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Hi Michael,
I hope you can bear with me, I have a few questions:
– I noticed that we stopped forecasting taxes after Jan 2022, because our assumption is that we sell the property in Dec 2022. Does this mean that we are essentially offloading the tax liability for Year 2022 on to the the buyer, and if so, wouldn’t they factor that into negotiating the sale price down? Also if there’s even a small bump in our construction schedule and we don’t get to sell the property at the end of 2022, wouldn’t we be liable for paying taxes on the property for the year 2022?
– Which brings me to my next concern of construction. In the budget breakdown, construction costs account for almost 60% of the whole project, this seems like a lot of risk riding on how successful the construction stays on time and on budget, and only allowing a 5% contingency (later reduced to 3% to make us competitve) sounds even more scary. In reality, do you have a consultant advising you on the construction costs and schedule for the model, or is it perhaps in-house experience from the partners? I know we just assumed $300/GSF hard costs, but every project is unique and has it’s complexities I’m sure. Is there something like error insurance that developers can protect themselves with?
– Lastly, on TI, instead of allowing for $65/RSF, if we are able to lease it out before the project construction even starts, can’t we save on that by fitting-out the space during initial construction? Also TI happens in Month 39, which is the same month the tenant’s lease starts. In reality, wouldn’t there be a sort of construction downtime, I can’t imagine a tenant agreeing to pay for a space when it’s not quite ready to move in?
After completing this course, I learnt that developments involve a lot more components and moving parts than an acquisition model for example, and it seems as though our return metrics are quite sensitive to even a minor change in our assumptions, which could make or break a development project. I guess most of what I’m asking points towards understanding how a developer handles all the risk that a project can throw at it.
Thanks for everything, and have a great weekend!
Cheers,
JoshJoshua,
Thank you for such great questions! I am going to answer them in multiple responses as they will be lengthy.
Q1 – I noticed that we stopped forecasting taxes after Jan 2022, because our assumption is that we sell the property in Dec 2022. Does this mean that we are essentially offloading the tax liability for Year 2022 on to the the buyer, and if so, wouldn’t they factor that into negotiating the sale price down? Also if there’s even a small bump in our construction schedule and we don’t get to sell the property at the end of 2022, wouldn’t we be liable for paying taxes on the property for the year 2022?
This is a great question and is a nuanced topic per deal that could result in many different outcomes of who owes who what.
If the scenario was indeed as you described, you could customize this model to account for the tax as a credit to the buyer, or a decrease in the purchase price. However, another possible scenario here is that the seller did pay the tax obligations for 2022 and the buyer actually owes the equivalent of 1/12 of the taxes to the seller assuming they take ownership on 12/1/2022.
How taxes are determined and trued up between buyer and seller vary enough everywhere that I wanted to provide a general foundation for how to think about modeling it out, rather than discussing the numerous and nuanced ways one may have to account for this in each deal. However, it is an important topic and since you are asking about it, let’s further elaborate on it, below are some further considerations:
Reassessed value at occupancy or sale. Once the building is occupied by the tenant, it is not uncommon for the tax assessor to reassess the property using a different methodology known as the income approach rather than the cost approach, and taxes would be owed based on this new assessed value, which is usually a substantially higher value. Furthermore, the sale itself could trigger another appraisal and the property could be reassessed using a sales comparison approach to determine the assessed value.
The tax fiscal year may be different than the calendar year. A tax fiscal year for a certain municipality may not be a calendar year, so payments and determining who owes what will alter based on the fiscal year rather than the calendar year.
Payments may partially cover periods that span to both the future and the past. For example, you may have a fiscal tax year from July 1 to June 30 and pay two installments. The first installment could be due in October 1, while the second payment would be due on April 1. The October payment covers July through December, while the April payment covers January through June. So in this example, if a buyer purchases on November 1, he or she would owe the seller for two months (seller already paid for November and December) and if the buyer instead purchases in February 1, the seller would owe the buyer for one month (buyer will pay in April for January through June).
So with all of these nuances, you can see that the ultimate answer here to your question is ‘it depends’ and that you will almost certainly need to dial in your model for your specific project.
With that said, however, in the early stages of underwriting a development deal, in most cases, you can think of property taxes as a budget line item that won’t be a major driver of the valuation and so as long as you are roughly capturing the cost, you should be fine. As the project evolves, however, and you are ‘sharpening your pencil’ on the deal, this could be an important component to refine and get right.
Q2-a – Which brings me to my next concern of construction. In the budget breakdown, construction costs account for almost 60% of the whole project, this seems like a lot of risk riding on how successful the construction stays on time and on budget, and only allowing a 5% contingency (later reduced to 3% to make us competitve) sounds even more scary. In reality, do you have a consultant advising you on the construction costs and schedule for the model, or is it perhaps in-house experience from the partners? I know we just assumed $300/GSF hard costs, but every project is unique and has it’s complexities I’m sure.
