Our Due Diligence (DD) process for Ground-Up Development (Los Angeles)
Our Due Diligence (DD) process for Ground-Up Development (Los Angeles)
Here is what we do before we buy land to build an apartment building...
Step 1: Figure out Unit count (see unit count substack post)
Since we typically know how many units we can build based on zoning, as soon as the lot is in escrow, we engage with the architect to conduct a study of how many parking spaces we can fit. This used to be the limiting factor in the number of units we could include in the project in Los Angeles, but recent state-level law changes mean that parking minimums are no longer required if the project is near transit, which is the case for most of our deals.
However, I wouldn't significantly under-park traditional units.
When designing the parking, our ideal approach is determining how many spaces we can fit on grade. Then we consider below-grade options and, finally a combination of the two.
The best scenario is when height is not a limiting factor, and we can have two levels of parking above grade and five levels of wood above that. Going above grade with parking allows us to avoid excavation and hauling dirt offsite, shoring, and ventilation of a subterranean garage. Going below grade with parking can double the cost per parking space due to the additional expenses of shoring, excavation, and ventilation.
Knowing the cost of doing all of this helps. We know this because we've done it many times, and we've self-performed construction, which means we know what each part of the building costs.
After parking is designed, we go to what I scientifically call the "Wooden Box" that we can build above the parking.
The "Wooden Box" is kind of like the size of a pizza, with a maximum FAR (Floor Area Ratio) that we can develop given the setbacks and height limitations.
Then we try to figure out how big the "slices" or units need to be and how many of them we need to slice the pizza up into.
Smaller units cost more per square foot to build than larger units. Fixed costs such as kitchens, appliances, and bathrooms increase the cost per gross square foot ($/GSF) of the smaller units.
The more "air" you add to the unit, the cheaper it gets to build it on a per $/GSF or net rentable square foot ($/NRSF) basis.
What many developers have discovered is that building micro-units doesn't make financial sense because even though they rent for a higher price per square foot, they also cost a lot more to build per square foot. In parts of LA where we used to build, it doesn't make financial sense to build studios or one bedrooms with parking.
When we're designing a project, we're trying to maximize net operating income while minimizing costs. This is an art, not a science.
To do this effectively, one needs a solid understanding of construction costs and rental rates. As a vertically integrated developer with in-house construction, property management, and development capabilities, we're probably as good at this as anyone. However, it's still not an exact science since construction involves a lot of commodities, and commodity prices are always changing, especially during volatile times like COVID and these very inflationary times.
When looking at costs, we're using historical data from similar projects to estimate future costs. We try to adjust for increases from the past. When looking at rents, we're using current rental rates and trying to make the numbers work using Untrended Yield on Cost (UYOC). "Untrended" means we're using current rental rates and current costs. We don't project rental rates into the future to make the deal work. That would be more aggressive and speculative underwriting.
Side note: Most architects have little knowledge about costs; they can’t solve for costs or the highest return on $ because that would involve knowing costs. It’s not the architect’s job to know costs; it’s the developer's and GC's job to be able to estimate that.
It’s really the GC's job to really know the costs, and the developers have to rely on the GCs for costs.
Unless a GC has done a similar project recently, he’ll likely not have accurate costs; he’ll need a full set of plans to bid out to his subs and assemble all the bids to arrive at the current price.
Engage with GCs already developing the types of projects you want. They’ll have a better grasp on costs vs. one that has not recently done similar projects.
Now that you have a conceptual “Box” or Pizza that you can build. Now you need to figure out how much it’ll cost to build it.
The goal is for it to cost all-in at least 20-40% less than what it’ll be worth on the market once completed.
In a hot market like LA, creating a 20% margin is not a terrible deal. That’s like buying a new building at a 20% discount.
Most people talk about it in terms of the difference between spot cap rates (existing cap rates) and Yield-on-Cost (YOC), aka Built to Cap Rate, aka What are you building to? Conservative developers talk about UYOC (Untrended YOC, meaning today’s rental rates, not projected future rental rates)
Typically, developers have looked for 150bp-200bp (100bp=1%, so 1.5%-2%) spreads between existing cap rates and YOC or UYOC.
That spread between the spot cap rate and YOC is the EQUITY you’re creating and the whole point of developing a building vs. buying existing apartments.
I personally feel it’s safer to build vs. buy existing. Why do you ask? If the market turns, we lose our sweat equity first. We don’t lose real equity initially because prices could go down 20%, and we’d still not lose any investor money (assuming we created at least 20% equity). Whereas if you bought a building and prices dropped 20%, that could be game over for your LPs and maybe your career.
As one older wise developer once said, “I don’t mind losing sweat equity; I just don’t ever want to lose real equity”
Anyway, back to the DD process.
Once we determine if the project is financially viable, we will begin spending actual money on inspections and reports, including soil inspections, a survey, a Phase I and possibly Phase II assessment, a historical assessment (or asking the city if it has been designated as historical), an attorney review of the title policy before closing, pulling all historical permits on the property, and obtaining an SB-8 determination (new requirement).
Assuming you have the capital lined up, your attorney can review the title policy before closing, and you will be ready to close.
If you don't have the capital, you must work on lining it up during the due diligence process, which is its own separate post.