In Chicago, Bethel Commercial Center includes retail space, offices, a bank, and a daycare center.
ALAN SHORTALL PHOTOGRAPHY
Aside from the location and configuration of the site, the keys to success for small developers are the quality of their development team and their access to capital. Small developers can often use the same professional consultants as larger firms, buying not just expertise but credibility in the marketplace by affiliation. Even experienced developers, moving into new markets or product types, will often find that appropriate local consultants, or firms experienced with the particular product, can mitigate their risk in pursuing innovative projects.
More fundamentally, the cyclical history of real estate development has proved repeatedly that a lean central organization is a key to surviving downturns. One way to maintain a small, lean organization is to use consultants for noncore and project-related tasks. To select a consultant who will enhance the team, find the best person or company available, even if it costs a little more (when price must drive the decision, spend first on the knowledge areas furthest from your own internal expertise); be certain that the person or company has direct experience with the particular type of product under consideration; consider the prospective consultant’s strategic value beyond the project at hand; look for people and firms that add value beyond their core competence: an engineer, for example, who might have productive relationships with planning staff; beware of firms that depend completely on one, or a few, clients; select people who are familiar with local conditions, who have worked constructively with the anticipated approval authorities; and solicit other developers’ opinions on consultants in the area.
Finding the best team for the job can take time. From the day they start in business, beginners should assemble names of prospective consultants and interview them. Development often follows a “hurry up and wait” pattern, and slow times between tasks are a great time to periodically extend the developer’s network. Assembling a team from scratch is difficult; more experienced developers have already established a network of consultants, contractors, and professionals, and building a permanent team takes more than one project. Nonetheless, the time and effort spent in finding the best possible team are a good investment. Developers can spend as much time in search of relationships as they do in seeking investment capital.
Even more important than the assembly of the team is the structuring of the development or operating partnership. The result of a hastily assembled partnership can be heartache and financial risk. The safest partnerships are those in which the partners have come to know each other through a long history of working together. Over time, the partners can understand each other’s strengths and develop confidence in their associates’ integrity. Beginning developers, of course, seldom have such historical relationships, though they may have some. The beginner must remedy this limitation by making good strategic partnership choices and being diligent in the legal structuring of the development entity.
Partnerships are frequently formed around specific projects, and developers might have different sets of partners for each of several projects. Partnership arrangement can evolve over time. Early deals might involve several partners, each filling a major function, like financing or construction. In subsequent deals, the number of partners might diminish as the developer learns how to obtain the needed expertise without sharing project equity.
Landowners are often partners in a beginner’s early projects. Even if the landowner is not able to contribute critical analytical or management skills, his or her involvement can be very valuable. Landowners may contribute their property as equity—always scarce for the beginning developer—but they might also supply debt, via seller financing, at terms unavailable through financial institutions. Even if they do not materially participate, landowners can tie up land while financing and approvals are obtained. In income property, key tenants might also be offered partnerships to induce them to lease space in the project, particularly if the project can be designed around the tenant’s specific needs. Both landowners and tenants, however, generally view real estate as a noncore activity, for which they will tolerate little risk.
A common mistake in forming partnerships is to choose partners with similar rather than complementary skills. Typical complementary pairings include capital and development experience or construction and management experience. Whatever the match, partnerships work best when everyone shares equitably in risks and returns and is equally able to cover potential losses. In most partnerships, however, one person is wealthier than the others and will understandably be concerned about ending up with greater risk, even if the partnership agreement allocates this burden equally. This concern may be overcome in several ways, beginning with the concerned partner’s selection of an appropriate liability-limiting structure, before entering the partnership. Within the partnership agreement, the capital partner may also specify that a partner who is unable to advance the necessary share of capital will lose his or her interest, and from the beginning the wealthier partner can be given more of the return, or less of the management workload, to compensate for greater potential liability.
Hudson Green, a 48-story mixed-use complex in Jersey City, New Jersey, was developed by a partnership between Equity Residential and K. Hovnanian.
ALAN SCHINDLER PHOTOGRAPHY
A major source of problems in partnerships, especially general partnerships in which everyone has equal interests, is uneven distribution of the workload, or inadequate compensation for partners handling the day-to-day work of creating and implementing a project or projects. Successful developers think of compensation primarily in terms of incentive, rather than fairness. Key areas of responsibility must be determined in advance, and types of compensation should be defined appropriately to incentivize each. For example, one partner might receive a greater share of the development fee, with another receiving more of the leasing fee. To save cash, it might be preferable to accrue fees rather than to pay them as earned, so long as funding is adequate to meet expenses and provide a “living wage” and tax distributions to the working partners.
Even if accrued compensation is not part of the initial deal, variation in cash flow may require timing adjustments. Accounting for partners’ interests in a “capital account” is good practice, offering an ongoing check on the appropriate equity investment of each partner and allowing management to address imbalances at distributions or capital calls.
Partnerships can last for years, so the choice of partners is critical. Large developers that bring in less experienced partners for specific deals generally enjoy a rather one-sided partnership, ensuring them management control; beginning developers, however, do not have the same negotiating power and must carefully weigh each additional partner who dilutes their potential equity interest and management flexibility.
Working out the partnership arrangement in advance, with legal advice, is essential for anticipating and avoiding conflict. A written agreement that defines each partner’s role, responsibilities, cash contributions, tax needs, and share of liabilities and that sets out criteria for the dissolution or modification of the partnership is an essential document. Many members of general partnerships formed casually and on the basis of verbal assurances have been shocked to discover that they are liable for their partners’ debts unrelated to the partnership’s purposes. In fact, those types of liabilities are often the default condition of a general partnership constructed without good legal advice.
The most basic approach to a partnership combines someone with extensive development experience and someone whose credit is sufficient to obtain financing. The financial partner should have net worth at least equal to the total cost of the project under consideration, and preferably twice that amount. Some banks might require a higher multiple or specific collateralization of the loan. If the partnership does not include someone with sufficient credit, then the partners will have to find someone to play that role before they can proceed. Other developers, high-net-worth individuals or syndicates of these investors, or family and friends may be promising candidates for beginners without access to institutional capital.
Bringing in any financial partner before the full requirements for cash equity and the amount of net worth are known is a mistake. If, for example, the financial partner is to provide the necessary financial statement and, say, $800,000 cash equity for 50 percent of the deal, the developer may be required to give up an unnecessarily high portion of ownership if he later finds that an additional $100,000 cash equity is needed. On the other hand, with no financial partner waiting in the wings, a prospective lender could lose interest while the developer is locating one. The ideal situation is to line up one or more prospects in advance, with a general understanding of the types of projects being pursued and a commitment to invest if certain criteria can be met by a deal, in a particular time frame.
Development is always a team effort. A development team can be assembled in one of several ways. At one extreme, a large company might include many services, from architecture to construction management and leasing. The advantages of a robust organization are obvious: at each phase of development, critical services are performed in house, presumably with better quality control and coordination than outside vendors would offer. Additionally, each ancillary business can become a profit center for the firm, as principals find themselves asking, “Why give the broker that 6 percent?”
Developers must, however, be careful of “mission creep” into activities too far from the core competence of the principals. More common is the other end of the spectrum: a development company might consist of one or two principals and a few staff members who hire or contract with other companies and professionals for each service as needed. Although requiring more contract management and external communication, the advantages of a lean organization are substantial. This lesson is learned at every market downturn, when firms that are able to shed overhead quickly can extend their viability with low or no operating income. Limiting the “burn rate” of the development firm is good practice in a strong market, and it becomes an essential survival skill in a serious downturn.
From the perspective of organization, development can be a low-cost business that is relatively easy to enter, assuming one has the credibility and relationships needed to access investment capital. A development company can be started by just one person, with little investment in equipment or supplies beyond an office. Small developers are often able to compete effectively against larger organizations, using technology and consultants to leverage the capabilities of the principals. Although larger developers might obtain better prices in some areas and will certainly have easier access to money, they also tend to have higher overhead expenses and are usually slow to respond to market changes.
Like most enterprises, development firms typically pass through three stages—startup, growth, and maturity—and each stage is characterized by distinct risks and opportunities.
STARTUP. Startup is characterized by work toward two short-term goals—successfully completing the first few projects and establishing consistent sources of revenue to cover overhead. During this stage, firms are more likely to be merchant builders, selling their projects after they have been completed and leased, rather than investment builders, holding them for long-term investment. “During the startup period, the developer’s entrepreneurial skills are the critical ingredient. The developer has to develop contacts—with investors, lenders, political leaders and staff, investment bankers, major tenants, architects, engineers, and other consultants. Eternal optimism and the ability to withstand rejection are essential.”1
A common startup pitfall is overexpansion before the company has developed the staff and procedures to handle greater activity and new types of business. When tenants or buyers sense that a developer is not responding to their needs quickly enough, that developer’s reputation is likely to suffer. The growing developer must build staff and establish procedures for accounting, payable and receivable processing, leasing, tenant complaints, reporting functions to investors and lenders, construction administration, property management, and project control. Successful developers know that accountability is just as important for functions handled by consultants as it is for in-house services. A related mistake is hiring too many people too quickly. A startup business seldom has enough cash to pursue every line of business, and those that watch the overhead closely during startup tend to fare better than those whose first priority is projecting a high-profile image. Some of the most successful developers have built thousands of apartment units and millions of square feet of industrial and office space with a professional staff of only three or four, contracting with consultants for virtually everything. Although homebuilders operating this way can suffer a reputation as a “briefcase contractor,” the developer role is already one of entrepreneurial coordination, and limited in-house capabilities are seldom marks against the firm’s reputation, if the principals’ standards of integrity and professionalism are consistently upheld.
GROWTH. A firm in the growth stage has achieved a measure of success. It has instituted procedures for running the business and has assembled a team of players to cover all the major development tasks. It is beyond the point at which a single mistake on a single project can lead to bankruptcy. This firm is in a position to make strategic decisions about its future: what kinds of projects will be pursued, in what markets, with what sort of capital structure?
Maintaining the mission and entrepreneurial energy of the founders and inculcating that spirit into new team members are always challenges for growing firms. The firm must implement controls and procedures, without bureaucratic sclerosis. Development at any scale requires quick decisions. The key is to maintain direct involvement of the firm’s principals through this growth phase. Adding capacity and processes must always be considered as a way to leverage principals’ time, rather than as a replacement for their judgment and expertise.
Employees who are used to the freewheeling atmosphere of a startup organization sometimes resist the increased level of oversight by senior management; thus, in the growth phase, a firm may find itself with a new problem: retention of key players. The firm must maintain an entrepreneurial environment that motivates qualified, aggressive people. A one-person firm succeeds because that one person accepts risk and controls every aspect of the process. But when staff becomes necessary to handle the workload, the transition from one-person leadership to greater hierarchy can be difficult. Not only must the right staff be in place, but the founders must also be able to delegate.2
The right staff for a startup organization is not necessarily right for an organization in the growth phase. Many development firms are, at least at the beginning, family businesses. The difficult transition in this case is often generational. Family dynamics can complicate the transfer of management control, and, even after the transfer, the founding parent may remain in the background, giving directions that may not match the firm’s current model. Many firms never make it through this transition.
Conflict can also arise in family firms when the second generation is eager to take risks and try new projects at a time when the founding generation is becoming more risk averse. If the founding generation cannot find a way to let the second generation pursue its goals or have a chance to fail, the younger generation may leave the firm, at least for a time. Recognizing this dynamic, some developer-parents insist that their children work elsewhere before they join the family firm. This strategy offers the additional benefit of making principals in the firm aware of benchmarks and best practices in other organizations. Often, family-controlled development companies skip a generation; the second generation leaves the business to work elsewhere while the third generation enters the business. Wise managers plan ahead for problems, recognizing their children’s needs to achieve success on their own and understanding their forebears’ needs as stakeholders.
MATURITY. Firms reach maturity after they have established a track record of successful projects and have built an organization to handle them. Mature development companies have built a network of relations with financial, political, and professional players and have cash flow and assets that confer staying power, the so-called deep pockets. These firms tend to focus on larger, more sophisticated projects that tend to be more profitable and that require fewer managers than multiple smaller, less predictable projects. With higher barriers to entry, they usually face less competition.
Mature firms are more averse to risk, and their managers want to fully comprehend and mitigate the risks that they take. They have often built up a large net worth that the owners want to protect. They do not need to assume as much risk as they did previously, as lenders and equity investors are eager to participate with them. Developers can often reduce or avoid personal liability on notes, and financial partners are willing to assume more financial risk in return for an equity position in the project.
Several characteristics are typical of mature firms, regardless of their size, organization, and style of management:
• They know how to manage market risk, particularly in overbuilt markets.
• They have distributed authority and responsibility within the firm.
• They can evaluate the firm’s effectiveness and efficiency.
• Most important, they can attract, challenge, compensate, and retain good people.
Wolverton Park in Milton Keynes, United Kingdom, is a redevelopment of a former railroad engineering works. Today, the mixed-use development includes office, residential, retail, and more than 400 parking spaces.
During startup, organizational structure is less an issue than it is during growth and maturity. In the early years, most developers resist formalized organizations. Everyone reports directly to the owner, who makes all the major decisions. As firms grow, the delegation of authority, especially in financially sensitive areas, becomes essential because the owner’s time and availability are limited. Sometimes, an outside consultant or new CEO is needed to instigate necessary change.
In most firms, the principals control the same few decisions: site acquisition, financing arrangements and major leases, and timing and terms of the sale of a project. A common practice among even very large firms is for the principals to retain the responsibility for making deals, initiating and maintaining strategic relationships, hiring and compensation, the activities most reliant on personal contacts, reputation, and understanding of the firm’s strategy, while tactical responsibilities may be delegated.
Development firms are organized by function (that is., construction, sales), by project, or by some combination of the two. Smaller firms are more often organized by project, larger ones by function. That is, owners of small firms tend to appoint one individual to be in charge of each project, with the group working on that project responsible for all aspects of it—financing, construction, marketing, leasing, and general management. In large firms, on the other hand, one group is responsible for each key function across all projects.3 In some organizations, employees report to two different managers, one responsible for function and the other for geographic area or product line. Increasingly, firms use a hybrid model, where partners, who may represent expertise in leasing, construction, or deal structure, each take on direct responsibility for general management of a project, drawing in the other partners on project tasks where their expertise falls short. A firm’s organizational structure often reflects how it has grown and evolved over time. Some of the largest firms maintain a project-manager structure because they have grown by giving partners responsibility for specific geographic areas, product types, or both. Regardless of where firms begin, structure should be evaluated periodically as the firm grows, to maintain partners’ comfort with the framework as their responsibilities change.
Manager compensation is a major issue facing owners who want to align employees with the firm mission. One answer is to give key individuals equity in the firm. According to John O’Donnell, chair of the O’Donnell Group in Newport Beach, California, “The reason you give employees equity is you can’t pay them what they would command on the open market. Instead, you give them a stake in the future.” For senior executives, this might be true partnership equity, whereas key personnel at the project level might receive phantom equity.
