Development and management

Real Estate Principles: A Value ApproachLing and Archer

Outline

Process of development Operation: ongoing management

Occasions for development

A use in search of a site: New locations for expanding franchise. Need for a new school.

A site in search of a use: Raw land in path of urban growth. Land adjacent to new freeway intersection.

Resources in search of an opportunity: Pension fund with money to invest. Private investor looking for high-yield

investment.

Process of development

1. Establishing site control

2. Feasibility analysis, refinement, and testing

3. Obtaining permits

4. Design: Architect and other professionals

5. Financing

6. Construction

7. Marketing and leasing

8. Operation

The time line

1. Establishing site control

Wide differences in access to land. Land already owned.

Dream case. Land assembled for specific purpose.

Difficulty of land assembly often justifies government involvement in urban renewal.

Assembly of land for Walt Disney World—devised elaborate blind entities to acquire all of the pieces of land to eliminate a “hostage/holdout” situation.

A holdout in ChinaThe builders have since excavated a 10-metre pit around Yang's house, so he is holed up there without water or electricity, threatening to use his martial arts skills against anyone who tries to dislodge him.

Source: CBC News; AP

Another holdout

Source: AP

WSJ, June 15, 2007

“The Clise family began buying prime real estate here (Seattle) in 1889…Now, after patiently accumulating 13 contiguous acres downtown…the family is putting the land on the market.”

“The area…has the potential for 13 million SF of development—which would rival the size of…the entire World Trade Center complex in New York.

“My father talked to me about this…you do not want to sell this off piecemeal…the value is in the assemblage as a whole.”

Tools for site control

Options: right (but not obligation) to purchase land in future before a certain date, at a predetermined price. This gives time to developer for conducting

feasibility analysis, run construction and environment evaluation, to obtain necessary zoning, etc.

Joint venture: landowner puts land into development in return for share of profits. May do joint venture with future tenants as well.

2. Feasibility analysis, refinement, and testing

Financial feasibility question: does the value, when built, exceed the cost? An application of NPV analysis.

Tests and surveys that may be necessary: Soil tests. Environmental tests. Critical habitats (Endangered Species Act). Seismic tests (earthquake vulnerability). Archaeological (prehistoric ruins).

3. Obtaining permits

Multiple layers of permits may be needed. Site plan review. Regional and environmental impact review. Zoning change.

Site plan review: an inevitable hurdle. Complex set of issues. Rules and criteria involve interpretation by authorities. Neighbors usually resist change. Negotiation is critical skill: important to building support of

authorities and citizens in advance. Negative decision can kill a project in one meeting.

Hurdles

NIMBY: not in my back yard. BANANA: build absolutely nothing

anywhere near anything. “Every successful developer is a good

negotiator …. Through a thicket of obstructions and objections.”

4. Design

Architect: represent developer in hearings for permits; provide pre-design schematics of user functions and resulting spatial interactions; provide complete design; serve as project manager.

Land planner: creates development layout or “map.”

Landscape architect: Shapes topography, soils, vegetation, and other objects around a structure to harmonize with and enhance it.

Engineers: soil, mechanical, electrical, civil, etc.

Greener buildings, greener bottom line

Toyota Motor Sales USA likes green the way Henry Ford liked black…the division's new Torrance, California, headquarters is one of the largest environmentally friendly building complexes in the U.S… All good intentions aside, Toyota went green more for the payback than the praise. At a minimum…the Leadership in Energy and Environmental Design (LEED)-guided design for the complex had to surpass a 10 % return on investment. "The project focused on long-term operational savings to increase the rate of return."

Source: CFO.com.

5. Financing

Development has a sequence of financing needs: Land acquisition and

preconstruction. Construction. Gap or “mezzanine” financing. Postconstruction.

Land acquisition and preconstruction financing

Land acquisition cost: cost of the land. Preconstruction costs (“soft costs”): title

examination; feasibility analysis, market research and testing, permitting process (legal and architectural fees).

Typical dilemma: developer faces capital constraint, but banks and other institutions are reluctant to lend on asset with no cash flow.

Solutions: use of option, joint venture, and equity partners.

Construction financing

Covers soft costs and hard costs (for direct costs of materials, labor, etc.).

Typically from a bank. Floating rate is popular (over prime rate

or LIBOR). This type of financing is less risky than

land acquisition financing: No title, environmental or ecological risks; permits all in hand.

Mezzanine debt

Banks usually lend only 70 – 80% of construction costs.

