As the 2008 recession continues to take a toll on the US economy, numerous commercial and residential real estate development projects are stuck in a holding pattern. Investors are unwilling to invest, and lenders are unwilling and/or unable to lend. Business owners find it extremely difficult to obtain financing that would allow them to develop businesses that would lease commercial units from developers, and residential buyers cannot obtain financing to purchase single-family homes or condos from developers. The general devaluation of properties, lack of equity, limited availability of credit, and the overall decline of economic conditions created a chain of events that has made it increasingly difficult for real estate development projects to succeed, or even survive within the current market. However, a number of strategies exist to help “un-stick” real estate development projects by overcoming these barriers and challenges.
The lending industry has played an important role in this chain of events as hundreds of lenders have retracted real estate development loans, refused to issue new loans, and tightened financing criteria despite the millions of dollars in “bailout” money that many of them received (intended, in part, for the purpose of opening new credit channels and lending opportunities). As a result, numerous real estate developers have been left with pending development and construction loans that their lenders are no longer willing to fund. Many developers have opted to negotiate deed in lieu agreements with their lenders to avoid litigation and foreclosure by essentially transferring the properties to the lender with no monetary gain for the developer. Other real estate developers are simply stuck in this holding pattern with properties that they cannot get funded but are responsible for concerning payment of property taxes, maintenance expenses, and debt service payments to lenders. For many of these developers, the prospect of developing their properties to generate a profit in the near future has become negligible. The expenses associated with keeping and maintaining these properties coupled with the lack of revenues generated by them has created a downward spiral effect that has led to bankruptcy and foreclosure of thousands of real estate developers in recent years.
Properties that were once slated for development of residential communities or new commercial venues that would help create jobs and improve economic conditions have been stuck for several years. Lenders typically sell these properties through auctions or a “fire sale” processes for pennies-on-the-dollar in order to get them “off of their books” as a liability and as an impediment of their funding capacities. Opportunistic investors or “land bankers” often purchase these properties and hold them for future gains in anticipation of an eventual market turn-around. Hence, these properties remain undeveloped and “stuck” for years to come, instead of becoming revenue generating assets for their communities.
So how do you “un-stick” a real estate development project in today’s economy? Many real estate development projects can benefit from various strategies that can be implemented to convert them into revenue-generating profit centers that also create jobs, facilitate the provision of needed goods and services, help improve the local economy, and enhance the aesthetic appeal of the area by improving a vacant or deteriorated property. The strategies provided in this article are described as summaries of more complex processes that require strategic planning and development tactics in order to achieve significant results; However, these strategies have been effective for the turn-around of numerous real estate development projects within the current economy. While it may not be an easy task to “un-stick” a real estate development project in today’s market due to the challenges described above, it is achievable to convert such properties into profitable endeavors by incorporating the appropriate strategies and techniques that are designed to overcome these barriers despite the current economic conditions. Following is a list of various strategies that can be incorporated for this purpose:
Strategies to “un-stick’ real estate development projects
1) Revise the existing development plan
Intricate analysis is likely necessary to determine the current highest and best use(s) for the property considering recent physical, social and economic changes within the local environment. For example, a property that was originally designed for development and sales of high-end condominium residences may be suitable today as a mixed-income apartment complex that can be developed in a phased manner to minimize the need for substantial upfront equity, to minimize risk, and to facilitate development in a staged process in correlation with the propensity of demand. The condominium development and sales model would have provided short-term profits and payoff of the development loan as the units were to be completed; Whereas the development of an apartment complex would provide long-term profits and require a long-term financing arrangement to facilitate incremental pay-down of the loan over time. It would also require ongoing property management, maintenance and marketing efforts that must be demonstrated in the revised plan. Therefore, in this example the real estate developer must be willing to change the original model and to employ the expertise that would be necessary to make the new model successful.
Numerous examples can be provided of projects that had to change their existing model in order to adapt to the recent social, physical and economic changes of their environments. The key is to determine, with accuracy, what the highest need and demand generator will be for the specific property, and to create a development plan designed to meet the demand in a cost-effective manner. A number of additional tactics are needed for the preparation of an effective revised development plan and to obtain funding, such as preparation of a strategic financial analysis and capitalization plan, operating plan, market penetration plan, etc. The tactics and format vary depending on the project.
