Real Estate Development - 5th Edition: Principles and Process

Index

PART 1

Introduction

The principles and process of real estate development should be studied by looking at both the people who are involved in the process and the people who are the end users of the product. Although this book focuses on the role of the developer and the development firm, a great many people affect and are affected by real estate development. Everyone consumes the end product. Individuals form the lending institutions and investment firms that provide financing for a project. Individuals make up the public sector that both allows development and provides infrastructure to a development. Individuals in many allied professions produce the built environment that is used by people of different backgrounds and income levels.

Although the private entrepreneurial developer is often considered the most typical type of developer, it is important to note that developers can also be financial institutions, corporations, universities, medical centers, cities, municipalities, and other entities. Regardless of the kind of developer or real estate sector, the process laid out in this book remains essentially the same. Market decisions must be made, pro formas should be sound, the development team must be retained, and all of the stakeholders should be consulted. The process may be layered with various institutional procedures, committees, and boards of trustees, but the product is achieved by going through the same steps.

Profiles of developers and the diverse set of professionals who work with developers are interspersed throughout the text. Their career paths are interesting and often surprising. Their perspectives on development are especially valuable because these individuals have lived the process this book describes.

In addition to the profiles, the book features two case studies depicting two developers and their respective projects. The first is Larry Short, who is developing high-end student housing in Chapel Hill, North Carolina. His development, Shortbread Lofts, consists of a 271-bedroom community in six stories of apartments above ground-level amenities. The second is Wil Smith, a developer working in southern California. His project, Irvine Tech Center, is a large, multi-building, mixed-use development in Newport Beach, California. These case studies tell stories of unexpected complications and their resolution in the developers’ own words.

Part I looks at the people who make a development possible: the developer as prime mover, the future users, and the many participants who work with the developer to produce what society will want. Part II presents a historical overview of real estate development in the United States and the roles of regulatory and political actors. Part III builds on that history with a contemporary view of the public sector’s role. Part IV introduces the eight-stage development process with the first stage, inception of an idea. It also covers the financial decision-making mechanics that support development and are used at each stage of the process. In parts V, VI, and VII, the book proceeds through the eight-stage model, looking in detail at decision making in the real estate development process.

Chapter 1

Introduction to the Real Estate Development Process

Real estate development is the continual reconfiguration of the built environment to meet society’s needs. The creation of roads, sewer systems, housing, office buildings, and shopping centers requires much work. Someone must initiate and then manage the creation, maintenance, and eventual re-creation of the spaces in which we live, work, and play. The need for development is constant as population increases, technologies evolve, and tastes continue to change.

Both public and private participants have compelling reasons to understand the development process. The goal of private sector participants is to minimize risk while maximizing personal or institutional objectives—typically profit, but often nonmonetary objectives as well. Fortunes have been made and lost in real estate development. Few business ventures are as heavily leveraged as traditional real estate development projects, magnifying the risk of ruin but also the potential for high returns to investors. The public sector’s goals are to ensure public safety, to manage the impacts of real estate development on the community and the environment, and to promote smart development that is consistent with community’s interests. These goals require balancing the market’s need for constructed space against the public sector’s responsibility to provide services, improve the quality of life, and limit environmental harm. A key tenet of this book is that all participants enjoy a higher probability of achieving their goals if they understand the nuances of how the development process works, who the key players are, how their objectives are interwoven, and why it is important to achieve consensus.

DEFINING REAL ESTATE DEVELOPMENT

Real estate development is the process of bringing built space to fruition. It starts with an idea and ends when consumers—tenants or owner-occupants—occupy the physical space put in place by the development team. Each real estate project is in essence a separate business entity employing the three factors of production—land, labor, and capital—to create a product. To transform an idea into reality, these factors are coordinated by entrepreneurial management and delivered by teams. Value is created by providing space to meet the needs of society. Although the definition of real estate development remains simple, the process grows more and more complex as municipalities, financial markets, and consumer tastes evolve.

Developments do not happen without financial backing, which often requires multiple agreements negotiated by multiple players. The developer works with public sector officials on approvals, zoning changes, exactions, building codes, and the provision of infrastructure. Community and special-interest groups play increasingly important roles. The time needed to conduct public outreach, negotiate with the public sector, and obtain financing must thus be factored into the equation when evaluating a potential project. Only after these functions are organized can the team of designers, engineers, and construction workers begin the physical development. The project is completed with the leasing or selling of the space to users. This final phase requires the expertise of marketing professionals, graphic artists, salespeople, website developers, and other specialists. The developer tries to ensure that every element in the process is properly executed on schedule and within budget.

Today, development requires more knowledge than ever about the specifics of prospective markets, patterns of urban growth, neighborhood associations, traffic patterns, legal requirements, local regulations, contracts, building design, site development, construction techniques, environmental issues, infrastructure, financing, risk control, and time management. Ever-increasing complexities in each arena have led to increased specialization within the development team. As more affiliated professionals work with developers, the size of the team has expanded and the roles of some members have changed. As development has become more complex, it has generated the need for better-educated developers.

THE EIGHT-STAGE MODEL OF REAL ESTATE DEVELOPMENT

Despite the growing complexity, developers still follow a standard sequence of steps from the moment they conceive a project through the time they begin ongoing asset management and/or sell the finished product. Although some may delineate the sequence of steps slightly differently, the essence does not vary significantly from the eight-stage model shown in figure 1–1.

The eight-stage model also applies to the redevelopment of projects, which requires most of the same steps as new development. In very large development projects, individual components can be nested within a larger development plan and may each be at different stages at a given time.

Before proceeding further with the model, a few points should be emphasized. First, the development process is neither straightforward nor linear. The flow chart shown in figure 1–1 can identify the discrete steps and guide an understanding of development, but no chart can capture the constant repositioning that occurs in the developer’s mind or the nearly constant renegotiation that occurs between the developer and the other participants.

Second, real estate development is an art. It is creative and complex, partly logical and partly intuitive. Studying the components of development can help all players make the most of their chances for success. What cannot be taught are two personal qualities essential to success: creativity and drive.

