Key Takeaways:
- Raw Land & Development is a time-consuming venture
- Increase in time from initial investment to cash flows as revenue = increase in risk
- Risk/Return balance is highly subjective & based on investor goals
- Mitigate risk through prevention and forward thinking
In this blog post we will explore some characteristics of raw land development which make it particularly risky for an equity investor. We will also discuss risk mitigation strategies and equity return as compared to equity risk.
Equity investor’s risk in a real estate deal is increased with exposure. In many ways, risk and exposure are the same thing. That is, exposure to changes which may negatively affect the outcome of an investment project. Time has a dramatic effect on this concept of exposure on risk. The more time is added to a project, the greater the exposure, and the greater the risk. Risk factors that can play havoc on real estate development projects include Business Risk (fluctuations in economic activity over time), Liquidity Risk (non-cash flow assets tend to be non-liquid), Legislative Risk (such as unexpected zoning changes), and Interest Rate Risk (dramatic rise in rates during development). These risk factors are exacerbated by introducing longer duration(s) before equity investors earn cash flows and return on their investment (ROI). Essentially, the longer the time between initial equity investment and incoming cash flows, the greater chance an unknown variable related to risk will begin to impact the development/investment. Raw land development or the development of a vacant structure both involve a great deal of time (certainly months and typically years) prior to the stabilization of the asset and delivery of consistent cash flows.
The question of whether these increased risks are offset by adequate returns is highly dependent upon the equity investor, the development itself, and the current risk environment. I will use a response that drives my new Realtors crazy, “It Depends”. It depends upon a great many things. If the equity investor has an aggressive outlook and is willing to take on moderate risk for moderate return. If the development itself has a superior value proposition to the competition. If the current risk environment is acceptable to the investor and the potential gain is worth the moderate risk. If these are in alignment, then yes, the return may justify the increased risk.
As a development partner or sponsor, presenting an investment opportunity to an investor, I seek to put myself in their shoes. What is it that they will be most concerned about? What risk factors can we control and what can we not control? What information can I present to them and what steps can I take, to mitigate the risk over which we do have control? A thorough market study, understanding of the local legislative environment, and understanding of the market forces of the broad economy (interest rates, inflation, environmental shifts), can all help to decrease the exposure felt by the investment partner. Planning and forecasting the moves of our competition, and the local market’s impact on our project, can greatly reduce the risk the development faces. The development partner can help mitigate risk by having useful relationships (local) with decision makers or those in the “know” on the legislative scene, by providing loan guaranties, or by taking responsibility for construction cost overruns.
As we discussed above, increases in time between the investment of equity and the return of cash flows, will increase the risk to the equity investors. So, as a development partner, we should seek to reduce the time to market (cash flows), to as great an extent as is possible. This can be done through effective product placement (choosing the right product), thorough marketing campaigns, aggressive pre-leasing (or pre-sale), and affective project management that keeps the development moving forward ahead of schedule.
Questions?
Should you, or anyone that you know, have any questions related to this post, please do not hesitate to reach out via phone, email, or text. I am passionate about helping others along their real estate journey.
– Nick Schlekeway