The Life of a Developer

Helpful hints for budding LIKE VIRTUALLY ALL businesses, development is about pro- developers from a seasoned pro. ducing when demand exceeds supply. My observation, after forty years in the development business, is that very few development companies spend much time and energy analyzing historical supply and demand trends. Only during a recession, as supply exceeds demand due to over- building or a contraction in demand, do they begin to question the development business model. The recession of 1991 to 1993 for apartment developers resulted from over- building in the late 1980s, accentuated by a recession and the attendant fall-off J. RONALD TERWILLIGER in demand. In the early 1990s Trammell

REVIEW 83 Crow Residential (TCR) was unable to outlook for future real estate development finance new apartment development in in the United States to the ULI trustees. most of our markets. Carrying a sub- Tony pointed out that demographic and stantial development, construction and economic factors in the United States administrative overhead, we realized that would require significant additions to a loss of development and construction the built environment over time. The fee income would quickly result in nega- dilemma is that supply and demand is tive cash flow, rendering us unable to not a smooth function, and periodic over- cover overhead. building results in an inevitable pause in Unable to find any comprehensive the development process. research on the historical patterns of sup- Demand for new development, and ply and demand for rental apartments, most obviously for housing, is strong- we contracted with Ron Witten at MPF ly influenced by household growth as Research to help fill the gap. In that first well as the make-up of households. As year, TCR worked with Witten as part of Generation Yers reach employment age, a strategic planning effort to determine they are more likely to rent rather than whether the rental apartment development buy. Increasingly, young adults want loca- business would sustain TCR for the long tions close to entertainment and work (and term. Ron and his team worked with us transit where available), as well as mixed- to study the factors affecting market rate use environments with low-maintenance rental apartment supply and demand. As a living. Historically, demand for home- result, beginning in 1991, and for the next ownership has strengthened as households two decades, we produced the rental apart- reach their thirties, and is influenced by ment/multi-family outlook that analyzed financing costs and availability, tax advan- current circumstances and forecast future tages of ownership, family/job stability trends for occupancy and rent growth. and the expectation of price appreciation. During the early 1990s, developers of However, the downturn in housing prices all product types were constrained by a in the past several years (along with tough- lack of financing and product oversupply. er mortgage underwriting) will defer home At the Urban Land Institute semiannual ownership for many households. meetings, a mood of gloom and doom In part because developers need the prevailed. Many developers wondered if fees associated with development, supply there was a future for the development frequently follows the cost and availability industry. I will never forget Tony Downs of financing rather than a logical analysis from the Brookings Institute presenting an of demand. During my career, I have

84 ZELL/LURIE REAL ESTATE CENTER observed several periods where the avail- project for an upside of being repaid plus ability and cost of both equity and debt a spread above their cost of financing, he financing were highly irrational. In the responded that the head of real estate had early 1970s, mortgage REITS (sometimes been given his departmental profit objec- sponsored by major financial institutions) tive for the next year, which could only be would lend 100 percent of the cost of met through sustained lending. That exec- development. My experience in commu- utive, he suggested, could either resign on nity development in South Carolina at the spot, or hope that during the balance of Sea Pines Company, where we borrowed his real estate lending career we would not for both resort community development have another economic downturn. He lost and primary home communities, was that his job a year later. loans were typically at 5 percent floating Supply should logically increase when over the prime rate and had five-year demand (or projected demand) drives terms, even though the communities were down vacancy. Unfortunately, our sys- expected to take ten to twenty years to tem of real estate finance typically does develop. The first several years of loan not anticipate markets coming into bal- interest was funded by the loans, and then ance, is late getting back into lending, sales projections would provide for contin- and seems always to be late in anticipat- ued interest rate payments as well as loan ing overbuilding. amortizations during the initial five-year term. At Sea Pines, the recession of 1974 and the increase in the prime rate to 12.5 FUNDAMENTALS FAVOR percent caused a very quick default and the DEVELOPMENT proverbial handing over of the keys to the mortgage lender. U.S. population growth of approximately In the late 1980s, commercial banks three million people per year (one million were lending 95 percent of total costs to from net immigration), along with nor- apartment developers who would contrib- malized household growth of 1.3 million, ute their 5 percent of equity in the form provides the demand to add to the built of deferred development and construction environment. Jobs and the incomes associ- fees. Once again these banks frequently ated with working are used to pay the rent became owners of the properties—this or mortgage and to consume. Even with- time as a result of the early 1990s recession. out the demand stimulated by population When I asked one bank executive why they and household growth, functional obso- would effectively take the equity risk on a lescence along with a loss of properties

