The Life of a Developer Helpful hints for budding LIKE VIRTUALLY ALL businesses, real estate 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 houses) 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 zoning 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.