Big Mistakes to Avoid in Your First Real Estate Development Project

By Matthew Baran

Real estate is a great way to build wealth, but it's actually more than that: it's also a way to shape the environment around us. Developers have broad-ranging objectives, from making big profits to helping the environment through sustainable design. Sometimes multiple interests converge—good design and profit are not mutually exclusive.

Although there is great opportunity in real estate development, it is important to keep in mind that real estate development is inherently risky. The rewards can be great, but the possibility of failure is very real and can be financially devastating. This guide will help you avoid costly errors so that your first real estate development deal is a successful one.

Your first real estate development project—common errors to avoid

There are certain areas of real estate development projects that we see repeatedly falling through the cracks, resulting in projects that are less profitable than they could be. As the property owner and developer, you are ultimately responsible for the success of a project, and at the very least you want to ensure you don't overlook any details that will impact your bottom line.

Due diligence phase: common errors

The due diligence phase of a real estate development project should take place before you close on a property or move forward with a project. Here is a list of some of the things to watch for during this phase. (For a comprehensive list, see the due diligence checklist at Property Metrics here.)

Title: A clean title with no claims or other encumbrances is of great importance. Always check for accuracy and errors, and unknown or missing conditions such as liens or heirs. Easements and other encumbrances or any type of dispute are also important to watch for. Hire a reputable title company and review documents carefully.

Environmental: For large projects, an Environmental Impact Report (EIR) may be required. There are about 20 states that require some form of environmental review. For example, the California Environmental Quality Act (CEQA) requires large projects to perform an EIR; smaller projects may be exempt.

Even if an EIR is not required, larger projects and commercial property buyers often request a Phase I Environmental Assessment to ensure a property is cleared of environmental problems. Smaller residential projects rarely perform this assessment because it is unlikely these properties will have environmental contamination; however, it is always better to be safe than sorry. If you suspect there is some sort of environmental contamination (from a former gas station or dry cleaning facility for example), you should order a report. If there are any problem areas in the Phase I report, a Phase II assessment may be required.

Also note, if you order a report and anything is missed, as the owner of the property you will still be liable for it later. Therefore, be sure to hire a reputable company to do this work.

Survey: If you are building new or adding any footage, it is recommended that you obtain a survey. This will confirm the boundaries of the property and is much more accurate than other forms of identifying boundaries, such as measuring identifying features or relying on a tax assessor's map. Relying on less accurate information can lead to problems down the road, such as accidentally building too close to a property line.

A survey will also tell you if any utilities are running through the property (you need to be aware of these during construction), if any other entity has rights over your property which might not allow you to build in particular areas, or if you are near a creek or other protected natural feature.

Finally a survey tells you the slope or "contours" of the site, so you can plan for proper drainage and appropriate foundation systems.

Zoning: If you are building new or adding any footage or volume, it is important to verify the zoning requirements. However, just because a zoning calculation says you can divide your property by a number to get the unit count or allowable FAR (floor area ratio), it does not necessarily mean you will have the spatial configuration to do so.

Planning requirements for parking, height limits, setbacks, and open space can impact the density of a project. Sometimes physical limitations define the density of a project more than the actual development standards. If you are not familiar with these requirements, hire a qualified professional to evaluate your site.

Keep in mind that aesthetics are subjective, and any given planning department may have particular biases around architectural massing and style. It is important to understand these leanings before beginning design.

Also, keep in mind that entitlement is inherently risky—potentially the most risky part of the real estate development process. No design professional can guarantee an approval from a city agency. Because codes are often complex and open to the interpretation of city officials, projects can be denied on the basis of an interpretation.

In addition, it is important to keep in mind that the more elements you want to fit on a site (units, office space, parking, etc.), the more complex the design becomes. A bigger project may yield more profit, but there are risks. Making the design work can be challenging, if not impossible, and bigger projects draw more attention and scrutiny from city officials, neighbors, and others who may not want the project, and who will work hard to fight and stop you.

Neighbor issues: Political climate and neighborhood sentiment is always an indeterminate factor. Make sure you understand the risk of extreme resistance. Research a neighborhood before you close on land because you never know how vehemently opposed to your plan anti-growth neighbors can be, which can delay your project by months, or even years, and in some cases derail the project permanently.

