[8 Steps] Credibility is the key to becoming a successful real estate developer. Learn how to earn it and keep it with these critical steps.
As a startup founder, I read and listen to a lot of tech and business material, and my reading recently took me through a couple of NFX’s blog posts. NFX is an early stage venture capital firm that specializes in betting on tech-enabled marketplace startups that can take advantage of network effects to achieve rapid growth.
I was inspired by the idea from NFX’s Ladder of Proof framework, not only as an early stage tech-enabled marketplace entrepreneur, but also because I think it’s applicable to real estate investing with some minor tweaks.
Here’s their original blog post: "The Ladder of Proof: Uncovering How VC's See Your Startup"
Reading it over, it dawned on me that this concept applies to real estate development deals, and attracting the right capital for them (both debt and equity). Similar to the ladder of “proof”, real estate developers need to climb the Ladder of Credibility to earn respect for their investment deals from lenders, equity partners, and other stakeholders.
At StackSource, we’re in the business of evaluating a real estate sponsor’s credibility all the time, acting in an advisory capacity when investors think they’re ready to get their project financed. Some of those real estate deals are ready for prime time right away, in which case our job is fun and easy, because we collect all the info through our online portal, approve it, and it’s out to market for debt quotes extremely quickly.
Many of the deals that are submitted to StackSource never make it through our own screening and analysis, so they don’t see the light of day with our end capital providers (banks, credit unions, debt funds, etc). For our own credibility with lenders, we only approve and release deals out to the market that we know have a great chance of seeing successful execution.
Here is StackSource’s own credibility screening process when it comes to development projects:
In the classical logic framework, “arguments” are truth claims. These claims can be tested to see if they are valid, meaning that if the premises are true, then the entire claim is true. For example, one might say, “All pens are blue, this object is a pen, therefore this object is blue.” Are all pens blue? No. But, the argument here is valid in that if both of the premises (pens are always blue and the object is a pen), then the assertion is true.
Pro forma financial statements are like arguments, in that the assert information about the future financial data for a property. The first rung in credibility is not whether all of the assumptions in a pro forma model are true, but just that the model itself makes sense. Do the formulas work? Has the investor included all the major expense categories? If we plug in correct assumptions, is this a good projection of the deal?
With a valid financial model, underwriters can focus their scrutiny on the actual assumptions it contains. The first and most important data point to look for is on the income side — are the rent/lease assumptions justified to the market?
Real estate professionals rely heavily on Comps to establish expectations for rent. Similar assets that are in the same area help reveal the demand in the market. If a sponsor is projecting rents that are way out of line with similar assets in the area, that’s a red flag that hurts credibility.
When there is a believable NOI, lenders still need to take cap rates into account in establishing value. Like rental rates, cap rates are also justified to the market, so providing a reasonable comp set adds to credibility that there will be value in the project.
If a strong pro forma for the deal is the vehicle, then the team executing on the plan is the driver. A developer with experience completing projects and generating investment returns in the past is important. The more relevant a developer’s track record, the more points they score in this category. It’s viewed as a significant risk if the sponsor hasn’t developed in the same asset class, geography, or dollar range and then asks for other people’s money to complete the project.
How complete are the architectural drawings? How impressive are they? How strong is the architect’s portfolio?
This is a very subjective point, but design is important to human beings. The design of the building will be important to the eventual users of the building, and it’s important to those who will potentially fund it.
One of the persistent enemies of development is problems and cost overruns in construction. If a project goes over budget and runs out of money, it’s a bad situation for all involved. In fact, a half-built property is often worth less than the land was to begin with.
A reliable construction management team, properly incentivized, is an absolute necessity. It’s common practice for certain lenders to require the construction manager to be bonded to the project, which is a guarantee they’ll finish it (or else!).
Here’s where you’ll hear the term “skin in the game”. Lenders want guarantors who can ensure success of the project, and, even in a non-recourse loan scenario, the sponsor’s financial strength plays a role in mitigating risk.
Having the right balance sheet as a borrower isn’t quite enough for credibility though — the developer should have a reasonable amount of their own capital at play in the investment, or their commitment to its success can be called into question.
The government doesn’t allow every potentially profitable business plan or real estate development. City planners, neighborhood councils, and ultimately politicians, may have broader plans for a community or a different set of incentives than an investor seeking to maximize profit. “Highest and best use” is a common phrase in the real estate industry, but some may consider a public park the highest and best use for a piece of land when thinking about a town or city holistically, rather than trying to maximize tax revenue for a particular parcel (another strong incentive for local government).
There’s probably a smaller microcosm of a credibility ladder here that could be fleshed out here, but the major points to check off are:
✔ Land is zoned for intended use
✔ Plans are approved by local government (city council)
✔ Construction permits have been obtained
The more of these items that are satisfied, the higher the credibility of the deal in the eyes of capital providers. Don’t treat this as a hard checklist, but as a guideline for how to establish much-needed credibility if you’re looking to conquer a major project.
For the aspiring real estate developers out there who can’t check off multiple items on this list yet, think about partnering with more experienced players who can fill in the gaps. The capital markets will evaluate these factors as they relate to the team developing a piece of real estate; one person doesn’t need to have competency in every aspect.
For the lenders out there reading our blog — let us know if we missed something you focus on when evaluating sponsor credibility for construction loan deals.