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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   November 2005

Think Like a Developer

Understanding the real estate project as a whole can help you better negotiate loans

Approaching real estate development and ownership without a sense of vision is like approaching any great endeavor similarly. At some point, the process likely will stall. The end product will probably not match the potential. And economics will undoubtedly be impacted. Successful development requires wisdom, a strong sense and conviction about the end result, a fair amount of clairvoyance and constant attention to the bottom line.

Why should brokers analyze real estate from a comprehensive perspective? The answer is that it improves your ability to negotiate real estate transactions. Approaching a transaction with a sense of the end use of a property and the steps required to arrive at that use allows you to assist in the issue-resolution process. The better professionals are at issue-resolution, the better they can ensure transaction execution. Further, you can accomplish more if you have a thorough knowledge of an asset, especially when you can actively help resolve key issues.

Ask the big questions

The starting point for any part of the development process must be a sense of need. Who needs this development and why? What demographics and trends will feed occupancy? Who are the end-users and what will they pay to occupy the property? What property characteristics will attract particular end-users and why?

Answering these questions correctly will go a long way to deal with issues of location, economics and design of the development proposal.

Then there is a deeper layer of analysis. Can the site support the need and use? On one side of the analysis is the question of demographics. For example, imagine that Frieda, a developer, wants to develop a skilled nursing facility. She wants to understand the factors people consider when selecting a facility. Knowing that adult children of senior citizens are involved in that decision and that they look for locations close by is important for Frieda when deciding where to build.

As we all know, however, one cannot just build with abandon. The process of developing and building also requires a detailed understanding of legal and title compliance. Developers must determine whether the use is a permitted use or whether it can be made permitted. A site that is a preferred-use will prove much easier to develop in the long run.

The property also must contain all the necessary entitlements. Unless they are acquired, the project will quickly find itself without a right necessary for operation. Access, drainage, utilities and life-safety systems all come into play.

Consider other factors

But such site issues, once again, are just a piece of the puzzle. Obviously, the project must be financed, which requires a combination of debt and equity. Developers or their joint-venture partners may have guidelines that restrict debt and equity levels on the property. Frequently, tax considerations play into the choice of debt versus equity. Debt builds basis into a property without an equity contribution. This, in turn, allows a party to take the benefits of losses generated by that debt, such as interest deductions. Equity has no such benefits.

Coupled with equity is the return on investment. A partner in a transaction will want a piece of the pie, which  impacts the project’s bottom line. The larger the project, the harder it becomes to determine the economic shares between partners.

Particular types of equity might have special legal requirements to meet. With pension funds, for example, a concern arises about potential sources of taxable income from unrelated business. Like-kind exchange money has a set of regulatory requirements that must be met under section 1031. For example, in a like-kind exchange of real estate, one should ensure that an interest in real estate is created. Moreover, if an exit mechanism is created, one should ensure that it makes effective use of accepted tax-deferral strategies whenever possible.

Equity investment also includes discussions of control over the project and of major decisions affecting it. These decisions can be as straightforward as who files the tax returns and as complicated as who determines the timing for capital transactions. The former will frequently sit with one party while the latter will typically require input from all key partners. And in the event of deadlock, the parties will want to build in break-up mechanisms such as buy-sell rights. But this is not the only concern. Funding requirements also raise the concern of how to create an ownership structure that prevents a party from not meeting a capital call. Dilution rights are critical to ensuring that a party has something to lose if it doesn’t perform.

Inevitably, all of these considerations will involve discussions and negotiations with different players. Determining critical-path items early will be helpful. The preferred approach is to consider as many relevant concerns as possible at the inception of a project and develop a strategy for each. In doing so, understanding the entire project not only is beneficial but also is virtually a necessity in today’s competitive real estate environment.


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