Research can be conducted through online searches, newspaper and local magazine research, walking the neighborhood, and even talking to neighbors. A design professional or architect will often be familiar with the climate of a neighborhood, so a simple phone call can provide you with a wealth of information.

Building codes—fire, life safety, and accessibility: During the process of establishing a zoning envelope, the design needs to be cross-referenced with building code requirements. Be sure that any yield study that is being examined from a zoning perspective will also work when considering building code requirements, with particular regard to general building limitations, construction type, fire setbacks, egress requirements, and any ADA (Americans with Disabilities Act) issues. Also, be sure there is adequate fire truck access (where required) and the property meets requirements around fire hydrants.

Construction costs: Without a design, it is difficult to obtain accurate cost estimates, but you can research general opinions regarding cost per foot and information on the state of the construction market. Most design professionals and contractors can give you some sense of construction costs and where the market is headed. Any estimates should be updated throughout the process to ensure the project stays on budget and the pro forma stays in the black.

Real estate market research: It is important to understand how the project will financially perform once it is completed, so gathering information on how much profit you will earn when you sell or lease is paramount. Upon project completion, if you've spent more than you have received, you will lose money or possibly go bankrupt. Consulting with a local real estate agent or broker can help you determine how comparable projects have performed.

Pro forma: Based on your research, you will need to calculate and make some assumptions about how your project will perform. Total cost and net profit (or lack thereof) need to be clear to know if the project is worth pursuing.

Construction lending: Early in the process, make sure that your lender is in agreement with your project's intent. A lender will likely be interested in the project's cost and value, constructability, and marketability.

Cost and value is important because lenders will want to confirm those figures are in alignment to mitigate their risk. Constructability ensures no unusual or difficult construction issues will prevent the project from being built. Marketability is important for ensuring the project is not so unusual that it cannot be sold, rented, or refinanced.

In addition, the more developed the project is, and if you have permits in hand, the more comfortable the lender will feel giving you money. But if you don't have your permits, don't let this keep you from approaching a lender to confirm that at least your initial assumptions are acceptable to the institution. Find out at what point they would be comfortable funding the project.

Some lenders are willing to fund soft costs, as well. Of course, any arrangements will be contingent on acceptable LTC (loan-to-cost) and LTV (loan-to-value) ratios.

Design phase: common errors

Design elements should be gone over as part of due diligence, but they come into play during the design process. Some of these will be defined by code and other limitations, but it is important to know what works in a particular market (minimums are usually not adequate). They can be based on experience, research, or personal preferences.

Typically the developer has thought through the vision or “highest and best use” for a site before or during the due diligence process, but a design professional can also help with site selection and determining the best possible use for a given site. When the developer does come with a given use, a design professional should verify all assumptions before beginning work.

The following are some of the design parameters that should be evaluated before beginning work:

Use: Almost always there is a use looking for a site or a site looking for a use. If you are in the former camp, you will need to keep an eye out for properties that are zoned and at a location which suits your intended use, whether it be residential, commercial, retail, or mixed use.

If you have found a site, you will need to know which types of use are allowed and determine whether they match your intended use. For example you may believe a site is best suited for housing because people are moving into the neighborhood. But if that use is not allowed on that site, then you have a problem.

Many municipalities will allow mixed use or a combination of uses for a site.

Construction: Decisions will need to be made around construction, and the sooner they are made, the faster and smoother the project will go. These decisions are contingent on construction costs, as well as other factors, such as project type and program, loan structure, and exit strategy. Changing a decision late in the process can be costly.

If you are unfamiliar with the implications of these decisions, you should have a conversation with your design and/or construction professional early on. This conversation can be combined with discussions you have with other experts, such as engineers, city agency staff, and real estate professionals. Depending on the scope of the agreement with your consultants, these items may or may not be included in your design and drawings.

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Project management: common errors

When executing a real estate development project, a certain amount of general project management is required. This may be performed by the developer or the owner, or will be picked up by the architect, the contractor, or some combination of the two. Items that fall into this category are listed in this section, while aspects that pertain to the management of the permit process are broken out in a separate section.

