Real estate development is the process of construction or reconstruction of real property for value. The process varies from buying raw land for new construction, renovation and improvement to the existing property and resale of property to others. As the development ranges it is important to determine from the outset the reason for undertaking this endeavor, whether it be to turn a quick profit or remaining involved with the project post-development stage.
The process begins with a concept. During this step an idea is generated as to what will be built on the land. Once there is a concept the next step is to find suitable location. However, oftentimes developers look for property with a potential for development and then come up with the concept. When selecting an appropriate site it is important to keep in mind land restrictions and any covenants or easements that may exist on the property.
Real estate development can be a very risky process. It requires a series of complicated steps from the inception to the completion of the project. However, if executed properly, development projects may offer high profit and long-term success. A successful developer assesses all risks before commencement of construction with the help of a skilled professionals including but not limited to architects, engineers, lawyers, accountants, finance strategists, construction managers and town planners. Making educated decisions prevents the developer from making assumptions, which can result in costly losses and undesired outcome of the project.
Some of the fundamental steps of the development process include the following stages:
1. Research/Market Analysis/Feasibility
2. Land Acquisition
3. Land Use Approval
4. Building Approval/Contractors
The pre-development stage is considered the riskiest stage, as there are many unknowns. During this phase the developer gathers information to set down the plan for the project development.
Research / Market Analysis / Feasibility
Due diligence has to be done on part of the developer when selecting a parcel of land to identify any and all potential issues. When considering a parcel of land the developer has to determine what can be built on that property. In this assessment the developer makes an inquiry into any existing land restrictions and potential land covenants or easements and zoning requirements. Becoming educated in this respect informs the developer of all implications that the potential restrictions have on the use of the land. As policies on development vary in different localities, the developer has to make inquiries into the local jurisdiction to determine what can be constructed on the land.
Additionally, the developer has to assess the need for the underlying development project in that demographic area. In doing so the developer conducts a market analysis to determine what types of structures are in demand in that particular area. Market research encompasses a wide range of property characteristics such as the area, size of the dwelling, the number of units, the number of floors, amenities, neighborhoods and closeness to roads, market places, transportation and schools.
Once the developer has a site in mind the next step is a feasibility study. This phase is crucial as poor and inadequate planning can result in failure of the development project. Keeping in mind prior consideration, the developer at this stage determines the highest and best use for the property. Careful planning allows the developer to minimize risk, calculate required finances, obtain land and building permits, and set a manageable construction timeline. Most of all, the developer is able to assess the approximate profit before spending substantial time, efforts and resources.
As a feasibility study forecasts the finances required for the entire project, this allows the developer to stay within the budget and avoid cost overruns. Additionally, evaluating the numbers gives the developer an opportunity to obtain additional finances if needed and a thorough feasibility analysis can help secure potential investors and bankers.
To remain better appraised and ensure a successful outcome the developer should generally conduct a number of feasibility studies throughout the duration of the project. After each study the developer can make a qualified decision as to whether it is feasible to proceed with the project in light of the information available. Additionally, it is important for the developer to be surrounded with a skilled and professional team that helps the developer research and find solutions along the way for best possible outcome. The developer should also consult with skilled professionals such as architects, lawyers, accountants, real estate agents and town planners to better understand what obstacles may arise along the way and work on possible solutions to overcome them.
There are a number of considerations to keep in mind when it comes to purchasing property. Establishing a project budget is essential to a successful investment. This step permits the developer to anticipate all costs associated with the completion of the project and gives the developer an opportunity to set allowance for unanticipated expenses.
When developing a project budget the developer should outline all costs in order to have a full picture of what it will actually cost to develop the project. Some of the main budget considerations include:
· The Purchase Price/Down Payment;
· Transaction Costs;
· Inspection/Surveys/Appraisal Costs;
· Expert Consultation Costs;
· Developer/Architect/Engineer Fees;
· Market/Feasibility Study Reports;
· Legal/Conveyance Fees;
· Title/Recording Fees;
· Marketing Fees;
· Construction/Rehabilitation Costs;
· Interest Charges;
· Utility Fees;
· Insurance Fees;
· Taxes/Tax Credits;
· Construction Contingency;
· Operation and Management Costs.
An essential part of the development process is securing funding for the project. Developing a project budget shows the developer how much funding is required to complete the project. This in turn allows the developer to determine how much equity the developer is able to invest and how much more funding needs to be raised to cover the full cost. Generally, developers turn to lenders and investors to finance a significant portion of the development project. This is another reason why it is important for the developer to conduct various studies and present a thorough analysis of the numbers to secure potential lenders and investors.
Prior to finalizing the purchase of the property the buyer has already performed extensive research, conducted feasibility and market studies and is able to make a well-informed decision regarding the success of the potential project.
At the outset, the buyer has to determine what will be built on the property before making inquiries into potential sites. Once the buyer has a concept in mind, land acquisition journey begins.
