Getting Financing & Developing Land
Introduction
Getting
Started
Anyone
who embarks on a big undertaking without proper preparation is inviting
disaster. This advice applies equally to generals at war, to students in school,
and to business owners about to finance raw land development for the first time.
You
may find books of advice about how to get money for your business, with all
kinds of takes on how to go about it. Unfortunately, most of them are pretty
theoretical. When it comes time for you to sit across a desk from a loan officer
or venture capital investor, you need to be armed with hard information- facts
and statistics. You don't want so many that they overwhelm the other person, but
enough to demonstrate that you know what you're talking about. This book is
designed to help you prepare for the big step, by showing you how to:
- Take
an idea and express it in terms of specific goals.
- Identify
the steps you need to get there.
- Present
these ideas in the dollars and cents that bank people like to see.
Just
as you need a blueprint and tools to build a house, you also need plans and
tools to get the money you need to develop a project. It isn't enough to explain
how interested you are in doing that project; you need to show the lender or
investor how their risks are going to be managed carefully and methodically. In
this book, you'll find those useful tools, including checklists, sample forms,
and examples you can use to prove that your ideas make financial sense. That's
the entire purpose and focus of this book.
The
best and most obvious advice when you start any project is always this:
"Begin at the beginning." When you're looking for financing for land
development, the beginning means defining exactly what you want. That means
answering these three questions:
1.
How much do you need?
2. How will you use it?
3. How can you get it?
This
book shows you how to answer those questions so you can get the money you need.
Along the way, you'll learn how to:
- Study
your operation and look for routines and procedures you 'II have to change
so you can manage the new demands that more complicated projects will bring.
- Examine
the local land market, economic situation, and political climate to discover
the "rules" of the development game in your community.
- Make
informed decisions about the best and most profitable type of development
for your locality and talents.
- Assemble
and present a convincing appeal to your lender for the cash you need.
You're
going to ask an institution or person for money you need because they have that
money to loan. But they didn't get the money, or control of it, by being
foolish. They're going to ask tough questions designed to find out if they're
going to get their money back, and how much profit they're going to get. They're
not going to take chances just out of respect for your eagerness.
So
before you go looking for the money, you need to answer for yourself the
questions a lender or investor will ask. There's little sense in starting up a
venture before you've thoroughly explored its pitfalls and possibilities.
Consider these points:
- Can
you find suitable land?
- How
is the land zoned?
- Can
you get the zoning changed if you have to?
- Is
there a demand for your project?
- Will
your plan make money?
- Will
the cash flow work out?
- What's
the political climate?
- Are
you experienced and qualified for this project?
Your
answers to these questions will determine whether land development is right for
you.
The Importance of Land Investment
Land
- its purchase and development - is an essential element of progress. Those who
own or control the land determine how and where growth occurs. Naturally, other
factors, including local politics, the current state of the economy in your
region, and the willingness of lenders to work with potential developers, have
an effect. But the essential truth remains: Ownership and use of land is the
engine of growth. As a buyer and developer of land, that makes you the engineer.
Here
are some statistics that make the case for successful land development in
today's economy:
- Census
reports estimate that population growth between 1995 and 2010 will be 36.2
percent. That's about 100 million more people and 30 to 50 million more
households. And all those people will need homes and jobs. The largest
increase will be in the age group between 40 and 64, as today's population
ages.
- The
aging of the population is good news for housing, commercial and industrial
construction, as well as for high-end industrial properties. People in the
40-64 age group earn the most money and are the most stable in both their
personal and career lives. Most families in this bracket want to own homes,
can afford relatively expensive ones, and may even want a second or third
home as well.
- New
home sales for the 1990s were over 6 million, near the record set in the
1970s. During the first decade of the new millennium, the second-generation
baby-boomers will get into the market, and records will probably continue to
be broken.
- More
than eight out of every 10 homes built in the United States are built by
"small" builders (those having fewer than 25 employees).