Consultants: Have an understanding of all the consultants who will be involved in your project. There will be typical consultants, such as architects, engineers, and surveyors, who are part of conventional project design as well as specialty consultants, such as waterproofing and sound engineers, expeditors, and environmental graphic designers, who only get involved with specific projects. Be sure that your architect and consultants carry their own insurance if you plan to carry their contracts. Architects may have umbrella policies that cover their consultants as well.

In addition to becoming familiar with consultants who are necessary for your project, it is also important to be aware of possible issues that could arise as a result of their work. An architect or a structural engineer may not necessarily have the most cost-effective design in mind. If the architect is simply trying to create the most beautiful project he/she has ever designed, and the engineer is simply trying to support the design, there may not be a coordinated effort to minimize cost. For example, a building that would commonly be built out of wood may require expensive steel or concrete shear or cantilevered elements, ultimately rendering the project infeasible.

Project delivery: Keep in mind that with conventional bidding, a contractor may be motivated to deliver a low upfront bid to win the contract and then issue change orders later once the contract is secure. These are typically more expensive than getting a bid upfront, because your job is already in progress and you have little leverage to negotiate at that point. If a contractor is chosen early in the process independent of bidding, they may help "value engineer" (suggest different, less expensive design options) to reduce costs and minimize change orders.

Delivery method—how the contractor executes your project—and contract arrangement will also impact the quality of the project documents produced. There are a variety of delivery methods, with the most common being design-bid-build, design-build, and construction management.  For instance, with a design-build contract, some of the design decisions will go to the contractor and not the design professional. This means the contractor will find inexpensive construction methods, but you lose some control over the quality of the construction.

Discuss delivery methods with your design professional to determine which method will work best for you.

Bid coordination: Under conventional design-bid-build, you will likely field multiple bids. Keep in mind that the low bidder is not necessarily the best contractor for the job. The lowest bid may be suspect—beware if it seems artificially low. Ultimately know the contractors who are bidding the job, and understand that quality and cost are often related. There is truth in the saying that you get what you pay for.

Utilities: Applications for utilities (gas, power, water, and sewer) often slip through the cracks. Make sure you are managing this area yourself, or that it is being actively handled by someone on the project.

Permit coordination: common errors

It is typically not the responsibility of the architect to handle certain aspects of the permitting process during a real estate development project. When reviewing a proposal from an architect, be sure to ask if the following is included or specifically excluded from their scope of work.

Coordination with city agencies: Bureaucracy can be slow. As the project owner you are carrying all of the risk; delays to the schedule will impact you greatly. Managing city agencies is an art, and requires the right relationships and the right amount of pressure.

An architect can leverage their relationships and tell you whom to speak to, but an architect's voice will not be heard in the same way as an owner’s. Just like subconsultants and your contractor, in many ways the city also works for you. It is best if you are the one reminding city officials that the speed at which they complete their work and whether they approve or deny the project have a material impact on you and your livelihood.

Usually the architect will handle your zoning approvals and permit, and your building department approvals and permit. Other permits may be your responsibility or the responsibility of the contractor or other consultants. Be sure to review your contract for specific inclusion of all services if you expect them to be performed by the architect or others.

Application: There are a number of documents that will need to be prepared for your application submission—drawings, project specifications, and government forms—that need to be turned into the city for review. Your design team will prepare most of the materials for you. Ask your design professional which items you will be responsible for and what they will take care of. Be sure to obtain an exhaustive list of the required items from the agency you intend to submit. These requirements should be understood far in advance of the intended submittal date. Be sure that your consultants scope includes everything on the list you have obtained from the city agency.

Approval letter: Review your planning and zoning approval letter carefully. Check that the details are correct, and in particular, look for any unusual or erroneous conditions of approval. As these letters are often boilerplate text, errors can be carelessly included and be potentially demanding enough to have serious cost implications.

Finding success in your real estate development project

Using this information will hopefully help you have a more successful real estate development project. Please keep in mind that this is not meant to be a comprehensive or exhaustive list, but it is a guide to some of the commonly missed elements of a real estate development project. Good luck!

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