Developing the Developer

Editor’s Note: This article first appeared in the July 1975 issue of the Real Estate News Observer.

Recently I was a moderator at a marketing session attended by some 75 well-above-average real estate professionals. One broker was presenting an excellent pack­age, part of which was some land ready for development. I asked the 75 brokers, “Who represents a developer?” and only one hand was raised. Only one! This is appalling. Probably half of all real estate transactions involve new properties or land being purchased for development, and practically none of us are tapping that market. The developer’s life blood is buying and selling real estate. It is not a matter of moti­vating a passive investor or interesting some speculator: ­the developer must buy and sell or he is out of business.

NOW, as never before, the de­veloper needs the creative real estate broker. Developers are faced with problems they could not foresee, even in their wildest nightmares, ten years ago. In this article we will examine some of the developers’ problems, some of the solutions the creative bro­ker can offer, and some of the problems he will encounter in working with the developer.

The developer’s most impor­tant problem is, as always, selling a product. He has always been faced with a multitude of prob­lems and decisions in this area. For example, the price to charge to maximize profit but still be competitive, the amounts to budget for marketing, and how to distribute the marketing dollar (e.g., should he allot more to commissions and less to adver­tising—in theory, getting better sales people, or should he allot more to advertising and less to commission—thus relying on the advertising to do most of the selling and making the sales people order takers).

In addition to the normal problems of mar­keting, the high interest rates of the 1970s have caused sev­eral almost impossible situations. If the developer is a house build­er, the home buyer cannot afford, or qualify for, the high loan pay­ments. The difference between a 6.5% and 9.5% $30,000 25-year loan is $60 per month. A prospec­tive home buyer has to make an additional $270 per month (using a 4.5-1 ratio) just to qualify.

If he is an FHA builder, he may have to pay points, which are running from 2–8% of the loan. This $600 to $1,800, in addi­tion to runaway inflation, has caused building costs to soar. Some building components have had price jumps over 200%. If the builder pre-sells homes (which used to be the best of all pos­sible worlds), he may now find himself having sold them for less than his costs.

One other problem materially affects the developer’s costs. This is the high cost of construction financing. Most construction loans during the last few years were on a variable interest rate. Interest rates varied from 2 over prime by a bank to an A-1 bor­rower to 6 over prime by RE­ITs to a marginal borrower. So, in addition to soaring material and labor costs, the developer was paying up to 18% interest on his construction money.

The income property builder has the same problems. The shopping center, apartment house, or industrial building that he could build for $6 to $10 per square foot in the ’60s is now $12 to $20 per square foot, and up to $60 per square foot for some high-rise office buildings. Let’s see how this affects an apartment house and its income stream. As­sume a 900-square-foot, two-bed­room apartment in a building of similar apartments, where the building is operating at 95% occupancy and 40% expenses. Assume the build­er’s land cost per unit has re­mained stable at $2,500, but that his construction costs, including builder’s profit, have jumped from $10 to $20 per square foot. Also assume the investor buyer of the completed apartment building expects to buy at a 10% cap rate. When the builder was able to build for $10 per square foot, his price was $11,500 ($9,500 building plus $2,500 land). In order to receive his 10% cap rate, the buyer could rent the unit for $168 per month. After the 5% vacancy and 40% ex­penses, the unit brings in $95.76 per month, or approximately $1,150 per year. Assuming the same two-bedroom apartment was built today with builder’s cost and profit at $20, the price on the 900-square-foot unit would be $20,500 ($18,000 building plus $2,500 land). To receive the same 10% cap rate, the unit must rent for $300 per month. In spite of what the consumer groups say, most rentals have not kept pace with inflation, and it might be quite difficult for the develop­er or investor to obtain 95% occupancy in the $300 per month, 900-square-foot, two-bedroom unit. (Please, New York and other high rental areas, don’t write in saying you could rent them all day at $300 per month. If you can, you probably can’t build them for S20 per square foot, or your land is above $2,500 per unit. This is only an example.)

The shopping center developer can no longer rent his space for 20c NNN. He must get 35c. The industrial building developer and motel and office building de­velopers all are faced with the same problems.