Third, at each stage of the process, developers should consider all the remaining stages. Developers should make current decisions fully aware of their implications not only for the immediate next step, but also for the life of the project. The development process requires managing the interaction among the functions (design, construction, finance, management, marketing, and government relations) in each of the eight stages as well as over time.

The developer should recognize the importance of asset management and property management after the project is built by providing for those functions during design and construction. For example, operating a sophisticated building with advanced technological systems may require skills beyond those of most property managers in a particular market. Or, maintaining a particular material may require greater expense than would a different product.

Figure 1–1 The Eight-Stage Model of Real Estate Development

Furthermore, to keep a space competitive in an ever-evolving market, asset managers need to remarket it continually and to upgrade or remodel it periodically. Institutional investors and corporate owners are keenly aware of the periodic need for and cost of major remodeling to prolong a building’s economic life. Careful planning during stages one through seven should enable developers to find ways to minimize the frequency and cost of retrofitting, while respecting the original concepts. Whether or not developers manage a property for the long term, they are responsible for considerations that affect asset management during the first seven stages. Given that developers’ decisions help determine future operating costs and that such costs represent a significant part of the project’s value (i.e., what it will sell for), developers typically focus sharply on making building operations cost-efficient.

Fourth, although the model for development is grounded in reality, it represents an ideal version of the process. The model assumes a well-informed developer, a thorough analysis of the market, accurate assessments of the construction costs, and so on. Real estate development is full of stories of people whose intuition has led them to success. The stages described here do not account for the lucky, intuitive person who had a gut feeling and used unconventional means to get a project built. Still, it is better to be skilled and lucky than just lucky.

Fifth, the development process is inherently interdisciplinary and dynamic. It is a complex process that demands attention to all aspects of creating the built environment. The developer must be conversant in many disciplines, in order to make informed decisions and balance competing goals. Furthermore, many of the components of this interdisciplinary world are changing rapidly, and the interfaces between disciplines are constantly in flux.

Finally, real estate development is a global industry. Financing sources are sometimes global, major tenants have international connections, and real estate service companies operate and compete globally. Most important, global factors are spurring changes in lifestyle preferences that are changing what people want in the built environment.

CHARACTERIZING DEVELOPERS

Developers are like movie producers; they promote and finance a project, assemble a team of specialists, and then manage that team to make sure that the project is realized. Developers are proactive; they make things happen. As discussed in later chapters, a great deal of uncertainty is associated with the development process, just as with the introduction of any new product. However, unlike many other industries that make new products which have limited lives, real estate development involves long-term commitments because buildings last for decades. Thus, the cost of making a mistake is extraordinarily high. The amount of related risk the developer assumes personally is an important issue that commands significant attention throughout this book. Regardless of which risk control devices the developer finds appropriate for a particular project, the developer ultimately is responsible for managing all aspects of that project. Clearly, successful developers must be able to handle (and thrive under) intense pressure and considerable uncertainty.

Developers are not all alike. Some develop only one type of property such as single-family homes; others develop a wide range of product types. Some carve out a niche in one city; others work regionally, nationally, or internationally. Some run extremely lean organizations, hiring outside expertise for every function from design to leasing; others maintain needed expertise in house. Some operate as publicly traded companies, such as real estate investment trusts (REITs), while others stay private, forgoing certain capital market advantages to avoid the shortterm pressure of quarterly earnings. In between are many gradations. As in most professions, developers range from those who put reputation above profit to those who fail to respect even the letter of the law. Likewise, in ego and visibility, they vary enormously. Some name buildings for themselves, while others cherish anonymity.

Private developers must balance an extraordinary number of requirements for completing a project against the needs of diverse consumers of the product. First, as figure 1–2 shows, developers need the blessing of local government and often of neighbors around the site. In many cases, to obtain public approval, developers must redesign a project. Thus, appropriate flexibility is one of a developer’s most crucial traits. Second, developers need to be able to find tenants or buyers (users) who will pay for space and associated services over time. Third, developers must lead an internal team of specialists who depend on the developer for their livelihoods and recruit external players whose businesses contract with developers. Fourth, developers need to demonstrate the project’s feasibility to the capital markets and pay interest or offer equity positions in return for funding. In each of these areas, developers use various forms of risk management, initiating and managing a complex web of relationships from day one through the completion of the development process.

CASE STUDY    Shortbread Lofts Summary

THE DEVELOPER

Larry Short/Shortbread Lofts LLC

PROJECT LOCATION

Shortbread Lofts is located in downtown Chapel Hill, North Carolina, within a short walk of the University of North Carolina. It sits along a bus route that runs throughout the town. Prime development sites such as this one are scarce, and approvals are painstakingly difficult to obtain, making this site a rare development opportunity in a market with limited competition.

LAND

The total land area is 1.28 acres on two sites. The primary site is 1.08 acres, level, and rectangular, with 313 feet of frontage on W. Rosemary Street, a commercial corridor. The secondary site, across the street, is 0.2 acre and is used for additional surface parking. The property was rezoned TC-3 (Town Center 3) for the development of Shortbread Lofts.

BUILDING

A seven-story podium construction building contains 85 units (271 bedrooms) of student housing. The six stories of residential units sit above a ground level that contains a leasing office, 6,459 square feet of retail space, and a parking garage. The residential units are two-, three-, and four-bedroom units, with a bath for each bedroom. The garage has 121 parking spaces that are leased to residents.

INITIAL CHRONOLOGY

DEVELOPER BACKGROUND

Larry Short moved to Chapel Hill in 1979, when the prime rate hit 18 percent. He had been in Chicago, earning an MBA at Northwestern University, working first as a CPA at Arthur Anderson, then doing real estate makeovers. He started developing single-family units while in school and eventually moved to developing small apartments full-time. His deals were usually owner-financed. When he hit Chapel Hill he couldn’t write a $10,000 check.

