Fundamental Skill for Real Estate Development Professional I (Charles Long) - 10.26.11

915 views

Published on

Published in: Business, Economy & Finance
0 Comments
0 Likes
Statistics
Notes
  • Be the first to comment

  • Be the first to like this

No Downloads
Views
Total views
915
On SlideShare
0
From Embeds
0
Number of Embeds
2
Actions
Shares
0
Downloads
43
Comments
0
Likes
0
Embeds 0
No embeds

No notes for slide
  • A real estate development is a self-contained enterprise. Its economic viability is based on whether, when built, it will pay its cost of development. But at the beginning, a real estate development has no income, it is only an idea into which the developer invests at-risk capital to determine whether the project can pay its costs if built. And, at the beginning of a project there are a lot of unknowns, and the risk of losing the money needed to gather the information on these unknowns is high. The developer needs to spend money on finding out: What is best way to respond to the market?What is the best design?How much will the best project costWill the project value pay the costs?What will the community supportWhat will the community require as development conditions.The earlier that a developer knows these things, the sooner the project viability can be determined.
  • Fundamental Skill for Real Estate Development Professional I (Charles Long) - 10.26.11

    1. 1. Fundamental Skills for Real Estate Development Professionals I Site Selection and Due Diligence October 26, 2011 Charles A. Long Charles A. Long Properties LLC 10:45 a.m. -12:00 p.m.Site Selection and Due Diligence 1
    2. 2. Topics we plan to coverI. Risk management during site acquisition.II. Maximum supported investment and residual land valueIII. Six focus areas of project management and due diligence.IV.Acquiring the site while conducting due diligence Site Selection and Due Diligence 2
    3. 3. Learning Objectives: For you to understand:1. Managing risk in site acquisition as a continuum of managing risk in development.2. Determining price and terms for site acquisition reflecting the value the project can afford.3. Due diligence as part of site acquisition. 3 Site Selection and Due Diligence
    4. 4. Our approach Overview with class discussion Ground rule:Ask questions as they occur to you. Site Selection and Due Diligence 4
    5. 5. •Charles A. Long•Charles A. Long Properties, LLC•Oakland, CA • Developer specializing mixed use development in California, US • Consultant on real estate development, redevelopment, capital finance and economic development • Instructor for ULI Real Estate School on development process, public- private partnerships and sustainable development • Former city manager of Fairfield, CA and interim manager in Mammoth Lakes, Pinole, and Hercules, California. • Author of “Finance for Real Estate Development” published April 2011 and contributing author to ULI Retail Handbook. • Served on 14 ULI advisory panels, chairing panels in Salem OR, Boise, ID and Dallas, TX • Masters in Public Policy, UC Berkeley; platoon sergeant, US Army 5 Site Selection and Due Diligence 5
    6. 6. Managing Risk in theDevelopment Process Site Selection and Due Diligence 6
    7. 7. Development today is more complicated physically and economically • More urban and mixed use • Entitlement is longer and riskier • More complicated economics • More conversions from old uses • Less leverage and no ―value add‖ financing Appleton Mills, Lowell, MA • Density confusionLakeside Steel Plant, Chicago West End Commons, Oakland, CA 7 Site Selection and Due Diligence
    8. 8. The Great Recession has changed the capital stack Much higher equity: now 35% or Equity more—recourse provisions tighter Mezzanine or Disappearance of "Gap" financing performing debt to pay for ―value-add‖ conversions Much lower debt: now 65% Debt or less Site Selection and Due Diligence 8
    9. 9. Development is…a separate self financing enterprise that goes fromsmall to large. •9 Site Selection and Due Diligence 9
    10. 10. The Development Process has three phases Site Selection and Due Diligence 10
    11. 11. ―The developer is the conductor of a chaotic and multi-disciplinary process, albeit one that depends onexogenous forces, especially market demand and capital availability.‖ ―No industry involves the collaborative effort of so many different disciplines to create a product in such a publiclyaccountable process as development.‖ Site Selection and Due Diligence 11
    12. 12. 80% to 90% of project value is created in the pre-development phase Acquisition, design, entitlement, financing, risk management Project Value 12 Site Selection and Due Diligence