Computed from firm or project profits like a bonus, phantom equity is an incentive for project managers, encouraging them to think like entrepreneur-owners. Unlike real equity, however, the individual does not legally own an interest in the project and is not liable for capital contributions. The project manager’s signature is therefore not required for transactions, which is important because junior staff turnover is not uncommon in this cyclical business. Also, if a partnership includes more than one property, phantom equity in the firm avoids the accounting difficulty of project-specific interest, which may complicate operating agreements or joint ventures. O’Donnell’s firm measures the performance of each property each year and contributes the appropriate share of the manager’s profit to a phantom equity account. If, for example, the property makes $100,000 and the manager has a 5 percent interest in it, the account is credited $5,000. If the property loses $100,000, the employee does not have to cover his share of the loss out of pocket, but paper losses accrue to the account and must be “repaid” before future profits are distributed. In this way, the employee does not have to worry about raising cash to cover potential liabilities but participates materially in both the upside and downside potential of the business.
Many firms provide for a period of five to ten years before an employee’s phantom equity becomes vested. O’Donnell’s firm, for example, might give an employee 2.5 percent of a project after three to five years of employment. Each year after the employee becomes vested, he or she receives an additional 0.5 percent, up to a limit of 5 percent. If a vested employee leaves the company, O’Donnell retains the right to buy out that person’s interest at any time based on a current appraisal of the property and he retains the right to select the appraiser. If someone leaves the company without notice, he might buy out that employee’s interest immediately. On the other hand, a longtime secretary who leaves to start a family or a manager who gives advance notice (say, three months) might receive profit distributions for years, thus enjoying the project’s potential to the extent that his or her tenure vested these rights.
FIGURE 2-1 | National Real Estate Compensation Survey, 2011
No formula exists for determining how much equity a developer should give away to attract top managers. Beginning developers may have to pay experienced project managers 25 percent of a project’s profits, whereas established developers may need to pay only 1 to 5 percent. Employees’ risks are lower with a more established developer, so their shares of the profits are lower. One major developer, for example, has three levels of participation, which are given not as rewards but as career paths. The lowest level is principal. Project managers who are star performers are eligible. They receive up to 10 percent (5 to 7.5 percent is typical) of a project in the form of phantom equity. The next level is profit and loss (P&L) manager, someone in charge of a city or county area. P&L managers are responsible for several projects and principals; they receive 15 to 20 percent of the profits from their areas. Their interest is also in the form of phantom equity. The top level is general partner, reserved for managers of a region, state, or several states. General partners receive real equity, are authorized to sign documents on the firm’s behalf, and incur full risk.
Real estate is a cyclical business; in each downturn, a substantial portion of capable junior and middle managers leave the industry. As a result, even in relatively weak markets, the most experienced professionals can be in relatively short supply. Firms respond with creative and highly motivating compensation packages to attract and, more importantly, to retain these experienced hires. Compensation for top performers is usually paid through bonuses rather than salary and can range from 10 percent of salary, at the project level, to well over 100 percent for executives.
Strategic Planning and Thinking: Planning the Business
EVALUATE THE PRESENT SITUATION.
• What are the company’s accomplishments? How do they compare with previous goals?
• Where is the company headed? How should it get there?
• What are the owner’s or founder’s interests and expectations?
• What is the external environment?
• Market changes and trends
• Changes affecting products and services
• Opportunities from changes
• New and old risks and rewards
• Political environment
• Who are key competitors? Where do they excel?
ANALYZE THE COMPANY’S STRENGTHS AND WEAKNESSES.
• What properties has it developed, bought, marketed? How successful have they been?
• How has the firm done in the past?
• Management capabilities
• Threats
• Opportunities
• What past decisions would be changed?
SPECIFY GOALS FOR THE STRATEGIC PLAN.
• What is the financial strategy?
• What is the firm’s strategy regarding products?
• Quality
• Investor or merchant builder
• Does the company need to diversify its product?
• Does the company need to diversify its location?
• What is the company’s strategy regarding land?
• Land banking versus carrying land in slow times
• Developed land versus raw land
• What is the marketing strategy?
• What is the strategy regarding production and construction?
• How does the company get the job done?
• What is its management and organizational strategy?
SPECIFY AN ACTION PLAN—PROGRAMS, STEPS, OR TASKS TO BE CARRIED OUT—CONCERNING RISK, REWARD, AND REALITY.
• What activities is the company engaged in now?
• What is the state of financial planning?
• Where do equity and debt come from?
• Are changes expected?
• How strong are financial suppliers?
• What will be its financial needs in the next 24 months, the next 36 months, or longer to meet strategic goals?
• What are the company’s objectives? What metrics is it committed to achieve?
• How strong will lines of communication and internal controls be for
• Financial results
• Acquisition and development
• Operations: property management, leasing, tenant improvements, customer relations
• Controls and measurement
• Responsibilities and budgets
Source: Sanford Goodkin, president/CEO, Sanford R. Goodkin & Associates, San Diego.
Personnel costs are typically 60 to 80 percent of most operating budgets, and they are the most critical component of a management or operating company. Benefit costs, especially for health care, continue to rise, and as in every industry, managers are increasingly sharing these increases with employees. Even before the financial crisis of 2008–2009, many firms were also downsizing, and the uncertainty and cash flow disruption of the past few years have made many managers consider the benefits of a lean payroll. The lean organization will use more outside contractors to fill interim needs. “They just can’t afford to pay everyone market rates [for high-end people] every day, all the time,” says Chris Lee, president of CEL & Associates in California.
Most beginning developers—and even many large ones—do not have a formal strategic plan. Rather, they may focus on a specific demographic market, or a neighborhood, or a property type, but within these parameters the firm will respond to opportunities as they arise. In this way, developers build expertise and a track record of success, and more opportunities tend to arise within a well-chosen market. Organically, the firm’s competence can become its business strategy.
As firms gain maturity, size, and diversity, they may benefit from more formal strategic planning. A strategic plan gives junior team members a sense of the direction of the business and gives them direction on how to contribute at the deal or project level. The effect of a good strategic plan, then, can be counterintuitive: encouraging more decentralization of the day-to-day activity of the firm. The plan should include budgets, a master schedule tied to the budget, and systems for approving and tracking projects. The accompanying feature box summarizes the major issues that strategic planning should address. Just as important is to include the assumptions, identified trends, and external dynamics that underpin elements of the strategy, so that they may be reevaluated in future revisions of the plan.
The strategic plan helps the company achieve its objectives faster, because everyone understands the firm’s immediate goals and longer-term objectives. Such plans are most effective when prepared with broad participation and when the resulting strategy flows into clearly defined tasks. Whereas the business plan is strategic, the budget is tactical; that is, the budget lays out the specific approach that will be used to follow the broad strategy of the plan. The strategic plan culminates in an action plan, which should establish specific protocols for managers to follow—for example, policies for evaluating the competition and an area’s long-term economic outlook, or for evaluating individual deals, contractors, or joint ventures against the criteria of the strategic plan.
Assembling a team of professionals to address the economic, physical, and political issues inherent in a complex development project is critical. A developer’s success depends on the ability to coordinate the completion of a series of interrelated activities efficiently and at the appropriate time.
The development process requires the skills of many professionals: architects, landscape architects, and site planners to address project design; market consultants and brokers to determine demand and a project’s economics; multiple attorneys to handle agreements and government approvals; environmental consultants and soils engineers to analyze a site’s physical and regulatory limitations; surveyors and title companies to provide legal descriptions of a property; contractors to supervise construction; and lenders to provide financing.
Even the most seasoned developer finds that staying on top of all of a project’s technical details is difficult. For beginners, a key is to find consultants and partners who can help guide the development process, as well as provide technical knowledge. Regardless of experience, most developers can benefit from continuing investment in their own training, and in updated software and communications tools to leverage their personal project management abilities. Developers may find small subcontractors lack technologies and communications tools—even e-mail. Working with these firms may present continuing difficulties.
To begin the search for a consultant with particular expertise, developers should first seek the advice of successful local developers who have completed projects similar to the one under consideration. They should ask experienced developers about the consultants they use and their level of satisfaction with the consultants’ work. Beginners should also remember, however, that established developers may consider newcomers the competition, and it may take some time to build the trust necessary for a frank exchange of opinions. Beginning developers might take advantage of networking opportunities by joining associations of local developers or national organizations geared toward the real estate product of interest, be it residential, shopping centers, or business parks. The key is to be active in such organizations by serving on committees and participating in events.
Developers should obtain a list of the consultants whose work has impressed public officials and their planning staffs. Staff is often prohibited from recommending professional service firms, but usually at least an informal opinion for or against a specific firm can be obtained. Certain approvals might hinge on the reputations of specific team members; indeed, part of consultants’ value could lie in the connections they maintain with the public sector. Because governments have pulled back from some services, relying on certifications of outside professionals, many tasks that were once performed by public servants may now be performed in the private sector by the very same people. A common example is soil evaluation, a function of departments of public health, which is commonly performed by “authorized evaluators,” who are typically former department employees who retain both the knowledge of their field and relationships with the approving agency.
Associations of architects, planners, and other development-associated professionals are another source of potential consultants. Such organizations usually maintain rosters of members, which are useful as a screening tool because most professional and technical organizations have defined certain standards for their members. Those standards might include a certain level of education and practical experience, as well as a proficiency examination. Most associations publish trade magazines that provide a wealth of information about the field and are often available online.
Strategies for selecting consultants vary according to the type of consultant being sought. The most common approach is a series of personal interviews. Beginners should not hesitate to reveal their inexperience with the issues being addressed or to ask potential consultants to explain clearly their duties and the process of working together. Consultants will profit by dealing with a developer, so they should be expected to take the time to explain the fundamentals.
A proper interview should address the developer’s concerns regarding experience and attitudes. The developer should look for a consultant with experience in developing similar projects. An architect or market consultant who has concentrated on single-family residential development would be inappropriate for a developer interested in an office or retail project.
The developer must be sure to ask for references and then must contact those references personally to learn about the consultant’s quality of work and business conduct, ability to deliver on time and within budget, interest in innovation, tolerance for clients’ direction, and professional integrity.
The developer may also inspect some of the consultant’s work—marketing or environmental reports, plans and drawings, and finished projects. The developer should be comfortable with the design philosophy of a prospective member of the creative team and satisfied with the technological competence of a potential analytical consultant.
The developer must be certain that the chosen firm has the personnel and facilities available to take on the assignment. This balance is difficult to achieve because the developer is likely to be attracted to small firms’ personal attention to his needs, while being sensibly wary of involvement with an organization without capacity or staying power. If a consultant appears to be struggling to keep up with current responsibilities, the proposed project is likely to suffer from neglect. A good rule of thumb is that the proposed project should represent no more than a third of the consultant’s overall business.
Having ascertained the overall fitness of the consulting group, the developer should establish who will be the project’s manager and request a meeting with that person and then examine several projects for which that manager was responsible. Beginning developers are often reluctant to involve themselves in “other people’s business,” but it is not inappropriate to ask that specific personnel and time allocations be delineated in the professional services agreement. Toward that end, the developer is well advised to find out what subconsultants the firm would be likely to hire, and how the scope of work will make each sub accountable to the project timeline and performance standards. It may be possible to speak with key subconsultants as well, to map out a plan for completing the assignment together. Successfully accomplishing the assignment will require coordination between the consultant and its subs, and the client who will be dependent on these individuals should know who will be responsible for what.
Hiring a firm is a two-way street. While the developer is sizing up the consultant, a similar process is going on across the table. Displaying a positive attitude about the project and the consultant’s potential contributions is important. A beginning developer should not be offended when the consultant asks about his experience and competence to complete a development project, the existence of adequate financial resources and accounting capacity to pay the bills, the feasibility of the proposal, the ability to make timely decisions, and what might happen if the project is delayed or aborted.
Consultants need to be confident about a developer’s ability to meet obligations and should know when they are working “at their own risk.” This last consideration has become especially important over the last few years, as cash flow difficulties for developers and owners of real estate have trickled down into crises at firms offering development services. An experienced consultant will appreciate an open and honest conversation about when work will be compensated, and some caution in releasing work for future projects.
Finally, the developer should judge whether he has established a rapport with the people being considered during the preliminary interview. The ability to get along with these people is essential for the project’s completion, so if problems arise at this point, the developer should consider whether dealing with them daily is possible. Thinking ahead to the long timeline of some development projects, the developer may wish to consider whether the organization has the same rapport at the junior level as is found at the executive level. Compatibility is a key to the project’s success—and to preserving the developer’s sanity.
If, after checking references, the developer feels uncomfortable with any aspect of the consulting firm, eliminating the firm from further consideration may be the most sensible move. If the developer’s responses are favorable about the firm as a whole but not about the particular person being assigned to the project, he should raise these concerns with the firm’s principals. A larger firm should have another staff person available, but a smaller firm may not. The developer must be assured that the most qualified people will be assigned to the project, that those people will continue to be available until the project is complete, and that the team will leave behind it a legible paper trail for future phases or operating partners to recover the design logic, legal justification, or operational guidelines for decisions made during development.
Who Is Involved, and When, in the Development Process?
SITE SELECTION
• Brokers
• Title companies
• Market consultants
• Transactional attorneys
FEASIBILITY STUDY
• Market consultants
• Economic consultants
• Construction estimators
• Surveyors
• Mortgage brokers and bankers
• Land use attorneys
• Engineers
DESIGN
• Architects
• Land planners/landscape architects
• General contractors/construction managers
• Surveyors
• Soils engineers
• Structural engineers
• Environmental consultants
MARKETING
• Brokers
• Public relations firms
• Advertising agencies
• Graphic designers
• Internet service firms
FINANCING
• Mortgage brokers and bankers
• Construction lenders
• Permanent lenders and syndicators
• Title companies
• Appraisers
CONSTRUCTION
• Architects
• General contractors
• Engineers
• Landscape architects
• Surety companies
• Authorized inspectors
OPERATIONS
• Property managers
• Specialty and amenity maintenance teams
SALE
• Brokers
• Appraisers
THROUGHOUT THE PROCESS
• Attorneys (title, transactional, land use, litigation)
Consultants should willingly quote a fee for their services, presenting a written proposal reflecting the costs for delivery of the desired product. Depending on the particular expertise, this quote may be a simple lump-sum bid, an hourly rate, or a menu of services and associated costs. The developer will benefit from having as much information in writing as possible. Although cost is an important factor, it must be balanced by experience and by the quality of the consultant’s past work. Developers should be careful not to choose simply the lowest price. If detailed proposals are available, developers should compare the proposed budgets to see how the money is allocated and to identify the differences in proposals to judge whether the numbers are reasonable. They should also ensure that the prices include the same types of services. For example, a lower fee could possibly exclude services that will later be required, necessitating future additional charges. A lower quotation might also exclude the amount needed to cover unforeseen incidents. The issue of unforeseen costs is a hazard of the development business, and it is often the case that changes to the scope and cost of services ultimately represent a larger range than the differences in initial quotes. It is therefore essential that any professional services agreement spell out clearly the types of events that could trigger additional costs (inadequate base drawings, new regulatory requirements), the process by which the scope may be changed and the notice required to do so, and the specific unit prices for additional work.
