How are Commercial Real Estate Development Costs Calculated?
How are Commercial Real Estate Development Costs Calculated?
The process of developing commercial real estate requires the developer to incur a number of different costs. These costs can be analyzed in two different ways. The first way is by segregating the costs by the different phases of the development (pre-development, land preparation, construction of the structure, etc.) and the second way is to separate costs into categories of “hard” costs and “soft” costs. This article will discuss both methods and provide a breakdown of some of the specific costs associated with each method.
The Difference Between the Two Methods
While the two methods described above will include the exact same costs, they provide a different way of understanding what functions in the development process those costs will address and when a developer can expect to incur those costs. As we’ll see, the timing of certain costs impacts the amount of other costs in the process.
The timing of costs is pretty self-explanatory. At a very high level, the timing of activities for a real estate development are:
Pre-development planning | Land Preparation | Construction | Stabilization
The distinction between hard costs and soft costs is a little less intuitive, though. So we’ll first take a look at the difference between hard and soft costs and then explore the timeline of development. This approach will allow us to see what kind of costs are incurred at what point in the development life cycle.
Hard Versus Soft Costs Method
Hard costs are sometimes referred to as “brick-and-mortar costs” as a reference to the physical nature of these costs. Hard costs include the physical components involved in developing a property such as material, labor, equipment, land development roads, utilities, etc. Hard costs can include even the landscaping around a property.
Soft costs, on the other hand, include expenses that are indirectly related to the construction of a property. Soft costs include architectural and engineering fees incurred during the planning of a development, permits and fees associated with the approval process, legal expenses incurred throughout the life of the development, and interest charged on the financing of the development.
An easy, although simplistic, way of remembering the distinction between a hard and a soft cost is that if you can touch something that’s either a part of the building or was used in the actual construction of the building, it’s usually considered a hard cost. If the cost is related to, but not directly involved in, the physical construction of the building, then it’s probably going to fall into the soft cost category.
Phases of Development Method
Every development has roughly the same process from start to finish. There are always differences depending on the current state of the property (raw land vs. existing structure or rural single-family home vs. urban high-rise office building), but for the most part each development will look pretty similar conceptually. The phase of development is important for two reasons. First, once you better understand the components of development and the difference between a hard and soft cost, you’ll have a better feel for which costs fall into which phase of development. Second, knowing when funds will need to be used and for what purpose allows a developer to better estimate the total amount of interest that will be incurred on financing.
As an aside, we’re assuming that the land in which the development will be built is already owned or is in the process of acquisition. The land acquisition process for a development is a topic that will not be covered in this article. We’re also assuming that the development is a physical building, such as an office or multifamily property, rather than an infrastructure project, such as a highway.
Planning and Pre-Development
The first major component of development is the planning and pre-development phase. This phase will consist almost entirely of soft costs as the developer is focused on physical and economic feasibility studies, drafting architectural and engineering plans, surveying the land, addressing environmental or legal issues, and applying for permits and approvals to begin any kind of physical construction.
Preparation of Land
The second major component of development is the preparation of the land for a physical structure and will often consist of both hard and soft costs. The hard costs associated with preparation of the land are the equipment and labor needed to excavate and grade the land, install utilities and infrastructure (if needed), and other potential activities such as stormwater management. Soft costs will consist of inspection fees, surveys, any legal fees, and financing interest.
The third component involves the construction of the structure itself and is usually the phase where most of the hard costs are incurred. While there are soft costs such as inspection fees, legal fees, and financing interest, the majority of costs in this phase include all the material and labor needed to construct the property. The amount of hard costs incurred will largely depend on the size and quality of the structure. For example, a single-family home in the suburbs will cost much less than an 80-story high-rise in a major city.
Finally, the stabilization of the property is the last stage in the development of a property. While it does include some final construction hard costs such as interior buildouts and final touches, this phase is largely focused on leasing the building out to tenants and reaching a level of economic stability. Soft costs common in this phase are leasing commissions, tenant improvements, covering operating shortfalls, and carrying costs associated with the financing of the development of the property. In most developments, the development/construction phase is concluded when either the developer takes out a “permanent” loan that pays off any debt and interest incurred during the development and often provides the profit to the developer or the property is sold to a new owner.
While the descriptions above are not exhaustive, they should provide an introduction to the types of costs associated with development. Costs for developments will vary widely depending on many different factors. An analysis should be performed to determine the level of costs associated specifically with the proposed development, including the extent of land preparation needed, the type, quality, and amount of material, the labor needed throughout the process, the cost of permitting and approvals through the local jurisdiction that oversees development in the area of the project, and the cost of any financing needed to fund the development.
It’s important to note that the earlier in the development process the funds are used, the more financing cost (interest), which is a soft cost, will be accrued throughout the development. In areas where approval for a development is quick and relatively simple, interest accrued on pre-development costs may be a lesser issue. However, in areas such as California, notorious for a strenuous approval process that can take years, financing costs on pre-development activities can sometimes become large and impact the viability of a development project.