Part IV: Project Feasibility – Financial Feasibility
Courtesey: http://foursquarebuilders.com
Backing up for a moment, a financial feasibility analysis enables the real estate developer to determine whether the proposed project will live up to performance expectations. Financial analysis initially begins with a simple “back of the envelope” calculation then followed by an iterative process that results in a multi-year discounted cash flow analysis. At the early stage of the game, the financial analysis does not need to be detailed. The goal is to determine a go/no-go decision on the proposed project.
Let’s walk though a simple financial assessment of a retail project. Whenever I go about assessing a retail project, my initial goal is to determine the projected return on cost of the project. Often, when I assess smaller NNN retail projects, I will target a minimum of a 11% return on cost with a goal of 12%. Return on cost is stabilized net operating income divided by the total development cost of the project. Hence, if a project cost $100 and I was targeting a 10% return on cost, I would expect the the stabilized net operating income of the project to be $10 on an annual basis.
Let’s start with determining the net operating income of the project. In order to determine net operating income (revenue – expenses), I will determine the income that the project will generate (income is dictated by the amount of rent that tenants pay). I would first determine the building square footage that the site would support. Next, I would call some local retail brokers to get an estimate of how much retail rent tenants would pay on a $/psf basis and also obtain an estimate of the operating expenses on a $/psf. Knowing the building square footage, the rent on a $/psf, operating expenses on a $/psf, I would then be able to determine the net operating income of the proposed project.
Now, let’s determine the cost side of the equation. Costs involved in the development of a project include construction costs, appraisal fees, fees paid to consultants, interest paid on a construction loan, leasing commissions, contingency for cost overruns, land, and much more. The land cost, or the purchase of an existing property, is the first cost that you should include. Afterwards, I would determine the project’s hard costs which are the physical construction costs to build the building, improve the site, and any tenant improvement building work. I will often call a general contractor to provide some rough estimates of building and sitework costs. Thereafter, I would then determine my soft costs. Soft costs often include fees paid to consultants, interest reserve, and leasing commissions. Once I have gathered a total of my soft costs, I would add up all my costs to arrive at a total estimated cost. Now that I have my net operating income number and my total cost number, I would then be able to determine the return on cost of the project. If the return on cost is too low, I will not proceed forward with the project. Either I would have to lower my costs, or increase net operating income to make the deal pencil. Sometimes a developer will seek to obtain a higher rent amount from retail tenants, lower construction costs by designing a less elaborate project, obtain cheaper financing, or other methods to get the project to pencil. Rather than talk at length about how to financially assess a project, I will discuss it in a later post. Until next time, we will discuss some specifics related to how a real estate developer get’s started and how to set up a small shop to get going.
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