How A Financial Feasibility Study Can Help Prevent Undercapitalization
As a real estate developer, you know that a successful real estate development project can be financially rewarding. You may also know that development projects can be costly and require a hefty investment. Although you might have access to cash reserves and financing, the challenge in real estate development often lies in the ability to budget for your project correctly. Poor budgeting can result in undercapitalization. To avoid the possibility of undercapitalization, you should always conduct a financial feasibility study for real estate projects.
What Is Undercapitalizaton?
Undercapitalization occurs when a company doesn’t have enough money to pay its creditors and continue running its business. Suppose you’re developing a real estate project; in this case, undercapitalization means that you’ve run out of funds to continue with the project’s development (for instance, to keep paying contractors to continue construction on the land you’ve purchased).
Many factors can contribute to undercapitalization, such as a fluctuating market, unforeseen issues that cost more than expected, or poor budgeting. The best way to avoid undercapitalization is by performing a thorough financial feasibility analysis.
What Does A Financial Feasibility Analysis Consist Of?
If performed correctly, a financial feasibility analysis will provide you with a breakdown of all projected costs, the projected cash flow, and the predicted return on investment (ROI). By analyzing these financial aspects of your project, you’ll be able to determine if the project is worth investing in (if the ROI is less than the projected costs, it may not be). You will also be able to more accurately calculate how much is needed at each stage of the project to know what kind of financing will be required. A more in-depth breakdown of a typical financial feasibility analysis follows:
Determine The Project’s Costs
The first step in a financial feasibility analysis is to break down the development project’s costs, from the beginning to the completion. The following are the primary costs that you will need to calculate to determine how large of an investment is required to finish the project:
The cost of buying land goes beyond just the price tag. You will have to pay various associated costs, including brokerage fees, a land survey fee, impact fees, title search fees, and other closing costs. There may be legal fees that you will have to pay for if the land title is challenged or if there are conflicts concerning the land’s boundaries.
License and Permit Fees
Once you purchase the land, you can’t just do what you want with it. There are a lot of rules and regulations governing the use of land no matter where you are in the U.S. As such, you will have to obtain the necessary licenses and permits, all of which will cost money. You may need septic, well, water, building, and right of way permits to build any of those things. Learn what licenses and permits you will need for construction so you can budget for them and obtain them.
Most developers will take out loans to cover the costs of development that can then be paid back over time using their returns. However, loans are not free. You will need to account for any financing fees in your budget as well as the interest on monthly payments you’ll be making throughout development. Keeping track of these fees may seem easy if you’re just taking out one substantial loan to cover the entire development. However, many developers take out multiple loans throughout the project’s timeline to cover different costs throughout the development process. If you’re doing this, then accounting for financing fees throughout the development is critical.
Working with a single contractor will make it easy to determine the construction costs; however, if you’re working with multiple contractors, it could be a little more challenging. You also need to account for potential issues and delays, which can result in higher-than-expected costs. On top of your building’s actual construction, you will also need to plan for the costs of preparing the land for construction. These costs include earthworks (such as excavation, removal of trees, and grading), paving (for roads and driveways), and landscaping.
No matter what kind of building you’re constructing, you will need to connect it to local utilities. You will need to pay utility connection fees (often referred to as “tap fees”) for sewer, electrical, municipal water, and gas connections. These fees may include:
- Underground utility trenching
- Oil or propane tank
- Transformer installation
- Electric and gas meter installation
- Extension of utility lines
Not only will you need public liability insurance and insurance against damage caused by storms, fires, and the like, but you’ll also want insurance to help protect your investment throughout the construction stage. For example, you’ll want professional liability insurance to protect against wrongful acts committed during the preparing, negotiating, and awarding stages of the construction bid. Other types of insurance you may need include:
- Environmental Insurance – To avoid being held liable for damage done to natural resources.
- Course of Construction Insurance – To protect against accidental loss or damage during construction and covers the loss or damage of equipment, supplies, and materials).
Selling And Marketing
Don’t forget that further investment is required even after construction. Just because you’ve completed construction on your real estate project doesn’t mean that buyers will magically show up. Marketing your property will be required to find buyers or renters, and marketing costs can add up, so be sure to account for them.
Eventual Goods and Services Tax
Once your property is completed and you’ve closed a sale, you will have to pay a goods and services tax. It’s essential to keep this eventual cost in mind to understand your potential return on investment (ROI).
Predict Cash Flow Projections
Most real estate projects will take some time to complete., so developers typically don’t take out just one large loan to cover all potential costs. Instead, they obtain financing for various stages of development. Begin determining what your cash flow will be throughout development by calculating how much money you’re taking in from other real estate ventures against what you’re investing into the project. If you don’t predict the required cash flow accurately, you may find yourself undercapitalized at certain construction stages, which can delay your project.
Account for Potential Negative Cash Flow Projects
There may be points during the development at which the money being put into the construction exceeds the money coming in from other real estate ventures, resulting in a negative cash flow. The last thing you want is to be surprised by a negative cash flow, as this can lead to undercapitalization. Predicting negative cash flow ahead of time can help you secure the funding required ahead of time.
Predict Return on Investment
The last step is to predict the eventual ROI of the project. You’ll need to do thorough market research to predict your project’s ROI accurately. If you don’t calculate the numbers accurately, you could end up undercapitalized in the future, especially if you’re undertaking multiple real estate development projects around the same time. You might be counting on profits from one project to help fund another, making it critical that you predict an accurate ROI, or else it could threaten other projects.
A Real Estate Financial Feasibility Analysis Will Help Prevent Undercapitalization
Undercapitalization can be a real threat to your existing and future real estate development projects. It delay your project and increase costs and can threaten the project’s completion. To avoid the threat of undercapitalization, you must perform a thorough financial feasibility study. A properly conducted financial feasibility study can help provide you with a detailed breakdown – and a big-picture view – of the project’s costs. This information will allow you to plan for success with greater accuracy and avoid potential undercapitalization.