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Keeping Failure in Mind

APARTMENT FINANCE TODAY • September 2008

If you plan ahead for all the ways a project can fall short of the mark, you’ll be sitting pretty when things go right.

BY R. LEE HARRIS, CRE, CPM

As developers, we are optimists by nature. We can look at a piece of ground and envision a gleaming new apartment complex. We can look at a run-down 30-year-old apartment property and see the end result of some creative repositioning and innovative renovation.

What most of us do is focus on the upside: the financial rewards, the accolades from the community, and the emotional rush that occurs when a project succeeds. What most of us don’t spend enough time contemplating are the opportunities to fail.

Whether you’re doing your first deal or you’ve been buying and developing apartment properties for many years, I challenge you to modify your approach on your next project. Before ever looking at the upside, start with the downside.

Conduct a brainstorming session with your team and identify every conceivable way your deal could go upside down. Don’t try to resolve the numerous issues during the brainstorm—just list the various negative possibilities. Then set the list aside and ruminate on it for a few days.

Next, schedule a second session with your team to brainstorm exactly how you will mitigate each of the downside elements. Specificity is the byword here. Don’t get caught in the trap of being too general in the methods for mitigation.

At the end of the exercise you will either decide not to build or buy the project because you cannot satisfactorily manage the risks, or you will proceed with a healthy margin of safety incorporated into your program.

To help you with an opportunitiesto- fail exercise, here are some downside questions to ask. Naturally there will be many, many more that are unique to your particular situation, so use this list as a base from which to build.

  1. What if our unit mix is wrong?
  2. What if our initial rents are too high?
  3. What if it takes longer to lease up than expected?
  4. What if we have to give more in the way of concessions to complete the
    initial lease-up?
  5. What if we hit rock during development (new construction)?
  6. What if the soil is bad (new construction)?
  7. What if capitalization rates are higher than projected at the time of disposition?
  8. What if rents trend at a lower percentage than projected?
  9. What if long-term interest rates increase during development?
  10. What if code compliance issues arise during renovation?
  11. What if weather causes delays in construction?
  12. What if property taxes increase substantially?
  13. What if operating costs trend at a higher percentage than projected?
  14. What is the possibility that competing projects will be developed in the immediate area? What kind of impact would this have?
  15. What happens if the single-family home market becomes soft and people start renting homes?
  16. What if Mega Employer, Inc., closes it headquarters and plant facility?
  17. What is the crime trend in the area, and what is the likelihood that it will increase? What impact would that have on the project?
  18. What percentage of qualified renters in the trade area needs to be captured to fill the property? What if this percentage is too high?
  19. What if unforeseen physical conditions are discovered during renovation?
  20. What if our unit sizes are too small?

As a further step in understanding this process, let’s look at the mitigating responses for a few of these questions.

A fairly simple example involves hitting rock and/or bad soil during construction. The answer is to perform an adequate number of soil borings for the foundation of each building as well as borings in all parking areas. Once upon a time we built a project where we only bored the foundation, but we failed to test the soil under the proposed parking lot. It turned out that the soil conditions were bad in the parking area, and it cost an extra $80,000 to remediate the problem.

What can be done about lease-ups that take longer than expected? One obvious approach is to project the anticipated lease-up timeframe and then pad it. Assume that you believe that your project should be fully leased in 12 months. Then build your financial model for a 24-month lease-up period. If you achieve stabilized occupancy sooner than expected then it’s a pleasant surprise for you.

Rent levels are tricky. You’ve done extensive market research and paid big bucks for a professional report that proves your contention that one-bedroom rents should be $750 per month. If your financial model doesn’t work at $675 per month, you could be setting yourself up for a major opportunity to fail.

It doesn’t matter whether you are involved with affordable housing or market-rate apartments; an opportunities- to-fail exercise is a smart move. Look for all the downside risks. Develop very specific mitigation methods. Then, and only then, should you focus on how to exploit the opportunity.

R. Lee Harris, CRE, CPM, is president of Cohen-Esrey Real Estate Services, LLC, a Kansas City, Kan.- based commercial real estate organization that has managed more than 53,000 multifamily units since 1969. The firm is active in 95 markets spanning 17 states and is involved in the management, development, and acquisition of conventional and affordable housing. For more information, visit www.cohenesrey.com.