Developers attempt to determine if a development project makes financial sense by performing financial feasibility analyses. Simple “back of the envelope” calculations provide an initial indication of whether it makes sense for a developer to take on development risk for a particular site before spending time creating a detailed spreadsheet model.
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The build to calculation (e.g., “build to a 10”) is an expression used by developers to state a threshold for expected income return on a development project. The chosen threshold is, at a minimum, the yield sufficiently attractive to entice equity and debt sources to finance the project. A developer that “builds to a 10” expects a 10% stabilized NOI return on expected total costs (Build to 10 = 0.10 = Expected Stabilized NOI / Expected Total Development Costs). Total development costs consist of land, as well as all hard and soft costs.
Developers often have an estimate of what the cost to build will be on a unit basis (e.g., $350 per square foot (SF)). Factoring in estimated soft costs, land costs and financing costs per square foot, they can quickly get a rough sense of how much the development will cost per square foot. From that point, they need to solve for the numerator (NOI per square foot) to see if the project will meet or exceed the targeted yield.
This is done as follows: first, determine the rent on leased space (i.e., Market Rent per Leasable SF * (1 – Stabilized Vacancy %)), by plugging in the expected market rent per leasable square foot and the expected stabilized vacancy percentage. Next, calculate the rent per gross square foot by adjusting for the loss factor, which depends on the building’s design (i.e., Rent per Leased SF * (1 – Loss Factor %)). Finally, deduct the expected operating costs per gross square foot from the rent per gross square foot to arrive at the stabilized NOI per gross square foot (i.e., Rental Revenues per GSF – Operating Costs per GSF).
If the yield calculated is lower than the developer’s required return threshold (10%), the development is not feasible.
Build to x% Calculation (yield on cost) = Expected Stabilized NOI / Expected Total Costs
- Rent per Leased SF = Market Rent per Leasable SF * (1 – Stabilized Vacancy %).
- Rent per Gross SF = Rent per Leased SF * (1 – Loss Factor %).
- Stabilized NOI per Gross SF = Rental Revenues per Gross SF – Operating Costs per GSF
- Yield on Cost % = Expected Stabilized NOI / Expected Total Costs.
Developers also analyze the feasibility of a development project by determining the Replacement Rent per Gross Square Foot necessary for a potentially viable project (i.e., what market rents have to be for the project to yield the developer’s required return). A developer that expects to build to a targeted yield will solve backwards for the replacement rent. However, since market rents are quoted on a Leasable Square Foot basis, it is necessary to exclude the loss factor and stabilized vacancy from total square feet built. The figure calculated as the Rent per Leased SF must be supported by the market for the development to be viable.
- Replacement Rent per GSF = (Build to Return * Expected Total Cost) + Expected Operating Costs
- Replacement Rent per Leased SF = Replacement Rent per GSF * (1 / (1 – Loss Factor)) * (1 / (1 – Vacancy)).
A common mistake developers make is simply extrapolating rising rental trends to assess if the market will support expected rents rather than analyzing supply, demand, and development costs. A good rule of thumb to keep in mind is that once rents rise above replacement rent, developers will develop. As this new space comes online, rents will revert towards replacement rent, rather than continue on an upward trend.
A developer can also determine the maximum amount to pay for land by making land cost the unknown variable in the “build to” calculation, given a targeted yield for the project. It is important for developers to consider the Floor Area Ratio (allowable density) of the site when calculating the price they are willing to pay, so as to determine the cost of land per buildable square foot.
These are the types of questions you’ll be able to answer after studying the full chapter.
1. Alexis Development Corp. was recently given the opportunity to bid on an attractive development site in the financial district in downtown Philadelphia. The executives at Alexis believe there is growing demand for high–end office towers due to the growing demand by pharmaceutical companies in the area. The investors at Alexis expect to achieve an 11% return on development projects and do not wish to begin developments if such return cannot be achieved. Doug is the Head of Development at the firm who was given the task of assessing the feasibility of the Alexis Office Tower project.
Below are the cost and income data Doug has collected for the project:
a. Calculate the expected return on cost (build to return/yield on cost/going in cap rate) for the Alexis Office Tower development project.
b. Does the expected return meet the investors’ threshold of 11% return on cost?
c. What is the minimum replacement rent per gross SF and per leasable SF that Doug must expect for the development to meet the investors’ expected return?
d. Given that FAR for this site is 5, how much should Doug be willing to pay per acre of land and still meet the return threshold set by the investors of Alexis Development Corp.?
e. How can Doug increase the expected return on the site? Give 3 ideas.
Development risk from the developer’s point of view (9:39)
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Analysis and evaluation of a proposed project to determine if it is technically feasible, feasible within the estimated cost, and will be profitable.
How much gross square footage of the building is unleasable.
The build to return, expressed as a percentage of total development costs.
On a per-GSF basis: (Build to Return * Expected Total Cost) + Expected Operating Costs
The tendency to extrapolate recent rental rate data points at the same slope when conducting feasibility analysis.
The process of valuing land with development potential where the land value is equal to the net of total completed project value, total development costs and total required profit.
The ratio of a building’s above-grade gross floor area (both vertically and horizontally) to the area of the lot upon which the building is constructed.
The process of reducing construction cost where possible without destroying the value of the final product.
A reserve set aside for unknown but expected project cost overruns.
How much is being spent daily (or weekly, or monthly) during development; typically, the run rate is low in the beginning, rising as construction gets into full swing, and then stabilizing upon completion at your interest-carry cost.
- Development Feasibility Assessment
- Simple Calculations
- Solve Backwards for Replacement Rent
- A Common Mistake
- Land Cost
- An Example: Anoop Court
- Hard Costs
- Forecasting Hard Costs
- Soft Costs