Members of ULI’s three Small-Scale Development councils speak about the advantages small-scale developers have and the challenges and opportunities they face in the current economy.
The Urban Land Institute’s three Small-Scale Development councils—Blue, Gold, and Silver flights—focus on real estate projects that are small—but not necessarily that small. According to ULI’s official council focus summary, among those that qualify are retail and mixed-use projects of less than 500,000 square feet (46,450 sq m), office/high-rise buildings less than 350,000 square feet (32,520 sq m), and multifamily housing of less than 250 units. “The word that suits this council best would be ‘entrepreneurial,’” says Keith Ulstad, Silver Flight chair. “Far more than in any other council, many of us are signing personally on the construction loans for projects and funding mistakes with our own money.”
David Chandler, chair of the Blue Flight, adds that the councils are primarily composed of individuals, as well as smaller development companies with a local focus. “But it doesn’t necessarily mean they work only on small projects,” Chandler says. “The projects could be very large because they have partnered up with institutional money or institutional capital.”
Contributing their insights are David Chandler, managing director of finance for Faison, based in Charlotte, North Carolina; Mac Chandler, managing director, west, of Regency Centers in Los Angeles and chair of the Gold Flight; Bob Lalanne, president of the Lalanne Group in San Francisco and former chair of the Silver Flight; John McNellis, founder of McNellis Partners in Palo Alto, California, and member of the Silver Flight; Dan Petrocchi, partner of the Evergreen Company in Sacramento, California, and member of the Silver Flight; and Ulstad, senior vice president, retail, of United Properties in Bloomington, Minnesota.
Q: What kinds of advantages are there at the smaller scale?
John McNellis: For projects below $10 million, we’re not competing with institutional players like large opportunity funds, pension funds, or publicly traded REITs [real estate investment trusts]. No matter how well-intentioned institutional investment managers are, it’s not the same as if they were using their own money. They’re competing with one another and are satisfied if their purchases are made at a capitalization rate competitive with that of their peers. Thus, they often pay significantly more for a given property than an individual using his own money would. We find our best deals in the $3 million to $8 million range.
Bob Lalanne: Smaller developers can operate below the radar of larger players. We would never chase a 15-story, $20 million office building, especially where there are a dozen or two bids on it. There are many more small and medium-size buildings and infill sites than large, and therefore there are many more opportunities, which we find are not as publicly advertised or shopped. Some of them surface through word of mouth. It’s a great time for the smaller developer to buy property because it’s a perfect ugly storm of low rents, low values, higher cap rates, and very low price per pound with not a lot of debt available. So you have to put capital into these deals. We look at real estate as an annuity with current cash flow. Many private investors are looking for places to put their money. With historically low interest rates, we are closing with 30 to 40 percent leverage and achieve a 400- to 500-basis-point positive leverage spread, which yields low- to midteen pretax returns on cash invested—even higher after tax when you include annual depreciation. Whereas we have been mainly builders for two decades, today we are mainly purchasing existing product at a very low price per pound.
Dan Petrocchi: We can change our strategies more quickly. For example, it’s possible to be a developer focused primarily on retail, have purchased land for a retail development, and see a monumental change in the housing market that makes apartments a much more dynamic product type. We can change the project to residential without having committee meetings, without seeking a corporate philosophical change. There was a small-scale developer in Virginia who had a great project on hundreds of acres of zoned land, a project that the community really wanted to occur. During the excavation, an archaeological remnant was found, and it was going to take several years to work through the problem. The solution available was for him to open a temporary ice skating rink on the property. So on weekends, this developer was behind the counter renting skates in order to cover his expenses for that time period, which he did. That’s outside the realm of what a large developer could do.
David Chandler: Small-scale developers are more nimble. Most members of the Small-Scale Development Council are not in New York, San Francisco, or Washington, D.C. They are in the second-tier or tertiary markets, so they have to cover a lot more territory. Our members do projects in a lot of places, so they get to see a lot, and they are probably doing multiple product types, so, for example, they might do office and retail. They know the markets and the municipalities better, and they can probably see the trends coming back a little faster than someone coming from outside of their area.
Keith Ulstad: We’re coming out of a period where things were so good for so long that you could make money in real estate as long as you stayed out of your own way. A lot of projects that weren’t requiring local knowledge and hands-on management are requiring that now. A smaller-scale developer understands local markets and individual nuances within local markets. Minneapolis, where I live, is a perfect example. Over the last 20 years, out-of-state, large-scale developers built large downtown office buildings here that are not connected to the Skyway. They thought they could get a better deal on land if they went one block off the Skyway. If you’re not from Minneapolis, you don’t appreciate that that’s the kiss of death. Once it gets to 10 degrees below zero, no one wants to walk outside.
Q: What are the biggest challenges that smaller, more entrepreneurial developers are facing in this economy?
McNellis: Financing is virtually unobtainable for anyone who truly needs it. If one has serious liquidity, it is still possible to borrow money, but for a young developer starting out, it’s going to be very, very difficult to borrow money for the next several years. The money is there, it’s just that the underwriting requirements are so stringent, particularly for a less-experienced developer, that 50 percent or more in equity will be required.
