I am reminded of this story after completing every one of our developments because I have often sworn that I would never develop another building – LOL. Real estate development is a complex and often challenging process that can take years from conception to completion. From selecting a building site to overseeing the construction process, to running or selling a property.
The development business is really quite crazy when you think about it. It sometimes takes two to three years to negotiate the purchase of land and get it to the point of being ready for construction, and then it can take two to three years to construct the building. The economy could have been terrific at the time of the land purchase and terrible at the point of completing the building. This is why God invented real estate developers!
Remember that nothing worth having comes easy and that development projects have the potential to be wildly profitable investments, given the right circumstances and management. Known for our unique ability to turn around assets in Florida, Feldman Equities leads in commercial real estate development. Here’s what you need to know about that process.
The term “commercial real estate development” typically refers to the ground-up construction of commercial investment properties that are leased out to third parties. Commercial real estate includes office buildings, retail centers, industrial facilities, and other commercially oriented properties. Multifamily apartment buildings and condo projects also fall within the scope of commercial real estate development. Commercial real estate development encompasses many different methods for generating returns for investors.
For instance, a commercial condo developer might be focused on erecting and selling units in a building and moving onto the next project, while a multifamily apartment developer might be involved in the planning, construction, and leasing of rental apartments. Some developers even work with large industrial concerns like General Electric or Dupont to create manufacturing facilities or office campuses. For the purposes of this guide, let’s go with a simple definition: commercial real estate development is the process of starting from raw land to construct a new building for sale or lease.
Site selection and assessment are the most important things that you will do as a real estate developer. It is the most important decision you will make for almost any project. Your success or failure will hinge almost exclusively on how you approach the site selection and assessment process. It is better to pay up and buy the absolute best property in the best location possible rather than try to score a deal and end up with land you can’t use to make a profit.
In other words, go for properties like Park Place and Boardwalk instead of Baltic Avenue. While there are many things you can change during a development project, the one thing you cannot change is the location – you can’t turn Mississippi into Manhattan. Many greenhorn developers make the mistake of trying to scoop up a cheap property thinking they’ll have a low-cost basis and a larger profit, but in reality, the reverse is true.
When we bought our first big development project in Manhattan, we knew that there was going to be a wave of new construction in the Times Square area of Manhattan. Previously, Times Square was a place that was suffering from a great deal of blight. There were drug dealers and prostitutes on almost every corner, and it was a downtrodden place. If you go back to the 70s, New York Times Square was really at its bottom.
But we knew that there was going to be a wave of growth when in the 80s, Disney announced that it was going to put a live Broadway theater right in the heart of Times Square. That gave us an incentive to build so we built right on the edge of Times Square, in a fantastic location right along 6th Avenue.
At the time, this particular land went for about sixty dollars per buildable square foot (between 1986-1988). That same land today would be worth at least six hundred and fifty dollars per square foot if you could find it. So it just gives you an idea of how buying the right land, in the right location, and what can happen to its value.
There is a version of property flipping and development of commercial real estate, which is also referred to as merchant development. A merchant builder is a developer that specializes in building buildings for near-term resale. For example, let’s suppose a developer has a relationship with an industrial user that needs a 100,000 square-foot industrial building. Before beginning construction, the developer signs a long-term lease with that company.
The developer finds the land, gets the entitlements, zoning approvals, gets his building permit, gets his financing, and awards the construction to a contractor who builds the building, and now it’s all shiny and new, and it’s fully leased.
At that moment in time, with a fully leased industrial property with a long-term lease, in a good location, the developer has created a very, very hot commodity. Very often, a merchant developer elects to sell immediately, within as little as a year after opening the building. That way, they eliminate their risk of holding long term, and they may realize an immediate profit. However, that’s not something that we like to do. We like long term holds, which we believe is the way to create long term value.
If you go back to my first major development in New York (Tower 45), our total project cost was $140 million. At the time we completed the building (1990), the financial markets had nearly collapsed and we thought that the cost of the building was such that we would never succeed with the property. Recently, this building sold for $364 million.
Remember that you’re building a building from the ground up. There needs to be a lot of excitement generated around the building to drive sales/leases. While it’s under construction, it’s not yet on the radar of a lot of brokers until it gets closer to opening, and that’s because brokers want to make money by entering into a lease that they can collect a commission on. If the building is just a raw piece of land, it’s most often viewed by the real estate world as being somewhat far off and not as exciting a place to bring clients to right away.
This means that the amount of effort on a development deal in the way of marketing needs to be ramped up very significantly. The amount of energy and effort that goes into marketing a new development project is significantly higher than it is with respect to an existing building.
