In real estate development there are many reasons and ways to determine what a parcel of land is worth.  It’s easy to figure out what a house in a neighborhood that has an abundance of sales activity is worth.  We all start with the average sales price per square foot on recently sold homes in the same neighborhood.  Adjust the per sq ft number up or down based on the level of finish (floors, counters, fixtures, etc.), amenities (pool, outdoor kitchen, 3 car garage) and precise location (backs up to permanent open space, views, away from heavy vehicular traffic).

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It’s far more imprecise when considering the value of that neighborhood’s vacant land in the state when no development improvements had begun, and houses had yet to be constructed or sold.  Appraisers are independent certified professionals who can offer an opinion of value on the land, your building, your house, or whatever else you need.  They’re most often called in when you’re securing debt on property, from a construction loan to mortgage, or even the public financing options that I discussed in the previous blog post.  Appraisers are hired by the group or institution that is doing the lending to provide some comfort that there is value in excess of the debt to be provided.

Appraisers are doing the same work as the county assessor and the underwriter for the developer who is trying to figure out what a piece of land is worth.  There are two key ways to determine value on an undeveloped land parcel.  Appraisers use discounted cash flow models or look for market comparables.  In a perfect world they have both.

A discounted cash flow is a business model that shows the cash flows, in and out, over the life of the project.  In real estate development the first big outflow will be for acquisition.  Second, you’ll see outflows to design the project and obtain county or city approvals.  Next, you’ll see outflows for construction of infrastructure and for the team to manage the process.  Finally, you’ll see marketing outflows that ideally soon generate sales, and cash inflows. 

The discounted cash flow (DCF) will take those periodic cash flows and discount them by a factor that incorporates the relative risk of the project, inflation, and bakes in the cost of the invested capital that is used to fund the costs.  DCFs are strange in that the discount rate is negotiable but should be relatively similar to projects with similar profiles and life spans.  Regardless, take all the cash flows in and out over time, apply the discount rate, and you have a present value of the project.  The appraiser is generally going to start with the developer’s model since it’s presumed the developer has a reasonable handle on the costs and the market for sales.

In almost every instance the developer wants the appraisal or valuation to come in as high as possible.  Except when you’re dealing with the county assessor, in which case you want their DCF to generate as low a present value as possible.  Adjusting costs higher or lower, adjusting sales volume and pace, and tinkering with the discount rate will all drastically change a project’s value.  Excel is the tool most everyone uses.

This just begins to touch on the art and science of valuation.  There is a lot of gray area, but it can be critically important in determining if a project will get off the ground.

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Public Land Finance

There are many ways to finance real estate development.   Owner or investor equity and bank debt are the traditional ways to fund development.  But there is another way, unknown to the general public, rather mysterious and complex, and dominated by experts in this niche industry.  Developers can unlock serious funding for public infrastructure if they can develop relationships with governmental entities that are willing to sponsor their plans and can assemble the team of attorneys, engineers, consultants, and financiers that it takes to get it done.

Public finance is a local industry.  As far as I can tell it differs from state to state and some states utilize the tool more than others.  In Colorado they have Metro Districts, in Nevada they have Special Assessment Districts, and in California they have Community Facilities Districts.  I’ve worked on several Community Facilities Districts (CFDs) but assume the mechanisms are similar in every state and also assume all 50 states have a similar tool on their books.

CFDs in California are commonly called Mello-Roos districts, named famously (or infamously) after the California legislators who sponsored the bill that created the structure.  All these districts are a way to promote development of public infrastructure while funding it with a tax assessed on the land that is developed and assumed to have a much-increased value once the roads, sewers, electric lines, stoplights, fire stations, and water tanks are completed that will benefit the land.

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A developer/landowner must partner with a municipal agency that has the legal authority to levy a tax.  Municipal agencies (cities, towns, utility districts, services districts) will engage if there is some benefit to them such as a new fire truck or a new well.    It also allows them to build their empire by increasing the size of the public infrastructure they manage and the residents/customers for their services.