Once a firm has been selected, most developers prefer to employ a fixed-price contract, using the figures quoted in the proposal. Payment can be made in several ways, depending on the nature of the product to be delivered. A schedule could be used to establish milestones, such as the delivery of a specified work product that triggers an agreed-on payment, or developers might find that allowing projections of cash flow to establish a monthly schedule is more advantageous. Smaller jobs might require a lump-sum payment up front.
Some consultants, like lawyers, work according to a time-and-materials (T&M) agreement, with the client billed according to staff members’ hourly rates and the cost of materials used to complete the task. Materials include reimbursable expenses, such as printing or shipping, which may receive a markup for management time. New clients are an unknown for which many consultants will prefer T&M arrangements. T&M agreements are complicated, however, and require constant monitoring to verify the amounts that are being billed and to understand them in relation to the overall project scope. Less experienced developers lack benchmark information about appropriate costs for handling specific tasks, making these agreements inherently risky. When constructing T&M agreements, the client should be clear on a dollar value that may be billed each period without prior approval, so that a casual approval to “take care of that” does not turn into an unanticipated receivable at the end of the month. One experienced construction manager advises, “Regardless of careful construction and monitoring, T&M agreements require trust and common expectations for the work to be performed. Executing these arrangements with strangers is a recipe for administrative headache and hurt feelings.”
Retainer agreements that pay the consultant a flat monthly fee should be avoided because such arrangements can be very costly in the long run. When delays stop work on an aspect of the project for which billing continues apace, not only is cash flow impaired but the incentives of developer and consultant may become warped when 50 percent of the work is completed, but 90 percent of payment has been received. Retainer agreements are usually appropriate only for elements of a project that are truly ongoing, such as public relations management during the lease-up period, or for services that may be thought of more as insurance for eventualities that may occur, such as land use counsel during the development period.
Regardless of the chosen method of compensation, both the developer and the consultant must negotiate a mutually agreeable performance contract. The contract must explicitly list each duty that the consultant is expected to complete. The developer should expect that services not explicitly included in the agreement will probably require future negotiations that will most likely lead to additional costs for the developer. The contract should clearly spell out a schedule for the delivery of services, including a definitive date for delivery of the final product, and expected turnaround for major steps in the process.
After the parties sign the agreement, the working relationship with the consultant begins. The developer must work closely with the consultant to ensure that everything proceeds according to schedule. The development team is made up of a group of players whose tasks are interrelated, and the tardiness or shoddy work of a single firm could set off a chain reaction and cause costly delays.
As the team leader, the developer must ensure that each consultant is provided with accurate information and that information produced by one consultant is relayed to the others. Any changes in the project’s concept should be communicated immediately. The developer must be sensitive to the effect that changes in the project will have on the consultants’ collective analysis; sudden change could alter requirements for the design, environmental analyses, and parking, for example. Any alterations could be costly, as consultants might demand extra compensation to address the changing elements of the project. It is advisable that the developer begin due diligence and have some idea of the project’s viability before spending significant funds on designers.
A healthy working relationship with consultants is vital. Developers should contribute information and ask questions throughout the process but should also show a willingness to accept consultants’ ideas. Good consultants can decrease development costs and improve a project’s marketability.
A developer must have the management skill necessary to coordinate consultants’ efforts while ensuring that all parties respect the developer’s ultimate authority to make decisions. Problems can also occur, however, when a developer’s ego gets in the way of good advice. A good developer knows when to listen to and accept the advice of others.
The design/construction team includes an array of consultants and contractors who perform tasks ranging from site analysis and planning to cost estimating, building design, and construction management. The work that they perform and/or manage represents the bulk of the project’s total soft costs, and effectively managing their contributions is critical to the success of the development project.
Both beginning and experienced developers depend on architects for advice and guidance. Some developers appoint the architect to head the design portion of a project, and sometimes the construction period as well. Most developers, however, prefer to be their own team leaders, both to maximize their influence on the design and to expedite time-critical processes. Beyond building and site design expertise, architects usually offer extensive experience with the regulatory and physical constraints placed on development and are a valuable asset in communicating with other consultants and in coordinating design with construction processes.
Jamestown Properties converted Warehouse Row, a redevelopment of 19th-century warehouses in Chattanooga, Tennessee, into an urban, mixed-use project with restaurants, boutiques, offices, and event space.
JAMESTOWN PROPERTIES
The search for an architect must be thorough. Only those firms and individuals whose experience is compatible with the proposed project should be considered. It is crucial that the architect be focused on delivering a workable product at a reasonable cost. Those more used to designing high-end custom homes where cost is not an issue may not be suitable for a development of production homes. Beginning developers especially may lean on the project experience of the architect, and an inexperienced architect is likely a better match for a more seasoned client. The developer should always check a firm’s credentials and ensure licensure in the state where the project will be built; building departments require the stamp of a state-admitted architect.
The developer and the architect must share a common philosophy of design, though the developer will often benefit from the broader experience of a design professional, and the developer must feel comfortable with the architect selected. A good architect respects the developer’s opinions and can work through disagreements. At the same time, the developer must consider every decision but respect the architect’s knowledge and experience. Some developers prefer to hire an architect whose work has withstood the test of time; others look for an architect known for innovative designs that make a distinctive statement and may give the developer a competitive advantage or a benefit in public relations or approvals.
When the developer has found an architect, the next step is to reach a written agreement. A set of standard contracts provided by the American Institute of Architects (AIA) provides the basis for defining the relationship between developer and architect. AIA Document B101, Standard Form of Agreement between Owner and Architect, clearly outlines the architect’s duties in the development process and is widely used in real estate development. Developers should remember, however, that this agreement was written from architects’ perspective and seeks to protect their interests.4 In some circumstances, modifications to the AIA agreement form are appropriate, although both parties should be aware that a body of opinion and case law exists for interpreting this standard document, and changes may introduce uncertainty in interpretation of additional terms.
Sometimes, architects are given responsibility for all facets of the project’s design, as well as selecting and supervising land planners, landscape architects, engineers (except survey, soils, and environmental engineers), and parking and other programmatic consultants, as well as all facets of the project’s design. Few experienced developers recommend this practice, however, and some prefer to maintain every subdiscipline in direct contractual relationship with the developer/owner, to maintain long-term accountability to the project and to better understand and manage cost.
The design phase lasts from the creation of the initial concept to the completion of the final drawings. The design is based on a program that outlines the project’s general concept, most notably its identified uses and amenities, and initial allocations of floor area or acreage for each. It is increasingly common for planners or architects to participate in the programming phase, particularly in urban, mixed-use locations where this calculation can be very complex.
Initially, the architect prepares schematic drawings that include general floor and site plans and that propose basic materials and physical systems. A construction cost estimator or contractor should review the design and assess its economic implications at least at the conclusion of each design phase. These schematic drawings are an important component in presentations to lenders and should include a basic set of presentation images, such as rendered elevations or a physical or digital 3-D model.
Upon approval of schematic drawings, architects typically move into a “design-development” phase, where the original concept begins to be fleshed out into construction systems and a more precise division of functional spaces. Most major design decisions are made in the schematic and design-development drawing stages, and as each phase proceeds, changes to the design become more difficult and expensive. Even under the inevitable time constraints, it is nearly always better to address design concerns as they arise than to table these issues assuming they can be fixed later. The design team should include not only the contractor or construction manager but also marketing, leasing, and property management representatives. If those team members are not yet named, then the developer should ask potential contractors, brokers, and property managers to review and criticize the preliminary drawings. Beautiful, but unmarketable projects can lead to finger-pointing later.
After approval of the design-development package, the developer typically has the first real handle on the potential cost of the project. At this point, estimates are reviewed against the design drawings, and major budget busts should be resolved before going forward. Upon approval of the design and cost, the architect produces specification drawings, also called working drawings. Specifications include detailed drawings of the materials to be incorporated with the mechanical, electrical, plumbing, and heating, ventilating, and air-conditioning (HVAC) systems. Generally, drawings pass through several iterations before the final plans and specifications are finished. The developer should review these interim drawings, referred to as 25 percent, 50 percent, 75 percent, or 95 percent complete. After addressing all the developer’s concerns, the architect completes final drawings and specifications.
Site plans are the result of a team effort. Consultants should be involved early in the development process to ensure that they have a say in important decisions. Site plan for Granite Terrace, vancouver, Canada.
Because most developers are interested in the project’s image and feel, they often spend their time reviewing drawings, at the expense of specifications. Doing so is a mistake. The quality, durability, and safety of a structure are as dependent on “the spec” as on the drawings. The spec is typically organized around the Construction Standards Institute’s Master-Format, which groups construction materials into categories consistent across all types of projects, and a master specification defines not only materials but also precisely how and by whom each material should be installed. It is therefore an incredibly important document for the long-term operation of the building because it governs the warranty of nearly every material in the building. In reviewing partially completed designs, both drawings and specifications, the developer should pay particular attention to the implications for potential users by visualizing how commercial tenants or residents will react to the design, asking brokers, tenants, and other developers to identify the needs of the target groups and soliciting real estate professionals’ comments on the design drawings as they progress.
The next phase of the architect’s duties involves compiling the construction documents, including the package used to solicit bids from contractors. This package includes the rules for bidding, standard forms detailing the components of the bid, conditions for securing surety bonds, detailed specifications identifying all components of the bid, and detailed working drawings. The developer also relies on the architect’s experience to analyze the bids and to help select the best contractor for the job. Although the architect is best suited to understand the components of bids on a design, the developer is the one who will have to live with those bids, and with missing or misunderstood scope or cost during the development phase. For this reason, developers must thoroughly understand the bids, and they may wish to introduce special format requirements so that bids dovetail with the development and operating budgets they will be administering on the project.
Once construction begins, the architect is responsible for monitoring—but not supervising—the work site. The architect is expected to inspect the site periodically to determine whether contract documents are being adequately followed. Constant monitoring is beyond the scope of the architect’s responsibility, requires additional compensation, and is more effectively achieved with a fee-compensated construction manager.
The developer also relies on the project architect—or project engineer, in the case of infrastructure development—to confirm that predetermined phases during construction have been satisfactorily completed. The approval involves a certificate of completion necessary for disbursement of the contractor’s fee. The AIA provides another standard certificate that addresses the architect’s liability resulting from confirmation, noting that the architect’s inspections are infrequent, that defects could be covered between visits, and that the architect can never be entirely sure that construction has been completed according to the plan.
The relationship between architect and developer commonly follows one of two models. The design-award-build contract is most traditional in the United States and breaks the project into two distinct phases, with the architect completing the design phase before the developer submits the project for contractors’ bids. The alternative, the fast-track approach, involves the contractor during the early stages of design because the contractor’s input at this stage could suggest ways to save on costs, making the project more economical and efficient to construct.
The fast-track method is primarily a cost-saving device, as it uses time efficiently to reduce the holding costs incurred during design. The developer is able to demolish existing structures, begin excavation and site preparation, and complete the foundation before the architect completes the final drawings. One risk involved with the fast-track approach, however, is that the project is under construction before costs have been determined, and before necessary approvals are finalized.
Several methods are available for compensating architects for their services, including T&M agreements and fixed-price contracts. The latter specify the amount that the architect will receive for completing the basic services outlined in the performance contract; any duties not listed in the contract are considered supplementary and require additional compensation. Another method calculates architectural fees as a fixed percentage (usually 3 to 6 percent) of a project’s hard costs. Architects contend that this method fairly accounts for a project’s complexity. The disadvantage of this method is that it provides no incentive to the architect to economize. It is often necessary to engage the architect and other professionals on the basis of either T&M or a short-term retainer during project conceptualization, because the project scope remains unclear, and then shift to a fixed-price arrangement when the project is more defined and subject to better quantification. Hybrid models of compensation are also popular, where a particular milestone will be priced as a “not-to-exceed,” with hourly billing against the maximum, and no cost authorized beyond that number. In this way, the architect offers the client protection against overruns but is paid within an established range for work performed.
Regardless of the mode of calculating compensation, the architect is always entitled to additional reimbursable expenses—travel, printing, photocopying, and other out-of-pocket expenses. Beginning developers should be aware that, on a project with even a fairly simple path through public approvals, printing costs for the many dozens of required drawing sets can be well into five figures.
Landscape architects do much more than plant trees and flowers. Landscape architects work with existing conditions—topography, soil composition, hydrology, and vegetation on a site—to create a functional setting and a sense of place for the project. They are responsible for working with the architect to produce an external environment that enhances the development, for devising a planting and hardscape plan, and for incorporating components into the project, like plants, trees, furnishings (benches, for instance), walkways, artwork, and signs. Landscape architects can also save energy costs by selecting plants that provide shade and with grading and planting approaches that solve drainage problems.
It is becoming increasingly common for landscape architects to take a leading role in entitling projects. Communities commonly demand open space of new projects, and at any rate expect to have a say on landscaping of public roads and views. In land development projects, in fact, landscape architects may take the lead, because their drawings are often the most instructive to the community and, with emphasis on the green and natural, sometimes the most appealing vision of the project.
Landscape architects first develop preliminary plans and then manage the completion of those plans. They obtain bids, complete working drawings and final specifications, prepare a schedule, and inspect the site to verify that the contractor implements the plan correctly. Expertise in other kinds of construction does not necessarily translate into landscape construction and installation. Many very expensive installation problems in landscapes can be virtually invisible to the untrained eye—inadequate soils testing or preparation, or poor subsurface drainage—so it is advisable to have someone with specific expertise inspect the project at least upon completion, if not periodically through construction.
Hiring the landscape architect can be the architect’s responsibility, but developers should inspect the chosen landscape architect’s work to determine that they are comfortable with the design philosophy. The American Society of Landscape Architects maintains rosters and certifies its members. Landscape architects typically work through conceptual planning on a T&M basis, then bid a lump sum to complete working drawings and specifications, and, generally, return to working on an hourly basis to supervise completion of the plans. A monthly or weekly retainer may also be used for construction administration.
With land development projects and larger building projects, land planners allocate the desired uses to maximize the site’s total potential and determine the most efficient layout for adjacent uses, densities, and infrastructure. Individual building projects usually rely on the judgment of the architect and market consultants. The land planner’s goal is to produce a plan with good internal circulation, well-placed uses and amenities, and adequate open space. Land planners should prepare several schemes that expand on the developer’s proposal and discuss the pros and cons of each with the developer. The developer coordinates the land planner’s activities with input from marketing, engineering, economic, and political consultants to ensure that the plan is marketable, efficient, and financially and politically feasible. On land development projects, the land planner is the principal professional consultant. Reputation and past projects are the best indicators of a land planner’s ability. A key characteristic to look for in a land planner is the ability to work well with the project engineer and architect. Because the activities of a land planner vary widely, many architects and landscape architects offer “planning” on their menu of services. Although the skill sets certainly overlap, and some architects are definitely capable of high-quality site planning, professional planners often bring more to the table than simply their skills. When evaluating a planner, developers should be aware of the office’s relationships with the entities granting approvals, as well as its relationships with infrastructure contractors and landscape construction firms.
