Development: What it Means, What it Entails

Why would we consider development? One reason is that over the last few years, the competition for commercial income property has intensified, and thus prices have risen to a level where making decent returns on your money is more difficult. So, instead of purchasing an existing property, the idea is to build your own. Some of the types of property you might build include a strip mall, a stand alone retail building, a self storage facility, or even a hotel. Many times, development projects are done within a Joint Venture Structure, which joins money people with experienced development people.

While returns can be large, the risks and complexities are many. The first step is finding a developable location. There are many aspects to finding a suitable location which need to be determined, and now the list includes zoning. If our desired use does not conform to the present zoning it is possible to get it changed, but that is often an arduous process. Once we have found a piece of land which meets the needs of the desired use, and taken into account the cost of the land and its zoning, we put it under contract and begin the due diligence process. During this process, we will need to hire engineers to research environmental history and any remaining issues, analyze the soil compaction to determine suitability for building and drainage, and determine any needed remediation.

Simultaneously, we will engage an architect and engineer to begin the design process for the structure and land improvements (landscaping, parking, etc). Once they have created an early draft design, you can begin your pre-leasing activities. Our banks and our spouses will rest easier knowing that once the building is up, we will already have many if not all of our tenants determined, and cash flow assured; much will be determined before we even close escrow on the land. This is good, because our banker will want to know the cost of the project and the tenancy before lending us the money to go forth and build. One excellent and often overlooked item is to have a qualified engineering firm analyze the building design and perform a cost segregation study, which will identify many items which can be depreciated much faster than the typical 39 years. Often up to 30% of a building can be depreciated over 5, 7 or 15 years, yielding a significantly higher ROE.

When the due diligence period is over, we will have determined the land is suitable, has no skeletons in the closet, and we can close the deal on the dirt. A general contractor will now take over the project and - hopefully on schedule and under budget - your building gets built. The general will take care of permits, variances, manage the subcontractors and myriad other things.

In parallel with the building process, we will be working with an attorney and our potential tenants to draft the lease document. There are many items to be worked out in a lease, but the most significant include term, option periods, bumps or raises in the lease rate, when they occur and what they are based on (often CPI). Other items include tenant and landlord responsibilities for utilities, insurance, taxes, repairs and maintenance. As mentioned in the credit-tenant article, triple net leases (NNN) are best for the owner/builder, as they move all expenses which are subject to increases to the tenant side. This makes for a very predictable cash flow for the owner.