How Do Developers Determine Project Feasibility?

Matt Gregory, SIOR, CCIM
Senior Vice President, NAI Ohio Equities

After nearly 20 years in the Commercial Real Estate industry, I am frequently asked questions about how economic development works and how developers/business make decisions. As urban-type developments have moved more into suburban settings, I’ve seen an increased interest from residents regarding development projects and how they work. This article shares the basics of what developers consider when making a decision about a new project.

Sometimes there is a misperception that developers come into cities pushing building plans that only benefit them and ignore residents’ desires and concerns, when in actuality there are legitimate factors that must be considered to determine if a development project is feasible and has the potential to be successful and I recommend that they do so. While understanding community need is critically important, this paper examines the variables a developer must consider before proposing a project. It is intended to provide a basic overview of how economic development works and is not intended to ignore the importance of public input. It is important to understand what goes on behind the scenes of a project to minimize the disconnect between residents and developers.

Occupant Priorities

Businesses consider several factors when searching for space. Some of those factors differ depending on the industry, as well as from business to business. This section outlines some of the most common elements business today are seeking, though it remains to be seen if COVID will impact any of these in the long term.

Office users have specific requirements when selecting a building, as follows:

• Prime location, centrally located

• Easy commuting access for employees

• Nearby amenities within walking distance (hotels, restaurants, shopping)

• Ample parking

• Building attributes

  • Modern image

  • Abundant glass (full panel window line)

  • High ceilings (9 to 10 feet)

  • Outdoor terraces

  • Creative elements (exposed ductwork, brick, polished concrete, etc.)

  • Efficient flexible floorplans (low common area factor)

  • ADA accessibility

  • Visibility (prominence)

• Costs (land/building value, lease rates, utility expenses, property taxes, etc.)

• Economic incentives (income tax, real estate tax abatement, tax increment financing)

• Workforce demographics (education, diversity, age, etc.)

• Access to variety of housing stock to accommodate all employees (apartments, condos, single family residences, entry level homes, patio homes)

Retailers have many of the same priorities that office users do, with the following additions:

• Customer demographics (density, discretionary spending, average income)

• Visibility (signage)

• Daytime population (weekday breakfast, lunch, happy hour)

• Complimentary uses

• Tourism (visitor and convention traffic)

• Zoning (permitted vs. conditional uses)

• Curb cuts & traffic patterns

While most of these elements are measurable values, there are also intangible factors such as:

• Ease of zoning process (transparency and speed)

• Welcoming and united messaging (from staff, planning, council, and community organizations)

• Peer-to-peer recruitment

• Ability to establish roots

• Feeling of community

• Ease of doing business

Market Desire vs. Feasibility

These requirements shape a developer’s plans for a project. Typically, developers go where there is a need and try to serve that demand. Development projects are only successful if they provide a product that businesses and residents will embrace.

To make sure they accomplish this goal, developers spend significant resources studying market drivers and talking with professionals across many industries, including but not limited to architects, engineers, appraisers, lenders, commercial brokers, large employers, and in a perfect world, community organizations.

When putting together their plans, developers must weigh what the market desires versus what is feasible from a cost perspective. The most critical item is almost always the ability to finance a project. Historically, large scale developments could only get off the ground in one of two scenarios: either a certain percentage of the development was leased before construction began (“pre-leased”) or a high net worth individual agreed to sponsor the development (e.g. think New Albany).

Relying on a development to reach the pre-leased threshold could take years, if not decades, for all the stars to align. More recently, developers have satisfied the banks’ underwriting without having the development pre-leased by proposing a certain percentage to be multi-family housing. The Mid-Ohio Planning Commission predicts that the Central Ohio Region will grow by 1 million people by 2050, and multi-family housing is already being filled as soon as it is constructed. Creating future rent revenues through multi-family housing increases lender confidence when approving or denying financing for a project in the same way as pre-leasing the commercial portion of the project.

In addition, when a lender is underwriting a property on behalf of a developer, the lender looks at the return on investment compared to the total development costs and potential risks to determine if the project is feasible. In essence, the lender requires a high likelihood that a project will produce a satisfactory return to approve financing for a project. If a project is too risky, the lender will move on to the next opportunity.

Land Value vs. Lease Rates

In locations where land is scarce, there is a disproportionate relationship between land values and commercial lease rates. This means that if a developer pays fair market price for a piece of land in a high land value area and builds only commercial property, the average tenant cannot afford to pay the rent necessary for the developer to make the project feasible according to lending requirements. 

There are three ways to overcome this hurdle: acquire government subsidies, build a mixed-use development where the developer can generate additional income to satisfy the lender’s risk vs return ratios, or sell off individual parcels to offset the initial investment.

Even with the latter, the buyer of those individual parcels must still be able to develop product that justifies their initial investment. When determining market value of these parcels, the parties must consider the “highest and best use” the zoning will allow. When a city limits density, height, and use and stipulates certain design standards, it is in essence limiting the value of a property. This means a developer must pay high land and development costs with limited potential and must be able to cover those costs with rents. In this scenario, development can only occur if the land can be acquired at a lower price or if a business agrees to pay an above market rent. If neither is achieved, development within a community becomes stagnant.

While it is important for a city to be thoughtful in the master planning of its land, it is also imperative for the city to consider that its tax base is directly impacted by that plan. Payroll taxes based upon the salary of employees who work in the development help fund city operations and services. Property taxes, which typically go to the school system, are based on the value of the land and buildings on the property. To successfully fund the services and amenities that community residents value and expect, the city where the development is proposed must maintain a healthy economic income tax base and sometimes that is not possible when a city’s master plan creates a barrier to entry for developers and businesses.

Reasonable Lease Terms

One of the remaining hurdles for businesses wanting to occupy modern office space is the long-term commitment they must make to a developer. In addition to a top of the market rental rate, a ten- or fifteen- year lease is required to make the economics work. Even for the most stable companies, this is a large commitment. Regardless of industry type, there are always extenuating factors (political, economic, and otherwise) that make companies hesitant to commit to long-term leases.

Many submarkets in the Central Ohio area took more progressive development measures in the previous decades so now they benefit from having a healthy inventory of newer office buildings. These new office buildings are now past that window of needing to recoup up-front building costs that necessitate high rent rates. This provides landlords the flexibility to offer intermediate shorter-term lease options. Just as the residential market needs housing at various price points to be successful, the commercial market also needs to offer space at various rent rates.

It's also true that office buildings in many submarkets can offer lower tax rates, which makes them more desirable than locating in a city’s core. 

Employee Recruitment and Retention

In today’s economic climate, workforce recruitment and retention are major business challenges. Employers are seeking modern facilities within walking distance of restaurants, hotels, shopping, recreation and housing. In today’s environment, employers must constantly compete to recruit and retain top tier talent. One of the ways to make a good impression is by projecting a modern image and providing a workplace that pleases employees.

Conclusion

Hopefully, this article has introduced you to what developers must consider before deciding to move forward with a new development. The market drives the mix of that development as does leasing and tax rates. It’s never a one-size fits all, but a combination of factors that make a development work. 

This article is adapted from a version Matt authored for his role in a community organization.