fundamental skills for real estate development professionals i. site selection and due diligence
DESCRIPTION
2010 ULI Fall Meeting Presentation October 13, 2010 10:45 am to 12:00 pmTRANSCRIPT
Fundamental Skills for Real
Estate Development
Professionals I
Site Selection
and Due Diligence
October 13, 2010
Charles A. Long Charles A. Long Properties LLC
10:45 a.m. -12:00 p.m.
1
Topics we plan to cover I. Managing risk in the development process.
II. Maximum supported investment and residual land value
III.Six focus areas of project management and due diligence.
IV.Acquiring the site while conducting due diligence
Site Selection and Due Diligence 2
Learning Objectives:
For you to understand:
1. How to manage risk in a development project.
2. How to determine price and terms for site acquisition.
3. How to conduct the process of site acquisition including due diligence.
Site Selection and Due Diligence 3
Site Selection and Due Diligence
Our approach
Overview with class discussion
Ground rule:
Ask questions as they occur to you.
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•Charles A. Long
•Charles A. Long Properties, LLC
•Oakland, CA • Developer specializing mixed use development in California, US
• Consultant on redevelopment, capital finance and economic development
• Instructor for ULI Real Estate School on development process, public-private partnerships and sustainable development
• Former city manager of Fairfield and interim manager in Mammoth Lakes, CA and Pinole, CA
• Contributing author to ULI Retail Handbook and currently writing book for ULI on real estate development and investment
• Served on 14 ULI advisory panels, chairing panels in Salem OR, Boise, ID and Dallas, TX
• Masters in Public Policy, UC Berkeley; platoon sergeant, US Army
Site Selection and Due Diligence 5
5
Managing Risk
in the
Development
Process
Site Selection and Due Diligence 6
Development today is more complicated
physically and economically
Site Selection and Due Diligence
• More urban and mixed use
• Entitlement is longer and riskier
• More complicated economics
• More conversions from old uses
• Less leverage and no ―value add‖ financing
• Density confusion Appleton Mills, Lowell, MA
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Lakeside Steel Plant, Chicago West End Commons, Oakland, CA
The Great Recession has changed
the capital stack
Site Selection and Due Diligence
Debt Much lower debt: now 65% or less
Equity Much higher equity: now 35% or more—recourse provisions tighter
Mezzanine or performing debt
Disappearance of "Gap" financing to pay for ―value-add‖ conversions
8
Development is…
a separate self financing enterprise that goes from small to large.
Site Selection and Due Diligence •9
9
The Development Process has three phases
Site Selection and Due Diligence
10
The developer is the conductor of a
chaotic and multi-disciplinary
process, albeit one that depends on
exogenous forces, especially market
demand and capital availability.
No industry involves the
collaborative effort of so many
different disciplines to create a
product in such a publicly
accountable process as development.
Site Selection and Due Diligence 11
80% to 90% of project value is created in
the pre-development phase
Site Selection and Due Diligence 12
Acquisition, design, entitlement, financing, risk management
Project Value
Pre-development work
manages risk for all phases
By the start of construction, risks should be
reduced to factors that have already been
addressed and are controlled through good
management.
Site Selection and Due Diligence •13
Pre-development funds are at risk
• Funding for pre-development comes primarily from developer capital.
• If source is outside investors, required return at least 25% and higher.
• Many projects are abandoned when information about costs, markets or government approval conditions show that the project is unviable.
Site Selection and Due Diligence •14
5 Principles of successful
development management
1. Invest in information wisely: More
information reduces risk but it also has a
cost. Is the risk of loss worth the reduction in
risk?
2. Manage time: the longer it takes, the more
expensive the process will be.
Site Selection and Due Diligence •15
5 Principles of successful pre-
development management (continued)
3. Manage tasks: Identify and budget all tasks
and monitor.
4. Anticipate: Things go wrong in the
Development phase because somebody
didn’t spend the money early enough, or
somebody didn’t communicate key
information. Things going wrong early are
cheaper than later.
Site Selection and Due Diligence •16
5 Principles of successful pre-
development management (continued)
5. Foster teamwork among the professionals:
Select an effective team of multi-disciplinary
players. Especially, focus on the relationship
between the architect and contractor.
a) As much as 80% of project costs will be spent
through the contractor, another 5% through the
architect. These two disciplines MUST work
together.
Site Selection and Due Diligence •17
Six areas of project management
Site Selection and Due Diligence
Site conditions
Construction cost
management
Market and Marketing
Product type and project design
Entitlement
Financial Viability Analysis
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Site Selection and Due Diligence
Successful Developers
ANTICIPATE!
It is cheaper to solve problems
earlier than later.
Most of the value of a real estate project is
created before you start construction.
