Investment strategy for property development

Investment strategy for property development

Jean-Marie Murphy

As real estate markets recover from the turmoil of the past several years, a dynamic market is emerging that offers some interesting opportunities for astute investors.

With the renewed demand of institutional investors, prices for investment grade real estate are being bid up, which is forcing yields downward. This has created a dearth of investments that produce the high returns usually associated with real estate.

Many capital sources are now bullish on real estate, and have rushed back into the market as equity investors. Lenders, however, are still wary, and are slow to re-enter the arena, especially for development deals. Most commercial lenders currently require a minimum equity investment of 20 to 30 percent in a development deal before they will consider financing it.

The lag between demand for real estate and the re-entry of lenders has helped to decrease the oversupply that was created during the last decade. It has also strengthened some markets so that they are poised for growth.

As real estate investors, institutions are rarely willing to take on development risks. The result is a shortage of capital available to fund new real estate projects, including many that make economic sense based on real estate fundamentsals. This has produced a strong demand for investors that are willing to assume some development risk.

Greystone has devised a strategy to benefit from this capital shortage. Recent pursuits include a number of successful “development joint ventures,” in which an equity source is matched with a top developer in a strong market. Getting in on the ground floor enables investors to acquire investment grade real estate at wholesale prices.

Although a few precautions must be taken to minimize risks to a level acceptable to an institutional investor, the key to these deals is to take calculated risks in strong real estate markets, and to choose partners that have a proven track record.

Greystone’s approach is to control development risk by committing funds only after a project has been planned, zoned, and has received the appropriate approvals from all federal, state and local authorities. Thus, risks associated with the planning process are avoided, and an equity investor is not burdened with the carrying costs that frequently mount when a project experiences resistance.

To eliminate the risk of cost overruns, Greystone closely scrutinizes a project’s financial soundness, including budget structure, required reserves, construction loan draws, and project performance versus budget.

These financial indicators are helpful in spotting potential problems. Construction costs can be minimized by negotiating contracts with a guaranteed maximum price from a bonded general contractor. These precautions combined nearly eliminate the possibility of cost overruns.

Creating a realistic exit strategy is another way to manage risk. Currently, institutional investors prefer multi-family and retail properties, which historically have produced attractive returns. These property types are now in high demand as investors return to the real estate market.

Developing multi-family and retail properties will therefore have the additional benefit of creating a steady stream of product, which will reduce the risk associated with an exit strategy.

To minimize the risk associated with retail properties, an experienced real estate advisor will limit funding to projects with commitments from tenants with strong credit ratings. This will increase the likelihood of the property attracting other desirable tenants.

Greystone mitigates multi-family project risk in three ways. First, an advisor must be capable of performing extensive market analysis on a project-by-project basis. Factors such as employment growth, population trends and local attitudes toward new developments are the most significant factors affecting demand. For example, an approved project in a city with an anti-development attitude and high population growth would be a universally appealing investment.

Second, the project’s specific location within its market can substantially impact its success. Greystone limits acquisitions to sites with superior characteristics relative to competitive projects. A well-located multi-family project with superior characteristics, such as a panoramic view, a golf course or a waterfront location, should achieve higher occupancy and rental rates than the market as a whole and is more resistant to adverse market conditions than its competition.

Finally, marketing risk is managed through prudent project underwriting. By making conservative assumptions in constructing pro forma financial statements, the temptation to invest for subjective reasons can be avoided.

Depending upon the objectives of the investor, once the property is stabilized it can either be held or sold to one of the many institutional investors who prefer a finished product.

Greystone anticipates benefitting from this opportunity as long as equity for real estate development is scarce, and quality development opportunities exist.

COPYRIGHT 1994 Hagedorn Publication

COPYRIGHT 2004 Gale Group