Risk & Reward in Ground-Up Development

Ground-up development is one of the riskiest types of real estate investments you can make–but it can also lead to the greatest rewards. The best thing an investor can do if they want to focus on maximizing returns and growing wealth is to get really good at vetting a sponsor. There are many areas of risk that an experienced sponsor will mitigate. When done well, the return profile is typically the most attractive, allowing investors to double their money or better.

Gaining the entitlements needed to start construction requires time and money, and you may not be able to get the project done in the end. “Gaining entitlements” means getting the right to build your project, and usually, it is not just a piece of paper but an entire process that can take years and many thousands of dollars to complete. You are at the mercy of community groups like HOAs, planning and zoning committees, and city councils. These groups can also require expensive designs like this DXD self storage facility in Bristol, Rhode Island.

Not only can experienced sponsors navigate this process successfully, they also make the upfront investment of time and money. Investors typically enter a project when it’s ready to go and, more importantly, when that part of the risk has been fully mitigated. This graphic shows all the steps before an investor puts money to work.

Construction is risky too. Many things are completely out of anyone’s control–like hurricanes–so it is essential to invest with a group that negotiates a favorable contract that limits cost overruns through guaranteed maximum price or stipulated sum language and incentivizes general contractors with shared savings. The contract negotiation is, of course, just the first step. When you’re looking for a sponsor, ask if they have experienced construction managers who oversee the general contractors and experience finding mistakes as something is built. Mistakes happen, but they are much cheaper and easier to fix if caught early.

Once the project is open, commercial real estate usually relies on a successful lease-up period to drive investor returns.  

Questions investors should ask:  

• Does the sponsor pay a fee to a third party or do they self-manage?  
• Can they easily and cheaply fire a third party that doesn’t do its job? Do they have management experience?  
• Do they have any pre-leases in place?
• When does the project become cash flow positive?  

An experienced sponsor should be able to answer all of these questions in great detail and discuss the assumptions that support their business plan with you.

Investing in commercial real estate development can go wrong in many ways. The sponsor’s processes, people, and experience can mitigate many risks up front and along the way. While risky, this area of investment has a very high return profile. Risk-adjusted returns for ground-up development should be high teens to low twenties IRRs and around a 2x multiple. Of course, as many ground-up investors know, the rewards can often be well in excess of projections, which is why investors choose development over and over again.

‍