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Site Selection and Due Diligence
Questions 1. Why does a real estate project have the greatest risk
of losing money in the early phases?
2. What are the 5 principles of pre-development
management?
3. What six areas do you need to focus on to reduce
risk and create value in the pre-development phase?
4. What do you need to have accomplished before you
spend significant amounts of money on a real estate
project?
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Site Selection and Due Diligence 21
Maximum Supported
Investment and
Residual Land Value
Project viability
Will the project value result in
sufficient return on costs to
1. attract debt and equity to fund those
costs and
2. compensate the developer for skill and
time?
Site Selection and Due Diligence 22
– Sale project: Total sales price (e.g.
homes, townhomes, condominiums,
etc)
– Income project: Total capitalized value
from NOI. (i.e. annual income: lease
revenues from retail, office,
apartments, etc.)
Project value is
Site Selection and Due Diligence 23
Will the amount you spend on the project
be low enough that the return from project
value will be sufficient to attract debt and
equity to fund those costs and compensate
the developer for skill and time?
Or,
Site Selection and Due Diligence 24
Use a cash-on-cash hurdle rate
to evaluate project viability
• The minimum overall return on cost to proceed
with a project.
• Uses a weighted average of return on debt and
equity to determine the hurdle for a project’s
construction/absorption period
Site Selection and Due Diligence •25
How much deposited today produces
$120 in two years if the earning rate is
9.5% per year?
Site Selection and Due Diligence 26
Deposit 1.095 X Deposit
1 Year
1.095 X 1.095 X Deposit
2 Years
1.095 X 1.095=1.2
$120/1.2 =$100
How much can you afford to spend on a real estate
project to produce enough return to pay interest and
equity return over 2 years?
IF:
Site Selection and Due Diligence 27
• Debt funds 75% of costs at 6% interest
• Equity funds 25% of costs at 20% rate of return.
• The weighted average annual cost of capital is
.75*.06+.25*.2 = 9.5%.
• At this cost of capital and delivery period you
need a 20% return on costs
Cash-on-cash hurdle rate changes with different capital
mixes and different absorption periods
Site Selection and Due Diligence 28
Absorption
period
Debt Equity
Annual
ROR
Hurdle
Rate
% funding Interest % funding Annual
return
36 60% 4.00% 40% 20% 10.4% 35%
36 80% 6.00% 20% 20% 8.8% 29%
24 60% 4.00% 40% 20% 10.4% 22%
24 80% 6.00% 20% 20% 8.8% 18%
18 60% 4.00% 40% 20% 10.4% 16%
18 80% 6.00% 20% 20% 8.8% 13%
12 60% 4.00% 40% 20% 10.4% 10%
12 80% 6.00% 20% 20% 8.8% 9%
The most you can afford to spend
Maximum supported investment
= Project Value
1 + hurdle rate
Site Selection and Due Diligence •29
• Be careful to include adequate cost allowances
for all categories and, especially, contingency.
• Use a cash-on-cash hurdle rate for projects
with similar capital stacks and absorption
profiles.
A cash-on-cash return evaluates project
viability based on estimates of
cost and value
Site Selection and Due Diligence 30
Cash-on-cash hurdle rate is an
approximation that saves time and
allows quick evaluation.
With more detailed information, do a
more detailed IRR analysis.
Site Selection and Due Diligence •31
Internal Rate of Return is the detailed
way to measure project return.
Spreadsheets make it easy:
Income for each period
Initial Investment 1 2 3 4
-$100.00 $6.00 $7.00 $8.00 $110.00
7.63% Internal Rate of Return
The discount rate at which the present value of the stream of income equals the amount of the investment.
Site Selection and Due Diligence 32
Pop quiz 1
What is the maximum supported investment?
Project Value Hurdle Rate
$36,000,000 20%
$39,000,000 30%
$50,000,000 25%
$60,000,000 25%
Site Selection and Due Diligence •33
Land is worth what you can use it for.
Residual Land Value is:
The price you can afford to pay at the start of construction that will result in sufficient return to attract investors and provide profit commensurate with risk.
Site Selection and Due Diligence 34
How much should you pay for the land?
Residual land value is the land
component of supported investment.
MINUS
Development costs without land
=Residual land value
Project Value
1 + hurdle rate
Supported investment
Site Selection and Due Diligence 35
It is important to determine land price
as soon as possible because:
If the land price cannot be supported by the
project, the developer should immediately
abandon the project.
Site Selection and Due Diligence •36
• Long and costly pre-development?
• Longer construction period?
• Higher market risk?
• High land deposit payments during pre-
development?
• Higher city development fees?
• Land as ―equity‖?
