Managing Risk While Developing Real Estate
Careful research and planning vital in taking building an idea into a successful development.
Real estate development is a great way to make a lot of money, if it’s done right. Investors in commercial and residential real estate will beat a path to any door that offers a building property or any other development that meets a pent-up demand within the marketplace. As a developer, you have the ability to build that door.
But developing real estate is a complicated, lengthy, expensive and potentially risky process. It can take years for a project to go from the initial idea through the design and planning stages, construction, and final completion. That provides plenty of time for unexpected obstacles or challenges to emerge.
Fortunately, these unexpected challenges can be mitigated if a real estate developer plans carefully to manage risk through the life-cycle of a development project. A well-executed development plan could turn an initial idea into a runaway success.
The Risks and the Rewards.
The amount of risk developers take on depends a lot on the types of projects they take on, and the stage those projects are at. Risk changes throughout the life-cycle of a project, increasing as the developer spends cold hard cash taking their project from initial idea towards completion, until finding a buyer or a tenant to provide an income stream or other backing. Different types of projects have different risk curves.
One type of development project that offers that offers relatively low risk regardless of the stage in the life cycle is the “built-to-suit” project. This project, usually a retail development, starts when a developer secures a major and long-term tenant before design and construction starts. Examples can include Starbucks or Walmart. Once the agreement is made, the developer then builds a development that suits the tenant. Not only does having such a tenant in hand reduce the risk of having to find a tenant to fill the building, the type of building these tenants prefer often comes pre-designed, so there are few surprises when it comes to construction. A downside is that, because these developments are so common, a developer is not really addressing a pent-up demand within the market, and thus won’t get as high a return on their investment as they could.
Developments that potentially offer higher rates of return also offer higher risk. These developments are sometimes called “spec projects” because they are built on speculation. Serving a pent-up market demand will net high returns, but a market demand that is pent-up is not being served, and a market demand that’s not being served is not always seen. How do you know that the demand is pent-up if you can’t see it?
Will they Come?
Speculative projects often require a developer to start construction without a leasing commitment. The hope is, “if you build it, they will come.” More than that, without identified tenants committed at the start of the project, a developer is building almost blind, designing a property almost from scratch in a way that they hope will address a tenant’s needs in serving pent-up demand. The fact that the design differs from the standard also presents hurdles at the pre-development stage, as plans encounter possible regulatory or bureaucratic hurdles. Financiers can see this risk, which makes financing harder and more costly to obtain.
For a multi-family residential example, consider a developer building a new apartment building in an area that already has a number of apartment buildings offering mainly one and two-bedroom units and catering to young couples. The developer knows that a building offering a mix of mainly one or two-bedroom units will lease-up. More than that, financiers already have an understanding of how such a property will perform and will often be happy to lend towards that development. However, the rate of return may not be as high as the developer will like.
The developer may see a need for family-friendly apartment housing, with three-bedroom units, as young couples grow into families with young children. This may seem obvious, but the marketplace hasn’t begun to address this pent-up demand. The developer may only be guessing that the demand is there. Not only that, but zoning bylaws may have to be changed to allow a development of larger apartment units. Financiers also know that, in taking this leap of faith, the risk exists that the developer could build something, and the tenants do not come.
Taking on Risk at Pre-Development
The risks of real estate development cannot be eliminated, but developers can take steps to identify these risks and ways to mitigate them. The tools developers can use change as the risks change, and risks change not only with the different types of development, but the different stages each development is at. Early in the process, a developer has committed few of his or her resources, but the potential for unexpected obstacles or challenges is high, making it challenging to attract investors. As the development passes through each stage, more resources are committed, but challenges are revealed and addressed, making it more likely that the development will be built.
In the pre-development stage of a project, a developer should focus on researching the marketplace, and the regulatory landscape. The developer needs to do due diligence to identify the pent-up demands that aren’t being met, and what permits or zoning variances may be needed to address. The tools at the developers’ disposal should include marketplace analysis and feasibility studies, research on how to acquire land and where the best sites are, environmental assessments, development plans, site plans, and building plans. Once these are in place, the developer should do further research on the permits required, and whether the development will require improvements to nearby infrastructure. Once these are received, then the developer can reach out to arrange construction financing.