Short avoids publicity. He hires the right people to work on his developments, people who have the right local connections. Before his first major development, the Warehouse, and the Shortbread project, he had rehabbed several small condominiums in Chapel Hill; he acquired the units, upgraded them, and resold them to new users.

Case study begins on page 176.

CASE SIUDY   Irvine Tech Center Summary

THE DEVELOPER

Greenlaw Partners in single-purpose partnership with Guggenheim Plus Leveraged LLC

PROJECT LOCATION

Irvine Tech Center (ITC) is located in the Irvine Business Complex, a 2,700-acre planning area rapidly transitioning from relatively low-density industrial and office properties to mixed-use and residential development. The transformation is driven by proximity to Orange County’s principal airport and to the University of California at Irvine, and by underlying shifts in the county’s economy. The site sits at the intersection of two major arterials. One connects the airport to the university campus, and the other connects Orange County coastal cities to two major interstate highways and to inland job and residential areas

LAND

The site was acquired in three phases:

ITC I, 10 acres and five buildings

ITC II, 8.9 acres and seven buildings

ITC III, 4.2 acres and one building

The project is divided by a collector street that separates ITC I from ITC II and ITC III. The existing tilt-up buildings provided interim income during the entitlement period.

DEVELOPMENT STRATEGY

Acquisition of vehicle trip allocations from other parcels in the IBC to support the density proposed for the ITC site.

INITIAL chronology

DEVELOPER BACKGROUND

Wilbur (Wil) Smith came to Los Angeles to attend the graduate program in real estate development at the University of Southern California. Having an extensive family background in real estate, Smith had worked construction, leased and managed properties, and made acquisitions. After graduating, he joined Maker Properties, a private firm in Orange County engaged in residential, mixed-use, hospitality, and commercial developments.

In 2003, Smith formed Greenlaw Partners and began an acquisition program focused on office, industrial, and other income properties. He joins with institutional financing sources to identify opportunities where the highest risk-adjusted returns can be obtained on the buy by purchasing properties at or below replacement cost. He then creates and implements a business plan to increase cash flow or base asset value and to optimize the equity multiple and the internal rate of return (IRR).

Case study begins on page 132.

This case study was written by John Brady, (retired) Guggenheim Real Estate, San Francisco.

This book refers many times to the development team that assists the developer in the design and construction of an idea. It is worth noting that only a small proportion of the people in real estate development are developers—the entrepreneurs who initiate and execute a project. The bulk of the players come from a wide range of professionals, support staff, and building tradespeople who are indispensable to the process. Clearly, challenging work abounds in real estate development for many participants, not just for the developer. In fact, most developers start their real estate careers in one of the supporting professional trades.

The developer’s job description includes shifting roles as visionary, promoter, negotiator, manager, leader, risk manager, and investor—a much more complex job than merely buying low to sell high. Developers are more akin to entrepreneurial innovators (like Bill Gates or Elon Musk)—people who realize an idea in the marketplace—than to pure traders skilled primarily at arbitrage.

Balancing these roles is an art that is mastered through experience. Equally important as that mastery is a goal-oriented disposition to overcome problems and obstacles. Developers must be highly focused on success with the ability to negotiate, compromise, and shape a project to meet the demands of stakeholders. Without the drive of a developer, few developments would occur because the potential roadblocks are numerous.

REPUTATION OF THE INDUSTRY

By definition, developers are agents of change. As in any profession, some are models of ethical behavior, making innovative and attractive contributions to the community, while others exhibit little sensitivity to community standards. But unlike other consumer goods that can remain in a showroom, the developer’s product is clearly manifested in the built environment. It is there for everyone to see and judge. It is extremely difficult to communicate the qualities of a project before it is completed. Thus the developer’s public persona can be as much a part of a project as the product itself, making developers easy scapegoats for everything from more traffic to higher taxes or crime rates.

As growth infringes on communities, the appearance of NIMBYism (not in my backyard) is inevitable. Without even knowing the individual or the firm, many people are wary of a developer’s involvement in a project in their neighborhood. Neighbors await bulldozers with trepidation. In the face of growing animosity, developers, city planners, elected officials, and others involved in community growth have learned the hard way about the necessity of involving the broader community in guiding development. Chapter 8 discusses how a developer can address these challenges. Communities will always change, with or without developers. A good developer can manage change with vision and sensitivity, and thus have a positive effect on a community.

Figure 1–2 The Developer’s Many Roles and Interactions

THE DEVELOPMENT TEAM

The developer is the leader of a development team. He coordinates people and helps realize a vision. That vision may be his own, that of the community, one that is shaped by the team, or a blend of all of these. Developers seldom work in isolation. To design, finance, build, lease or sell their products, developers must engage the services of many other experts—public and private—some of them specialized professionals, others entrepreneurs like themselves. Chapter 3 describes the typical array of team members in detail.

With each project, developers must shape and sell an idea to secure commitments from others. Thus, they are first and foremost promoters. Like any team leader, they must also motivate players, often with incentives beyond money—with pride in the project, with the hope of future work, and with fear of the consequences of nonperformance. Knowing when and with whom to use different incentives is a key leadership skill for developers.

THE PUBLIC SECTOR: ALWAYS A PARTNER

The public sector is involved—as a stakeholder or a partner—in every real estate project. Real estate development is highly regulated, and the legal and regulatory environment surrounds the entire development process. Developers usually work hand in hand with local governments and the community, giving them the same respect and attention they would give any other partner. Chapters 7 and 8 discuss the public sector’s involvement in depth.

MARKET AND FEASIBILITY STUDIES

Developers rely on market research to make decisions throughout the development process. Textbooks on marketing and market research seldom cover real estate in great detail. Likewise, real estate textbooks often fail to connect market research to broader marketing principles. Yet the connection is critical. Developers, planners, public officials, lenders, and investors need to apply the fundamental concepts of marketing to make better-informed decisions and control risks. That means they must gather information—and information carries a cost. The cost of a market study depends on what the level of detail is, who performs the analysis, and how much rigor a developer wants (or is required) to pay for. As with all risk control techniques, the developer must weigh the cost in relation to the magnitude of the risk.