How should you adjust residual land value for:
Site Selection and Due Diligence 37
Pop quiz 2 What is the project residual land value?
Project Value Project Cost (w/o land) Hurdle Rate
$36,000,000 $25,000,000 20%
$39,000,000 $25,000,000 30%
$50,000,000 $35,000,000 25%
$60,000,000 $43,000,000 25%
Site Selection and Due Diligence •38
Questions
1. Why is it important to determine land
prices as early as possible?
2. What information do you need to
determine whether land price is affordable
by the project?
Site Selection and Due Diligence 39
Site Selection and Due Diligence 40
The six focus areas of
project management
and due diligence
Site Selection and Due Diligence
Shape the land acquisition terms to
the information Market
assessment
Project
design
Community
Support
Financial analysis to acquire
land at no more than its
Residual Land Value
Site
analysis Construction
costs
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Site Selection and Due Diligence
Site analysis affects development
potential and costs • Is there a recent survey of the site?
• Any investigation of hazardous waste?
• Unstable soils or flooding on the site?
• History of the development of the site?
• Is the title for the site clear?
• Encumbrances on the site and who will be
responsible for clearing these?
• Are adequate utilities and traffic capacity available
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Site Selection and Due Diligence
The market determines what your
project is worth
• Market familiarity requires experience, immersion
and research.
• Visit other projects, watch transactions and
understand trends.
• Outside experts cost money but should be
involved early in evaluating market potential and
shaping the project design.
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Site Selection and Due Diligence
Know the community
(the entitlement process) • Understand how zoning and development regulations
affect use and costs.
• Visit the city council and observe how they make
decisions.
• Map the concerns of community groups
• Chart the time it will take.
• Try to reach agreement on processing steps and time with
the local jurisdiction.
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Site Selection and Due Diligence
Project Design will lay out the site
• Engage the architect during due diligence.
• Respond to the market
• Respond to the community
• Parking, density, height
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Site Selection and Due Diligence
Product type selection drives market acceptance
(high density residential product types)
FLATS 200 Second Street, Oakland, CA
•74 Luxury Condominiums
•Parking ratio 1.11
•148 units/acre
TOWN HOMES, Oakland Estuary, Oakland, CA
•Parking ratio 2.5
•31 units/acre
Interlocking townhouse configuration
Up to 35 units/acre with 2 car garages
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Site Selection and Due Diligence
Construction costs
• Research costs and construction techniques.
• Know the market for construction services.
• Identify and resolve areas of uncertainty
• AS PART OF DUE DILIGENCE: Hire the contractor to give you up-to-date information on a specific site for a specific design.
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Cost pro-forma includes:
Site Selection and Due Diligence
1. Building costs
2. Site Development (demolition, grading, utilities and landscaping)
3. Parking (may be included in building for some types of projects)
4. Connection and impact fees
5. Offsite costs such as traffic signals or road improvements
6. Design (architecture, engineering, consultants, etc)
7. Marketing (brokers, advertising, etc.)
8. Construction management
9. Financing /legal/administrative
10. Taxes during construction
11.Contingency: 10-15% in early stages
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Site Selection and Due Diligence
DO NOT LUMP COSTS!
YOU CANNOT CUT THE BOARD
LONGER
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Site Selection and Due Diligence
Financial Analysis
• Use current market and costs—avoid wishful thinking!
• Identify sensitive numbers—focus on reducing uncertainty by paying for and getting more information!
• Incorporate time and cost of capital—use a valid hurdle rate!
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Site Selection and Due Diligence
Project Management
• Development is a ―team process‖—create and foster a common vision.
• Have a complete list of all tasks—Monitor!
• Foster the architect/contractor relationship: Insure it is collaborative not confrontational.
• Civil skills are local—Design is portable
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Site Selection and Due Diligence
Understand the economics
• Off-site improvements
• Design and amenities
• Fees
• Parking ratios and costs
• Density
• Recognize that an early design will change
during entitlement.
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Evaluate all project characteristics in terms of what it costs and what it is worth.
Site Selection and Due Diligence
Density: More is sometimes less
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Site Selection and Due Diligence
Why things go wrong
• Somebody didn’t spend the money early enough.
• Somebody didn’t communicate key information.
• Things going wrong early are cheaper than later.
• Control risk through due diligence and
communication.
The best way to solve a problem is to find out
about it early enough to do something about it.
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Site Selection and Due Diligence
Questions
1. Why is development a team process?
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Site Selection and Due Diligence 56
Acquiring the site
The first six steps
1. Look for sites, investigate and identify
those with promise.
2. Do the six part analysis on the promising
sites and decide what the site is worth.