Because there are so many unknowns at this stage, this can be the riskiest stage of the project. It helps to have a project sponsor at this stage – an investor or partner in charge of finding a property and acquiring it for the project. Such a sponsor often invests a seed amounting to 5-20% of the total equity capital of the project, and then helps raise the remaining finds. Because investors are taking on a higher level of risk at this stage, they will require a higher return on their investment than people who invest at a later stage in the process. However, if a developer has done their due diligence, investors will have confidence that their investments will pay off.
The Permitting Challenge
Possibly the biggest challenge during the pre-development process is obtaining the proper permits for a development from the local jurisdiction. Usually, developers have to secure two sets of permits: one to approve the building, and another to approve the building’s land-use. The land-use permit requires a developer to explain how the property is to be used – for example, if it is industrial, commercial, or residential — as well as the physical characteristics of the building (how tall it is, how far is it set back from the street, how it affects local density, etc).
If a proposed development’s land-use differs even slightly from the area’s official plan and zoning bylaws, it can add months to the approval process as local officials consider rezoning applications, consult with local residents and other interested parties, and settle any disputes between the developer and the local jurisdiction. By comparison, the building permit process is less time consuming, as the goal is to ensure that the structure meets all safety standards and building codes.
The Construction Phase
Once through the pre-development phase, a developer has secured the necessary permits, and has won over equity investors after going through a very rigorous process. Chances are now far better that the development will be built. However, building the development has its own challenges that must be overcome, and associated risks. In addition, if the developer hasn’t yet begun to consider how to market the development, the time has certainly arrived to begin pre-leasing the property. It’s also time to find and hire a property manager.
Financing also goes through changes at this stage, as the developer draws on construction financing. At this point, the development is typically being financed by the sponsor and outside investors and through a short-term construction loan. Debt is often given over to the developer in incremental “draws” as construction passes key milestones.
A development finishes the construction phase once inspections are done to ensure that the property is safe, and a certificate of occupancy is granted. Well before this time, the developer should be moving towards arranging permanent financing or a final buyer for the development. Construction financiers will want to see their returns on their investment, and so a new mortgage or other financing arrangement must be taken to hold the property as it moves into the final phase of lease-up and operation.
Time to Make Some Money
Even after a development has been designed, pushed through the permitting process, and built, risks remain. What if, after the property has been built, the expected tenants do not come? What if, after building a building to sell, no buyer turns up? Developers need to have planned how to handle this stage in the process, preparing marketing plans to attract tenants for lease-up, and determining whether they want to sell the development for a quick profit, or hold onto it for long-term income.
Investors at this point are looking for a development to achieve a “stabilization threshold”. This means that the property has sufficiently leased up (usually at an occupancy level of 90% or higher) that the income from the tenants covers the development’s operating costs. This is why potential tenants should be courted and leases signed as early as possible, so there is less chasing to be done to achieve stabilization.
The Experts Who Can Help
The many different tasks that have to be performed and the tools that can be used to take a development from an idea to reality and the phases in between can be daunting. The knowledge and resources required is often beyond the means of individual developers. This is why it’s important for developers to have a team behind them to take them through every stage of the process. Consultants with experience in the industry and the local marketplace can perform unbiased research to craft marketplace analysis and feasibility studies to help a developer choose the best site, and build the best product to meet pent-up demand. The same experts can identify potential equity partners, construction financiers, and other investors who can take on the development once it is stabilized. They can create marketing plans to ensure lease-up, and help develop a strategy for what to do once a development is complete.
At SVN Rock Advisors, we offer decades of experience in the industry and the resources to provide top-notch unbiased research that can help developers make the best, most well-informed decisions possible. The risks of real estate development can never be fully eliminated, but they can be managed, and the rewards for doing so are well worth it.