In place of equity to fill gap, developer may seek high-interest-rate mezzanine debt.

Often secured by pledge of ownership shares, but not of property.

More expensive than first mortgage construction debt, but often cheaper than equity financing.

Postconstruction financing

Construction financing usually lasts less than 2-3 years.

Most construction financing providers (e.g., banks) expect to harvest their loans shortly after issuance of a certificate of occupancy.

Postconstruction financing can be a take-out permanent loan that kicks in when the certificate of occupancy is issued. This financing may be come in stages; at the

beginning, the financing size can be small, called “floor loan.”

Another financing approach is to have a “miniperm loan.” A miniperm loan is a construction and postconstruction loan. The typical loan term is 5 years.

6. Construction

Construction is a complex organizational problem with dozens of subcontractors and hundreds of steps.

General contractor: oversees and controls project.

Construction manager: liaison and representative of developer during construction.

7. Marketing and leasing

Marketing normally is carried out by an “outside” broker.

8. Operation

Chapters 21 and 22. Effective management is important to

maintain and increase value.

Home construction steps, I

1. Layout; homesite is cleared and staked out.

2. Excavation: grading with proper drainage.

3. Footing: foundation’s foundation, a concrete base below the frostline, upon which the foundation sits.

Home construction steps, II

4. Foundation 5. Framing: floor, wall, and roof

framing forms the "skeleton" of the home.

6. Mechanicals: heating, cooling, plumbing, electrical systems.

7. Insulation

Home construction steps, III

8. Drywall 9. Flooring 10. Trim: a carpenter installs doors,

cabinets, and molding. 11. Paint 12: Final trades: light fixtures, faucets,

commodes, and appliances. 13: Carpet/wood flooring and final cleaning.

Operation: ongoing management

Commercial RE is extremely management intensive; it is not like putting $ in stocks or bonds.

The value of commercial RE is largely created by holding the property for a long period of time, say 10 years.

Transaction costs are too high to buy and sell property frequently.

Thus for a long horizon, effective ongoing management is particularly important.

2 layers’ RE management

Asset management: asset manager deals with physical, financing, or ownership structure of the property. Managing the principal’s RE portfolios Refinancing Expansion Making recommendations for buying and selling properties

Property management: property manager is responsible for day-to-day operations of the property. Marketing Selecting tenants Collecting rents

RE management

Asset manager

Asset manager (who has RE expertise) usually work for institutional investors (who do not have RE expertise).

Usually requires an advanced degree.

Asset management functions, I

Before property is acquired: Finds specific assets in which owner/client can

invest. Researches/arranges the financing. Negotiates acquisition price. Oversee due diligence and closing process.

Compare to asset managers of stock or bond portfolios.

Asset management functions, II

After property is acquired: Monitor and control operating performance.

Site visits, property tax assessments, etc. Report value-enhancing opportunities for

rehabilitation, historic preservation, modernization, and conversion.

Suggest strategies for lowering owner’s cost of capital.

Be aware of opportunities to restructure equity ownership.

Continually reassess sell vs. hold decision.

An asset manager’s required knowledge set

Portfolio theory Asset pricing Capital market (financing) Urban economics (location) Investment value analysis Appraisal Property management Get an MBA, MSRE, or MSRED.

An asset management firm: PREI

Prudential Real Estate Investors (PREI) is the real estate investment management business of Prudential Financial. PREI, comprised of fund management centers in the US in Parsippany, New Jersey and Atlanta, Georgia; and globally in Munich, London, Singapore and Mexico City; is supported by a network of local offices throughout the world. PREI’s specialized operating units offer a broad range of investment opportunities and investment management services in the United States, Europe, Asia and Latin America. As of December 31, 2006, PREI managed $36.9 billion of gross assets ($26.2 billion net) on behalf of more than 400 clients and is ranked among the largest real estate investment managers.

www.prudential.com/prei

Property manager

Often needs to report to an asset manager.

Detail-oriented.

Property management functions

Marketing the property Leases are perishable assets. Independent brokers are usually paid on a

commission basis. Selecting tenants

Credit tenants. Vast majority of potential tenants are not credit tenants.

Tenant mix. Signing leases Collecting rent Repairing and maintaining property Communicating with owners Maintaining tenant relations

Property management education

University education rarely focuses on this profession; the closest one may be hotel management.

A number of professional and trade organizations (education providers) exist: Institute of Real Estate Management (IREM) Building Owners and Managers Association

International (BOMA) Human skills.