Spring 2021 Issue - 86

BUILDING

or over coffee with someone testing an idea. How much
will the land cost? How much can I develop on the site?
What kind of rents or sale prices can I expect? What will
it cost to build? How long will it take, and how much
money will I need to make it happen?
These are all inputs that can be quickly assembled
to frame a project scenario and test the result. Although
graduate-level courses will teach you about leverage and
internal rates of return, most small projects result from
a simpler capital structure and feasibility test that starts
with " what if " and ends with a detailed pro forma.
The purpose of the initial feasibility effort is to assess
whether your kernel of an idea has potential. It helps
you confirm whether the price you are considering (or
have negotiated) is appropriate for the contemplated
project. More than anything, it helps you identify the
metrics to watch so you can constantly assess and reassess whether your ultimate project outcome will be a
home run, cost you everything you own, or result in what
developer and author Howard Kozloff calls a " volunteer "
or break-even project.

Small Tips for Testing Project Feasibility
The following are some of the tools for testing project
feasibility.
l Return on cost as the first test. Before running a complex pro forma or dynamic model of cash flows, costs of
capital, and timing flows, a simple static (meaning not
time-dependent) model can tell you if you have a project
that could make sense. Total all your project costs: land
cost, construction, fees, and sales or leasing commissions. Do not underestimate soft costs, approvals, design
and engineering, permits, and your fee. Calculate total
potential revenue-as an exit sale price or as a function
of anticipated net operating income at a conservative cap
rate-and subtract costs from income. If your resulting
gross return is at or in excess of 20 percent, you have the
beginning of a project that could make sense.
Most small developers use 20 percent because it provides adequate margin for changing costs, price reductions, and unforeseen surprises. This does not mean
it is your profit from the project; it is just an indication
that the project has enough latitude or margin of error to
weather the inevitable changes that will occur over the
project's development.
l Residual land value analysis. To confirm you are
not overpaying for a site, a residual land value (RLV)
analysis should be prepared and compared to listing/
asking prices for land. An RLV is basically the value of
the land after all (residual) costs are subtracted from the

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future development. This is the value the land can support, after costs of construction, development, required
profit to attract needed capital, and your fees or upside
to make the project worth undertaking. And in an ideal
situation, the list price will be less than the RLV, giving
the project an excellent foundation for future success. In
cases where the asking or listing price is higher than the
RLV, be cautious about compromising or paying more
than the analysis indicated.
l Sensitivity analysis to understand deal resilience.
Sensitivity analysis is one way to manage risk and is an
important tool for talking to investors. The basic premise
is: how much can exit prices fall, or project costs go up,
before the equity receives no return? The goal of this
analysis is to understand the " sensitivity " of the project's success to factors that are beyond your control. So
if development costs go up by 10 percent, and all your
profit and a good bit of your equity are wiped out, the
project may be too marginal to succeed. Conversely, if
you find that even if project prices fall by 30 percent you
can still pay the bank back and return all equity, you
have pretty good latitude to weather market cycles.
Site acquisition must be approached with the same
attention to detail as every other step in the development process. While there are no formulas for developing small, there are tools and guidelines to help you
through the process. Passion, tenacity, and brute force
are good attributes to start with, but success is achieved
only with rigorous analysis and continued " fiddling with
the dials " -fine-tuning the costs, capital structure, program, revenue projections, and schedule to ensure your
project does not sink you forever. UL
J I M H E I D is a real estate developer and strategic real estate adviser
focused on the tools and techniques that lead to a more sustainable
built environment. For more than 30 years he has advised cities,
nongovernment organizations, legacy landowners, and private
developers on more positive ways to build community. In 2017, he
founded CRAFT Development, a real estate company focused on
incremental development and intentional place building. D A V I D
F A R M E R , chief executive officer of Metro Forecasting Models LLC, and
L O R E N Z O P E R E Z , principal of Venue Projects in Phoenix, contributed
to this article.

Building Small: A Toolkit for Real Estate Entrepreneurs, Civic Leaders,
and Great Communities. © Urban Land Institute, 2021. Available from
bookstore.uli.org, $49.95.

SPRING 2021

4/1/21 9:45 AM

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Spring 2021 Issue

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