Large Developments - Key Indicators for Success (or Failure!)

14 Replies

Experienced developers (or underwriters) of large multi-units or commercial deals:  What do you think are the most important factors when analyzing deals that are close to execution (i.e. past entitlement phase)?  I've been vetting deals lately for private equity consideration and notice the due diligence files number between 150-250 (many legal, accounting, civil engineering).  Beyond credentials of the developer and great market research, what do experienced people think are the key variables to look at for whether a deal is likely to perform as predicted?  Most likely red flags? What have you missed in the past that came back to hurt? What things hurt your performance that were unpredictable? 

@Jim Froehlich If the business plan passes muster developers and equity investors look at three main numbers for a first glance analysis. Cash on Cash, IRR and return on equity.

If these numbers look good on the surface the project will get a deeper look. You mentioned some basic preliminary items and for these purposes we will assume the project is fully entitled and shovel ready.

First thing is to take a close look at construction costs, timelines and draw schedules. This is where the project can go south very quickly and you can vet a developer very quickly.

Second is validating all other assumptions, running stress tests and scenario tests.

This is an oversimplification but the number one thing that talks most development projects is overestimating profits and underestimating costs. 

@Greg Dickerson , thanks for the great feedback!  I am definitely intrigued with the idea of "running stress tests and scenario tests".  I can say that I notice experienced sponsors and investors seem to fret much less when the developers/partners coming to table have strong track record of success in the asset class and geography

Originally posted by @Jim Froehlich :

@Greg Dickerson, thanks for the great feedback!  I am definitely intrigued with the idea of "running stress tests and scenario tests".  I can say that I notice experienced sponsors and investors seem to fret much less when the developers/partners coming to table have strong track record of success in the asset class and geography

Yes you want a developer with multiple successful exists not just projects in the pipeline. There’s no replacement for experience. 

Knowing what not to do is way more valuable than knowing what to do and the most dangerous thing is to know your your right when you’re not. 

Originally posted by @Greg Dickerson :
Originally posted by @Jim Froehlich:

@Greg Dickerson, thanks for the great feedback!  I am definitely intrigued with the idea of "running stress tests and scenario tests".  I can say that I notice experienced sponsors and investors seem to fret much less when the developers/partners coming to table have strong track record of success in the asset class and geography

Yes you want a developer with multiple successful exists not just projects in the pipeline. There’s no replacement for experience. 

Knowing what not to do is way more valuable than knowing what to do and the most dangerous thing is to know your your right when you’re not. 

I don't really have experience in building MF but have a lot of experience borrowing money for my projects that are as big as MF deals. Just different as they are SFR deals ( communities) the bank underwrites the probability of success as well and relies heavily on MAI appraisals and data gleaned from those.. with MF I would think there are companies that do market studies.. just like for storage you hire a company to do a study to prove your project will have demand.. So it comes down to absorption..

In commercial office its seems they put those up.. and they can take some time to fill..  there is a project around the corner from one of my deals that has been vacant going on a year..  I think some lenders would want you to pre lease before they loan the funds.. 

So to me you have two components can the sponsor actually build it on time on budget.. and will the market support it.. 

Originally posted by @Jay Hinrichs :
Originally posted by @Greg Dickerson:
Originally posted by @Jim Froehlich:

@Greg Dickerson, thanks for the great feedback!  I am definitely intrigued with the idea of "running stress tests and scenario tests".  I can say that I notice experienced sponsors and investors seem to fret much less when the developers/partners coming to table have strong track record of success in the asset class and geography

Yes you want a developer with multiple successful exists not just projects in the pipeline. There’s no replacement for experience. 

Knowing what not to do is way more valuable than knowing what to do and the most dangerous thing is to know your your right when you’re not. 

I don't really have experience in building MF but have a lot of experience borrowing money for my projects that are as big as MF deals. Just different as they are SFR deals ( communities) the bank underwrites the probability of success as well and relies heavily on MAI appraisals and data gleaned from those.. with MF I would think there are companies that do market studies.. just like for storage you hire a company to do a study to prove your project will have demand.. So it comes down to absorption..

In commercial office its seems they put those up.. and they can take some time to fill..  there is a project around the corner from one of my deals that has been vacant going on a year..  I think some lenders would want you to pre lease before they loan the funds.. 

So to me you have two components can the sponsor actually build it on time on budget.. and will the market support it.. 

Great comments Jay.

The banks generally banks like to see 50% pre-lease on commercial development projects like office and retail. Of course this all depending on the strength and track record of the developer and the amount of equity invested. Multifamily is different. It's all about the financials and the track record of the developer. Pre-leases are not a consideration or requirement however they do look at projected rents to determine the feasibility. 

This actually provides an additional layer of support as the banks are very thorough with underwriting ground up developments especially multifamily since they take such a long time to get to stabilization. 

Originally posted by @Greg Dickerson :
Originally posted by @Jay Hinrichs:
Originally posted by @Greg Dickerson:
Originally posted by @Jim Froehlich:

@Greg Dickerson, thanks for the great feedback!  I am definitely intrigued with the idea of "running stress tests and scenario tests".  I can say that I notice experienced sponsors and investors seem to fret much less when the developers/partners coming to table have strong track record of success in the asset class and geography

Yes you want a developer with multiple successful exists not just projects in the pipeline. There’s no replacement for experience. 

Knowing what not to do is way more valuable than knowing what to do and the most dangerous thing is to know your your right when you’re not. 

I don't really have experience in building MF but have a lot of experience borrowing money for my projects that are as big as MF deals. Just different as they are SFR deals ( communities) the bank underwrites the probability of success as well and relies heavily on MAI appraisals and data gleaned from those.. with MF I would think there are companies that do market studies.. just like for storage you hire a company to do a study to prove your project will have demand.. So it comes down to absorption..

