Real estate investing and development is often a tricky and challenging endeavor. Seven years in, I’m still often amazed at just how difficult it is to make money in the business. Between high costs of land, often lengthy and expensive permitting process, challenges imposed on developers by the municipalities, and the ever-present risk of construction delays and cost overruns, it’s simply a very tough business.
Having done over a dozen development deals, totaling $100m+ of projects, we have had our share of fabulous successes and our share of mistakes in the process. We had to learn not to over-leverage our capital structure and recognize the importance of having a long-enough study period to flush out potential issues prior to closing on a transaction. Some mistakes however, can be more challenging to overcome than others, and the below three mistakes are the most common ones we see even experienced developers make.
Overpaying for Acquisition
Every seller has a dream. Sellers often don’t appreciate of all the development and carry costs that will go into turning their “piece of land” or “vacant building” into a viable, completed, project. This in return skews their perception of the realistic value of their property.
When a buyer is a real estate developer, they often have an excel model in place that justifies paying a certain number. If that number falls below the seller’s “dream” figure, developers sometimes re-work the excel model in order to justify paying a higher price to win the deal. The thinking goes, “we can save on construction through value engineering”, or “we can be more aggressive on rent increases to make up for the higher land acquisition costs”. These seemingly small adjustments at the onset can be fatal. Just because it is easy to play with numbers in excel in order to justify a higher acquisition price, getting those higher rents/sell-out values in real-life can be mission impossible.
A client of ours, let’s call him Sam, bought a building next to one of our existing projects. The building is in distressed shape, and it requires a full gut rehab in order to be converted to either apartments or office space. Sam overpaid for the acquisition by about 30%, in hopes of figuring it out later. The plan was to get financing based on ultra-aggressive underwriting figures for the rents that apartments would generate, which is a bad plan. The “figuring it out” part on how to make this a viable project never materialized, and Sam then tried to sell the building to another developer. The plot deepened when the other developer did a better job at underwriting and said that the acquisition price would need to be lowered by 25% for him to make any money on the project. After holding out for his dream price for some time, Sam ended up auctioning the property at a loss. The moral of the story is to not overpay for the acquisition in hopes of making up for it later. The making-up part often doesn’t come, costing you lots of money and headaches in the process. If anything, experience has showed that things will cost more money than anticipated and take more time than budgeted.
Wrong Design Team
Sad to say, it took us a few bad actors to figure this one out. The developer can get really hurt if the design has major flaws, and there are plenty of possibilities why a developer may have mistakes in their design process.
For example, if you are thinking about building a self-storage facility, make sure the architect that you are using has proper experience designing self-storage buildings. Even with proper experience, if the architect doesn’t have incredible attention to detail, and doesn’t sufficiently coordinate his drawings with those of the various project engineers, the “Legos might not fit”, triggering change orders, delays and increased construction costs. Architectural design flaws can potentially make a highly profitable project a mediocre one, so make sure you deal with highly capable professionals who are very experienced in your particular field.
Sometimes even capable professionals make big mistakes. On one of our self-storage projects, the structural engineer had a particular vision on how to design the building. When we suspected that the structural component was “over-designed”, leading to increased construction costs, we consulted with another reputable structural engineering company who redesigned the structural system to save us $300,000 while still meeting all code and life safety requirements. We ultimately had to switch structural engineers because our original engineer refused to admit they had over-designed the project and redesign the building. Changing a team member probably cost us an additional $60,000, but at least we walked away from making a $300,000 mistake.
Poor budgeting/ Not managing liquidity properly due to time delays
Poor budgeting is the ultimate “oops” that can cost you dearly. It is easy on an excel model to think that a small contingency (e.g. 3% of project cost, but a big number in dollars), may be adequate to deal with surprises. But in reality, that 3%-5% contingency is often a best-case scenario. A local municipality can drag out the time to grant you permits, causing your cost-of-carry (i.e. taxes, debt service, wages, etc.) to skyrocket, or there could be a bad winter throwing your schedule back 2 months during construction (with the owner paying for those delays and snow removal costs and temporary heating, etc.), or any plethora of other scenarios that quickly escalate costs. As discussed earlier, even design flaws could end up in material change orders, escalating costs even further.
The important thing to remember is to manage your liquidity, as it is critical to successful investments. The old adage, “cash is king”, is very relevant for real estate investing. The last thing that you as a developer want to do is wait for a miracle to happen to save the day (in a form of construction savings, cooperating city inspectors, or favorable weather conditions in the fall, etc.), and if it doesn’t, only then start looking for the necessary cash to keep the project going.
On our earlier development projects, we worked on re-positioning historic structures where we would change its use to a multifamily or self-storage from its original use. Whenever you work with historic structures, as opposed to ground-up construction, you will always have more surprises because you simply don’t know what’s behind the walls nor do you have a perfect ‘computer picture’ of how the existing building is built and exists in our three dimension world. On existing buildings in particular, we now always recommend 10%+ reserves for surprises given this discrepancy between what is “really there” in the real-world v. “what we design in the computer world” and then hope to build.
Question Your Assumptions
Every developer is under pressure to close on deals. Home run deals are few and far between, however one should expect to hit plenty of solid singles and doubles. It is when you need all the stars to align just to hit your single or double, that you need to question whether the deal is worth taking on. If you are relying on near perfect execution of permit timing, construction timing, construction budgets and lack of surprises to get to an “acceptable” return on a project, you are seeing yourself up for a potential world of hurt and surprises. Whenever everything has to fall in place for you to make a profit, it’s probably a good sign to pass and focus on better opportunities ahead. There are plenty of developers who went bust going against the odds, don’t become the next one.
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Should you find a great investment real estate deal and have a need for financing, please consider PSG Lending (www.psglending.com) for helping you financing the transaction. We close in as little as 1 week and finance anything from flips to commercial real estate.