Statistics
also show that today's market is favorable for contractors who want to borrow
money. When we talk about markets, we usually mean how many buyers there are for
what we sell. But here I'm talking about the capital market - whether there's
enough money available for you and others who want to borrow to invest in and
develop land. Many sources predict that this decade will see a boom in new
development. A primary cause of that boom will be the simple fact that money is
available.
Planning for Land Investment
Since
you 're reading this book, you 're already thinking about how to make money by
buying and developing land. You may want to buy land and apply for a rezone,
then lease, sell or develop it. Maybe you prefer a specific type of commercial
or industrial development.
Sometimes
a client will come to you with an empty lot and ask for a custom home. But that
isn't how developers work - that's custom contracting. Developers tend to be
land investors first, and builders second. Contractor-developers make more
profit on the land than on the improvements.
Many
contractors start out small. They buy a single lot and build a spec house. If
all goes well, they sell it and use the profit to finance a larger, more
expensive home. Perhaps you're ready to take on two or more projects at once, or
move up to tract development or part of a planned community.
For
all these scenarios, you'll have to create a project plan for a project that you
can build to make a profit. Owning land isn't the end result. But it is a
necessary part of the plan. And in the best of circumstances, the land will
appreciate while you own it. There are a number of features that contribute to
increases in land value, including improvements, more valuable use of the land,
potential value created by land use changes, and the emerging path of progress
which brings development pressure.
That
path of progress (the direction in which growth occurs) depends on a variety of
conditions:
- Increased
employment and economic growth produce more demand for buildings of all
kinds.
- Local
governments may create progressive land use policies because they want to
attract an industrial employment base.
- Development
of transportation corridors bring tourist and travel related activity.
- Other
local attractions lead to changes in population, employment, and land use.
Owning
the land yourself increases your profit potential. But to own land, you probably
need to borrow money - and that means paying back the loan. You'll have to make
those periodic loan payments on schedule without fail. That means your cash flow
must be healthy enough so you can make regular monthly payments while you
continue to pay your other bills. When you buy land for development, it won't
pay for itself until it's improved. It's impossible to find a use for raw land
that will cover its investment cost - other than development.
You
must prepare a realistic business plan and budget to offset that problem. Can
you survive several months of negative cash flow while you build your project?
If your project requires rezoning, you can expect a significant delay before
construction starts. That will increase the time lag before profits begin to
roll in.
And
there's another possibility to consider. You could end up owning that land even
longer than the time it takes to develop it. Many novice developers (and even
some experienced ones) end up renting out a finished project when a falling
market makes it impossible to sell the development at the predicted profit.
That's
why you have to do your homework and lay a firm foundation by preparing yourself
and your business for the changes that growth and expansion will bring. Only
then can you successfully build a project that will fulfill your goals and
expectations, and that will make money.
Speculation vs. Investment
What's
the difference between the two? The dictionary defines speculation like this:
assumption of unusual business risk in hopes of obtaining commensurate gain. In
other words, speculation is an unusually risky investment. As a contractor
looking for financing to buy raw land, you could be either an investor or a
speculator, or combine the characteristics of both. It all depends on the level
of risk.
When
you listen to the political rhetoric about land use, it can sound like all land
purchasers are either angels or devils. Angels are investors who buy land to
improve it for the good of the community. Investors treat their land as a
personal asset to make sure that values remain high over the long term. And
devils, of course, are short-term speculators who just want to make a quick
buck. Speculators buy and sell land only to drive up prices and take advantage
of the local folks.
Neither
of these definitions is necessarily true - nothing's that black and white. But
when you invest in land, sooner or later you'll run into the politics of
development, where labels are used to divide the good guys from the bad guys.
You
want to be one of the good guys. So when you search for financing to develop
land, you need to present yourself as a responsible developer whose project will
benefit rather than harm the community. No lender will be anxious to advance you
money unless you can convince them of three things:
1.
There's proper zoning in place (or you have a reasonable promise of getting
it).