2) Government incentives and participation
Real estate development creates temporary construction jobs and permanent local jobs. It facilitates the provision of goods and services, and production of tax revenues on local, state and federal levels. This helps stimulate the local markets and promotes financial stability for the economy as a whole. The lack of real estate development projects have the opposite effect, and have contributed significantly to the current recession. For this reason, numerous government entities have incentive programs that are intended to spur new real estate development projects for the private sector. The benefits of these programs for the real estate developer can translate into reduced project costs, additional equity that can be used to leverage financing, infrastructure improvements, use of public services, enhanced lender and investor participation, and other important advantages. This strategy requires identification of specific government programs that are available for the project, understanding of how to incorporate the programs and how to meet specific program criteria, negotiations with public officials, and strategic collaboration efforts between the parties. Numerous real estate development projects within the current economy would not have otherwise been developed, but were able to take advantage of a variety of government programs and leveraged those programs to enable their success.
3) Equity strategies
Equity is necessary to leverage senior financing; Now more than ever. Prior to 2008 the equity requirements for many lenders was much less stringent. Numerous financing programs existed that allowed projects to obtain funding at 80%-100% loan-to-value ratios because the higher valuation of properties at the time provided payback assurance to lenders. In today’s economy, however, the lending ratios are generally acceptable if they fall within 40%-65% on a loan-to-cost basis. The devaluation of properties has created a situation in which real estate developers must have substantially more liquid capital and/or other assets to pledge in order to leverage financing, however, the availability of liquid capital and assets has also decreased significantly. Therefore, the strategies for securing the equity needed to leverage financing has become increasingly more important in the development process.
Equity can be obtained from a variety of sources, including, the principal/owner, land, other assets such as properties, equipment and materials, partners, investors, contractors, service providers and other professionals. In many cases, the real estate developer is not the sole provider of the equity that is needed for the project, but the equity is assembled from various sources in order to mitigate risk for the developer and to increase possibilities for financing. In order to accomplish this effectively in today’s market, the revised development plan (described in Paragraph 1, above) should be tailored specifically for potential equity investors and/or partners, and presented in a manner designed to effectively answer most of the questions they may have. A strategic plan to identify and source potential equity investors and/or partners should be developed, and the appropriate investment agreements and documentation must be professionally prepared and presented. Recent real estate development projects have benefited from this approach and were able to secure the equity needed to leverage financing by incorporating this strategy.
4) Other lending sources
While many conventional lenders have become ultra-conservative in their approaches to financing real estate development projects in recent times, other private lending sources have evolved as viable financing alternatives for such projects. These sources often offer similar interest rates and terms as conventional lenders, or higher rates and stricter terms depending on the perceived risk. The private lending sources vary from investment groups, to international organizations, to private companies, to high net-worth individuals, and others. Identifying the right private lending group for a specific project, and the presentation format and strategy that will be implemented is critical to securing financing from these sources. Financing brokers or organizations that have existing relationships with such lenders can be especially helpful in this process.
5) Participation from team members
The current economic crisis calls for unconventional strategies that may not have been prevalent prior to 2008. Engaging the participation of professionals, contractors, service providers and material providers is an effective strategy that is more widely accepted today than in previous years. These individuals and companies become team members of the project, and provide participation in the form of services, equipment and/or materials that can be used to launch the project with reduced upfront capital requirements, and as equity to leverage financing. Many of these team members have experienced a reduction in volume of business due to the economic downturn, so today they are more willing to defer a portion of their fees until the time of funding or in return for a membership interest in the owning entity of the project. For example, an equipment manufacturer can pledge $10MM of equipment for a project, which can be used as equity to leverage financing. An architect and other consultants may agree to perform work with a portion of their fees to be paid upfront, and the remaining portion to remain in the project as equity. Numerous examples exist of projects that have leveraged equity, services, equipment and materials using this approach in recent times. It is important for team members to understand the project, believe in it, and for terms to be negotiated that favor both parties.
As mentioned earlier in this article, the above strategies are provided as summaries and examples of tactics that can be used in today’s economy to help “un-stick” real estate development projects. Each project is different. Each project requires intricate analysis and strategic planning to determine the specific strategies that can be implemented in order to make them profitable despite the economic constraints, barriers and challenges that exist today. While surviving and thriving in today’s economy may not be easy for real estate developers, it is achievable to “un-stick” your real estate development project by implementing these and other critical strategies.
By Ricky Trinidad, Consultant
Metronomic, Inc. is a business and real estate development consulting organization with offices in Schaumburg, IL, Chicago, IL and Miami, FL.