REVIEW 85 through fire, earthquakes, and so on inevi- roughly one million immigrants per year tably requires some new development. In create demand for housing, particularly in addition, as the population migrates south locations in the Southwest and West. and west, demand for new production is further stimulated in those regions. The median income per household WHAT KIND OF in the United States is slightly more than DEVELOPMENT? $50,000 and provides the cash necessary to purchase residences or rent apartments Given the known demand, as well as the and homes, as well as to buy the goods unique factors that can affect supply, how that enable retailers and other businesses should a developer proceed? A devel- to expand. Increased employment adds oper may choose to pre-lease or pre-sell his to the need for new office space, and product (contracted development), or he increased purchasing not only adds to may build speculatively, assuming that “if retail expansion but creates the need for you build it, they will come.” Speculative new warehouses. development is obviously much riskier, The baby-boom generation (born and should result in higher profitability, between 1945 and 1964) creates a demand assuming the new development is carried for specific products (including ) out on a risk-adjusted basis. Home build- consistent with where they are on the age ers such as NVR, on the other hand, take spectrum. Senior housing for boomers, a relatively low-risk posture, preferring who are between forty-six and sixty-six to option single-family lots and build today, is seen as a strong opportunity, as new homes after a contract to purchase is this generation begins to retire and con- signed and mortgage approval is obtained. sume financial products, vacation homes Other homebuilders inventory lots, and and other goods suitable to middle age build speculative homes assuming future and early retirement. Generation Y, on demand will absorb their product, and the other hand, is just beginning to form that buyers will be anxious to purchase households, and should create strong and move in quickly rather than wait for demand for rental apartments and con- their homes to be built. The recession of dominiums as well as student housing. 2008 and 2009 demonstrated the high Generation Y should begin to influence risk associated with inventorying lots and homebuilders with starter home demands building homes speculatively, as one can as it moves into the workforce, mar- see in many markets where large tracts of ries, and begins families. On top of this, land with only roads and storm drains sit

86 ZELL/LURIE REAL ESTATE CENTER empty, waiting for the houses that were GEOGRAPHY OR PRODUCT? never built. The length of the development cycle Some developers, Tom Bozzuto for exam- also influences the risks associated with ple, have chosen to limit their geographical new development. Long development reach, focusing on being the best in one cycles, common for dense, urban and or a small number of metropolitan areas. mixed-use products, make speculative Other developers, such as TCR, focus development risks even greater. A develop- on one product line (rental apartments) ment cycle of three to five years can result and build regionally or nationally. While in delivering the product into a much dif- financing is national and international in ferent economy than existed when devel- nature, development, with conditions such opment began. Northeastern and West as and building regulations, tends Coast markets, where land entitlement to be local. It is easier to understand mar- takes years and is often uncertain, make ket characteristics and nuances if you live new development risks and land acquisi- in the market. You can become an expert tion risks even greater. Certain types of in such local issues as development pat- development, such as rental apartments, terns, soil conditions, climate influences, are speculative developments by nature, local service providers, entitlement issues, as apartment renters will not lease a new risks, and timeframes. As a local developer residence unless it is immediately available. you may more comfortably build several Mini-warehouses are another example of product lines with confidence, although speculative development, as are small retail most developers limit their offerings to sites in new shopping malls. Market stud- residential, retail, or commercial. ies should in theory reduce the risk of Some developers choose mixed-use speculative development, but only if the projects, although these are hard to finance economy behaves as forecast. and typically require a solid balance sheet A number of companies go out of busi- and lots of equity. Mixed-use development ness during each recession as a result of used to be thought of as a way to diversify speculative development. The Trammell risks, but if one of the product types fails, Crow Company was badly hurt in the late risk increases. In Atlanta, for example, 1980s as a number of speculative office TCR was a co-developer of a new St. buildings were delivered virtually empty Regis Hotel and Residences building. As into the early 1990s recession. As the most the economy has improved, the 150- recent recession demonstrates, developers room hotel is doing relatively well, but we have short memories. sold less than half of the fifty-one luxury