Engineers play a vital role in the development of a building. Several types of engineers with specific expertise—structural, mechanical, electrical, civil—are required to ensure that the design can accommodate the required physical systems. They are sometimes engaged by the project architect and sometimes contract directly to the owner or developer. Regardless of the relationship, they must maintain a very close relationship with the architectural staff as the project design unfolds. For this reason, the client should seek the architect’s input when selecting all the project engineers. Larger architectural firms may have an in-house engineering staff, which can expedite coordination but limit competition; smaller firms prefer to hire individual engineers project by project.
Although the architect may make recommendations or offer a list of candidates, the developer should reserve the right to select engineers after inspecting their qualifications; reviewing previously completed projects of the same scope and property type, including interviewing the project’s proponent; and checking their working references with various general contractors and local building inspectors. Contractors may have strong opinions about engineers that they have worked with in the past. Although these opinions should be considered, the developer should also understand that projects often place engineers and contractors on opposite sides of the process, and contractors can resent the oversight of an engineer.
Engineers must be licensed by each state in which they operate, and plans cannot receive approvals unless signed by a licensed professional engineer. Developers should clarify which submittals require stamps from which kinds of engineers.
The architect may hire certain engineers as subcontractors and then must be responsible for subcontract deliverables, schedule, and budget. Engineers are generally required on all substantial construction projects, including new developments, renovations, or additions to existing structures. The engineer’s fee schedule is usually included in the architect’s budget and generally ranges from 4 to 7 percent of the overall soft cost. When engineers subcontract to architects, evidence of payments to subs should be required in the architectural contract, because nonpayment or default by the architect can sometimes result in a mechanic’s lien5 on the property.
During the initial design phase, the architect works with the engineers to develop and modify working drawings to accommodate the project’s structural, HVAC, electrical, and plumbing systems. Each engineer then provides a detailed set of drawings showing the physical design of the systems for which the engineer is responsible. The architect is responsible for coordination of each successive drawing set and for instructing the engineers to resolve any conflicts.
Structural engineers assist the architect in designing the building’s structural integrity. They work with soils engineers to determine the most appropriate foundation system and to produce a set of drawings for the general contractor explaining that system in detail, especially the structural members’ sizing and connections. Structural engineers can range from sole practitioners who produce framing plans for single-family homes to large professional practices that can engineer steel-framed high rises. Developers of specialty buildings for medical offices, labs, and the like should be aware that these building types require specialized expertise beyond the generic professional engineer credential.
Mechanical engineers design the building’s HVAC systems, including mechanical plant locations, airflow requirements for climate control and public health, and any special heating or cooling requirements, such as computer rooms in office buildings or isolation wards in hospitals. Many firms offer a combined MEP (mechanical, electrical, plumbing) practice, allowing them to take responsibility for the building’s plumbing design, but developers should never feel obligated to lump all engineering specialties together in one firm if specific expertise can be found elsewhere.
Terrazzo is a ten-story residential tower located in the Gulch, a LEED-ND neighborhood in Nashville, Tennessee. The tower is certified LEED Silver.
BILL LAFEVOR, COURTESY OF CROSLAND
Electrical engineers design the electrical power and distribution systems, including lighting, circuitry, and backup power supplies and specifications for inbound site electrical utilities. Civil engineers design the on-site utility systems, sewers, streets, parking lots, and site grading. Wise project managers clearly delineate where each engineer’s jurisdiction terminates: for example, “site utilities” may extend to within three feet (0.9 m) of the building envelope, while “building electrical” may be within this boundary.
Effective project coordination relies on upfront communication, and engineers should be included early in the design process. Experienced developers generally facilitate a series of meetings with all architectural and engineering project personnel to define scope and communication channels and to discuss each discipline’s goals and objectives in depth. For example, if the goal is to construct a high-efficiency building with systems that result in lower operating costs—digital thermostats, automated or remotely monitored off-site HVAC system controls, automatic water closets—these project aims need to be spelled out early in the process. It is increasingly common for developments to aim for performance certification, such as LEED (Leadership in Energy and Environmental Design), EarthCraft, or at a minimum EnergyStar, and such goals magnify the importance of early engineering and cost-estimating coordination. Costs of LEED certification, for example, vary widely by product type and by the strategic choices made to get to certification. Increasingly, developers report that the “green premium” for more sustainable construction is falling rapidly, with faster payback as utility costs rise. Developers should be aware of cost tradeoffs between higher development costs and lower ongoing operating expenses and furnish engineers with the criteria they will need to make decisions on their behalf.
Ronald Stenlund, president of Central Consulting Engineers, advises developers and their engineers to insist on two-year warranties on all installed mechanical systems.6 It is vital that each component, particularly for a building’s heating and cooling systems, go through a full season of startup and shutdown to be evaluated. Unfortunately, a one-year guarantee is the industry standard, and this period generally begins on the shipping date rather than the installation date. Further, maintenance people must be properly trained in the nuances of each system and gain familiarity with their operations.
One concern of all developers is having their soft costs come in over budget. According to Stenlund, “Failure to achieve effective communication among the developer, architect, and engineering staff early in the process is the single most common cause for project delays, redesigns, and cost overruns. Coordinating the team early, defining expectations, and developing a congruent project vision are the three keys to minimizing this risk factor.”
Experienced developers recommend completing at least a few basic soils tests on a site before purchasing the property. Soils engineers can conduct an array of tests to determine a site’s soil stability, the level of its water table, the presence and concentrations of common toxic materials, and any other conditions that will affect construction. Geotechnical engineering is not an exact science, but hiring skilled, registered professionals reduces uncertainty and can at the very least indicate whether further testing should be conducted.
A soils engineer first removes a cross section of the soil by boring the surface of the site to a specified depth. That sample is then analyzed. Laboratory tests disclose the characteristics of the soil at various levels, the firmness of each of those levels, and, if requested, the presence of certain toxic materials. On smaller sites with no water or other potential problems, one boring test in the middle may be sufficient. On other sites, boring tests are usually completed in the middle and near the anticipated building corners and critical roadway or bridge locations. If the presence of toxic materials is suspected across the site, more borings may be necessary, but the project engineer should be consulted for a customized test approach. The soils engineer prepares a detailed report on the composition of the underlying soil, complete with an analysis of the characteristics of each layer. Soil composition is classified according to color, grain size, and firmness. The soils engineer also recommends the type of foundation system most appropriate for the site, based on the laboratory findings and tests to determine the soil’s strength.
A bearing test determines the soil’s ability to support the planned structure at the anticipated depth of the foundation. The soils engineer digs out a portion of the site to the designated level to complete the test. The soils engineer also determines the stability of the site’s slope. During excavation, for example, digging straight down may be difficult because the remaining soil might cave in. The engineer is expected to use the results of the test to calculate the excavation angle that will leave the remaining soil intact.
Soils engineers participate with the architect and the structural engineer to design the most effective type of foundation system to support the proposed structure. They generally work on a lump-sum basis. A soils analysis can cost from $1,000 to $100,000, depending on the site’s size and the number of test borings and types of tests necessary.
Though increasing environmental regulation has resulted in a substantial increase in specialty environmental consulting for real estate, there are two basic types of environmental consultants: one type, engaged during feasibility and approvals, analyzes the project’s economic, social, and cultural effects on the surrounding built environment; the second type, engaged in the design phase, determines, in conjunction with soils engineers, mitigation for impacts associated with the development. Impacts can range from intrusion on streams or wetlands to increases in traffic, noise, and emissions. Planning and budgeting for environmental consultants can only follow a solid understanding of the regulatory process. Land use attorneys and planners are good sources of information, and they should be consulted early. Some aspects of on-site evaluation require long lead times, and some can only be accomplished during certain times of year. Emergent or seasonal wetlands, for example, might only be identifiable when wetland-associated plants are visible in the spring. The developer must also understand at what point in the approvals process formal environmental reviews are required.
Environmental reviews are often necessary for development projects of significant size and scope, and they are generally required and administered by state environmental quality agencies. Reviews usually focus on impacts to the immediate surroundings caused by the proposed development, such as increased traffic, reduced air quality, sunshine and shading, and infrastructure requirements.
The environmental approval process varies in rigor based on state and local regulations and attitudes. These reviews are often sensitive political actions and demand a balancing diplomacy and insistence from the developer. Although no developer wants to be perceived as an environmental threat, it is also important to insist that statutory timelines and requirements are followed, as many developers have found the environmental review process to be abused by project opponents as a way to delay legitimate and low-impact projects.
The financial outlay, time, patience, and perseverance required to successfully navigate an environmental review and secure final building permits must not be underestimated. The process is governed by the appropriate level of government that first determines whether or not a developer is obligated to complete a formal environmental analysis, and which tier of study is indicated by the project. This process is triggered if a project exceeds various size or scale thresholds or affects environmentally sensitive areas, such as wetlands or an endangered species’ habitat. Empowered by federal legislation, including the National Environmental Policy Act of 1969, each state and locality has created its own environmental laws to which developers must adhere, and these laws vary widely.
Biltmore Park Town Square in Asheville, North Carolina, integrates retail and entertainment uses, offices, a hotel, and a variety of residential types on a 57-acre (23 ha) site. The master plan is LEED-ND certified.
PATRICK SCHNEIDER PHOTOGRAPHY
The least stringent type of required analysis is usually an environmental impact statement, which is sometimes referred to as an environmental site assessment. A more stringent environmental impact report (EIR), based on state and local legislation, may be ordered when a project is expected to pose substantial alterations to the built or natural environment. It is advisable to analyze the legislation to understand the various thresholds that trigger a partial or full EIR, as there are times when more thoughtful design can eliminate or limit the scope of an EIR.
A developer should select an environmental consulting firm that is respected for its technical expertise, independence, and impartiality. Because the results of an environmental report can become a political issue, developers must judge the level of complexity and controversy their project is likely to create and select a consulting team that has experience in projects of a similar magnitude. To ensure impartiality, some cities provide a list of acceptable firms from which a developer may choose. In California, the public sector often randomly assigns an environmental consulting firm to the developer and in some cases, the public agencies may reserve the right to select and manage the consultant, while requiring the developer to pay the consultant.
An EIR not only describes the proposed development, the site, the overall design parameters, and the project’s effect on the local community but also proposes appropriate mitigation measures to offset negative effects, such as increased traffic congestion, soil runoff, and construction impacts. In the case of traffic impacts, the mitigation measures may include widening certain streets, adding left-turn lanes, adding traffic signals, converting some streets to one-way, or expanding public transit service to the area. Major projects may require significant off-site improvements, even new freeway interchanges.
Once a draft of the EIR has been prepared, it is submitted to various state and local agencies, circulated to concerned parties, and made available to the general public; each is allowed a specific period to submit comments. These comments may lead to significant design changes, but they will at a minimum require some sort of response, usually in writing. At this point, a developer must be extremely careful of making promises and making statements beyond the facts at hand.
Thereafter, the developer’s environmental consultant must produce a final EIR that responds to all comments. Any mitigation measure(s) recommended by the consultant must be feasible for the developer to implement. In fact, agencies that regulate environmental impacts typically offer multiple methods of mitigation for those impacts, often allowing cash payment to a state-administered fund in lieu of specific performance. The timing and magnitude of these measures can vary greatly, so the developer must insist on analysis of the potential avenues for mitigation and make an informed decision. Public bodies, usually the planning commission, the city council, or both, generally include mitigation measures in their conditions for project approval, or at least as a condition for the release of completion bonds. These conditions are sometimes referred to as exactions, which are burdens placed on the developer to make financial payments or complete on-site and off-site improvements to mitigate the project’s environmental effects.
Any change to the development plan requires simultaneous changes to the consultant’s analysis and will sometimes require an informal check with regulators to ensure continued compliance with the rules as understood before. A sound development strategy is to secure input from all concerned parties as early as possible, even before the draft submission of the EIR, and to incorporate as many of those changes into the proposed design as possible. Regulators, for the most part, understand this strategy, and many are willing to meet informally, before submittals or review, to answer questions and to outline the process ahead. Developers should take advantage of such an offer, but they should be wary of releasing information in a public process before the design is complete. A balance can be struck by making the conversation about the rules rather than about the development.
The environmental review process can be a moving target and, if not managed effectively, can lead to skyrocketing development costs and delays that wipe out returns. For complex urban projects, it is not unheard of for a developer to have to change the entire project, including use, height, and overall square footage. As this process unfolds, it is important to keep an eye on the market, as the time it takes to secure permits is independent of economic and market cycles and may cause the developer to miss the market or the financing window altogether.
The cost of hiring an environmental consultant varies according to the size and complexity of the project analysis. Most consultants work on a lump-sum basis, with payment schedules tied to performance milestones. Developers should consider that the contract scope of an environmental consultant likely assumes typical regulatory jurisdiction and action, but environmental regulation is a relatively new field. As Matt Kiefer of Goulston & Storrs says, “We are entering a phase of regulatory experimentation. As the public sector has pulled back from direct involvement [in development], the emphasis has moved to performance-based measures.”7 Compliance with these standards can be notoriously difficult to determine. Surprising regulatory interpretations are to be expected, and they will often result in changes to the scope of the consultant.
The consultant’s contractual obligations usually end with the production of the final report, although the developer might additionally require the consultant to make presentations and answer questions from municipal staff, or from the public at hearings. Following contract expiration, the consultant’s compensation is based on a T&M agreement. The contract with the consultant must be reviewed to determine what is and is not included in the initial scope of responsibilities. It is worth noting that, at the point of completion of the contract, the developer will be deeply bound to the consultant by his prior work on behalf of the project, so T&M rates should, if possible, be negotiated up front, as the developer’s leverage typically declines after the initial contract.
Another type of environmental consultant a developer may have to engage specializes in detection, containment, and removal of hazardous materials. Hazardous materials have become a major concern for developers and a significant source of litigation and liability, as well as delays and increased costs for containment and soil removal. Consequently, environmental analysis, including soils analysis, should incorporate tests to determine the presence of toxic materials, particularly heavy metals and known or suspected carcinogens. Ascertaining a property’s previous use(s) is important, as particular uses connote the potential presence of different materials. Developers should be aware that brownfield sites with known or perceived contamination are not the only sites that warrant caution. Greenfield sites that, at the time of acquisition, appear the picture of cleanliness and health may, for example, have supported commercial orchards in the 1930s, when the pesticide of choice was powdered lead arsenate. In this example, the appropriate testing might only be ordered if historic aerial photos have been analyzed.
Environmental reports consist of three phases of analysis. Many lenders require a Phase I analysis for almost any kind of project; it simply involves a title search of previous users to determine the likelihood of toxic contamination. If the Phase I report finds potential contamination from, say, a gas station, dry cleaners, or industrial user, a Phase II report is required to determine the extent of any perceived problem. It usually includes analyzing soil samples, and it always includes at least a cursory examination of the property for clues to the location and potential extent of any problems. If the Phase II analysis finds possible off-site contamination or a serious threat of contamination of the water table, a Phase III analysis will be required.