    13. 13. Pre-development work manages risk for all phasesBy the start of construction, risks should bereduced to factors that have already beenaddressed and are controlled through goodmanagement. •13 Site Selection and Due Diligence
    14. 14. Pre-development funds are at risk• Funding for pre-development comes primarily from developer capital.• If source is outside investors, required return at least 25% and higher.• Many projects are abandoned when information about costs, markets or government approval conditions show that the project is unviable. •14 Site Selection and Due Diligence
    15. 15. 5 Principles of successful development management1. Invest in information wisely: More information reduces risk but it also has a cost. Is the risk of loss worth the reduction in risk?2. Manage time: the longer it takes, the more expensive the process will be. •15 Site Selection and Due Diligence
    16. 16. 5 Principles of successful pre-development management (continued)3. Manage tasks: Identify and budget all tasks and monitor.4. Anticipate: Things go wrong in the Development phase because somebody didn’t spend the money early enough, or somebody didn’t communicate key information. Things going wrong early are cheaper than later. •16 Site Selection and Due Diligence
    17. 17. 5 Principles of successful pre-development management (continued)5. Foster teamwork among the professionals: Select an effective team of multi-disciplinary players. Especially, focus on the relationship between the architect and contractor. a) As much as 80% of project costs will be spent through the contractor, another 5% through the architect. These two disciplines MUST work together. •17 Site Selection and Due Diligence
    18. 18. Six areas of project management Market and Site Marketingconditions Entitlement Financial Viability Analysis Construction Product cost type and management project design Site Selection and Due Diligence 18
    19. 19. Successful Developers ANTICIPATE! It is cheaper to solve problems earlier than later.Most of the value of a real estate project is created before you start construction. Site Selection and Due Diligence 19
    20. 20. Questions1. Why does a real estate project have the greatest risk of losing money in the early phases?2. What are the 5 principles of pre-development management?3. What six areas do you need to focus on to reduce risk and create value in the pre-development phase?4. What do you need to have accomplished before you spend significant amounts of money on a real estate project? Site Selection and Due Diligence 20
    21. 21. Maximum SupportedInvestment andResidual Land Value 21 Site Selection and Due Diligence
    22. 22. How much money does a realestate project need to make to be financially viable?The minimum required (the ―hurdle‖)return on costs depends on: • Cost of capital, and • Time to construct Site Selection and Due Diligence 22
    23. 23. Rate of return-lots of choices• Net operating income/Total cost=“the Development Cap”• Internal Rate of Return• Return on sales (ROS)• Return on costs (ROC)• Return on equity (ROE)The Hurdle Rate is the minimum rate ofreturn for proceeding with a project •23 Site Selection and Due Diligence
    24. 24. Internal Rate of Return is the detailed way to measure project return. Spreadsheets make it easy: Income for each period Initial Investment 1 2 3 4 -$100.00 $6.00 $7.00 $8.00 $110.00 7.63% Internal Rate of ReturnThe discount rate at which the present value of the streamof income equals the amount of the investment. Site Selection and Due Diligence 24
    25. 25. To measure how much a project makes: Project Value minus Project Costs Equals Project Return Site Selection and Due Diligence 25
    26. 26. The return on a project pays:• Cost of debt: interest on a construction loan (4%-6%)• Return on equity: return to investors (15% to 20%)• Developer profit: based on project performance after debt costs and equity target is reached Site Selection and Due Diligence 26
    27. 27. Developer profit comes from:• Fees: Developer fee of 2-4% of cost with incentive bonuses.• Co-investment: Developer is an equity investor in 10-15% of equity requirement.• Sharing of success: – Participation in profits over the ―preferred return‖ of 8- 12% – Higher participation in profits over a target of 15-18%. Site Selection and Due Diligence 27
    28. 28. Project value is– Sale project: Total sales price (e.g. homes, townhomes, condominiums, etc)– Income project: Total capitalized value from NOI. (i.e. annual income: lease revenues from retail, office, apartments, etc.) 28 Site Selection and Due Diligence
