Setting up a Real Estate Development Company: An Outline

More than any place in the world, the United States is famous for its vibrant and widespread construction industry which has transformed the face of its cities and its countryside. Boosted by ever rising real estate values and tremendous tax benefits available to the owner of real property, the industry has become one of the most powerful factors in the American economy.

The United States long recognized the utility of having many small companies involved in construction so, unlike much of Europe and Japan, the laws promote the ability of relatively small companies to be involved in relatively large construction projects. Mechanics Liens and related security rights make it possible for small contractors to ensure that the labor and materials installed on projects must be paid or the owner faces foreclosure of the liens on the property. That, in turn, allows contractors and subcontractors with few assets to purchase vast quantities of material since the suppliers, by perfecting their own lien rights, know they will be paid. One thus may be a small company on a large project.

It has been said that more millionaires have earned their first million from real estate development than any other industry. While that may be true, with the possible exception of running a restaurant, being a developer is probably one of the highest risk businesses to begin. It is probably safe to say that the majority of first time developers fail to make any profit and a significant number fail entirely and face bankruptcy.

The reasons for failure are multiple but an underlying problem facing most first time developers is that they do not have the business and legal skills necessary to succeed at development. Knowing how to build a structure is not the same as knowing how to form and operate a development company, obtain appropriate financing, interact with banks, subcontractors and material men, create the basic contracts and contractual rights to assure efficient construction, investigate and obtain the required zoning and building permits, protect oneself from the powerful lien and stop notice rights of the workers and material men, etc, etc. The actual construction is only one part of the skill set needed and many developers, who often were general contractors who have done well, find that they are in the midst of a disastrous construction project, with lenders furious at liens filed, subcontractors walking out due to disputes, building inspectors demanding walls be removed, etc, etc. when before, when they were building on behalf of someone else, it seemed so easy.

So why do people become involved in development? Because it is one of the most leveraged investments possible, thus capable of generating profits of remarkable proportions IF things go right. In a market that is relatively stable, such as the United States, with the laws firmly established and the financial institutions used to the needs of construction, the risks can be minimized if the developer creates an effective plan of operation which takes into account the variables and problems that exist on a project and plans for them. This article shall outline the initial planning that a developer should consider to achieve maximum chance for success.

1. THE BASIC DEVELOPMENT TEAM

A builder is not a developer. A developer uses a builder to achieve a finished piece of construction and sells it. Building is one of the many processes necessary and while the most obvious, no more critical than the financing of the project, the purchase of the land, and the sale of the project at the end.

A developer is any person or entity who takes property, improves it, and sells or rents it out to third parties, either on its own behalf or for other people. Normally the developer will arrange a large group of professionals who will perform the various tasks necessary for the development which will normally include at a minimum the following people:

1. A lending institution to arrange the financing of both the purchase of the land and the development.
2. Legal experts to assist in the creation of an entity to purchase the property, financing for same, construction contracts, zoning and use issues, mechanics lien issues, and leasing or sale of the finished project.
3. Tax experts to assist in the appropriate planning for the structure that will do the development and to maximize tax advantages of the development.
4. Real estate professionals to locate the property to purchase and ultimately sell or lease the units created.
5. Engineers and architects to plan (and sometimes supervise) the project.
6. General contractor (often the developer) to manage the construction itself and interact with the subcontractors.
7. Subcontractors to work on the project (at least electrical, plumbing, drywall, roofing and related trades.)
8. Often environmental and/or land use experts to interact with local agencies on the issue of zoning and hazardous wastes, etc.
9. Often local counsel who can interact effectively with local city officials for variances.

The above is a minimum and the unique requirements of each project may require much more. For instance, HUD construction or construction in an environmentally sensitive area will require specialists in those fields and the plans will normally have to be presented to the local building department which can result in weeks or even years of negotiations. A simple rule is that the larger the project, the more the neighbors may object and the more time should be expected to be needed for final approval of the project from the local building authorities. (That is one reason building from scratch is much harder than improving existing buildings - more local governmental approval is normally required.)

Further, if the developer, itself, is composed of various parties, such as a partnership or corporation, careful planning is necessary in the structure to avoid disputes within the structure leading to a break down of the entire project due to internal strife.

The developer is, thus, an executive commanding a multitude of various separate departments who do not have the same criteria for performance. Disputes between the engineer and architect or the contractor and both are common and at all times the lender can be a constant presence capable of grinding the entire project to a halt by stopping the flow of money.