Additionally, it is important for the buyer to plan for the costs of the property. A properly established budget takes into account all relevant costs of buying the prospective property and ensures that the buyer has sufficient funding to cover all costs including unexpected contingencies. Understanding that the acquisition process requires a number of steps, the budget should encompass the following essential considerations:
· Purchase price and required down payment
· Research, appraisals, study and evaluation reports
· Carrying costs
· Conversion costs
Subsequently, the buyer has to conduct his own due diligence and extensive research with respect to the property prior to the purchase. Assumptions and lack of caution can prove very costly and potentially resulting in the buyer being unable to use the land for the intended purpose. Important considerations that the buyer should keep in mind prior to the land purchase address availability of utilities. For instance, are sewer/septic, water, gas, and internet connections accessible, and if not, whether the property is capable of handling such services and the cost of their development. Similarly, accessibility is another important consideration – is there an easy access to the roads or will the developer have to build new roads, keeping in mind any existing easements.
Another important aspect deals with land restrictions ranging from environmental issues (dealing with septic system, alteration of wetlands, hazardous waste, and storm water management) to zoning issues (ordinances prohibiting or permitting certain land uses) as well as concerns related to title, building permits and site plan approvals. It is important that the developer engage the services of a surveyor to assess physical characteristics of the property to determine topography, soil and flood/waste hazards.
While the buyer should conduct his own research, and a real estate agent can offer some insight, the buyer should hire professionals to conduct investigations and financial analyses. Doing this helps the buyer identify all potential issues and make an informed decision as to whether to complete the purchase. With the planned development in mind, along with the aid of skilled professionals, the buyer should test a conceptual drawing of the development to carefully assess whether permitted land use will ultimately result in a desired goal.
With the concept and budget in mind the buyer can search for suitable property that meets both considerations. There are a number of ways that a buyer can go about searching for property, most commonly through a real estate agent or broker. Other options include reviewing postings online or ads in newspapers.
Additionally, the buyer has to determine how the purchase will be financed. At this point buyers are aware of how much they can afford to cover and how much capital needs to be raised. Typically, the buyers work with lenders and potential investors (generally in commercial real estate development) to cover the remainder of funds needed for the purchase. Securing capital for raw land (property without any improvements) as opposed to developed land is more difficult, as lenders take higher risks on land purchase loans. When buyers seek a loan for developed land, for instance a home, the lender can repossess that home if the buyer defaults on payments. In case of a land loan default lenders can also repossess the land, but there is no secure collateral structure apart from the land itself. This is why lenders require higher down payments on land loans, ranging anywhere from 20% - 50%. The size of the loan that the buyer can ultimately borrow is determined by the Loan-To-Value ratio (LTV) – the amount of the loan divided by the value of the property. The down payment requirements are based upon the buyer’s ability to repay the loan. Additionally the lenders evaluate buyer’s design concept and feasibility of the purchase. This is why it is essential for the buyer to submit a thorough proposal encompassing numerous studies to reassure lenders of an ultimately viable and successful development.
Although banks remain the major source of funding, buyers can secure financing through other means. As an alternative, buyers can turn to mortgage brokers, private funders (investors) or joint venture funders. Additionally, buyers may require different types of loans; land acquisition loan (covers the purchase price, application and pre-construction related costs), development loan (covers improvements made to the property), acquisition and development loan, construction loan (covers the building of a home or real estate project), or an investment loan (if the buyers intends to remain involved in the project post development stages).
Once buyers find suitable property, then comes the offer and purchase and sale agreement. Buyers can enter into negotiations using a buyer’s agent or rely on their own research to make an offer. Typically the asking price is higher then what the seller is willing to accept, and therefore the buyer has to conduct research and compare what similar properties are worth. By this point buyers should have done their own due diligence to evaluate physical and legal characteristics of the property to have an informed idea as to any potential issues that may exist, which in turn would affect the initial offer. Additional concerns that the buyers should keep in mind when making their offer is why the vendor is selling the property, how much the vendor has paid for the property and how long the vendor has owned the property. Moreover, buyers should consider how long the property has been on the market and whether there were any other offers made. Regardless of whether buyers make the offer themselves or decide to use a buyer’s agent, the offer should be in writing. Although the offer is not a final agreement, it should contain all essential information affecting the buyer’s ability to use the land in a desire way or the value of the property. The offer should contain contingencies, giving buyers opportunity to walk away from the deal depending on any negative findings prior to contract closing. Additionally, having an idea what the property is worth and the concept for its development, buyers should set a firm offer price and not exceed it. Although the buyer’s goal is for the vendor to accept the offer, the buyer should ensure that there is enough time between offer and acceptance period to conduct all final research and gather necessary documentation in time for closing.
The closing process generally entails the following major steps:
· Escrow – a contractual agreement, where a third party receives and holds funds in an account of the two transacting parties until the escrow agent receives instruction that all contractual obligations have been fulfilled, or until one party pulls out of the agreement in accordance with the terms set forth in the escrow agreement.
· Signature Verification Authorization (commercial real estate) – in the commercial real estate world, where transactions typically involve a number of individuals/entities, sometimes parties want to limit their liability and create entities for real estate ownership. For the purposes of signing, an individual has to be present and in such instances they will have to present proof of signing authority.
