An excerpt from Building Small: A Toolkit for Real Estate Entrepreneurs, Civic Leaders, and Great Communities.
Acquiring your site intelligently requires a combination of math, intuition, and dispassionate objectivity. A project has so many unknowns that you can never “perfect the model” and use it to replicate the next project. But you can establish the basic assumptions that matter, test potential scenarios, and gain a working knowledge of the key factors that will ultimately influence the project’s financial outcome. This process helps identify which “dials” you need to pay attention to and which deserve constant review to manage your project to a successful result. That result always starts with acquiring your site intelligently.
Two of the earliest steps in the development process are site control and feasibility testing. The first is the industry term for getting control of your development site. The second comprises the analyses that help determine whether a project makes economic sense and what it will take to be successful.
Taking Site Control
Most nondevelopers assume that developers just buy the site outright and thereby have control of it. But small developers typically have limited financial resources, and the process of envisioning, designing, gaining approval, and then constructing may take a while. This makes obtaining site control through an outright purchase difficult. And even if they could buy the site outright, taking on that level of cash outlay upfront can seriously hinder the project’s ultimate return.
In addition, the process to secure a site is time consuming. There are initial inquiries. If the property is not for sale, making sure the owner knows you are interested and has a comfort level with you is key. Do not think tying up off-market properties is just about price—or that price is a function of a rational process. Most legacy landowners have a lot of emotion tied up in their properties: they recall working there; they hear their parents still in the building; they remember family moments. And while dollars are critical, they also want to know you are creating something that could honor that legacy, add to the neighborhood, and make sure their history continues.
This is a rarely a rational process. If it is a great site, or a great building, owners have probably heard decades of pitches and many brokers who offered unrealistic values for the property. In their minds, owners have “already sold” the building or site and have “spent” the proceeds. If there are multiple heirs, they each want their share, which is generally a big, round number. In chasing deals with legacy landowners, the seller formula at valuation is pretty simple: there are four of us, and we each want $500,000. So the price is $2 million. Land residuals, comps, and complicated where-is, as-is appraisals rarely help win the day. Persistent, personal communication and building trust do.
Your objective is to help them see your vision, help them understand how your idea is a win-win for everyone, earn their trust, and get them to sell the property at a price that will make your project work and ensure that they feel they were appropriately compensated.
Site control is critical because there is inherent value created from your idea once you control the site. The chicken-and-egg dilemma for many small developers is how to get control of the site while still protecting the intellectual property of their idea. If you have a killer concept from another community that you feel is ripe for your neighborhood, it may be hard to raise funding on just an idea. If you have an idea, a financial feasibility model or pro forma, some market data, and site control, you now have something of interest to prospective investors. But before you share all your ideas with prospective investors, you want to make sure you have the site locked up so that someone else will not take your concept and beat you to the acquisition.
Small Tips for Finding Sites
The ultimate objective is to secure a site where you can get a reasonable return on your investment of time, capital, creativity, and commitment. Many great projects have been doomed from the start—not because of the program, developer, or market, but because they overpaid for the land. It is not just about price: there are multiple factors in what constitutes a reasonable price for the land. The biggest mistake a developer can make is to overpay for the real estate and overestimate demand (and hence revenue) and underestimate the difficulty in permitting. Smaller projects have less room for miscalculation in these areas. When looking for potential projects, the developer must keep these mistakes in mind and work to avoid them.
Sources and leads for new deals or projects are generally found in these four ways:
- listings from brokers;
- pocket listings from agents and brokers;
- unlisted property of interest; and
- real estate already owned by you or your family.
Many small developers do not rely on buying sites that are already on the market. They are more inclined to find an off-market site—an interesting building with character, an underused plot of land in an emerging neighborhood, a family property held for generations that is now in the path of change. Here are some ways to identify such properties:
- Approach other developers about remnants of land from their existing and future deals. From time to time, a developer must buy more land than is needed for the primary project or may have an odd parcel that will not work with the more formulaic or conventional product template. Letting a larger developer know the price, size and shape, zoning, and entitlements necessary for your project can lead to a win-win for both developers. Of course it will be essential to know that the other developer’s project will complement yours and not be a negative either in terms of product or market potential.
