Investing in commercial real estate carries varying levels of risk. The “safest” investments are generally considered well-located, stabilized Class A assets. Core-plus and value-add investments fall in the middle of the spectrum. Ground-up development is arguably the riskiest and is often referred to as “opportunistic” real estate investing. Of course, with risk comes the ability for greater rewards, e.g., profits. Skilled developers who can successfully navigate the ground-up development process can achieve impressive results on behalf of their investors.
In this article, we examine the various phases of the ground-up development process, including key considerations within each phase.
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What is Ground Up Development?
Ground up real estate development refers to the process of constructing a new building or development on a vacant or undeveloped piece of land. It involves starting a project from scratch, typically beginning with site selection and acquisition, and progressing through various phases, including design, permitting, construction, and ultimately, sales or occupancy.
In contrast to other forms of real estate development, such as renovations or adaptive reuse of existing structures, ground up development involves creating an entirely new structure or development on previously unused land.
The Four Stages of Ground Up Development
In commercial real estate, the ground up development process can be both complex and time consuming. The geography, product type, local zoning and regulations, and experience of the development team can drastically impact both the complexity and how long it takes to design, construct, and stabilize a new building.
Here, we look at the four phases of ground up development.
Phase 1. Site Selection, Due Diligence, and Acquisition
Determining where and what to build on a preferred site is no easy task. At Wolfgramm Capital, we generally source our deals either internally or through our network of partners.
For example, someone may come to us with a site they own and have a vision for already, but they lack the experience or capital to execute. They might approach us to partner with them. Where they are in the process might vary. Some might have a fully baked site plan, conceptual design, underwriting, and a lending partner on board already. In other situations, the property owner may realize they have a well-located site but are unsure of how to maximize its value.
In either case, assuming we like the bones of the deal, we might then enter into a joint venture or other arrangement where the other party contributes the value of land as their equity stake in the deal.
Many times, however, our team will find on- or off-market properties that are being sold outright. We then evaluate those sites to determine whether we could build something profitable within our area of expertise, such as a condo building or a hotel.
Determining the Highest and Best Use for a Site
There are several factors to consider when determining the highest and best use for a property, including geography, local zoning regulations, local politics, and micro- and macro-level market conditions. In terms of geography, we look at the site’s proximity to amenities, transportation, schools, and other key facilities. We generally look for properties in growth regions – areas like Houston and its surrounding suburbs, for example. Houston continues to outperform other markets and has a strong, diversified economy which indicates future growth is on the horizon.
Then, we will look at the zoning code. We want to know what the site is permitted for today under local zoning. Is the property located in a commercial or industrial district? Would housing be a permitted use? What sort of density could we achieve under local zoning? Would we need zoning relief, like a variance, to build what we would want to build?
Some municipalities are much more “development friendly” than others, and this is something we carefully consider. For example, in a municipality like Friendswood, Texas, we know that there is virtually no political support for multi-family projects at this time. Likewise, given the limitations with the fire trucks owned by the City, they will not permit any project with more than four-stories.
Lastly, we look at the micro- and macro-level market conditions. Although we have experience in almost every type of commercial real estate, our areas of expertise generally fall within the condominium, multifamily, and hospitality realm. As we evaluate specific sites, we will look at whether the market could support one of these product types in that location before moving forward.
For example, we have been monitoring Montrose, one of Houston’s suburban neighborhoods. There are a lot of people moving to this area to take advantage of jobs in the oil and gas, aerospace, education, and life science industries that continue growing. Recently, we were approached by one of our contracting partners who had placed a site under agreement and was now considering housing on this site. Based on our familiarity with the local area, and based on the sales velocity of comparable projects nearby, we determined that the highest and best use for this site would be mid-rise, luxury condos. We then entered into an agreement with the contractor and have since acquired the asset on West Gray, which will be developed as a premier luxury condo building, ideally located in suburban Houston.
Conducting Site Due Diligence
Prior to acquiring a property, we conduct thorough due diligence on the site. This includes market research and underwriting, but also environmental, geotechnical, and other studies.
Environmental studies are critically important. We start by doing a “Phase I ESA” or Environmental Site Assessment. A Phase I ESA is a desktop analysis that looks at the historic use of a property and whether there is any recorded history of environmental contamination. Properties that have an industrial legacy, or that were once home to specific uses like dry cleaners and gas stations, could signal that there is environmental contamination. The Phase I will tell us if there is any known environmental contamination and if so, whether that contamination has already been remediated.
