How I evaluate real estate development deals

I try to write on topics that I am interested in but cannot find good books or reads on the internet.  Evaluating real estate development deals is definitely one of those subjects.  Here is how I evaluate residential deals for value-add or ground-up development in a 5-step process: Market Analysis, Development Concept, Preliminary Due Diligence, Financial Modeling and Returns.  

Step 1 - Market Analysis

Market analysis is usually the first step of any deal evaluation. It will provide a lot of useful information, such as area insights, demographics, product type/design, comps, etc. The most important information to a developer is probably the supply/demand and comps data of the specific product that you choose to develop. As legendary real estate entrepreneur and investor Sam Zell highlighted in his book Am I Being Too Subtle that real estate business follows the simple law of supply and demand! Here is the thought process on how I develop the supply/demand and comps data:

Neighborhood -> Demographics -> Product Type and Design -> Supply/Demand and Comps

I usually start with a look at the “livability” and vibe of the neighborhood which includes crime rate, access to mass transportation, local schools, WalkScore, street retail, and other cultural, sports and fun establishments to get a sense of how vibrant the area is.  I usually use Areavibes for this purpose.  Places like East Village, Williamsburg or Bushwick are very different from Chelsea or Upper West Side of Manhattan. You will need to study it carefully and keep asking questions like, is it safe to walk at night, is it a 24-hour neighborhood or 18-hour neighborhood. Information on the neighborhood will also provide key insights into the area demographic.

Next step is to look at the neighborhood demographic, what kind of people living in the area, their age, marriage status, income, consumer behaviors, etc.  The information will become the foundation in developing the annual rent assumption (30% of gross income).  There are many places online offering bits and pieces of the information (Moving.com, NeighborhoodScout, etc.).  I found MyBestSegment by Claritas (used to be Nielsen) to be the best and it’s free!  It can be a bit overwhelming to use at first.  Here is a good tutorial.  PolicyMap is another resource.  You need a subscription but it’s well worth it. 

With the demographic information, you shall now be able to identify the specific product type to serve the area population. Is it condo or townhouse? Is it luxury or workforce rental? Is it co-living or student housing? The demographic information shall also inform you ideal product design, such as high/low rise, unit type, mix, size, finishes, desired building amenities, etc.

Another important piece of information is comps!  Real estate is a highly localized business so walking the neighborhood and looking for comps in person is probably the most effective and direct way to identify competitions and shape your opinion around many development decisions.  For a quick desktop study, I found StreetEasy (free!) and PropertyShark to be great resources.  Listing brokerage firm can help develop comp report as well.  You also need to pay attention to concessions and distinguish between gross rent and net rent.  

Finally I will look at supply and demand (to check on my rent growth assumption).  To get up to date information on supply data, you will need to walk the neighborhood. I usually do it once every month in areas that I am interested in.  For a quick desktop study, NYC DOB made building permits data public and you can search NYC Active Major Construction.  For example, I found there are 1,607 active permits for new residential buildings in NYC with proposed 80,344 dwelling units.  You can narrow down the search area (close to your deal) by selecting nearby Community Boards.  REBNY publishes new construction data in NYC on a quarterly basis. You can find the reports here. You can also get research data done by reputable brokerage firms (Cushman & Wakefield, CBRE, JLL, etc.).  Many of them publish reports indicating new supply by asset class and neighborhood or area on a quarterly basis.  I also found The Real Deal Data to be quite useful in tracking new development.  It’s based on NYC DOB building permits data and free to use for TRD subscribers.  On the demand side, I typically use recent and projected job growth in the area to come up with an estimate on population growth and resulting housing demand.  It’s not perfect by any means, but will give you a rough demand to compare with the supply and confirm your rent growth assumption, and inform on net absorption rate, etc.  

If you want to know more about market analysis, I found Real Estate Market Analysis by Adrienne Schmitz and Deborah Brett a good book to read.

Step 2 - Development Concept

Once Market Analysis is done, I will try to come up with a very high level development concept.  I usually start with Zola Map by NYC City Planning to obtain information on the site (lot and block number, zoning district, width and depth of the zoning lot, lot size, etc.).  With the lot size, applicable FAR and lot coverage requirements, I can come up with a rough buildable SF of the site, size of floor plate, number of floors, maximum unit count (dividing buildable SF by 680), size of retail component and number of parking required, all of which will be used in the development proforma.  I usually add 3-5% mechanical deductions to get above-ground gross SF and add basement SF to get total gross SF of the development.  As to the rentable SF, I would deduct 1) lobby/hallway, 2) staircases/elevator shaft, 3) above-ground amenity spaces, off the buildable SF to get the net rentable SF. 

For value-add deals, understanding existing building layout is key in developing the repositioning concept.  Owner and listing broker may or may not provide building as-built drawings.  You can perform a drawing search with NYC DOB by using an expeditor for a fee. I’ve done that a few times on several important deals but I won’t do it on every deal due to associated cost.  You may also find floor plans through HPD’s i-card records.  The hand-drawn layouts were recorded by building inspectors in the 40’s and 50’s.  You can access the HPD’s i-card records here.  

To come up with any development concept, you need to have a pretty good understanding of the NYC Zoning Resolution, a comprehensive set of rules to define use, bulk, height, shape, setbacks, parking, etc.  It’s very involved and can be intimidating at first.  I got used to it after several years of analyzing deals and developing concepts.  It’s a living document and you can find the latest version online here.  