- Find suitable surplus public properties. School districts, property yards, storage buildings, and parking lots are often owned by public agencies. The entity may be cash-strapped, or the former use may no longer be needed or helpful to the community. Although your inquiries may ultimately require you to compete for the land in an open request for proposals (RFP) process, small enough sites may not command much competition.
By doing your homework in advance, you can have a stronger leg up to win. If you can secure an exclusive negotiating agreement early and without an RFP, you may be able to structure a better land price or long-term ground lease in return for providing much-needed public benefits (open space, affordable housing, community meeting space) as part of your project, thereby reducing your upfront cash requirements. - Consider family or “legacy” real estate, which may be right for a development project. The developer of legacy real estate must be careful to go through the same analysis as if buying the land to determine the suitability for the intended project. The analysis should include the potential value of selling the property and looking elsewhere for a more suitable site. Land value is strongly dependent on what can be developed and the demand for said development.
Before reaching out to a landowner, think carefully about your first-contact strategy. This is where your reputation (or brand) can help or hurt you. Are you known as someone who has integrity, can execute and close a deal, and will honor their interest? Or are you considered to be a fast-talking, shady character who tells a great story but rarely closes or always asks for a discount once at the closing table?
Expect the owner to research your company to understand whom they are dealing with. The developer’s vision may or may not help convince the owner to sell. The developer usually needs to show the owner how he or she arrived at the offering price and show the offer is fair. When no brokers are involved, the developer can make a case the offer is better than a slightly higher price because no commission is required.
Small Tips for Gaining Site Control
A small developer often lacks the cash to buy a site outright. It pays to think creatively to craft a purchase strategy that can benefit both the seller and the purchaser.
- Option agreement. An option agreement provides the seller some immediate compensation and secures your option to buy the property at an agreed-upon price. This helps you minimize the upfront expenditure of funds while you are doing studies, testing the market, and raising funding, without risking having someone else take your idea and buy the property. Terms are typically based on a certain milestone (i.e., completion of due diligence, receipt of entitlements, and so on). Price at that milestone can be “where is, as is” or, in some cases, the value of the property after you have created value by securing the approvals.
In this scenario, you take the risk and bear the cost for securing the approvals, but you do not have the cost burden for acquiring the land until you know you can actually implement the project from a regulatory standpoint. Because you are not buying the land until you are certain your entitlements will be granted, the seller receives a higher price for the land than if it was sold as is. This is because the seller is sharing some risk with you in the entitlement process and therefore has earned more than if the property sold as is. - Project participation. In some cases, the seller may agree to invest the land in the project. If the seller is aligned from a vision standpoint, and has both the capacity and the experience, this can be a great technique for small developers. It provides site control with little to no cost while helping provide equity for the project. In this scenario, the seller would contribute the land to a newly created, project-specific special-purpose entity (SPE) as part of the capital stack. Although this is typically an equity contribution, the deal terms and where they fall in the stack are part of the negotiations.
One caution is to ensure that the seller possesses the sophistication and long-term staying power to ride out the approval and development process. Sometimes legacy landowners—especially third- or fourth-generation family owners—get impatient waiting for their payments, are not comfortable with the risk involved in real estate development, and may have monetary gains as their sole motivation. This situation can be extremely difficult when a project hits a rough patch or needs to change course. - Seller carry. In this case the seller may act as the bank, providing financing for the purchase of the property. Some sellers may prefer the long-term income and revenue stream this kind of agreement generates, reducing the immediate tax liability that could occur from a one-time sale. It also permits you to reduce the amount of upfront capital you require. Critical in this approach, however, will be ensuring that the landowners are willing to subordinate their debt to any construction financing or other commercial debt you may place on the property. If they remain in first position for all future payments, finding a lender to provide your other debt will be very hard—or very expensive.
Testing Project Feasibility
Regardless of the source, every deal must be evaluated for potential to return investment of time and money. As the developer, you need to research the specific market to understand construction costs, market lease and common area maintenance charges, actual sales prices (not listing prices), and the existing supply/pipeline of competing projects. To accomplish these tasks, continuous research is required. Pricing and rates can change quickly such that information can soon become irrelevant. Armed with accurate and up-to-date information, the developer is ready to evaluate potential projects.
