Residential Real Estate Development
by James H. Burton
James H. Burton firstname.lastname@example.org is Professor of Business Administration in the Marketing and Real Estate Department at the University of West Georgia. He has taught university level courses in real estate development, and market feasibility analysis. He has also been a practicing real estate developer, having developed a 160 acre subdivision and a 2,000 acre subdivision.
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The central purpose of this article is to describe the research, procedures, steps, and processes involved in successfully developing a vacant residential real estate parcel. The most typical real estate development procedure may be outlined as follows:
Create the development idea
Control the vacant site or undeveloped land
Complete a preliminary market feasibility study
Have the preliminary plans and specifications drawn
Obtain a mortgage financing commitment
Cause the final market feasibility study to be completed
Complete the engineering final plans and specifications
Estimate the final total costs, direct and indirect
Complete a Discounted Cash Flow analysis of inflows and outflows
Analyze various risks associated with the proposed development
Begin actual construction of the streets, utilities, and lots
Marketing and Selling
The reader should realize that each of these development steps is interrelated. While they are listed in a specific order, these steps cannot always be treated in this exact order or in isolation. For example, a real estate developer may already own the land, and then proceed to determine its highest and best use.
The real estate developer must have an idea, usually based on experience in the market place, or intuition, about a residential real estate development that he/she believes the market demand for exceeds market supply. For example, if the population and number of households in a local market are growing, and the developer believes that he has an idea for a residential subdivision with innovative amenities and attractions, and if the developer has a strong desire for creating that type of development, then the developer should pursue the creation of that development. The two key factors about having an idea for a real estate development are: (1) strong market demand for that type of development or a market niche, and (2) a strong emotional and financial commitment by the developer to create that type of residential development.
Purchase an Option on the Site
After the developer has a clear development idea in mind, he should review the number of available appropriate sites in the market area. Hence, the first step in selecting the vacant site is to define the market area. The market area could be a city, county, or a specific neighborhood in a city or county. Obviously, the market area should be located in a high demand area, typically indicated by a growing population and number of households. The development example used in this article will be a single-family residential subdivision; however, the real estate development procedure would be similar for various types of real estate developments.
Once the market area is clearly defined, with boundaries and limits, a simple way to locate available potential sites is to tour the market area and review the listings of local real estate firms. Once potential sites are located, the developer should select the optimum site based on location, access, topography, zoning potential of highest and best use, and available utilities. When the optimum site is selected, the developer should purchase an option on the land, or negotiate a contract for purchase subject to zoning, final market feasibility, and specific financing terms and conditions. The key to negotiating an option agreement on the land is to minimize the cost of controlling the site during the period of preliminary market feasibility and arranging financing and zoning.
Preliminary Market Feasibility Study
When the developer has executed an option agreement or a contract to purchase the site, he/she must complete a preliminary market feasibility study. An independent real estate expert usually completes it. The study involves the research and analysis of demand based on population demographics and supply based on an investigation of competing single-family residential developments in the market area. An accurate preliminary analysis of demand is critical to the market feasibility of any proposed development. For a proposed single-family subdivision, the number of existing households in the market area should be estimated and the expected or forecasted growth of the number of households during the next five years should be estimated. This data is readily available from local planning agencies, "Sales and Marketing Managements Survey of Current Buying Power" for counties and MSA areas in the United States, and national demographic data services, like Claritas.
In addition to the number of existing and forecasted households in the market area, the annual income distribution within the market area per household is important. Such information reveals the income available for housing expenses, and hence, the likely price ranges of lots and homes in the proposed subdivision
The data available annually from "Sales and Marketing Managements Survey of Current Buying Power" is categorized by states, counties, and metropolitan areas. The reported data includes current total population and population by age groups, the number of households, total retail sales by store groups, total and median effective buying income by percentage of households, and buying power index. The "Survey of Current Buying Power" also includes five-year data projections for major urban areas by counties; this data includes population, households, effective buying income, retail sales, and buying power index. Household demand can be categorized by income levels, which can be used to estimate the prices of lots and homes demanded. For example, if the market area is expected to increase by 2,400 households each year, and 25% of those households have incomes in the $50,000 to $75,000 range, house prices should range from $156,000 to $235,000. This analysis assumes that typical housing costs are 25% of income, and a mortgage interest rate of 7% that is amortized over a 30-year term.