2. Your project has passed environmental review.
3. There's no strong opposition from neighborhood groups.
Before
you can get the money you'll need, you have to convince the investor that local
groups and politicians favor your project because they believe the community
benefits outweigh any real or perceived negative consequences. They must also
believe that you'll invest much of your time and a lot of your own money in the
development project.
Remember
that even if today's demand for your project is strong, it may weaken before you
get the project finished. If your project will take two years to complete, you
need to start exactly two years before the market hits peak demand for your type
of project. Good luck in predicting that! The "sure thing" in real
estate is rare. But you also expose yourself to risk in a number of other ways:
- Can
you develop the management skills necessary to handle the transition from
contractor to land developer?
- Can
you find land that's priced so you can make money?
- Can
you get the financing required to complete the project?
- Can
you finish the job on schedule?
- Can
you maintain a healthy cash flow during development?
We'll
address the last four issues (and more) in later chapters, but for now let's
consider the first one.
Prepare for Your Company's Growth
It
isn't enough to just know where you want your business to go. You have to know
how to get it there. Growth itself isn't hard. But keeping it on track takes
special skill and attention. You have to keep one eye on the big picture while
you watch the smallest details with the other.
Details
have a tendency to take over. The expression, "The devil's in the
details" is never more true than when it applies to running a growing
business. Everything from interviewing, hiring and training a new supervisor to
making sure you can rely on your office manager to keep paper clips on hand
distracts your attention from the big picture - if you let it.
The Nature of Growth
The
nature of growth is to dominate. If you take no action at all, it's still more
likely that your company will grow than that it won't. That's because of another
rule: The nature of overhead is to increase. If you've been a contractor for any
time, you know this. And as your overhead increases, you're under pressure to
take on more business (even if you don't want to) just to cover higher
administrative expenses and continue to make a profit. But there's a better
approach. Get expenses under control and keep them there.
Controlling
expenses isn't just an accounting exercise. If you plan to move into new lines
of business, to develop raw land by using other people's money as part of your
financing plan, overhead is your "soft underbelly." If you fail to
control overhead, you're at great risk. However, if you think of the control
mechanisms as part of the business planning and development process, you stand a
better-than-average chance of succeeding in your business expansion.
Not
all aspects of growth are positive. You'll encounter many pitfalls while your
company is growing. For example, growth often places personal demands on you
that you didn't expect. You have to work longer hours, often for less income
than you would receive as an employee - and all the problems are yours.
Business
owners often pursue growth for its own sake, believing that growth is not only
good, but necessary. You may have heard that if your business doesn't grow, it
will stagnate and die. That simply isn't true. The truth is, you need to
decide how large an operation you want, how much risk you can tolerate, and how
much time you 're willing to spend running the business.
But
once you decide to expand your business, you need to control your rate of
expansion. That means you have to put on the brakes if your company's growth
happens too fast and gets out of control. You might ask, "What's wrong with
fast growth?" To answer that, let's look at some of the problems associated
with growth.
When
you decide to expand into land development, you may be concerned about whether
you'll have enough new business to sustain the growth. But that isn't the
problem. The business is out there. Instead, the health of your business depends
on deciding which activities to encourage and which ones to avoid.
The
secret is to stay focused. Don't become so involved in a scattered collection of
activities that you lose touch with what you really want - to purchase and
develop raw land in a way that will return the most profit.
When
is the right time to grow? The best time is when the current economy, money
supply, the market and your competitive position are all favorable. If they're
not, you're better off waiting until the situation changes for the better. But
if you think now is the time to take the leap, consider the expansion
challenge.
The
Expansion Challenge
Expansion
isn't limited to a single direction, such as upgrading equipment, producing new
products or entering new markets. Expansion often occurs in several ways at the
same time. We'll look at four types of expansion: volume, people, geography and
competition.
Volume
This
is the most obvious - and easiest-to-understand - type of expansion. But it
involves more than just higher gross income dollars. You have to watch the rest
of your profit-and-loss picture, too. If your direct costs rise to a higher
percentage of sales than they were before, then you can count on one thing:
lower profits.