Developers look for indications of the kind of space that will satisfy the market’s needs over a project’s long expected life. The future is not just the one year or five years that it takes to develop a project; it is the entire useful life of the project, which may last 50 or 100 years. Although the market analyst scrupulously examines past performance and is exacting in determining current market conditions, it is what the analyst has to say about the future that matters most. No one can fully anticipate the future, but the developer’s challenge is to be at least a few steps ahead of the pack.

A feasibility study completes the analysis (see chapter 13 for details). Simply put, the project is feasible if its estimated value exceeds its estimated costs. Value is a function of projected cash flow and a market-derived capitalization or discount rate (defined in chapter 11).

DESIGN: NEVER AN AFTERTHOUGHT

Good design has never been more important than it is today. Serious attention to the market—the people who will use the project—can show developers and their architects and planners how to capture market share from competitors or how to build for a new niche.

Design is a tool for connecting with and discriminating between specific market segments. Building designs convey direct messages, and architects have had to become proficient in creating appropriate ones. It is important to remember that for some uses and certain tenants, the appropriate message is pure functionality—that is, the most functional bay sizes and core elements, covered with a skin whose operating costs are low.

Each player in the development process brings some expectation of how a completed project will look and function. For example, stakeholders who want to maintain a town’s character are concerned about continuity, context, preservation of a way of life, and interactions with surrounding areas. The developer brings her own aesthetic preferences and her vision for the project. Financial sources may be reluctant to depart from proven designs—and market successes—of analogous projects. The developer charges the architect and design team with resolving the diversity of expectations into a single, coherent image. Still, the ultimate responsibility for a suitable design rests with the developer.

In Portland, Oregon, the Brewery Blocks is a mixed-use urban community encompassing seven buildings on five contiguous blocks. The project transformed a deteriorated warehouse district into a thriving neighborhood.

Design is about far more than aesthetics. Architect Louis Sullivan coined the phrase form follows function in the late 1800s, and today it is truer than ever. Sustainable design that is softer on the environment and more energy-efficient and cost-effective to manage over time wins out over beautiful but less functional design. Today’s architects, landscape architects, and other designers take a holistic approach, considering a host of factors when designing a new project or redevelopment. Their goals include making the most of the site and location, minimizing energy consumption, using the most environmentally friendly materials, conserving water, enhancing indoor air quality, and optimizing long-term operational practices.¹

EVOLUTIONARY CHANGES IN THE DEVELOPMENT PROCESS

Evolutionary changes in the process in recent years have required adjustments to the time-honored eight-stage model. These changes are noted here and illustrated in later chapters.

Availability of Data

Good developers have always relied on a great deal of background information gleaned over a lifetime of conversation, observation, and reading—newsletters, newspapers, academic journals, websites, and the like. Data are fundamental to sophisticated players in the marketplace. More accurately, the ability to turn raw data into useful information often makes the difference between profit and loss.

Throughout the discussion of the eight-stage model, this book refers to a host of traditional information sources. What is new is the extent and delivery capacity of the information available today. Technology now makes vast databases easily accessible to the development community through the internet. Companies such as SNL Financial provide real-time information on the financial condition of publicly traded real estate companies. CoStar provides a sophisticated online commercial-property equivalent of a residential multiple-listing service. Websites such as GlobeSt.com and crenews.com send out daily market summaries that focus on national and regional news in commercial real estate. Most cities have local business journals that maintain websites that contain real estate sections. Moreover, it is easier than ever to find property listings and potential prices through websites such as LoopNet.com, Zillow.com, Trulia.com, and many others. And many more websites and resources continue to come online. The result is that the internet continues to make more local, national, and international market information ever more accessible, leading to better educated investors, developers, owners, tenants, and residents.

Technology and Social Media

The rise of technology and social media has had a profound impact on the evolution of real estate. As technology continues to improve, so do construction practices. New building techniques accelerate the pace of construction as well as boost its safety. The way that property owners and tenants interact with real estate is changing drastically from just a few years ago. People can now monitor their utility consumption and set certain preferences through online portals and smartphone applications. Rent can be paid online, and expense tracking systems can provide minute-by-minute analysis. These continuing technological advancements change the way people live in and use their built environment. Smart homes and office buildings are becoming the norm.

Social media, in particular, have grown in importance. Most property management firms have websites that include a messaging component or Facebook groups for their properties through which residents can communicate about upcoming events and happenings at a development. Twitter provides almost instantaneous news on transactions and other activities. Websites and smartphone applications such as Flickr and Instagram enable users to share pictures of their apartments or the hotels they visit. These changes in the way people interact provide a convenient medium for reaching a larger audience with more information. There is no doubt that advances in technology and the spread of social media will affect the evolution of how people select and interact with real estate. Most important, the new technological possibilities will influence what consumers want in their built environment.

Sustainability

A few years ago, sustainability and green building methods were interesting buzzwords. Now sustainable and green development is often a legal requirement, as detailed in chapters 7 and 8. Many professional organizations now offer resources and services related to sustainable and green building techniques, as well as education on the value of sustainable practices to developers and investors. Groups such as the Rocky Mountain Institute provide comprehensive guides like, How to Calculate and Present Deep Retrofit Value for Owner Occupants, which focuses on demonstrating the creation of value through sustainability.² The U.S. Green Building Council has created its LEED (Leadership in Energy and Environmental Design) rating system, which offers building owners and operators a framework for identifying and implementing practical, measurable solutions for green building design, construction, operations, and maintenance. It is heavily used by local jurisdictions for project approvals.³ Going forward, sustainability and green building will be staples of the real estate development process.

