Continuing in our series we are pleased to share Part 2 where we are focusing in on development cost metrics which are critical in evaluating a real estate project for investment.
By way of background, real estate development involves a number of core activities including site identification, due diligence, land acquisition, land entitlement, architectural design, environmental remediation (if required), site planning, building permits, construction financing, building construction, lease-up, and stabilization to name a few. A major consideration in development is the significant interaction with government to ensure the zoning approvals are in-place and the potential to negotiate incentives to help reduce the burden of development charges and other levies.
When evaluating a project’s development costs there are numerous metrics to evaluate. For the purposes of this blog we have highlighted them across the following key areas:
- Land Acquisition Considerations (Cost per Foot) – The tested and true expression in real estate is location, location, and location. In the case of land development its important to evaluate the cost per square foot purchased and more importantly how much of the land can actually be used for development. The existing land may not be zoned appropriately as an investor you need to get an understanding of estimated approval timelines as they vary widely by jurisdiction. The development potential is greatly impacted by the current area and future plans for the area.
- Development Cost Estimates and Contingency – The development project involves soft cost, hard costs, and construction financing. The soft costs typically involve architect fees, environmental consultants, surveyors, planners, and many other consultants. From a hard costs perspective these are the actual costs to build which are measured on a cost per foot basis with a contingency added of 5 to 10%. It is common to add a contingency on your soft costs of approximately 10%. A major consideration on the cost side is developing an understanding of how much of the pricing is already fixed or tendered to ensure costs can be contained with a competent project manager that is aligned to meeting the timelines. Typically construction financing will cover 60 to 95% of the project therefore understanding where the developer is with financing approval is critical.
- Profit and Yield on Cost – Yield on Cost is a common metric that helps you determine the amount of Net Operating Income (NOI) for every dollar spent on development. Developers will make a profit on the deal by comparing the exit value to all of the costs to complete the development including financing and broker commissions. Construction financing is a major consideration as the mix between debt and equity in the project will greatly impact the return and risk of the project.
The exit value mentioned in point #3 above is critical as it a major variable that determines the overall profitability of the project a few years into the future. Stay tuned for Part 3 of this series where we will dive into the exit value, stabilized property returns and investment exit considerations. Investors need to evaluate if the project has a viable exit strategy to ensure their hard-earned capital can be recouped along with a return that compensates them for the risk taken.
As you embark on this real estate investing journey our team at Finalyze Real Estate CFO Services would be pleased to be of assistance. Our unique Plan, Raise, and Manage approach can support your investment objectives throughout the investment lifecycle. We are pleased to be the trusted advisor to real estate investors, developers, and investment funds in Canada and the United States. Please reach out at Info@FinalyzeCFO.com or www.FinalyzeCFO.com to learn more about our services.