It is vital to inspect every development site for the presence of hazardous materials, because liability for any future cleanup falls to any and all parties named on the chain of title and may result in personal recourse to the developer—even if the contamination predated the developer’s acquisition of the site in question. Because hazardous waste contamination can involve millions of dollars in cleanup costs, years of delay, and potentially expensive litigation, prudent developers perform the necessary environmental analyses before they acquire a property.
Surveyors determine a property’s physical and legal characteristics—existing easements, rights-of-way, and dedications on the site—and prepare a site map plotting these characteristics. This critical information reveals how much of the site can be built out and the allowable square footage and densities. Because of this obvious relation to parcel value, and because of the central role of the survey in the documentation of the purchase and sale transaction, surveyors are typically among the first project consultants to be hired, typically well before money goes hard on a purchase. Developers often attempt to delay soft-cost expenditures as long as possible, but paying for surveys early can avert disaster in the acquisition. Developers should note that some survey services critical to both design and approvals, such as aerial-topographic interpolation, can only be done (or done accurately and economically) during certain times of year in some regions.
Developers commonly use four types of survey services: a boundary survey, a construction survey, a construction stakeout, and an as-built survey. The boundary survey determines the boundaries of the site (easements and other legal requirements affect ownership of the property being plotted on a map). The construction survey plots the location of relevant infrastructure—water, sewers, electricity, gas lines, and roads—to assist in planning connections to utility services and physical characteristics related to development, such as flood zones, watershed areas, and existing improvements. Surveyors also augment the work completed by soils engineers, analyzing a site’s topography, likely runoff and slope, and the implications for civil engineering of the building’s proposed location. The surveyor will typically return after project design to perform a construction stakeout, which involves the physical setting of annotated stakes that will direct the grading, excavation, and paving crews in construction. Precision of the construction staking directly affects the quality of construction on site. Finally, when all major construction is complete, a surveyor may be brought back to the site for an as-built survey. Approval authorities often require as-built drawings, which precisely indicate building corners, utility locations, public and private roadways, and drainage improvements critical to offsite uses.
A good surveyor also shows all title impingements by making sure everything in the title is found in the survey. One developer suggests walking the site with the surveyor to observe any positive or negative influences on the site that can then be reconciled with the title.8
Costs for surveyors vary according to the type of work they perform, the detail required, and the number of surveys requested. The American Land Title Association has defined standard survey types for various kinds of real estate transactions. Developers should find out early which level of survey will be required by their lender and buyers and commit to at least that level of detail. In addition, municipal, state, and federal regulators may require differing levels of survey accuracy, particularly in topographic surveys. Developers should inquire about these requirements and contract for the most stringent that will be required by any agency during the development period.
Surveyors may work on a lump-sum contract or a T&M agreement. As with other consultants, developers should insist on predictable and firm pricing as early as possible, but additional survey work will likely be required at some point in the process. It is thus advisable for clients to negotiate T&M pricing in the context of the initial agreement, so that this work can proceed affordably and quickly when it is needed. As a general rule, someone who has surveyed the property in the past will be less expensive because he has already done a vast majority of the work. A search of existing plats of the property will indicate the name of the surveyor firm at that time; if it is still in business, the developer would be well advised to solicit a bid. Surveyors can also be important allies because of their involvement with the local regulatory community. In smaller communities, surveyors perform many of the roles more commonly ascribed to land planners and can often represent projects to zoning boards and city councils more effectively than lawyers.
Parking and traffic capacity are often major limiting factors for real estate development. High land values and restrictive local parking ordinances require a well-devised parking plan. A qualified parking consultant takes into account all the significant factors involved in designing the optimum parking for the site. The parking consultant should be included early in the design process so that the architect can incorporate parking recommendations in the overall design.
Parking consultants may be responsible for many aspects of a project: (1) evaluating the economics of a surface lot versus a parking structure, (2) designing an efficient parking configuration, (3) discovering whether local municipal codes can accommodate the estimated parking demand, (4) determining whether parking should be provided free or at a fee, and (5) deciding where the points of ingress and egress will be.
Parking is an expensive undertaking, costing tens of thousands per space for a structured garage. Consequently, the services of a well-qualified consultant are often essential to project economics. Referrals from the architect and other developers can provide a list of potential consultants. Parking consultants usually work under a lump-sum contract or at an hourly rate.
At Ballantyne Corporate Place in Charlotte, North Carolina, more than 1,800 parking spaces are accommodated in garages, allowing more open space to be preserved.
Traffic consultants are included here because their firms’ capabilities often include parking consultation, but the variety of issues they can address is much wider. Traffic studies, for example, are a common requirement of the EIR process detailed earlier. In many jurisdictions, the developer must prove that the proposed development is adequately served by existing roads and transit; inadequate infrastructure is a prime justification for delay and denial by approval authorities.
Renovation or adaptive use of a building constructed between 1920 and 1976 is likely to run the risk of asbestos contamination. Pricing for abatement is competitive in major construction markets. The industry has developed efficient methods of service delivery, and the amount of asbestos requiring removal is declining. Asbestos was commonly used for fireproofing and insulation in the United States until 1973, when federal legislation prohibited its future use for those purposes. Asbestos was sprayed on underlying columns, beams, pipes, and ducts of buildings; above ceilings; and behind walls. It was also used in building materials, such as tiles, exterior siding, and countertops. And in some parts of the country, fibers were mixed directly into wet plaster for interior wall surfaces. Asbestos is hazardous when friable (that is, flaky or powdery); if disturbed, its fibers become airborne and are likely to be inhaled. The U.S. Environmental Protection Agency (EPA) regulates activities like renovation and demolition that could release asbestos into the air and outlines appropriate methods of disposal. Even the installation of sprinkler systems, electrical and plumbing repairs, and any interior reconfiguration might require some form of asbestos abatement.
Removing asbestos requires the services of qualified professionals and permits for disposal of the waste; the hazards inherent in the process could lead to legal repercussions if inexperienced firms are hired to carry out the tasks. The firm selected should be bonded by a certifiable surety company. Both the consultant hired to determine the extent of contamination and the contractor responsible for removing it should be licensed by the state, and it is generally a good idea to engage separate individuals for these two tasks. Developers may contact the regional office of the EPA and the National Asbestos Council for lists of qualified professionals.
Asbestos abatement occurs in two stages: inspection and removal. Consultants charge by the hour or by the square foot. Surveys for a typical 20,000-square-foot (1,860 m2) building, for example, might be around $3,000 for the physical inspection. Consultants collect about 50 samples from the building to determine what material requires removal. These tests cost about $30 per sample.
Estimates for abatement can vary widely, but one important factor is often out of the developer’s control. Many jobs must be carried out while other areas of the building or complex are occupied, which can greatly increase the cost of removal as HVAC systems and connecting spaces must be protected while work proceeds.9
Construction contractors are required to complete an array of services (both before and during construction) on time and, ideally, on budget. They can provide a reality check on such critical matters as construction materials, structural and architectural design, local construction practices, and pricing information and can help establish a realistic budget when brought in early on a project.
Developers can select a contractor through negotiations with a particular firm or through open bidding. To find a good contractor, developers should solicit a number of contracting firms, asking them to submit proposals or general statements of qualifications. Responses should include descriptions of past projects, references from clients and lenders, résumés outlining the experience of key employees (particularly the proposed project engineer or manager), and, possibly, verification that the company is bondable. Payment histories from business credit-reporting agencies, such as Paydex, and audited financial statements should also be reviewed. These submissions can be used to select a company for direct negotiation.
In open bidding, developers send out a notice requesting bids and statements of qualifications. The problem with this approach is that contractors are reluctant to spend time bidding on a project unless they think that they have a good chance of being selected. As a result, the developer may not attract an adequate number of responses from which to choose, especially if the firm is new to development and proposing a relatively small project in a hot market. Two to four weeks are necessary to allow contractors to return satisfactory responses. A comprehensive bid will take longer, on a complex project, but the time can be accelerated by involving likely bidders as the project goes through construction documents.
The most effective way to limit the number of bidders but still ensure that the targeted firms will respond is a combination of a request for qualifications and competitive bidding. After reviewing several contractors’ qualifications, developers may ask the best three, four, or five contractors to prepare a bid for the project. A preference for one contractor could result in direct negotiations with a particular firm. Developers should not feel obligated to conduct protracted bidding if they have already found the best contractor for the job. It is equally important that developers who wish to continue working in a market must respect the time of major contractors. Contractors should not be brought into a bidding process in which they have no chance of success, simply to “keep the other guy honest.”
Jonathan Rose, principal of Jonathan Rose Companies, suggests keeping in mind three points when choosing contractors:10
1. Find someone who is experienced in the product type being considered for the project. A specialist in assisted living facilities will likely not be an appropriate choice for multifamily housing.
2. Be certain that your project amounts to no more than one-third of the contracting firm’s total workload, a good benchmark for organizational and financial stability. That is, if you have a $20 million project, look for a contractor with at least $60 million in total business at the time the contract is signed.
3. Ask for and check references to understand how the contractor has performed for past clients.
During the design stage, a contractor working for fees or a construction price estimator (also called a quantity surveyor) should check the architect’s drawings and formulate an estimated budget for completing the project. A permanent contractor, once hired, is responsible for completing a construction cost estimate based on the construction drawings completed by the architect. If the developer chooses to put the project on a fast track, the contractor should be a helpful source of creative and cost-effective suggestions during preliminary design.
One of the contractor’s tasks is to set up a projected schedule for disbursing loans from the construction lender. The contractor’s major responsibility, however, is the project’s physical construction, including soliciting bids from and then hiring all the subcontractors—construction workers, plumbers, painters, and electrical and mechanical contractors. The contractor is legally responsible for building a safe structure and must hire the best-qualified employees and subcontractors.
Two Constitution Square in Washington, D.C., transforms an obsolete industrial area into a vibrant business and residential district. It is located near transit and has been certified LEED-ND.
Two basic methods are used to determine the contractor’s compensation: bids or contracts. Bids are requested to be in the form of a lump sum or some derivative of a cost-plus-fee contract. A lump-sum bid is used when the design is already established and all the construction drawings are complete before selecting the contractor. This option is rarely feasible for beginning developers, however, because they are probably not willing or able to underwrite the cost of complete drawings until the decision to construct is finalized.
Contractors’ fees are based on the size of the project, the number and amount of anticipated change orders, and so on. On a $10 million project, a contractor should be expected to charge a fee equivalent to 5 percent of total hard costs—in addition to project overhead and on-site supervision costs.
A cost-plus-fee contract is a preferable means of compensating experienced contractors with excellent reputations. Under this option, all costs—labor, salaries of accountants and other such employees, travel, construction materials, supplies, equipment, and fees for all subcontractors—should be explicitly set forth in the contract. The costs should not include overhead and administrative expenses for the contractor’s main or branch offices, and they should not include full costs for assets that are used only partially for the job being bid. Costs that cannot be accurately estimated before contract should be negotiated on a unit basis, such as price per cubic yard of fill, leaving only the quantity to be accurately recorded during construction.
The contractor must calculate the time required to complete the project as a basis for a fixed or percentage fee. Most developers avoid a percentage fee because it does not incentivize the contractor to minimize costs, but these concerns can also be addressed with performance bonuses.
Often, the construction lender requires the contractor to guarantee a maximum cost, or gross maximum price, when the cost-plus-fee method is used. In such cases, the architect is responsible for providing drawings with sufficient detail to allow the contractor to solicit quotes from subcontractors to calculate the maximum cost. Guaranteed maximum cost contracts can include an incentive to save costs; perhaps 25 to 50 percent of the developer’s savings could be shared with the contractor if total project costs are less than the guaranteed maximum. Another model is to split the contingency fee; that is, the developer and the contractor split every dollar saved under budgeted costs, which could amount to 5 to 10 percent of a project’s costs.11
The developer must make sure, however, that the contractor does not sacrifice quality to receive the bonus. Maintaining high quality is accomplished by detailed attention to project specifications and construction documents. Other types of incentive bonuses can also save costs. A bonus for early completion pays a defined amount for completing the work by a specific date; some contracts pay a fixed amount for each day that work is completed before the deadline. By the same token, bonus clauses can be used to penalize the contractor for being late. Some contracts include a liquidated damage clause or a penalty clause to cover late completion. Not surprisingly, contractors dislike such clauses, which, they argue, undermine teamwork.
Bonus and incentive clauses are a tool for guaranteeing the contractor’s performance. The developer incurs costs, however, most notably in the necessary monitoring of the contractor’s performance.
A variety of service firms can provide a wide range of real estate services that are critical in the development process. These firms are usually brought into a project to perform specific, short-term tasks.
Successful real estate decisions hinge on the availability of reliable and accurate information. A market consultant provides the professional assessment of a proposed project’s appeal to various quantifiable groups or types of buyers and tenants. Their deliverable, the market study, analyzes the proposed project’s feasibility based on current and projected market conditions. Lenders, investors, design professionals, and sales staff all use the market study at various points in the development process.
Some developers complete their own market studies, and lenders may accept a well-documented study by a developer, particularly for a small project. But it is always a good idea to get a third-party perspective on the market from a professional market analyst. Which market consultant to hire is one of the most important decisions made during the predevelopment period. Developers may ask other developers for recommendations; however, lenders’ recommendations are particularly important because their decisions depend on the market data proving the project’s feasibility. Although a few national consulting firms offer real estate market studies, market intelligence is a highly localized business. Developers in a well-documented geographic area, trading in a common product bought, sold, or leased frequently, may be well served by a nationally known firm. For niche products, in secondary markets, local knowledge is irreplaceable.
The databases the market consultant maintains are useful indications of the consultant’s approach. Aside from being technically proficient, the consultant must be able to understand the nuances of the market that may not be readily apparent. A good market consultant can identify the proposed competition and thoughtfully analyze the political situation.
Developers should ask to see several market studies that the consultant has produced and make sure that they are comfortable with the assumptions and techniques used. The style of writing and presentation of the report should be carefully examined as well.
The market consultant is responsible for producing a final study that should address all factors affecting the proposed project’s feasibility. As a client, the smart developer looks for a comprehensive study that will give independent evidence about the marketability of the development proposal. (The specific features of the process for various property types are discussed in the appropriate sections of chapters 3 through 7.)
The study should include a profile of tenants or buyers to be targeted and the amenities and lease terms to be offered. It is increasingly common for marketing professionals to define these target groups in “psychographic” terms, rather than simply demographic and income criteria. As such, a well-conceived market study may go beyond identifying the buyer and begin to suggest ways of reaching, vetting, and converting leads to sales. The architect should use the market information to help determine the project’s design, unit sizes, amenities, and so on so that they appropriately address the market.