A Much Longer Venture Capital Period

Chapters 10 and 11 cover the traditional financing cycle, which moves from land acquisition financing to land development financing to construction financing to permanent financing. This sequence still holds, but the time required to move from the early stages to the closing of the construction financing has lengthened. Why? Because building sites in infill locations are more complex and negotiations are more difficult as ever more participants enter the development process. Why does this matter? Because the cost of funds is considerably higher in the early stages of the development process. A lender putting up money for hard construction has relatively high-quality collateral. A lender or investor putting up the capital needed to carry out planning work and political negotiations over a period of many years before construction can start does not have good collateral. In fact, at this stage, financing is much like the financing that a venture capital company would extend to a new small business. If the business fails, not much is there to liquidate and sell. The longer time period before construction means a longer venture capital period and thus a longer need for expensive financing. This issue significantly affects how relationships among the development team are structured throughout the first five stages of the development process.

Feasibility from Another Perspective

It has always been important to understand the feasibility of a project as well as the feasibility of continued participation by all members of the development team. As the process grows more complex and the venture capital period lengthens, it becomes more important to focus on feasibility for the individual members of the team, sometimes called level two feasibility. As the timing of a project gets extended, everyone has to worry about how they personally are able to manage their finances and careers during what could be a long period with little or no cash inflow. As discussed throughout this book, it is the developer’s responsibility to consider the viability of the venture for each member of the development team.

Wall Street (and Related Avenues)

During the 1990s, securitization became much more important in real estate investment. As will be explained in the chapters on finance, few large, publicly traded real estate companies existed before 1990. In fact, the market value of all REITs then was less than $10 billion. Today, with an equity market capitalization of more than $650 billion, REITs are included in numerous stock market indexes, such as the S&P 500.⁴

This change has had two obvious impacts on the development environment. First, it created a new level of reporting and thus made information more available. The Securities and Exchange Commission requires public companies to report their financial status, and Wall Street analysts provide considerable commentary on these public companies. Second, the investment banker mentality has hit real estate development because the major investment banks are now actively involved. In addition, large private equity firms such as KKR (of Barbarians at the Gate fame), Apollo, Blackstone, TPG, and the Carlyle Group now have extensive investments in real estate. Wall Street moves to a different beat than the commercial banks, insurance companies, and wealthy families that have traditionally financed development. To find the right investment partner, today’s developer must contend with a faster-moving and often harsher world.

Increased Pressure on the Public Sector

A primary theme of this book is that the public sector is always a kind of partner in the development process. The evolution of community planning, environmental safeguards, hazardous waste cleanup, and other concerns has produced a more complex approvals environment. Government officials at all levels are under tremendous pressure to perform better (often with fewer resources) and to deal more rapidly with this more complex environment.

SUMMARY

As the book moves forward with the introductory framework in chapters 2 and 3, it is important to keep the following concepts in mind:

Everyone is in some way connected to the development process. Consequently, the developer should see the public sector as a partner.

The developer ultimately is responsible for creating buildings and spaces with appropriate associated services that meet society’s needs over time.

Because the decision-making environment of the development period is complex and interactive, a model is useful for evaluating the future ramifications of current decisions.

Real estate development is an art that requires drive and creativity coupled with appropriate flexibility and risk management.

Development of the built environment is a long-term activity that justifies considerable planning. Early consideration of future operational management needs should be a critical element of such planning.

Few people have the background needed to connect all the aspects of the development process. Readers of this book should skim the areas where they have the background to make the connections and focus their attention on the areas where they are less proficient.

TERMS

The following terms are introduced in this chapter:

Asset management

Built environment

Capital markets

Development team

Entrepreneur

Equity

Feasibility studies

Infrastructure

Institutional investors

Interdisciplinary

Leverage

Market research

Operating costs

Private sector

Public sector Risk control

Value

REVIEW QUESTIONS

1.1    What is real estate development?

1.2    Why does every real estate development project involve both the public and the private sectors?

1.3    What is the role of the developer in the development process?

1.4    What are the eight stages of development as delineated in this textbook?

1.5    What are the advantages of using such a model? What are the pitfalls?

1.6    Why is real estate development inherently an interdisciplinary process?

1.7    Why and how do developers use market research and feasibility studies?

1.8    Discuss the importance of good design in development.

1.9    Discuss the many roles a developer must play.

1.10  What role does time play in the real estate development process?

NOTES

1 www.gsa.gov

2 www.rmi.org/retrofit_depot_deepretrofitvalue

3 www.usbc.org/articles/about-leed

4 www.reit.com/REIT/REITbytheNumbers.aspx

Chapter 2

The Raw Material: Land and Demographics in the United States

The search for future opportunities benefits from ongoing examination of changes in basic demographic and economic indicators. The evolution of urban areas reflects changing social, technological, and political forces, and the developer should understand his place in this context. Reviewing the recent past and the present tells developers where the real estate markets have been, while carefully prepared projections can tell much about what future users of real estate will want. This chapter looks at five key indicators:

Population growth;

Employment growth and economic cycles;

Land supply;

The interaction of real estate values with gross domestic product, national wealth, and employment; and

How the built environment will need to change to accommodate technological change and expected shifts in population.

It provides historical context on the basic issues that developers should consider as well as sources for current data and trends. It is not intended to be a resource for demographic trends but an introduction to some of the issues that developers should evaluate. More context for these topics will be discussed as the book moves through the eight-stage model.

This chapter looks at broad, national data as background for the more exacting local analysis of these components that follows. It begins with demographics and market demand. It is important to understand that real estate is not like other products, in that it is location-specific. Unlike for other investments, such as stocks or bonds, the market potential of real estate is tied directly to its location and it cannot be moved to a more desirable location. Thus, it is important to understand local factors such as consumer wealth and education, and the density of the surrounding development.

POPULATION GROWTH

Population growth, new household formation, job creation, and increases in household income levels are key drivers of real estate demand. The best population data comes from the full census undertaken by the U.S. Census Bureau every ten years. Between the decennial censuses, the Bureau carries out regular updates that provide more current information at a less detailed level, as the survey sizes are smaller. This chapter looks primarily at the ten-year reports to obtain an overview of longer-term national trends. Clearly, the developer will want local information and the latest estimates as well as these big-picture trends.