In commercial office its seems they put those up.. and they can take some time to fill..  there is a project around the corner from one of my deals that has been vacant going on a year..  I think some lenders would want you to pre lease before they loan the funds.. 

So to me you have two components can the sponsor actually build it on time on budget.. and will the market support it.. 

Great comments Jay.

The banks generally banks like to see 50% pre-lease on commercial development projects like office and retail. Of course this all depending on the strength and track record of the developer and the amount of equity invested. Multifamily is different. It's all about the financials and the track record of the developer. Pre-leases are not a consideration or requirement however they do look at projected rents to determine the feasibility. 

This actually provides an additional layer of support as the banks are very thorough with underwriting ground up developments especially multifamily since they take such a long time to get to stabilization. 

Morning Greg  Hope U had a nice long weekend. !!! Portland weather has been over cast in low 70s  LOL.. I guess summer starts Monday.

the point I was trying to make is that if there is a Senior lender in the capital stack they are going to do some pretty good due diligence on the feasibility of the project.. 

I guess one thing a person could look at also is how much dirt is available within range of the project to compete .. We are seeing stress in the PDX lux market IE over built a tad for high end new apartments and in our market you cannot make anything pencil if its not high end lux .. given that 300 to 400 bucks a foot to build nothing else works.   Low income MF housing is just an Oxymoron and a dream of politicians.. :) 

@Greg Dickerson   Also for the first time ever I saw a lux apartment complex with a booth on the concourse of our major Mall here in Portland..  just like you would normally see someone marketing resort condos in aspen or something.. 

but it was for rentals..  I think that is an indicator that the owners need to be more aggressive with their marketing to fill the units.. 

Originally posted by @Jay Hinrichs :

@Greg Dickerson  Also for the first time ever I saw a lux apartment complex with a booth on the concourse of our major Mall here in Portland..  just like you would normally see someone marketing resort condos in aspen or something.. 

but it was for rentals..  I think that is an indicator that the owners need to be more aggressive with their marketing to fill the units.. 

Yes awesome 4th of July weekend I hope yours was as well. Thats a huge tell there. Interesting times ahead for sure. 

The two largest risks of new development MF at this point in the cycle are market risk and short-term financing risk.  It's also hard to find appropriate investor risk adjusted returns on new development relative to value add opportunities.

@Greg Dickerson , @Jay Hinrichs , and @Mike Dymski , thanks for all the great feedback here, I really appreciate your perspectives! I'll say I've learned a ton by being on phone calls with experienced developers and private equity providers over the last few months. I was hyper-focused on absorption rates within markets we've been looking at, along with Year 0 vs. stabilization projections (like Year 3), and checking validity of rent $/sf of other Class A multi-family in competing market and believe these are all important. However, once involved in the discussions, I noted that experienced guys on equity side appear to pretty much trust the experienced developer's numbers, round down on estimated sales/exit - as in "you're projecting a sale of $92.5M, let's just say $90M", and then reminding developer that a very high preferred rate will be given to passive investors, so if projections are off, they will be the first to suffer, followed by the equity sponsor (i.e. very good alignment of interests since these guys are all taking very little fees, instead focusing on back end and trust in themselves and their deals.) Finally, since the CAP rate at time of sale is so sensitive for IRR projections, I'm hearing various mitigation strategies for driving CAP rate lower or worst-case holding for awhile until sales conditions improve.

One of my main points is following these discussions (where I've been focused on the trees and suddenly the forest becomes clear), I'm digging back into files (looking at the trees) wondering, "okay, how can this thing go wrong?!"

Your input is helping me confirm where to look and what to pay attention to.

Also, relative to @Mike Dymski's point, maybe I'm naive, but I'm starting to feel like investing in new developments (of shovel ready, experienced crews) is LESS risky than counting on refinance of short-term bridge loans or even value-add MF with 5 or 10 year notes (of which I'm involved in a handful of syndications).  That's of course, assuming the developments have safer long-term debt.

Originally posted by :

Also, relative to @Mike Dymski's point, maybe I'm naive, but I'm starting to feel like investing in new developments (of shovel ready, experienced crews) is LESS risky than counting on refinance of short-term bridge loans or even value-add MF with 5 or 10 year notes (of which I'm involved in a handful of syndications).  That's of course, assuming the developments have safer long-term debt.

MF new development uses short-term financing and will not go to perm until lease up and subsequent stabilization around year 2-3 (in a benign environment).

Cash flowing value add real estate with permanent financing is far less risky than new development with short-term financing.  Neither one is better than the other...they just have far different risk and return profiles.

My highest risk and return passive investments right now are in value add SS that also includes adding some units.  The LP returns are better than any ground up construction offerings I have seen in any asset class and the strategy is far less risky (in-place cash flow, easy value add on existing units, and simple construction on the added units).

Originally posted by @Mike Dymski :
Originally posted by :

Also, relative to @Mike Dymski's point, maybe I'm naive, but I'm starting to feel like investing in new developments (of shovel ready, experienced crews) is LESS risky than counting on refinance of short-term bridge loans or even value-add MF with 5 or 10 year notes (of which I'm involved in a handful of syndications).  That's of course, assuming the developments have safer long-term debt.

MF new development uses short-term financing and will not go to perm until lease up and subsequent stabilization around year 2-3 (in a benign environment).

Cash flowing value add real estate with permanent financing is far less risky than new development with short-term financing.  Neither one is better than the other...they just have far different risk and return profiles.

My highest risk and return passive investments right now are in value add SS that also includes adding some units.  The LP returns are better than any ground up construction offerings I have seen in any asset class and the strategy is far less risky (in-place cash flow, easy value add on existing units, and simple construction on the added units).

The storage project sounds like a solid play. The best of both worlds.