Fundamental Skills for Real Estate Development Professionals I Site Selection and Due Diligence October 26, 2011 Charles A. Long Charles A. Long Properties LLC 10:45 a.m. -12:00 p.m . 1 Site Selection and Due Diligence
Site Selection and Due Diligence 1
Fundamental Skills for Real Estate Development
Professionals I
Site Selection and Due Diligence
October 26, 2011
Charles A. LongCharles A. Long Properties LLC
10:45 a.m. -12:00 p.m.
2
Topics we plan to coverI. Risk management during site acquisition.
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
Learning Objectives: For you to understand:
1. Managing risk in site acquisition as a continuum of managing risk in development.
2. Determining price and terms for site acquisition reflecting the value the project can afford.
3. Due diligence as part of site acquisition.
Site Selection and Due Diligence3
Site Selection and Due Diligence 4
Our approach
Overview with class discussion
Ground rule:
Ask questions as they occur to you.
5
• Charles A. Long• Charles A. Long Properties, LLC• Oakland, CA
• Developer specializing mixed use development in California, US
• Consultant on real estate development, 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, CA and interim manager in Mammoth Lakes, Pinole, and Hercules, California.
• Author of “Finance for Real Estate Development” published April 2011 and contributing author to ULI Retail Handbook.
• 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 Diligence5
Site Selection and Due Diligence 6
Managing Risk in the
Development Process
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 confusionAppleton Mills, Lowell, MA
7
Lakeside Steel Plant, Chicago West End Commons, Oakland, CA
8
The Great Recession has changed the capital stack
Site Selection and Due Diligence
DebtMuch lower debt: now 65% or less
EquityMuch higher equity: now 35% or more—recourse provisions tighter
Mezzanine or performing debt
Disappearance of "Gap" financing to pay for “value-add” conversions
9
Development is…
a separate self financing enterprise that goes from small to large.
Site Selection and Due Diligence• 9
10
The Development Process has three phases
Site Selection and Due Diligence
Site Selection and Due Diligence 11
“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.”
80% to 90% of project value is created in the pre-development phase
Site Selection and Due Diligence12
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
18
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
Site Selection and Due Diligence 19
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.
Site Selection and Due Diligence 20
Questions1. 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?
Site Selection and Due Diligence21
Maximum Supported
Investment and
Residual Land Value
Site Selection and Due Diligence 22
How much money does a real estate project need to make to be
financially viable?
The minimum required (the “hurdle”) return on costs depends on:
• Cost of capital, and• Time to construct
• Net operating income/Total cost=“the Development Cap”
• Internal Rate of Return• Return on sales (ROS)• Return on costs (ROC)• Return on equity (ROE)
Rate of return-lots of choices
Site Selection and Due Diligence
The Hurdle Rate is the minimum rate of return for proceeding with a project
• 23
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 24
Site Selection and Due Diligence 25
To measure how much a project makes:
Project Value minus Project Costs
Equals
Project Return
Site Selection and Due Diligence 26
The return on a project pays:• Cost of debt: interest on a construction loan
(4%-6%)• Return on equity: return to investors (15% to
20%)• Developer profit: based on project
performance after debt costs and equity target is reached
Site Selection and Due Diligence 27
Developer profit comes from:• Fees: Developer fee of 2-4% of cost with incentive
bonuses. • Co-investment: Developer is an equity investor in
10-15% of equity requirement. • Sharing of success:
– Participation in profits over the “preferred return” of 8-12%
– Higher participation in profits over a target of 15-18%.
–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 Diligence28
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• 29
How much deposited today produces $120 in two years if the earning rate is
9.5% per year?
Site Selection and Due Diligence30
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 Diligence31
• 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
32
Cash-on-cash hurdle rate changes with different capital mixes and different absorption periods
Site Selection and Due Diligence
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• 33
• 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 Diligence34
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• 35
Pop quiz 1What 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• 36
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 Diligence37
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 rateSupported investment
Site Selection and Due Diligence38
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• 39
• 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 Diligence40
Pop quiz 2What 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• 41
Site Selection and Due Diligence 42
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 Diligence43
The six focus areas of
project management
and due diligence
Site Selection and Due Diligence 44
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.
• Understand what components cost compared to their value.
Site Selection and Due Diligence 45
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
Site Selection and Due Diligence 46
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
Site Selection and Due Diligence 47
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.
Site Selection and Due Diligence 48
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.
Site Selection and Due Diligence 49
Project Design will lay out the site• Engage the
architect during due diligence.
• Respond to the market
• Respond to the community
• Parking, density, height
Site Selection and Due Diligence 50
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
Site Selection and Due Diligence 51
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.
Site Selection and Due Diligence 52
Financial Analysis• Use current market and costs—avoid wishful
thinking!
• Reduce uncertainty by paying for information!
• Use a valid hurdle that incorporates time and cost of capital!
• Analyze the economics of each component!
– What is its cost?
– What is its value?
Site Selection and Due Diligence 53
Cost pro-forma includes: 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
Site Selection and Due Diligence 54
DO NOT LUMP COSTS!
UNDERSTAND COSTS AND VALUE!
YOU CANNOT CUT THE BOARD LONGER!
Site Selection and Due Diligence 55
Understand the economics• Off-site improvements• Design and amenities• Unit size• Parking ratios and costs• Density• Early design will change during
entitlement.Evaluate project components in terms of what they cost and what they are worth.
Site Selection and Due Diligence 56
The economics of density: More is sometimes less
Site Selection and Due Diligence 57
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.
Site Selection and Due Diligence 58
Questions
1. Why is development a team process?
Site Selection and Due Diligence59
Acquiring the site
Site Selection and Due Diligence 60
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 61
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 62
The first six steps(continued)
6. Conduct the due diligence process prior to escrow deposits becoming non-refundable so you can get them back if you decide not to proceed.
Site Selection and Due Diligence 63
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 64
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 65
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 66
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 67
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 68
The purchase contract• The property is “tied up”. • Now you can spend money on investigation
(due diligence). • Insure that there is adequate due diligence
time. Try to get as long as possible. • Refundable deposit during due diligence.• Minimize amount of non-refundable
deposits prior to close of escrow.
Site Selection and Due Diligence 69
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 70
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.
71
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
• 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
64Site 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)
65Site Selection and Due Diligence
Site Selection and Due Diligence 74
A real estate project’s 3 funding baskets
Basket 1Prior to site control
Basket 2After site control
Basket 3Begin 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
Site Selection and Due Diligence 75
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.
Site Selection and Due Diligence 76
Acquisition Don’tsDON’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.
Site Selection and Due Diligence 77
Questions
Why is effective due diligence so important to the success of a real estate project?