How Does Commercial Real Estate Valuation Work?
Commercial real estate questions? Here are some important things to know.
There are many ways to invest in commercial real estate. Some opt for direct ownership, while others pursue value-added strategies. Some will invest passively, as limited partners in funds or syndications. Those looking to preserve liquidity may opt to invest in real estate investment trusts (REITs), which can be purchased and sold as easily as a stock. It depends on the investors’ objectives, investment timeline, and risk tolerance.
One strategy that fewer people pursue, at least personally, is real estate development. Real estate development can be complicated, with many unknowns. Developing raw land, or redeveloping an existing site, has many variables and costs. These costs include both hard costs and soft costs, which collectively make up the developer’s real estate pro forma. The accuracy of a developer’s pro forma will impact overall returns.
Anyone interested in investing in real estate development, whether directly or indirectly as a limited partner, should understand the actual costs of a project. In this article, we examine the difference between hard costs and soft costs and the various line items associated with each of them.
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Anything related to the physical development of a property is generally considered a hard cost. This includes the physical materials needed to build a project (e.g., steel, concrete, interior furnishings, etc.) as well as the contractors whose labor is required to do the project.
The breadth of materials that go into a real estate development project are quite astounding. Material hard costs can include steel, timber, cement, drywall, carpet, appliances, life safety systems, HVAC systems, landscaping, and more. To calculate the materials needed for a project, a developer needs to have an advanced design with its architects and engineers. There are third-party construction estimators who can help put quantities and costs to each of these material line items. Most developers will use a market average (e.g., a specific dollar amount per square foot) as an estimate during their early underwriting exercises.
Labor costs are one of the most significant and most variable hard cost expenses that goes into a project. The big differentiator is whether a developer utilizes union or non-union labor. The former can be significantly more expensive than the latter. Still, in some markets, there’s a requirement (or incentive, i.e., the unions won’t come out to protest your project) to utilize union labor for a certain percentage of construction.
Labor is needed throughout the project and usually includes people from the following disciplines: construction (e.g., carpenters, plumbers, electricians), site work professionals (e.g., excavators, environmental remediators, and others involved in site grading); and landscapers.
In a constrained labor market, developers will pay a premium for labor costs. In a down market, labor may be more affordable. It really depends on the availability of workers, which is why labor costs can vary by so much from year to year or market to market.
Every construction budget includes a contingency line item. A contingency is a reserved amount of money that is set aside to cover unforeseen costs or site conditions. For example, during the due diligence phase, a contractor might come across an underground storage tank that has leaked oil onto the property, thereby requiring costly remediation (see more on environmental remediation below). Or, during construction, a developer might be hit with a new requirement, such as a regulatory change that stipulates projects must be LEED Certified. Developers will usually carry a 5-10% contingency in their hard cost budget.
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In addition to the site work expenses noted above, there are other site-related hard costs for a developer to account for in their budget, including:
Most developers will spend significant time investigating opportunities before actually moving forward with a purchase and sale agreement. For example, a developer may sign an LOI (letter of intent) with the seller. They’ll put some money into escrow to confirm their good faith intent to move forward with the deal. Then the developer will spend some time investigating the site conditions and beginning preliminary design work (soft costs) before executing the purchase and sale agreement (PSA).
Between PSA and closing, there may be additional conditions to satisfy, such as securing permits needed to proceed with the development. Oftentimes, the PSA functions as an extended option to purchase the land and may extend for many months or even over a year as the developer confirms project viability. The developer is incurring various soft costs throughout this project even before acquiring the parcel. Upon closing, the developer will then transfer the funds needed to purchase the property, otherwise known as land acquisition.
Depending on the location of the property and its prior use and history, the site may need some sort of environmental remediation. Many urban projects have some level of remediation necessary. “Greenfield” sites, the least contaminated, tend to be in outer suburban and rural areas. Remediation costs can vary depending on the extent and nature of the contamination.
Soft costs are all of the costs outside of the hard costs accruing to a project. They are often considered intangible but are critically important to a project. These expenses can generally be classified into two groups: professional services and regulatory fees.
The bulk of labor costs during development are associated with various professional services. The most significant professional services line items generally relate to architecture and design, with project management coming in as a close second.
Depending on the size and scale of a project, there could be several architects involved in a project. These could include master planning architects, concept design-level architects, construction drawing architects of record, and landscape architects, among others.
