Can it make money and can the developer be counted on to pull it off? In the end, the totality of the surveyed evidence and business terms of the relevant documents will either confirm the validity of the developer’s commercial real estate development financing proposal or they will provide grounds to refute it. Commercial real estate developers are creative geniuses who eat what they kill. Unfortunately, like the dinosaurs, most of them go hungry and then perish. The odds of success are daunting – especially for those who are undertaking their first project or a new class of commercial real estate income-producing property. Obviously, there are problems with both understanding the commercial real estate development financing process, as well as managing the execution of the process that need to be more clearly understood.
The process starts with acknowledging the obvious: we live in a market economy, therefore; business investment opportunities based upon the local market consumer/end-user purchasing preferences will, all other things being equal, be more likely to succeed than those business investment opportunities that are not based upon the local market consumer/end-user purchasing preferences. From an underwriting viewpoint, the most common flaw is to submit an application for funding consideration and then decide to have a project feasibility study produced to substantiate the business opportunity after the property is already designed and permitted. This out-of-sequence approach creates significant risks as the unit mix, amenities, unit sizes, schedules of services and/or other operating components are not likely to match the purchasing preferences of the local market. Asset obsolescence risk, term risk and maturity default risk become potential failure issues as a result because the developer is not going to willingly redesign the project to meet market expectations. Rejection is the likely result and failure becomes the only option.
The second issue of critical importance is the nature of the due diligence documentation. The due diligence documentation speaks directly to the management of execution risk and the mitigation of potential loss events. The issues left open that have not been clearly defined and for which no risk management measures are defined become the basis of rejection because the only conclusion that can be reached is that execution risk will be a significant risk that will not be a fully manageable element of the business. If you are wondering why your wonderful opportunity cannot attract capital investment check the following:
- Was your first due diligence task the creation of an enterprise risk management plan?
- Did you have an independent opportunity valuation of the potential alternative intended-uses and the potential yield they may have created?
- Was the development program based upon a full project feasibility study or was the feasibility study done after the fact?
- Does the due diligence documentation demonstrate a comprehensive approach to execution risk management or are important issues assumed to be manageable even if the developer entity is no longer part of the deal?
The answers tell you the odds of success. May the odds always be in your favor.