Redevelopment and Change of Use Deals - Making Silk From a Sow's Ear
by Ray Alcorn
Redevelopment and change-of-use is one of my favorite deal strategies. Many
properties are functionally obsolescent, or the market has passed them by for
that property type. These properties are often producing income, but not at the
level of the highest and best use of the land.
A reader sent me a good example recently. The property is a six unit apartment
building, about thirty years old in rough condition, with a low-end rent roll
and loads of deferred maintenance. It’s located on a main thoroughfare that had
developed as a commercial strip with a traffic count of 30,000 vehicles per day,
and this property sit on the corner of a signaled intersection. With a deal like
this it's possible to get "paid to play". The existing income stream carries the
property while you're solidifying the plans for redevelopment. The steps to
investigate the feasibility of a change-of-use redevelopment are not at all
complicated.
Step One: The Planning Department
The first stop should be the local planning department, either in person or
online. We need the street address, tax parcel number, or other identifying
information for the property to proceed. (Many jurisdictions now have GIS
systems that are accessible online with all the relevant tax data. Some also put
the zoning and subdivision ordinances online as well. For those that don’t a
trip to get a hard copy will be necessary.)
Verify the existing zoning district for the property. If it is already zoned for
commercial use you’re in luck. Look in that chapter of the zoning ordinance for
a list of permitted uses, maximum density, maximum height, and development
standards (e.g. setbacks, green space, # of parking spaces, etc.). That’s the
information we need to determine the maximum amount of developed space, and type
of space, that can be built on the property. If it is not zoned appropriately
for the use desired, then you'll need information regarding the rezoning
process. At this point a general overview is sufficient, required forms, any
required engineering, exhibits (e.g. site plan, survey, etc.), and a rough idea
of the time required to go through the process.
Step Two: Estimate Total Cost of Improvements
Now we’re ready to crunch some numbers. But don’t worry, this is not rocket
science. We know how much space can be built (per the zoning ordinance), and the
required site improvements (e.g. parking, storm water, utilities, landscaping,
etc.). Using local building costs, or a rough estimate of per square foot costs
from a local contractor, we can do a preliminary estimate of the development
costs. To that add the demolition costs for the existing structures. Again, a
local contractor can usually give you a ballpark estimate of what it will cost
to remove the existing structure(s). Together, the sum of cost of development
and the demolition costs is the total cost of improvements.
Step Three: Total Project Cost
Now we add an estimate of soft costs such as engineering, architectural, loan
fees, appraisal and third-party reports, developer's fee, etc. You’ll have to
make some calls to local engineering and architectural firms to get these
estimates. Some may want to know more details than you are prepared to give at
this point, in which case you can ask for the average cost per square foot, per
parcel size (i.e. per acre), or per project. Don’t worry if the estimates are a
range. That is the usual case, and will allow you to later establish the margin
of error for your estimated costs. Add the soft costs to the cost of
improvements. Then add the purchase price of the property and the answer is the
total project cost.
Step Four: Calculate the Projected Income
Use existing market rental rates and expenses to construct a rough pro forma
projected income statement. For rental rates in the market you can use the “For
Lease” side of Loopnet.com. Estimated expenses can come from other property
listings, your own experience, or from an appraiser. Calculate the first year
NOI (Net Operating Income, gross rent - operating expenses = NOI). Divide the
NOI by 1.25 (the typical minimum debt coverage ratio for lenders). The answer is
the maximum allowable annual debt service (DS).
Now estimate the loan terms (rate and amortization period) available for this
type of deal using typical bank financing. (This is where having a relationship
with a banker that knows commercial real estate is invaluable.) Once you have
the loan terms, divide the DS by the loan constant. (for direction in how to
calculate the loan constant, see the article “What’s it Worth”). That's the
maximum loan amount. Add any equity you're putting in the deal to the maximum
loan amount. If that sum is more than the total projected costs, you've got a
viable project.
I also use one more calculation at the end to establish feasibility. Figure the
cash flow by subtracting the DS from NOI. The result is the cash flow, and if
you divide that by your minimum required return, the answer will be the amount
of equity that can be put into the deal and meet your requirements. Add that
amount to the maximum loan, and if the answer is at or above the total cost, the
deal is worth pursuing.
Bio:
Ray Alcorn is an active investor who averages over $10 million in deals per
year. He has over 25 years of experience in owning, developing and managing
commercial real estate of all kinds, including mobile home parks, single-family
subdivisions, apartments, hotels, restaurants, office buildings, shopping
centers and multi-use projects.
When not writing books and causing mayhem on internet newsgroups, Ray is the
Chief Operating Officer of and a principal in Park Real Estate, Inc., a real
estate development and investment firm with headquarters in Blacksburg,
Virginia.