If anything is flagged in the Phase I ESA, but we still like the possibilities, we then move onto a Phase II ESA, which usually involves doing borings where we collect and analyze soil samples. It can be cost prohibitive to remediate contaminated soils, at which point we will walk away from the deal. Once we take title to the property, we then become liable for the environmental contamination even if the contamination occurred decades earlier under prior ownership. This is why thorough due diligence is essential.
Collecting geotechnical data is also important, especially when we start looking to do mid-rise or higher construction. Our “sweet spot” for residential tends to be a 5-over-2 podium structure, where the first two levels are used for parking and then the housing is located on floors 3-7. However, in order to achieve this, we must first look at the soil quality. We need to ensure that the soil can support that level of density. Otherwise, we may need to provide enhanced structural support – something that carries a cost premium.
Phase 2. Design and Permitting
Once we have decided to acquire a property, even before closing, we will embark on the design and permitting process. We typically have to start with a site layout and conceptual drawings in order to get prospective investors and lenders interested in the deal. Similarly, we need some basic architectural information about our proposed project before we initiate the permitting process.
There are several third parties who we engage during the design and permitting process. At a minimum, we engage an architecture firm and civil engineer. We may also need a traffic consultant, sustainability consultant, code consultant, structural/mechanical engineers, a local permitting attorney, and sales broker. The building architect, landscape architect, and civil engineer represent the lion’s share of the design effort – in terms of both workload and cost. It typically costs at least $1 million (sometimes much more) to bring a building through complete design and permitting.
Creating Unit Layouts and the “Stacking Plan”
Once we have established the general building footprint, we will then engage with a local broker to better understand the ideal unit mix for our project. This informs how many one, two, or three-bedroom units we will include, as well as the size and layout of any proposed penthouse units. Local brokers have access to the most current market data; a firm like Sotheby’s is in the market on a day-to-day basis and can see exactly what is selling and at what price point. Local brokers will generally work with us on a low- to no-cost basis as we lay out the project with the understanding that they have the first shot at selling the units once the project moves forward. It is a win-win partnership.
This market data is essential as it paints the picture of our “ideal” buyer. We can then design the building with those buyers in mind. This data also informs the future sales prices. We must carefully balance providing fixtures and amenities at the price point that our target buyer can absorb. Too often, developers will over- or under-design the building which impacts sales.
As the units are laid out on each floor, we compile a “stacking plan”. The stacking plan is essentially a floor plan of each unit showing how each of the units is stacked on top of others. Let us say we are building a mid-rise project. We will usually put parking on the first and second floor. Level 3 generally contains all of the building’s common amenities. Levels 4-7 will then contain the bulk of the actual residential square footage. The layout of each of these floors is reflected in the stacking plan.
Most residential developers will realize efficiencies by stacking the plumbing for units directly on top of each other. This translates into cost savings since you are running less plumbing to different parts of the building. Instead, we can run plumbing and other HVAC equipment in a vertical line.
Determining the Building Amenities
The design phase is where we begin to assess the in-unit and building amenities that we intend to provide. This also includes the furnishing, fixtures, and equipment (FF&E) that we plan to install during construction.
In some cases, we will offer a few different model units where the buyers can decide what layout and finishes they would like in their unit. Their choices may ultimately impact the final sales price, if the buyer opts for something even higher-end than we were already planning to provide. Typically, we limit the unit layouts to three or four options, otherwise it becomes unwieldy.
The quality of the finishes can range from very basic, to above average, to truly luxury. What a developer chooses depends on the market, the product type, and their target buyer. For example, our luxury condo project at West Gate will feature top-of-the line appliances like Viking and Subzero – brands that are highly recognized and sought-after. Our target buyers will expect nothing less.
Permitting a Ground Up Development
In CRE development, we often refer to getting a project “entitled” prior to construction. This is effectively the process of obtaining all necessary permits and approvals. As noted earlier, some municipalities (and states) are much more development-friendly than others. Some have very lax zoning codes which allow more flexible by-right development. Others require the developer to go through a stringent review process to ensure that the project complies with all applicable zoning regulations.
This is one reason why we are drawn to the greater Houston area. While some joke that Houston “has no zoning regulations,” that is not entirely true. However, zoning and permitting in Houston is much easier to navigate than in other areas.
