MATH FOR DEVELOPERS

If you’re going to be a real estate developer, you have to know the math.

This is one of the top questions I receive every day:

I’ve got this great site, Sean. But how do I know if it will work?!

Answer?

Dude, you better not have bought it yet! Start with the math. You have to.

I sat down recently over breakfast with another aspiring developer and broke out some of the back-of-the-napkin math I do as I’m brainstorming any project. This math happens before I put a property under contract, before I raise funding, and definitely, before I’m taping imaginary paint samples to an imaginary wall.

Here we go. And I’m going to talk you through this because if you’re anything like me, you’re not a big fan of someone dropping equations on your head :-)

In order to figure out if a project is viable, we need to know:

The zoning

The number of units we’re going to build

The average rent per unit
The cost to build

For the sake of this exercise, we’re going to assume that you have sufficient zoning for your project (I promise I’ll circle back to this topic in another newsletter, but suffice it to say, zoning can mess you up. Remember my little two duplexes and a gas station dilemma? Exactly).

Okay, so let’s assume we have a lot large enough to build a 50-unit building.

We're going to build studios and one-bedrooms, and although we haven't figured out the exact layout, we've calculated that, on average, each unit will be 600 SF. Why don’t I know the exact combination of studios and one-bedrooms and the number of square feet per unit? Because paying architects too much too early in the process is a rookie move. No matter how pretty the drawings, you’re never going to appease the Math Gods if you’re math doesn’t… math. And what if you pay an architect $10k for some initial basic drawings, and the project is a no-go? Answer? Your business partner/banker/wife/boyfriend makes you sleep on the couch/office floor.

So, we know that, on average, each unit will be 600 SF. Take a look around your market. Is there a shortage of one-bedrooms? Are they, on average, 600 SF as opposed to, say, 2 BR luxury units averaging 1800 sq ft? The market will give you some guidance here.

The second number we need is the average rent in our submarket.

For the sake of this example, we're going to use $3.00 a square foot. How can you calculate this number for yourself? Go online and find the five closest comparable buildings in your submarket. What are they charging in rent per unit type?

If our average unit size is 600 sq ft. and our average price per sq. ft. is $3.00, then 600 x 3 = $1800 (our average rent).

So, what's our top-line revenue per month?
$1800 (average rent) x 50 (number of units) = $90k/mo or $1,080,00/year.

Once we have our yearly top-line revenue, we calculate what is known as the NOI or Net Operating Income.

We do this by taking our top-line revenue and multiplying it by 40%, as 40% of your revenue is expected to go to the building’s operating expenses once built. Marketing, real estate taxes, insurance, repairs and maintenance, unit turnovers, administrative expenses, etc.

$1,080,000 x .40 = $432,000
And then…
$1,080,000 (top-line revenue)
-$432,000 (operating costs expenses)
-------------
= $648,000 of net operating income

Once we have our NOI, we then divide THAT number by the cap rate, in this case, 4.5%. How will you know what the cap rate is?

This is where you have to pick up a phone and call a sales broker who specializes in selling apartment buildings. Or know your market extremely well and be tracking sales, like I do.
$648,000 (our NOI) divided by 4.5% (our cap rate) = $14,400,000 = the value of the future to-be-built building.

We then make a call to a builder and ask him/her what they are seeing as the current price to build. No, they don’t need to call you back next week. If they’re building regularly and have a lot of projects in place, they should be able to give you a ballpark number. Remember, we’re just testing viability in broad strokes here, so ballpark numbers are just fine. In this example, our builder told us that it would cost approximately $265k/unit to build.

We take $265,000 X 50 (number of units we want to build) = $13,250,000.

So we know that THIS is what it's going to cost us to build.

Then we take the value of the building and subtract out the cost to build:

$14,400,00 (value of the building) minus $13,250,000 (cost to build) = $1,150,000. THIS number is the value we've created in the deal HOWEVER, it does not yet account for soft costs or the price of the land.

Soft costs (architectects, engineers, financing, etc.) are typically 25-30% of the cost to build, so we can see that in this example, our soft costs would be $3,312,500.

Ouch!

Does this project work? Nope. Not even close. Here’s a quick look:

Land: $1,100,000
Hard costs: $13,250,000
Soft costs: $3,312,500
= $17,662,500 total all-in cost

The value of the project is $14,400,000, but the total cost to create this value is $17,662,500, which means that before the first resident has crossed her threshold, we're in the hole $3,262,500. It also means this project would never get built because it would never get financing, equity, or a developer willing to do it!

Stay tuned because, in the next newsletter, we’re going to dive into some numbers that DO work.
Have questions about any of this math? Let’s hear them!

PS. Here's the condensed cheat sheet!