancelled.

* Unwieldy and costly design: Design affects costs. As an example, if a high-rise residential condominium project has many unit floor plans, construction costs may be higher than expected and delivery of the units for sale will be delayed because of longer construction time. This kind of problem could be avoided if the contractor, architect, and marketing consultants work closely during predevelopment to streamline the design with fewer floor plans, thus streamlining the construction process and lowering costs.

* Change in market conditions: Markets are dynamic. If the market for buyers or tenants drops dramatically or capital markets deteriorate, the project can fail. Changes in the market are hard to anticipate, but taking another look at market conditions before the start of construction and making contingency plans to respond to possible changes in market conditions can help a developer mitigate the risk of a deteriorating market.

* Changes in the local political dynamics: For example, a supportive zoning board member quits a less supportive one joins the board, or a neighborhood group becomes vocal in its disapproval of the project.

Excerpted from "Finance for Real Estate Development" by Charles Long. Copyright © 2013 by Charles Long. Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher. Excerpts are provided solely for the personal use of visitors to this web site.
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