Figure 2–1 Population Growth in the United States: 1790 to 2020

Sources: U.S. Census Bureau, Population Division, 2010 Census, Table 4, Population: 1790 to 1990, and 2010 Census Briefs, Population Distribution and Change: 2000 to 2010.

Populations grow in two ways: more people are born than die, and more people migrate in than leave. Figure 2–1 shows decade-by-decade changes in the number of Americans. In the earliest days of the country, immigration was the key source of population growth. This trend continued through the early part of the 20th century and then immigration dropped to a trickle during the 1940s and 1950s. In a dramatic reversal, both the number of newcomers and their share in population growth rose dramatically after 1980.

As shown in figure 2–2, legal immigration during the 1990s was at an all-time high. Yet the official immigration rate (the number of legal newcomers per 1,000 residents) was still less than half that seen at the start of the 20th century. Illegal immigrants, mainly from Mexico and Central America, add to these totals. Demographers estimate that in 2013, about 11.7 million undocumented immigrants lived in the United States, down from a peak of 12.2 million in 2007.¹

In 2010, nearly 13 percent of U.S. residents were foreign born, compared with fewer than 5 percent as recently as 1970 (figure 2–3). And despite stricter scrutiny of potential entrants after September 11, 2001, immigrants continue to flock to the country’s shores.

Although new Americans can strain local government resources, they are an important source of demand for housing, goods, and services. Homeownership rates for naturalized citizens are about the same as for native-born Americans. Sixty-five percent of naturalized immigrants live in owner-occupied housing units, in line with the 66 percent of U.S.-born citizens who are owner-occupants.²

National Demographic Trends

In the United States today, the rate of population growth (net natural increase plus immigration) is lower than that of most emerging nations, as seen in figure 2–4, but much higher than those of Western Europe and Japan. The population growth rate in the United States has been slowly decreasing since the 1960s. Nevertheless, the sheer number of new Americans is expected to be significant for years to come. Census Bureau demographers project that the population of the United States will reach nearly 346 million by 2025.³

Figure 2–2 Legal Immigration to the United States

Source: U.S. Immigration and Naturalization Service and Census Bureau, 2010 Current Population Survey (CPS) Data, 2008 Immigration-Emigration Supplement.

Figure 2–3 Foreign-Born Persons as a Percentage of U.S. Population

Source: U.S. Census Bureau, 2011 Current Population Survey (CPS) Data, People and Households.

As the population expands, its composition is changing dramatically. In determining opportunities for future real estate development, these changes will be as important as total population size. Readily available demographic data show not only how many more people will reside in the United States over the coming decades but also their ages, household composition, and ethnicity. Looking beyond the totals helps predict and segment consumers’ needs and desires.

Demographers used to refer to the population pyramid, showing large numbers of children on the bottom and relatively few old people at the top. In 1970, the nation’s median age was 28. By 2000, it was greater than 35, and in 2010, it was greater than 37. In 2030, the age distribution will look more like a pillar than a pyramid (figure 2–5). Age cohorts younger than 75 will become more equal in size. The baby boomers (born between 1946 and 1963) constituted 35 percent of the population in 1970 but will account for only 20 percent in 2030.

Figure 2–4 Projected Population Growth Rates: Developing Nations Versus Developed Nations

Source: U.S. Census Bureau, International Database, World Population Growth Rates: 1950-2050, 2010.

As shown in figure 2–5, no single generation will be large enough to dominate public policy, and the cohorts will have more comparable numbers of real estate consumers (although their relative purchasing power will be quite different). Politicians and retailers will try to appeal to the various age groups in new ways. Overlaying the distribution of population by age with the distribution of variations in income and other household characteristics reveals the large number of discrete target markets. This variety creates opportunities for developers.

For retailers, it is crucial to understand the various market segments. Aging boomers mean better-educated and savvier consumers with higher disposable income, who spend more money on discretionary purchases than on necessities. Millennials lead more urban lifestyles, are likely to have less discretionary income, and do more purchasing online.

For housing, the relocation of some boomers from the suburbs to some urban cores has been a modest but noteworthy trend. A certain percentage of senior citizens will seek specialty housing catering to their lifestyle preferences, health needs, and ability to pay. However, the share of seniors who move during retirement is fairly small. As a result, absorption has been slow for some types of retirement communities. Demographics alone have been insufficient to gauge demand: increasingly, focus groups and other types of research are used to evaluate consumers’ desires in terms of the features, functions, and benefits of the built product.

Speaking very broadly, millennials’ preferences and lower incomes mean that large numbers will rent longer and live in smaller housing units. But as with boomers, gross generalizations do not fit all members of the cohort, and finely tuned market research is needed to gauge demand for specific product types and locations.

In the coming decades, the U.S. population will become more ethnically and racially diverse—partly because of differences in the age composition and birth rates of the minority population but also because of new immigrants and their offspring. Non-Hispanic whites constituted 76 percent of the population in 1990 but only 72.4 percent in 2010.⁴ Hispanics (13 percent of the total in 2000) will continue to be the fastest-growing minority in absolute numbers, having reached 16.3 percent of the population in 2010. It is important to recognize that immigrants are not simply Asian or Hispanic or European. These broader categories contain numerous subgroups. Thais and Japanese, Puerto Ricans and Peruvians, Irish and Italians are very different subgroups of Asian, Hispanic, and European. Within each cultural group, many socioeconomic variations further segment the population. Real estate professionals need to be sensitive to the different cultural and economic norms that are reflected in the shopping and housing choices of the various subgroups.

Figure 2–5 Population Pyramids: 1970, 2010, and 2030

Source: U.S. Census Bureau, 2010 Census, Age and Sex Structure by Core Based Statistical Area (CBSA) Status: 2000 and 2010.