Another great question. Some groups may have in-house expertise, but even with that, a smart and cost-conscious approach would be to meet and network with local General Contractors (“GCs”) in the market. If the deal you are looking at is of sincere interest, reaching out to grab a coffee or lunch to both connect and discuss the deal with a few general contractors is a great idea. It is ok to ask them to put together a preliminary budget (at no cost) as this is also a way for them to potentially secure work and they may have already done it for another interested party. Getting pricing from a few local and experienced GCs can help you hone in on a good budget estimate. However, it is not advisable to approach the GC community to ask for a preliminary budget or cost info if you are not seriously pursuing a deal or considering them for the project as you need to be considerate of their time and do not want to sour an important relationship.
To further discuss your question on contingency, the construction hard and soft cost numbers you get should always have further contingency line items baked in as well, most commonly for cost escalation and estimating inaccuracy. Review any detailed construction budget for these line items to ensure what types of contingency and how much is included. So while you have an overall project contingency line item, there should always be more hidden within your construction costs.
Contingency in a budget is always a balancing act. Too much and it can make you non competitive in pursuing a project, too little and you are at risk of busting your budget.
Q2 – b – Is there something like error insurance that developers can protect themselves with?
In terms of risk protection, i.e. insurance, there are many layers.
– Partnership Provisions. There are usually detailed clauses in the partnership docs that outline who’s responsible amongst the partnership for cost overruns at the partnership level.– Construction Bond. Developers will require GCs to put up a construction bond that guarantees that the GC can do the job as outlined and will compensate the owner for major defects or large GC caused disruptions. (should be included in construction budget)
– Liquidated Damages. There will usually be a section in the GC contract on Liquidated Damages detailing out the day for day cost for GC caused delay in construction completion that is owed to the owner from the GC.
– Insurance. There are a few common insurance policies to consider as well. Subguard insurance, liability insurance, and builder’s risk. (should be included in construction budget)
Q3-a – Lastly, on TI, instead of allowing for $65/RSF, if we are able to lease it out before the project construction even starts, can’t we save on that by fitting-out the space during initial construction?
Having a tenant on board early enough, although not common unless it is a build-to-suit or you are in an extremely supply constrained market, would be ideal as you can coordinate with them on base building components and make design decisions that would better accommodate the tenant’s needs and TI desires. It would help significantly to be able to coordinate this on the front end rather than post design or construction, which is more the norm. Keep in mind that ‘before project construction even starts’ could still be too late if the design process is complete or close to it and the project has been bid out. It is extremely time intensive and costly to change a design and all the design drawings if the A&E team is past the schematic design phase, which can be months before construction. Even in the SD phase any changes could be extremely costly.
However, to your main question about saving on TI’s, perhaps a good way to think about TI components is as items that are put in place on top of the base building that are unique to the tenant. So despite us possibly having the ability to better accommodate the tenant by making some modifications to the base building, the TI’s are still considered additional scope items. With all this being said, TI’s are first and foremost a negotiation, so nothing is set in stone on this topic. As an example, you could in fact come to an agreement that any modifications that increases costs to the base building come out of the TI allowance. Additionally, what specifically constitutes TI and Base Building items when having a tenant on early enough in the design process is an important topic to get very specific about. For example, is the elevator finish a TI or base building cost?
Q3-b – Also TI happens in Month 39, which is the same month the tenant’s lease starts. In reality, wouldn’t there be a sort of construction downtime, I can’t imagine a tenant agreeing to pay for a space when it’s not quite ready to move in?
Correct. In our model, we give our tenant three months of free rent, which is two extra months after TI’s are complete. However, this is a point of negotiation in a lease as well. As an example, let’s say a TI build out for a tenant is unusually extravagant and will take longer than a typical TI build out, a Tenant may have to eat some rent before finishing the TI build out, especially if there are other tenants in the market that will pay the same rent and start earlier. The market, tenant, building quality, location, lease term, etc., all play a part in the larger context of rent payment and timing. All these things impact each other.
Josh, thanks again for these questions and I hope I’ve answered them sufficiently.
All the best,
Michael
Hey Michael,
These responses were extremely informative, and I’ve learned a lot from them, so thank you for that. Sometimes when modeling these spreadsheets, it’s hard to visualize why we’re assigning certain assumptions, or how a certain process line item plays out in real life. I guess sharpening the pencil is something that really comes with real life experience and getting a feel of how things are done in the field.
I’d like to add one last observation to what you mentioned about GCs: While it’s highly beneficial to build a strong relationship with the GCs, pulling their bonding or charging them with liquidated damages is a very quick way to undo the relationship. Much of Real Estate field is interdisciplinary and so it’s a very tricky balancing act to handle, but I find it fascinating all at the same time.
Thank you once again for taking care of my questions!
Cheers,
Josh
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