When the developer owns all the land, they can vote to allow a special tax to be levied on the land.  The municipality can then sell tax-exempt bonds based on the special tax they are going to collect over the next 15, 20 or 30 years.  The municipality will engage an investment bank to do their magic to figure out how much total dollar volume can be sold based on the projected tax collection.  They’ll figure out what interest rates need to be offered (lower rates mean more debt can be serviced) and how to sell the bonds to institutions and retail clients.  Of course, the bigger the issuance the bigger the commissions collected by the bank so they’re properly motivated.

The bonds are sold with many disclosures to ensure that bond buyers know the revenue sources that will pay them, what the bonds paid for or will pay for (the facilities), and how the bonds fit into the overall tax load on the properties that will pay them back.  The tax load cannot be too high relative to the value of the property.

The bonds are generally regulated by the SEC and can achieve a rating from the bond rating agencies.  However, if the bonds are being sold ahead of the development happening that will create the value that will support the bonds then you have “story bonds”, with no rating.  The buyer has to believe the seller’s story and believe they can execute on what they promise.  As a bond owner, you look forward to the day in the future when your cash flows are supported by the 1500 new families that own new houses in the brand-new subdivision rather than paid by the one developer/landowner who is in the early stages of taking a large risk in developing the land.

The public financing can significantly reduce the upfront capital investment in the project required by the owner when the bond proceeds are used to acquire the completed public infrastructure from the developer, but the tax obligations and servicing of the debt, and ultimately repaying the bond debt, remain attached to the land until they’re paid off.

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Due Diligence

Due diligence is a term common to many lines of business and industry. It simply means to do your research before making a purchase. According to the Investopedia site it became a common practice and common term with the Securities Act 0f 1933. The law was meant to ensure that investors had access to truthful and relevant financial information and disclosures when considering the purchase of publicly traded stocks and other financial instruments.

In real estate due diligence is a similar concept but can be a very lengthy and complex process, with lots of room for interpretation and errors. You’re looking for a piece of land to develop. You think you have a good idea for how to use the land that will be in demand. You’ve got some money committed for purchase and improvements based on your plan generating a return. Now the fun starts.

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The nice thing about buying land is that you can see it, feel it, walk on it, observe the activity that happens on and around it. But in 21st Century America it can often be what you cannot see that matters. There is no land that someone doesn’t own. And there are a lot of individuals and groups that have rights to land they don’t own.

In Nevada the federal government owns approximately 85% of all land. Even when land is not publicly owned it usually has some designated use in the municipality in which it exists.

The first step in your due diligence will be to figure out what you’re allowed to do with the land. Can you build residential units? Homes or apartments? Can you build commercial? Can you farm it? Does a certain percentage have to remain undisturbed? How tall can you build? Etc.

You’ll find most of the critical information about the property in a title report. The title report will list all the ownership claims to the land. It will list all the easements. The easements determine who is allowed access to the land for various uses. Is there a major utility that runs underneath your property that can’t be disturbed and occasionally needs maintenance? Does someone have the right to drive cattle across your property every spring and fall ? (I’ve seen it). Does a mining company have rights to access some valuable mineral found deep underneath your foundation? Better know now.

When you enter into contract on land the contract will usually define a due diligence period which allows some time for you to perform this research before closing on the property. The contract will usually allow for refund of the deposit if you find anything that’s detrimental to the value of the property. The seller will usually provide any relevant information they have about the land that will help facilitate a sale, but not always. It can be a nice head start but you’ll want to rely on your own team of experts. Lawyers, land planners, engineers, architects, hydrologists, geologists, biologists, and lobbyists may all be critical in determining the allowed use.

There’s plenty more to consider when purchasing land and I’ll revisit this topic in the future. Just remember to leave no stone unturned. It’s often what you don’t know that can be dangerous.

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The term leverage is used a lot in real estate development finance.  It goes back to concepts I’ve discussed in previous blogs, that typical real estate project financing will involve debt because it tends to be cheaper money than equity.  To say that another way, the debit has a lower risk profile and therefore demands less return for its use.

When we describe leverage think about how you might use a lever to move a heavy object or to pull a nail.  You will use less force to achieve the results you’re after. 

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Using leverage in a real estate development means you’ll use less of your money, or equity, to achieve the same result.  You’ll have additional costs in the form of interest (and fees) so you’ll make less total cash, but the percentage return on the investment increases dramatically.  See picture below and explanation that follows.  I’ve used simple numbers to illustrate the concept. 

