Return, Absorption, Risk
Understanding the differences in return, absorption, and risk profiles among sectors is also important. Here are four examples:
A retail project usually needs preleasing commitments from major tenants before it can be built. Once these commitments are secured, investors are likely to feel more comfortable that the prospects for attracting other, smaller tenants to the project are good - thus reducing perceived risk. As risk is reduced, the cost of capital to finance the project can also be reduced.
A single-family home developer with a large enough project typically builds model homes as the means of marketing the residential units. The market risk in this type of project is that the initial investment in model homes will not be returned if the market turns bad and orders for houses do not come in. Consequently, investors demand a high rate of return on the upfront investment in models but accept a lower rate of return on capital advanced for the actual construction of units for which orders have been taken. One industry that grew during the mid-2000s when prices were increasing was model-home financing. GMAC Mortgage and private individuals would provide such financing to defer the cost to the developer. The idea was that the capital provider would own the model home, enjoy the run-up in prices for development, and earn a return of and a return on capital as the models were sold at the conclusion of the project. In a market with stable or declining prices, the capital carrying cost for model homes becomes a challenge to overall project viability.
A high-density condominium project also delivers units on the basis of customer orders. In contrast to a single-family home project, the developer must finish almost the entire building before units can be occupied. Depending on the size of the project, capital may need to be invested for 24 months or longer, creating a substantial risk that conditions may change by the time those units are ready for delivery. Consequently, investors demand a relatively high rate of return.
A land development project typically takes a very long time between the contract to purchase land and the sale of developable parcels or finished lots. The developer may spend substantial sums to entitle the property and then may install some basic infrastructure, such as arterial streets and water and sewer mains. The project is then sold in phases to other developers, who build components of the total project. The developer attempts to minimize the capital invested in land acquisition by contracting for a phased take-down of the land tied to the construction schedule or a close of purchase only upon entitlement. Although entitlement costs may be modest compared with overall project costs, these investments are likely to be tied up for quite a long time with a high risk of loss, depending on the nature of the community and its attitude toward growth. As a result, investors demand a very high rate of return on capital invested in a land development deal.
These different risk profiles and absorption characteristics mean that the capital necessary for producing a project is invested for different periods of time at different levels of risk. As a consequence, different real estate sectors tend to have different return-on-investment parameters.