After the feasibility and business-planning phase, a good market study provides a foundation for sales and marketing decisions and can be particularly useful when multiple brokers or sales agents must cooperate on a single project. The market study can provide the framework for a sales narrative about the project, its neighborhood, and qualitative aspects of the project’s “lifestyle.”
A market consultant’s fee is based on the level of detail that the developer requests. Preliminary information may be obtained for less than $5,000, while a detailed report may cost from $25,000 to $100,000 or more, depending on the complexity of the study. For a preliminary analysis or a quick inventory of the market, the consultant may work on an hourly basis, but larger, more complex studies require a fixed contract.
The appraisal report should state the property’s market value and offer supporting evidence. Three methodologies can be used to complete an appraisal: the income approach, the market approach, and the cost approach. The income approach is preferred for all income-producing property (commercial, industrial, office, and rental apartments). Value is determined by dividing the project’s net operating income by an appropriate capitalization rate. Income determination of value depends on the definition of net income used, and when comparing multiple properties, developers should know that the terms are the same. The market approach uses recent information about sales of properties similar to the subject property to determine a market value. This approach is used most often with single-family residential properties, condominiums, and land. The cost approach estimates the cost to construct a project similar to the one under consideration. It is used to determine the value of recently completed buildings or of buildings without a deep and liquid market, such as specialized industrial facilities. The appraiser should use standard techniques and professionally accepted forms to produce a credible report. Appraisal costs range from $500 for a single-family house to $10,000 or more for a large office building.
Investors, potential buyers, and lenders require a professional appraisal to arrive at a market value that will set the amount of the loan for the proposed project.
Lending institutions usually employ in-house appraisers or select an independent outside firm. Professional appraiser organizations can supply references; their members must demonstrate certain minimum standards to gain admission and are issued a credential such as MAI (Member of the Appraisal Institute).
Many facets of real estate development—taxes, land use, leases, and joint venture partnerships, for example—require separate legal specialists. No single attorney can be an expert in all these topics. For zoning and other activities involving public hearings, an attorney with a proven success rate in cases involving a particular public body might be the proper choice. The ability to work behind the scenes with the local planning staff and politicians may be an attorney’s greatest asset in such cases. Developers of the type of project under consideration can often recommend good land use attorneys.
Attorneys are essential for producing partnership or syndication agreements and contracts for consultants, acquiring property, writing up loan documents and leasing contracts, and negotiating the public approval process. The process of obtaining public approvals can be an intimidating maze for a beginning developer without an experienced attorney and may lead to costly delays or outright rejection. Even when a developer chooses to represent himself in dealings with public authorities, the opinion of a knowledgeable land use attorney is critical. A zoning opinion, for example, provides the owner or developer with a defensible understanding of the development potential and constraints on a particular site, and a seasoned attorney can provide, very early on, a review of a proposed project and an educated opinion on the required steps to approvals and on appropriate time allocations as the developer plans a schedule.
Most developers request that a partner of the law firm or a well-established attorney work on their cases, preferring to pay a little more for the top person to guarantee the best job. For technical work like syndications and contracts, highly recommended junior associates with three or four years of experience may be more cost-effective. Attorneys generally bill clients by the hour, although fixed prices for certain transactions are not uncommon. The developer should obtain an estimate of the total cost for a job before authorizing it and should reach an understanding early on about what constitutes “approval” for work done on the developer’s behalf. Developers who are not lawyers themselves must also admit that they do not necessarily know how long certain tasks will take, and they must be open with their attorney about their fee expectations.
Wisconsin Place is an infill development in Chevy Chase, Maryland. The project includes retail, office space, underground parking, and luxury residences. It was developed by a partnership of three large developers: New England Development, Archstone, and Boston Properties.
STEVEN PURCELL
Leonard Zax, the retired chair of Latham & Watkins real estate group, gives the following tips for getting the best work from one’s attorneys:12
• The scope of different attorneys’ work may overlap, and important issues and transactions sometimes slip through the cracks. The development firm’s general counsel is the best person to ensure legal continuity for a project. In lieu of retaining corporate counsel, it is prudent to appoint one individual already involved in the project as responsible for patching any gaps in representation.
• Distinguish legal advice from business comment.
• Clients need to understand the greater context in which their legal counsel is operating. Be aware of all matters pending between a firm you have hired and public bodies that have influence over your project.
• The most effective lawyer is not always the tough table pounder, nor is he or she effective by always agreeing with the developer. The most effective lawyers take time to listen and formulate a candid opinion of the legal elements that need to be addressed. And developers should listen to their attorney. Too many developers rush to judgment and do not have the patience to hear their counsel’s entire opinion—often on complex issues that are critical to the project’s success.
• Do not establish a fee structure that encourages cutting corners.
Title companies certify who holds title to a property and guarantee the purchaser and lender that the property is free and clear of unexpected liens that may cloud the title. Title companies will defend any future claims against properties that they insure. The type of title policy determines the extent of the protection. Most policies follow a standard format, but many real estate investors fail to read and understand what protection their title policy provides, and to whom, which can lead to problems if claims are asserted after closing and costly litigation ensues.
When selecting a title company, developers should make sure that the company has the financial strength to back any potential claims—they are rated like other insurance companies—and should research its record to find out how long a company takes to obtain a clean title.
Title companies often provide additional services. They provide, free of charge, both current and potential customers with a profile of a property in which the customer is interested. The profile details ownership, property taxes paid, liens, easements, size of lot and improvements, grant and trust deeds, notes, and most recent sale price. Title companies also provide local data, such as comparable sales information and plat maps.
A preliminary title report specifying current liens against the property can be prepared for a fee. The preliminary title is not an insurance policy, but it is a close reading of the existing title. It highlights any potential problems a future owner may need to clear before title is transferred. Standard title policies do not usually provide insurance protection for taxes or assessments not shown as existing liens; interests, claims, or easements not shown by the public records; conflicts in boundary lines; mining claims and water rights; or liens for services, labor, and material that do not appear in the public records. Of particular interest in some areas are historic but unrecorded easements of access, for example, historic public rights-of-way known as “phantom roads,” rights to which can be asserted long after actual use has been discontinued. More common are potentially valid claims, such as family members’ interests in property, which have not been claimed or recorded, but which might still be within the statutory time limit for doing so. An ALTA (American Land Title Association) policy offers extended coverage that does cover such unrecorded claims; it requires the kind of in-depth survey that sophisticated purchasers usually demand.
Title fees can be obtained from any representative of the company and are usually applicable statewide. They are commonly quoted on a scale that slides according to the sale price of the property being insured. More often than not, the seller pays for title insurance, though terms of the purchase and sale agreement can address this directly. Costs associated with ALTA title insurance are variable but are nationally competitive and are usually under $1 per $1,000 of asset value.
Developers need insurance to guard against a consultant’s or contractor’s failure to perform an agreed-on task, and municipalities often require similar guarantees for a developer’s performance. Such a failure may have serious economic and legal consequences for the development project, and potentially for the community. For instance, a contractor’s failure to meet obligations could result in a lien on the developer’s property, delaying if not stopping sales altogether. All public works projects must, by law, be bonded for performance because liens cannot be placed on public property. Private projects do not have to be bonded, but in most instances some form of bond is recommended, and bonding of infrastructure can allow developers greater flexibility in constructing improvements at a pace consistent with sales. Contractors are generally required to be bondable, meaning that they qualify for surety coverage.
General contractors deal directly with a surety company to obtain performance and payment bonds. The developer is required to inform all contractors that bonds will be required before bids are submitted, and contractors consequently adjust their bids to pass on the cost of bonds to the developer. Bondable contractors generally establish a relationship with one surety company and fix an upper bonding limit of credit, which restricts the amount of bondable work that the contractor can perform. Construction bonds are a specialized product, offered by few insurance companies. A surety bond involves a three-party contract in which a surety company (or, simply, a surety) joins with a principal, usually the contractor, in guaranteeing the specific performance of an act to the developer or municipality, also referred to as the beneficiary.
Bonding should not be interpreted as a negative comment on the contractor. Rather, it is a validation of the contractor’s ability to deliver a finished product. Before issuing a bond, the surety thoroughly analyzes the contractor’s firm, including its qualifications and previous experience, its financial stability, and its management structure, and inventories its equipment.
Based on these facts, the surety appraises the contractor’s ability to complete the project. If the firm is deemed stable, the surety issues the appropriate bonds and work can proceed. Even if the developer chooses not to require any construction bonds, the surety’s seal of approval is an affirmation of the contractor’s quality.
The three main types of bonds are performance, payment, and completion.
Performance bonds guarantee the developer that if the contractor fails to complete the agreed-on contract, the surety is responsible for seeing that the work is finished. The agreement allows the surety to compensate the developer with an amount equal to the money needed to complete the project or to hire a contractor to finish the job. Lenders sometimes insist on bond coverage for their own protection. The general contractor, either at the developer’s request or on its own, requires subcontractors to purchase performance bonds and may be requested to provide evidence of this bonding to the client.
Payment bonds guarantee that the surety will meet obligations if the contractor defaults on payments to laborers, subcontractors, or suppliers, protecting the property against liens that might be imposed in response to nonpayment. Developers, lenders, or both often require the general contractor to purchase these bonds to protect them against any future claims of nonpayment made by subcontractors or suppliers. Payment bonds are usually issued concurrently with performance bonds; both bonds often appear on the same form.
Completion bonds, often referred to as developer off-site or subdivision bonds, ensure local municipalities that specified off-site improvements will be completed. Many states require local municipalities to secure the bonds as assurance that the developer will complete the improvements.
The developer may require bid bonds during the solicitation of contractors’ bids. A bid bond, issued by a surety, guarantees the developer that winning contractors will honor their accepted bids. If, for example, a winning contractor finds out that its bid was significantly lower than the others submitted, it may be tempted to withdraw the offer. In such instances, the surety pays damages to the developer, in theory to compensate for time and money lost.
A municipality may not require bonding for private on-site improvements, but it may prohibit presales of property dependent on those improvements until they are completed. Such a prohibition can be a major impediment to some kinds of development projects. In some jurisdictions, the developer may post a bond, surety, or cash deposit to the benefit of the municipality, guaranteeing construction of private, on-site improvements, such as roads or utility service, and thereby gain the right to close sales on properties dependent on those services. The benefits to project cash flow of this approach can be considerable. Where on-site infrastructure is bondable, the municipality will make an independent assessment of the cost to complete the approved improvements and will set the bond amount for each major segment of infrastructure. Bonds will be released by application when the work is complete, following an inspection by an agent of the municipality. Some jurisdictions allow for partial release, such as when a particular road within a development is complete. Rates for these bonds are comparable with the others outlined here.
In most states, surety companies must charge uniform rates. For performance and payment bonds, the rate charged is the same regardless of whether 50 or 100 percent of the contract price is guaranteed; therefore, developers should ask for 100 percent coverage. Rates are based on the contract price and are calculated on a graduated payment scale. The rates for completion bonds are generally higher because they involve additional underwriting.
Opinion is divided about the need to secure the various forms of surety bonds. Performance and payment bonds cost roughly 1 percent of the construction costs, so it is up to the developer to decide whether or not bonding is worth the abated risk.
Ventura Lofts in Houston was developed by Sueba USA Corporation on the site of an abandoned office building. It consists of 265 rental apartments.
PAUL DYER PHOTOGRAPHY
FIGURE 2-2 | Typical Real Estate Sales Commissions
Real estate brokers and leasing agents are hired to sell or lease a project to prospective tenants and buyers. Developers can benefit greatly from the services of a skilled salesperson who is able to quickly and completely lease or sell a project at or near the pro forma pricing. Developers must decide whether to sign an agreement with an outside real estate broker or to place an agent on the payroll. The decision is usually based on the type and magnitude of the project.
The use of in-house agents is most appropriate for large projects and large development firms that can carry the cost. The benefit of an in-house staff is that the developer hires and trains the staff during initial planning, and the agents become very familiar with the project, providing input during design and merchandising. Using in-house sales staff typically results in more complete attention from brokers, who are by nature always on the lookout for the next listing. Direct control over sales on one project also has benefits for other projects of the development firm, as leads, techniques, technological investment (such as website development and mass communications), and advertising can be coordinated and shared. Brokerage can also be a profit center for the project, especially once a project has achieved some operational stability, and general awareness and interest are high.
Small development firms may find it useful to retain outside brokers with local knowledge and who have lower carrying costs. Brokers are usually aware of potential tenants with existing leases that are about to expire; brokers from large brokerage houses may have information about regional or national tenants. In residential and resort sales, a regional or national firm may have relevant experience selling similar products in other markets and may offer creative ways to approach out-of-town relocation buyers.
It is essential to interview representatives from a number of firms to select one with relevant experience. If a perspective broker does not respond positively to the project, another broker should be found, but consistently tepid response from the broker community should concern the developer, especially if elements of the design and marketing plans are still being refined. If a prospective broker currently represents a competitive development, that broker should not be hired because of potential conflicts of interest. Brokers and agents typically have deep roots in their communities and can be early voices in support of the positive economic and neighborhood effects of a project.
The working relationship between developer and broker is defined in a contract referred to as a listing agreement. Under an open listing agreement, the developer may recruit several brokers and is responsible for paying a commission only to the one who sells or leases the property. If the developer completes a transaction without the broker’s assistance, no commission is necessary. An exclusive listing agreement involves, as its name suggests, a single broker.
The most common form of agreement for developers is an exclusive right-to-sell listing. In this instance, the developer selects one broker, who automatically receives the commission no matter who sells the property, including the developer. In the event that another broker brings a buyer to the listing broker’s property, it is usually up to the two to negotiate a split of the commission. To prevent conflicts that might scuttle sales, developers may wish to specify the split in the listing agreement. Predictability and fair treatment are essential, as in all dealings with brokers, who must spend substantial and uncompensated time learning about properties, with hopes of someday being compensated by matching a buyer to the product. Respect for the broker’s time and business needs will go a long way toward a friendly reception for the beginning developer’s project.
Successful projects have been completed with marketing and sales in house, both with outsourced and with a combination of in-house marketing and independent brokerage. Allowing brokers to plan, implement, and pay for the promotional campaign involves them and gives them a sense of responsibility. Since they are compensated only upon sale, the logic goes, they should control the investment of marketing dollars and reap the rewards of success. Developers often prefer to pay for the promotion themselves, however, to retain control over the timing, intensity, and nature of marketing, as well as to maintain the overall image of their project.
FIGURE 2-3 | Typical Lease Commissions (Percentages by Year)
In leasing, the broker’s responsibility is to negotiate leases with prospects while keeping in mind the developer’s goals regarding rates of return and preferred type of tenant. The developer should establish lease guidelines for the broker to follow and should readily accept leases presented by the broker within those guidelines so as to maintain credibility with the brokerage community. Once the project is leased, the developer may retain the broker to lease space as it becomes available.
The developer should negotiate a schedule for commissions that will provide incentives to lease or sell the building as quickly as possible—for example, by providing higher commission rates or bonuses for tours and contracts early in the project to gain momentum.
