All Forum Posts by: Scott Choppin

@Josh Kundrat Sure thing!! Let me know if you have any questions as you move through your search. Please also post updates if you land a new job in the development space.

Thanks.

@Audrey Ezeh @Michael Reyes @DG A.

Thanks guys! Really appreciate the kinds words.

Project underwriting - Proforma analysis and apartment financial return basics

Now that we have found the site, determined that our product type is appropriate for the location, checked the zoning and assessed the zoning standards to our particular product type and design, we can now move towards an initial underwriting of the deal or what we call a "proforma analysis".

The basics of a financial model or “proforma” for a development project:

Income and Expense

Construction Period Cash Flow

Internal Rate of Return

Income and Expense Analysis 

On apartment deal underwriting or financial analysis, we’ll first break it down very simply for you to gain an understanding of the fundamental components of income and expense analysis for an income producing property. Once you get that, you’ll be able to use it daily and effectively, then make it more complex as you get more seasoned in your underwriting skills. But as you underwrite deals, you will always be able to hold the basic structure in your mind, then work the details on each deal in a spreadsheet that you can easily build yourself.

Basic rental income and expense summary:

Rental Income from all units, also called Gross Income

Less Vacancy Factor (typically 5%)

Equals Gross Adjusted or Effective Gross Income (has various names, but this is what I call it)

Less Operating Expenses and Reserves

Equals Net Operating Income

This fundamental formula applies to all income producing properties, apartments, office, retail, self-storage, etc. Each component may have a different name, or be subject to slightly different allocation of cost (triple net office has the tenant pay most of the operating expenses and property taxes), but the bottom line number that we care about is Net Operating Income or NOI.

When you hear people talk about NOI, you'll know how that is defined (formula above). What it means is the amount of money or cash flow that is available to make the loan payment, and the amount of cash flow that can be used to value the property in a sale or refinance. Using this formula, combined with cap rates (see below), you can underwrite all types of income property investments.

Construction Cash Flow Analysis

This is the flow of expenditures during the construction period. This cash flow schedule is particular to a development project, as you will need to calculate the interest on borrowed funds and the preferred return paid on equity as a function of your construction period expenditures. A normal investment property doesn’t have major expenditures beyond the purchase, whereas a ground up development project has all the neccesary expenditures to complete the units and lease them up.

The construction cash flow is nothing more than a spread of each construction cost line item over the specific time period of your construction schedule. 

Generally, the time period of construction is derived during your initial due diligence and provided to you by your in-house construction team, or a third party general contractor. A rule of thumb is to always allow more time than you think to build. Unless, you are a production home builder constructing the same unit plan over and over again, a custom or one-off design can only be roughly assessed for total construction schedule. You always need to leave yourself extra time in your schedule. This can be for the normal friction of time loss due to city inspection delays, weather delays, RFI’s, and owner initiated plan changes. On the opposite end of the spectrum, you could assume significantly longer time periods for construction than your team indicates, but this will erode your financial returns due to overly conservative (meaning higher) amounts of interest carry and pref returns on equity. So you need to strike a balance, with some “cushion” to protect against normal friction.

Internal Rate of Return Analysis

This is where you delineate the financial cash flows of the deal in order to calculate the investment returns available to yourself as the developer and for your investor partners. See below for explanation of the Internal Rate of Return or IRR

Assessments of Value - Using Capitalization Rates

Once you have the NOI, you can then value the property using the Capitalization Rate or Cap Rate. These are market based assessments of value, that can then be used to underwrite your project. On a development deal (and on all "value add" deals) we have two cap rates:

1. Development cap rate, which is the NOI divided by the cost of the project, or NOI/Cost. When we speak, we say "NOI to Cost". This is what is used when running proformas to determine value at sale or refinance once the project is built out, leased up and producing income (or projecting these values during initial underwriting). This ratios is also used as a comparison tool for the market or what other development projects are producing with which we compete. You might say: "we are building to a 6% NOI/Cost, what are you building to?" or "the equity investor says they want a 7% minimum NOI/Cost, do our numbers meet that criteria?"

When an equity investor is making an assessment of your project, they will ask what is your NOI/Cost ratio (i.e. development cap rate). Example: Our Cedar project is producing somewhere over a 7.5% NOI/Cost. If other developers' project is producing a 7% ratio, our project is producing a superior offer or more NOI to each dollar of cost spent to produce that NOI.

2. Exit cap rate. This is the cap rate in the market upon sale of the project, that determines the value of project upon sale or refinance. This is derived by taking the NOI produced by your project and divide by the going cap rate gained from market research.

Example: 

"Broker says that our project should sell at a 4.5% cap rate, our NOI is $100,000, so our value should $2.2M at sale" ($100,000 divided by .045 = $2,222,222).