You
also need to control overhead costs so their rate of increase is far less than
the increase in volume, direct costs, and gross profit. While overhead expenses
invariably increase with volume expansion, there has to be a limit.
Remember
that it's easier to control overhead through diligent planning and monitoring
than it is to cut back once expenses have raced out of control. Controlling your
overhead is the real key to higher profits after expansion.
Look
at the two simplified profit summaries in Figure 1-1. In Summary 1, overhead
expenses are controlled well in an environment of increased sales. Net profits
increase to 22.3 percent of sales. But in the second year, in Summary 2, the
same volume is accompanied by significantly higher overhead expense. The outcome
is a 9.8 percent net - virtually no change from the lower volume period.
|
Summary 1: Expansion
with Controlled Overhead
|
|
Year A |
Year B |
| Sales |
$518,500 |
$753,400 |
| Less: Cost of Sales |
264,100 |
377,800 |
|
|
|
| Gross Profit |
$254,400 |
$375,600 |
| Less: General Expenses |
204,600 |
207,500 |
|
|
|
| Net Profit |
$49,800 |
$168,100 |
|
|
|
| Profit (percent of sales) |
9.6 |
22.3 |
|
|
Summary 2: Expansion
with Excessive Overhead
|
|
Year A |
Year B |
| Sales |
$518,500 |
$753,400 |
| Less: Cost of Sales |
264,100 |
377,800 |
|
|
|
| Gross Profit |
$254,400 |
$375,600 |
| Less: General Expenses |
204,600 |
302,100 |
|
|
|
| Net Profit |
$49,800 |
$73,500 |
|
|
|
| Profit (percent of sales) |
9.6 |
9.8 |
Figure 1-1 Profit
Summaries
|
In
this case, increased volume is really no more profitable. Summary 2 shows how
you could expose yourself to greater risk and work harder, only to realize no
real improvement in your company's operations. This is the essence of
profitability - you can't just look at the numbers.
Controlling
expenses is where you have the best chance of increasing your return on
investment (profit divided by the amount you invested). You can't do much to
reduce merchandise and labor costs. But by holding down overhead, you can
significantly improve your profit when volume grows.
Overhead
isn't the only thing you 'II have to watch. If you plan to continue your current
activities while you 're managing your expansion, beware of one common pitfall.
You may have a tendency to sell more on credit as your business grows. Don't
do it. Combining higher overhead and expenses with higher accounts
receivable and a slower collection cycle can be deadly. You have to plan
carefully to keep your cash flow in line. Otherwise it's too easy to let your
overall financial health suffer while your time and attention are focused on new
operations.
More
volume usually means you'll need more equipment. When you spend money for
equipment, you have two choices: pay cash or borrow money. If you finance the
purchase, that means interest expense and monthly payments. Before you take that
step, you need to be sure that the money you need will be available from
operations. Will the equipment generate enough income to cover payments? Will
income begin immediately? The payments will! And is that income going to be
regular or seasonal?
Equipment
only generates income to the degree that it reduces labor costs. For example, a
new piece of equipment may let two workers do as much as four. This cuts labor
costs in half. So you can easily measure equipment productivity by comparing
operating costs for current equipment against those for new and improved
equipment, then balancing that against reduced labor costs.
The
answer to the question of whether to lease or buy equipment depends on current
need and future plans. If you expect to use a piece of equipment over many
years, it makes sense to buy it. Leasing is expensive because you 're paying for
time as well as equipment in exchange for a smaller investment up-front. But if
the equipment is something you won't need beyond the short term, a one- to
three-year lease may make more sense.
When
you take on larger projects, you may be forced to stockpile materials. Perhaps
you won't be able to find materials in the volume you need on a dependable
schedule, so you 'II need to order more at one time. That usually gives you the
benefit of a discount. But there's a downside. You have to pay for the
inventory, you have to find a secure place to store it, and you have to insure
it.
