Profits Go With Risk

A basic tenet in the business universe is that higher profit expectations accompany higher perceptions of risk. High risk investments can only be contemplated when there is a potential for higher reward.

Real estate development is inherently risky. Unpleasant surprises may await the first shovel to hit the dirt. Market trends can change much faster than the time span needed to bring the project to market. A bad hurricane season can suddenly place a premium on plywood prices nationwide.

The development process is fraught with unknowable risks that are beyond the control of the risk-taker. Clearly, a real estate developer will be looking for a level of profit that is significantly better than the return on a bank note or a mutual fund. Risk goes hand-in-hand with reward.

This fundamental relationship between risk and reward leads to three important principles in real estate development:

1. Time is Money — Extended Time is the Enemy

From our hypothetical case study, we can see that if the production timeline extends, certain production, operating, and financing costs continue to be incurred without any commensurate increase in revenues.

The cost meter keeps ticking, but the revenue bell isn’t ringing. This is particularly crucial during the pre-construction approval period. All of the carried taxes, interest, and professional services (design, environmental, engineering, legal) continue to mount if the approval process becomes protracted.

This accumulated burden will all have to be financed until revenues start coming in, which just compounds the “carry” that project revenues will eventually have to cover.

2. The Consumer Often Pays for Amenities or Increased Risk

One point I have hoped to convey in this introduction to real estate proformas is that a developer will try to protect his profit margin to a level that is commensurate with the perceived level of risk. Planners not familiar with the development process might think that increased costs come out of the developer’s pocket or the project’s profit. That does happen, but another likely response is to increase prices or rents to cover the increased costs.

If a local board requests more community amenities, those costs may very well be passed through to the price sheet (i.e., to the home buyer / consumer). The same may be true if a project becomes riskier or more costly as a result of extended time or uncertainties in the approval process. Whether in the form of higher home prices or, for commercial projects, in the form of higher commercial space rents (which may be passed along as higher merchandise and service prices), it may be the consumer, not the developer, who ends up paying for increased amenities or risk.

3. Limiting Uncertainty Limits Risk

A developer will perceive a lower level of risk if the approval process has fixed standards, a predictable procedure, and a timeline set by a standard schedule. When the approval process has fixed standards, procedures, and calendar, the perception of risk can be reduced — and so can target profit levels. But, when the approval process becomes open-ended as to the criteria being considered, or incurs a protracted review time, the level of risk climbs exponentially. Developers will correspondingly increase their target profit levels to cover this risk.

Board members can help limit risk by strictly adhering to the existing approval criteria, and holding to the stipulated calendar for hearings, technical reviews, and submission of opposing positions. Keeping risk under control is in everyone’s interest.

The late Wayne Lemmon was a real estate market economist with a degree in architecture from Cornell University, and urban planning from the City College of New York. He had over 30 years of experience with national real estate consulting firms and development organizations, and served as the Director of Market Research for a regional homebuilder.

Lemmon was also a member of the Planning Commissioners Journal’s Editorial Advisory Board. In addition to Proforma 101, Lemmon authored “The New ‘Active Adult’ Housing” in our Summer 2003 issue.