Another way is that you actually sell at a price derived from a bidding process that you produce in the market, and then divide the sale price by the NOI to get the cap rate at sale: "Our sale price was $8.69M, our NOI was $400k, so our cap rate at sale was 4.6% ($8,690,000 divided by $400,000 = .046 or 4.6% cap rate)

The difference between the development cap rate (NOI/Cost) and the Exit Cap Rate is your development profit. Let's say you can develop to a 7.5% NOI/Cost and sell at a 4.5%. Your spread is 3%, which is the value you've produced as the developer. You may more simply say total sales prices less total project costs is your development profits, but I want you to see where we get the value for the sale or refinance first, then you can use that to subtract and calculate the profit. Of course, the market always dictates, so the more buyers you have bidding for your project the better the price you can demand. We always want to create an auction for our project when able. But the market sometimes goes against you, so you may not get an auction, or worst case, in a down market you may sell at an actual auction. But the main purpose of delineating cap rates here, is to understand the meaning of NOI in the creation and assessment of value for an income producing project.

Remember: when speaking with sophisticated investors, knowledge of these ratios and the ability to work them and speak them, will set you apart from the rest of the market.

Assessments of Value - Internal Rate of Return

First, the textbook definition:

Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero.

Internal rate of return is used to evaluate the attractiveness of a project or investment. If the IRR of a new project exceeds a company's required rate of return, that project is desirable. If IRR falls below the required rate of return, the project should be rejected.

Now, the real world definition:

IRR is the rate of return produced by investing equity into a development project at the beginning of a project's investment cycle (this could be cash used for predevelopment costs, land close, and funds for construction) and getting repayment of original investment plus yield on the invested capital at the end of the project. The nice part of the IRR, is that it takes into account the time/value of an investment, and so IRR or rates of return can be compared between investments with different time cycles. You can compare a equity investment for a project that takes 1 year to invest and repay, to a project that takes 7 years to invest and repay, then choose which produces the higher IRR. This is why IRR is used by sophisticated and institutional investors.

Understand this: the longer an investment takes timewise, the more likely the total IRR will be lower and trend downward. As well, the opposite is true, if the investment time cycle of a project is very short, the IRR could spike very high, especially when an investment period is under one year.

Once the first dollar of equity is invested then the clock to calculate the IRR starts and ends upon the final repayment of the original equity investment, any preferred return (called "pref") and the backend profit splits allocated to the equity investor. We'll explain more about the practical aspects and presentation of IRR's when we write about raising capital in the equity markets.

There are other ratios to use like the Equity Multiple, which will be covered later. In the development business these are the major financial ratios used by professional developers and institutional level equity investors.

Here is a sample proforma, using data from one of our recent projects on Cedar Avenue (some data redacted to protect proprietary data in the deal):

Proforma Income and Expense Analysis

Construction Cash Flow Analysis

Internal Rate of Return Analysis

@Patrick Regan

So there's some additional info needed to complete an assessment of sell vs. build.

Questions:

A. You say you got stuck, what does that mean? Ran out of money, permitting issues, real estate issues? Do you have experience in this domain, of designing and building large spec house? Do you have a team in place, architect, civil engineer, soils engineer, general contractor?

B. Did your realtor friend give you an assessment of your original 850k land price? How does he arrive at his 775k price?

Depending on your answers to question "A" above, my advice is to sell if you can minimize your loss. Try asking your realtor friend to give you a discount on his brokerage fee. The risk is certainly less. You may chalk this up to a "learning" opportunity. 

If you decide to build, here are some assessments to ground:

1. What's the cost to design and build the 3,500 house? 

2. Is 3,500 the right amount of SF given comps? 

3. Are there other comps in the market besides the ones you list? The comps you list don't quite feel right, #1 assumes they will tear house down, but for sure?, #2 is it nearby?, #3 on Biscayne Bay, is this a much better location than your site? Can your realtor friend give you his opinion of value for a completed spec house?

4. What finish levels do you need to deliver to make your house most marketable?

5. Do you have the financing in place to build?

6. How is the market generally and what phase of the real estate cycle is your region/city/local neighborhood in presently? You don't want to build spec then sell into a down market.

Last, selling the land as is, and taking a loss will avoid all the issues in Questions 1-6 above. 

We have sold a number of land opportunities, where we put the land into escrow, completed the entitlements, design, and subdivision mapping process, then sold to another "builder" who took on the risk of the actual financing, construction, marketing, and sale of the project. By doing this, we skipped the entire build process and avoided the market entirely, plus we went FAST. In the real estate development business, I say "slow kills". These type of land sale projects have been some of the most profitable projects in our company's history. 

I am an offer of help, feel free to ask questions if it can be of further help.

Thanks.