Step 3 - Preliminary Due Diligence

I will start with searching for any red flags (landmark, environmental issue, flooding hazard, SRO, potential rezoning, major violations, etc.) associated with the deal.  Information on these topics can generally be obtained using the local department of buildings information system if available.  In NYC, you can find the DOB BIS here.  Each issue is different and requires in-depth analysis on a case by case basis.  Some of these issues can be serious and a deal killer.  So once a red flag issue is identified, you shall really dig deep and understand your exposure and adjust your valuation accordingly or simply say no to the deal.  Remember what Warren Buffet once said, “The difference between successful people and really successful people is that the really successful people say no to almost everything.”  

Another important piece of important information is real estate taxes (RET).  For value-add deals, I will verify the asset’s current RET and nearby comp’s RET.  For ground up development, I will check on the current assessment on land value and on any existing structure (if applicable).  Additionally, properties might receive tax incentives through a number of programs (421a, J-51, etc.).  They usually show up in property’s RET.  RET data is public information and if the deal is in NYC, you can assess them via DOF’s online records, just input the block and lot number from the Zola Map discussed earlier.  All these information will help validate my RET assumption in the proforma which I will discuss later in the post.  

A few years back, I had a hard time finding affordable housing data on deals with rent stabilized (RS) or controlled (RC) units.  Property owners are required to register with NYS DHCR every April.  Part of the registration includes information on RS/RC units, their renewal, vacancy, rents, etc.  General public will not be able to access such information unless you are the owner of the property.  Listing broker through the owner may be able to provide a Registration Rent Roll Report with these information.  If not, there are a few ways I would go to look for the data.  One way is through the property’s RET records.  The number of RC and RS units will show on the property’s quarterly or semi-annual RET bill.  I’ve discussed how to access RET records earlier. It shall be noted that if a property has RC or RS units, it’s very important to review all leases (and required Rider) to determine your potential exposure for rent overcharge lawsuit.  The owner will share leases once the LOI is signed, which I will discuss later in the post. 

In NYC, The Office of City Register made property records public through the ACRIS System.  You can perform document search and review any properties’ prior sales records, deed restrictions or covenants, mortgage recordings, ZLDA (air rights sale or purchase), any tax lien, or any agreement with HPD, HDC, DHCR, ESDC related to affordable housing, etc.  

Step 4 - Financial Modeling 

Once I’ve done my homework with market analysis and preliminary due diligence, I will start working on a financial model of the deal, essentially developing a proforma.  Proforma is a cash flow projection for the entire duration of the development and asset holding period.   It can be very daunting just to read through a development proforma at first. I remember searching online and was looking at an example and fell asleep!  

I found Commercial Real Estate Analysis and Investments by Geltner (particularly Chapters 11, 13 and 14) to be very helpful in explaining the theory behind proforma.  The book comes with a CD and an example proforma to play with.  I also took a few courses at MIT and Fordham as well as ULI to learn more.  With some study and practice, you shall be able to build a development proforma on your own in 3-6 months like I did.  There are paid software and web tools available to do just that.  But I will encourage you to develop your own. It’s cool really!  I’ve seen some very fancy proforma with a ton of references, auto-calc buttons, etc.  No need to speed too much time going overboard. Remember a good deal is a good deal no matter how fancy the model is!

Once you have your development model, it's much easier and quicker to evaluate deals.  As I realize over time, the proforma is just a tool and the most important thing is the input and assumptions that you put in.  That's why I spent most time validating my assumptions in deal analysis nowadays.  The actual financial modeling part takes just 10-20 mins.  

Some typical assumptions used in proforma include design and construction cost, schedule schedule, lease-up period, rents, growth rate, vacancy, OPEX, RET include rate, growth and phase-in schedule, CAPEX, utilities, exit cap rate, business and capital gain taxes, interest rate, DSCR, LTC ratio, etc.  Knowledge in these assumptions usually comes with practice and experience over time.  Your understanding will increase quickly after you review many deals.  I encourage anyone who is interested in real estate deals to talk to brokers (investment sales and mortgage) and lawyers (transaction, zoning, RET, DHCR/HPD), architects and contractors, and property managers and building supers.  You will gain a lot of insight and make many friends!

One final note on financial modeling is tax abatement through 421-a or Affordable New York program.  You can find the information on the program here.  It’s a quite involved topic and I will write a separate post on that soon.   

Step 5 - Returns

The key outcome of the financial modeling is the projected returns of the deal.  There are typically 2 types of return that I am interested in: the development yield (DY) and internal rate of return (IRR). The discussion on DY and IRR below is both unlevered.  Depending on the leverage on the deal, its return can be much greater for obvious reasons.   

The development yield (NOI/Total Development Cost) focuses on the income potential of the deal once the development is complete and the asset is stabilized. Usually, institutional developers and investors demand a minimum DY between 5%-7% although it's not uncommon that certain deals can achieve much higher than that depending on a number of factors, such as deal size, market conditions, execution, etc.

IRR looks at cash flow for the entire holding period of the asset, including the initial construction costs, annual income (NOI minus CAPEX), and final reversion proceeds of the asset.  It takes into consideration 2 more things that DY overlooked: 1) asset appreciation (through final reversion), and 2) time.  Usually institutional developers and investors are looking for a minimum 5-Yr IRR of 10% or 10-Yr IRR of 7%.  Again, development deal IRR can be significantly higher than that depending on a number of factors.  

I found RCA Insights by Real Capital Analytics are great resources to gain insights on market movement, industry trends, historic statistics and institutional owners/investors appetite.  It’s always enlightening to read their latest research. 

What’s next?

Once all the homework are done and everything checks out, you might decide to move onto the next steps: deal negotiation, LOI, "formal" due diligence, contract, financing, closing, business plan execution.  There are a lot more involved in these steps and I will write additional posts to cover them.