It requires an intense amount of knocking on doors and an awareness campaign, letting people know where you are on construction, when the building will be ready, as well as announcing exciting developments like newly signed leases. If the project is an office building, an exciting new tenant like Google or Apple would be a sexy tenant that might attract other tenants to the building. In the case of a retail property, the anchor tenant may be the vitally important tenant that draws other retail tenants to the shopping center. Think announcing an anchor tenant like Whole Foods or Nordstrom’s.
You want to keep the news fresh and moving and you want to keep it in the eyes of the real estate broker. Almost every week, some kind of newsworthy event should be reported and promoted. The general cost of marketing and the general push for a building that’s being developed needs to be multiples greater than what it is for an existing building.
Let’s suppose you developed a new building, but for some reason, you did not get a lot of long term leases from the initial lease-up. It would be a mistake to try to sell that building with a fairly unstable rent roll. The buyer would have the risk of knowing that in a short period, a large amount of the space may roll to market and the buyer could find himself with a nearly vacant building.
Therefore, your holding strategy might be created based upon the length of the lease terms that you were able to obtain. The longer the lease term that can get, the more patient you can be before you sell. On the other hand, long-term leases will generate a very desirable sales price if you elect to sell the property as soon as you build it. Following the severe recession of 2008, investors want long-term leases with strong credit tenants. the value of commercial real estate is directly correlated to the longevity and reliability of the cash flow.
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Building operations refers to all aspects of property management in a commercial building. In most cases, there is a professional property management company that operates the building. The company may be a wholly owned subsidiary of the developer or owned/operated by a third-party. Property management and building operations encompass everything from emptying garbage dumpsters to making sure that the toilet bowl gets unclogged to making sure that every tenant has the proper insurance certificates on file with the property management office.
There are thousands and thousands of details that come under the heading of building operations, and a good property management company has to be cognizant of these thousands of details. They also have to be of the mindset that the customer service is paramount to the success of the property, as tenants do require upkeep and regular contact for a whole host of issues.
For example, on a commercial property, let’s say an office building, typically the leases are five to seven years. If property management is doing their job well, there’s a high probability of renewal at the end of those five to seven years. If operations are doing a poor job servicing the tenant, the tenant is more likely to move out, causing a significant amount of downtime, meaning they could see lost rents for investors. Building operations are critical for a commercial real estate development, following the opening of the building and then continuing into perpetuity as long as the building is open. Any way you put it, property management is critical to the success of the real estate endeavor.
Both marketing and leasing are critical for stabilizing a commercial property. A building reaches stabilization when occupancy hits a certain level, meaning it’s 90 to 95 percent leased typically in an office building or an industrial building or retail project. The amount of financing that can be obtained and the interest rate at which money can be borrowed is directly correlated to the extent of occupancy and the longevity of cash flow.
A brand-new Class A building that has reached stabilization with long term leases in place, is the kind of loan that a bank will be very aggressive to lend on with very low interest rates. And so you as the borrower will benefit greatly by owning a property that has reached stabilization.
Anybody can build an office building or an industrial building or a retail property. These are easily reproducible. With that in mind, when you develop from the ground up, if you seek to develop something that is yet another commodity product that looks like and functions like a thousand other buildings, you are totally subjected to the whims of the economy or which way the wind is blowing. The chances that you’re going to outperform with a “commodity product” IS not as great as if you come up with a unique piece of property with great architecture and great functionality.
That means a one of a kind of a building that isn’t already one of a thousand, but one unique structure that brings something new to the table. In commercial real estate development, it’s vital to have that vision. The commercial real estate business, like any other business, needs a visionary. It requires a vision statement. And so a ground-up development needs to be something that will be a product that will attract attention because it’s so different.
If you take away anything from this article, let it be this. Your first duty is to ensure your commercial development is something that tenants need and want because it’s got something inside of it that’s exclusive and distinct from the competition. When you go out to develop your property, think about all of that: how do you differentiate this product entirely from everything else in the marketplace?
That is the key to any successful commercial real estate development. Although you can make money reproducing a building that looks like a thousand other buildings, it’s not the business that you should be in. When you develop commercial real estate, by doing something unique and special, you can make more money because you’ll be rewarded by forward-thinking tenants and consumers. Not only generating financial returns, but creating something that you can be proud by contributing to the quality of life of your customer.
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You might chuckle at a three-page sublease clause in a commercial lease, thinking that some lawyers are putting their kids through college billing with this wasted verbiage. The reality is that owners of commercial real estate do need to properly restrict sublease rights to protect their profit, income streams, and property value. It’s important that landlords don’t allow high-profile tenants to weaken these crucial sublease clauses that protect their interests.
Anyone interested in investing in real estate development should understand the actual costs of a project. In this article, we will examine the difference between hard costs and soft costs.