How Commercial Real Estate Development Works
This is How-To's, How Comes, And What Are's, where we answer the most common questions about commercial real estate asked around Orange County.
Today's question is:
How Does Commercial Real Estate Development Work?
Everyone loves the idea of developing a building from the ground-up. But, what does it actually take to get from Point A to Point Z? This post will approach commercial real estate development from several angles: Development for your business, development for an investment, and land development passed off onto another company to deal with.
Development For Your Business
If you're fortunate enough to be operating a business that's had the benefit of constant growth year-over-year to the point where you have the opportunity to purchase and/or develop property on new or existing land that you own, this can be one of the most lucrative investment opportunities for you.
Example of Business-Oriented Development: Tesla Motors Inc.
It's no question Tesla is the premier shining star of the business world. They're also one of the most exciting leaders in innovative real estate development across the nation. With massive "Giga-Factories" in Nevada, New York, Shanghai, Berlin, & soon-to-be Texas, Tesla takes full advantage of developing their own factories through land acquisition deals.
It saves them money. Sure it will absolutely cost more upfront to develop the property, but over the span of 5+ years as real estate values appreciate, and with the tax write-off incentives that come with property ownership, Tesla will inevitably turn a profit after the sale of these factories, rather than be in the hole for millions of dollars from collective rental payments over the years.
Development As An Investment Vehicle
If you're interested in commercial real estate development solely as an investment vehicle to park your equity and capitalize on potential returns, your approach will lean entirely on microeconomics and data analysis.
Example of A Commercial Real Estate Investment: Self-Storage Asset Buildings
For this approach, you would need to work backward to determine if a potential land acquisition/development deal is worth undertaking.
By working backward, here is what you would need to discover:
What is the highest and best use asset that can I develop on this lot (land)?
How much can I expect to make each year after leasing this project (revenue)?
How much would it cost to develop this project (construction costs)?
How much would it cost to maintain this property each year (operating expenses)?
What would my net income be after accounting for all expenses per year (NOI)?
What is the minimum ROI I would expect to see each and every year (CAP Rate)?
What is the maximum I can pay for this lot to achieve that ROI (purchase price)?
That is how commercial real estate development is typically approached, albeit a very simplified take. You would also need to factor in temporary funding, permanent funding, capitalized interest, debt service, etc. However, funding should have its own dedicated blog post, so we won't be spending any time on it here.
Buying Land and Letting Another Company Develop On It
One of the most wonderful land deals to exist for landowners is the opportunity to sign a ground lease agreement with a Fortune 500 company. A ground lease occurs when you lease out land that you own to another party for XX years, allowing them to develop a storefront, restaurant, building, etc. Through a ground lease, they will not only pay for the development of the property, but they will also maintain it and allow you to keep the building once the lease expires.
Example Of A Ground-Up Lease Deal: McDonald's
While returns may not be as lucrative as the other two development possibilities, a ground lease is usually the safest. Fortune 500 companies are some of the world's highest-rated credit tenants, meaning they pay their debts and their rents on time, all the time. Ground-up leases can last anywhere from 25 - 50 years depending on lease option extensions, with returns increasing by a set percentage every 5 - 10 years.
While Commercial Real Estate Development is much more complex than this article may insinuate, it's important to recognize that with the right team behind you, understanding and completing a successful development project can be within your grasp much sooner than you think.
To talk more about development opportunities, schedule an introductory 15-minute phone call with Wyatt Franta here. Until next time, take care of yourself, and never stop growing.