REVIEW 87 residences, making it difficult to service oper and his team. Market research is construction debt. important and should be objective, not Companies that restrict their develop- contrived research similar to MAI (made ment to a single product line, such as as instructed) appraisals. Research should rental apartments, are able to develop enable developers to ascertain product a core competency in financing, design, gaps and to determine important product construction, and leasing. While there are features, amenities, and locational con- always subtle differences across markets, siderations. If family housing is involved, as the national CEO of TCR I felt more public school quality is important. For comfortable being able to evaluate new most product types, proximity to transit, development risks for rental apartments, access to retail, and access to major trans- since I had done this type of development portation corridors will be relevant. For over hundreds of projects. In order to some products, access to other businesses avoid mistakes related to the local nature will be important as well. of development, TCR embraced local part- Once an opportunity for new develop- ners who lived in the local community. In ment is determined to exist, a developer essence, we tried to have the best of both should write a “word program” describing worlds by having both geographic diversity to the architect, engineers, and land plan- and local partners who could bring impor- ners the characteristics expected of the new tant local knowledge to the process. development. The program should include An additional advantage for developers site characteristics as well as building fea- with a product focus is the ability to cred- tures including architectural style, floor ibly participate in each part of the business plans, amenities, and so on. Whenever cycle by raising funds for rehab (value possible, the contractor should be part added) as well as acquisitions during parts of the design team at the outset. A typi- of the business cycle in which development cal error made by developers is designing is not feasible. As I will discuss later, having something they cannot afford to build; diversified revenue streams is important to contractor input to the design team as a developer’s stability and longevity. you move from conceptual drawings to working drawings should keep everyone informed as to the projected cost of the THE DEVELOPMENT PROCESS end product. Design professionals should be select- Development should address an unfilled ed based on experience with the product need that is identified by the devel- type, and developers must ensure that the

88 ZELL/LURIE REAL ESTATE CENTER planning, architectural, and design team (the on-site manager is key), and over- has the capacity to execute. Developers see leasing or selling. The asset manager should determine which partners on must continuously evaluate the prop- the design team will work on their proj- erty management firm’s performance. ect, and ensure they have the requisite If the asset is held long-term (or is an background to execute on time and on acquired older asset), repair or rehab budget. Before commencing construc- needs must be evaluated on a continu- tion, developers should ensure they have ing basis, in addition to the opportunity a firm construction budget, which is to refinance. Repositioning the asset only possible if completed working for a different market niche may also drawings are made available in advance be appropriate. for pricing. Excellent property management, Construction can be self-performed or which optimizes NOI, drives value. In via a third party contractor. Construction apartments, which often sell at 5 percent executed by an in- contractor cap rates, an additional $100,000 in NOI should use, if possible, a fixed-price translates into $2 million of additional contract. Fixed-price contracts are desir- value. But be careful in structuring incen- able because they give the owner of the tives for property managers. Property construction company 100 percent of managers will push for a conservative the cost savings. On the other hand, if budget that they are sure to meet or a third party is selected you will most exceed (and blame the economy if they likely want a cost-plus-guaranteed-maxi- don’t). Push for realistic budgets and mum-price contract with a specified fee. evaluate them accordingly, being sensitive The developer should keep 75 percent of to changes in the economy during the the savings and 100 percent of the con- budget year. An excellent asset manager tingency that goes unused. Irrespective can add millions to your portfolio. Asset of how the contract is structured, ensure managers set the annual operating and the contractor is motivated to build on capital plan, and should review the stra- time and on budget. tegic plan for the asset at least annually. Regardless of ownership intentions, Refinancing an asset at the right time you will need strong asset and property can significantly change the value of an managers. The asset manager will hire asset by itself, and strategic investments a property management firm (or if in- in certain capital improvements can alter house will supervise), ensure you have the course of NOI for a property as well if experienced and competent personnel done thoughtfully.

