Successful real estate developers can make a ton of money. As a result, new investors often ask our team about the development process. In particular, people want to know about real estate development companies. How do they work? What do they do? In this article, we’ll provide an overview of real estate development companies, helping to answer questions many new investors share.
Specifically, we’ll cover the following topics:
- What is Real Estate Development?
- Real Estate Development Company Overview
- 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.
For example, one deal may begin with a parcel of unimproved land. A real estate developer could look at that land, design a plan for improving it into a series of townhomes, figure out how to finance the construction of those homes, receive local permitting approval, then supervise the construction of those townhomes. Following the construction process, this developer could continue to lease the homes for rental income or sell them to a real estate investor.
Regardless of strategy, real estate developers focus primarily on the financials 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.
Real Estate Development vs. Construction
Real estate development and construction are intimately related. But, they are not the same. It helps to think of the difference this way: construction involves hammers and nails, while developers figure out how to pay for those hammers and nails.
In other words, real estate developers act as a combination of high-level strategist and project manager. They define a vision for a real estate project, figure out how to finance that project, then oversee the day-to-day execution to complete that initial vision. On the other hand, construction professionals (referred to as general contractors, or GCs), focus on actually building the property.
Real Estate Development Requirements
Real estate development offers significant rewards, but that doesn’t mean anyone should try. Rather, successful developers share the following characteristics:
- Experience and Risk Acceptance: Development projects entail large amounts of risk. Mitigating this risk and successfully completing a development requires a tremendous amount of experience. Developers need to understand and supervise tasks related to commercial financing, municipal zoning, construction, design, accounting, and law, among others. While developers may not be experts in any one of these topics, they must have the experience to understand how these fields integrate into the broader project.
- Access to Capital: Frequently, developers need to pay tens or hundreds of thousands of dollars in feasibility studies and planning – before a deal even has municipal approval. And, developers typically shoulder these costs themselves, not seeking outside investors until they’ve received approval from the local government. Once they do receive approval, commercial development projects cost far more than simply building a home. From soft costs to hard costs to holding costs, most developments easily run into the millions (or more). Without access to significant capital, developers cannot make deals happen.
Real Estate Development Company Overview
What is a Real Estate Development Company?
Simply put, a real estate development company is a business entity focused primarily on developing real property. That is, these companies generate revenue by finding and developing real estate.
This revenue comes in several forms. Many development companies charge a development fee – typically a percentage of total project costs – for their services. When these companies plan on selling properties post-development, they may also earn an incentive fee if the returns exceed a certain threshold. Some development companies also act as property and/or asset managers, in which case they earn a fee for managing stabilized properties.
Additionally, real estate development companies often indirectly earn money for their principals. In many situations, the owners of a development company are also the owners of the property entities that they develop. In this fashion, these individuals earn the rental income and disposition income from the properties they develop – just via a separate entity.
Many real estate development companies focus on a specific strategy (e.g. ground-up development, value-add acquisitions, etc.) and property type (e.g. multifamily, office, etc.). But, some pursue good deals, regardless of strategy and type.
While often overlooked, real estate development companies are businesses, meaning they still need to address requirements faced by all businesses. For example, development companies have to consider ideal legal structures, tax considerations and planning, insurance needs, office administration, bookkeeping, and human resources. Focusing on real estate doesn’t mean development companies don’t still need to take care of these basic business responsibilities.
Can Real Estate Developers Also Be General Contractors?
Yes, many real estate developers also serve as general contractors – though typically through separate business entities. For instance, Bill and Ann may own B&A Development Company, LLC, a real estate development company. But, they are also both licensed contractors. Accordingly, they establish B&A Construction, LLC, which serves as GC for all of the development entity’s projects. This means that, as the principals, Bill and Ann ultimately receive a deal’s fees going to both the developer and GC.
Common Real Estate Development Company Deal Structure
Countless ways exist to set up a specific deal, depending on the unique situation. But, for demonstration purposes, the below serves as a fairly common way to structure a deal:
- Property Entity: This is the legal entity that holds title to the real property (e.g. 123 Main Street, LLC).
- Principals/Managing Member Entity: This is the legal entity in which the principals – for instance, Bill and Ann – directly own a percentage (e.g. 123 Main Street Managing Member, LLC). This entity in turn owns a percentage of the property entity.
- Investment Member Entity: If the development requires cash above and beyond the contributions by the deal principals (e.g. Ann and Bill), the development company will seek an additional investment member or members. This could be an individual or separate entity (e.g. Multifamily Investments, LLC). This investment member also owns a percentage of the property entity.
- Developer Entity: The developer entity (e.g. B&A Development Company, LLC) is responsible for finding, financing, and supervising all aspects of the 123 Main Street, LLC deal. For liability purposes, this entity typically does not have an equity interest in the property entity. Instead, it collects fees for its development services without an ownership stake.
- Lender: The lender provides debt financing for the deal, directly issuing a loan to 123 Main Street, LLC. With debt financing, the lender doesn’t actually own a portion of the property entity (though it will place a lien on it while the loan’s outstanding). The development entity (e.g. B&A Development Company) is responsible for securing the actual loan.
- General Contractor: The GC handles all of the construction, to include supervising and paying the subcontractors. The developer will ensure that the GC is paid as construction progresses, but the actual payments to the GC come from the property entity and, likely, its construction loan.
Final Thoughts
We used the above article to provide an overview of real estate development companies. Successfully starting your own company, as discussed, requires a significant amount of experience, willingness to take risk, and access to capital. Fortunately, you can access development deals by investing with established development companies like us.
If you’d like to discuss different real estate development 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.