Common Steps in Pre-Planning a Commercial Real Estate Development
The process of developing real estate is a careful blend of art and science. While some components, such as zoning and legal use, are often well-documented, other components such as what to build and whether or not the project will be financially feasible are less clear at the inception of a project proposal. In this article, we’ll discuss five of the major components you should be aware of when considering whether or not to proceed with the development of a commercial real estate property.
The Five Main Components of Development Feasibility
In practice, there are often hundreds of factors you’ll need to consider before determining whether or not to proceed in building a property and that number increases as the size and complexity of the project increases. For example, a high-rise office building in midtown Manhattan will require a much more intense feasibility study than a single-family home in the suburbs. The depth in which your feasibility analysis goes should be consistent with the complexity of the property.
The five components we’ll look at in the rest of the article include:
- Financial – will this project be profitable for the developer?
- Market – will the market support the development?
- Legal – do the legal uses for this land align with the planned property?
- Technical – can the land preparation and construction be performed successfully?
- Political – is there an appetite for new development or strong resistance?
Each of the components will be discussed in isolation below, but in the real world this is an extremely iterative and dynamic process. Let’s say that you perform a financial analysis based on your initial assumptions of what could be built on a specific piece of land. Then after your market analysis you realize that your rental rate per square foot assumptions were a little high for what you now think renters will pay. At this point, you need to go back to the financial analysis and revise your model to reflect a lower rental rate. This lower rental rate may impact the end value of the property, requiring a change to the quality of interior finishes of the property to lower the cost of construction so that the project will remain financially profitable upon completion.
So it might be a good idea to read through these components a couple times and think about how they would affect each other through an iterative development process.
Although the financial analysis will be driven by the market analysis, it’s usually a good idea to create a rough draft of the financial performance of the property. This serves a couple purposes: 1) provides a very early indication of whether or not the project is close to meeting investor/developer return requirements and 2) allows an analyst to think through the various aspects of a specific development that can raise questions to be explored during the market analysis phase.
The financial analysis should include the following factors:
Legal and predevelopment costs
Prior to any physical activity occurring on a development, the developer must obtain approvals and permits from local authorities, design the property with architects and engineers, and obtain financing. Depending on where you plan to develop, these costs can be significant and take several years.
Land and infrastructure preparation costs
Depending on the specific piece of land, a project may require raw land to be prepared for development or, as is common in urban environments, a property to be demolished. In more suburban developments, infrastructure such as roads, water, and sewer may need to be installed.
This includes the cost of material and labor required to physically construct the property. These costs will also vary widely depending on what you plan to build and where you plan to build it. Part of the market analysis should include an exploration of costs in the area you plan to build the property.
Income and expense assumptions
The value of the property will come from operations. Income assumptions can be found through a thorough market analysis and expense assumptions include local tax rates, local utilities rates, and other factors necessary to operate the property such as property management, salaries, and insurance.
Market value and return assumptions
In most cases, the purpose of developing a new property is to earn a profit for investors and developers. After all costs associated with development have been calculated and the stabilized income has been estimated, the analyst can use several valuation approaches to estimate the value of the property and the return to the developer. These approaches include the capitalization rate method for a snapshot of value and the discounted cash flow valuation method for a better look at the potential long-term returns the property will generate.
Performing a good market analysis is a necessary part of a successful development. There are entire books written around market analysis, but we’ll cover some of the high-level components here. For a more in-depth look at market analysis, there are several books from The Appraisal Institute and the Urban land Institute that you can consult.
Lease rates currently being observed in the market and submarket are an important component of the financial analysis discussed in the previous section. Revisions are made to the financial analysis based on information gathered during the market analysis phase, not only for lease rates, but also for the other components in this section.
Understanding the rental rates that similar properties are achieving is important, but it’s also important to understand trends in the market. If rental rates are, say, $40 per square foot, we know what they are today. If last year rental rates were $35 and the year before they were $30, and the year before they were $25, then we have a really good positive trend. But if rates have slowly declined over the past years, we may have a very different view about the ability to support necessary rates over the long-term.