Real estate brokers work almost exclusively for commission. The broker and the developer negotiate the rate of compensation, which varies according to the type, size, and geographic location of the project, and is typically based on a percentage of the total price for sales (see figure 2-2).
Lease commissions payable to the broker are calculated as an annual percentage of the value of a signed lease for each year of the lease. Over the term of the lease, the percentages paid to the broker are scaled down (see figure 2-3). Half the aggregate commission is typically paid upon execution of the lease and half is paid at move-in.
Promotion spreads the word about the project to the community and differentiates it from the competition in the minds of potential users. Developers often neglect promotion, hoping instead that the project will sell itself; this approach is almost always a mistake.
Part of the process of selecting a public relations or advertising agency involves attending presentations at which the agencies under consideration offer examples of their previous work, samples relevant to the proposed project, and promotional ideas for the project.
Public relations firms not only produce news releases, press kits, newsletters, and mailings conveying information about the project but also can create situations that will give the project positive exposure in the community. Different projects and product types require different approaches to attract interest from potential consumers, and the agency chooses the tools that are most appropriate for a given project. The agency should also be a source of creative ideas to market the project effectively, and it should be involved as early as possible in the conceptual design phase. Aesthetic and programmatic choices, typically made to satisfy concrete demand illustrated in market studies, may also have implications for the project’s branding and identity. Simple and inexpensive choices like street names and amenity locations and types can also be important to advertising strategy, and the input of professionals with these concerns in mind can be invaluable.
Good promotional plans draw attention to the project at strategic moments—groundbreaking and topping-off ceremonies, for example. A good public relations firm can be an invaluable asset when a project is proposed in a contentious political environment. A well-conceived campaign can gain favorable publicity for the project and sell it to the community. Organized community events, complete with well-designed presentations, introduce the company and the project to the neighborhood and local politicians and leave a favorable impression.
A public relations firm can handle advertising, and an advertising agency can often handle public relations. Sometimes, a firm with one or the other strength can be retained for both duties, with support from a stronger player in their secondary skill set. Advertising involves placing ads strategically to promote the project and maximize its exposure vis-à-vis the cost of appearance in media. Many different media and promotional techniques are available, including newspapers, radio and television, and outdoor signs, but most real estate developments receive the majority of inbound traffic now via Internet search and social media websites. A paid Internet search is a cost-effective way of gathering self-directed potential buyers and tenants and depends on a comprehensive strategy developed by experts in the algorithms of search engines. Most advertising firms are well versed in at least the basics of online campaigns, but the developer should not be satisfied with basic knowledge. If a firm’s online facility is weak, its efforts should be supplemented by an experienced technology-oriented firm.
Regardless of how many entities make up the team, it is essential to assemble a comprehensive marketing and public relations plan, with the developer’s input, early in the project, preferably at least a year before sales or leasing begin. Advertising and public relations firms, as well as associated professionals in digital media, generally work on monthly retainers plus expenses to cover radio, television, online, newspaper, billboard, and magazine advertising.
Following construction and lease-up, the developer’s focus becomes operational rather than visionary, with the new focus placed squarely on maximizing value at the time of sale. The two overriding goals are to maintain rental rates and high occupancy rates. As such, this next phase of the project’s life calls for sustained property management.
Property management can be handled through an in-house staff or through a skilled outside service provider. This decision rests squarely on the development firm’s internal organizational skills, whether property management can be a profit center, the amount of time this activity will command, and the opportunity costs inherent in this activity as opposed to pursuing other revenue opportunities. Each situation is unique, and the developer should reflect on the overall vision for the company and how it meshes with this activity. Maintaining property management in house provides certain advantages:
• direct property oversight and quality control;
• constant tenant contact;
• a diversified organizational revenue stream; and
• insight into changing tenant operational issues, which can lead to future development opportunities and higher project quality.
But in-house property management also has some disadvantages:
• Time cost may be high compared with other revenue-producing activities.
• Property type organizational skills, staffing, and experience are limiting factors.
• Economies of scale place smaller developers at a competitive disadvantage compared with professional property management firms.
• Property management can end up becoming a cost center as opposed to a profit center.
The manager should provide a comprehensive short-, medium-, and long-range strategic property plan specifying the frequency of physical inspections, maintenance needs, and a replacement schedule. This plan is particularly important for large capital expenditures, such as roof maintenance and replacement, HVAC systems, and other physical and structural issues. In certain projects with repeated units, even very small expenditures like window washing can add up to severely affect cash flow. Budgeting and planning for the year ahead will reduce unforeseen operating costs and diminish the likelihood of emergency repairs. As frontline personnel, property managers address all aspects of the developer’s relationship with tenants. Initially, managers should supervise the tenant improvement and move-in processes, making sure everything proceeds smoothly; it is very important for tenant relationships to start off on a high note.
Effective managers maintain communication with tenants, so that any problems can be quickly resolved with a high degree of customer satisfaction. It is important to keep in mind that the developer’s reputation is at stake; complaints from tenants directly to the developer are a signal that the property manager is not performing effectively.
FIGURE 2-4 | Developing a Marketin g Strategy
Some contracts call for the property manager to also serve as the leasing agent. This arrangement can be beneficial, as the management firm has the most intimate relationship with the property. A large number of vacancies, however, may call for a more aggressive leasing strategy or may require the expertise of a leasing broker with broader market knowledge. Each situation is unique, and the developer must decide who is more capable of filling any vacancies that arise. High turnover rates are a sign that something—physical, managerial, or both—is amiss, and the developer should take action to determine the causes and remedies.
Operations run more smoothly when the management company is given authority to sign contracts, to release budgeted funds for scheduled maintenance, and to implement capital improvements. The agreement between developer and property manager should specify dollar limits on what the manager can spend before the owner’s approval is required, with the owner’s approval necessitated in all instances of projected capital expenditures.
It is important for tax, audit, and tracking purposes that funds belonging to the property owner and to the management entity be maintained in separate accounts. The management firm should set up a trust account to protect the owner’s funds and to prevent any commingling of funds between properties and entities. Audit reports should be prepared regularly (twice a year is recommended) so the developer can verify rental collections, deposits, occupancies, vacancies, management expenses, and capital expenditures.
Property management services are generally priced as a percentage of the property’s gross revenue, except for very high-end residential units, where the fee might be a fixed dollar amount per unit). Property managers typically negotiate a fee ranging from 1 to 5 percent of gross revenue.
The fee is predicated on the amount of management activity and degree of difficulty the project presents. When comparing bids from management firms, the developer should be careful to determine which costs are included in the fee and which are additional billable expenses to the property (management and maintenance salaries are most notable). This fee does not include maintenance labor and material costs provided by outside vendors.
Some management firms offer to perform property management at break-even cost or at a loss in exchange for securing the right to all potential leasing or sales fees generated by the project. And some brokerage firms offer management services. Developers should proceed cautiously in this regard, as the skills required to effectively engage in each activity are very different.
Most larger developers manage their own properties through dedicated in-house staff or a wholly owned subsidiary. Beginning developers generally choose to use an outside source because property management represents an enormous commitment of human resources to the project, and many management tasks become profitable only when personnel, equipment, and purchasing can be amortized over multiple properties.
The third-party property management firm should be evaluated based on its experience with the type of project under consideration. Careful evaluation should examine a list of all properties under its management, a client contact list, and the résumés of staff assigned to the project. It is important to visit (preferably unannounced) representative properties currently under management to get a sense of maintenance quality, staffing, and overall tenant satisfaction. An additional selection criterion is the buying power of the management firm, which generally is a function of its size: larger firms can purchase services less expensively by employing economies of scale, which can lead to lower operating costs.
A good source for locating a third-party property management firm is the local chapter of the Institute of Real Estate Management, which is part of the National Association of Realtors.13 A property manager’s job begins in earnest once tenants begin to occupy the property. Daily functions include collecting rents from tenants and paying recurring expenses, maintaining common areas, and ensuring that necessary repairs are carried out by soliciting bids, selecting vendors, and overseeing the quality of workmanship.
Lenders have two major concerns: the developer and the project. Lenders first evaluate the developer’s experience and credibility. They learn whether the developer has ever defaulted on a note, how much the company is worth, whether the developer will guarantee the note, and whether the developer has the ability to deliver the project on time and within budget. Lenders then analyze the project, assessing location, the pro forma, and whether it is sufficiently preleased if already constructed.
Among the most important qualities that a lender looks for in a developer are honesty and organization. Demonstrating these qualities is especially important for developers without a track record or without a reputation in a given community.
Construction lenders lend money to build and lease a project. Permanent lenders finance the project once it is built through long-term mortgages. For both types of lenders, the developer’s potential gain is less important than the lender’s potential loss. For instance, can the developer withstand fluctuations in the interest rate during the development period? Does the developer have sufficient equity to cover extra costs if interest rates go up during the construction period or if it takes longer to lease the project?
Relying on their knowledge of the area, lenders weigh the developer’s potential for success against their own fees and exposure. For a construction loan, lenders usually require the developer to supply a market feasibility study and an appraisal. Permanent lenders are concerned about a project’s long-term potential.
The amount of preleasing that lenders require depends on the type of project and whether the loan is for construction or permanent financing. Apartment buildings require little preleasing for either type of financing. Office projects must be 50 to 75 percent preleased, or more in soft markets or shaky economies. Preleasing requirements for retail and industrial projects fluctuate dramatically with the market.
Lenders study a project’s tenant mix carefully. Strong anchor tenants with high credit ratings and a diversity of other tenants are desirable in both retail and office projects. Construction lenders are concerned about tenant mix because they depend on the permanent lender to take out the construction note. Thus, determining the criteria for tenant mix before leasing begins is a critical step. Special project types, such as mini-warehouses and auto marts, are harder to finance because they are considered riskier than conventional retail and industrial projects, having a very limited pool of buyers in the event of foreclosure action. Some lenders finance them, but at higher loan rates than for conventional projects.
Even experienced developers need to convince lenders about the economic viability of their projects. Beginning developers, or those lacking a reputation in the community or real estate industry, must sell themselves and their firms as well.
To find a lender, developers can begin by making a list of prospects. They may want to start at the bottom of the list and practice their presentations before introducing the project to a lender with which they really want to work.
To build a reputation, developers need to avoid common mistakes. In addition to understanding the local market and demand for their product, they must have a well-developed, thorough, and realistic budget; set a realistic timeline with milestones; and have money in reserve or access to capital. Additionally, the developer must demonstrate competency in construction, sales, and leasing.
Cosmopolitan on the Canal in Indianapolis is a luxury rental development of 218 apartments. It was developed by Flaherty & Collins Properties as part of a redevelopment of the downtown.
JERI REICHANADTER
Fees are often based on the size of the deal. For projects under $10 million, lenders typically assess between zero and one point (0 to 1 percent of the total loan amount) for the service of providing the loan.14
Each lender receives a fee as well as coverage of certain expenses, such as appraisals. Additionally, if loan brokers are involved in finding a lender, they too will be paid a fee, typically 1 percent of the loan amount. If a project is anticipated to be unusually risky, an additional one to two points may be added. If the project is larger than $10 million, the fee may not increase proportionally; the net fee may actually be less.
The following are factors that lenders consider when evaluating a potential borrower.
FINANCIAL BACKING/EQUITY. Both permanent and construction lenders are interested in the sources of excess capital. Does the developer have enough resources to carry the project or will the lender be expected to do so (unacceptable for lenders)? Many developers fail because they do not plan cash flow and are unable to finance unexpected costs. Lenders want evidence that the developer has cash available, or at least the ability to raise capital if interest rates go up during construction, if leasing is slower than expected, or if extraordinary cost overruns occur. Lenders also want clear evidence that the borrower understands his financing needs. For example, does the borrower want to find the cheapest loan, one with flexibility, or one with the highest loan proceeds?
MANAGERIAL CAPABILITY. Does the developer understand real estate? In particular, does the developer understand how to work with the local government, subcontractors, and leasing agents? The developer must assemble a team that satisfies these concerns. It is helpful if developers show a catalog with the economic results of transactions they have been involved in, such as cash in and cash out, time period, and internal rates of return. They may also want to include a description of both the good and the challenging aspects of their past development projects. An organized, thorough, and internally consistent application with necessary photos, maps, plans, and financial information creates a good first impression and demonstrates a developer’s managerial capabilities.
CHARACTER. Is the developer open and honest about the obstacles and challenges associated with the development? Lenders look for developers who share their values regarding development quality, marketing, and management. Does the developer repay debts and keep promises? Is the developer litigious?
Developers should answer all lenders’ concerns, recognizing that lenders’ greatest fear is that they will be left with an unviable project. Developers must demonstrate their commitment, resolution, and professionalism. It is best if the developer anticipates problems before lenders point them out.
Several types of financial institutions are potential sources of real estate loans.
Commercial banks are a principal source of both construction and miniperm loans. They usually prefer to lend money for a short term—one to three years—through the construction and leasing period, at which time the permanent lender pays off the construction lender. For larger developers, commercial banks may grant miniperm loans up to five years. These loans are especially attractive during periods of high inflation when developers expect permanent mortgage rates to fall. One hundred percent financing is sometimes available on a superior project, although 70 to 80 percent financing is more common today. In tight money markets, 60 to 65 percent loans are often the only financing available. Beginning developers are more likely to find a local bank than a larger national bank to fund their first few projects. Construction loans are usually made by local and regional banks because of their familiarity with local conditions. Moreover, they have the ability to oversee and properly manage the loan during the construction phase and to monitor the process and progression of construction. After a developer has completed three or four successful projects, larger national banks, which tend to lend greater amounts of money, show more interest. Banks are reluctant to participate in joint ventures but will take part in participating mortgages, which offer the developer higher loan-to-value ratios while giving the bank higher yields through participation in project cash flows.
Although S&Ls were once a prime source of financing for beginning developers, their role today has been greatly diminished. They are no longer allowed to own subsidiary companies, and they cannot participate in real estate joint ventures. Today, they make primarily home and apartment loans.
Life insurance companies fund large projects with long-term loans, typically ten years, and provide both construction and permanent financing. Loans may have fixed rates, unlike those from most construction lenders. Beginning developers with a limited track record will have difficulty attracting an insurance company to a project. For merchant builders, though, the requirements for insurance companies may be worth investigating, as they can provide a source of funding for institutional buyers of completed and stabilized projects.
Pension funds have become a major source of financing for real estate as they have sought to diversify their investments. Their large and increasingly diverse portfolio targets have made them attractive financing prospects for developers. They finance both construction loans and longer-term mortgages, usually at fixed rates. Generally, they finance large projects undertaken by experienced developers. Pension funds often employ advisers who perform all the functions that a traditional real estate owner or lender performs on behalf of the pension fund. They evaluate the project’s location, market potential, projected cash flow, the developer’s reputation, and the project’s quality. Pension fund investments can take longer to finance because decisions do not rest with an individual, but are made by a committee in the organization.15
Global money markets, including foreign investors and foreign banks, play a role in real estate, both in the United States and abroad. Both private capital and sovereign funds poured into U.S. markets during the early 2000s’ boom. Looking ahead, an increasingly globalized financial system will no doubt continue to attract capital from abroad. Just as important, real estate developers and owner/managers must contend with high-growth foreign economies as competitors for investment capital that once would have been reluctant to accept the risk of overseas investment. Although most foreign investors prefer to buy developed properties, usually employing low rates of financial leverage, they also have been important sources of development capital for larger firms.