In addition to estimating the demand side, the market analyst must consider the existing and planned competition for the proposed development in the market area. The analyst must tour the market area to inspect the competing subdivisions in the trade area. The local planning authorities should be contacted to discover any proposed subdivisions that have been approved for development. Then the analyst must compare the total existing competing developments plus the proposed subdivision developments with the forecasted demand for single-family lots and homes within the market area. If the forecasted quantity of demand exceeds the projected quantity supplied, the preliminary market feasibility study would indicate potential success for the proposed development. Of course, if the existing competing developments that are available exceed the forecasted demand, then the developer should not pursue the development of this new single-family subdivision.
Preliminary Plans and Specifications
If the market feasibility study indicates sufficient demand, the developer must contact an engineering and/or architectural firm to draw preliminary plans and generate specifications for the subdivision development. In the case of a single-family residential subdivision, the plans should include the road layout, the preliminary lot designs (including the number of lots and typical size and frontage), the layout of electric lines (either overhead or underground), the layout of the water lines, and the layout of any sewer and drainage systems. Typically, the preliminary plans and specifications are sketches with preliminary cost estimates. As a general rule of thumb, the cost of the development should be allocated 33% for the raw land or site cost, 33% for development costs, and 34% for profit to the developer. Although many developers use these figures as a general rule, a discounted cash flow analysis should be completed. This analysis will be discussed later in this article.
When the preliminary plans and specifications are completed, the developer should coordinate his plans with the appropriate zoning and planning authority. If a zoning change is needed, it should be reviewed and evaluated early in the development process.
After the preliminary plans and specifications are completed, the developer may apply for a development mortgage loan. Because of the riskiness of such loans, the normal loan-to-value ratio may be in the range of 60-66% of the total retail prices of the lots. The developer should shop for a development loan as he/she would in shopping for a car or a home. He/she may contact many mortgage lenders and actually present a loan submission to two or three lenders. The information furnished in the loan submission should include the preliminary market feasibility study, the preliminary plans and specifications, a description of the proposed development, the proposed mortgage loan terms and conditions, a financial statement, and a resume showing the developers experience.
Typically, the development loan provides sufficient funds to pay for the site acquisition and the development costs. The term of the loan would normally be a short-term loan, one to three years, depending on the absorption forecast of lot sales. Because of the short term of the development loan, the interest rate is usually fixed. The loan is repaid as a percentage of each lot sale, for example 50% to 75% of each lot sale would be deducted at each lot closing to repay the development loan as the lots are sold. The mortgage lender will require that the development loan be repaid faster or more proportionally than 100% of the lot sales. For example, the lender may want 100% payback within 75% or 80% of the lot sales. This would, of course, require that the developer receive most of his/her profit during the later stages of lot sales.
Final Market Feasibility Study
Once the developer receives a mortgage loan commitment, the developer should have the final market feasibility study completed. This study should include a detailed analysis of the population demographics including the number of households, income per household, typical expenditures per household, and an estimate of housing costs by income levels per household, or housing expenditures by income levels per household. The final market feasibility study should describe in detail all existing and proposed, competing residential developments in the defined market area. It should also include an informed estimate of lot absorption and prices, or how many lots are expected to be sold each month and the suggested prices of those lots to fit with the supply and demand analysis.
Final Plans and Specifications
Concomitantly with the final market feasibility study, the developer should work with the engineering firm to finish the final working drawings for the proposed subdivision development. This would include final engineering drawings for the roads, exact legal descriptions of each lot, the plating and staking of the lots, as well as any engineering drawings regarding earth moving, and utility layouts. These final plans and specifications should be coordinated with the construction contractor and the appropriate utility companies. Once the final market study and the final construction working plans and specifications are completed, the developer can close the development loan, acquire the property, and begin construction of the roads, utilities, and lots.
Cost estimates are categorized as direct and indirect costs. Direct costs are land acquisition costs, engineering costs, construction costs, and marketing costs. Indirect costs include professional fees for market feasibility analysis and appraisal, legal and accounting fees, and financing costs. Based on the authors development experiences, cost overruns can be disastrous to expected profits; hence, development costs must be estimated accurately and include a contingency fund to pay for unexpected additional costs.
