It takes more than bricks and mortar to complete a successful commercial development. Today’s developers also need to be able to predict the future. Will oil prices continue to rise, driving down demand for hotel space? What impact will demographic shifts have on plans for a mall? Will lenders be willing to finance a multifamily housing project? Failure to anticipate the future can mean the difference between a highly profitable project and a project that fails.
It’s impossible to predict precisely how the world will change by the time a project is completed, but careful fiscal planning can help anticipate changes and better realize the project’s full value. When developing a property, consider having a business advisor create a fiscal plan that reviews these five key issues:
• Form of ownership. Of the five issues, this is the easiest issue to address, as today almost all development projects are structured as limited liability companies. Key factors to consider when considering the form of ownership include liability protection, tax planning and ease of use, and the LLC is usually ideal in all three of these areas. The managing member and investor members cannot be held personally liable for LLC debts. Also, because all losses, profits and expenses flow through the company to individual members, the LLC avoids the double taxation of paying both corporate and individual taxes. LLCs offer flexibility for tax-planning purposes and profits do not have to be split equally. LLCs are also generally easy to set up and administer. Unlike corporations, for example, they are not re-quired to issue annual reports or hold directors’ meetings. Each state has its own rules for how LLCs are formed and taxed, so be informed about the rules for individual states. In certain cases, it may be preferable to consider forming a limited partnership, but an LP does not have all of the advantages of an LLC. The general partner is not protected from personal liability claims, for example.
• Local permitting. Understanding the local political climate, and how local boards and officials will react to your project, can be critical. Will your project be embraced or shunned by the community? Will the planning board, building inspector, fire chief, mayor or town administrator be accommodating? Are zoning changes needed or are there any environmental issues that will require approval from the local conservation commission? Even if your development appears to meet every regulatory requirement and benefits the community, local residents may oppose it and may even try to stop it. The community may, for example, need your project to meet the low-income housing requirements of Chapter 40B, but that won’t stop local residents who don’t want the housing in their part of town from opposing it. Residents know that a court case, whether merited or not, can hold up development for years, during which time the economic climate may change, potentially making your project unprofitable in its current form. Check the municipality’s development history and how it has reacted to past projects. Consider whether your project will add to, or detract from, the local aesthetics and tax base, and how it will affect the infrastructure. If zoning changes are necessary, consider the overall impact and anticipate any reluctance to accept the changes your project requires. Be prepared, in case the change you’re seeking is not approved.
• Development costs. It’s critical to have a means of estimating not only direct project costs, but indirect costs. Many standard models exist that can help determine the cost of architects, taxes, permitting, materials and construction. But what will happen if the cost of steel doubles? You’ll need to know the alternatives to using steel. What if town officials delay your project longer than anticipated and interest rates increase during that period? Know your assumptions and how sensitive they are to changing economic conditions. You may have to scale back your project to maintain profitability, so be prepared. Projects can be scaled back without going through the approval process again, as long as the project still meets regulatory requirements. If you scale back, it’s important to keep the ultimate user in mind. If you have a high-end retail tenant committed as an anchor in your new mall and you decide to skimp on materials because of rising costs, you may find it difficult to appease the tenant.
• Leasing market. How will a softening market affect your project? Developers who failed to ask that question six months ago are likely to be hurting today. In the retail market, for example, demand has dropped to the point where rents are about 10 percent less than they would have been six months ago. For retail projects, a significant prelease – 50 percent to 60 percent of the space – is needed to reduce risk and obtain financing. Even then, making a profit may be difficult. Developers typically must give quality anchor tenants significant discounts, as they are key to attracting other tenants. But developers must then be able to charge higher rents to the other ten-ants.
• Financing. Given the subprime crisis and today’s unstable economy, lenders are being especially conservative. Most money is going to acquire stable projects, not to finance new, unproven projects. If you’re trying to develop a new property, you’ll need to show strong demand before a lender will even consider financing the project. Even then, developers will need to put up more of the construction costs themselves than they have in the past, so they will need to have their equity lined up. Lenders’ loan-to-value ratios were around 90 percent to 95 percent not long ago, but today they have dropped as low as 60 percent to 65 percent. In addition, the construction loan and permanent financing are likely to come from two different lenders. The developer will have to show value from the project before securing permanent financing.
Many development projects result in profits in the 30 percent to 40 percent range from day one. Yet others never achieve profitability, or at least fail to achieve their full potential. If a fiscal plan is thorough enough, the developer should be able to adjust to market changes, perhaps by scaling back the project or revising the design.
Another option, if the developer can afford it, is to delay the project. The real estate market is cyclical and the cycle always carries prices up to a higher level. The developer who has the ability to hold will eventually make money. Predicting that prices will rise is a safe prediction, but predicting when is much harder. A good fiscal plan will help keep your project on track, reducing the risk of having to delay development to make a profit.
