How Property Fund Investors Can Fare Better Than Real Estate Developers

Are real estate developers disadvantaged relative to property fund investors?

Most real assets are performing better than the volatile stock market. But for some, property funds hold greater attraction over developed real estate.

Since the financial crisis of 2008, investors have soured on traditional investments due to factors of poor performance. Instead, they’re turning toward alternatives that include land investments and property funds. The reasons for this are easily understood: The growing housing shortage in the UK portends good near- and mid-term value growth for all aspects of residential real estate, particularly in light of robust (7 per cent since 2001) population growth.

Of course, not all real estate is the same for investors. Within real estate are two distinctly different types of investments, built properties and raw land. Some investors choose built properties or to invest in the developer who is managing the construction and sale of homes and commercial structures. An option to that is raw land, ripe for plan rezoning from, say, agricultural to residential-designated land.

Both have their merits, of course. But land investment might hold the advantage for at least three reasons:

• Adaptability to market needs – Raw land can be converted (pending approval of Local Planning Authority approvals, of course) to the use that is most critical to the local economy. This flexibility allows the land investment fund to prepare parcels for what will be needed in a relatively short period of time. On already-built property, investors have only what is there unless circumstances allow for the extraordinary expense of demolition and rebuilding – which only rarely makes sense from an asset growth perspective.

• Less investment in development (and associated risks) – The boom-bust cycles of the past several decades remind us of how a billion Pounds can be squandered rather quickly when a large property comes online at the precise moment when no one wants it. See “Canary Wharf, Olympia & York” for a spectacular illustration of how badly property investments can fail.

• More liquidity (but still not volatile) – Perhaps the Achilles Heel of real land assets is the illiquidity of land, with or without property. But land investments that at most involve the light infrastructure required of residential neighbourhoods (roads, sewers and other utilities) are much more easily sold than property involving structures. While that pales in comparison to real estate investment trusts for liquidity, real property is not nearly as subject to market fluctuations as are REITs.

To be sure, both investors in property funds and land investments tend to achieve asset growth in well-managed situations. But from land to property development, the path is quicker. With a seasoned team of land investment professionals, a joint venture partnership can identify and manage properties for maximum value appreciation and resale between 18 months and five years after acquisition.

All investments carry risk and should be considered in relation to one’s full portfolio of financial instruments. Be sure to contact a personal financial consultant before embarking on any investment.

Finding Opportunities for Real Estate Development

People often think that in order to be a real estate developer you have to stick a shovel in the ground. Nothing could be farther from the truth. What land developers do is make some change to the real estate that will increase its value. Real estate development potential exists where the parcel can be transformed in some way so that it will appeal to more types of buyers. Two of the cardinal rules in the land development business are that the value of land is always relative to how (or if) the property can be used, and the value of the land parcel increases when the property can be used by either more buyers or additional categories of buyers.

In reality, opportunities for real estate development are all around you because there are several ways of developing land that don’t involve building. It is true that sometimes development through change involves building, such as modifying an existing structure or demolishing it and building a new one. But many more real estate development opportunities exist where the change to the property is invisible.

For example, suppose you find a residential property located on a street that takes a lot of traffic. The appeal (and therefore, the value) of the parcel is limited because the only potential buyers are people who wouldn’t object to living in a house on a busy street. Chances are, the highest and best use of this property is something other than straight residential. So you would want to determine if there were alternative uses possible to expand the market for this property and increase its value. How would you find this out?

The first thing you should do is determine what uses of the property are allowed under the current zoning by reviewing the zoning map and ordinance available at the municipal office. Once you locate the property on the zoning map, you will see what zoning district the property is in. Then you would read the provisions in the zoning ordinance for that district. These would deal with several issues: uses permitted “by right” (meaning that no use approval is necessary), special uses permitted only when approval is given by a municipal board, and dimensional requirements, such as the minimum lot size and width, building setbacks and the height of structures. (You should review the entire ordinance because there may be other provisions elsewhere in the book that would also apply to the property.)

The particular zoning classification might permit single-family detached houses on the specified lot size by right. But it might also allow the property to be used as a school, church, or day care facility when authorized by the municipality so long as the property satisfied some specific conditions. These might require that the total land area of the parcel be a certain minimum size (e.g., at least 10 acres), the property be serviced by public utilities, or that the building and paved areas not exceed a certain percentage of the total land square footage of the parcel.

