An Email Reply to a Prospective Small Developer

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You raise a lot of good points and express concerns which I have also heard from other folks looking to get started in incremental development.  We should probably talk about this by phone or video chat when you have an opportunity.  Some responses;
The most satisfying projects deliver on several levels
  • They post good financial returns that justify the risk of construction and leasing.
  • The process of getting the the building built or renovated builds relationships of trust among your team making it possible to take on another effort with greater confidence.  I think that working with people you genuinely like and respect, seeing them grow and develop new capabilities is very rewarding.
  • A good project contributes to the social and economic flywheel of the neighborhood.  The best projects have lots of synergy that benefits other people.  A restaurant opening across the street from a coffee place strengthens both enterprises and makes that block a good place for someone to want to open their new office.  Building projects that create local wealth and local jobs within a neighborhood protects the long term value of your own buildings in that setting.
Farming
I think it is critical to have a geographic focus for incremental development.  Monte and I talk a lot about “farming”–identifying specific areas and getting to know them well.  That investment of focused time and attention reduces your risk, because you can know the place well enough to understand where catalytic efforts will have the impact needed.  Have you picked an area or neighborhood where you would want to concentrate your efforts?
New Construction vs. Renovation for a first project
I started out in the trades as a carpenter and later, an electrician.  So, I tend to think it is always better for folks who want to understand the nuts and bolts of development and property management to start with a piece of new construction, rather than an ambitious renovation.  That first construction project should also be of modest scale.  Small scale helps you limit your risk and focus your learning. You are not looking for economies of scale on your first building experience, you are looking for an opportunity to learn the basics and connect the pieces so that you can communicate effectively with your team.  Once you get a handle on the  fundamentals and mechanics, you move to more subtle stuff like refining the design to make construction and maintenance easier, or to making the units more pleasant for your tenants.  Renovation and new construction both have risks, and tradeoffs that you need to identify from the start and manage through the process.  (I just think the risks and tradeoffs  of new construction are more straightforward).
Affecting people’s lives
If we think about the resources we have; capital, skills, determination, and vision as things that we have stewardship over, understanding how  we manage them in ways that affect the lives of people in the neighborhood should guide what we do and how we do it.  Building a culture within the team that looks outward is really important in my view.  Conventional development practices applied to existing neighborhoods tend to displace people who have limited choices and opportunities, so we need to have different strategies grounded in the principle of increasing choices and opportunities for local folks.  I really appreciate the way that Monte Anderson finds the local entrepreneur tenants and puts them on a track to eventually buy their own building, so they are not displaced by Starbucks or some national tenant down the line.  The local entrepreneur gets to build local wealth which stays in the community.  That’s  better for everybody.  The current shortage of skilled construction labor presents a problem and an opportunity for an incremental developer working in an underprivileged neighborhood.  A small developer can generate steady work  for the trades.  That steady work can become the platform for training local folks in the trades, with the goal of helping them sort out the logistics of having their own contracting enterprises and eventually owning their own buildings.  There are more opportunities in these neighborhoods than there is capacity to meet them, so the wise strategy would be to build a local trade base to add to that capacity.
Acquiring and sharpening tools
I understand that you have capital you want to put to work soon.  Rather than look for deals right now, I encourage you to sharpen your tools and build your skill set for a while. Maybe set a target of getting into a project by the end of 2016.  One potential way for you to get up to speed on the tools and techniques that will help you as you look at opportunities for incremental development is to come to a boot camp.  The concentrated format of two and a half days gives you a lot of information in a short period of time and getting to know other folks at various stages of doing this kind of work will help you build a network of people you can reach out to for counsel when things get tough.  You will find the the network of small developers has a culture where nobody wants to see their colleagues repeat their learning curve.  There is a lot of lateral support among the crew.  They are generally looking for a chance to pay it forward.  We are scheduling at least one event a month through most of 2016.  Keep an eye on the Incremental Development Alliance website for new dates as events get confirmed.
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Who says you can’t get financing for a small mixed use building???!!

3story mixed use 203K diagram

Small Mixed Use Building in Geneva, NY.  Photo by Mike Puma
Small Mixed Use Building in Geneva, NY. Photo by Mike Puma

The typical 2 and 3 story main street mixed use building is perfect for a rookie developer to use the FHA 203K purchase rehab loan program to finance their first project.  Understand the Loan program and fill out the forms carefully, design your rehab to fit the rules. Now from the start, understand that this loan program is for owner occupants.  You would have to live in the building for a minimum of one year.

