One Hit Wonder part 1

Developing commercial property by Bill Roberts

When developing commercial property there are a lot of things to think about:

            What do I want to use the property for?

            What are the "allowed" uses?

            How much of the property can I use?

            How much rent can I get?

            What is the vacancy factor?

            How many similar businesses are in the area?

            How much is it going to cost to build this?

            How much can I finance? At what rate?

            How much do I need to get started?

Step one is to collect all the data to answer the questions above. You start by going to the local zoning agency, whether city or county or whatever. There you will check the zoning map and the use matrix. If your desired use is allowed you are good to go. If not, you have a couple of options, either move on to something else or seek a use change or conditional use permit.

If the local authority will allow the use you need to know if it is economic for you to do this. You can begin this analysis by doing a rent survey. Once you know the market rents and the number of vacancies. The market rent will determine the "value" of the property after you develop it. What it costs to develop has no bearing on the value.

So now we can take a good hard look at what it will cost to bring this project to fruition.

Land Coverage Ratio (Footprint)

In metropolitan areas the footprint can be up to 100% (also known as zero lot line). The only set-backs are for sidewalks and alley access.

In sub-urban and rural areas the footprint might be limited to 25% to 50% land coverage.

For sake of our example, we will assume a fifty per cent footprint as maximum coverage.

You have probably noticed that if you can only use half the property for your structure, then the land cost component will be double what it would have been if you could have used all the land for the structure. Actually, it will be more than double because you will have to do something with this "extra" land such as pave it or landscape it.

We have found a commercially zoned lot of 160 feet deep and 250 feet long in the middle of a block in town. There is alley access. This lot is a total of 40,000 square feet (a commercial acre).

We will obtain a Phase 1 and Phase 2 environmental report at our cost before we buy this lot to make sure that there is no contamination.

We were very fortunate to have found this lot in a semi-developed area. The curbs, gutters and streets are already completed and all the utilities are to the property.

We paid $1,200,000.00 for the lot.

Now we are going to get an architect/engineer to develop a set of plans for the improvements we wish to make to this lot. We will use these drawings to obtain permits and bids. The architect will also prepare a rendering of what the finished project will look like. Also included in the set of plans are a site plan, grading plan, utilities plan, access plan, a floor plan, and a complete set of "working drawings" for the actual construction and a detailed "bill of materials."

Estimating the value of the finished project

We have 20,000 square feet of ground  floor retail space @ $3.00 per square foot triple net ($60,000.00) and 15,000 square feet of office space on the second floor $1.50 per square foot triple net with janitorial service included ($22,500.00) for a total rent of $82,500.00 per month.

This is a "Triple Net" leased property but there are still some expenses that we will pay (approximately 10%) or $8,250 per month.

This leaves a net operating income (NOI) of approximately $74,250 per month or $891,000.00 per year.

In our area comparable commercial properties are selling for 12.5 times NOI which equals a cap rate of 8% ROI (return on investment).

Therefore, our completed fully leased project will be worth slightly more than $11,000,000.00.

So what did it cost us to "create" this $11 Million property?

This gives us a Cost/Value ratio of 50%, which means that we will have the other 50% as equity in the finished project.

NOTE: Financing is NOT based on appraised value, but rather on the property's ability to cover expenses and mortgage payments. This is called the Debt Service Coverage Ratio and most commercial lenders look for a DSCR of 120%-125%.

In our example our monthly NOI of $74,250 is 125% of $59,400. Therefore our monthly mortgage payment cannot exceed $60,000 per month for interest and principal. At 8.5% rate amortized over 25 years that then is a maximum loan amount of $7,500,000.00.

In other words we can "recover" our entire cost of buying the lot and building the structure.

In order to obtain this financing we will need to have the property fully "Leased Up" with good quality tenants.

As a practical matter it is better to lease the property BEFORE beginning construction. The construction lender DOES NOT want to "own" the property. They want to know how you are going to take them out (pay-off the construction loan).

This is just an example of the process. DO NOT RELY ON THESE NUMBERS. But the basic concept is sound. For most of us one of these projects will generate enough money to last us our entire life. In other words, a one hit wonder!