Real estate development is ideally a multi-faceted process that can be complex, risky, and lengthy. Bringing a project from the initial planning stage to completion through construction can take years, and many kinds of obstacles can pop up any time along the way. Yet, real estate development projects can be profitable investments. Understanding the life cycle of a development project enables the investors to confidently assess some of the risks that are associated with any CRE investment.
Development projects offer an opportunity to bring forth a product that currently doesn’t exist in the market, in most cases by providing a fresh new supply aimed at satisfying the pent-up market demand. This aspect of a development project, when executed well, can deliver a runaway success story, which is simply not nearly as possible with already existing assets. By better understanding the different aspects of the “life-cycle” of a development project, an investor will be better placed at assessing the various risks associated with construction.
Risk Across the Type and Stage of a Project
The type of the project and its stage are the two factors that play a critical role in determining the risk of a project. The type of the project determines the extent of risk it has across the life cycle of the project.
One example of a project with a relatively low risk profile across its life cycle is a “build-to-suit” retail project. In such a project, the developer secures a long-term credit tenant, say for instance Walgreens or McDonald’s, and then develops the property in a way that suits the tenant requirements. These kinds of projects have a low construction risk because the building is fairly uniform, and they have minimal or no leasing risk because the tenant has already been identified and is under lease with a limited capacity to terminate. Depending on the regulatory hurdles, there can be some pre-development risk, as we’ll look at in the Pre-development section below.
On the other end of the spectrum is a ‘speculative’ or ‘spec’ project, which typically has a relatively high risk across all the stages. In a speculative office or industrial project, the developer may have none or a few leasing commitments before construction commences. The project is usually justified by pointing into a projected or an existing demand for that kind of property after completion. For spec projects, there’s a high leasing risk because there are no identified tenants at the outset, there’s a high construction risk if the design of the project is unique, and a high pre-development risk in case there are regulatory hurdles abound or if it’s difficult to obtain financing.
As every stage of the development project is completed, the overall risk on the project abates incrementally. This is because the early stages of the cycle have more potential obstacles and many unknowns. But as the project approaches the “shovel-ready” construction phase, much of the potential obstacles are usually already resolved, and the execution has a bit more certainty in terms of the cost and schedule.
Now let’s look at the common items that are consistent across different types of projects.
Early Stage: Pre-Development
The pre-development stage of a project ideally focusses on research, due diligence, and permitting. It’s usually the most variable in terms of duration. As such, investing at this stage comes with the most varied and greatest risks, since there are so many unknowns about the project. Some of the most common steps in the early stage include:
- Feasibility and market analysis studies
- Environmental assessments
- Securing option rights to purchase land or land acquisition
- Site plans, building plans, and development plans
- Arranging for construction financing
- Some infrastructural improvements
Since this is the riskiest stage, the pre-development work is often financed by the project sponsor, or by the source of seed equity, which can be taken out by a construction loan. Therefore, any investments that are made during this stage usually provide for higher returns than those done at a later stage. One important thing investors should note is that applying for and obtaining financing for a contraction project from a bank and other lenders is often a rigorous process. Plus, if the developer has a construction loan arranged already, it often means that some of the major hurdles have been cleared.
Obtaining the local jurisdiction permitting is possibly the biggest obstruction to capital formation during this stage. To begin a construction project, there usually two separate approvals needed: building approval and land use permit.
A land use approval governs the jurisdiction’s permit for a project on its conceptual level. Nearly every jurisdiction in the US, with a notable exclusion of Houston, Texas, has in place a form of land use regulation. This essentially provides a standardized system of qualifying and sorting out proposed uses of land (industrial, retail, residential, etc.), as well as the physical characteristics of the improvements (density, height, setbacks, etc.)
The approval process for land use permit can delay the project for months or years. As such, although it’s not the final approval for commencement of construction, the land use permit is regarded as the greatest hurdle in accessing project financing. Some factors that can delay the land use permit include:
- Rezoning process
- An appeal from any interested parties, such as the neighbors
- A design process that needs multiple iterations of the site plan
- Disputes between the jurisdiction and the developer
When a building permit is approved, the jurisdiction ideally approves the project on a technical level. Through its engineers, a jurisdiction reviews the building plans to establish whether certain safety standards are met, and whether they conform to the existing building codes. In comparison to the land use process, the building permit application process is relatively quicker, since it’s supposed to be based on the objective criteria. It’s therefore not likely to delay the search for financing. In general, the building permit is the last milestone during the early stage.
Middle Stage: Construction
This stage involves the construction of improvements. Since the early stage processes have been completed, the risk at the middle stage are significantly reduced, though not eliminated. Some of the common steps under this stage include:
- Project marketing
- Vertical construction
- Drawing on the financing of the construction
- Arranging for a permanent financing, if skipped during pre-development
- Obtaining a project manager, if not done during pre-development
At this stage, the project is typically financed by the sponsors, a short-term construction loan, and outside investors. In most cases, the debt will be distributed to the developer, usually in increments known as “draws” as construction milestones are achieved. Loans and investments made during this stage usually have lower returns compared to pre-development investments, but generally have higher returns than those made for stabilized or fully-constructed buildings.
The end of the construction stage is marked by the certificate of occupancy, which allows for the start of property operations. Just like with the building permits, the certificate of occupancy is based on the objective criteria for construction quality and is generally an administrative process.
Final Stage: Operation
Operation is the last stage of the development process and is the first stage of the life of the building. While at this point much of the pre-development and construction risks have been removed, obtaining tenants still poses a risk. Some of the steps in this stage include:
- Ongoing leasing and marketing
- If not done earlier, finding buyers
- Establishing a hold strategy, if the property is not selling
- Achieving stabilization
- Ramping up property management
At this stage, the project is usually financed with construction financing or more short term ‘bridge’ financing, until it reaches a stabilization threshold. This is where the development reaches a given occupancy level, such as 90% of higher, for a given duration such as 3 consecutive months. Once the stabilization threshold is achieved, long-term or permanent financing can be placed and used for construction financing. Based on the amount of pre-leasing achieved during construction, this can be the stage with the least amount of risk. Therefore, equity investment and permanent loans will give the lowest returns.