3. Begin negotiation with owners.
Site Selection and Due Diligence 57
The first six steps
(continued)
4. Make the offer: Letter of intent (LOI) or
letter offering to purchase. This step
frequently goes on for a while.
5. Execute a purchase contract setting forth
detailed terms of purchase and period of
due diligence.
Site Selection and Due Diligence 58
The first six steps
(continued)
6. Conduct the due diligence process prior to
escrow deposits becoming non-refundable
if you decide not to proceed.
Site Selection and Due Diligence 59
Looking for sites
• Immerse yourself in the community, drive
it, bike it, walk it, understand it.
• Meet with community groups
• Map it: Google maps, parcel map services
• Immerse yourself in the market: Internet
data, visit projects, talk to tenants.
Site Selection and Due Diligence 60
Looking for sites
(continued)
• Talk to city hall
• Attend city council meetings
• Understand the entitlement process.
• Develop relationships with brokers, but
recognize that brokers have only a part of
the market.
Site Selection and Due Diligence 61
Decide what the site is worth
• Organize your analysis around the six focus areas.
• Identify the areas of uncertainty and do more research.
• Exercise judgment about market, construction and entitlement risk.
Site Selection and Due Diligence 62
Begin negotiations
• Find out about the owner.
• Obtain as much information as possible from the owner during negotiations.
• Understand before proposing.
• Use the open book, where possible
• Be trustworthy: never, never promise something you can’t do.
• Recognize that buying land is a relationship.
Site Selection and Due Diligence 63
Making the offer
• A clear succinct letter of intent (LOI) or offer sets forth the major business terms.
• Ask for concurrence on the letter as pre-requisite to the attorneys negotiating the purchase contract.
• Provide a reasonable time to execute the contract.
Site Selection and Due Diligence 64
The purchase contract
• The property is ―tied up‖. Spending money on investigation (due diligence) now makes sense.
• Insure that there is adequate due diligence time. Try to get as long as possible.
• Refundable deposit during due diligence; try to minimize amount of non-refundable deposits prior to close of escrow.
Site Selection and Due Diligence 65
The purchase contract (continued)
• Focus on buyer’s conditions to close:
– Condition of title and buyer’s obligations to
deliver clear title.
– Environmental and soils
– Conditioned on receiving entitlement?
– Maximum period to meet conditions
– Deposit refund conditions
Site Selection and Due Diligence 66
Due Diligence
• Engage your development team on the six areas of focus and pay them to get more reliable information.
• Decide impact of more reliable info on contract price.
• Decide whether to
– proceed,
– renegotiate, or
– abandon.
Site Selection and Due Diligence 67
Typical due diligence cost:
first 60-120 days
(<$100 million project) Item Cost
Soils, survey, title and environmental $20,000
Market Analysis $7,500
Preliminary project design $10,000
Determine entitlement process and likely
conditions
$7,500
Pre-construction services $5,000
Total budget during refundable period $50,000
Site Selection and Due Diligence 68
• Title to property not clear.
• Easements prevent full site utilization.
• Survey finds less land.
• Soils not good for construction.
• Environmental hazards.
• Zoning or development requirements different
• Development fees higher
Common issues encountered in
due diligence
64 Site Selection and Due Diligence
• Construction costs higher
• Market strength weaker
• More controversy in community
• Site layout or unit production different
Common issues encountered in
due diligence (continued)
65 Site Selection and Due Diligence
Site Selection and Due Diligence
A real estate project’s 3 funding
baskets Basket 1
Prior to site control
Basket 2
After site control
Basket 3
Begin construction
Preliminary research,
purchase contract,
refundable deposits,
initial due diligence
Entitlement, non-refundable
(hard) deposits and design.
Time is not your friend Construction and
delivery
Limit expenditures from Basket 2 with careful initial due diligence, good
purchase terms and careful entitlement management.
EASY HARD EASY
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Site Selection and Due Diligence
Acquisition Do’s
• Base value on market, entitlement, and current costs and prices, not on comps and guesses.
• Create a relevant list of ―buyer’s conditions to close‖
DO
•Be prepared to abandon the site if due diligence discloses information that is inconsistent with the assumptions that determined price.
•Understand how much ―Basket 2‖ money you will need.
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Site Selection and Due Diligence
Acquisition Don’ts DON’T
• Close without entitlement
unless prepared to live with
the consequences of no
entitlement
• Deposit non-refundable
money un-necessarily.
• Make un-necessary
commitments to Seller or to
entitlement entity.
• Skimp on the cost of
researching due diligence
issues.
• Proceed beyond due
diligence if there are major
issues unresolved.
• Engage in wishful thinking
about resolving due diligence
concerns.
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Questions
Site Selection and Due Diligence 74
Why is effective due diligence so important to the success of a real estate project?