Common Commercial Real Estate Development Terminology
The number of factors that must be considered for a successful commercial real estate development are immense and dynamic, meaning that a change to one input assumption often means needing to change many other input assumptions to accommodate modifications to the development. While many people consider the “development process” simply the act of constructing a property, there are also many other steps that are necessary to ensuring a development is done properly, including highest and best use analysis, environment feasibility, financial feasibility (valuation and operation), market analysis, and financing the development, among others.
However, an in-depth exploration of the entire development process is well beyond the scope of this article. In fact, entire books have been written about market analysis, the development process, construction, financing developments, etc. This article will instead focus solely on the financial aspects of the development process and will introduce you to some of the more common terms you’re likely to come across when working within real estate development. Many of the concepts below are addressed in more detail in other articles in the Altus Group Insights series.
The Iterative Nature of Real Estate Development
Although each of the items below are described individually, real estate development is a highly connected and iterative process. For example, let’s say a developer plans to acquire a piece of land for the construction of a 200-unit condominium building and sell the condominiums individually upon completion of the project. The financial model the developer created assumes a cost of development of $180,000 per unit and a sales price of $200,000 per unit (for a total cost of $36,000,000 and total revenue of $40,000,000), offering a return of around 11.1%. But during the market analysis phase of the development, the developer learns that there is a competitive property under development a short distance away and this will likely lead to increased competition and sales prices of only $190,000, reducing the developers return to just 5.56%. Let’s also say that the developer requires a return of at least 10.0%. In order to achieve this 10.0% return, the costs of construction need to be modified, perhaps through a decrease in the quality of the materials used or fewer property amenities, and the financial model must be updated to reflect all of these changes.
So keep in mind as we go through the terms below that while they’re listed individually and somewhat sequentially, you will revisit each one for revisions throughout the development process.
Common Terms/Phases of Real Estate Development
An appraisal is an estimate of the value of a property by a certified appraisal expert, often an appraiser carrying the MAI (Member Appraisal Institute) designation. The appraisal can value multiple aspects of the property, including the land value, the improvement value, the “as-is” value, or the fully completed value of the development.
- Highest and best use (HBU)
The highest and best use analysis theoretically determines the optimal use for a piece of land or an existing property. The analysis considers the existing condition of the property, the market, and legal constraints such as zoning.
- Sensitivity Analysis
As discussed at the beginning of this article, there are hundreds of inputs that go into the analysis of a potential development. Usually, each of these inputs have ranges that are reasonable. For example, the cap rate a property sells for could be 5.0% or 5.1%. The interest rate obtained on the loan could be 4.0% or 4.25%. Lease rates upon completion of the property could be $30 per square foot or $32 per square foot. When you add up all the possible scenarios the developer could experience throughout a development, the range of values can be wide. A sensitivity analysis helps the developer understand what the most significant risks are to the success of the development.
- Land Cost
The land cost is straightforward. It’s the price that the developer paid for the piece of land or property where the development will occur.
- Acquisitions costs
In addition to the cost of the land/property itself, the developer will incur what are referred to as “acquisitions costs.” These costs include any legal fees, consultants, analysis, and other costs associated with the acquisition, but not part of the cost of the land itself.
- Construction cost
Construction costs and development costs (see below) are referred to in different ways. In this article we segregate construction costs from development costs. Construction costs are considered the actual construction of a physical structure on the project and includes both labor and material.
- Development cost
Development costs, on the other hand, are costs and fees associated with the planning and execution of the development. This includes permitting fees, architectural and engineering services, legal representation, etc. It also includes costs associated with preparing the land for development, such as site preparation and infrastructure (sewer, water, utilities).
- Cost of capital
The cost of capital can be thought of as the interest rate on the financing a developer receives as a result of raising debt and equity for the costs of the development. Debt is typically lower cost than equity and is provided by banks or other large financial institutions, while equity can come from multiple sources. The cost of each depends on many factors, including the risk of the development, the experience and financial situation of the developer, and others.
- Weighted average cost of capital (WACC)
The WACC is the average cost (interest rate) of the funds raised for development. As a very simplistic example, let’s say the developer needs $10 million for the development. If the developer raises $5 million (50% of the cost) in debt at an interest rate of 5.0% and also raises $5 million in equity (the other 50% of the cost) at a rate of 10.0%, the WACC would be 7.5%.
