This will be a Series in eight parts.
- On commercial Real estate
- Defining project Value in CRE
- Identifying Risks in RE
- Sample table Project development
- On Construction contracts
- Essential types of project development
- Capital funding
- Components of project development
I find it fascinating that in my whole career I have never done a residential real estate project. I am very happy to take up this new challenge, as there are many new skills to be learned and issues to be addressed. I guess the nuances are much different than in public or commercial projects. Open spaces, for example, are much more used, an need to be designed more carefully.
The technical details do not worry me that much, as I got great experience in the last time. Also communication with the Architects or Engineers should not be an issue. I hope for more interaction with the investor, as they will be selling one project to multiple customers. They will probably have different expectations, and we should be able meet many of them.
Luckily this time the investor has decided against making a design competition. We can test different design directions, and through the dialogue refine the right solution, no need to be blank shooting with one design.
It would make sense to prepare myself for the future challenges in this project. First one is to understand the investors, the second one the users. I have read some material about who the investor is, what are they doing, and what are their pain points. For it is still very general, as I have to find the nuances, yet. In the following chapter I will take a look in some basis of RE development.
Just to quickly recapitulate the process in RE investment. it goes: (1) Land acquisition (2) Design, planning (3) Construction (4) Selling or operations. There are three possible ways of RE investment:
- IKL: Idea is looking for capital and location. Popular with shopping centers and franchises. A mature project idea, usually in the form of franchising, is looking for local investors and suitable locations.
- LIK: Location is looking for idea and capital. A depleted location is looking for financing and new possible uses. For example, newly created industrial parks.
- KIL: Capital is looking idea and location. For example, real estate funds or insurance companies, which have some free resources and want to invest these funds in suitable properties. Most often..
Defining a right project budget is very tricky. First step are the feasibility studies, to determine if the project is doable or not: location analysis, market analysis, competition, users, finance, risks (the feasibility study will be redone, again, later). In simple terms, we need to define what is the minimal number of apartments/sqr. meters to make the project doable, and what usage will these sqr. meters have. There are two ways to define the project costs:
- The frontdoor approach is based on the expected planning+construction costs and from these numbers calculates a minimum feasible possible rent. This rent must then be in line with the market, otherwise the project is unfeasible.
- The backdoor approach is based on a market rent, from which the maximum possible total costs of the project can be calculated. As the construction costs are not very elastic, we can calculate maximum price for the project. This method leaves a lot of room for purchase negotiation with the property owner.
Limitations to feasibility Analysis:
- If a project is financially feasible, may not necessarily be desirable as an investment.
- If a project is not feasible using debt financing, does not necessarily mean that it is undesirable:
- A project may appear “not feasible” with debt financing, yet it might be a desirable project from a total return to investment perspective (more equity financing).
The next variable is the project financing. In the context of the project development calculations we can prepare different financing scenarios and compare them. The proportion and the conditions of the debt financing have a significant influence on the profitability of the project. It is hard to go into the details, as costs are very project-dependent.
When we have a location, an idea, and the finance, we can move into planning. Many other stakeholders will enter the picture: future users, investors and possibly also the public. Therefore, several analyzes have to be carried out at this stage:
- Market analysis. This time more in detail. We want to determine the projections on the short- and medium-term supply and demand situation in the neighbourhood. We need to know the legal, technical, socio-cultural and economic conditions, so that we can determine the potential for the future development of the project.
- Area analysis. We want to understand the location and location qualities. Soft factors are: general image, recreational and residential quality, business address. Hard factors are: Infrastructure connections, land use and population mix, and topography. We want to be as objective as possible about the present and future qualities of the location.
- Land use analysis. We need to determine who will be the future users. We take into account various aspects, such as: the size and orientation of the apartments, need for parking spaces, construction quality and execution, services and technical equipment. We have to take into account the structure of buyers or landlords, which significantly influence the layout of the floor plan. Not only the current need, but also, if possible, future changes in demand must be included in the analysis.
- Competitions analysis. It is a synthesis of previous points: of market, location and usage analysis. What is the positioning of the planned object compared to competing objects. We need to identify and evaluate our competitors. We create a ranking list of all objects, including our own, and thus can see how we compare to the competition. The result is a list of strengths and weaknesses of our project. We can then easier modify and correct our concept. The aim is to adapt as well as possible to the needs of future users and to distinguish us from possible competitors.
Managing risk is most probably the most important thing a RE manager is doing. In construction are many variables which could go wrong, from contractors to macroeconomic changes. I was working once on a project with enormous earthworks, more than 100.000 cubic meters. The idea was to sell 70% of the earth masses (as it was mostly high quality gravel). But the 2009 financial crisis came and there was no market for the gravel anymore. The investor was left with three bad news: lots of gravel, reduced project costs, need to project changes. At the end we elevated most of the constructions, built some flood protection dykes, and left the rest on the side to be sold later.
These risks are real and can affect a project severely and very fast. We need to be aware of those risks, and be able to mitigate them. I like to think in alternative scenarios: what is the best and worst possible outcome for a specific issue. If we need to reduce the budget for a specific element, what will we do?
- Development risk. This refers to the risk that we developed the wrong project, according to use and location. It usually happens to inexperienced developers.
- Forecasting risk. As to this point, we made a lot of assumptions. This is the risk that the reality deviates from these assumptions.
- Planning risk. If, during later phases we find out that the building cannot be realised as intended, we are creating a lot of expenses. We have lost all of the expenses for starting the project.
- Time risk. This is the risk of exceeding the predicted time frame. It can negatively affect many parameters: the rebates to clients because of delays, permits, organisation of the construction site, etc.
- Approval risk. If the project is not approved as planned, the entire project may collapse. This is called approval risk. To reduce this risk, close involvement of the relevant public authorities in the earliest possible phase of the project is recommended.
- Financing risk. This refers to the risk that the funds required for project development can not be raised or prove inadequate during the course of the project. Macroeconomic changes are vital, especially the influence on interest rate.
- Soil and subsoil risk. Contaminated sites, contaminations or unfavorable subsoil conditions discovered in the course of the project can lead to considerable additional expenditure, which can ultimately cause a project to fail. Prevention is recommended with careful preliminary investigations and corresponding contractual provisions for the securing of the property.
- Cost risk.The cost risk is closely related to the financing risk. Due to the sometimes very long project durations, not all costs can be planned precisely. However, cost overruns can also arise from management errors during the project period.
These phases are not to be understood in a strict chronological order. Rather, as a rule, the individual phases will overlap. For example, the project marketing can already be started during the project conception. The conception phase in turn may overlap with the management phase. The completion of the project is followed by the management of the property over its entire useful life, the so-called building management.
So far I have learned about the risks and risk mitigation. It is an serious issue and things can quickly get out of hand. The average sq. meter price influences the whole budget. But the biggest point I have learned so far are the risks developers have to mitigate.
Next time I will be writing about the users.
- Stephan Bone-Winkel, Karl W Schulte: Handbuch Immobilien-Projektentwicklung. Immobilien Manager Verlag, September 2008, ISBN 3899841670.
- Willi Alda: Projektentwicklung in der Immobilienwirtschaft: Grundlagen für die Praxis. Vieweg+Teubner Verlag; Auflage: 4., akt. und erw. Aufl. 2011, ISBN 3834815144.
- Jürgen Schäfer, Georg Conzen, Wilhelm Bauer, Stefan Blümm, u. a.: Praxishandbuch der Immobilien-Projektentwicklung. C.H.Beck; Auflage:3, 26. September 2010, ISBN 3406639194.