their craft, and explore their own aesthetic ideas. If their peers consider their work important, they may also win design awards and attract positive media attention. To wealthy investors, real estate development is a way to earn a higher rate of return on their money than they can earn through the stock market or other less risky investments. From the developer’s viewpoint, real estate is all of these things but first and foremost it is “product” and real estate development is “product development.”
In the same way that Apple Computer, Inc., developed the next generation of computers, phones, pods, pads, and other must-have gadgets, real estate developers constantly work to produce the next generation of office spaces, warehouses, retail centers, or housing units. Developers even use the same language as other product manufacturers. They “develop,” “design,” “produce,” “market,” and “sell,” and they talk about what is in “the pipeline,” whether or not they have enough “sales velocity,” and the problem of having too much “inventory” or “product on the shelf.” Products change over time, however, and if there is one constant to the product-development process—and the real estate development process—it is innovation.
The Role of Innovation in Real Estate Development
In The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail, Clayton Christensen differentiates between “sustaining” and “disruptive” innovation. Sustaining innovation is an innovation that does not affect existing markets and can either be “evolutionary” or “revolutionary.” An evolutionary innovation is an improvement to an existing product that consumers expect, such as fuel injection for automobile engines. A revolutionary innovation is one that is new and unexpected but that does not affect existing markets. The automobile itself, for example, did not affect the horse-drawn carriage business because it was so costly and out of reach for the average consumer.2
Disruptive innovation, however, creates a new market by “applying a different set of values,” and it ultimately and sometimes unexpectedly overtakes an existing market. The use of the assembly line to manufacture the Ford Model T at a significantly lower cost is an example of disruptive innovation because it overtook the entire existing automobile industry and made cars cheap for the masses. Products based on disruptive technologies are typically cheaper, simpler, smaller, and more convenient to use.3 Examples of disruptive innovations and the markets they overtook include over-the-road trucking and railroads, digital photography and chemical photography, and cloud computing and USB flash drives.4
Real estate usually falls in the category of sustaining innovation, with evolutionary innovations including incremental improvements to materials and building systems for all product types as in the increasing emphasis on sustainable design and construction. Revolutionary innovations in real estate often take the form of variations on existing product types and locations. Over the past century, revolutionary jumps in retail products, for example, have led from downtown department stores to suburban strip malls, regional shopping centers, mega-malls, entertainment centers, and lifestyle centers. Similarly, revolutionary jumps in residential products have led from dense single-family and multifamily housing in cities to single-family homes and townhomes in the suburbs and then back downtown to loft conversions, new townhomes, high-rise condominiums, senior housing, student housing, and luxury apartments.
Whether evolutionary or revolutionary, different types of products evolve at different rates. In his book about product design and development, Where Stuff Comes From, Harvey Molotch points out that the introduction of entirely new products is relatively rare, and most products are based on existing but constantly evolving “type forms.” Vacuum cleaners, toasters, and other household goods evolve over time but do not change in terms of their general look and function. Across the spectrum of goods, “quick-turn” type forms like mobile phones evolve rapidly while products such as household appliances, automobiles, and homes that are more costly and expected to last much longer are called “slow-turn” type forms. In product-development terms, real estate is a “slow-turn type form,” and there are a number of reasons for this.5
First, real estate development is very risky. Every time a developer initiates a project he or she is attempting something that has, in effect, never been done before. Each project represents a unique combination of price, product, location, and market timing. Second, real estate development is very costly. Unlike other entrepreneurial ventures that can be cash-flowed or “bootstrapped,” development requires the upfront investment of large amounts of capital. Developers use their own risk capital—cash—and that of their investors to obtain control over a piece of property, complete a conceptual design, seek and obtain key approvals, and test the market for their product. The expenditure of these funds, however, is no guarantee of success and if the project does not get completed those funds are lost. So in order to preserve capital and minimize risk, developers are more inclined to adapt a product slightly rather than strike out into the unknown and try something significantly different. Equity investors and banks take a similarly conservative view—they want their money returned and so they are less inclined to try far-out things. For example, a developer may not think he needs to provide as much parking as a typical project because the site is near a transit line. He may have difficulty, however, obtaining a construction loan because the product does not provide the same basic features as its competitors, so the bank sees increased risk. On the other side, the market’s tastes evolve slowly too, so developers are careful not to get too far ahead of their buyers in terms of price, product, or location. There have been plenty of examples of development projects that were too exotic, in the wrong place, mispriced, or simply before their time, which is why, as one saying goes, “pioneering developers are the ones with arrows in their backs.”
When compared to the latest cell phone, real estate—housing, office, retail, and industrial—is a product type that evolves slowly, and yet it is always evolving. It takes a long time to get a real estate product to market—years and even decades can go by between the time a developer conceives of a project and the day the last unit is sold or the last lease is signed. During that time many things change, from market tastes and demographic trends to construction costs and the efforts of the competition. How, then, does a developer go about successfully conceiving, producing, and selling a real estate product? What are the steps and who are the actors?
The Five Stages of Development
Concept Stage
The real estate development process can be divided into five basic stages: concept, approvals, design, construction, and sales. First, during the concept development or “pursuit” phase, a developer must have an idea or a vision for a product that will serve a specific market, for which there will be adequate demand, and that can be built at a cost and sold at a price that will yield a minimum profit. This idea may start with a piece of land or a building in a good location, a product type for which there is demand, a real tenant or buyer, or an amount of investment capital under the developer’s control. The developer will take into account supply and demand for the product type and local, regional, and national business, technological, and population growth trends.
The developer will also begin assembling a skeletal team, starting with an architect whose job it will be to test what kind of project will fit on the property, including use, numbers of floors, and numbers and types of units. The developer may also ask a contractor to provide a simple cost estimate for the project, based on the architect’s preliminary sketches and an anticipated quality level. This cost estimate will serve as the basis for an economic model of the project or “pro forma” that summarizes project costs, financing, and potential profits based on anticipated prices. The developer will need access to capital to finance the project through to completion so she will begin to court potential investors, lenders, and other individuals and institutions that may be potential sources of funds. The developer rarely has a monopoly opportunity, so she must also scrutinize the marketplace and consider what her competitors are doing, what comparable products are already in the development pipeline,
