Friday, August 8, 2014

Build #CRE and they will come? Seven reasons they won't...

Image Attribution: www.whsc.emory.edu
Early in my commercial real estate career, which now spans four decades, I received an objection from buyers. It went something like this...why should I pay X amount for the building? I'll just buy a piece of land and build it myself...it's bound to be cheaper. Hmmm, maybe they are right, I thought. I learned early on that I better be well versed in the "replacement cost" argument.

Please indulge me and I will explain why building your own building rarely (if ever) makes sense...even if you want to lure the Chicago Black Sox.

I provide Location Advice to owners and occupants of industrial buildings in Southern California...AKA, I sell and lease commercial real estate for a living and have since 1984. Some expertise is intrinsic...if I can exorcise it...

What buyers of commercial real estate (who believe they can build cheaper than buy existing) often overlook is as follows:

Land prices: Remember if you want to build a 20,000 sf industrial building with a normal parking ratio...two spaces of parking for every 1000 sf of building, you will need to purchase an acre (an acre is 43,560 square feet) to an acre and a half of land...or approximately double the building square footage. This building to land relationship is referred to as a coverage ratio or an FAR (floor to area ratio).  Rarely will a city allow a coverage ratio, for an industrial building of greater that 50%. If you pay $20 per square foot for the land, at 50% coverage, the cost of land under building is $40 per square foot. The smaller the land parcel the more valuable...thus the price per square foot will be higher. A production developer who buys ten acres and builds ten, 20,000 square foot buildings will pay less per square foot for his land. You will pay more for your land.

Soft costs: Architectural, engineering, off-site improvements (curbs, gutters, utilities), on site improvements (demolition, clearing) will add 20-25% to the total project cost. These costs are overlooked or under estimated.

Entitlements: City approval for the development. Catch 22 here. You don't want to invest in a parcel of land that you can't improve BUT rarely will land sellers tie up their property while you endeavor to receive permission to build. If you begin with a raw piece of land this can take a year or two.

Time value of money: Entitlements and construction time can easily eclipse two years or more. Rarely does an occupant have that much time to plan for a move or the foresight to predict their building needs. During this time, a great deal of money is tied up in the land purchase.

Financing: Typically, the land will have to paid for in cash, a construction loan originated and replaced with permanent financing once the project is completed. Consequently, there are loan points, fees, interest carry, and interest rate risk (if rates are rising during the construction) for ALL of the loans...construction and permanent. You will pay twice as much to originate financing (because you have two loans) than simply buying an existing building. Loans are more expensive.

Economies of scale: You are building ONE building. A production developer is building ten. Who do you suppose if going to drive cheaper construction costs? Additionally, some costs are fixed regardless of the square footage being built...a water main to the project, as an example. The more square footage that can be prorated, the cheaper the price per square foot of buildings.

Market forces: When you buy an existing building, you have the market forces to your advantage. The more buildings available, the more competitive prices will be. If you are building your own building, you cannot take advantage of market forces.

Does it ever make sense to build your own building vs buy existing? Certainly...but only if your use of a building is special purpose (cold storage, data processing, warehouse clearance in excess of forty feet, etc.) and there are NO buildings available in the desired area, OR if your existing location includes some excess land which is not improved and can be developed with no cost associated with the land, OR if you are a general contractor, architect, or engineer and can provide your services wholesale.

Otherwise, don't build it they will not come (SPOILER ALERT...they didn't in the movie either).