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Fundamentals for Survival

One of the first things for someone starting in the real estate development business to learn is that one cannot forecast interest rates or real estate recessions. Most large real estate developments require several years from beginning to completion and, therefore, will experience slow times as well as good, high rates of interest as well as moderate. Keeping debt low has been a key to surviving in the real estate business over time. In the late 1970s, developers could usually borrow 100% of their costs as well as one or two years of interest, but that all came to an end with the great real estate crash of the late 1980s.

When real estate development came back in the early '90s, 20% to 30% of real money equity was required; therefore, much greater equity in the form of money from investors had to be used. Institutional investors led by funds jumped into real estate investing seeking the high return usually found there, away from the low returns found in many market instruments in turn caused by abnormally low interest rates pushed by the Federal Reserve. The real equity provided a cushion when its market softened.

Unfortunately, many banks and other lenders and investors seeking loans and higher returns over the past two or three years have pushed loans to 90% or over 100% of cost. Bankers have no memories. And many loan officers as well as developers came into the business after the late 1980s crash. They had never experienced a downturn until now and didn’t understand the causes.

Protection from market risk also meant pre-selling and pre-leasing of land and buildings. A standard rule is never start a building unless it’s 60% pre-leased, preferably with a take-out loan set to provide long-term financing when its project is finished. Down payments by builders acquiring lots from developers not only gave developers needed equity but assured the buyer to be in place when the lots were finished. One of my favorite sayings is from Jack Welch: “If you don’t have a competitive advantage, don’t compete.” This adage works well in infill central-city development where few other developers are active. Much infill building has occurred over the past 15 years. Doing smaller deals not only cut financial risk but helped create a sense of urgency in the buyer by limiting the amount of space on lots or houses available.

Lastly, there is no substitute for good market analysis and research. Most of the poorly performing projects built in the past three or four years ignored the market, thinking that if you build it, they will come, but if there is no market, they won’t come.

 

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James R. Harris Partners, L.L.C. | 2929 W 5th Street | Fort Worth, Texas 76107 | 817-332-9600

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