Testing the Development Waters

 OP COMMERCIAL ED PIC 1By Scott Saulino

Every real estate developer takes on a significant amount of risk when entering into a new development project. If you’re set on testing the development waters, your first step should be preparing a detailed budget and analysis of the costs to be incurred. These can help minimize your risks. 

Some considerations include, but are not limited to:

* Evaluating hard costs;

* Minimizing cost overruns;

* Keeping track of soft costs incurred; and

* Executing a detailed lease-up analysis.

Hard Costs

Hard costs include the land cost, site preparation, permits, contractor fees, construction materials, labor and project management and developer fees, to name a few. A common mistake is assuming that hard costs can be estimated with complete accuracy as they are directly related to labor and building materials. In reality, these costs carry inherent variables that can shift drastically during the lifecycle of the development phase. 

Minimizing Cost Overruns

Before starting any project, a real estate developer must perform its due diligence of the area in which the development will take place, as hard costs will vary widely by market. This should include putting together a detailed analysis of the individual line items that will make up the entire project. A cost should then be attached to each line item identified based on market data available, including a comparison of the projected costs to actual hard costs incurred for similar projects in the area.

In addition, developers need to account for potential cost overruns, which can (and often do) occur at any stage of the development process. One of the more common cost overruns includes fluctuations in the cost of materials and labor due to delays in the project. There are various reasons as to why a project gets delayed including weather, final city and town approvals for zoning and applicable building permits and shortages in material/labor in the area. Factoring in such potential market conditions can help alleviate potential delays going forward.

Another common cost overrun includes scope changes for the project. No matter how thorough of an analysis the developer prepares, it is inevitable that there will be changes to the scope of the work that will increase the total project costs. As a result of these inherent variables, developers need to incorporate contingency costs into their budgeting analysis. A good rule of thumb is to budget an additional 5 to 10 percent of the overall projected hard costs to be incurred. This will take into account the possibilities listed above as well as other potential cost overruns.

Once the budget is completed, the developer should obtain several bids from general contractors and compare those to the estimates prepared internally. Because of the complexities of the development process, first-time developers should not look to oversee the project themselves. Rather, they should utilize a reputable general contractor with knowledge of the process to oversee the project. 

Soft Costs

Though hard costs can prove tricky to pin down, soft costs can arguably be even more difficult for a new developer to estimate. Soft costs run the gamut, and can include:

* Real estate taxes;

* Legal and accounting fees;

* Marketing and advertising costs;

* Loan fees and associated interest;

* Architectural and engineering fees; and

* Insurance costs.

The inherent variable associated with these types of expenses is driven by the estimated length of the development project. Note that certain soft costs, such as real estate taxes and interest expense (if the property was financed with third party financing) are incurred immediately even if the development process has not yet begun or gets delayed midstream. A developer needs to determine a realistic time frame not only for the completion of the project, but for the time up until the property is stabilized in order to accurately budget for these costs. 

Detailed Lease-Up Analysis

Executing a detailed lease-up analysis is critical before moving forward with any rental development project. First and foremost, a developer must consider the expected time it will take for tenants to occupy the space. As noted above, this is critical as certain soft costs and operating expenses of the property will continue to be incurred when the development is completed. Such costs must be factored into any cash flow analysis considering the property will not generate any cash inflows until the tenants move in.  

In addition, the developer must consider estimated market rents based on similar properties in the area; for example:

* Free rent periods and escalations and expense reimbursement terms;

* Leasing commissions incurred if utilizing a third party broker; and

* Tenant improvement allowances provided to new tenants. 

Once these factors have been considered, the developer should prepare a stabilized net operating income for the rental property and compare the results to industry norms.

Although there is a lot of money to be made on a rental development project, the potential pitfalls make real estate a very risky endeavor. The previous are just a few examples of the budgets and analysis that a prospective developer can prepare to help minimize the substantial risks associated with any rental development project.   

As a rule of thumb, prospective developers should consult with their professionals, including a CPA and attorney, after preparing some of these modeling techniques.

Scott Saulino is a senior manager at MWE with more than 12 years of public accounting experience. Since 2010, he has concentrated his professional efforts in the real estate industry where his clients include several large real estate developers, operators, and owners of commercial office buildings, industrial properties and residential rental properties. 

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