As published in Scotsman Guide's Commercial Edition, October 2007.
With land-development loans, it's not out of the ordinary for clients to see profits of 30 percent to 50 percent or more. If they find the right piece of land in the right area and develop it correctly, there are mountains of money to be made in helping them finance it.
There are two basic types of land development -- horizontal and vertical. Horizontal construction involves taking raw land through the entitlement process and gaining the necessary approvals to build something on that land. Vertical development is the process of actually building something.
Let's take a closer look at the horizontal process. Say, for example, some developers approach you about a parcel of raw land on the fringe of the suburbs. One of the first things you'll want to do is to visit the site together and assess the local market.
Let's assume you determine there's a strong need for housing in the area. The next thing your developers need to do is to review average lot and home sizes and decide what's viable to develop on the land. While doing this, they'll need to figure in road construction and other common issues along with zoning codes that restrict how closely buildings may be built to property lines. Things such as curbs and sidewalks also come into play, and governing laws and guidelines must be researched and followed.
Costs and revenue
When planning horizontal development, it's important to keep costs and revenue in mind. Estimate the price of development by looking at:
Land acquisition and development costs;
Hard costs, including site preparation and construction of utilities;
Soft costs, including engineering, city approval fees and interest reserves;
Operating expenses (including Realtor commissions, property taxes and advertising); and
Because the property won't generate any income during construction, most development loans have some sort of reserve for interest that will remain in an account to ensure timely loan payments. This increases the loan amount.
Once the total costs are calculated, the developers must determine if the market will support sales to generate revenue to cover costs and allow for a profit.
Loan package and documentation
If they decide to move forward, your developers will submit the cost and revenue assumptions in a spreadsheet along with a feasibility study and executive summary to the lender.
If the lender charges a rate that fits within your clients' guidelines, you'll now need to provide a financial statement showing the creditworthiness of the borrowers and their capacity to keep the project moving if the market hits a snag or if costs escalate. There's no steadfast number for liquidity, but it's safe to say that the bank isn't going to let your developers borrow $100 million if their net worth is only $200,000.
In construction lending, banks usually rely on projected figures using loan to cost. In the case of construction or development loans, your clients will almost always be borrowing higher than 100 percent of initial land value. Even though some costs, such as marketing, don't come in until the property is ready to be sold, the bank will still want your clients to have that money upfront to ensure follow-through with the plan.
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