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WHY REAL ESTATE DEVELOPMENT IS AN
Admit it! Americans honor and respect success. Horatio Alger ranks with George Washington in our national mythic consciousness. Moreover, we love and sometimes exalt the progeny of success: money.
There are few businesses in the United States that offer as many rewards and opportunities as real estate development. But it wouldn't be such an attractive and lucrative business if it wasn't for one fact: development is first and foremost about land. Why is land so special? Will Roger's advice, "Buy land, they ain't making any more of it," contains all of the reasons why land is a good investment. Those reasons are:
Land is unique. No parcel of land is like any other parcel of land in the world. It is unique in its physical location, as well as its physical characteristics. This is why "location, location, location" are often cited as the three most important factors in real estate in general and development in particular.
Land is indestructible. You can mine land, blow it up, move the dirt, but you can never destroy the surface of the earth. Think about it: homes, cars, factories, humans, everything else decays and falls apart, but "the earth abideth forever," in the words of Ecclesiastes. This is why land has always been considered such good collateral, and why lenders consider it a good investment. People come and go, but the land is always there.
Land is immobile. You cannot pick up land and move it anywhere. You cannot lose it, steal it, or hide it. You nevergo looking for a piece of land you own and say, "Gee, it was here yesterday." Your land is always where you saw it last.
Uniqueness, indestructibility, and immobility are the distinguishing features of real estate. What about development, which is the specific branch of the real estate business that constructs buildings? In addition to the factors discussed above, development has the following specific features that make it an attractive proposition.
This is the primary advantage of development. Leverage is the use of other people's money to make money for yourself. When a house is built today, chances are that at least 75 percent of its total cost (including land, construction, marketing, overhead, etc.) is financed by somebody else, usually a commercial bank or savings and loan association. In return, you pay interest to the lender.
A lender will allow you to use leverage because the property that you are developing should rise in value through the fruits of your labor. You can be assured that your lender will use your developed property as collateral on your loan, so if you go broke your lender will foreclose on property that is worth more because of your efforts. This is the advantage developers have over other manufacturers--land is unique and, if it is built to a specific market, should not be difficult to sell. By contrast, the manufacturer of plastic balloons does not have this advantage. A lender will not lend as much to the balloon maker as he would to the developer, since what would a lender do if he were to foreclose on a million balloons? Lenders also invariably have the first lien on a property, which will give them comfort but not a total guarantee that they will be paid in the event that you go broke.
Leverage is important to the profitability picture of development. For example, the profit for a small developer is typically between 10 and 20 percent of the sales price of a house. You may say that 10 percent is not a great return, given the risks inherent in development. You may think you can make at least that much by playing the stock or bond market, and you may be right (but we wouldn't bet on it). The main difference, however, is that when you play the stock or bond game, you are using your own money, while with the development game you are using someone else's money.
An example can illustrate the difference. Suppose you built a house and sold it for $100,000. Assume that $85,000 represented the total cost of building the house (land, construction, interest, overhead, etc.). Assume further that you obtained a loan for 75 percent of that $85,000 from a commercial bank, so that your actual investment was only $21,250.
Since you sold the house for $100,000 and it cost you $85,000 to build, you made $15,000, or a 15 percent net profit. But wait--you only invested $21,250, so your actual profit (your return on investment) is 70 percent ($15,000 return (British Pounds) $21,250 investment = 70 percent return on investment). How did you make that much money? You used leverage. Had you taken that $21,250 and invested it in the stock market and received a 10 percent return, you would have only made $2,125. You made seven times that much in your development deal.
The real skill, however, is to be able to build that house for $85,000 and to find someone who can pay $100,000 for it. This is the challenge of development--building profitable, affordable housing by containing costs and building for a market. Both of these issues will be discussed in later chapters.
In the past, developers were able to deduct interest and depreciation on their projects. Tax shelters were major incentives for being in rental real estate. The Tax Reform Act of 1986 shifted the developer's investment strategy from tax shelter losses to making a profit.
For the homebuyer, however, the greatest tax advantage is still intact-the power to deduct mortgage interest on first and second homes. This alone will continue to fuel new home sales for many years to come.
There is a constant demand for new construction in this country, for two reasons: a growing economy needs new buildings, and old buildings wear out. Housing, shopping centers, schools, office buildings, and industrial facilities all get old and need to be replaced. An estimated 100,000 to 400,000 homes are lost each year to aging, fire, flood, and other hazards and need to be replaced.