In commercial real estate development, there are usually many engineers involved in the design and execution of a project. Engineers can come from many disciplines: traffic, environmental, wind tunnel, and more.
Real estate development projects typically have a dedicated project sponsor. The role of that sponsor may have been to identify, acquire, and aggregate capital for the development effort. Sometimes the sponsor will spearhead the development process themselves; other times, they’ll outsource these duties to a third-party project management company. Regardless of who serves as the project manager, the sponsor or a third party, the project manager will usually collect a percentage of construction costs or set monthly fee in exchange for providing the day-to-day management of the development project. The project manager will typically serve as the quarterback to the other consultants and contractors involved with the project.
Accounting and legal fees are two additional soft costs that must be included in the pro forma. Accounting is sometimes managed in-house by the sponsor or developer; sometimes, it’s outsourced similarly to project management responsibilities. Even large real estate developers that have their in-house legal teams will usually look for some support from outside counsel, depending on the nature of the project. Legal fees may be associated with permitting and entitlements, managing city and state regulatory processes, and the like.
Anyone who has invested in residential real estate will be familiar with a home inspection. Commercial real estate projects also utilize inspectors but in a different fashion. Inspectors are generally used during the due diligence process and then again as needed for code inspections once the project is underway and nearing completion.
Some construction projects require new utility connections and roadway extension. Both forms of site work are considered hard costs and will be reflected in the budget accordingly.
Every pro forma should account for carrying costs. Carrying costs are the non-negotiable items that a real estate developer must pay each month, regardless of the status of the project. This typically includes taxes, insurance, and utility bills.
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Real estate developers need to pull a range of permits for their projects, again, depending on the size and scale of the project. For example, there may be fees associated with renovating a site for a new use. If a variance is needed, there’s usually a fee associated with that, as well. State permits may be necessary, such as permits provided by environmental regulatory agencies or highway departments. Determining which permits and regulatory fees will apply is usually one of the responsibilities of the outside counsel and project manager.
There are additional soft costs associated with development projects, even as that project nears or reaches completion. These costs include:
Most developers will hire a marketing agency or brokerage shop to assist with advertising their property. This helps with lease-up or sales efforts and allows projects to become stabilized faster.
Assuming a developer chooses to hold (instead of sell) the property upon completion, a property manager will be necessary. A property manager – which is an individual or a team of people, depending on the scale of the project – will oversee all day-to-day activity at the property. This includes lease oversight, rent collection, routine repairs and maintenance, investment in capital improvements as needed, and more. Property managers will often hire third-party contractors for several tasks, such as landscaping and snow removal.
The cost of security must be built into every development budget. On a small scale, this could be investing in and then monitoring security cameras. On a larger scale, like at a downtown office building, maybe a fully-staffed team of people who operate a desk in the lobby.
Whether you’re a developer or a passive investor, it is essential to understand the inputs into a project’s pro forma. This requires a basic understanding of the soft costs and hard costs associated with the development project. These costs can be challenging to ascertain, especially for first-time developers. Still, a developer and its investors will want to have a high degree of confidence in the budget before moving forward.
This is because all project returns are profit is calculated using the pro forma assumptions. In the early stages of the underwriting, a price per square foot can be used to estimate both hard costs and soft costs depending on the local market and historical averages. This helps the developer craft its financing strategy. As architecture and engineering advances, the developer can start to plug in more refined numbers to reflect these costs with more accuracy. Any developer, particularly someone who is less experienced, will want to build in healthy reserves (i.e., contingency) for both hard and soft costs to account for project overruns.
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Many costs go into a real estate development project. This is true whether it’s a relatively straightforward value-added play or whether it’s a comprehensive, ground-up development project. As an investor, it is important to work with a developer who truly understands the project budget and the various costs that will influence a project’s returns. Investors should always ask to see the pro forma and should review it with a fine-toothed comb. Any quality sponsor will happily walk investors through its underwriting. Most will provide valuable insight as to the assumptions that underpin those numbers. This process – reviewing the underwriting with the project sponsor – will shed light on a developer’s expertise with the product type and the market in which you’re looking to invest.
As always, if the numbers seem too good to be true, probe further and ask additional questions. No sponsor should be reluctant to share its numbers with investors, as these numbers will determine the overall success and returns generated by the project.
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Commercial real estate questions? Here are some important things to know.
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