2. THE BASIC STEPS

1. Determine the type of development you want to try. (Commercial? Residential? To own and lease? To improve and sell? Build from scratch? Improve existing? Location? Partnership or alone?
2. Determine your financial resources. Determine your borrowing potential.
3. Create a budget and time line that is likely and to do that - Obtain the first part of your team in the sense of discussing the matter with them. This would normally be a builder, perhaps an engineer and/or architect.
4. Find a good real estate broker and begin your search and learn the market. Don't buy anything yet.
5. Once the property is located, create the legal framework that will do the development. You will need the lawyer and CPA to accomplish that. This will cost some money.
6. Get financing arranged for both the purchase and the development.
7. Using the architect and builder get preliminary plans for the property. This will cost some money.
8. Conclude the financing package.
9. Have the property surveyed and soils, water, hazardous waste, etc, etc, checked and certified as appropriate.
10. Buy the property. If possible, buy it contingent on the approvals described below.
11. Have the architect create final building plans with the engineer. This will cost you money. Submit the plans for approval by all local building, zoning and environmental departments and agencies. This will cost money and take twice the time you think it will.
12. Enter into construction contracts with the general contractor (GC hereafter) and, if the GC does not, with the subs.
13. Supervise the construction. Expect and budget for many delays and problems.
14. Rent or sell the property.
15. Enjoy your profits and look for the next project.

3. THE USUAL PITFALLS

Clearly such a complex process has many places where things can go wrong. The problem is not that things go wrong, but that flexibility is not built into the structure or plan so as to allow such inevitable problems to occur. Thus financing that requires very strict completion dates or allows tremendous penalties or a construction schedule that ignores the weather or the slowness of governmental approvals must be avoided. You have to plan for things not working the way they should - as one successful developer said, "A good developer is not smarter than the failures - just more pessimistic."

There are certain common dangers that should be avoided:

• Be aware that the bank is not your friend. Most construction loans have them keeping money YOU still pay interest on and parceling it out to you once certain completion is achieved. Obviously they are in no hurry to move that process along and it is not unheard of to have a bank hope for failure of a project towards the end so they can foreclose and grab the almost completed project. Your financing documents must be very, very carefully structured.
• The internal structure and control of the developing entity must be carefully honed to avoid the danger of delay in decision making or disputes halting the ability to make decisions. Limited liability is critical in this high risk field and guaranties are to be avoided.
• Do not trust any one professional to the exclusion of the checks and balances you need from other professionals. Thus, the architect, engineer, contractor and subs need to be ALL listened to and advice from one compared to advice from others. Create good contracts so that performance (and freedom from mechanics liens) is required for payment.
• Learn the lien laws. A single sub not paid can end up causing chaos in your project if the stop notice or lien arrives before a loan advance date. Use joint checks and lien releases to protect yourself.
• Expect bad weather and bad subs to delay some of the project. Expect the government to be twice as slow as it should and at least one building inspector to be the worst person you ever had to deal with.
• If you are building in a neighborhood or locale with strong local community opposition, put aside enough money and energy to deal with them or expect failure. Learn the local politics and hire local professionals if necessary.
• Do not be the first to try to change the zoning laws. Do not be the first to change the nature of a neighborhood.
• Check environmental pollution and the history of the property before you buy. Once you have bought the property, YOU are liable for all environmental clean up. A gas station there fifty years ago can cost you hundreds of thousands of dollars.
• Use the right team and listen to them - but make your own decisions. No one has as much interest in success of this project as you - they all have their own agendas.
• Budget for the market slowing down for sale of your property (or delay in rentals) occurring just as you go on the market. Do not be in a position where you must sell or rent or disaster will occur. Everything will cost twice as much as you think and take twice as long.

FIRST STEPS FOR YOUR FIRST PROJECT

1. Explore the real estate market and assemble your team of professionals.
2. Get your financing in line and your co developers selected and bound by contract.
3. Think long and hard if this is the right time to start your company.
4. Pick the easiest and smallest project you can make money on for your first project and do not expand it no matter what anyone says. The first project is your university in becoming a developer. Expect things to go wrong, learn from them, and plan on your second project being your first truly profitable project.
5. Suck in your gut and go for it, going along the basic steps outlined above.

SO, WHY DO IT?

Developers make a lot of money because it is not easy to develop property and few have the tenacity, skill, and financial ability to do it. But once mastered, the same skills can be used to boot strap yourself into larger and larger developments, using the equity or proceeds from the last to make the next. As stated before, one of the fastest ways to tremendous wealth is development of property in the United States and while the risks are real, so are the returns.

And the satisfaction that comes from being a developer and seeing the project through seems to be quite high. Unlike most people in most businesses, you see the property improved in a tangible manner and feel the sense of pride in creating value where it did not previously exist.

One can be flexible as well, choosing to either rent or sell or use on one's own or some combination of the three. Often, a developer finishing in a poor market will simply rent the units rather than sell the building for a year or two and once the market improves, sell the property.

But above all, there is something almost mythical in owning and improving real property for most developers. Unlike stocks or bonds, unlike running a business, one is "connected" to the property and the land, one interacts directly with workers, professionals, government, and ultimately the users of the land and this seems to be more enjoyable to developers than the more typical ways to make money. One elderly developer who did not need the money any longer said that he kept developing because it was his way "to give birth." He laughed, but there seemed an element of seriousness in his voice. He was "creating" much as an artist or writer - but getting far more money for the creation than artists usually get!