Andrew Frey frequently reminds rookie developers to make their decision to proceed with a project or not, in light of the Capitalization Rate (Cap Rate) that existing projects are currently selling for in their local market. Let’s unpack that a bit.
Andrew recommends that the Return on Project Costs for your new construction project needs to be at least 2 points above the Cap Rate for the purchase of existing buildings that have no construction risk, no leasing risk and no refinance risk.
Here is some other advice for Small Developer/Builders from my favorite recovering attorney and practicing small developer:
Andrew Frey: Start with a market study. Your equity and debt will do their own underwriting, and you want to be one step ahead of them. For example, if new construction only makes economic sense when local rents hit $2 per SF per month, you have to have a really solid case that rents are already at that level or will be soon.
If the market for existing small rental buildings is around a “6 cap” (existing annual NOI / purchase price = 6% capitalization rate) and your proposed building will only generate a 6% annual return (future annual NOI / total development budget), then you are taking on risk without return AND it will be hard to make the balloon payment on your construction loan (can’t re-fi or sell).
Try to do your first project in a prototypical way, i.e. on a typical small lot with plans that can be re-used. Small development already suffers from lack of economies of scale (for an individual project), but you can achieve economies over the course of several projects (soft costs go to zero, hard costs get more accurate). Re-inventing the wheel for every small site is really expensive.”
A subsequent exchange between Dallas planner/urban designer Patrick Kennedy and developers Frank Starkey and Monte Anderson went like this:
Frank Starkey: Monte, don’t you implicitly “have a really solid case that rents are there or will be soon” (because of your value-added place making approach)?
Patrick Kennedy: I don’t think there are comps in the areas Monte Anderson typically operates. He is the pioneer.
Frank Starkey: True. So that’s the limit of applying Andrew’s advice on the frontier, where there is no demonstrable “market”. Two important but very different contexts and approaches: a) established (but hopefully rebounding) markets as Andrew describes and b) moribund locations like where Monte works. (Of course, his efforts transform the latter into the former, at which point the calculus changes.). Thoughts?
Monte Anderson: In the early days of the areas I work, I am always looking for the butcher, the baker or the candle stick maker who will do a project that is more suited for their use and not the investment initially. And yes John, I would like to do more deals that fit this model that Andrew Frey initially talked about. Also, I look for a neighborhood with good bones and one that is somewhat close to something else that is having success. If the streets are not good there is usually little hope unless the city is willing to make those expensive changes. It is a painful way to develop and the return is over a longer period, 10 years or more.
A heads up for folks attending CNU23 in Dallas next month, Andrew Frey and Monte Anderson will be joining me for a CNU202 Session on Wednesday morning at 9:00AM titled Understanding the Numbers and Asking for Money. Monte and Andrew are really sharp guys. I am looking forward to the Session.