· Due Diligence – ongoing investigative part of the purchase process where the buyer takes steps to remain appraised of all the assets and liabilities that may exist in connection with the prospective land and the effect in may have on the final project. The buyer should ensure that the contract of sale has been properly executed, final detailed review of title and other reports and financial records, if necessary perform additional surveys and inspections, confirm zoning compliance, and obtain most current title insurance policy. The purchase agreement should set for all conditions of the sale. Some of the essential details to be included in the sale agreement are: (a) the name of the vendor and buyer; (b) property address; (c) the purchase price and down payment amount; (d) conditions of the sale (i.e. closing date, closing costs and who pays them, inspections, finance terms); e) default clauses; f) contingency clauses; g) type and condition of the title; and h) deadlines (i.e by when relevant inspections should be completed).
· Date of Closing – Closing marks the final step in the purchase process. During closing, property ownership/title is transferred from the vendor to the buyers. By this point both the vendor and the buyer have agreed to all terms and are ready to sign a series of closing documents. (Common documents to be signed include: title abstract, warranty deed, closing disclosure, promissory note, payment letter). Once all of the documents have been signed the final step is recording the deed.
Prior to commencement of the development project the developer has to obtain approvals for development plans. This process in knows as an entitlement process – the legal method for obtaining approvals to develop property for specific uses. This is a complicated and a lengthy process requiring approvals from multiple regulatory authorities.
During the process, the developer, with the help of the development team, will prepare and present a pre-application for the development to the city’s planning department. The plan should comply with all local codes and include due diligence reports. As the process is regulated by various regulatory authorities it is important for the developer to remain cognizant of the municipality’s concerns with respect to what effects the development will have on the local and neighboring communities. Addressing any such concerns increases the chances of the proposed development being accepted and lessens the risks of future conflicts. After pre-application is submitted a meeting will be scheduled where the developer can present the project to the assigned staff members of the Planning Department. At this time the developer also submits environmental application addressing any adverse environmental factors of the project. There is also a special consideration if wetlands are located on the property. Then, the Planning Department reviews and makes recommendations on the application. The developer will also have to pay the required application fees, which vary depending on the jurisdiction. Even though the application may comply with all codes and regulations the neighborhood may oppose the project and in many circumstances approval from city council is also required.
Depending on the type of the project, the following is the list of some common examples of entitlements:
· Zoning/Rezoning – process of land division into zones with specific provisions for allowable and prohibited land uses. When owners of the land desire to use the land in a way not permitted by the zoning ordinance, they have to file a re-zoning application with the appropriate governing agency to change the zoning requirement.
· Variances – waiver of certain zoning restrictions, developer/property owner may request to depart from strictly complying with the zoning codes based on distinctive hardships imposed by such requirements. Although variances afford for dimensional changes they do not allow changes to the character of the zoning district.
· Conditional use permits – land use allowed by the zoning ordinances so long as certain conditions/standards are met.
· Utility and Road approvals – permission to build roads or use existing roads, as well as access to all necessary utilities.
Once the developer has obtained all necessary land use approvals the next step is to obtain building permits. Building permits are required to ensure safety and compliance with construction and zoning requirements. The developer should obtain the services of a professional engineer or registered architect to draw up plans to be filed with the appropriate agency. Next, the developer should accept quotes from potential builders, negotiate a contract and hire a contractor. At this stage the developer should also enlist the services of a project manager. After the building permit has been approved the contractor can file for a work permit and construction can begin.
At this stage vertical development begins by construction of building improvements. If developers haven’t done so already, it is recommended that they hire a builder and a project manager to oversee the process and ensure a safe construction site, compliance of all regulations and successful completion progress in accordance with all deadlines. At this time the developers, depending on their future goals, may want to start marketing the property and obtaining pre-leasing once the project is complete.
After project completion, but before developers can lease out or sell the property, a certificate of occupancy has to be obtained. Throughout the construction process a number of inspections will be required to ensure that the development complies with building codes and regulations. During the final inspection, the developer will have to provide the certificates from all trade professionals that have conducted work on the project such as electricians and plumbers. Once it is determined that all project work complies with relative regulations and meets the safety requirement, certificate of occupancy will be issued.
The final stage of the project’s life cycle is operation. During this step developers either sell the property for profit or hold it as long-term investment. Depending on developers’ goals, they may want to sell the property, thereby making a quick profit (short term gain) or hold and lease the property (long-term investment). Marketing of the project is ongoing at this stage, whether it is to attract the prospective buyer or secure potential tenants. Developers will have to settle construction funding before they can sell to another buyer. If the developer decides to hold the property they can refinance their construction loan into an investment loan. This can be beneficial as construction loans are usually short term and have a higher interest rate. If developers decide to hold the property their goal will be to achieve stabilization to maximize the benefits. Developers will want to maximize the project’s income and enhance long-term value of the development. In most instances, developers will want to engage the services of property managers to handle day-to-day management of the project. Developers’ goals are to keep the project full of rent-paying tenants, maintain the project in a good condition while keeping pro forma expenses. Whether developers decide to sell or invest in the property long-term they should evaluate their goals and current circumstances realizing that selling the property ensures a quick return while holding the property can ensure long term capital appreciation.