As with existing commercial real estate assets, assets in a pre-construction or construction phase require valuation for capital raising purposes, whether funds are to be borrowed or raised via equity investors. Unlike existing assets, however, construction projects lack financial history to demonstrate value—there’s no rent roll, leases, or income statements for an appraiser to review. How, then, do commercial valuation consultants place a value on a construction project?
Construction Valuation Basics
The value of a construction project combines the value of the land on which the project is built with the project’s anticipated income potential once complete. It can be greatly impacted by market changes and setbacks in project execution. There are three points for construction valuation: as-is, which is the value of the land/project site; at completion, which includes leases executed when construction is complete; and at stabilization, which is when the project reaches 85%-100% occupancy depending on property type.
Land is appraised using comparable sales when available, and by considering the attributes of the parcel in the context of its highest and best use. Characteristics such as size, shape, location, topography, utilities and improvements, accessibility, natural features, and environmental factors affecting the property make it more or less desirable to buyers, much like the features and amenities of a building.
Supply and Demand
Beyond land value, appraising a construction project is a study of supply and demand. Construction projects should fulfill a need in the market. Typically, multifamily construction happens in areas where there is employment growth and/or amenity growth (i.e., pro sports teams, bars, or restaurants). Office construction tends to be build-to-suit; that is, the project is pre-leased or mostly pre-leased because currently, there is not sufficient demand for speculative office construction in most markets. In today’s economy, new retail construction tends to be limited to discount stores, pharmacies, and similar single tenants—there is little to no demand for large shopping plazas or lifestyle centers. To be successful, a project must have sufficient demand to warrant its construction.
When appraising a construction project, a valuation consultant must consider whether there is sufficient demand for the project, and whether the completed project will be appropriate to meet the demand. Take, for example, multifamily projects and employment growth. Since people like to live near their workplace, there will be demand for housing in employment hot spots. But is the project designed to fit the demand? Say an apartment complex is being constructed near a large distribution center that employs many warehouse workers and drivers. Will the apartment complex contain affordable units in a mix of sizes to accommodate individual renters and families? Or, if the complex is being constructed near a downtown financial or technology district, will it offer luxury units?
Factors that Can Impact Project Value
Even with strong, well-matched demand, there are variables that can undermine the value of a construction project. First, there is the execution of the construction itself. Cost overruns can degrade profits and reduce value. Construction delays can result in poor timing of project delivery. Using the multifamily example: prime leasing seasons for apartments are spring and fall. Ideally, a multifamily project will be completed when leasing activity is strong. If construction issues delay completion until January, leasing will be slower, and the project can miss a leasing season. If the project is in an area with severe winter weather, leasing activity could be dampened for months, resulting in an extended lease-up which negatively impacts value.
Because construction is a lengthy process, often taking a year or more for large projects, changes in the market during construction can impact value. Never has this been more apparent than during the COVID-19 pandemic. Buildings were designed to meet pre-COVID demand, but during COVID, the needs and preferences of end-users changed drastically. In the office market, open workspaces had been the trend pre-COVID, but the virus created the need for more separation between workers, so design specifications changed. People on lockdown or working remotely wanted larger homes, and commuting was less of a concern, so the multifamily market changed. In retail, drive-throughs and curbside pickup became more important than spacious dining rooms or storefronts, so the retail market changed. Even now you are seeing prototypes from restaurants that are all drive-through and curbside with no seating offered. Developers and project owners had to pivot to meet changing demand or face the consequences: a product that was no longer viable.
Those familiar with the Chicago real estate landscape may recall a particularly vivid example of this scenario in the failed Waterview Tower project at 111 W. Wacker Drive. In 2006, a local developer launched construction of a 90-story, mixed-use tower including ultra-luxury condos, a luxury hotel, retail spaces, and parking. The massive project was expected to take about three years to complete and the developer self-funded the construction. Whether there was sufficient demand for ultra-luxury housing in that market in 2006 is debatable; however, as the economy began to falter, demand declined, and by 2008 the developers could no longer get a construction loan. They walked away, leaving a 26-story shell for about four years until Related Midwest took over the project. After a complete redesign that scaled the tower back to 59 stories and eliminated the proposed condominium and hotel uses in favor of luxury rental units, the project was sold in 2015 to Heitman for a record-breaking price.
Protecting Project Value
While the Waterview Tower example is a dramatic one, it illustrates a key lesson for owners seeking to preserve the value of a construction project. It’s not enough to assess demand before beginning; owners must stay abreast of the market and be sensitive to shifts in demand. More importantly, they must be able to pivot to meet those demands. In today’s market, for instance, interest rates are a significant barrier for many would-be home buyers. A developer with a condo development in progress might consider shifting towards a multifamily rental model instead of constructing units for sale to individual buyers. Recently, some multifamily developers have replaced the large community spaces in their plans with several individual “WeWork”-style office space amenities in response to shifts in tenant demand. Flexing with changes in demand can keep a construction project viable and protect its value through delivery.
Another critical component of protecting project value is managing construction risks: stay on budget and stay on schedule. Use safeguards such as construction monitoring to avoid cost overruns and delays. An investment in third-party construction risk management can help protect your project from common pitfalls that undermine project value.
The potential for shifts in value during the span of a construction project reinforce the importance of engaging qualified valuation consultants who are attuned to the relevant sector and market. Sophisticated market analysis is required to assess supply and demand and place a credible value on a construction project. Project owners should select an experienced commercial valuation advisor with reliable data sources and well-developed industry connections to ensure their construction project valuation reflects the most current market conditions.