In an earlier article we discussed the first of two ways that developers traditionally use to look at the feasibility of income-property projects. That one was called the “Back Door” approach. It will come as no surprise to learn that we call the other method the “Front Door” approach.
The difference between these two approaches lies in what you consider to be the unknown variable. With the Back Door, you believe you know the rental rate that you can obtain for the space once it is built. You also know the cost of financing your project and what you consider to be an acceptable rate of return on your own equity investment. Blend this all together and what you’re really saying is that you know the revenue stream and want to figure out is the maximum total project cost that you can support with that revenue stream.
Once you get that far, you can refine the process a bit by breaking the total project cost into land and improvements. If you can estimate your cost for improvements, that allows you to back into the maximum land value that you can justify for this deal. We say land “value” rather than “cost” because you may already own the land. If that’s the case, then the decision you reach via the Back Door is whether or not the project you have in mind is in fact the best economic use of your land.
As its name suggests, the Front Door approach is a bit more direct. In this case you believe you know the total project cost – your outlay for improvements and the cost or value of your land. Now the unknown variable is the revenue stream. What rent must you generate in order to make this deal worthwhile? To ask this question another way, if you charge market rent does the deal provide an acceptable return?
Let’s look at an example. We’ll start with the project cost, which is made up of hard costs, soft costs and land. Recall from the earlier article that hard costs include construction as well as related items such as civil/mechanical utilities and environmental remediation; and soft costs include architectural and engineering, loan fees, development loan interest, legal fees, zoning-related costs, permits and similar items.
Hard costs: $1,700,000
Soft Costs: $750,000
Land Costs: $350,000
Total Project Cost: $2,800,000
The market capitalization rate for properties like this in your area is 11%. (If you haven’t done so already, you should read our article about cap rates in the Learn section of realdata.com. Even better, my book, What Every Real Estate Investor Needs to Know About Cash Flow…, provides a detailed tutorial.) In order for the property to yield such a rate, it needs to have a Net Operating Income that we calculate as follows:
Net Operating Income = Cap Rate x Value
Net Operating Income = 0.11 x 2,800,800
Net Operating Income = $308,000
We need a few more puzzle pieces to complete the picture. We know that we are building a project that will offer a total of 20,000 square feet of rental space. We must build in an allowance of 3% of the Gross Scheduled Income (the total potential rent) for possible vacancy and credit losses. We estimate that our operating expenses (property taxes, insurance, etc.) will be $50,000 for the first year. We can use the same format as we did in the Back Door analysis:
Total Rentable Square Feet x Average Rental Rate
= Gross Scheduled Income
– Vacancy and Credit Allowance
= Gross Operating Income
– Operating Expenses
= Net Operating Income
Let’s fill in what we know:
20,000 x Average Rental Rate
= Gross Scheduled Income
– 3% of Gross Scheduled Income
= Gross Operating Income
– Operating Expenses of 50,000
= Net Operating Income of 308,000
I’ll spare you the algebra involved and reveal the precise answer in a moment. It is for times like this that you use professional real estate software, so I’ll digress to suggest that you look at our Commercial / Industrial Development software, which we have offered since 1983. It’s designed specifically to analyze development projects and to help you sort out this sort of front-door back-door feasibility.
In real life what you would probably do next is to plug in the current market rental rate to see if in fact it would give you at least a $308,000 Net Operating Income, thus demonstrating that the project is feasible. Let’s say that the market rate for this space is $18.50 per square foot per year and try that:
20,000 sf x 18.50 per sf
= Gross Scheduled Income of 370,000
– 3% of Gross Scheduled Income of 11,100
= Gross Operating Income of 358,900
– Operating Expenses of 50,000
= Net Operating Income of 308,900
We were looking to achieve a NOI of $308,000, so for all practical purposes we nailed it. Based on these numbers, the project makes sense. For those readers who labored to calculate the exact rate to get the $308,000 NOI, it is a fraction of a cent more than $18.45.
Neither the front- nor the back-door approaches is a just brain teaser. These are effective methods to look at income-property projects to help you decide if they make economic sense.
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