The project costs $100, but it costs $105 if you’re going to pay $5 (6.25%) interest for the $80 you’ve borrowed from the bank.  The project revenues are the same.  You’re building the same product so the market sales price (revenues) will not be affected one bit by how the project was financed.  Your total cash return goes down in the bank finance model because you the have the additional costs related to bank borrowing.

But the reason projects use debt is because of the ability to lever that return, to really crank up the % returned on the smaller equity investment.   You give up some dollars, and you give up some control due to the bank’s involvement, but if everything goes well the results are tremendous.

This example is simple but is another way to show how real estate development can generate tremendous returns when done right.  There is a reason for the term real estate mogul and this principle of generating huge returns on a project show how you get to the level of owning professional sports teams.  Commercial and residential real estate development are the same in this regard.  Access to bank debt can make or break your ability to get projects done and the ability to generate impressive returns for you as owner or for your investment partners.

Now, leverage can also turn.  The Great Recession was the result of leverage gone bad.  It’s important to remember that when the project is selling the debt is getting paid off first.  Generally the equity is only returned, and the equity return earned, when the debt is gone.  The capital stack defines how proceeds are distributed.

If the project does not generate enough cash flow to pay the debt, if project sales are delayed and the interest payments exceed what was planned, if the debt is not paid off in the time frame laid out in the loan docs, it’s easy for problems to snowball.  The financial crisis was a result of getting too loose with debt.  When the underlying assets were reduced in value in such a way that the debt was silly relative to what supported it, lots of people and businesses got crushed.

Leverage can be very good, but it can also be very bad.  Use with caution.

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Bank Debt Financing

In the capital stack, having some of your own money, or at least money you can control, the equity, is critical. When you’re looking for land, when you’re planning a project, when you want to put land under contract and need to hire a team of consultants to understand exactly what you’ve got, you’ll need some cash to spend. It’s a given that the first dollars you’ll spend will be equity, creating value and an ownership position in the project you want to develop. After that, most real estate development projects will seek debt financing.

Lenders need to loan money. It’s what they do to earn revenue. Banks are the obvious choice of funding for good reason. Their mission is to loan money. Think back to how George Bailey explained it in It’s a Wonderful Life to his fellow citizens of Bedford Falls. The money doesn’t stay in the bank, it’s loaned to help the local businesses and property owners in the community. Banks lend, but they’re cautious and risk averse. They only need to make a minimal return on their debt investments, but they desperately want to avoid losing a penny.

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If you can get through the bank hurdles, the money is cheap, and the funding can be readily available. But it’s not easy or quick, generally, to establish a lending relationship with a bank. Because real estate is risky, they want to be in a position so that even if the worst happens, they can recover their funds.

You’ll need an environmental study to prove there’s no nuclear waste or major earthquake faults on the site. You’ll need a very detailed land survey so there’s absolute clarity about what is being offered as collateral. You’ll need an appraisal that validates the value of the land. You’ll need a nice sales piece explaining the market and why your project is a can’t lose proposition.

You’ll need attorneys to review the documents the bank wants you to execute. You’ll need proof from all the local government agencies proving you’re allowed to do the project and that they will provide services. You’ll need pretty pictures and maps. You might need to offer up everything else you own as a guarantee. And you’ll have to pay for all of this, including for the bank’s attorneys who draft the documents with a bias against you, to get it done.

Any significant business decisions you make about the project design, construction, and sales will be subject to approval by the bank. But the truth is, it’s worth it for the prime rate money available to pay for 70% to 80% of your total project costs, including the land acquisition.

There are other options. The hard money guys who are happy if you fail so they can take the project. The mezzanine debt lenders who may take your company if you fail. So, banks, despite the time and complexity they bring to the process, are a critical source of funding for almost every real estate development you see. Also, equity returns can be increased on a percentage basis with leverage. I’ll break the concept down and demonstrate that simply in a future blog post. 

