“High-risk high return” is how most people would describe a ground-up real estate development due to the many risks and challenges to overcome. But while ground-up real estate development can be risky, it can also be extremely rewarding—which is why so many investors opt for this type of investment, despite the possible pitfalls.
If you want to get into ground-up real estate investing, though, it’s important that you do everything possible to mitigate risks and maximize the possibility for returns. Not sure how to do that? In this article, we will guide you on how to vet a development deal by evaluating the fundamentals, risk exposure, and financial return to help you invest in a development deal with greater confidence.
What exactly is ground-up development?
Ground-up development is the process of buying a plot of land and building on it from scratch—or the ground up. If there’s an existing building on the property, then the process involves vacating the tenants and demolishing the building prior to development.
There are a number of unique factors involved in each development project, so it can be tough to estimate how long these projects will take on average. In most cases, you can expect a development project to take as little as two years to as long as 10 years or more, depending on its complexity. You can expect most projects to come with a price tag of between $5M to $50M, and most take, on average, between two and four years to complete.
For example, in Los Angeles, a $25 million, 50-unit multifamily development project takes about 3.5 years to complete. That includes about 1.5 years for entitlement and permitting plus two more years’ worth of construction.
As a result of development taking a long time and requiring industry knowledge, developers typically charge 3-5% of the total project cost as their fee. This also varies, obviously, depending on the scope of the project, the experience of the developer, and other factors.
Why is ground-up development risky?
One of the reasons why development is riskier when compared to a stabilized or value-add property is that there is no cash flow to rely on during the development period. This means that the financials for these projects have to be in order well before the start date to avoid the pitfalls of falling behind on loan or mortgage payments.
And there are other factors that make this type of investment risky, including:
Development fee or compensation
Many costs need to be controlled during the development phase. This includes the land purchasing cost; the soft costs for permits, overhead, design, and consultant fees; the hard costs for construction; financing costs; real estate tax, and so on.
The hard cost is the hardest to control because construction is so unpredictable. All other costs are more predictable—and in some cases fixed—which makes it easier to know what could be coming down the pipeline. As such, you should do what you can to understand the hard costs that can come with your project. Some tips for doing this include:
Tip #1: Evaluating a developer’s experience
The first thing you want to pay attention to when reviewing a development deal is the developer’s experience. Have they completed a similar project before? If not, do they have general partners who have this type of experience?
Make sure that they are not new to the market. Even if the developer has completed a similar project in the past, be aware that entering a new market can make the entire scope of the project very different from the developer’s prior experiences. That is due, in part, to the fact that each city has a different entitlement process, and these processes can also vary within the same city. The developer will also be working with new general contractors and consultants, which could become an issue over time.
The second thing to pay attention to is the developer’s competitive advantage. What makes this developer unique and better compared to the other developers? Why should you invest in this deal?
Some competitive advantages could be the developer’s extensive knowledge and background; the unique product type or features that the developer is providing, such as micro studios, student housing, amazing amenities, etc.; or a vertically integrated team with its own design, construction, or property management department.
Tip #2: Evaluating specific project risks
While there are many different risks for these types of projects, we are going to focus on the following risks: the developer’s underwriting and assumptions, the entitlement risks, the environmental risks, tenant issues, and construction. We could dedicate an article for each topic, so we will focus on the big picture instead.
Underwriting and assumptions
What financial assumptions did the developer make for the project? These are metrics such as vacancy rate, project timeline, expense ratio, rent projections, etc. that should be part of their offering memorandum (OM), which is a form of business plan in real estate. The cap rate at the sale may be the most important one, though, because even just 10 basis points can vastly affect your projected return significantly. And, since the sale price plays a major role in the projected return, make sure the sale comparables in the OM are realistic and achievable.
You don’t necessarily have to spend hours doing market research for each potential deal, though. Just pay attention to the assumptions and ask the right questions. A good OM should already have data to back these assumptions.