Similarly, households are not homogeneous, and neither are their housing preferences. Also, housing preferences change as each cohort ages and their needs change. For example, only 35 percent of millennials were homeowners in 2010, but 67 percent expected to be owners by 2015. Of those who expected to own, 82 percent expected to live in a single-family detached house.⁵

More than one-fourth of all households consist of a single person, and that proportion is rising rapidly. In the 2012 National Association of Homebuyers profile of homebuyers and sellers, 16 percent of all homebuyers were single women and 9 percent were single men compared with 20 percent in total for both categories in 1981. Growth in single-person households is fueled by adults who marry later or never marry, by high divorce rates, and by an increase in the number of older widows and widowers.

The number of traditional married-couple-with-children families has declined sharply—from 40 percent of all households in 1970 to 20.2 percent in 2010 (figure 2–6).⁶ Only 29.8 percent of all households include any children under 18. In a growing share of families with children, more than 32 percent have only one parent (or another adult relative) in the household, up from 11 percent in 1970.

To gauge demand, homebuilders focus on aggregate growth in the number of households in their market areas, within the context of national and regional trends. Average household size has been falling in the United States, from 3.14 persons in 1970 to 2.63 persons in 1990 to 2.59 persons in 2010.⁷ But those statistics vary considerably between regions and population segments. Nationwide, the number of households is still growing, but at a slower rate than in the past. Harvard University demographers project that the United States will gain between 11.8 million and 13.8 million new households between 2010 and 2020.⁸ Consequently, aggregate demand for shelter will not grow at the same pace as in the past. Further tempering demand will be the long-term effects of the Great Recession, which is expected to reduce earning power for a generation.

Figure 2–6 Changing Composition of American Households

Source: U.S. Census Bureau, 2010 Census, Households by Type 2000 & 2010, Table 2.

Residential and retail developers closely monitor household income characteristics and are alert to how age, race, education, and household composition affect both spending power and preferences. As shown in figure 2–7, income can vary dramatically by age. Earning power is greatest in the 45 to 54 age bracket, followed by 35- to 44-year-olds, and then by people age 55 to 64. As the number of middle-aged households increases in coming years, the potential demand for discretionary goods and services and for move-up housing and second homes could increase. However, the astute analyst will evaluate all contributing factors.

Household income data vary dramatically by place of residence (metropolitan versus nonmetropolitan areas, central cities versus suburbs), by household type, and by race. For example, median household income in the Northeast is about 14 percent higher than in the South. For non-Hispanic whites, it is about 70 percent higher than for African Americans.⁹

Census income data may underestimate household purchasing power because of the growing informal economy, which operates beyond the realm of traditional reporting practices. The magnitude of this economy varies among markets, and unreported activities take many forms (for example, second jobs, ad hoc tutoring, and various services paid in cash or barter). In addition, market analysts who focus only on current earnings miss part of the household wealth picture—those assets that can be used for home purchases and will be inherited by the next generation. In 2010, U.S. families had a median net worth of $77,300 and a mean worth of $498,800 held in investment vehicles such as equity in owner-occupied homes, interest-bearing accounts, stocks, bonds, and retirement plans. Net worth is highest for households of those aged 55 to 64: their 2010 median net worth was $179,400¹⁰ and their mean worth was $880,500. Senior citizens, on average, have modest cash incomes but can tap into savings, investments, and home equity to pay for units in active retirement communities or assisted living facilities. Many young households, which may not be earning much now, will enjoy greater affluence upon inheriting family assets.

Figure 2–7 2012 Median U.S. Household Income by Age of Householder

Source: U.S. Census Bureau, Income, Poverty, and Health Insurance Coverage in the United States: 2012.

Finding Demographic Data

Current and historical data about national demographic trends can be found in many different places. The U.S. Census Bureau’s website (www.census.gov) provides a wealth of data that are constantly being updated and reinterpreted. The website provides easy access to population and housing data in the annual American Community Survey.

National income data can be found through the Bureau of Economic Analysis (BEA) on its website (www.bea.gov). Developers are likely to also require data for metropolitan statistical areas (MSAs) and even smaller areas, like zip codes, census tracts, or custom designated market areas. In addition, state, regional, and to a lesser extent, local governments often maintain websites that provide demographic data.

Usually these data are available from planning and research agencies. But most often a developer or analyst will purchase a complete set of data from a provider such as Esri (www.esri.com), Claritas (www.claritas.com), or Moody’s (www.economy.com). These companies—and others—assemble raw data from a wide variety of sources and package it in formats to meet customers’ needs, including manipulating the data to suit a customized geographic area. From these data, they also produce forecasts.

EMPLOYMENT GROWTH AND ECONOMIC CYCLES

Economics and job growth—both national and regional—have perhaps the greatest effect on real estate development. At the national level, economic cycles affect demand for space and the availability of capital for real estate development. At the regional level, developers analyze real estate markets at a fine grain. Regional economies are often described in terms of export (primary) and spin-off (secondary) employment. Primary employment is activity that results in the export of goods and services from a region, and spin-off employment is activity that supports primary employment. For example, Boeing and Microsoft are primary employers in the Seattle region; banks, barbershops, and architects there are secondary employers. Thus, when Boeing and Microsoft expand, so does the demand for all types of real estate. Without growth in primary employment, there is little demand for new space. Thus, when regional economies collapse, as did the Rust Belt of heavy manufacturing cities in the 1980s, demand dries up for all kinds of real estate.

Whereas demand for housing and retail space is primarily a function of population and of household growth and composition, demand for other commercial property development—office buildings, factories, research and development facilities, warehouses—is tied more closely to changes in the economy and employment. The office construction boom of the 1970s and 1980s was fueled, in part, by a dramatic shift in the focus of the U.S. economy from the production of goods to the delivery of services and the resulting growth of white-collar occupations. As a share of total employment, manufacturing jobs dropped but those in the service sector—a diverse mix heavily concentrated in business services and health care—grew dramatically. Women entered the labor force in ever-greater numbers, and new technology created opportunities for both professional and clerical services and knowledge workers. Typical anchor tenants of new office buildings were the expanding law, accounting, and investment firms, as well as corporations and private businesses.