The zoning code essentially dictates what uses are allowed on various parcels. It then outlines the dimensional standards – e.g., building height, setbacks, lot coverage, parking, etc. – to which the developer must adhere. If the developer wants to deviate from the zoning code, they must seek a variance from the local zoning commission. Some municipalities are very forthcoming with these variances and will grant them with few conditions. This is where local politics becomes essential. In some places, certain deviations (e.g., height) from the zoning code are considered a non-starter. Developers must be keenly aware of the local environment before filing for their zoning approvals.
Permitting risk should not be taken lightly. There are countless examples of projects that have been derailed after one or two vocal opponents swayed the permit granting authorities to vote down the approvals needed. This can add valuable time and money to the development schedule as plans are altered and resubmitted.
In an ideal scenario, we can have a ground-up project entitled in six to 12 months, especially in a development-friendly area like Houston. Larger, more complicated or controversial projects may take longer. At Wolfgramm Capital, we generally deploy a strong ground-game where we speak with local elected officials prior to filing to ensure we have general support for the project before seeking formal approval. In places like California, the entitlement process can take upwards of two or three years given the cumbersome restrictions in place.
We must strike a delicate balance when advancing design during the entitlement process. On one hand, we want to be able to move quickly into construction once we have our approvals. A certain level of design is needed before pulling a building permit. However, advancing design too far before obtaining zoning approval is also a risk. The local Planning and Zoning Commission may request changes to the building size or design prior to granting approvals. Any redesign costs money, too. In some cases, we will have the architects go “pencils down” while we advance the entitlement process until we are confident that the building as proposed will be approved.
Lastly, it is worth noting that our purchase and sales agreements are often contingent upon us seeking zoning approval. This negotiation point is essential. We typically assume a purchase price of XYZ amount based on our ability to construct X number of units. If we cannot entitle the project for that many units, it may impact the purchase price and/or kill the deal altogether. Relatedly, we may include language in the Purchase and Sale agreement where we increase the purchase price by a certain amount if we are able to entitle the project for additional units above what was originally contemplated. This is a key risk mitigation strategy that we use to protect our investors’ capital.
Phase 3. Construction
The third phase is construction, which is the actual ground up building process. The construction phase begins with bringing in the utilities and other infrastructure (roads, etc. if needed). Then we will start to dig foundations as necessary, pour concrete, and then we will start to erect the final structure.
After the core and shell of the building are constructed, making the project watertight, we will begin to rough in the plumbing and electrical for the interior. We start to construct the walls that will form the individual units and common spaces. We place significant emphasis on getting a model unit or two constructed first that we can use during the presales process. Having a unit that people can feel and touch makes all the difference in terms of sales velocity. Once the model unit(s) are complete, we then move forward with the remaining condos, lobby/amenities, and other interior spaces.
The Role of the General Contractor
The general contractor, or “GC,” is the company that oversees the construction project. The GC sometimes self-performs the work or in conjunction with a project manager. In some cases, usually depending on the size of the job, they might outsource portions of the job to subcontractors. Ultimately, the GC is responsible for their subcontractors’ work, so choosing a GC who can manage a team effectively is important.
In ground up development, the contract with the GC is one of the most negotiated and critical parts of the project. It is critical that the scope of work, payment schedules, insurance obligations and other deal-specifics are spelled out and worked through carefully.
At Wolfgramm Capital, we typically prefer “GMP” contracts with our GC. GMP stands for Guaranteed Maximum Price. Essentially, the GC guarantees that they will be able to complete the work as proposed within a certain dollar amount. Overruns are only allowed if the GC and owner agree to those additional costs in advance. Otherwise, the GC must absorb any additional costs.
Depending on the type and scale of a project, we will sometimes GC a project in-house. One of our key team members, Curt Stidham, has been a GC for more than three decades. He keeps an eye on the project and will facilitate the work of subcontractors. Typically, however, we bring on a third-party GC when we are constructing larger projects simply given their complexity and the need to have a team on-site daily. When we are bringing on a GC, we will still look to Curt for his expertise; he can weigh in on the pricing to ensure we are getting a fair deal in line with market standards.
To support our presales efforts, we commonly will build a model unit early in the construction phase as this helps sales velocity and effectiveness.
Phase 4. The Sales Process
The sales process might be considered “Phase 4” but, in reality, sales begin long before construction is complete. In fact, we begin the sales process as soon as we have our permits and approvals in hand. Once we have renderings and unit layouts confirmed, we will work with our brokerage partner to start shopping those condos around. In some cases, 70% or more of our condos are pre-sold prior to obtaining our final certificate of occupancy.
