Symposium Addresses Risk and Return in Real Estate Development Ventures
February 16, 2006
Analysts generally agree that developing real estate is far riskier than simply purchasing real estate as stabilized, fully-leased assets. A speculative industry by nature, real estate development must offer higher returns to compensate for the inherently higher risk. But how much higher? What is a fair rate of return?
On February 16, 2006, a symposium co-produced by the Alumni Association of MIT’s Center for Real Estate (AACRE) and New England Women in Real Estate (NEWIRE) sought to answer that question. Attended by 75 developers, brokers, architects, lenders, investors, and CRE alumni/ae, the symposium offered viewpoints by leaders in development theory and practice.
Sponsored by the New Boston Fund and by Overland Realty Capital, and hosted at Boston’s Four Seasons Hotel, the symposium had a single focus. “Our purpose is to try to answer a basic question,” said Tod McGrath, moderator of the symposium, President of AdvisoRE, and Lecturer at the MIT/CRE. “If I bear the greater risk of construction and lease-out – rather than just buying a fully-constructed and fully-leased office or apartment building – how much more return should I get?”
“How Much More?” – An Economics Perspective
Professor David Geltner addressed the question with a mathematical framework based in economic theory. A Professor of Real Estate Finance, and Director of the MIT Center for Real Estate, Geltner opened his presentation by using a concrete example drawn from his own experience.
Development: an Example
Earlier in his career, Geltner explained, he had served on the investment committee for a Midwestern pension fund managing $50B in assets. Though the fund was generally conservative, it diversified its portfolio by allocating a fraction of its assets to riskier development ventures.
The fund elected to invest in a technology park development in California’s Silicon Valley. “The year was 1999,” Geltner said, “at the height of dot-com boom, and the Valley was an extremely hot market.” A forecast of the project’s development phase projected that after two years of construction and lease-out, the return on the development (its IRR) would be 28%.
Geltner then asked the symposium audience for a show of hands. “Should we develop? Is 28% a sufficient return?” The response was a unanimous yes. “But how do we evaluate this project?” he asked. “We agree that the return should be higher than for an equivalent stabilized property, but how much higher? What’s fair? Or as an economist would ask: what’s the market equilibrium return for the development phase?”
An Economic Framework
Geltner then presented a mathematical framework for evaluating the decision to develop. Using fundamental economic ideas of market equilibrium, opportunity cost, and net present value, Geltner proposed that the answer could be determined relative to expected returns in three capital markets: the property market (for stabilized property), the debt market (for construction costs, etc.), and the developable land market.
“A lot of trading occurs in stabilized properties and in debt,” he said, “so we can be confident about projecting returns in those markets.” Emphasizing equilibrium between the markets, Geltner developed an algebraic equation (his “Canonical Formula”) based on the concept of net present value, and thus established a mathematical relationship between the three markets.
Applying his formula to the pension fund project, he determined that a 13% return would be the market equilibrium point. In other words, the development should provide an expected return of 13% in the first two years in order to be economical. Comparing this figure to the original expected return of 28%, he said, “We now have a rigorous answer to what we all intuitively knew to be true: we should do this project.”
Scenarios of Success and Failure
Professor Geltner then offered two dramatic and wildly contrasting scenarios. In the first, he simply related what happened to the pension fund’s development project. Although the fund had originally expected to lease the property to as many as eight tenants after completion, the entire property was leased to a single large tenant even before construction was done – for 10 years, and for more than double the pro-forma rent!
The return on the fund’s investment (IRR) was an astonishing 80%. “That was the nature of dot-com boom.” Geltner said. “A sleepy little pension fund wouldn’t normally seek such adventure, yet this one hit a grand slam!” Shortly after construction was completed, the economic “bubble” burst; the pension fund had profited handsomely, but the hapless tenant never even moved in.
Geltner then presented a contrasting scenario: what could have happened if the construction or lease-up phases had met with significant delays. “In the calendar year after signing,” he said, “the market imploded.” Even if a tenant could have been found to rent, the estimated IRR in the development phase would have been stunning loss of -47%. Geltner’s two scenarios dramatically illustrated the tremendous risks and rewards that developers face.
Asked how heavily developers and investors should rely on a model such as his, Geltner replied that any economic framework should be only one part of a larger process for decision making. “There are organizational, political, and other factors at work in any development project,” he said. “You can’t computerize the decision-making process. This framework should be considered in conjunction with other broad business perspectives.”
