Understanding the Real Estate Development Process
Before making any decisions to invest in a commercial real estate development project, it’s important to understand how the entire development process works. That will allow you to be able to track the progress of your investment.
There are 7 major steps to commercial real estate development.
Due Diligence and Feasibility
Site acquisition is where the development process really begins. There are several things to look at when selecting a site for development including:
Demand Drivers – Understand the characteristics that make the asset you are wanting to develop successful. That could be number of homes in an area, retail anchors, airports, etc. These will be different based on the asset that is to be developed.
Traffic Counts & Patterns – Certain traffic counts and patterns are essential to a successful development. This is all dependent on the type of asset you are developing and may come in to play more for certain assets that rely heavily on drive-by traffic.
General Neighborhood – The general neighborhood is important to make sure that you are developing a product that is consistent with the surrounding neighborhood. The general rule is you don’t want to develop an A+ class project in an older or lower income neighborhood. Likewise, it’s usually unwise to build a C class project in an extremely upscale neighborhood. Obviously, there are always exceptions to these, but remember, those are exceptions, not the rule.
Due Diligence and Feasibility
This is where you take your site analysis to the next level and ensure to the best extent possible that the project fits within the desired investment range. In general, it is recommended that this is done before or concurrently with site acquisition. Unexperienced developers get themselves in trouble by acquiring a property before this phase has been properly completed. Due diligence and feasibility usually consist of the following:
Conceptual hard cost estimates (these usually come from a general contractor unless the developer is very familiar with the product being developed)
Conceptual soft cost estimates (this is everything that goes into the development except for the actual building hard costs)
Cash flow and net income projections
3rd party feasibility study
Supply and demand analysis
Market conditions analysis
Exploring financing options
Vetting and identifier project consultants (architect, engineers, etc.)
While this is not an exhaustive and all-inclusive list, this does give a general idea of all the items that go into this phase on a new development.
Next, it’s on to entitlements. In simple terms, entitlements mean that you get approval from all necessary parties in order to be able to develop and construct what you are wanting to develop and construct on the property. Usually this means getting approval from the city you are developing in, state departments as necessary, and other vested parties who the developer requires authorization from.
Entitlements can be as simple as checking with the city that you are allowed to build what you are trying to development to complex enough to warrant getting an attorney involved to walk the project through the process. On extremely large project, this phase can take years before entitlements are received.
It’s worth noting that in some cases, a developer may never get a project entitled. Entitlements are a major milestone in the development process regardless of how easy or complex the process is because it removes a significant amount of risk from the project. This is usually one of the earliest period that investors will become involved in a project and many times, investors who are willing to take on entitlement risk will receive a premium on their investment for doing so because they are taking on a lot more risk than later investors.
Design consists of getting all of the drawings and plans done so that the project can begin construction. This mostly consists of working with the architect, engineers, and other project consultants to bring your project to life (on paper). While this seems like a simple step in the process, depending on the project, this phase is oftentimes one of the most time consuming.
Usually, developers don’t have all the money on hand to develop and construct their projects. If they did this, they would only be able to develop a fraction of the projects they currently are developing. This is the most typical stage where equity investors and lenders are brought into the deal. Developers are expected to take on most of the risk and rightfully so because that’s why they get paid a developer fee.
Equity investors are necessary in commercial real estate deals because lenders will only lend up to a certain percentage of the total project cost. Think of it like a down payment on a home. Because of this need for equity investors, developers often give up huge portions of ownership in their projects to equity investors. Depending on the project, equity investors can expect 15%+ on a lot of new development projects.
Lenders are also an essential piece to the financing puzzle and lenders should be carefully selected by the development team. Not all lenders are created equal and it’s important to use the right lender in the right situation. For example, it might be necessary and prudent for a developer to use a hard money lender for the construction loan. Hard money loans are usually quicker, easier, and allow more leverage on the deal. That being said, hard money loans are also very expensive. While that type of loan might work well in one situation, there are also many situations where it would never make sense. This is why it’s important to invest with an experienced developer because they will understand these nuances and be able to get the right kind of loan for the project.
Some developers think that they are done when the project gets to construction, but that is how you can tell an experienced developer for a novice. Experienced developers will never just turn over the reins to a construction company to build the project. The developer should be communicated with the general contractor frequently and regularly. On most of our projects, we have regularly scheduled meetings either weekly or bi-weekly depending on the project.
Construction can be very tricky and there’s a lot of mistakes that can be made at this stage. Experienced developers have the foresight to see problems coming down the pipeline and solve them before they become huge delays and money pits.
Lastly, there’s lease-up. Some may argue that development is complete after construction, and if the project is sold at the completion of construction, then I completely agree. But if the investment is expected to be held until the asset is stabilized than it is crucial that the development team stick with the project through lease-up. Some companies have the same personnel that handle this as the earlier phases and a lot of companies have different personnel that handle this phase.
If you’re considering investing in a new development project, it’s important to understand the steps that go into the entire process. New development is usually not as clean cut as an acquisition of an existing asset, but they also have the potential to be much more lucrative. Understanding this process will help you be an informed investor and be able to react to and anticipate situations appropriately with your partners.