In condo development, we often use the term “sales velocity” to describe how the product is selling. Our projected sales velocity is factored into our pro forma, as it impacts what our cash flows will look like during the hold period. How fast or how slow we sell the condos dramatically affects the deal’s return profile. It affects the equity multiple for the return to an investor as well as the IRR, or the internal rate of return. During our due diligence phase, we create a defensible assumption about the sales velocity. At Wolfgramm Capital, we like to be very conservative and therefore tend to under-promise about sales velocity, fully expecting to overdeliver.
Unless market conditions dictate otherwise, we generally assume that we will pre-sell about 1/3 of the condos prior to completion. A common assumption is that we will then sell two condos a month thereafter until project closeout. Again, every location and product is different. We have been fortunate to exceed projections in our deals, but again, we tend to be conservative with our underwriting.
Several things can impact sales velocity. Did we pick the right product for the market? Did we pick the right amenities and Fixtures, Furnishings, and Equipment (FF&E)? Have the condos been priced properly? There are also macro-level factors, like inflation or rising interest rates, that can have unintended consequences on sales velocity. Again, this is why having a conservative pro forma is key. We show investors best and worst-case scenarios, and plan for our investors earning sufficient returns even in the downside scenarios. Anyone can jot down lofty projections. The skill is in anticipating actual costs and timelines.
Why Presales Are Essential
As noted above, we begin selling condos as soon as possible. We take our product out to the market and show them what we are building, the timeline for the project, and the sales price range depending on final interior design details. We try to incentivize people with better pricing to get them to commit to buying sooner. This strategy generally appeals to people who know they will be in the market for a new home on that timeline and who want to be in that geography.
Someone who is interested in a condo will then sign a pre-sale contract where they put down a deposit, usually 10% of the future sales price, which (depending on state law) must remain in escrow until closing. If for some reason we cannot deliver the product as intended, we would be considered in default and would be forced to return those deposits.
Presales are important because it allows us to begin to pay off our lender as soon as we complete construction. Our construction loans are usually structured where the first 95% of every condo sale goes to pay down the loan and then we retain the remaining 5% for closing costs or other expenses. This reduces our carrying costs, and therefore, our risk and liability. Only after the loan is paid off do we start to earn any money on the project.
For example, if we need to get an extension on the construction loan, we can go back to the bank and show them how well the project is selling which will make the bank more inclined to extend the loan. If we need to raise more equity for some reason, we can highlight the sales velocity and how this will positively impact the deal’s return profile.
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Mitigating Risk in Ground Up Development Projects
Ground up development projects are considered among the riskiest types of commercial real estate projects – at least when compared to buying value-add or already stabilized assets. There are many ways to mitigate risk, however. Again, this comes down to the expertise of the developer.
A critical component to underwriting any deal, is to conduct a thorough sensitivity analysis. There will always be certain key or critical assumptions that have the biggest impact on the success of the project. Although as a company philosophy we make conservative assumptions from the outset, we also like to show investors what the deal will look like in best-case and worst-case scenarios.
For example, what if it costs 20% more to build the project than we originally expected? Or what if sales velocity is significantly slower than anticipated? How will that impact the IRR? We also look at what happens if interest rates go up. After all, when a project can take three years to deliver, a lot can change in the capital markets.
There are several measures we can take to protect against rising interest rates, such as locking in fixed-rate debt when we initiate the loan. We also buy rate cap insurance, where if interest rates increase by more than a certain amount, insurance covers the difference.
We even consider various doomsday scenarios, like a major economic downturn or investors pulling capital due to global unrest. We will consider, for example, whether the project could be converted from condos to multifamily apartments. This shift would allow us to carry the building until the market conditions improve and become suitable for sale. We want to ensure, for instance, that the rental rates would be sufficient to cover our debt while still providing some return for investors.
Managing ground up development is challenging, and can be risky, but most of the risk can be mitigated through various means – especially by experienced developers.
In summary, navigating the intricate ground up development process demands a strategic approach across four crucial phases. From the initial site selection and due diligence to design, permitting, construction, and the sales process, each stage requires precision and expertise. In an ever-evolving real estate landscape, aligning with an experienced developer becomes a cornerstone for success, transforming the ground up development journey into a rewarding venture with minimized risks and optimized returns for all stakeholders.