“How Much More?” – Perspectives from Industry
After Professor Geltner concluded, he was joined by three renowned developers for a panel discussion of development risks and returns. Moderator Tod McGrath began the discussion by asking the panelists what they thought of Geltner’s framework.
Industry Responses to Economic Framework
First to respond was Larry Ellman. Managing Director of Citigroup Property Investors, and a graduate of CRE’s Masters program (’92), Ellman focused on Geltner’s bottom line conclusion, saying that his organization would not develop a project with a projected two year return of only 13%. “I think of high-yield real estate investing as comparable to investing in private equities or venture capital,” Ellman said. “If you can achieve a 20–25% return in an alternate asset class with a similar risk profile, why invest in real estate at 13%?”
Ellman’s comments were echoed by Casey Wold, Senior Managing Director of Tishman Speyer Properties. While he appreciated the rigor behind the economic framework, Wold said that his typical threshold for developing a project is an expected IRR of 20%. He further suggested that many developers rely less on economic frameworks than on instinct honed by experience. “So much of whether you do or don’t do a development relates to your sense of market pulse,” Wold said.
Panelist Elizabeth McLoughlin agreed. London-based Principal of AISI Realty Capital, she said, “Professor Geltner offers a rigorous framework for what all of us approach more intuitively.”
Professor Geltner responded to the panelists by stressing that his method simply allows one to quantify risk and reward. The low 13% IRR was likely related to the relatively low projected risk. Riskier projects can certainly offer much higher projected returns.
When Moderator McGrath asked the panel for specific risks that typically worried them, Wold stressed volatility as a major concern. “Here in Boston in the past two years, construction costs have been the highest I’ve seen in my career,” Wold said. He noted that in this period, construction costs for residential and office properties have gone up as much as 25%.
McGrath agreed, citing Boston’s Columbus Center Development project. He said that the construction estimate for developing the combination residential/retail/hotel property was estimated at $500M a year ago, and is now up to $600M.
McLoughlin added that “Two huge elements in the real estate market are volatility and cyclicality – which of course are where the opportunities are.”
Hedging against Risk
The discussion about risk raised the next question: how can developers hedge against it?
McLoughlin suggested several approaches, from putting as much risk as possible onto the seller, to having completion guarantees and performance bonds in place to ensure that obligations are fulfilled. “Guarantees must extend beyond the development phase,” she said. “Contractors need to be around years after development to make good on their commitments.”
Ellman’s thoughts focused on preparation. “We try to do as much homework as we can up front,” he said. “Before we put a lot of money at stake, we spend a lot of time on cost estimates to diminish the risks in the predevelopment phase.” Ellman also noted that experience can serve to hedge against risk. “Even though first-time developers might be more willing to give us better terms and to take on more risk on their end, we’d much rather do business with developers who have a record of success in a given market.”
When the topic turned to overseas development projects, McLoughlin offered a mini-presentation based on her experience. “I operate mostly in Europe and in emerging markets,” she said. “Development risks in Boston or Paris are very different from those in Warsaw or Moscow.”
She stressed that many development issues in emerging economies are unique. “For example, in the city of Warsaw, the Master Planner was fired a year ago, and there is still no Master Planner, so permitting is a nightmare. And in Moscow, at least half the land has components of ownership by the mayor’s wife.”
Answering the question, “Why do we develop in emerging economies?” she presented the latest risk-adjusted returns for development in France (+9.7%), Poland (+12.7%), and the Ukraine (+15.4%). Clearly, for developers willing to take on the greater risks inherent in emerging economies, the potential rewards are great.
“It all comes down to your view of an opportunity,” said Ellman. “When you find a piece of land that stands out – in a great market and with good sponsorship – you stretch and you push and you pull until you figure out the best deal you can get.”
Common Ground between Theory and Practice
As the symposium concluded, Professor Geltner was asked about the differences between theoretical and practical perspectives in determining fair return for development risk. “We economists are good at seeing the big picture,” he said. “We gain insights based on a pure disciplinary perspective, and arrive at fundamental frameworks for how things work.”
But he went on to say that for developers in real world settings, the equations “get messier.” Developers must manage organizational, political, and other considerations, and must coordinate many transactions and people, each with different risk-reward objectives. But if economists can develop helpful tools for decision making that can be transmitted thru an organization, the theoretical and practical can find common ground.