Most project feasibility starts with the “back-of-the-napkin” rough estimate because, more often than not, an idea for a project starts over a dinner conversation or over coffee with someone testing an idea. How much will the land cost? How much can I develop on the site? What kind of rents or sale prices can I expect? What will it cost to build? How long will it take, and how much money will I need to make it happen?
These are all inputs that can be quickly assembled to frame a project scenario and test the result. Although graduate-level courses will teach you about leverage and internal rates of return, most small projects result from a simpler capital structure and feasibility test that starts with “what if” and ends with a detailed pro forma.
The purpose of the initial feasibility effort is to assess whether your kernel of an idea has potential. It helps you confirm whether the price you are considering (or have negotiated) is appropriate for the contemplated project. More than anything, it helps you identify the metrics to watch so you can constantly assess and re-assess whether your ultimate project outcome will be a home run, cost you everything you own, or result in what developer and author Howard Kozloff calls a “volunteer” or break-even project.
Small Tips for Testing Project Feasibility
The following are some of the tools for testing project feasibility.
- Return on cost as the first test. Before running a complex pro forma or dynamic model of cash flows, costs of capital, and timing flows, a simple static (meaning not time-dependent) model can tell you if you have a project that could make sense. Total all your project costs: land cost, construction, fees, and sales or leasing commissions. Do not underestimate soft costs, approvals, design and engineering, permits, and your fee. Calculate total potential revenue—as an exit sale price or as a function of anticipated net operating income at a conservative cap rate—and subtract costs from income. If your resulting gross return is at or in excess of 20 percent, you have the beginning of a project that could make sense.
Most small developers use 20 percent because it provides adequate margin for changing costs, price reductions, and unforeseen surprises. This does not mean it is your profit from the project; it is just an indication that the project has enough latitude or margin of error to weather the inevitable changes that will occur over the project’s development. - Residual land value analysis. To confirm you are not overpaying for a site, a residual land value (RLV) analysis should be prepared and compared to listing/asking prices for land. An RLV is basically the value of the land after all (residual) costs are subtracted from the future development. This is the value the land can support, after costs of construction, development, required profit to attract needed capital, and your fees or upside to make the project worth undertaking. And in an ideal situation, the list price will be less than the RLV, giving the project an excellent foundation for future success. In cases where the asking or listing price is higher than the RLV, be cautious about compromising or paying more than the analysis indicated.
- Sensitivity analysis to understand deal resilience. Sensitivity analysis is one way to manage risk and is an important tool for talking to investors. The basic premise is: how much can exit prices fall, or project costs go up, before the equity receives no return? The goal of this analysis is to understand the “sensitivity” of the project’s success to factors that are beyond your control. So if development costs go up by 10 percent, and all your profit and a good bit of your equity are wiped out, the project may be too marginal to succeed. Conversely, if you find that even if project prices fall by 30 percent you can still pay the bank back and return all equity, you have pretty good latitude to weather market cycles.
Site acquisition must be approached with the same attention to detail as every other step in the development process. While there are no formulas for developing small, there are tools and guidelines to help you through the process. Passion, tenacity, and brute force are good attributes to start with, but success is achieved only with rigorous analysis and continued “fiddling with the dials”—fine-tuning the costs, capital structure, program, revenue projections, and schedule to ensure your project does not sink you forever.
JIM HEID is a real estate developer and strategic real estate adviser focused on the tools and techniques that lead to a more sustainable built environment. For more than 30 years he has advised cities, nongovernment organizations, legacy landowners, and private developers on more positive ways to build community. In 2017, he founded CRAFT Development, a real estate company focused on incremental development and intentional place building. DAVID FARMER, chief executive officer of Metro Forecasting Models LLC, and Lorenzo Perez, principal of Venue Projects in Phoenix, contributed to this article.
Building Small: A Toolkit for Real Estate Entrepreneurs, Civic Leaders, and Great Communities. © Urban Land Institute, 2021. Available from bookstore.uli.org, $49.95.