    29. 29. Use a cash-on-cash hurdle rate to evaluate project viability• The minimum overall return on cost to proceed with a project.• Uses a weighted average of return on debt and equity to determine the hurdle for a project’s construction/absorption period •29 Site Selection and Due Diligence
    30. 30. How much deposited today produces$120 in two years if the earning rate is 9.5% per year? 1.095 XDeposit 1.095 X 1.095 X Deposit Deposit 1 Year 2 Years 1.095 X 1.095=1.2 $120/1.2 =$100 30 Site Selection and Due Diligence
    31. 31. How much can you afford to spend on a real estateproject to produce enough return to pay interest and equity return over 2 years? IF:• Debt funds 75% of costs at 6% interest• Equity funds 25% of costs at 20% rate of return. • The weighted average annual cost of capital is .75*.06+.25*.2 = 9.5%.• At this cost of capital and delivery period you need a 20% return on costs 31 Site Selection and Due Diligence
    32. 32. Cash-on-cash hurdle rate changes with different capital mixes and different absorption periods Debt EquityAbsorption % funding Interest % funding Annual Annual Hurdle period return ROR Rate 36 60% 4.00% 40% 20% 10.4% 35% 36 80% 6.00% 20% 20% 8.8% 29% 24 60% 4.00% 40% 20% 10.4% 22% 24 80% 6.00% 20% 20% 8.8% 18% 18 60% 4.00% 40% 20% 10.4% 16% 18 80% 6.00% 20% 20% 8.8% 13% 12 60% 4.00% 40% 20% 10.4% 10% 12 80% 6.00% 20% 20% 8.8% 9% Site Selection and Due Diligence 32
    33. 33. The most you can afford to spend Project ValueMaximum =supportedinvestment 1 + hurdle rate •33 Site Selection and Due Diligence
    34. 34. A cash-on-cash return evaluates project viability based on estimates of cost and value• Be careful to include adequate cost allowances for all categories and, especially, contingency.• Use a cash-on-cash hurdle rate for projects with similar capital stacks and absorption profiles. 34 Site Selection and Due Diligence
    35. 35. Cash-on-cash hurdle rate is an approximation that saves time and allows quick evaluation.With more detailed information, do a more detailed IRR analysis. •35 Site Selection and Due Diligence
    36. 36. Pop quiz 1 What is the maximum supported investment?Project Value Hurdle Rate$36,000,000 20%$39,000,000 30%$50,000,000 25%$60,000,000 25% •36 Site Selection and Due Diligence
    37. 37. How much should you pay for the land? Land is worth what you can use it for. Residual Land Value is:The price you can afford to pay at the start ofconstruction that will result in sufficient return toattract investors and provide profit commensuratewith risk. 37 Site Selection and Due Diligence
    38. 38. Residual land value is the landcomponent of supported investment. Project Value Supported investment 1 + hurdle rate MINUS Development costs without land =Residual land value 38 Site Selection and Due Diligence
    39. 39. It is important to determine land price as soon as possible because:If the land price cannot be supported by theproject, the developer should immediatelyabandon the project. •39 Site Selection and Due Diligence
    40. 40. How should you adjust residual land value for:• Long and costly pre-development?• Longer construction period?• Higher market risk?• High land deposit payments during pre- development?• Higher city development fees?• Land as ―equity‖? 40 Site Selection and Due Diligence
    41. 41. Pop quiz 2 What is the project residual land value?Project Value Project Cost (w/o land) Hurdle Rate$36,000,000 $25,000,000 20%$39,000,000 $25,000,000 30%$50,000,000 $35,000,000 25%$60,000,000 $43,000,000 25% •41 Site Selection and Due Diligence
    42. 42. Questions1. Why is it important to determine land prices as early as possible?2. What information do you need to determine whether land price is affordable by the project? Site Selection and Due Diligence 42
    43. 43. The six focus areas ofproject managementand due diligence 43 Site Selection and Due Diligence
    44. 44. Project Management• Development is a ―team process‖—create and foster a common vision.• Have a complete list of all tasks—Monitor!• Foster the architect/contractor relationship: Insure it is collaborative not confrontational.• Understand what components cost compared to their value. Site Selection and Due Diligence 44
    45. 45. Shape the land acquisition terms to the informationSite Market Community Project Constructionanalysis assessment Support design costs Financial analysis to acquire land at no more than its Residual Land Value Site Selection and Due Diligence 45