Discounted Cash Flow Analysis
A Discounted Cash Flow analysis should be completed to calculate the present values of the cash outflows and the present values of the cash inflows for financial purposes. An example of a Discounted Cash Flow analysis for a residential subdivision appears below. The assumptions used in this example are:
16% Discount Rate
48 Total Lots
6 Lot Sales per quarter
$36,000 Average Lot Price
$600,000 Development Costs ($12,500/Lot)
$500,000 Land Cost
$600,000 Loan Amount at 9% Interest & 50% Lot Releases
The discount rate of 16% is assumed in this example because of the relatively high risks in residential development. The Cushman & Wakefield National Investor Survey (Spring, 1998) reported internal rates of return expected by real estate investors to range from 12% to 13.8% for seasoned, income-producing properties. The DCF shows the present value of the outflows to be $71,000, the present value of the inflows to be $426,000, and the net present value to be $355,000. Under these assumptions, the residential development example appears to be quite attractive.
The primary risk in developing a residential subdivision is the marketing risk, or the risk of selling six lots per quarter at the average price per lot. Of course, there are additional risks: development costs overruns, bad weather, increased interest rates, labor strikes, and others. However, given the assumptions in the development example, the breakeven point is relatively low at 66% of lot sales, and the net present value is attractive. (See below.)
If you have Excel on your computer, click here to download the above table as a spreadsheet.
All during the initial phases of the development, the developer should coordinate with a construction contractor for the building of roads and installation of utilities. For marketing purposes, the developer may want to build a single-family model home and some amenities. Frequently subdivision construction is done in stages so that finished lots may come on line for sale as quickly as possible. Also, during construction the developer will initiate advertising and other promotion to stimulate presale of some lots. The developer may even sell packages of lots with favorable financing to local homebuilders so that construction of speculative homes in the subdivision can begin promptly.
The most critical stage of development is marketing and selling of the finished lots. Marketing includes promotion, advertising, and sales. A marketing plan must be planned and implemented that meets the sales goals based on the absorption and prices forecasted in the final market feasibility study. Promotion activities may include announcements in local newspapers, radio, and television, locating directional signs to the new subdivision, holding open houses, and creating brochures. Advertising can be classified according to the most effective medium. It may be specific, name, or institutional advertising. The advertising media should be selected based the results of the market feasibility study and it may include billboards, newspaper, magazines, radio, television, home shows, or other appropriate media. The developer should measure advertising results to insure the cost effectiveness of advertising expenditures.
An employee sales person or a local real estate brokerage firm can conduct the sale of lots. In either case, the sales commissions are a marginal expense and should be considered in the financial forecasts.
Real estate development can be very exciting, creative, and profitable. An experienced developer may have the opportunity to borrow all of the development costs. However, there are real risks associated with real estate development because risks and returns are directly related, and expected high returns usually indicate high risks. Some common subdivision development risks are cost overruns, bad weather, too few sales per month, lower prices, higher marketing costs, and labor strikes. Larger developments that require large initial development costs and longer absorption periods are considerably more risky than smaller developments. The trick is to sell lots much faster than interest accrues on the development mortgage loan and before economic conditions change.
Some Readings in Real Estate Development
AIREA Research Series, Real Estate Market Analysis and Appraisal, (Research Report 3, Chicago, 1988).
Appraisal Institute, The Appraisal of Real Estate, 10th Edition, (Chicago: Appraisal Institute, 1992).
DeLisle and Sa-Aadu (Editors), Appraisal, Market Analysis, and Public Policy, (Boston: American Real Estate Society, 1994).
Brueggeman and Fisher, Real Estate Finance and Investments, 9th Edition, (Homewood, IL: Irwin, 1993), Chapters 17 and 18.
Clapp, Handbook for Real Estate Market Analysis, (Englewood, NJ: Prentice-Hall, 1987).
Downs, Principles of Real Estate Management, 13th Edition, (Chicago: Institute of Real Estate Management, 1991).
Wurtzebach, Miles, and Cannon, Modern Real Estate, 5th Edition, (New York: John Wiley & Sons, 1994), Chapters 24, 25, & 26.