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One
of the perks of my veteran status in the commercial real estate wars is I
occasionally get to share my knowledge with a new person in the business. One
such conversation occurred this week - which I believed to be column worthy. “How
is a development deal underwritten?”
Following
are the considerations:
Land. A new project requires buildable land. Duh! However, the
land doesn’t have to be undeveloped presently. Specifically, in Orange County,
many of the new projects are a re-development of sites containing obsolete
buildings - the Boeing campus in Anaheim and the Beckman campus in Fullerton
are a couple of examples. Both of these sites were purchased, the old
improvements were scraped and beautiful new structures emerged. As we venture
east - our likelihood of finding raw, undeveloped land increases. Each site has
its own special mix of zoning, city entitlement processing, access, topography,
and off-site challenges such as curbs, gutters, streets, utilities, etc.
Finally, the land must be owned by a ready, willing, and able seller prepared
to meet the market price a developer will pay.
The market demand. What are occupants craving?
Generally, a developer must understand the mentality of the folks who will
lease or buy the new buildings. As an example - currently in North Orange
County - there is a shortage of available industrial buildings between
20,000-50,000 square feet. Coupled with this shortage is an acute demand for
this product. Conversely, another category - Regional Mall space - has a glut
of availability. So now the developer’s task is to figure out a way to build a
project of 20,000-50,000 square foot industrial buildings upon a site as
described above.
Income stream. So once the new premises are
complete - what is our expectation of rent? This is tricky yet critical - as
the development’s viability depends upon this metric. Taken into account must
be - recent lease comparables, available stock, and the direction of the market
- up or down. As an example - inland there are very few currently existing,
vacant buildings 100,000-150,000 square feet for sale. However, the cavalry of
new developments is coming as there are several projects under construction.
Cost to produce. Coverage. How many square feet can I
build on the site? In simple terms - if the site is one acre (43,560 square
feet) and I can construct 20,000 square feet - my coverage is 46%. Why is this
important? Because all the cost categories follow. If we pay $50 per square
foot for the land - a total of $2,178,000 - we must now divide by the coverage
in order to determine our land cost “under building”. $50 per square foot
divided by 46% equals $108.69 - which is the land cost component attributable
to the building. We now must layer in construction costs plus “soft costs” -
things like interest carry - remember we have some time before the structures
are finished. Now - based upon what we paid for the land and our estimate of
construction and soft costs - we have an idea what our building will cost us to
produce.
Exit strategy. Even though this item was left until
last - it’s actually the first consideration in any development or investment
deal. What’s the end game? Do I plan to lease the buildings and hold them as a
long term investment? Or should I simply sell them vacant upon their completion
and pocket the proceeds - less of course Uncle Sam’s, and Cousin Gavin’s taste.
I could lease the product and then sell the income stream as a leased
investment. Regardless of the exit strategy - each has its own risk, reward,
and profit potential.
So,
in its simplest terms -there you have it. Development 101.
Disclaimer - development may be hazardous you
your health and may cause extreme anxiety, heart palpitations, hair loss, rapid
aging and is not for the faint of heart. Proceed with extreme caution.
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