    46. 46. Site analysis affects development potential and costs• Is there a recent survey of the site?• Any investigation of hazardous waste?• Unstable soils or flooding on the site?• History of the development of the site?• Is the title for the site clear?• Encumbrances on the site and who will be responsible for clearing these?• Are adequate utilities and traffic capacity available Site Selection and Due Diligence 46
    47. 47. The market determines what your project is worth• Market familiarity requires experience, immersion and research.• Visit other projects, watch transactions and understand trends.• Outside experts cost money but should be involved early in evaluating market potential and shaping the project design. Site Selection and Due Diligence 47
    48. 48. Know the community (the entitlement process)• Understand how zoning and development regulations affect use and costs.• Visit the city council and observe how they make decisions.• Map the concerns of community groups• Chart the time it will take.• Try to reach agreement on processing steps and time with the local jurisdiction. Site Selection and Due Diligence 48
    49. 49. Project Design will lay out the site• Engage the architect during due diligence.• Respond to the market• Respond to the community• Parking, density, height Site Selection and Due Diligence 49
    50. 50. Product type selection drives market acceptance (high density residential product types)FLATS 200 Second Street, Oakland, CA•74 Luxury Condominiums•Parking ratio 1.11 TOWN HOMES, Oakland Estuary, Oakland, CA•148 units/acre •Parking ratio 2.5 •31 units/acre Interlocking townhouse configuration Up to 35 units/acre with 2 car garages Site Selection and Due Diligence 50
    51. 51. Construction costs• Research costs and construction techniques.• Know the market for construction services.• Identify and resolve areas of uncertainty• AS PART OF DUE DILIGENCE: Hire the contractor to give you up-to-date information on a specific site for a specific design. Site Selection and Due Diligence 51
    52. 52. Financial Analysis• Use current market and costs—avoid wishful thinking!• Reduce uncertainty by paying for information!• Use a valid hurdle that incorporates time and cost of capital!• Analyze the economics of each component! – What is its cost? – What is its value? Site Selection and Due Diligence 52
    53. 53. Cost pro-forma includes:1. Building costs2. Site Development (demolition, grading, utilities and landscaping)3. Parking (may be included in building for some types of projects)4. Connection and impact fees5. Offsite costs such as traffic signals or road improvements6. Design (architecture, engineering, consultants, etc)7. Marketing (brokers, advertising, etc.)8. Construction management9. Financing /legal/administrative10. Taxes during construction11.Contingency: 10-15% in early stages Site Selection and Due Diligence 53
    54. 54. DO NOT LUMP COSTS! UNDERSTAND COSTS AND VALUE!YOU CANNOT CUT THE BOARD LONGER! Site Selection and Due Diligence 54
    55. 55. Understand the economics• Off-site improvements• Design and amenities• Unit size• Parking ratios and costs• Density• Early design will change during entitlement.Evaluate project components in terms ofwhat they cost and what they are worth. Site Selection and Due Diligence 55
    56. 56. The economics of density: More is sometimes less Site Selection and Due Diligence 56
    57. 57. Why things go wrong• Somebody didn’t spend the money early enough.• Somebody didn’t communicate key information.• Things going wrong early are cheaper than later.• Control risk through due diligence and communication. The best way to solve a problem is to find out about it early enough to do something about it. Site Selection and Due Diligence 57
    58. 58. Questions1. Why is development a team process? Site Selection and Due Diligence 58
    59. 59. Acquiring the site 59 Site Selection and Due Diligence
    60. 60. The first six steps1. Look for sites, investigate and identify those with promise.2. Do the six part analysis on the promising sites and decide what the site is worth.3. Begin negotiation with owners. Site Selection and Due Diligence 60
    61. 61. The first six steps (continued)4. Make the offer: Letter of intent (LOI) or letter offering to purchase. This step frequently goes on for a while.5. Execute a purchase contract setting forth detailed terms of purchase and period of due diligence. Site Selection and Due Diligence 61
    62. 62. The first six steps (continued)6. Conduct the due diligence process prior to escrow deposits becoming non-refundable so you can get them back if you decide not to proceed. Site Selection and Due Diligence 62
    63. 63. Looking for sites• Immerse yourself in the community, drive it, bike it, walk it, understand it.• Meet with community groups• Map it: Google maps, parcel map services• Immerse yourself in the market: Internet data, visit projects, talk to tenants. Site Selection and Due Diligence 63
