Real estate development projects can command outstanding returns on investment. As such, new investors frequently ask us how commercial real estate development works. Successful developers typically have a significant amount of experience, making this strategy challenging for new investors. With that said, all investors – regardless of experience level – should have a decent understanding of the development process in order to better analyze investment opportunities. As such, we’ll use this article to provide a real estate development overview.
Specifically, we’ll cover the following topics:
- Real Estate Development Defined
- Major Real Estate Development Steps
- Final Thoughts
Real Estate Development Defined
Definition
Real estate development is the business process of improving either raw land or existing structures. Accordingly, 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.
Depending on the particular deal, real estate developers can focus on anything from ground-up construction to renovation to value-add improvements.
Requirements
Successful real estate developers share two key elements: experience and access to capital.
Development projects, as we’ll discuss below, 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.
Developers also require 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.
Risks and 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. If a given project doesn’t meet this required return on paper, developers either 1) adjust the deal, or 2) don’t pursue it.
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.
While experience helps mitigate the above development risks, they will always exist.
Major Real Estate Development Steps
In this section, we’ll outline the major steps in any real estate development deal. Individual deals will vary and can certainly include more steps. But, if you understand the below, you will gain a solid understanding of the real estate development process, an understanding that will allow you to better analyze potential investment opportunities.
Step 0: Assemble the Development Team
Real estate developers cannot complete all parts of a deal on their own. No single person has that level of expertise across so many fields. Instead, developers oversee and guide the efforts of a team of subject matter experts. Before considering a deal, developers should first assemble this team of experts. At a minimum, this development team will include:
- Commercial real estate broker: These real estate professionals will help you find potential deals and, if desired, assist with placing tenants during the lease-up period.
- Real estate attorney: These attorneys will assist with the due diligence portion of any deal (e.g. ensuring clean title), reviewing the purchase agreement, conducting the actual settlement, and, as required, drafting future lease agreements.
- General contractor: These licensed professionals handle the actual construction portion, to include permitting and overseeing sub-contractors.
- Architect: Licensed architects are responsible for developing approved design plans for a development, whether a renovation or new construction. They will need to have a close working relationship with the general contractor.
- Lender: Unless paying for a deal in cash, developers need to work with lenders to finance a deal, both for the acquisition/construction loan and, ultimately, the permanent mortgage.
- Property manager: These professionals manage a property’s day-to-day operations, to include leasing and maintenance. Some developers manage their own properties, while many instead hire third-party management firms.
- Potential investors: Related to financing, developers should have a pool of potential investors. That way, when they find a deal, they have the ability to quickly raise the necessary cash to make that deal happen.
Step 1: Identify and Underwrite a Potential Deal
Once you’ve assembled the development team, you can identify potential deals. Some developers focus on particular property types or markets, while others are willing to look at any potential deal. Regardless of approach, the process of analyzing a potential deal is known as underwriting.
While the details of underwriting are beyond the scope of this article, the objective of underwriting is straightforward: making sure a deal’s numbers work. That is, 1) do the projected future rents cover projected operating expenses and debt service, 2) does the associated net operating income translate to a valuation justifying acquisition and development costs, and 3) do the projected future cash flows meet your minimum required returns?
Step 2: Make an Offer and Go Under Contract
If the deal underwrites (i.e. the numbers make sense), you can make an offer to purchase the vacant land or existing building (unless you already own the property). If purchasing, you will likely end up negotiating the purchase terms with the seller, to include purchase price, closing dates, and contingency periods (e.g. financing and appraisal, feasibility, zoning).
Step 3a: Confirm Design/Construction Plans and Permits
During the underwriting step, developers will use rough rules of thumb for projected construction hard and soft costs (e.g. $250/sq.ft. in hard costs, 10% of hard costs in soft costs, etc.). Once under contract, you will need to work with the GC and architect to confirm the final design and construction plans – and the associated costs.
You, the architect, or the GC will then submit these finalized plans to the relevant municipality to receive permits to begin construction.
Step 3b: Confirm Financing (Debt & Equity)
With solidified plans, developers can confirm their financing. For debt financing, lenders will, at a minimum, require your full underwriting template (generally referred to as a pro forma). They will also want to see the design/construction plans if they are financing the construction.
If you’re raising equity funding as well (i.e. bringing on outside investors), their requirements will vary. Most investors will also want to see the pro forma and design plans. Additionally, investors will want to see projections of future cash distributions and ROI, as they will have their own required returns. Most investors will also want to see a demonstrated track record of successful deals before investing with a developer.
Step 3c: Complete Zoning and Feasibility Work
After going under contract, developers need to conduct the necessary zoning and feasibility work. At a minimum, feasibility should include title, survey, and environmental due diligence. Zoning tasks will depend on how the land is currently zoned. If not seeking a change to the zoning, you’ll still want a zoning confirmation letter. Local zoning administrators issue these letters to developers that essentially say, yes, you can execute your development as planned.
If seeking to change the zoning code, that requires far more time, and often, money. Depending on the municipality and type of change, you may need to file for a special use permit or a complete rezoning. In some cases, developers may close on a deal before completing this process, though that creates significantly more risk.
Step 4: Close on the Deal and Begin Construction
Assuming your deal clears all due diligence and feasibility thresholds, you’ll eventually close on the deal. Closing (or settlement), is the legal process where you formally purchase the land from the seller. And, if using debt financing, this typically occurs concurrently with closing on the acquisition/construction loan.
For the developer, the construction period entails overseeing the GC’s progress, maintaining associated accounting records, and submitting regular construction loan draw requests. Upon construction completion, the GC or developer will apply for a certificate of occupancy, or CO, from the municipality. Once the CO is issued, the property can be occupied.
Step 5: Complete the Lease-up
With a CO issued, the developer (or property manager), can begin leasing the property. Depending on the property type, this could mean anything from finding businesses to occupy offices or industrial sites to individuals to rent apartments. Once a property has been fully leased, it is said to have been “leased up.”
Step 6: Close on the Permanent Loan
Leasing up the property as quickly as possible is critical to securing permanent financing. Before lenders approve a permanent mortgage, they’ll want to see that a certain percentage of the building’s spaces have been leased (often 95% or higher). However, most developers identify their permanent lenders well before this period. That way, they can have all loan paperwork in place, allowing them to apply as soon as they hit the lease-up threshold.
Once you’ve leased up the property and closed on the permanent loan, you have successfully “stabilized” the property. At this point, you will either sell the property or continue with stabilized operations, depending on your development strategy.
Final Thoughts
We do not intend for this article to make new investors experts in real estate development. Rather, we hope to arm you with a solid overview of the process to better analyze potential investment opportunities.
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.