How Real Estate Developers Think. Peter Hendee Brown
to the column grid, the locations of stairs, elevator and mechanical shafts, and the selection of structural, mechanical, electrical, and plumbing systems.
The developer will keep meeting with potential investors and lenders and will also commission a market study to help demonstrate the viability of the concept. This document will be based on national, regional, and local economic and demographic data as well as information about comparable products, or “comps,” in the market. It will summarize existing inventory, how the project compares to similar projects in terms of location, features, and price, and how competitive the product is likely to be in the marketplace. If the developer is planning to use cheap appliances in a “luxury” condominium or providing one parking space per apartment unit when competitors are providing two, the lender either may be unwilling to make a loan without very good explanations for these decisions or may offer less favorable terms.
The marketing and sales team will begin to shape the image of the project from its name and logo to the design of its website and how it will be positioned, represented, and sold based on the target market—the buyers whom the developer hopes to attract. Developers differentiate their products to reflect the wants and needs of different types of buyers, and they vary their sales and marketing approaches for the same reason. Selling condominiums to first-time homebuyers on a budget, for example, is different from selling them to wealthy, retired, empty nesters. Similarly, leasing office space to small professional services firms is different from leasing to a call center filled with low-wage hourly workers in cubicles or to a prominent law firm that requires many large, private offices.
While the detailed design is being completed, the contractor will continue to fine-tune construction cost estimates, and the developer and sales team will determine final pricing. Marketing materials will be prepared, the sales center constructed, and the sales agents will be hired. The marketing team will grow to include public relations and media consultants; branding, graphic design, and creative firms; and an event planner. They will design brochures, signage, and collateral materials. Stories, opinion pieces, and ads will be placed in the local news media. And together they all begin to create excitement and “buzz” around the big and carefully planned grand opening of the sales center when the product will go on the market.
Construction Stage
Construction loans for real estate projects are secured by the future value of the completed property. Before a bank will make a loan, the developer must demonstrate this value by obtaining a specified number of purchase agreements or leases at or above projected prices to give the bank confidence that the project will sell out or lease up. The developer may turn to a bank with which she has a good relationship or she may shop around for the best loan terms.
As soon as the developer has settled on terms with a bank and closed on the loan, she will acquire or “take down” the land and break ground, with the goal of completing construction as quickly as possible. Throughout the construction stage, the developer will be involved in a million little decisions from materials selections to construction details to the review of monthly construction payment applications. Until the building is finished she will be constantly rebalancing the project’s design, materials, systems, and costs.
Closing dates with tenants or buyers will drive the schedule. For large projects the developer may complete and sell or lease up a part of the project while the rest of the building is still under construction. High-rise residential and office towers are often completed and occupied from the top down, while horizontal developments like townhomes and office parks lend themselves more easily to phasing that matches market demand and absorption. Whether the first condo unit or an entire building, the completion of construction signals the beginning of sales.
Sales Stage
Once construction is complete and the building is ready for occupancy, the developer’s objective is to sell or lease it up for the highest prices possible as quickly as possible. The developer must repay the construction loan with proceeds from sales. The longer it takes to sell out or lease up, the higher the interest costs on that borrowed money—the carrying costs—and the lower the developer’s profit. During this stage the developer’s attention will be focused on ensuring that buyers or tenants who have signed purchase agreements or leases remain satisfied and show up to close on those contracts.
The developer’s involvement will not end until the building is completely sold out or, in the case of a rental property, leased up and then refinanced or sold. Some developers build to “hold” over a longer time frame and they will have ongoing responsibility for property ownership from maintenance to periodic capital improvements. When the developer does finally sell or “dispose of the asset,” whether it is as soon as it has been leased up to a “stabilized” level of occupancy (for example 90 percent) or decades later, she will return all funds to lenders and make distributions of equity and profits to investors.
An Iterative and Fluid Process
The five stages outlined above offer an idea of the breadth of knowledge and experience required to be a successful developer. Each stage contains many tasks and many of those tasks span across some or all stages of a project. Many of those tasks are also different in character from one another, from negotiating a land purchase and directing an architect to drafting a pro forma and seeking the support of an elected official. So while they are sometimes portrayed as generalists who are “a mile wide but only an inch deep,” developers must possess deep knowledge in a broad range of subjects—they must be a mile wide and a mile deep. They must also know when to bring in specialized expertise in those instances when they are less knowledgeable. And they must know how and when to approach these many different tasks. Pat Prendergast, a developer from Portland, Oregon, offers a different view of the real estate development process through his own detailed checklist:
REAL ESTATE DEVELOPMENT TASK LIST:
• Project Initiation
• Site Control: Option/Purchase/Venture
• Initial Development Entity
• Selection of Development Team
• Project Conception
• Alternative Development Concepts
• Development Program
• Market Evaluation
• Site Evaluation
• Economic Analysis (Pro Forma)
○ Gross Income
○ Operating Expenses
○ Net Operating Income (NOI)
■ Debt Coverage Ratio (DCR)
■ Debt Service Constant/Loan Constant
■ Mortgage Loan Amount
■ Total Development Cost (TDC)
■ Equity Investment
○ Debt Service
○ Net Cash Flow Before Taxes (CFBT)
○ Return Ratio
■ Economic: Return on Assets (ROA)/Return on Cost (ROC) (ROA/ROC = NOI/TDC)
■ Cash-on-Cash: Return on Equity (ROE)
■ Discounted: Net Present Value (NPV) or Internal Rate of Return (IRR)
• Socioeconomic Analysis
• Development Prospectus
• Development Proposals
• Development Planning
• Development Agreements/Deals
• Land Use Approval
• Private-Sector Commitments
• Public-Sector Commitments
• Equity Participation
• Permanent Loan Commitments
• Construction Loan Commitments
• Public Site Assembly
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