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Debt can be good, unless Mr. Potter wants to wipe you out. Be careful.
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The Capital Stack (Part 2)

Because real estate development is risky investors in real estate demand a return commensurate with the risk.   You’re happy to buy a government bond supported by the good tax-paying citizens of your community and earn 4% tax free.  You’re happy to buy stock in Procter & Gamble (PG) and earn a 2% dividend annually plus expected price appreciation that will net your investment a return greater than inflation….between 6% and 8% on average would be just fine.  And you’ll buy that Vanguard index fund which spreads your risk across the performance of the largest U.S. companies and be happy to take your 7% return and go home.  If you’re buying riskier junk bonds you expect a promise to pay 8% to 10% interest rates.  If you’re funding a new tech startup out of someone’s garage, you’ll expect even more. Residential real estate can be even riskier. 

In my experience part of the capital stack is going to include an investor, or the “money partner” in a partnership, that owns the project.  There is usually a difference between the operator and the money partner.  There are plenty of groups across the country that want to invest money in real estate looking for returns in excess of what the stock or bond market can provide.  There are also plenty of groups that enjoy developing land, shaping their community, and creating places for people to live and work.  A typical structure pairs a deep-pocketed investor with a local operator who can bring the vision and the hands-on involvement to bring a project to fruition.

The local development group is usually happy to earn a management fee for the time spent working on the project but will also want to share in any upside should they create a profitable project.  The investor will want a return that makes the investment worthwhile.  Capital stack structures I have seen provide for the investor to earn a defined return (between 10% and 15% ) and get all their invested capital returned before cash generated (from sales or debt) goes anywhere else.  The developer will earn their management fee as a capitalized cost related to delivering the project.  But after the capital has been paid back, the return has been paid out, and the management fees have been earned is when the capital stack gets interesting.

The profits can be split in many ways, either a standard percentage (maybe 90/10), or can allow for the developer to earn an escalating share of the excess as profits are delivered.  The profits will drive up the return for the investor partner and incentivize the developer to manage the costs and drive the revenues.  I once had a colleague explain to me that successful developers aren’t in it for the salary (or management fees), they’re in it for that split.

Once a developer can prove to investors they can provide a desirable return on invested dollars the developer can demand better terms for themselves.  Again, it all goes back to risk.  Delivering a successful real estate project from land to final build-out and sale is complex, can take a long time, and may have to endure up and down cycles in the economy.  That is why there must be returns to the parties in the capital stack above and beyond what’s available in other investment products.

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The Capital Stack (Part 1)

You’ve got a project you think makes sense. It makes sense for your team, for the community, for the ultimate end users (the buyers), and your financial model says it will generate positive cash flow in an amount that justifies the investment.  The next step is to figure out how to pay for it.

Just like real estate developers are always looking for the next deal, they’re also always looking for funds.  Only large and well-established real estate companies (think Trammell Crow in office or Toll Brothers in housing) have enough cash within their organization to start and finish projects with their own money.  The typical developer will have just enough cash to prove to others they have some skin in the game and they think the project is good.

The capital stack defines how the project will get paid for and how the parties that invest in the project will share in the financials rewards (or losses). 

If you have a mortgage on your house, you have a capital stack.  You likely had to come up with some portion of the purchase price to buy your home.  That was the equity and that was your way to prove you believe in the value of the house.  You own it, but if you have a mortgage then there is a bank that also has a stake and is part of the stack.

Banks are not in the business of owning houses for long periods of time and trying to make money when they sell five or ten years down the line.  They are in the business of lending money and collecting interest payments on that money.  They’re part of the capital stack required to fund your home, but each party has their own purpose, their own defined financial rewards and risks, and their own protection.

You own your house and your name is on the grant deed recorded with the County, but the bank has a deed of trust recorded on the property that says they can take it from you if you don’t perform.  They want you to pay interest and pay them back the principal over time.  If both parties act as agreed, you end up owning your house and the bank makes decent interest on their loan.

The real estate development business operates under the same principles.  The owner is usually going to put up the first money to buy the land and start the development.  Then you hope to have a bank fund the balance of the project.  However, real estate development is different from a residence because the owner is likely to be a partnership, perhaps an LLC with multiple members, each with different responsibilities and obligations.  Those owners must have an agreement about who is going to fund the upfront dollars and who is going to get money back after any debt is paid off.  The capital stack is often defined in a partnership or operating agreement.

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