- Loan-to-cost (LTC)
The LTC is the ratio of the loan provided to the developer and the total cost of the development. If the total cost of the development is $10 million and the developer is able to obtain a loan (debt) from a financial institution for $7 million, the LTC is 70% ($7 million / $10 million)
- Loan-to-value (LTV)
Similar to the LTC, the LTV is a ratio. The LTV, however, is based on the actual or estimated completed value of the development (meaning the development of the property is complete and tenants have occupied/purchased the property). If we continue the LTC example from above and assume the market value of the property at completion is $14 million, then the LTV would be 50% ($7 million loan / $14 million market value)
- Lease-up phase
The lease-up phase is the part of the development where the property is ready for occupancy and the developer/new owner actively searches for tenants to lease the property. Sometimes tenants are identified before the development even occurs while other times there is a gap between completion of construction and the identification of a tenant. The ideal scenario is to keep this gap short because the longer it takes to find a tenant paying rent, the more costs the developer incurs.
- Operational cash flow
Often cash flow is mentioned as a single line item. Here we make the distinction between operational cash flow and net cash flow. Operational cash flow is considered revenue minus expenses, resulting in the net operating income (NOI) of the property.
- Net cash flow (NCF)
NCF differs from operational cash flow (NOI) in that, in addition to expenses, other items such as capital expenditures and debt service are also subtracted from revenue. The NCF is the end amount the developer/owner receives after all expenses and debts have been paid.
- Stabilized income
Upon completion of the development, the property goes through a phase of “lease-up” where tenants begin to occupy the property and pay rent. Once the property has reached a level of full (or market) occupancy and all leases are being paid in full, the property is considered “stabilized.”
Valuation and Return
- Market Value
The market value can be estimated at multiple points in the development process. Upon completion of the development and at a point of stabilization, the property value can be estimated using one or several valuation approaches, including using a discounted cash flow approach, a capitalization rate approach, or a net present value/internal rate of return approach (see below).
- Return on investment (high-level)
Also sometimes referred to as a “yield” on the investment. There are multiple different ways to calculate the return on an investment, including metrics such as an equity multiple or an internal rate of return (covered below).
- Required rate of return
The required rate of return is an arbitrary number. Each developer/investor sets a return level that the development must achieve in order for it to be worth their time and effort. This could vary widely depending on the risk of the investment, the investors individual preferences, costs of financing, etc.
- Discount rate
The discount rate is the interest rate/return amount the developer has set as the required rate of return for their time and effort developing the property. It is also the rate at which the discounted cash flow model (see below) is based.
- Discounted cash flow (DCF) analysis (returns and valuation)
The DCF valuation method is the most sophisticated valuation technique used in real estate and is probably the most common. The DCF approach to valuation estimates the future cash flows of the property as well as any profits on the sale of the property. Those cash flows are then “discounted” (see “discount rate” above) to the present time. Once these cash flows have been discounted, the developer can use several metrics to determine the attractiveness of the opportunity or the market value (if the project has already been completed).
- Internal rate of return (IRR)
The IRR provides an estimated percentage rate of return based on the developers’ total investment in the property compared to the amount of cash flow the property is expected to generate. The developer can then decide whether or not the estimated rate of return is sufficient to move forward with the development.
- Net present value (NPV)
The NPV metric provides a number that indicates whether or not the developer will be able to achieve the desired rate of return given the purchase price/cost of a property, the estimated cash flows, and a specified discount rate. A positive NPV indicates the future value of the cash flows is above what’s needed to achieve the desired rate of return, while a negative NPV indicates that cash flows are below what’s required for the desired rate of return. The option here is to lower the cost/purchase price to a level that makes the net present value at least zero.
- Cap rate valuation
The cap rate (capitalization rate) valuation method provides a quick way to estimate the market value of the property at a specific point in time. Determining the cap rate requires dividing the current net operating income of the property by the purchase price. Or, alternatively, dividing the net operating income by the market cap rate gives an estimate of the market value at a point in time.
This has been a very high-level introduction to some of the common terms you might encounter in the real estate development world. As you can see, the number of terms and the nuances associated with each of them are almost infinite, not to mention the number of combinations that could play out during a development. Given the number of factors and the long-term nature of real estate development, it should be expected that assumptions and inputs to valuation and financial performance models will change over the course of the development, sometimes drastically. But understanding these factors and how they might change is key to understanding and mitigating potential risks.