What is Ground-Up Development? Demystifying the Process for Businesses and Investors
A Short Story
As the real estate industry navigates its boom-bust cycle much like the macroeconomy, it's interesting how client conversations change depending on where we are in the process and the overall perception of a given localized market. We've experienced a period of artificially depressed interest rates and unprecedented demand for specific product types. The result has, of course, been lower supply, higher asset prices, and increased competition for the few available properties (and that doesn’t even consider inflationary pressures).
I recently had a real estate strategy meeting with a client experiencing rapid growth who needs more space to house his operations. We talked about his company’s balance sheet, growth prospects, liquidity concerns, and overall personal and professional goals.
He's been looking for more space for a while, but either hasn't found the right opportunity or has been quickly priced out of the competition. The conversation naturally pivoted into development because if you can't acquire what you want, the next step is to build it, right?
We discussed various development processes that could make sense, from build-to-suit to ground-up construction, even to a hybrid build-to-suit model with a possible option to purchase (lease-to-own). The point is that a world exists outside of the binary buy/sell or lease decision model – but the larger real estate industry has conditioned us to think otherwise.
I tell this story because it highlights a struggle that many small businesses and entrepreneurs deal with. They either don't know these opportunities exist or haven’t been asked the right questions. And they’ve subsequently missed opportunities due to overlooked strategic real estate considerations.
There is real merit to the real estate development vs. acquisition discussion during certain cycle periods and given specific underlying business metrics. But the journey begins with acknowledging these opportunities exist and understanding under what conditions they make sense.
What is Ground-up Development?
Ground-up construction is simply the development of a property from scratch. This can be achieved either by developing raw land or tearing down an existing structure and building on the "scraped" lot.
As a business, a ground-up development offers the flexibility of custom-built real estate in a hand-picked location (assuming there is available land). It can also help solve strategic business challenges, like problems with facility optimization or changing workplace strategy. The process is often managed by a real estate developer specializing in development and real estate/business strategy.
From an investor's perspective, a ground-up project, and more specifically a speculative ground-up development, can be the most lucrative type of commercial real estate transaction yet carries significant risk. It can take years to bring a project from initial planning and site acquisition to construction and ultimately property management and leasing.
And developing real estate with no committed tenants or end-user, hence speculative or spec development, can be a significant gamble, especially as you’re building into an unknown future.
The Ground-up Construction Process
Ground-up development requires all aspects of the development and construction processes. It can be broken down into 4 phases:
- Pre-development: The pre-development phase consists primarily of project and site due diligence tasks necessary to determine the feasibility of a project. Several common steps during this phase include:
- Site selection and land acquisition
- Civil engineering work
- Environmental assessments
- Rezoning (if necessary)
- Site plans, permitting, and building plans
- Ground condition assessments
- Development: After all pre-development work has been completed, a site is deemed feasible, and the municipality has blessed off on your project, you’re finally ready to move dirt. The development phase includes most of the site work necessary before you can begin construction, including:
- Land grading and excavation
- Site utilities including water/sewer or well/septic
- Stormwater collection, drainage, and water systems
- Heavy haul roads, rights of way, concrete, and paving
- Construction: Once a site has been appropriately developed and prepped, construction begins. By this stage in the ground-up development process, significant unknown risks have already been identified and dealt with during the pre-development and development phases. The construction process is managed by a developer and general contractor and is guided by the approved construction drawings developed earlier in the project.
- Delivery/Closeout or Operation/Management: Once construction is complete, as a business, you'll be able to occupy a property following a couple of municipal formalities and a certificate of occupancy. However, as an investor, the marketing and management intensity ramps up during the operations phase, especially if you haven't pre-leased the space.
It's essential to consider your timing for your ground-up construction project as well. Depending on the municipality, development may take 2-3 years, or even longer. Matching lease expirations with the conclusion of a project, or engaging in sale-leaseback, can help allocate your business's capital better to help fund your project or your core operations.
How is Ground-up Development Different From a Property Renovation?
Although the eventual end state may be the same, the glaring difference is in the process. A renovation consists of remodeling an existing structure, as opposed to building ground-up.
Companies that own their real estate and whose space needs haven't drastically changed may choose to renovate because of the cost and time savings. It is often easier to obtain building permits and navigate municipal ordinances during a renovation than attempting a ground-up construction project.
But a commercial renovation offers several limitations that have strategic real estate and business implications.
You are generally beholden to the already existing structure of a building during a renovation, that is, the four walls, roof, and any load-bearing systems. Horizontal expansion that was not planned during the initial building design can often lead to disjointed space and inefficient real estate.
And because the existing structure constrains you, you have less flexibility over allowable use and location. This could be a problem if you haven't analyzed your business medium and long-term growth prospects.
How do you Finance a Ground-up Development?
Because ground-up development projects can carry substantial risk, they can also be challenging to finance. Depending on your industry, desired use, and type of financing (SBA, conventional, etc.), you could receive funding anywhere between 60%-100% loan-to-value (LTV) of your proposed project as an operating company.
If the requisite cash outlay puts a strain on your business, but you're open to a partnership, a joint venture arrangement can help bridge the financing gap for a ground-up project. Real estate syndications are even enabling investors and small businesses to engage in real estate development projects.
But, as an investor, there is even more to consider. Ground-up construction does not include near-term cash flow, so equity investors must be patient. And if you’re proposing a speculative project, you’ll most likely need to bring at least 50% or more equity to a project to get a construction loan.
Lenders look at owner-occupants as a much safer bet than speculative projects, so they are more apt to fund more of the project. In one case, the cash flows securing the note are predictable – a viable business is occupying the space and paying a mortgage. On the other, rental income is much less certain.
Financing the various pre-development steps during a project can be problematic as well. Because these steps are so early in the process, they are considered the most speculative and risky to a lender or investor. Project sponsors will often be required to come out of pocket to fund the various due diligence activities until there is a certain confidence level that a project can move forward. However, there are situations where operating companies may be able to wrap up most of their expenses into the overall loan.
Once a project has passed a certain threshold, and a sponsor can qualify for a short-term construction loan, the loan is paid out in draws during the construction process. The incremental draws are distributed to the developer after specific construction milestones have been achieved.
Depending on the method of financing, construction loans may need to be converted to more permanent financing after project completion. Investors may even need to secure a bridge loan until they’ve stabilized their asset with certain occupancy thresholds. Once a property is stabilized, that bridge loan can be replaced with long-term financing.
When Should you Consider Ground-up Development?
If properly planned, your real estate and business strategy should be indistinguishable – your real estate decisions carry tax, legal, balance sheet, operations, and capital budgeting implications that ultimately affect your business. So, before you consider ground-up construction, you should have a handle on your short and long-term business strategy.
One of the tenets of space planning and real estate optimization is analyzing 5, 10, and 20-year growth projections. Combining these growth projections with an assessment of whether your top-line growth precipitates an increase in other business functions will ultimately inform your real estate needs. Ground-up development can be a great option if you are confident in your growth trajectory and space needs.
Companies that strongly emphasize organizational efficiency can significantly benefit from designing and building a property from scratch as well. And suppose real estate ownership is important to you because of the capital appreciation and diversification it offers. In that case, ground-up construction adds the ownership component that a build-to-suit doesn’t.
Still not quite sure if ground-up development makes sense for your business? Marsh & Partners’ real estate strategy assessment can help shine some light on your business and real estate strategy.