REVIEW 89 MERCHANT BUILDING VS in excellent locations have resulted in INVESTMENT BUILDING huge losses because the project execution had poor timing. An example is a project Many private developers in residential purchased at the end of a price apprecia- housing are merchant builders; that is, tion cycle, when cap rates are at the bot- builders who intend to sell the product at tom and rent growth is about to reverse. completion or as soon thereafter as pos- For a developer, the worst timing is when sible. During exceptionally hot markets, you buy your land and price construc- income properties can be sold during tion at the top of the cycle, delivering the construction with the investor taking the product into a recession where demand leasing risk. Income properties are gener- has vanished. ally sold on a yield basis. The capitaliza- are particularly vul- tion rate is often thought of as the cash nerable to bad timing. With mortgage yield a buyer would expect to receive financing available at 97 percent of pur- during the first year after acquisition, typi- chase prices it is virtually impossible to cally net of replacement reserves. While get a meaningful down payment on a “to merchant builders are likely to sell as soon be built” condo project. Some states such as they feel they are getting a fair price, as California do not allow the seller to investment builders will hold the asset as keep down payments in excess of 3 per- a portfolio investment. REITs that engage cent. That means that you are essentially in development are best thought of as building a spec project, hoping that the investment builders. economy and sales momentum are strong In a downturn such as the one we are when you deliver. now experiencing, some merchant build- Luxury condo developers, includ- ers find themselves turning into invest- ing high-end resort developers, often ment builders, choosing not to sell into get wealthy buyers to put up 20 percent a down market with hopes of managing to 25 percent of the purchase price to their assets until the situation improves. reserve a unit. Nevertheless, a serious This simply underscores the importance market correction (such as occurred in of timing. Although you frequently hear 2008-2010) can result in buyers walk- “location, location, location,” timing ing away, even from such large depos- means everything in your success as a real its, particularly when contract purchasers estate investor—particularly if you are an believe prices during the construction IRR-driven, short-to-medium-term inves- period have fallen more than their depos- tor. Many well-conceived developments it. Unfortunately, lawsuits often are filed

90 ZELL/LURIE REAL ESTATE CENTER to get the deposit back whether justified Compounding the economic losses or not. Speculators, who never intend to that come with recessions is our inability occupy the unit, are the most danger- to predict their arrival. Each of the past ous buyers if things don’t go as well as three downturns seem to have resulted expected. A technique to minimize condo from a different trigger, this past one developer closing risks, often used over- importantly involving a “housing bubble.” seas, as well as occasionally in unusually Rarely do you see recessions coming in strong U.S. markets, is to use the buyer’s time to make the necessary adjustments money to fund construction. Some devel- to your portfolio. Historically, when infla- opers induce buyers to fund construction tion reared its ugly head as a result of by giving them discounts at least equal to excess demand, the Federal Reserve raised construction interest savings. Regardless interest rates to reduce inflation, often of product type, investment timing is causing the economy to stall and resulting critically important. If you plan to hold in a recession with its attendant loss of the asset longer-term, timing on acqui- jobs. As the Fed seemingly has gotten bet- sition will be mitigated, but IRRs will ter at anticipating inflation, other factors nevertheless suffer if you build or acquire have triggered recent downturns. at the wrong time. So what does all of this economic uncertainty mean for a developer? Some real estate businesses are more vulnerable SURVIVING THE CYCLES to the cyclical swings of our economy than others. The most vulnerable is speculative You understand the supply and demand merchant building, while the least vulner- factors and have chosen your strategy. You able is property management. Asset man- try to be successful through good times agement is also a relatively secure business, and bad, even if your timing is not perfect, and may even grow during downturns. The and you know that the U.S. economy has best hedge against our cyclical economy is cycles, with strong economic growth usu- a business with diverse revenue streams, ally followed by recessions. Unfortunately, some of which may grow in a downturn the length and severity of economic down- when development and construction fees turns varies, making it impossible to pre- (as well as profits from selling assets) dict accurately. For example, who could decline. Firms such as Hines Interests foresee that the recession of the past several have diverse businesses that include devel- years would be the most severe since the opment, property acquisitions, and asset Great Depression of the 1930s? management. While diversified firms may