Avalon Burbank in Los Angeles County was developed by Avalon Communities, a REIT that specializes in developing, acquiring, and managing rental apartment communities.
MICHAEL ARDEN
Syndications and real estate investment trusts (REITs) provide a way of carving up real estate ownership into small pieces that many people can afford. They have been used for raising equity capital and mortgage financing for development projects. Both vehicles limit investors’ liability and provide pass-through tax benefits that flow directly to the investor, thus avoiding the additional layers of taxation associated with corporate ownership. Public syndications are no longer a significant source of capital, although private syndications remain the best source of capital for small developers through limited partnerships and joint ventures with a local or regional investment outlook.
REITs have become an increasingly significant mechanism for raising capital to fund development projects, and they are dominant players in the acquisition of medium to large completed development projects. REITs are entities that combine the capital of many investors to acquire or provide financing for all forms of real estate. A REIT serves much like a mutual fund for real estate, in that retail investors obtain the benefits of a diversified portfolio under professional management. Its shares are freely traded, usually on a major stock exchange, and the REIT’s assets are assembled by sector, with an eye toward specific investment goals, such as capital appreciation, current cash flow, or value potential. The acquisition criteria of REITs are important even to developers who never deal directly with them. Their size within the market for debt and equity financing makes their criteria important benchmarks for any real estate investment, and developers must contend with the presence of public REIT stocks as an alternative, diversified vehicle for investing in real estate. In any potential investor’s mind since the late 1980s must be the question, “Could I just get the upside, with far less risk, by investing in a REIT?”
The most likely financial partner for a beginning developer is a private investor, who can be almost anyone with sufficient net worth and sophistication to invest. Besides putting up the necessary equity, the private investor may be willing to sign a personal guarantee on the construction note—something that beginning developers often require to obtain their first construction loan, or a loan for a project substantially larger than their track record. Occasionally, a private investor funds a project’s total cost. The profit split with private investors may range from 80/20 (80 percent to the investor) to 50/50, but regardless of the split the return to the investor will be privileged over developer profit.
To align the partners’ incentives, the developer should always make some cash investment. On small deals, this investment ranges from 5 to 33 percent of the total equity, but in larger deals it may be as little as 1 or 2 percent. The developer may also be required to take on the first assignment of risk, that is, cover losses up to a certain amount. Because the investor risks a greater percentage of the equity for a lesser percentage of the profit, it is important to have complete confidence in both the project and the developer’s reputation before pursuing a deal.
Investment firms also assemble equity capital from multiple investors to fund new development or to buy existing real estate. Many of these firms work with Wall Street to match up investment funds with developers that provide desired program uses or desired markets in particular locales. Beginning developers who work hard to develop the track record to attract Wall Street money are often surprised at the prohibitive cost of this sort of equity capital. It is worth noting that reporting requirements and other administrative costs rise at least as quickly as the amount financed. Having made the jump to institutional financing, it is not uncommon for developers to recall fondly the simpler arrangements of small deals with high-net-worth individuals.
The issuance of commercial mortgage–backed securities (CMBSs)—the sale of bond-like interests in portfolios of mortgage-backed loans backed by commercial real estate and sold through the capital markets to individual and institutional buyers—gained market share in overall holdings of real estate debt, growing from less than 0.5 percent of the value of outstanding commercial real estate mortgages in 1989 to almost 14 percent in 2000. This sector ground to a halt in the 2008–2009 financial crisis and the forced receivership of the government-sponsored entities like Fannie Mae. As of this writing, issuance of CMBSs remains moribund. Still, the growth of securitized debt has deeper roots than the early 2000s’ run-up in real estate prices, and developers of quality large-scale projects should anticipate a return of these financing sources.
Some large U.S. corporations use their power in financial markets to establish credit companies. Some of these companies, such as GE Capital and GMAC, provide construction and redevelopment financing. Compared with banks, credit companies are subject to less federal government regulation. As a result, they are often willing to lend on projects that involve more risk or are more complex than those within the parameters of commercial banks. Often, however, they charge higher interest rates and require stronger recourse measures in the event of default.
Since the 1980s, mezzanine debt has been established as an intermediate funding mechanism that usually supplements the equity investment and first mortgage. Any of the lenders identified above may use it. Typically, deals with mezzanine debt are structured with a 70 percent mortgage, 5 to 25 percent mezzanine debt, and the remainder from the developer’s equity. Unlike a mortgage, a partnership interest is assigned in case the developer defaults on the loan, making mezzanine a convertible debt-equity instrument, whose pricing typically reflects that hybrid position. As such, mezzanine financing must always be compared with preferred equity investment. These loans are typically short term, anticipating takeout by lower-rate debt or sale, and have higher fees: 2 to 3 percent is common. Mezzanine debt loan rates were running 11 to 13 percent in the early 2000s (3 to 5 percent above prime) and like many other sources of project financing, the mezzanine market substantially collapsed during the financial crisis of 2008–2009. Although interest rates are significantly higher than construction and permanent loan rates, these loans take the place of equity, thereby reducing the most expensive money that a developer has to raise.
Several different types of lenders finance construction loans. The specific institution funding a project depends on the development team’s level of experience and the type and size of the project. Most construction loans today have interest rates that float with the prime rate. Construction loan interest rates typically run 150 to 300 basis points (1.5 to 3 percent) over prime, depending on the developer’s size, experience, and credit rating. Thus, if the prime lending rate (to a bank’s best customers) is 6 percent, construction loan rates would be 8 percent, assuming a 200–basis point spread over prime.
Beginning developers should start their search for construction financing with a banker they know. They should ask for referrals and choose half a dozen potential lenders. They may also solicit the advice of other developers in the field.
Once the construction loan is closed and the construction lender begins to fund construction of the building, the developer should be aware of the lender’s concerns and try to address them before they become problems. If a project is falling behind schedule or going over budget, the developer should inform the lender quickly and not allow the lender to hear the news from its inspector, or from third parties. All experienced real estate lenders understand the complications that can arise during the development process. They can often advise the developer about financial strategies that can be employed while the obstacles are being overcome. Regardless, it is paramount to keep lenders informed to maintain their confidence and trust in the developer.
Developers must recognize and address the varied concerns of construction lenders:
• Design—Lenders are increasingly concerned about a project’s design. The general trend is toward better-quality projects, and national trends toward sustainability or preferred project types (rentals versus condominiums, for example) may be built into lending officers’ guidelines for approval.
• Permits—Developers must prove that all permits and entitlements are either in place or forthcoming so that the project is not subject to delays or moratoriums.
• Environmental Factors—Most lenders require a borrower to indemnify and hold them free and harmless of any liability resulting from toxic or hazardous waste located on a site. Lenders typically require at least a “Phase I” assessment before closing.
• Insurance—The builder’s risk and general liability insurance must be in place; usually, with lenders named as additional insureds, and as new contractors join the project, certificates may be required of each.
• Developer’s Capacity—Lenders evaluate whether the developer’s associates or partners can complete the project if the developer is suddenly injured or they must bring in another individual.
• Credibility/Integrity/Cash—Lenders analyze the developer’s credibility and integrity and the status of his cash flow—anything that may prevent the completion of the project.
• Disbursements/Inspections/Lien Releases—Most lenders inspect the site monthly to verify requests for payments. If a lender has problems with lien releases (suppliers and contractors can file a mechanic’s lien against the property if they are not paid), the lender may write joint checks to the developer and contractor. A joint check must be endorsed by all payees, and it helps a lender ensure that the contractor and suppliers are paid so that the collateral is unencumbered. The check endorsement by the contractor serves as proof of payment and protects the lender (and the developer) against frivolous mechanic’s liens.
• Standby Commitments—Construction lenders are not in the permanent mortgage business. They require assurance that their loan will be repaid at or soon after completion. Standby commitments provide assurance to construction lenders when permanent financing has not yet been arranged. Normally, the standby commitment is never exercised because developers find permanent financing before their construction loans expire. Standby commitments are available from certain banks, insurance companies, credit companies, and REITs. Fees for standby commitments run 1 to 2 percent of the total loan amount each year that it is in force but remains unfunded (the developer has not borrowed any funds under the standby commitment). If the standby loan is actually funded, interest rates typically run 5 percent or more over the prime rate. Although standby commitments are expensive, they allow developers to proceed in situations where a construction lender demands some form of takeout commitment before it will fund the construction loan.
Once the loan agreement is operational, the developer must make prompt and punctual payments, maintain the project in good operating order, and keep all insurance and taxes up-to-date. If problems arise, the lender should be informed immediately. By being candid, a developer will retain the lender’s confidence and find it easier to obtain financing the next time.
Both mortgage bankers and mortgage brokers help developers obtain financing for their projects. In some cases, the broker assists the developer in getting financing but does not have direct access to funds, whereas the banker has direct access to funds and usually services the loan as well.16 The relationship between the banker or broker and the client differs somewhat. The banker has a fiduciary relationship with the client, whereas a broker acts as an intermediary and merely looks for the best combination of funding for the client. A developer may use a single broker or hire different brokers to help find mortgage financing and equity financing. Brokers assist the borrower in preparing a summary package for the deal, including underwriting and research, marketing the loan to many lenders using their established relationships, and negotiating, processing, and closing complex deals and transactions.
White Provision in Atlanta is an adaptive use of a 1910 meatpacking plant. The project comprises a mix of office space, retail, restaurants, and condominiums.
ROLEN PHOTOGRAPHY
Some developers believe that using a mortgage broker adds an unnecessary middleman, but others say it is necessary because loans can be very complex and a financial specialist such as a broker can help find more creative solutions to financing. Some developers also believe that it is important to give bankers or brokers exclusive rights to assemble the capital to maintain their full attention, rather than spreading this responsibility to multiple parties. In such cases, the developer may want to require the intermediary to seek other investors and split fees if necessary or to go to other bankers to access their exclusive list of lenders. In some instances, a developer may ask the banker or broker to work with the developer’s own established contacts for lenders, which may result in cutting the broker’s fee.
Not every banker or broker is suited for every project. Developers should not be afraid to ask brokers and bankers for their credentials and references and should find out which projects they have financed and how well versed they are in the real estate business. Developers must also question how a prospective lender’s specific system works: How do the developer and contractor request draws? Will the lender allow a land draw up front? How often will the lender visit the site? How and when are interest, points, and origination fees paid? At the same time, developers can indicate their readiness to use a lender’s services again if they prove to be satisfactory this time. Eventually, developers may want to approach lenders with the idea of starting a long-term relationship. Once a relationship with a banker or broker is established, a developer can get the most out of the association by considering the entity as an integral part of the team whose function is to bring expertise about the capital market to the table. It is also important to provide full disclosure of both the strengths and weaknesses of the deal to the banker or broker.
Mortgage brokers’ fees vary. The standard fee is 1 percent of the loan amount. The lender also charges fees for the application, the appraisal, and all the other costs of a loan.
The permanent loan provides the takeout (repayment) for the construction loan. Banks, insurance companies, and pension funds make permanent loans. Increasingly, permanent loans are securitized on Wall Street, where they are sold to investors in the CMBS market.
Traditionally, a developer must have a permanent loan takeout in place to obtain construction financing. Larger, more experienced developers with strong balance sheets may be able to get a construction loan without a permanent loan commitment, but beginning developers most likely will need to have a commitment for a permanent loan before they can begin construction. Permanent financing usually has fixed interest rates, and although the loan is typically amortized over 30 years, the term of the loan is often limited to ten years. At the end of that time, the note is renegotiated or refinanced by a new permanent loan.
Most of the concerns listed previously for construction lenders apply equally to permanent lenders. Permanent lenders look to the property more than to the borrower for assurance that they will not lose their investment. In most cases, developers do not sign personally on permanent loans. Thus, a strong and fully leased property owned by a financially weak party will obtain financing more quickly than an unleased property with a strong owner.
A developer should thoroughly understand the lender’s criteria, such as the percentage that must be preleased, and should compare effective borrowing costs on different mortgages—a computation (discussed in chapter 4) that takes into account interest rates, fees, points, prepayment penalties, and other costs, as well as anticipated holding time until the developer sells or refinances the property.
Development is always a team effort. The lenders, contractors, professional consultants, and other specialists described in this chapter represent the major players with whom developers must be familiar, but they are not the only ones. As development becomes increasingly complex, other talents and specialties must be found, and particular regional characteristics sometimes require unusual specialties. For example, environmental and political consultants were only rarely employed as recently as 20 years ago. Today, they are commonly part of the development team.
Successful projects depend on the developer’s ability to manage the many participants with divergent experience in a process toward a common goal. As development becomes a more complicated and expensive business, simply gathering and sifting through the relevant information becomes a herculean—and critical—task. The developer must be able to recognize high-quality work in many disparate disciplines and must know when to ask questions, whom to ask, and what to ask. The developer must strike a delicate balance between trust in the decisions of the players on the team and constant oversight of work on the critical path of the development timeline. If mistakes are made, the developer is ultimately responsible: to investors, to lenders, and to the community.
NOTES
1. Richard Hardy, “Strategic Planning in Development Firms,” Journal of Real Estate Development (Spring 1986): 29.
2. Interview with Peter Inman, Inman and Associates, Irvine, California, 2010.
3. Small homebuilding firms and industrial developers also tend to be organized by function because the nature of their business is repetition. Repetition, especially in leasing and construction, lends itself to more functional organization, in which activities are more specialized.
4. See www.aia.org for more information.
5. A mechanic’s lien gives a contractor the right to retain the property if payment is not made.
6. Interview with Ronald Stenlund, president, Central Consulting Engineers, Green Bay, Wisconsin, November 2010.
7. Interview with Matthew Kiefer, attorney, Goulston & Storrs, Boston, Massachusetts, 2010.
8. Interview with Jonathan Rose, principal, Jonathan Rose Companies, Katonah, New York, May 2002.
9. Interview with Douglas Hahn, senior environmental scientist, URS Corporation, Los Angeles, California, March 2002.
10. Interview with Jonathan Rose, May 2002.
11. Interview with Patrick Kennedy, owner, Panoramic Interests, Berkeley, California, March 2002.
12. Interview with Leonard Zax, Latham & Watkins real estate group, Washington, D.C., December 2001.
14. Points are expressed as percentages (1 or 2 percent), whereas basis points are expressed as hundredths of a percent (100 basis points = 1 percent).
15. NAREIM, the National Association of Real Estate Investment Managers (www.nareim.com), is the association to which pension fund real estate advisers belong. Member organizations represent a very important class of financing sources for developers, as well as jobs for real estate students.
16. Loan servicing involves collecting loan payments and sending them to the current holder of the loan. The originator often sells loans to another lender. The servicing agent does not necessarily change if the loan is sold.