People
To
support an increase in volume, you usually hire and train more people. You'll
need more supervisors, office and accounting help and consultants (estimators,
engineers). This means more expense. As your staff increases, you'll need more
office space as well as temporary buildings at the development site. It also
presents the potential for conflicts between you and your new
staff about operating methods. You'll need better internal organization and
scheduling to keep your trade workers busy every day.
Geography
All
communities are limited in terms of how much construction volume they can
support. Your competitors will always take their share of the local market. So
when you grow, you may have to branch out to neighboring communities.
If
yours has been a small company where you've supervised the job sites yourself,
you may find that quality declines and work goes more slowly when you're not
always physically present on the job.
Some
of the disadvantages of working at a remote site are obvious:
- Higher
cost to operate vehicles - fuel plus wear and tear
- Travel-time
costs for employees
- Delivery
charges for supplies and materials may increase
- You
may have to use new, more expensive, or unfamiliar sources for services,
materials and equipment
You
can estimate pretty accurately what those will cost. But there are other risks
that can be more expensive and harder to judge. Your presence on the job may
diminish as administrative tasks take more of your time. That may translate to
lower productivity by your crews, less efficient field supervision, and poorer
workmanship.
It
doesn't matter how diligent and trustworthy your site managers are. The fact
remains that remote projects are rarely as efficient, profitable, or produced at
the same level of quality as those you oversee regularly and personally. And
this deterioration in operations (and profits) can become worse the farther your
operation is from your home base.
Be
sure to take these things into account when you consider the location for your
development activities.
Competition
This
is a two-edged sword. When you move into a new area or adopt new lines of
business, you're confronted with a new set of competitors. These may be larger,
more experienced and better financed than you are. Their proven track record
might put you at a disadvantage when you approach lenders.
You
may also find that businesses who didn't see you as a competitor before (when
you were smaller), will now. They'll probably step up their own marketing
efforts to "keep you in your place."
The
best way to mitigate these challenges to expansion is to be very thorough when
you prepare your market study. You'll need this document when you're ready to
face a lender, and it will help you now to crystallize your plans for expansion.
We'll discuss this in detail in the next chapter.
The
Financing You Need
But
let's return to the questions at the beginning of this chapter.
How
Much Do You Need?
Unless
you have a lot of ready cash available, financing is essential for any
sizable expansion. You'll need money for the obvious things like land
acquisition, surveys, reviews, permits, materials, consultants and labor - and
don't forget related working cash for overhead, equipment and facilities, not to
mention your own living expenses.
The
amount of money you need to raise is related directly to the cost of the
development. As obvious as that statement is, many people seem to forget it when
they apply for a loan. Some people begin their quest for financing with the
question, "How much will the lender let me have?" That's the wrong
question, because it lets the lender dictate the size and scope of your
development plan. That's your responsibility, not the lender's.
How
Will You Use It?
When
you approach a lender or investor, your task will be to show how you plan to use
borrowed funds to develop your project. The size and scope of the project have
to make sense. If you can demonstrate that your development has a market and is
likely to be profitable, then the lender's risks are small, and so are your own.
How
Can You Get It?
Think
about this early in your expansion-planning stage. You might consider venture
capital or taking in a partner. You may need to combine financing from many
different sources to get what you want. For example, you may work with a
mortgage broker to locate long-term financing for land acquisition and
development, and with a commercial bank for a series of short-term working
capital loans - the ones you'll need to pay the day-to-day bills.
In
the early stages of development, you'll need a source for short-term financing
through loans or a line of credit. It doesn't really matter how long your
development project will take. You'll need flexible financing to help you during
the time when expenses are high, and the income stream hasn't started flowing.
Find
the Answers
Finding
the answers to those three questions is the subject of the rest of this book.
First, you'll learn how to approach the political aspects of land development,
determine the extent of the available land inventory in your region, and analyze
your market for poten
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