HUD GUIDELINES FOR FHA 203(K)

The program is for 4 units plus some amount of  allowed non-residential space which varies with the number of stories in the building.  Here is the breakdown from the FHA Guidelines:

“A 203(k) mortgage may be originated on a “mixed use” residential property provided that the percentage floor area used for commercial purposes follows these standards:

– One story building 25%

– Two story building 49%

– Three story building 33%

The commercial use will not affect the health and safety of the occupants of the residential property.”

The rehabilitation funds will only be used for the residential functions of the dwelling and areas used to access the residential part of the property.”  So you can stabilize the shell of the entire building including the non-residential portion, but you will need other funds to renovate the non-residential space.

If the building was built after 1991 the Federal Fair Housing Act applies.  In those newer buildings above the  4 units or  threshold for buildings covered by the Fair Housing Act requirement that all ground floor units must be accessible/adaptable, here’s what you do to rehab a small mixed use building using an FHA 203)k) loan:

  • ALTERNATIVE 1: KEEP THE NUMBER OF RESIDENTIAL UNITS TO 3 OR LESS AND THE SF OF NON-RESIDENTIAL FLOOR AREA WITHIN THE PERCENTAGES LISTED ABOVE.
  • ALTERNATIVE 2: CARVE OUT AN ACCESSIBLE UNIT AT THE REAR OF THE GROUND FLOOR WITH THREE UNITS ON THE UPPER STORIES.

This is not some exotic loan program.  It is a fixer-upper loan on a 1 to 4 unit dwelling that is conveted to a 30 year mortgage once the renovation is completed.  If you pay attention to the particulars of the loan program, you can use it to fix a main street mixed use building and be in a position to live in one of the units rent free.  Four or five local folks doing this within a couple blocks of each other could change the main street.  Seriously worth pursuing for a lot of towns.

A number of colleagues whom I respect have made a point to telling me that the process of getting a 203(k) loan to actually CLOSE can be really tough.  There are enough specific underwriting requirements that are different enough from more typical loans which lenders process that closings get delayed, or the lender withdraws their commitment.  So finding a bank that actually has their act together on this program is important.  Wells Fargo has invested in training their people on this, so start with them.

The extra brain damage involved in the loan is why I think the 203k program is an excellent vehicle for the rookie developer looking to step up their game. It requires that the project scope be well thought out and well documented. It requires the rookie developer to understand the lender’s underwriting way more than the average mortgage borrower would. (-and possibly the more than the loan officer does..) It requires a long due diligence period from the seller. In short, the process is hard wired to require the rookie developer to have an excellent plan and seek help from their colleagues to launch their first significant solo project. It puts the rookie developer squarely in the position of adding value by creating order out of relative chaos. That ‘s the job.

Working with grad students for a week has me thinking about the basics

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I spent the last week working with 14 teams of grad students in the University of Miami’s Masters in Real Estate Development + Urbanism program (MRED+U). Each of these teams of 4-5 people have been assigned an infill parcel in the Allapattah Neighborhood of Miami.  Their packet included a purchase price and the basic zoning information under the current Form-Based-Code Miami 21.  The team were typically a mix of  MBA candidates taking the class as an elective and students enrolled in the MRED+U program who are required to take the class.  Many of the MRED+U students come from urban design or Architecture.

Here’s what I found myself explaining in various ways:

  • Likely Rent is your first constraint.  Know what your tenants can afford to pay in rent.  If you can’t get the rent needed to support an expensive building, see if you can build a less expensive building.
  • If you are building a small project, look at the broad market for the neighborhood, but target staff from local institutions like the hospital and the airport.
  • Understand how design impacts construction cost.  Know how the building code, the zoning code and the Fair Housing Act impacts the cost and complexity of basic building types.
  • Form follows parking (especially in small infill projects). Figure out the most efficient parking approach early in your design and pro forma process.  The zoning may allow up to 5 stories, but may also require so much off-street parking that you don’t have room to park the number of cars required by the number of units that you would build in the 5 story building.
  • If you can’t figure out what to build, try two very different designs to force you to weigh the trade offs in cost and revenue.  Keep them at the same level of detail to help you see the differences.

Watching bright and engaged people trying to figure out how to do something for the first time is very compelling.