DEVELOPMENT ~ COMPONENT SERIES Fundamentals of Real Estate . Development by James A. Graaskamp The real estate development process involves three Basic Concepts major groups- consumer group, a production group, and a public infrastructure group. Each Introduction group benefits from cooperation and a full under- Someone rolled a rock to the entrance of a cave and standing of the values, short- and long-term objec- created an enclosed space for his family—a warmer, tives, and major limitations controlling the other two more defensible shelter, distinct from the sur- groups. A major limitation shared by all groups is rounding environment. This can be called the first the fact that each is a cash cycle enterprise which real estate development. Since then real estate ac- must remain solvent to survive and which must tivity has evolved and taken many forms to meet the create a surplus over time to maintain credibility needs of man and his society. Once based on need . with others. Cash cycle enterprises must continually and custom, real estate is now based on social make assumptions about future social norms, economics and statute. technologies, and the direction of complex changes . in personal, natural, and political conditions. The Real estate can be defined generally as space de- degree of error between assumptions and realiza- lineated by man, relative to a fixed geography, in- tions is what is termed risk, and in an enterprise tended to contain an ~ctivity for a specific period of economy most parties are attempting to shift a dis- time. To the three dimensions of space (length, proportionate share of the risk to others while re- width, and height), then, real estate has a fourth taining a larger share of the benefits. Unlike many dimensio-thqk f~f ~ssession and benefit. This mass production industries, each real estate project can be referred to as ~ space-time characteristic. is unique and the development process is so much The space-time concept is illustrated by the terms a creature of the political process that society has a apartment per month, motel rooms per night, new opportunity with each major project to square footage per year, and tennis courts per hour. negotiate, debate, and reconsider the basic issues A fundamental element in real estate is that any of an enterprise economy, i.e., who pays, who ben- space-time unit has a corresponding monetary efits, who risks, and who has standing to participate value. While many of the value judgments and de- in the decision process. Thus the development pro- bates about real estate projects relate to elusive cess remains a high silhouette topic for an articu- criteria of what is good and beautiful, in a money economy the ultimate criterion is cash. late and politically sophisticated society. The best risk management device for the producer group, which is usually the lead group in the initiation of a The creation and management of space-time units project, is thorough research so that the develop- is termed real estate development. Real estate de- ment product fits as closely as possible the needs of velopments range from a simple cave to the com- the tenant or purchaser, the values of the politically plex technology of the Park Avenue skyscraper. Like active collective consumers, and the land use ethic a manufactured product, a real estate project is part of the society. of a larger physical system programmed to achieve long-term objectives, but each real estate project is The Development Component Series (DCS) is a file of monographs on land use planning and development practices and cases published by UL1-the Urban Land Institute. Authors are practitioners or educators experienced in the component topic. The monographs incorporate the insights and suggestions of a review group comprised of seasoned practitioners on the subject. 1 Contents Author Basic Concepts Professor James A. Graaskamp, Ph. D., SREA, and CRE, has a double career as educator and real estate consul- Introduction Basic Real Estate Relationships tant. He is presently chairman of the Department of Real Cash Solvency—The Critical Common Concern Estate & Urban Land Economics at the University of Land Versus Location Wisconsin-Madison and president of Landmark Research, Linkages, Location, and Cash Cycles Inc., established in 1968, a consulting firm specializing in Cash Cycle of the User Versus Cash Cycle of courtroom appraisals, feasibility, and institutional invest- the Collective Consumer 8 ment. He has a background in home building and land The Cash Cycle of Infrastructure 9 development, and is well known for his work in feasibility The Concept of Property Rights 9 analysis and small computer applications to real estate 10 Most Fitting and Most Probable Use analysis. He is a member of the Board of Directors of the Risk Management in Development Wisconsin Housing Finance Authority, a ULI Research Fellow, and a member of the ULI Education Committee. Conditions of Uncertainty in Development 11 Basic Risk Management Techniques 12 Time as a Critical Risk Element 13 The Urban Land Institute and the U.S. Department of Energy shared in providing a $1500 grant to Preliminary Budget Concerns-Producer Group Ms. Barbara Gallagher, a graduate student completing a Feasibility Analysis 13 master’s degree in Real Estate Appraisal and Investment 14 Approaches to Determining Feasibility Analysis at the University of Wisconsin, to assist the author Regu Iation of Capital 22 in the preparation of this manuscript. Investment Purchase of After-Tax Cash Flow 22 Although this report was prepared with the support of the Marketing-The Key to Development U.S. Department of Energy (U.S. DOE Grant No. Market Research 23 DE-FGOI-80CS 24101), any opinions, findings, Market Data Versus Merchandising Data 26 conclusions, or recommendations expressed herein are Marketing Research and the Collective Consumer 27 those of the author and do not necessarily reflect the view The Preachitectural Marketing Program 28 of DOE. Anticipating the Future User 29 The Ethics of Fit and Monopoly 30 Reviewers Summary 30 Jack C. Byrd, Vice President and Project Manager, KINGWOOD, A Land Development Project of Friendswood Development Company and King Ranch, Inc. Houston, Texas Robert E. Engstrom, President, Robert Engstrom Associates, Inc., Minneapolis, Minnesota R. John Griefen, Boston Partner, Gerald D. Hines Interests, Boston, Massachusetts Alexis P. Victors, Senior Vice President, Western Pacific Railroad Company, San Francisco, California About ULI ULI Staff ULI is an independent, nonprofit educational and research Ronald R. Rumbaugh, Executive Vice President organization dedicated to improving the quality of land use Carla S. Crane, Senior Director, Program/Education Division planning and development. From its incorporation in 1936, Robert L. Helms, Administration Division Director ULI has been interested in resolving the problems surround- Joseph D. Steller, Jr. DCS Editor ing development by establishing, through research, a credit- Nadine Huff, Editorial Associate able information base for action and by using the educational Carolyn de Haas, Art Director process to communicate this information to the various ac- tors in land use development. Based on its experience, ULI strongly believes that research and education, presented objectively, can make a difference and that in most instances reasonable approaches to problem solving will prevail. Copyright 1981 by UL1–the Urban Land Institute, 1090 Vermont Avenue, N. W., Washington, D.C. 20005. All rights reserved. Library of Congress Catalog Number 81-51563. International Standard Serial Number 0276-4970. International Standard Book Number 0-87420- 601-4. Printed in the United States of America. Second Printing, 1986. Third Printing, 1989. 2 also a small business enterprise of its own. Thus, mortgage banker, lumberman and lawyer, city plan- the development process is a continuum of con- ner and hotel manager are all in the real estate struction technology, financing, marketing skills, business. The real estate business includes any per- administrative controls, and rehabilitation required son with expertise in creating and maintaining to operate the real estate enterprise over many spaces to house activities of space users in the years. marketplace. Real estate development also is a complex, collec- The public infrastructure group includes all those tive process, not only accommodating an activity enterprises that provide a network of tangible and within the parcel, but also adapting to the context of intangible off-site systems for the individual space a specific surrounding environment, involving dif- user, including physical networks of street and ferent personalities and interest groups, as well as sewer and other utilities, services like education, limited resources. The political and social process police and fire, and operational systems for deed to produce a real estate product must consider a di- registration, governmental regulation, adjudication, versity of impacts to find equitable reconciliation and all forms of economic activity with efficiencies between who pays and who benefits. of scale that suggest collective off-site action. Note that the difference between space production and public infrastructure has nothing to do with private Basic Real Estate Relationships or public ownership since private companies may The real estate process presented in Figure 1 is the provide utilities and public agencies may develop constant interaction of three groups—space users real estate. A necessary