Successful real estate developments can generate significant returns. But, these same projects come with a tremendous amount of risk. Development requires experience, skill, and relationships with a solid team of professionals. Before jumping at a potential development project, investors should closely examine the deal. As such, we’ll use the following article to provide an overview of how to evaluate a real estate development opportunity.
Specifically, we’ll cover the following topics:
- What is Real Estate Development?
- Evaluating a Real Estate Development Opportunity
- Final Thoughts
What is Real Estate Development?
Overview
Real estate development is the business process of improving either raw land or existing structures. Developers use these real property improvements to increase the value of that property. Depending on the particular deal, real estate developers can focus on anything from ground-up construction to historic renovation to value-add improvements.
Regardless of strategy, real estate developers focus primarily on the financials and planning behind a deal. A successful developer will underwrite a potential deal to ensure that the total future revenues justify the total development costs. If the return on investment doesn’t make sense, the developer will either alter the deal’s plans or not pursue it at all.
Risks & Rewards
Generally speaking, developers generate the highest returns among real estate investors. By designing the entire project, developers create real estate deals that – if executed successfully – will meet their high threshold of required return.
However, these high returns go hand-in-hand with far greater risk. In particular, developers face two major risks:
- Sunk costs prior to deal approval: Before actually breaking ground on any construction, developers must make significant cash outlays. Developers pay for feasibility studies, legal fees, zoning applications, and architectural designs, among other expenses, before receiving municipal approval. A failure to receive that approval – which can certainly happen – means developers forfeit all of these initial costs.
- Unforeseen issues during construction: Construction on larger developments can last for multiple years. During this time, countless unforeseen issues can arise to derail the development. For instance, an economic downturn may either dry up financing sources or make the project no longer economically viable. Or, an environmental issue could arise (e.g. discovery of chemicals in groundwater), causing a halt in construction and millions of dollars in remediation work.
Evaluating a Real Estate Development Opportunity
In this section, we’ll outline the major steps to evaluate a potential development opportunity. Depending on the specific type of deal, additional items may be required. However, for any ground-up development, investors must, at a minimum, take the following steps:
Step 0: Conduct Core Due Diligence Steps
Any development due diligence period should begin with ordering three key items. First, a real estate attorney can order a title search, which confirms that no issues with a property’s title (i.e. ownership history) exist. In simple terms, a title search confirms that the seller has the right to sell everything he’s selling.
Related to the title search, professional surveyors should conduct an ALTA survey. This survey ties a graphic of the property’s boundaries, existing improvements, and any recorded easements to the title research. Essentially, the ALTA survey allows developers to visually depict the property and all of its title history.
Concurrently, an environmental engineer will conduct a Phase I Environmental Site Assessment. This assessment reviews a property’s history and observable characteristics to determine whether or not any pollutants or other contaminants may exist. Commissioning one of these studies is critical to reducing liability as a developer, as it allows you to identify any major environmental concerns before purchasing the land. Once you own the property, you typically become responsible for remediating it.
Step 1: Develop an Initial Design Vision for the Land
A ground-up development converts vacant land into some sort of stabilized property improvements (e.g. an apartment building, warehouse, storage units, etc.). Developers typically have a general vision for a specific project, but they’ll work with a civil engineer and architect to develop the initial design – often referred to as a concept plan.
This concept plan won’t include the detail of a fully-permitted set of site and architectural plans, but it achieves two primary goals. First, the concept plan allows the developer to confirm the size, layout, and number of units in a development, which feeds into the below underwriting.
Additionally, a concept plan typically provides enough detail for a zoning department to review during a pre-application meeting. That is, when you submit a concept plan for a development, the local zoning authorities will be able to provide insight into A) whether or not the plan will ultimately be approved, and B) what updates will be required to eventually receive that approval.
Step 2: Underwrite the Development with Initial Numbers
With the unit breakdown from above, developers can conduct an initial underwriting of the project. This process includes using assumed rents and operating expenses to project a stabilized (i.e. fully leased) value for the property. This stabilized value then guides construction and permanent loan limits and, by extension, cash required to make a deal happen.
Of note, at this point, developers typically use assumptions about construction costs within their underwriting models. For instance, a developer may plug in $150,000 per unit in construction hard costs for an apartment building. While these numbers will change with final contractor bids, they allow developers to assess a project’s feasibility early in the planning process.
Step 3: Confirm the Site Will Support the Design
While underwriting confirms a deal’s financial feasibility, developers also need to assess the site to confirm it will be practically feasible. Some of the major items in any site review include: zoning reviews to ensure a parcel’s current zoning supports the intended development use; wetland protection determinations to confirm no environmental protections will disallow development; utility availability to ensure water, stormwater, electricity, etc. connections exist (or can be facilitated with easements through adjacent parcels); traffic analysis to determine whether additional traffic patterns (e.g. new turn lanes) will be required.
If the site won’t support your development plan, it doesn’t matter how good the numbers look – the deal won’t happen.
Step 4: Confirm Site Prep and Construction Costs
By this point, a developer should have a site plan from the civil engineer and a builder’s pricing set of plans from the architect. Armed with these items, you can solicit bids from site preparation contractors and general contractors to confirm the deal’s construction costs.
Step 5: Confirm Financing Options
With confirmed project costs, developers can then confirm financing options. From a debt perspective, this entails confirming interest rate, term, and maximum amount of the construction loan. From an equity perspective, the maximum loan amount drives the amount of cash a developer will need to contribute directly or raise via outside investment.
Step 6: Underwrite the Development with Final Numbers
Confirmed construction costs and financing options allow developers to underwrite the project with final numbers. Whereas Step 2 depended on numerous assumptions, this finalized underwriting model provides developers the ultimate evaluation of a deal. Within this final underwriting model, developers will show a deal’s projected returns and, from those numbers, make a determination to: 1) move forward with the deal, 2) adjust the plans before continuing, or 3) cancel the project.
Final Thoughts
Investors evaluating a real estate development opportunity will want to confirm that all of the above steps have been completed. If a developer pitches a project based on initial underwriting assumptions, the details have not been refined to the level required to execute a successful deal. As such, we recommend withholding investment until you can evaluate the deal’s final underwriting model and associated due diligence steps.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities – and the associated analysis.