Similar to lease rates discussed above, it’s important to know whether or not the market can support a level of occupancy the property requires in order to be successful. Also similar to lease rates, an analyst needs to be aware of trends in the market. Declining occupancy rates could point to weakening demand for an area or an increase in competitive supply.
While understanding what’s happening in a market is important, the real insight comes in determining how the proposed project will compare relative to the current supply for the proposed use case. If the proposed project is higher quality and better meets the needs of tenants than current properties, then the project may be well-positioned for success. On the other hand, if current properties have identical capabilities and offerings as the project you’re proposing, attracting tenants may be a more difficult process.
Just because the market can currently support a new development doesn’t mean that it will continue to support a new development in the future. For example, if a hotel is built in a rapidly growing area with few hotels, it might be a strong performer in the market over the near-term. However, if there are many pieces of land suitable for future hotel development, the market may eventually become saturated and depress occupancy and room rates. An analyst should be aware not only of any new properties under development, but also any new properties that have been proposed to the local jurisdiction and any pieces of land where a competitive property could potentially be developed.
Recent transactions in the market can tell you the value investors are placing on a given set of cash flows. Gathering information on the cap rates, price per square foot, financing arrangements, and time-to-sale can help in refining the financial analysis. Understanding the potential stabilized market value helps to determine the viability of a project and returns the investor/developer can expect to achieve.
As discussed below in the section on technical factors, the cost of materials and labor in an area needs to be well-researched. Attention should also be paid to potential disruptions or cost changes to material or labor.
Most parcels of land will fall under jurisdictions with specific zoning and use rules. For example, some parcels are specifically zoned for residential development, others for industrial uses, others for retail, etc. There are also limitations on how large a building can be on a specific piece of land (often referred to as the FAR – Floor Area Ratio), setbacks from sidewalks and other properties, and numerous other possible limitations. Obviously planning an industrial use on a piece of land that’s zoned for residential use is not likely to be approved, but there are other more nuanced rules that could be problematic if missed. This process usually involves specialists such as architects, zoning attorneys, and urban planners.
Technical factors include the feasibility of specific uses on specific pieces of land, design preferences, and cost limitations. There are numerous potential technical limitations, so we won’t go into details, but the analyst should make sure that the proposed design meets a few requirements:
- The design and quality of the property does not lead to a total cost of land development or a building that exceeds the potential value of the property. While an architect can design an amazing property, it may cost too much to build given the market.
- Building codes are different from one jurisdiction to the next. An analyst should be clear on the requirements of the jurisdiction in which the property is developed and ensure the costs of meeting those requirements is acceptable.
A project often requires approval from local authorities. This can be a tumultuous process depending on the attitude of the local community, the view of developers, and many other factors. Developers often face obstacles such as NIMBY (Not In My BackYard), BANANA (Build Absolutely Nothing Anywhere Near Anything), or CAVE (Citizens Against Virtually Everything). Developers should have a very good feel for how the community will react to a proposed development. The last thing a developer wants is to spend a lot of money on the pre-development process of planning and design only to figure out the community is adamantly opposed and will not allow the development to proceed.
A large part of the pre-development feasibility analysis is working back from the ultimate goal to the very inception of the project. Gathering each relevant piece of information is the “science” part of the process while then understanding the dynamic relationships amongst them is the “art.” Successful developers have processes in place to make sure they’ve considered the relevant information and have become very good at understanding the relationships, which comes from experience.
About the Author
Josh Panknin is a Visiting Assistant Professor of Real Estate at New York University’s Schack Institute of Real Estate and an adjunct professor in the school of engineering at Columbia University. Prior to academics, Josh was Head of Credit Modeling and Analytics at Deutsche Bank’s secondary CMBS trading desk where he helped develop and implement automated models for valuing CMBS loans and bonds. He also spent time at the Ackman-Ziff Real Estate Group and in various other roles in research, acquisitions, and redevelopment. Josh has a master’s degree in finance from San Diego State University and a master’s degree in real estate finance from New York University’s Schack Institute of Real Estate.