Part 2- What is Real Estate Development
Before we get too far into this, we should probably make sure we are clear on what we mean by real estate development. Oftentimes the simplest answer is the correct one, and the definition from Wikipedia suits us pretty well-
“Real estate development…is a multifaceted business process, encompassing activities that range from the renovation and re-lease of existing buildings to the purchase of raw land and the sale of developed land or parcels to others.”
As you can see, real estate development can mean a wide variety of activities, many of which we will cover here. Real estate sales and leasing can sometimes overlap with development, but in general, those are retail activities that are widely covered in other learning materials, and so we’ll not spend any time on those. Other areas, such as new home construction and property use re-purposing, are more widely considered development activities, and will be discussed often throughout this material.
Here are several examples of real estate development:
Spec home construction- most production residential builders produce a large percentage of their inventory as speculative construction, which can be moved into at closing.
Construction of specialty structures, such as Gas Stations and Car Washes- This is more of a niche area of development, but there are people who focus on this. It can be done as speculative, but typically requires actually getting the business started before a buyer can be found. Construction and running a convenience store are two completely different animals, so it takes a special person to do this type of development. But it can be lucrative if done right. Having a buyer in place prior to starting construction can make this a very solid development opportunity.
Conversion of commercial space into residential condos- In many urban areas, commercial buildings are finding new life as residential apartments and condos. Condo sales were extremely high during the early to mid 2000’s, but all but evaporated during the great recession period of 2007-2010. Rental apartment construction started to really take off during the recession recovery, but as the supply of apartments meets or even exceeds demand in many places now, the trend is reversing back to condos. We’ll spend more time talking about macro economic factors and other trends that should be considered during development evaluation later in this material.
Conversion of raw land into developable lots- Believe it or not, many home builders don’t actually develop raw land. Another firm will typically buy undeveloped land, install the utilities, streets, and sidewalks, and then parcel out and sell individual lots to builders. While this type of development can be extremely profitable, it also carries with it a very high level of risk as well. At the bottom of the residential market in 2009, a period when not many new homes were being built, raw land dropped in value considerably. Many developed lots stood empty for years, and developers had no way to recoup that expense. One of the last sections of this book covers risk, and discusses both some of the risk items to be considered, as well methods for mitigating that risk.
No matter the type of development you want to pursue, there is a key item that should be considered. What you will make on the investment is determined up front, not at the back end. What this means is that good analysis is your wing man on this endeavor. A potential project needs to be looked at in great detail, running through all of the possible expenses, before a decision should be made. If the deal doesn’t make sense up front, don’t pursue it. Because once you’ve started on the project, if it didn’t make sense before hand, it can only get worse from there.
It can be easy to get excited about a project you are looking at, envisioning the finished product and what it will look like. But it is the numbers that make the deal happen. If you let emotion trump analysis, you can easily fall into a trap, and find yourself in a hole that you can’t dig out of.
TIP- When evaluating a potential development opportunity, get professional feedback on your idea. If you want to build a spec home, talk with realtors and lenders that know the area to see if you’re building the right product. If you’re looking at building a car wash or gas station, talk with a business broker, see if the location makes sense. Surround yourself with people that have the knowledge and expertise that can help in evaluating deals. Taking someone out for a cup of coffee can be a great way to get free counsel, and let you operate more like a business, even if it’s just you.
Big businesses have lots of employees that can do their analysis and determine if the numbers make sense. Every time a bank builds a new branch, or a restaurant opens a new location, a great deal of time has been spent going through the numbers and making sure the investment made the required minimum level of return. You need to think the same way as a business, always ask yourself if the deal makes sense financially. If it doesn’t, don’t hesitate to walk away and look for another opportunity. And don’t be afraid to spend a little money before you pull the plug. A title search, subject-to appraisal, and market analysis are all cheap items that can save you from losing tens of thousands, hundreds of thousands, or even more, on a bad deal. The key item here is the deal has to look good on paper up front, or you won’t do it.
Now that we’re on the same page in terms of what real estate development is, and some of the different types of development, the following sections will take you through the development process from beginning to end, covering each major step along the way. The order of some of these steps can change, but it is important that you understand each of these steps before initiating a project. If there is a particular area of the development process you don’t feel comfortable with, leverage other resources to help you. In each step, we will make recommendations on who some of these resources might be.
Next Part- Development Lifecycle