    64. 64. Looking for sites (continued)• Talk to city hall• Attend city council meetings• Understand the entitlement process.• Develop relationships with brokers, but recognize that brokers have only a part of the market. Site Selection and Due Diligence 64
    65. 65. Decide what the site is worth• Organize your analysis around the six focus areas.• Identify the areas of uncertainty and do more research.• Exercise judgment about market, construction and entitlement risk. Site Selection and Due Diligence 65
    66. 66. Begin negotiations• Find out about the owner.• Obtain as much information as possible from the owner during negotiations.• Understand before proposing.• Use the open book, where possible• Be trustworthy: never, never promise something you can’t do.• Recognize that buying land is a relationship. Site Selection and Due Diligence 66
    67. 67. Making the offer• A clear succinct letter of intent (LOI) or offer sets forth the major business terms.• Ask for concurrence on the letter as pre- requisite to the attorneys negotiating the purchase contract.• Provide a reasonable time to execute the contract. Site Selection and Due Diligence 67
    68. 68. The purchase contract• The property is ―tied up‖.• Now you can spend money on investigation (due diligence).• Insure that there is adequate due diligence time. Try to get as long as possible.• Refundable deposit during due diligence.• Minimize amount of non-refundable deposits prior to close of escrow. Site Selection and Due Diligence 68
    69. 69. The purchase contract (continued)• Focus on buyer’s conditions to close: – Condition of title and buyer’s obligations to deliver clear title. – Environmental and soils – Conditioned on receiving entitlement? – Maximum period to meet conditions – Deposit refund conditions Site Selection and Due Diligence 69
    70. 70. Due Diligence• Engage your development team on the six areas of focus and pay them to get more reliable information.• Decide impact of more reliable info on contract price.• Decide whether to – proceed, – renegotiate, or – abandon. Site Selection and Due Diligence 70
    71. 71. Typical due diligence cost: first 60-120 days (<$100 million project) Item CostSoils, survey, title and environmental $20,000Market Analysis $7,500Preliminary project design $10,000Determine entitlement process and likely $7,500conditionsPre-construction services $5,000Total budget during refundable period $50,000 Site Selection and Due Diligence 71
    72. 72. Common issues encountered in due diligence• Title to property not clear.• Easements prevent full site utilization.• Survey finds less land.• Soils not good for construction.• Environmental hazards.• Zoning or development requirements different• Development fees higher Site Selection and Due Diligence 64
    73. 73. Common issues encountered in due diligence (continued)• Construction costs higher• Market strength weaker• More controversy in community• Site layout or unit production different Site Selection and Due Diligence 65
    74. 74. A real estate project’s 3 funding baskets Basket 1 Basket 2 Basket 3Prior to site control After site control Begin construction Preliminary research, Entitlement, non-refundable purchase contract, (hard) deposits and design. refundable deposits, Time is not your friend Construction and initial due diligence delivery EASY HARD EASYLimit expenditures from Basket 2 with careful initial due diligence, goodpurchase terms and careful entitlement management. Site Selection and Due Diligence 74
    75. 75. Acquisition Do’s DO• Base value on market, •Be prepared to abandon the entitlement, and current site if due diligence discloses costs and prices, not on information that is inconsistent comps and guesses. with the assumptions that determined price.• Create a relevant list of ―buyer’s conditions to •Understand how much close‖ ―Basket 2‖ money you will need. Site Selection and Due Diligence 75
    76. 76. Acquisition Don’ts DON’T • Close without entitlement• Skimp on the cost of unless prepared to live with researching due diligence the consequences of no issues. entitlement• Proceed beyond due • Deposit non-refundable diligence if there are major money un-necessarily. issues unresolved. • Make un-necessary• Engage in wishful thinking commitments to Seller or to about resolving due diligence concerns. entitlement entity. Site Selection and Due Diligence 76
    77. 77. QuestionsWhy is effective due diligenceso important to the success of areal estate project? Site Selection and Due Diligence 77

    ×