@Josh Kundrat

As a developer in training, you want a job that exposes you to the maximum amount of the development cycle with the maximum possible learning velocity (time and speed). You will need to learn all of these components of a development deal: land acquisition, site selection and sourcing, zoning and entitlements, architectural design management, deal underwriting, financing, construction, leasing, property management, and sale or asset management.

I would suggest working for companies that already develop the types of projects that you are ambitious to build in the future. For example, I come from a family of real estate developers, but I was ambitious to learn rapidly and work for others in the MF development domain, so I obtained my first job (asst. project manager) for a division of KB Home (Kaufman and Broad Multi-Housing) that developed in-house apartment projects. I started as a rookie APM, and left there as a seasoned senior project manager running the entire project myself from finding the land to putting the project into long term asset management phase. This gave me the exposure to all aspects of a development deal on multiple larger ground up development deals.

Search for companies in your local area: google search, look for ads that are selling or renting new projects and identify the developer, read news of company announcements, and most importantly, build your networks. Networks could be: local builders exchange, local and regional homebuilders association, search on websites for NAHB, NMHC, ULI, attend real estate meet-ups, attend real estate conferences. You're near Chicago, I speculate that there's a ton of space to build your networks in a large urban center like Chicago.

Your likely job title will be: assistant project manager, analyst, development associate.Whatever it is, you will be working for a more seasoned project manager or senior project manager. Know this: that person is worth their weight in gold, and can be the primary person that you run things past or ask questions as you move through your day. My best days, were when I would be tasked with managing a project (or part of it) and could at the end of the day ask a TON of questions about how to do it, what happened, what went wrong, what could be done better, and what could be done better than anyone else. I used to carpool home with a very seasoned PM, and we would be in the car together for 1-2 hours each day, and that poor guy got squeezed dry like a sponge by me for knowledge and information. He and I still laugh about it today, but damn that was the best learning I ever did.

One caveat, it will take some time. I spent over 5 years working for others, before deciding it was time to go out and form my own development company. You should more than likely work for a larger company, they have jobs that are specifically related to development, versus construction or some other non-development role. 

An alternative could be that you intern for a small development company, with the express purpose of gaining development experience, or at least that's how you should communicate it to them. You may have to work for free or at low cost to the small company, as they will be very sensitive to cash flow and costs.

The development business is one of the most complicated businesses that I know of combined with risk in land markets, underwriting, financing, and construction. While each component part is not overly hard to understand, there's a ton of steps, and each step has risk embedded in it AND you are dealing with people all along the way: brokers, land sellers, planners, politicians, bankers, construction folks, renters, property managers, and buyers. So your ability to both understand the process better than anyone else AND to convince other people to go your way, agree to allow you to do your project, or support your project with investment, is of paramount importance.

If you want to see the process in action, see my thread about a real world example from our development portfolio.

I am an offer of help, feel free to reach out if needed with questions.

Thanks

Scott

Thanks @Taylor Herman. Use me as a resource if needed.

Take care.

Hi @Dave G.

A few examples:

1. You find the land, correctly zoned or capable of being zoned for a viable project, ask for 25% of sponsor (developer) back end profits. No cash from you.

2. Same as above, but put up 50% of the equity on the sponsor co-invest, ask for 50% of sponsor's back end.

3. Find the land, put up the entire co-invest, find the LP equity, then ask someone to put up financials for the construction loan guarantees and give them 25% of the back end. 

I list finding land as a mainstay of your offer, as most developers need one of two things: deals and capital. And in many cases, land timing and deal flow is harder to control, meaning you can't set up land deals in advance, whereas equity or the co-invest you can. So land deals are more variable in their timing, and therefore more valuable to developers who already have the equity lined up.

4. Find land, tie it up, process entitlements, sell to another builder. 

5. Find land, process entitlements, joint venture with another builder, with the "value add" on the land, the value you generated above the land purchase prices as your equity for the co-invest.

6. Same as #5, but the value you generate suffices for all the equity in the deal, then combine with #3 for the CL.

I am an offer of help, feel free to reach out if needed.

Thanks.

Scott

Hi @Brendon Borrego

Not being familiar with this zoning designation for N. Nevada, a few questions to orient my offer of help:

1. You show that SF40 allows 40 units per acre density in your math, 1.3 acres X 40 du/a = 52 units, did this density come from the city's zoning ordinance?

2. Does the SF40 zoning allow multi-family residential already? Check the zoning ordinance, normally this would be in a table, in the ordinance, and it lists all the allowable uses in that SF40 zone. You want to know what other types of residential are allowed.

It would be unusual for a zoning designation to be single family and yet allow 40 du/a; that density is squarely in the MF zoning density. Check again, but I am betting the "40" designates a lot size for subdivision, say like 4,000 s.f. lots as the minimum subdivision for new lots.