Population increases also add pressure to build. While the U.S. population is growing at a slow rate, there has been an increase of about 1.3 million new households each year because of changes in lifestyle that have occurred over the past two decades. The traditional family (father who works, homemaker mother, children) now comprises only ten percent of all the households in America. Divorcees, single-parent households, unmarried couples with and without children, healthy retirees, and singles have caused demographic changes in the United States that greatly affect development. The migratory nature of the American population and the increase in second homes also add to the pressure for new development.
Age groups also will play a significant role in development. For example, the baby boom generation born between 1946 and 1962 helped fuel a rise in first-home buyers during the 1970s and early 1980s. Now that baby boomers are older and have children, they need bigger houses. These "move-up buyers" will be an important segment of the home-buying public in the 1990s. First-time buyers will decrease.
Empty-nesters are one of the hottest age groups in housing today. They are retirees, moderately affluent, in good health, with their children grown. They are eager to live in an active community with recreation and low maintenance and without the stigma of an old-age home. As discussed in the Sales and Marketing chapter, many developers now build their houses toward lifestyle and age segments in addition to income brackets.
Most of us are required to earn a living. Some are content to work for others. Many, however, view self-employment as the ultimate way to earn a living, knowing that for better or worse they are the masters of their own destinies. Each year, hundreds of thousands of people pursue this dream and start their own businesses.
If the epitome of success is to be your own boss, love what you do, and earn tons of money doing it, then development offers the best of all possible worlds.
Real estate development provides a tremendous feeling of accomplishment. It is a creative process that begins with locating a parcel of land and ends with the construction of a building.
Developers are a vital link in the economy of the United States, providing infusions of capital into the economy via jobs and materials. There are hundreds of economic and social effects that occur when a home, office, or factory is constructed and sold. The total value of all construction activity in 1987 was roughly $440 billion, about ten percent of the Gross National Product of the United States. For this reason, the construction industry has often been referred to as the backbone of the economy.
THE PLAYERS IN REAL ESTATE DEVELOPMENT
There are four main players in real estate development: speculators, subdividers, land developers, and builders.
Speculators buy raw, undeveloped land, hold onto it, and sell it at a later date for a profit. They do nothing to develop the land. The speculator presumably knows that land values will rise in an area in a short period of time. The reason could be a new employer, shopping mall, or interstate highway. Regardless, land speculators (and developers in general) always try to buy in the direction of growth. The advantages of land speculation are costs lower than development and high potential gain. The disadvantages are that raw land generally does not produce income, financing is difficult to obtain because nothing is done to improve the land, and future increases in value, needed to make the investment pay off, may or may not materialize.
Subdividers buy raw land and, if not zoned for its best use, attempt to change the existing zoning to a higher and more valuable use or density. One example is to buy land zoned residential and attempt to have it zoned for commercial or industrial use. Subdividiers also seek to divide the land into blocks, building lots and streets in accordance with government regulations.
Like speculators, subdividers gamble that the land they buy will be ready for development soon. Subdividers reduce their risk by doing market studies that decide if development is likely in the foreseeable future.
Subdividers can buy from land speculators or from private individuals. They will usually sell to a land developer or a land developer/builder.
Land developers install water, sewer, utilities, streets and curbs. These improvements are called "infrastructure." The land developer must first obtain all government approvals, notably zoning and subdivision approvals. They may try to do this themselves, or they may buy a parcel from a subdivider who has already done the work.
Builders erect buildings on the property--homes, apartments, stores, factories. They are the final participants in the development process.
Note that, with the exception of speculators, each o f the players adds value (and profit) to the land at each successive stage. For example, obtaining zoning and subdivision approval is a major challenge. Many developers are not enthusiastic about dealing with government agencies. Consequently, they will gladly pay a premium to a subdivider to buy land that already has approval to build. Similarly, many land developers do not want the added responsibility of being a builder, so they sell their improved lots to builders.
The most profitable procedure is to perform the entire operation: buy land, get zoning and subdivision approval, put in infrastructure, and build. Not only does the value of the project increase with each step, but you will be able to obtain more attractive rates of financing if you are the builder as well as the land speculator, because a house is better collateral than land alone. While the decision to become involved in all the four stages may seem enormous, the risks can be minimized if you have done your homework, made decisions based on facts, and surrounded yourself with competent professionals.
Each of these players can be active in all the markets for development: residential (both owner-occupied and rental), commercial, and industrial. While the principles discussed in this book apply to all of these markets, the emphasis will be on residential development because in our opinion it offers the aspiring developer the best chance to enter the business.
Before you become a developer, it would be wise to learn about those who came before you. You may be surprised to learn that real estate development is an ancient business.