Real Estate
The Economic aspect of Real
Estate Development
Real
estate development is essentially a cash flow business. By nature, real
estate is an expensive non-liquid asset. This means that though it costs a
lot of money to create and own it, and it can sometimes be difficult to
dispose it off in sale. In development activity, there also needs to be
taken into account the added costs of improvements - typically called
"hard costs" and the fees of various consultants necessary to get the work
done well - typically called "soft costs." Because expense is high, it
makes cost high in turn making a sale difficult, and receiving returns on
the investment is delayed; this makes real estate investment an inherently
risky business. A large part of the work of developers is the management
of risk.
Since the amounts of
money involved are typically very large, a majority of real estate
development projects are financed with a substantial amount of debt
leverage. While a higher leverage increases potential profit, it also
increases the risk and builds in a periodic negative cash flow owing to
the regular payments that need to be made towards the debt. Projects have
been generally found to be profitable when the upfront commitment of cash
is kept to a minimum, and the faster the project can start generating a
positive cash flow, the easier it is to cover debt service.
There are numerous
ways to finance a real estate development project. However, majority of
the financing arrangements fall into a few broad categories:
1. Private investors
(insurance funds, pension funds, joint ventures, wealthy individuals,
etc.)
2. Public investors
(share offerings, REITs, public-private partnerships, etc.)
3. Public debt
(redevelopment loans, etc.)
4. Private debt (individual loans, construction
loans, bank mortgages, etc.)
5. Private grants (non-profit target grants, etc.)
6. Equity
financing (use of cash flows from other projects owned by the developer)
7. Public grants
(affordable housing credits, tax incentives, anti-blight subsidies,
historic preservation grants, etc.)
8.
Subordination
Most successful real
estate developers can become enormously wealthy; this is due to the large
sums of money being transacted combined with the value of the assets they
control. However, due to the lack of liquidity of their assets, they are
also very often cash-poor. The inability to remain cash solvent is one of
the primary causes of business failure among real estate
developers.