Entitlement risks
This is where local expertise can become very valuable. Either the developer or the project consultant must be very knowledgeable regarding the topic of entitlement risks because each region has its unique set of rules and processes for entitlement. This process can even prove to be more difficult in different parts of the same city, as getting entitlement, by-right or not, can vary by district. One example would be the process of entitlement in Santa Monica vs. Los Angeles.
You should also check as to whether the developers already know what the project is going to look like—and be sure to ask what the entitlement process will be like. Proceed with caution if they do not already have an answer.
Environmental risks
Environmental issues could stop your project for years and cost you and the other investors millions, but the issue can be avoided if the developers do their due diligence. This often includes a Phase I environmental study. A Phase I study is preliminary research on the project history and records, but doesn’t involve any drilling or sampling. Depending on the project size and location, a Phase I study on the site may or may not be required.
Small projects typically don’t do Phase I studies. If it’s a residential area, then the risks should be lower. But if the area used to be used for industrial purposes or was used as a gas station or dry cleaner, then make sure to ask the developer about this.
Tenant issues
Evicting tenants can be very difficult in some counties, especially when there’s a memorandum to protect the tenants during COVID. If there are tenants in the existing building, make sure that the developer has a plan to vacate them, especially if it’s under rent control.
One way for a developer to mitigate this issue is to make vacancy one of the contingencies during escrow. This way, escrow won’t be closed until the property is completely vacant. A second way to handle this is to hold a percentage of the sale price in the escrow until the tenant or tenants have vacated. The developer can also negotiate a cash-for-keys agreement with the tenants directly, which is probably the riskiest method.
If the developer cannot get tenants to vacate the building, then the project will be put on hold indefinitely. Find out what the tenant condition is with a project beforehand and assess your risks accordingly.
Construction
Construction is generally the hardest factor to evaluate because it’s difficult for even an experienced developer to manage. Supply shortages could increase the construction costs, local unions could halt construction, weather delays could happen, and any other number of issues could arise.
One thing you could do to mitigate risk with construction is to ask the developer about the contractors. Find out about their experience and reputation. Has the developer worked with these contractors before? Does the developer have experience working with these contractors?
You should also make sure that the developer reserved a contingency, which should be at least 5-10% percent of the total construction cost. The project will likely need to use this contingency.
Tip #3: Consider climate change
The impact of climate change on real estate is a relatively new topic, but it’s getting more attention. A house flip that takes less than a few years might not be greatly impacted by climate change, but projects with longer timeframes might become harder to sell or even depreciate.
The most common risks related to climate change are drought, flood, storm, heat, and fire. Contrary to what one would expect, these risk factors tend to positively alter important real estate metrics, such as rents and vacancy rates.For example, if a hurricane damages many properties in your neighborhood and your property is somehow unharmed, then there would be a higher demand in your area in the short term because of the shortage of supplies.
If rents and vacancy rates are not always negatively affected by climate change, then does this mean that you should invest in areas with high climate risks? Well, maybe. You should consider the long-term impact of climate change on your property.
And one of the long-term negative impacts is a weaker capital market. If institutional investors stopped investing in this area, or if long-term residents started selling their houses and moving away, then this will have a permanent impact on the cap rate and real estate prices.
Some tools for evaluating the climate risks are Moody’s ESG Solution and climatecheck.com. Climatecheck.com is currently free to use and gives you a score for each risk category based on historical data.
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Final thoughts on mitigating ground-up real estate investing risk
Real estate development is risky and difficult because there are so many unique factors to weigh and consider. The good news is, though, that as you get more experienced at this type of investment, you will be able to invest intelligently and achieve greater returns. And, once you’ve vetted the developers and completed a few projects with them, then it might not be necessary to spend as much effort at evaluating each project. Find a trustworthy and competent operator, and let your money go to work.
I hope you found this article helpful in reaching your financial goals. If there’s a question or something that you’d like to add to this article, please comment below.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