At the turn of the 21st century, trends in employment suggested that the share of office-prone employment would continue to grow. The U.S. Bureau of Labor Statistics (BLS) predicted that the still rapidly growing service sector would create close to 14 million new jobs between 2012 and 2022 (figure 2–8). However, recent economic and social trends may temper those estimates.

In the near term, the demand for new office space will probably slow. Some of the growth in service sector jobs will be found at health care providers (home health care agencies, assisted living facilities, and nursing homes) that do not require office space. In most office-related sectors, a general focus on consolidation, greater efficiencies, productivity, and improved technology has resulted in job cutbacks and vacated office space. Employers are also cutting back on the amount of space per employee, by moving from individual offices to cubicles or open-office plans and allowing more telecommuting. Many companies are encouraging employees to work from home or are using so-called hotel offices that are shared among employees, cutting back on the overhead allocated to office expense. Office-related growth is likely among high-tech industries, such as software developers and biomedical research, but they will be subject to the efficiencies just described. And the corner coffee shop is becoming the office for growing numbers of those who can work anywhere, anytime.

Figure 2–8 Employment by Major Industry: 2002, 2012, and 2022 Projections

Source: U.S. Bureau of Labor Statistics, Employment by Major Industry Division, 2002, 2012, and 2022, Table 3, accessed December 19, 2013.

With the dramatic growth in online purchasing, the retail industry has also realized a significant change in the need for bricks-and-mortar space. Approximately 12 percent of all retail sales took place online in 2013, and that percentage is expected to reach approximately 17 percent by 2020. It is worth noting that these percentages were zero not long ago. The impact of this trend will be less demand for typical retail space in malls and shopping centers, but more demand for warehousing and distribution space for online retailers.

Regional and Metropolitan Shifts

Growth in population, households, and employment suggests opportunities for real estate development nationwide, but internal mobility data are what help identify specifically where development should occur. Movement across regions, between states, and within metropolitan areas creates demand for new homes, shopping centers, entertainment facilities, office buildings, and hotels. At the same time, a net loss of households or jobs leads to higher vacancies, lower rents, and softening home prices.

Mobility is the measure of population relocation. The U.S. population continues to shift from older metropolitan areas of the Northeast and Midwest toward the Sun Belt, the mountain states, and the West (figure 2–9). More than half of all Americans lived in the Rust Belt in 1970. By 2010, that share had dwindled to 40 percent. Between 2000 and 2010, the population grew at a rate of 9.7 percent nationally, but at the state level growth varied dramatically (figure 2–10).

Figure 2–9 Population of the United States by Region (Percent)

Source: U.S. Census Bureau, 2010 Census Briefs, Population Distribution and Change: 2000 to 2010.

In the 2010s, energy and technology are driving the economies of the fastest-growing cities in the United States. According to Forbes, the five fastest-growing cities in the country in 2013 were Austin, Texas; Raleigh, North Carolina; Phoenix, Arizona; Dallas, Texas; and Salt Lake City, Utah,¹¹ all of which have economies based on energy or technology.

Population figures for MSAs, as shown in figure 2–11, underscore the Sun Belt/Frost Belt dichotomy. Lifestyle preferences encourage both young adults and retirees to seek milder climates, but location decisions are primarily economic. Many Sun Belt markets have lower real estate costs and lower taxes, factors that encourage both employers and workers to move to metropolitan growth magnets such as Dallas, Atlanta, and Miami. Note, however, that the New York, Los Angeles, and Chicago metropolitan areas—all high-tax, high-cost cities—grew in the 2000s.

Figure 2–10 Percentage Change in State Populations, 2000-2010 (Total U.S. Growth = 9.7 Percent)

Source: U.S. Census Bureau, 2010 Census and Census 2000, Population Change for the United States, Regions, States, and Puerto Rico: 2000 to 2010, Table 1.

Figure 2–11 Population Change in the Ten Most Populous and Ten Fastest-Growing Metropolitan Statistical Areas, 2000-2010

Source: U.S. Census Bureau, 2010 Census Briefs, Population Distribution and Change: 2000 to 2010.

Central cities were more successful in retaining their population base during the 2000s than in previous decades. Some cities that lost population in the 1970s and 1980s, such as Chicago, registered net gains. Redevelopment generated new office space, cultural facilities, hotels, and downtown housing. In the aggregate, however, the shift of households from older cities to suburbs continues. Many Sun Belt cities can grow because they are able to annex adjacent unincorporated land—an opportunity not available to most cities in the Northeast or Midwest, which are ringed by incorporated suburbs.

For local public officials, growth is a source of civic pride and brings an expanding tax base, but it also triggers the need for public services and infrastructure. Rapid growth in the absence of adequate school, road, water, or sewer capacity often engenders no-growth attitudes among longer-term residents. Many states and metropolitan areas are implementing smart growth strategies designed to direct development into areas that have adequate utility capacity and transportation networks and to encourage walkable communities.

Like any other producer of goods and services, the real estate industry profits by satisfying buyers’ needs and wants. The developers, builders, and marketers who pioneer new products and techniques spot trends early and attempt to profit from their innovation. Looking at broad demographic data is useful, not only to see the big national and regional trends, but also to stimulate obvious questions. Is the same trend affecting my local market? Will it continue in the future? What opportunities does it present?

Finding Employment Data

Employment statistics are compiled by the BLS (www.bls.gov). For more than 60 years, the BLS used the Standard Industry Classification (SIC) system to collect employment data by industry; however, the SIC system was not flexible enough to handle rapid changes in the U.S. economy such as developments in information services, new forms of health care provision, and high-tech manufacturing. The BLS now uses the North American Industry Classification System (NAICS), which was developed jointly with Canada and Mexico. The NAICS uses a six-digit coding system to classify employment into 20 industry sectors.

The BLS provides timely data for MSAs and the larger consolidated metropolitan statistical areas (CMSAs). The Census Bureau defines CMSAs as two or more adjacent MSAs or smaller metropolitan regions that are combined, such as Washington, Baltimore, northern Virginia, and two counties in West Virginia, which make up the DC CMSA. The BLS uses MSA and CMSA data to