Scrutiny by Lenders Demands Better Preparation by Developers

Get It Together: Tighter scrutiny by lenders and a troubled economy demand better preparation in the due-diligence phase.

By Lawrence D. Maloney

Developers these days can feel like circus animals: They have to jump through more and more hoops.

Whether it’s meeting the demands of investors or passing muster internally, developers must work harder at the feasibility stage to prove a project is viable.

“We’re seeing a significant increase in due-diligence requirements,” says Joseph Hagan, president and CEO of Chicago-based National Equity Fund, a syndicator of low-income tax credits. “Projects go through a double underwriting, first by us and then by a third-party underwriter for investors backing the project.”

Passing Muster: Regency Centers’ internal watchdog, the Investment Services Group, has helped the firm achieve nearly 9 percent net operating income yields on its shopping complexes.

Developer examined three organizations from three principal sectors—public, private, and nonprofit—to learn the key feasibility challenges they face.

REGENCY CENTERS

You’d think Regency Centers’ development teams would have no trouble getting new projects off the ground. Based in Jacksonville, Fla., the publicly held firm has built some 180 shopping centers since 2000 and boasts occupancy rates of 95 percent.

Even so, each project undergoes rigorous review. “The environment out there certainly affects the outlook for projects,” notes Brian Smith, Regency’s chief investment officer, “especially if small retailers are having difficulty getting financing.”

To stay on track and avoid the show-stoppers that will scuttle a project during feasibility analysis, Regency relies heavily on an internal watchdog—its Investment Services Group. The division reviews pro forma documents prepared by the company’s 21 local investment specialists. Regency also tries to extend the “free look” period before closing on land. Th is eventually requires a nonrefundable good faith deposit during due diligence, but Smith considers that money well spent. “We would rather walk away from $50,000 than build an unsuccessful project that puts $20 million at risk,” Smith says.

The Investment Services Group reports to the chief financial officer and evaluates entitlements, reviews architectural and engineering plans, conducts a market research study, and hires consultants to measure sustainability parameters. The group issues a final pro forma to Regency’s capital allocation committee, which determines if the project should proceed.

The process works, which is great considering Regency’s current development pipeline of 50 projects representing a total net investment upon completion of about $1.1 billion. Case in point: The firm’s Deer Springs Town Center in North Las Vegas, a 700,000-square-foot complex anchored by a Target and Home Depot.

In contrast to the Vegas site, Smith points to other scenarios that raise red flags during due diligence. These include instances in which Regency would lease land rather than buy it; a major tenant buys its portion of the site, thus reducing rents; projects face substantial leasing challenges such as securing anchor tenants; or problems arise with zoning and obtaining permits. “If our fate is in the hands of the city council, we won’t take the risk,” Smith says. “We need to be certain about our right to build.”

CROSLAND

Decades before mixed-use was the darling of land developers, Charlotte, N.C.,-based Crosland made such projects a priority. But that doesn’t make the development process any easier for the firm today. That’s why, to help deliver its pipeline, Crosland watches the numbers internally while turning to outside help.

“The underwriting environment is such that developers are faced with greater equity requirements, which certainly boost your return targets,” observes Adam Ford, Crosland’s vice president of investments. “Due-diligence requirements … are being viewed with much more sensitivity. If you encounter added delays or unbudgeted costs in addressing such issues, you may not have the ability to get incremental financing as a buffer for your returns.”

Steve Mauldin, senior vice president for mixed-use development, notes that due diligence starts with market studies. “Market evaluation is all the more challenging for mixed-use projects because you need to get right several different sectors—housing, retail, and office space,” he says. Urban infill sites, where Crosland develops many of its projects in the South-east also pose additional challenges in areas such as entitlements, traffic patterns, and stormwater runoff . “The time to figure out what you’ll do about a buried gasoline tank is not when you are on the site with a bulldozer,” Mauldin says.

Ford adds that the usual concerns for about construction codes also are compounded for mixed-use developments, and that requires constant vigilance on changes in local ordinances. “You should build in contingency funds in case you need to alter your site plans,” he cautions.

Overall, Crosland executives say the greater risks associated with mixed-use demands a greater return. Still, they see growing support for such projects as communities seek to reinvigorate city centers and reduce traffic jams. One sign of their optimism: The company has established a new investment fund with Northwestern Mutual that will support about $225 million of land acquisition.

NATIONAL CHURCH RESIDENCES

The high costs and NIMBY obstacles of new construction have led National Church Residences of Columbus, Ohio, to focus increasingly on buying and rehabbing existing structures. That way, the nonprofit can create more affordable housing and implement its green initiative, explains vice president of development Jim Baugh. “Preserving existing housing stock is one of the greenest things you can do,” he says.

Even so, rehab presents plenty of due-diligence challenges for NCR, which owns or manages some 22,000 units at more than 290 properties. In fact, NCR must often address issues that market-rate builders don’t need to worry about. These include preserving Section 8 rental subsidies on apartment projects and building partnerships with other nonprofits to ensure that their housing complexes get ancillary health, nutrition, and counseling services.

NCR’s rehab focus also requires that environmental consultants investigate for hazards such as asbestos and lead paint.

Still, the credit crunch necessitates that affordable housing developers make a strong case during due diligence for a project’s viability, Baugh notes. “Not only are investors scrutinizing deals more closely, but the price you can obtain for your tax credits is going down,” Baugh says. What’s more, there are fewer investors in the game. Fannie Mae and Freddie Mac have moved to the sidelines of this sector because of their own huge losses.

As a result, Baugh says, investors are demanding realistic projections on rents and lease-up schedules. And, because of lower prices for tax credits, NCR must scramble during the feasibility stage to find gap funding from cities and states. “Lack of gap funds can sink a project or force you to reduce the scope of your rehab, which then raises questions with investors,” Baugh explains.

Project viability also often rests with NCR’s ability to negotiate with local tax authorities. And with states, it must negotiate the percentage of a project’s rehabbed units that must comply with requirements of the Americans with Disabilities Act.

The reality is these due-diligence requirements are essential, Baugh says, both to woo investors and capture tax-credit awards from state housing agencies. With fierce competition among developers, experienced firms with realistic project data are likely to come out ahead.