August 1, 2009

 Developer’s Reality
  by Andrew Zeck
     Andrew Zeck is a consultant with Keystone Development Advisors and can be contacted at
In good times of sinking cap rates, the developer made HUGE profits in excess of what his initial pro-forma indicated.  The party got even better when the small shops rented at much higher rates than anticipated and lower vacancy was used in underwriting deals.  A deal that was expected to net $2M in 2000 might have actually resulted in a $8m profit when sold in 2007 after cap rates fell 2 points and rents increased 30%. 
In the “good ‘ol days” cap rate declines, increasing rents and lower vacancy made millionaires out of those with the wisdom or dumb luck of perfect timing.  Pretty soon the rich and jubilant development industry, spurred by greed, bid up land values and attracted more players until the fat windfalls became less, but retailer demand, low equity requirements and low interest rates kept the party going. 

Optimistic about the future, developers hoped that there was always potential for a repeat of windfall profits, but in the meantime they were still happy with multiple deals that netted $2M each, (a typical profit for a grocery anchored shopping center.)  Trust me when I tell you that this handsome profit is justifiable when one considers the myriad of risks and costs associated with running a development business.   Add in the equity requirement and a typical 3 year cycle and it doesn’t look that impressive any more.
Furthermore, profits are generally governed by the anchor tenant that typically approves the pro-forma and structures its rent to ensure that the developer does not make an obscene profit that is only possible with the long term commitment of the anchor tenant. 

Nonetheless, $2M with hope of future windfall was good enough for many.  Little did they know that they really needed to structure a deal with $5.5M of projected profit to ensure against the horrible storm they are battling now.
But surely you are still in the money as a developer with a pipeline of  “bread and butter” grocery anchored shopping center developments… right?  Wrong. 
Even these venerable real estate investments are getting bludgeoned, albeit less than other retail product.  Besides the increase in cap rates there are 3 other important elements that are sharpening the opposite edge of the blade right now… lower rental rates, higher vacancy, and lower out parcel values. 

Seemingly shallow cuts into the solid pro-formas for these shopping centers make their rock solid investment foundations seem like brittle chalk.  The truth is that Johnny Economy slapped the erasers together and returns have vanished in a cloud of dust. Cuts like a 1 point move in cap rate, a 20% reduction in small shop rent, a 5% increase in vacancy, and a 35% decrease in out parcel values seem hurtful but not disastrous when considered individually, but taken together these demerits drastically change the developer’s position. 
 A typical grocery anchored shopping center might have required a total investment of $15M equity of $3M and generated a profit of +/- $2M for the merchant developer.   Today, the developer that engaged in this project has lost all of his anticipated profit ($2M) and all of the cash equity ($3M).  To pour salt in the wounds, he needs to bring about half a million dollars of his own money to the closing.
Developer’s Investment Summary
Time Spent:  3 years
Soccer Games Missed:  18
Grey hair increase:  20%
Profit from hard work:  $0
Money Lost : $3,500,000
My Conclusion:  The older I get, the more willing I am to seek advice.  Not because I am falling behind the peloton of practitioners, but because I can learn so much from their mad paced pedaling. 
Staying at the head of the pack means I can hear the real wisdom in the breath of a figure ahead of me wearing the yellow jersey.  Never assume you have earned the yellow jersey because then you have fallen to the rear of the pack. 

The real estate development and investment industry is very precarious right now.  Losses are terrifying but discounts are enticing. 
You may be stuck in the race and pedaling faster than ever or maybe you are conserving strength for the next stage.  Regardless, I encourage you to ask for advice and listen carefully.