To compound the problems, the sophisticated investor is now asking for his yield, cash on cash. He wants a 10% cash return (or more) on cash invested. This was fine when interest rates were 6% or even 7% or 8%. But let’s look at what happens when interest rates are 9.5% or 10%. Assume a $500,000 shopping center with a 10% cap rate and an investor who wants to invest $100,000 with a 10% cash on cash return. If you could arrange an 80%, 9.5% 25-year loan, the constant would be 10.48, making the annual pay­ments on the $400,000 loan $41,920. This only leaves $8,080 spendable from the $50,000 net operating income after debt ser­vice. Therefore, the developer would have to sell at $481,680 to meet the buyer’s requirements, as $40,000 per year will only ser­vice a $381,680, 9.5% 25-year loan. But even worse, what hap­pens if the best takeout loan available is 10%, 20 years? Now the constant is 11.58. The same $40,000 payments will now only support a $345,423 loan, so the developer must sell his property for $445,423 to the 10% cash on cash investor or hang on to it.

So, in marketing his property, the developer is being whip­sawed from both sides. Higher building costs necessitate higher rents, and higher interest makes the investment less desirable to the investor at the developer’s price. But the developer’s problems don’t end with marketing prob­lems. The developer now must invest considerably more time and money in getting his pro­duct ready to go. The require­ments for subdividing and de­veloping have changed so dra­matically in the last ten years that the old-time developers wouldn’t recognize development 1975. En­vironmental Impact Reports; Coastal Commissions; and local, re­gional, state and federal regula­tory agencies all are making the developer’s life a nightmare. Be­fore he can even start a project, he must spend months and sometimes years going through the government red tape. His days are spent talking to planning directors and public agencies, his nights appearing before planning commissions and city councils. He is insulted and demeaned as a spoiler, an opportunist. He spends thousands of dollars on projects that he can never build because an environmental group has the political clout to scare a city council.

All of the above leaves many developers with an inventory of overpriced or unmarketable pro­duct and makes it extremely dif­ficult for him to get started on new projects. This is where the creative broker becomes perhaps an absolute necessity to the sur­vival of the developer.

Let’s touch on a solution to the inventory problem. The product can’t be sold to an investor at a price that will make sense to the investor because the developer has too much in the project. He may not even be able to give it away because the loans may exceed the value. The buyer of the property will need a take-out loan, and not too many lenders want to make loans on a no-down-pay­ment basis. So, the only solution is to exchange the developer out. If he does have equity, the ex­change will allow the developer to save face. If he can acquire development land, he will re­ceive the bonus of raw product to build upon. If he has no equi­ty, nothing (encumbered land, un­finished buildings, or similar “z” bag properties) will allow the de­veloper—and lender—to save face.

The lender is one of the keys to this transaction. No other lender in his right mind is going to place a 100% permanent loan on this project. The construction lender might. They will tell you that they do not make perman­ent loans and that they don’t like exchanges. But they probably don’t want that project back. Most banks and REITs that made construction loans are up to their necks in REOs and are having a very difficult time keep­ing their statements, stockholders, and bank examiners reasonable. If they are brought face-to-face with the choice of having a loan on their books, and maybe even a legal loan if the “equity” in the exchanged-in property is suffici­ent, or owning the property, you may get your permanent financ­ing. But what about the client going in to the property? It probably isn’t full and an eater. If your client can’t stand a temporary eat, ask the lender for a partial moratorium on payments for a period of time.

The broker can be of new value to the developer in his acquisition of land and profit doing it. In the past the broker found a developer in need of land, got out his plat maps with the sewers drawn in, and called the farmers until he found one willing to sell at a reasonable price, and then brokered the raw land to the developer. Let’s as­sume $10,000 per acre is a rea­sonable price to both parties. I suggest that with home develop­ment problems the developer would rather pay $12,000 per acre for the property, zoned, En­vironmental Impact Report com­pleted, and tentative map ap­proved, than $10,000 raw. This leaves an opportunity for the broker to pick up $2,000 per acre for performing those functions. The land need not be purchased—a binding option would suffice. Naturally, both parties would be given full disclosure, and both should be delighted to have someone perform that function.

The developer needs the crea­tive broker.

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