Money Matters in Property Redevelopment
Three tasks can ensure your financing plan is on point when starting a redevelopment project.
The redevelopment of property is crucial to a community’s renewal and economic health. Naturally, commercial real estate professionals are in business to make a profit, but revitalizing a property and turning it into a revenue-generating piece of a neighborhood is a
financial benefit to more than just the developer.
Before a blighted property can be reinvigorated, though, you need the funds to acquire it. Acquisition can mean more than just taking the title — it can refer to a lease, lease-purchase, land lease, or multiple vehicles.
Projecting Expenditures and
First things first, in an acquisition, how much money will you need and where will it come from? If your redevelopment project will be 100 percent equity, that’s fantastic. But rarely is it so simple. If you need to include debt, know what you can afford.
Look at this from the lender’s point of view to better understand this part of the equation. In redevelopment, the big payoff is often the last step in the process. A lender will want to know if this property can support the loan on its own until that point. If not, what other property or income do you have that can support
your request if a project eventually requires debt service? You may have some performance bonds or additional guarantees, which are the things that you’ll need prepared for your potential lender.
For example, look at a common approach to redevelopment where the market conditions are not yet ready for you to take a product to market. In this case, from an underwriting standpoint, you have to be prepared for a long-term hold. Every project includes the unexpected, but it’s imperative you know where you’re headed. If
things change, you then know where the exits are and how to get to them.
Redevelopment projects include acquisition costs, capital expenditures, and additional expenses related to holding onto the property. That is to say, money tends to flow out before coming back in.
Income could be included in early stages, including property sales, if a portion of the initial acquisition can be sold to finance later phases of development. Could rental income be a consideration? It can be depressing to stack up the costs versus income as a project gets started, but this is why projections are vital to your success.
Looking at the construction phase, as the developer, will you be handling improvements? Will you be land banking it to a point where you can sell to a land packager? This is such a unique stage in the redevelopment process, simply because it’s when you are game planning the routes to various exits.
Looking at the overall timeline, at this point, you haven't closed on the property, but you have spent money on feasibility studies and due diligence. Once you decide to move ahead with a project, that’s when the big-time dollars are spent — either through a loan or equity contributions.
Financial Management and
All capital flows must be managed, funded, distributed, and reported in a timely way. In this redevelopment project, who are the various stakeholders and what kind of reports are going to be required by each one of them?
One commandment in real estate development is to know thyself. In this regard, be aware if you are capable of the necessary reporting with any particular project. (Here’s where it’s vital you are honest with yourself.) If not, arrange for the proper
accounting to collect the data, create the reports, and distribute them in a timely way.
The general rule is that good real estate projects have good accounting. Bad real estate projects, of course, have bad accounting. The developer is the conductor of the orchestra, who blends the horns, strings, and percussion at the right time in the right amount. As a developer, this doesn’t mean doing all the work — but you need to know when certain things need to be done.
Capital Formation and Accumulation
This step in the process involves digging a bit deeper into the sources of capital and their uses. For redevelopment projects especially, valuation can be an obstacle because it requires local knowledge. For larger developers, revitalization projects can be unappealing because they require an understanding of the area — and how the project will succeed. Often, this leads to teaming up with community lenders, who specialize in understanding the local market.
After estimating how the funds will be used, you need go looking for the source. When I say the source, I don’t mean necessarily going out and looking for a particular lender; it’s more about projecting how much of your funds should be on the equity side and how much should be on the debt side.
Once you know how much will fall on each side of the ledger, you can open your little black book and start contacting potential lenders. For these conversations, you need to estimate the construction costs, the potential loan terms, and what kind of loan — construction versus permanent lending — will best suit your project.
Focus on How Funds Are Used, Not Sourced
Let’s take a look at the sources and uses of funds for a hypothetical redevelopment project. It’s a two-year deal. The first step is acquisition, which will cost a little more than $1.26 million — that’s a hard cost right out of the gate. In the first year, the hard costs will top $2.4 million while soft costs, like engineering and architectural services, will cost roughly $350,000, for $2.79 million in Year One. The next year, hard costs will remain stead while soft costs jump over $1 million. In total, the project will run roughly $7.6 million.
Now that you have this laid out and understand the timing of the uses, look at the source of funds. In this case, equity capital will cover the initial acquisition. By the end of the first year, the project will include a $2.44 million construction loan, along with another $350,000 for soft costs. In this case, all hard costs are covered by the lender, while equity covers the soft costs.
In approaching this hypothetical project, it’s easy to look at the acquisition cost as the primary goal for what funds are needed. But you can see here, the needed equity is $2.65 million over the two-year term of this project — more than double the $1.26 million spent to get things started. That $1.4 million difference needs to be in reserves, knowing a bit more could be needed for mistakes and unexpected issues. But this example shows that it’s crucial to know the funds needed when putting a partnership together.
Redevelopment projects involve an aspect of delayed gratification, but they can be great opportunities. The keys to understanding how to finance these deals boils down to knowing how much money you need, where it will come from, and where it will go.
For more on this topic, check out CCIM Institute's “Real Estate Development: Property Redevelopment” course.