REVIEW 91 have to lay off employees in a downturn, frequently insist on three-year maturities they are likely to remain solvent, as certain even if a project takes that long to build businesses (such as opportunity funds) and lease-up. Being asked to remargin a may grow in a downturn. loan that is delivered in a weak market is a Developers can also hedge against real risk to a developer’s liquidity. downturns by the product lines they Borrowing using nonrecourse debt is choose, as well as how they finance frequently an objective. Unfortunately, their businesses. Short-cycle develop- you may have to inject 50 percent of ments such as apartment conversions to equity in a new development to get a condominiums, warehouse development, nonrecourse (completion guarantee only) strip retail and single family homebuild- construction loan, which limits not only ing can perform relatively well during a your IRR for the project, but also the downturn since construction inception amount of business you can do with a to completion is less than a year. Building finite amount of liquidity. properties with pre-leasing, or building Since buyers can disap- only pre-sold homes can add another pear overnight, TCR will guarantee com- layer of protection. pletion of condo projects, but not repay- The way development is financed can ment (amazingly such nonrecourse loans determine whether you survive a down- were available this cycle with only 20 per- turn. As everyone knows (but forgets), cent equity). We got hurt, however, when leverage cuts both ways, and excessive we guaranteed marketing costs, interest leverage has doomed thousands of com- and other carrying costs to loan maturity panies. Based on my thirty years in mul- rather than simply to physical completion tifamily residential development, I believe of the building. The lesson is that you must that 25 percent equity is the minimum always do a serious downside analysis of you should inject in the capital stack on what obligations you will be responsible for new construction of rental housing. When if the market vanishes before you get your downturns occur, effective rents decline, condominiums to market. but so do floating construction loan rates Surviving the cycles is enhanced when as LIBOR and the prime rate will normal- you have an alignment of interest with the ly also decline as the economy weakens. key actors in your business. At TCR we The financing issue that is far more embraced a partnership structure where dangerous than rising rates is short loan local partners who sponsored deals would maturities. Banks do most of the con- profit or lose along with the regional and struction loans for apartments, and they national partners based on the success of

92 ZELL/LURIE REAL ESTATE CENTER each deal. A netting agreement ensured of looking at our company’s history as that losses would be offset against profits. well as inventorying our current assets Having an aligned interest with equity was enlightening. We learned we lost investors (and lenders where possible) money on 20 percent of our jobs, we had gives everyone some peace of mind about limited hard bid capability, and we were motivation. One of TCR’s mistakes lead- heavily dependent on office construc- ing up to the Great Recession was taking tion. Additionally, we learned the two title to land before we were prepared to principals in the firm were almost solely begin construction. I counted (naively) on responsible for business development. We the investment of an equity investor in the also learned we were heavily dependent land to ensure we would start construc- on Texas as a source of business, with tion as soon as zoning was complete and a Atlanta secondarily important. While a construction loan in-place. Unfortunately, study of the outlook for office demand as market conditions deteriorated, the suggested the next few years would offer investors walked away from their land continued opportunities, with new office investments leaving TCR responsible for development projected to be strong for repaying the land debt. In some instances several years, we resolved to diversify the land value fell below the debt, and the our sources of revenue and our business banks immediately demanded repayment, development team, and additionally to or at least a paydown and remargin. When add a “hard bid” capability to enable us the downturn arrives, equity investors’ and to pursue countercyclical governmental bankers’ actions are determined by the construction opportunities. circumstances at their organization, and the alignment you envisioned in a suc- cessful project may quickly disappear in THE FUTURE OF a “workout,” as they struggle to minimize DEVELOPMENT the damage to their own organizations. I had the good fortune early in my Young men and women entering the career to serve as CFO of the Henry C. workforce in 2011 with a desire to be Beck Company in Dallas, a commercial developers must be wondering what building contractor. In the mid-1990s, kind of opportunity exists. Adding to with our construction backlog running (or reconfiguring) the built environment out, and anxious about the outlook for will vary greatly depending on product our company, we began a strategic plan- type. Nevertheless, unless the population ning process. Going through a process growth projected for the United States is

REVIEW 93 radically altered, new development will memories are short and we seem reluctant be needed to serve a growing population. to learn from past mistakes. Development Even if immigration policy becomes more can be a path to riches if a risk-adjusted restrictive, we will add more than two mil- return is properly evaluated and the proj- lion new people each year. We also have ect is soundly financed, but it can easily to replace existing structures that become lead to ruin in a cyclical business environ- obsolete or are destroyed by fires, floods, ment. Nevertheless, it is creative work that and so on. While the need for new hous- will continue to inspire aggressive hard- ing is easily understood, the demand for working men and women for many years retail, office and other commercial build- to come. ing may be more heavily influenced by technological advances. Internet purchas- ing may continue to grow and affect the nature and amount of retail construction. Similarly, if technology enables people to work more remotely without the need to occupy an office, the need for traditional new office construction will be affected. The availability of financing will affect the pace and nature of new developments. While I suspect construction financing will reappear in abundance once vacan- cies drop and rental rates increase to a point where new construction is justified, it is likely that more equity will be needed than was required before the most recent recession. This is typical at the beginning of each cycle before new construction begins again, and it remains to be seen how long the memories of the lenders will be this time. In conclusion, being a developer in a first world country where there are families and tenants who have the financial means to compensate you is attractive. However,

94 ZELL/LURIE REAL ESTATE CENTER