So check on those two details, and if you can't see that MF is allowable use, then call the city planning department, and ask them if they would support a zone change from SF to MF, and see what their answer is. You may also check the zoning around this site, to see if there is any adjacent sites with MF zoning already in place, that can be logic potentially for you to change your zoning. Just be aware, zone changes take time and money, more so than if the MF was an allowable use already.

I am an offer of help, feel free to reach out if needed.

Thanks.

@Taylor Herman I was writing my first response as you posted your last. 

Given that you've checked the zoning and determined "multi-story" complex, what was the dwelling unit/per acre that the zoning allowed? That will tell you how many units you can build on the site.

Next, do a full underwriting or proforma analysis of the project, of which the build costs, are one component in the model. You'll need to check rents, operating expenses, soft costs (architecture/engineering), development impact fees, and financing costs.

Getting land comparables is good, but you only have what other sites sold for, not necessarily that those sites sold with your zoning, land use, and density. What if all the land comps were for high rise office? You are best served when land comps match your type of project, even then, if someone does buy land and builds your exact same project, their build cost structure can be different. Example: many larger apartments complexes built by the major REIT's even in the Seattle market, can buy much better PSF build cost efficiency than a smaller developer can. It's amazing what discounts you can negotiate when you have a 500 unit project to dangle in front of a GC. That REIT can then pay more for the same piece of land just through lower build cost. Another example: a developer working on a smaller MF with a 20 year relationship with a local GC, that local GC can give preferential pricing because that developer had given him multiple projects in the past, or may have multiple projects going now, such that each projects total prices can be discounted. Again, but lowering the build cost, you can increase the amount you can pay for land.

We would very rarely make an offer on a site that we did not already do a proforma analysis on, to be sure we really know the deals works. On occasion, if we know the exact market well, and have build something recently, we might offer for land without a proforma, but that's a very specific situation with our having prior knowledge of projects that we've done recently.

Given what I see here, can I make the suggestion that you use your BP network to find someone with the knowledge that is needed here to partner up with? Find a developer partner locally who has done this a bunch, and make them an offer to partner up to bring their skill set to the table. Then you can use that project partnership to learn in detail this process and the underlying skill set for yourself.

I know a local Seattle based developer who does these types of projects, I would be happy to make in introduction. DM me if interested.

Thanks. 

Hi @Taylor Herman, the best approach really starts from the perspective of a real estate developer. Ultimately, per @Christopher Phillips link, the residual land value analysis is the preferred methodology. Basically it looks like this:

Revenue from sale (sale of house or apartment project) - build costs, soft costs, financing -  developer profit = residual land value (amount you can pay for land)

But before you can know what to build you first must ask yourself these questions related to this opportunity:

1. What can go on the land from a zoning standpoint? See my post for how to do this: 

Lifecyle of a CA MF Development Deal

2. Does the market demand support what the zoning allows and vice versa?

Check the zoning and see what is allowed.

Then as the developer (that's what you are now) you need to determine the match between the zoning and the market. Many time they are coherent, sometime they are not. Zoning changes much slower than real estate markets, meaning markets may start to demand units that zoning does not yet allow (that's why developers apply for zone changes).

Then do a basic underwriting of the deal to determine what can go there, how many units, what size units, etc. You can utilize an architect for this, but as I say in my Lifecycle post, you should learn this for yourself ultimately. 

This will then determine your revenue per the formula residual land analysis above.

Sometimes, you may find that the market demands something other than what you zoning allows. In the post from @Ted Lanzaro, he outlined that spec single family residential (SFR) are not in high demand in his area. If your zoning allows SFR, and there's low demand for those, either you negotiate a lower price to be in line with market demand, or the deal is a pass (BTW, you will and should pass on many many sites).

Other times you may find a positive mismatch, meaning the zoning allows a use that produces higher value than it's present use. Example: your site zoning may allow higher density, maybe duplex, triplex, or higher multi-family densities, but it's not obvious that's what's allowed, surrounding sites are all SFR or commercial. In the example from our Lifecycle post link above, the site is an SFR, yet we can build a multi-unit project on same site. When this happens, the land value goes up (obviously the market demand is higher, therefore the value is higher).

So all land had some value, if lower number of units, or lower value units, it means lower land residual. If higher number of units, or higher value of units, than higher land value. So both density (how many units you can fit on the land) and the price of each unit, will influence the land value (BTW, build costs, soft cost, etc also influence, but I leave them out in this example for simplicity)

3. Does the price the seller wants match what you need to/want to pay for the land based on your underwriting of the deal and the residual land value?

Most times in our experience, sellers have a much more aggressive view of pricing than the market. Our running joke: land sellers are the first to raise prices and keep raising AHEAD of the market in a market up cycle, and the last to lower prices (and maybe never) in a down cycle. So be cautious with the seller's pricing guidance. 

I am an offer of help. Please feel free to reach out if needed.

Scott