Ulstad: The debt crisis has probably affected us more than anyone because there are a lot of small-scale projects where a developer needs to give personal financial guarantees on the construction phase of the project. Lenders that are lending are few and far between, and those who are lending require cash equity. It used to be that you could defer your developer’s fee and put your land in at cost into a project, and the developer’s fee and the appreciation on the land were considered equity. Today, you need to show up and write a check for 20 or 30 percent of cost—whatever you can negotiate to get a loan.
David Chandler: The two big challenges are finding acceptable projects—both development or acquisition—that meet our risk profile, and then finding the capital to acquire or develop those projects. Given that the recession is turning out to be longer than expected, development may not be coming back for several years. You have to chase other things—anything from acquisition and turnaround properties to projects that need assistance or leasing help. Smaller developers are also chasing fee service business for the banks that have foreclosed on properties and need developer expertise.
Q: Is it harder to find viable projects in this climate? What kinds of opportunities are out there?
Mac Chandler: The affluent coastal markets are most ripe for development simply because the rents are higher in these markets and there’s higher demand. In the retail sector, tenants are expanding in the infill markets, and they are actually having trouble filling the pipeline for 2012 and beyond because they are sensing a lack of quality product. All the good deals have been picked off over the last two years, and that’s what’s driving rents up. So tenants, instead of kicking tires, are now moving much quicker than they have in the past year.
McNellis: Until very recently, it was almost impossible to find viable projects because anyone who didn’t have to sell wasn’t selling. But life trumps business. The Four Horsemen of real estate—death, divorce, disaster, and dissolution—will sooner or later force a sale. Just in the last six months, we’ve started seeing a number of projects in the $1 million to $5 million range that make sense from a redevelopment standpoint. One can purchase them, add value, and create a fair profit. In other words, they are accurately priced.
Q: How are developers of small-scale projects navigating the economic downturn?
David Chandler: You need to position yourself with a capital provider to do almost everything at this stage. That could be a pension fund or life insurance company or a boutique investment group that wants to continue investing in real estate. Before the downturn, you could do a lot of these projects with 10 percent equity. Today, probably three or four times that is required, which means you either have to joint venture or bring in many other partners. It’s more complicated.
Mac Chandler: In this economy, you have to go really small, and small projects aren’t easy because you have to do a lot of them. Or perhaps the most promising future for the small-scale developer is to team up with a larger developer, and then the small developer can play to its strengths, which is local political relationships. They can source projects that the larger developers wouldn’t normally see, and often they can navigate approvals easier than the larger developer because they are not perceived as a large institution with an open checkbook.
Q: Are there examples of municipalities that are particularly noteworthy in terms of fostering entrepreneurial development in smart ways?
Petrocchi: I have seen municipalities become kinder to tenants, so to the extent that the tenant and the developer interact, they are kinder to the developer. Small mom-and-pop retail franchises are the group of tenants most in danger in this economy. Municipalities have been allowing more signage to help retailers draw customers, whereas two or three years ago they were much less flexible about signage. In terms of larger tenants, the toughest retail tenant to get approved is Wal-Mart. But now municipalities are taking an even more favorable stance toward Wal-Mart because of the sales tax potential.
Mac Chandler: We are seeing small and large cities cooperate more with approving projects. The downside is that most cities have reduced their staff so much that, although the approvals process is getting easier, the time required to get approvals really hasn’t improved.
Ulstad: In the Midwest, in this economy, municipalities don’t have the capabilities to extend sewer lines or public transportation routes, so they have turned their focus toward redevelopment and infill. That’s where small-scale development shines. Minnesota just came up with new legislation: retail and office projects that are in the ground by the end of June 2011 now qualify for tax increment financing, where they wouldn’t have before.
Q: What other trends are affecting developers at this scale?
Petrocchi: One of the interesting dilemmas is that a lot of the pension funds have targeted an 18 to a 22 percent yield for real estate projects. If they are looking for a ten-year hold, their alternative is maybe 2.5 percent from a treasury bond or maybe 5 percent in the equity markets. But if you go to real estate, they are looking for 20 percent. Until those return targets become more realistic, there’s not going to be a lot of equity in our real estate world.
Mac Chandler: There is more talent in the marketplace than ever before, so you’re seeing a lot of small startup firms. At the same time, large and small tenants are gravitating toward larger, more capitalized developers because tenants are more concerned than ever that the small-scale developer isn’t able to execute. Large tenants are self-developing more than before. They can hire the talent and they don’t have to worry so much about the execution. At least in the retail business, tenants are our customers, but they are often our competitors.
McNellis: Supermarket-anchored shopping centers in northern California—our area of expertise—are getting better. We’re virtually done with tenant failures, we have far fewer requests for rent reductions, and leasing is considerably stronger than it was in 2009. Within a two-hour drive from San Francisco, necessity retail is through the worst of this recession.
Lalanne: Larger banks are working with their large borrowers right now, rolling debt and waiting for the economy to pick up. The Federal Reserve doesn’t seem as interested to protect the smaller lenders, so we are finding opportunities where smaller lenders and smaller borrowers have finally cried uncle and need to get all-cash deals and close within weeks. In terms of the economy, it appears we will be bouncing along the bottom for a while. As leases expire, rents are getting marked down to market rates, and as the months go by, net operating incomes on properties—except perhaps multifamily—are getting lower. If and when interest rates go up, there could be a continuing wave of distressed properties and opportunities.