The investment real estate land and development cycle generally has four stages, each with its unique risks, costs, and returns. Each stage has its own time frame, and each stage should be viewed as a separate purchase, even if a purchaser were to buy the raw land, entitle, and develop it into an income-producing asset. Stages will invariably overlap in many instances, but generally, these four points in time represent when value is added and/or realized.
Stage 1: Raw Land
Objective—Purchase raw land in the path of growth that has not yet been entitled for development. Hold the land until demand causes prices to increase thereby transforming the raw land into a development opportunity.
Timeline—Three to seven years.
Related expenses—Managing the land and paying property taxes. These expenses may be offset by possible farming rents or other short-term revenue opportunities.
Potential Risks—Public policy changes related to urban growth boundaries, endangered species, development moratoriums, or other anti-development actions affecting the property. Major economic and demographic shifts. If researched and managed properly, these risks can be mitigated.
Rewards—Land appreciation.
Stage 2: Pre-Development and Entitlement Approval
Stage 2: Pre-Development and Entitlement Approval
Objective—Buy the raw land and entitle it. Entitling is the process by which a certain type and size of project is approved by the appropriate jurisdictions. Sell the land to a developer once it is entitled, or proceed to develop, if the purchaser in this phase is also a developer.
Timeline—Six months to five years or more, depending on the approving public agencies and private influences.
Related expenses—Costs incurred while applying for and obtaining necessary approvals will include the principal's time, overhead and expertise, attorney fees, engineering fees (soil, traffic, and civil); architectural fees; supply and demand studies; surveyors; and other related costs.
Potential Risks—Economic and market changes, approval costs, changes in public policies, politics within local county boards and city councils, time required for approvals, attainability of proposed approvals, and demographic and demand changes.
Rewards—The increase in value during this stage can be significant and should not only cover the original cost of the land and all of the costs associated with obtaining the approvals, but also provide a profit to the purchaser for taking the risks involved in this purchasing stage.
Stage 3: Development/Construction
Stage 3: Development/Construction
Objective—Buy the entitled land and obtain necessary building permits (if not already obtained) and commence construction. Obtain pre-leases or pre-sales.
Timeline—Six to 24 months after the minimum or lender-required pre-leases or pre-sales are obtained and construction has begun. The project is developed while continuing marketing campaigns aimed at leasing or sales. Once the project is completed, an additional period continues until all sales are complete or additional leases are signed to reach stabilization.
Related expenses—The developer will incur significant costs to obtain the required building permits and mitigate other factors prior to starting construction. Costs will include architectural, structural, and civil engineering fees; attorney fees; marketing (pre-lease and pre-sales) costs; supply and demand studies; soils sampling; further environmental studies; and significant developer time, human resources, and overhead expenses, all before construction commences. Once construction starts, the developer's goal is to have many of the major risk factors mitigated, leaving just the construction risk.
Potential risks—Market changes (the market may go cold during an extended development phase) and economic downturns. Public policies, county and local politics, and attainability of desired approvals may affect the viability and profitability of the project. Other risks include construction mismanagement and costs, labor strikes, tenant demand, tenant bankruptcy, and many other related risks.
Rewards—The overall financial return is dependent upon the market and product type. Reasonable projections on total cost of 20 - 25% are typical. Individual rates of return can potentially be 20% to 30%, but actual returns will vary greatly depending on market conditions.
Stage 4: Income-Producing Asset
Stage 4: Income-Producing Asset
Objective—Purchase the stable income-producing asset from the developer at the end of Stage 3 and manage the property over an extended period of time.
Timeline—Ongoing
Related expenses—Continual costs, expenses, and capital requirements associated with managing and owning an income-producing asset.
Potential Risks—Short-term risks are minimal, unless the market changes dramatically and tenants are unable to afford rents. Other considerations include the real estate market at the time of lease rollovers, future interest rates, fluctuating capitalization rates, future purchaser demand, availability of debt, and mismanagement.