Next you would review the municipality’s comprehensive or master land use plan. This document might say, for instance, that the local government wanted to encourage professional office uses in the area where your property was located. This would indicate that the municipality might be open to either a change of the zoning classification for the property or allow it to be used for professional office by granting a “use variance.” A variance does not change the underlying zoning classification of a property, but essentially permits the property to “violate” some provision of the zoning. In this case, a use variance would allow the property to be used for something other than a single family detached home, church, school or day care. However, the municipality would likely impose some conditions and restrictions in exchange for the variance, such as preservation of the existing structure or limitations on the total amount of building square footage that could be built.

If you could develop this property by getting a change of use approved, the property would certainly be worth more than as a home. You could then sell it to buyers who wanted to construct an office building to either lease out the space or sell the property once the office facility was completed.

The 4 Principles of Securing Real Estate Development Finance

Unless you’re one of a very privileged group of people and you do not need to seek Real Estate development finance, getting the cash you need is probably one of the most influential aspects of whether your real estate venture will succeed. That said, even if you don’t need to borrow money for a development, it usually makes business sense to borrow at least some of the cost anyway (that point is for a different article!).

Make no mistake, like all investment – real estate involves an element of risk to a lesser or greater degree. And like all businesses, risk should be managed. However, it could be said that ‘risk’ allows profit (or loss) to be made. If a real estate Investor or Developer has no appetite for risk, they may as well stuff their mattress with cash rather than putting it into Property. If there were no risk involved, wouldn’t everyone be a Property Speculator?

So it could be said that Risk is nothing to be intimidated by, but that it should be monitored so you don’t lose the shirt off your back (and with property, it’s possible to lose an awful lot of money in a short space of time if ridiculous mistakes are made). A philosophical attitude to this is quite important, because the truth of the current situation is that banks would really prefer the customer to shoulder as much of the business and project risk as possible. Let’s face it banks are in a powerful position, they have the money that the Developer wants…they call the shots. If you haven’t got the nerve to take on the risk, the bank will lend the money to another Developer who is prepared to take the risk.

I personally don’t think that this is a bad situation. It could be argued that the current/recent financial crisis who due in part, to excessive lending to people who should have been subject to greater scrutiny.

The 4 (very) basic rules to consider before approaching banks for Real Estate Development funding are:

1. Make sure you have access to people with experience! It is often said “never invest in anything you don’t truly understand”, if you are a novice Developer you should not be attempting to learn everything my your mistakes….they will be too costly. Speak to people with experience. The bank will insist upon you having good and regular access to appropriate professionals such as Architects, Structural Engineers, Realtors/Estate Agents or Building Surveyors.

2. Don’t expect to borrow too much against the project! As a general rule, a bank will expect you to put up at least 25% of the combined total of initial project purchase and build/development costs. You should also include a contingency fund of around 5-10% of the total build cost figure. It’s also a good idea to have enough working capital to be able to fund the initial stages of the individual build stages just until the bank releases funds in a staged-payment arrangement.

3. Don’t use a Limited Liability Company when you are starting out! The primary purpose of a LLC is to limit the personal risk of the company owner(s), this is not what the banks want to see. They will want to ‘facility’ to pursue you to recoup losses if it all goes wrong. This may sound dramatic, however I am talking worst-case-scenario! In reality, banks would far rather work with you to sort out problems than immediately enforcing their agreement covenants.

4. The CV of the individual Developer. When you begin to establish a good track-record in property development, the banks will tend to be far less nervous about lending you money. It’s never a good idea to take on a huge project that the banks knows will challenge you. It’s far better to gain experience by carrying out light work (such as modernisation and redecoration) rather looking for a substantial rebuilding project as one of your first attempts. ‘Easing yourself’ into the field of Property Development is the way all very successful professional developers have done it. It’s not a way of life that should be entered into on a whim; if a Developer gets in ‘above their head’, they are far less likely to continue in the field. Completing a Real Estate development is a very satisfying thing, it’s much more sensible to complete several ‘quick refurbishments’ than jumping straight into a substantial project requiring specialist structural work.

To conclude, banks are willing to lend at the moment. they have simply become more scrupulous with who they lend to. If you have prepared yourself properly to begin your venture (and you’re creditworthy), then you will find that the banks are far more likely to accommodate your requirements for Property Development Finance.