10 Real Estate Development Lessons You Absolutely Do Not Want to Learn the Hard Way
When you're in our business, you know risk management is everything.
What's keeps most beginners on the sidelines of real estate development? Risk and capital.
If you're considering getting started in real estate development, this post is a must-read.
Real estate development is a risky business. To build a successful business, you must minimize the risk as much as possible.
Now, let's dive in.
1. Never close on a property without the zoning in place for your project.
Real estate is a capital-intensive game. When you close on a property, you tie up a significant amount of cash in what is probably not a cash-flowing asset. If it is and can carry itself, you can ignore this point.
It's easy to get stuck with a property you can't build on, especially in areas that are anti-development.
Many times, this is where you want to build your product because of high barriers to entry and higher incomes.
2. Never let your money go hard without a clear path for project approvals and financing.
You have limited capital. If your money goes hard and you can't close or don't want to close...you just lost a meaningful amount of cash for your next project.
Getting to "Go" on a project should be hard. If it's too easy, ask yourself, "What am I missing?"
Once your money goes hard, it is the property of the seller. Then you are in the deal whether you like it or not.
Track the Purchase and Sale Agreement (PSA) milestone dates closely and guard your capital like your life depends on it...because your career in real estate development does.
3. Always negotiate multiple closing extensions in a purchase and sale agreement (PSA).
A typical situation is that you have a project that you expect to take nine months to permit. It ends up taking 18 months. Maybe you negotiated one 3-month extension. What happens when you run out of extensions?
On a recent project, per the PSA, we had nine months to permit a project. We expected it to take nine months. It ended up taking 18 months. In the purchase and sale agreement (PSA) the seller only gave us 10 months to permit with no extensions. This is not a good setup for the buyer.
So, for each PSA extension, we had to show progress and ask the seller for an extension. It was totally at their discretion whether to give us the extension.
Fortunately, prior to the extension deadlines we had developed a solid relationship with the seller.
Even though we had a firm belief in the seller's good faith and our relationship, this is not something I would do again since my partners and I risked $1,200,000 on the project.
4. Stay Liquid.
In this business, it is too easy to be land-rich and cash-poor. You need cash to seize opportunities quickly.
On a new potential deal, when you finally make it past first base with the seller you have been courting for two years, you need to have capital available to make a deposit for your PSA.
5. Keep leverage low to stay out of trouble.
Real estate development is all about leverage. That's how the game works; without it, you can't play.
In 2021, it was too easy to take on a huge amount of debt. For example, we were seeing terms for $17M loans at an 85% Loan-To-Cost on a ground-up multifamily deal. You want to "Stay Liquid" like Point 4, but there is a balance you must achieve with project debt.
As many Sponsors are now (2024) finding out, your relationship with your lender is huge when your project can't cover the Debt Service Coverage Ratio (DSCR). But when your DSCR is too far underwater, your relationship doesn't mean much. So take on as little debt as you can and maybe you can avoid a Personal Guaranty (PG).
6. Real Estate is cyclical. Be prepared for an economic downturn.
Business cycles are natural. Up and down goes the economy.
When a market looks like it can't keep from going up, it goes down.
Real estate cycles are very long, but when they turn, they turn hard.
To prepare for a downturn:
Use low leverage on deals.
To understand how things could turn out, create a sensitivity table that projects different outcomes for different variables with significant (10-20%) changes.
Be cautious about the projections of rent and expense growth and vacancy assumptions.
Make sure you have ironclad contracts in place to protect you and your investors. Always use contracts.
7. Look to get beyond the personal guaranty.
Build your business to the point where you can get beyond providing a personal guaranty on project loans.
This is achieved by creating a real estate portfolio to leverage that equity.
You can also carve out certain assets, like your home, from personal guaranty's.
Talk to an attorney when negotiating your loan documents for your next project to determine if this is an option.
8. Isolate your liabilities with a special purpose entity for each project.
Do you like owning your house? I do. And I don't want to lose it because a real estate development deal went wrong.
Through the creation of special purpose entities (SPEs), you can isolate your liability from creditors on real estate development projects. This applies to both personal and professional assets. Please take a look at point #7 as it is related.
9. Use fewer lenders.
When borrowing for real estate development deals, the fewer lenders you use, the quicker the turnaround on your documents, and the more likely the bank/lender is to work with you in the event of a loan covenant breach.
Have you ever gone through the construction loan process? Or any loan process, for that matter? If you have, you know the amount of information you are asked to provide is painful.
When you work with a bank regularly, you know what they need, and they ask for less because they already know you. This simplifies the process.
Pre-2022, people looked for the cheapest debt possible. This was usually a good bet, but not so when a deal went sideways.
In that case, you want to know your lenders as well as you can personally so they will go to bat for you on their investment committee. Lenders can be flexible if they like working with you and can see future opportunities to lend to you.
10. Make sure your partnership agreement is ironclad.
Your partnership agreement defines who does what, who gets what, and what happens if things go sideways.
We recently did a deal with a prominent family office. After agreeing on deal terms, it took us about eight months to negotiate the partnership agreement. We both hired top law firms to represent us. The partnership agreement can mean the difference between you making or losing a lot of money. Tread carefully.
That's it for this post! There are lots of hard lessons in real estate development. These are some of the most important points.
Do you have any to add? Please share them in the comments below!
Godspeed and best of luck on your entrepreneurial real estate development journey! John
Deal of the Week: Boston MSA - Georgetown, MA 30 Acres of industrially zoned land for sale
***This is a new section highlighting deals that we or our partners are involved in.***. Send us deals you would like to promote for our readership.
Pugh Management in partnership with Howland Development is currently marketing a 30+ acre industrially zoned, development site for sale. The project is being marketed by American CRE and broker Dusty Burke. A link to the project page can be found here. A link to the brochure is here. The proposed project consists of two buildings a 145,000 SF Class-A warehouse and a 45,000 SF small bay building.
What We’re Reading This Week
In NCAA news, the UConn Huskies won the men’s NCAA D1 championship last week. Clinton has already declared for the 2024 NBA draft. He is quite a player and I would speculate additional players from the team will declare as well this year.
Around the NBA…The Play-In Tournament begins today Tuesday 4/16! Lakers are the favorite against the Pelicans. Golden State is the favorite against the Sacramento Kings. Heat are favorites against the 76ers and last but not least, the Hawks are favorites against the Bulls. The Boston Celtics continue to roll. The Orlando Magic lock a 5th place spot in the playoffs. The first time they have been in the playoffs since 2012. The Bucks prepare to play without Giannis for the series against the Indiana Pacers. Giannis has a left calf strain…so who knows.
WNBA - Caitlin Clark goes as the first pick of the first round to the Indiana Fever…It will be interesting to see how she alters viewership of the women’s game. She’s exciting to watch!