REA Development & Feasibility Analysis 2 — Questions and Answers
Question 1: What is a 'guaranteed maximum price' (GMP) contract in real estate construction?
- A contract where the contractor agrees to complete the project for no more than a stated maximum price, bearing cost overrun risk (Correct answer)
- A government guarantee that ensures the developer will receive a minimum sales price for completed units
- A lender's commitment to fund construction draws up to a stated maximum loan amount
- An insurance policy that guarantees the project will be completed if the developer defaults
Correct answer: A contract where the contractor agrees to complete the project for no more than a stated maximum price, bearing cost overrun risk
Under a GMP contract, the general contractor caps its fee and bears the risk of cost overruns above the guaranteed maximum price, protecting the developer's budget.
Question 2: What does 'yield on cost' measure in real estate development?
- Stabilized NOI divided by total project cost, indicating the project's return on invested capital before sale (Correct answer)
- Annual cash flow divided by equity contribution, measuring cash return to equity
- Market cap rate applied to land value, determining the land's development potential
- NOI divided by the current appraised value of the completed building
Correct answer: Stabilized NOI divided by total project cost, indicating the project's return on invested capital before sale
Yield on cost (stabilized NOI ÷ total development cost) measures the return generated relative to the total capital invested in the project.
Question 3: What is a 'residual land value' analysis used for?
- Determining the maximum price a developer can pay for land while still achieving return targets (Correct answer)
- Estimating the land's value after the proposed development is completed and stabilized
- Calculating the tax basis of land after depreciation over the holding period
- Determining the minimum proceeds needed from a land sale to pay off existing liens
Correct answer: Determining the maximum price a developer can pay for land while still achieving return targets
Residual land value works backward from projected development revenues and costs to determine how much can be paid for land while still meeting return hurdles.
Question 4: In development underwriting, what is an 'interest reserve'?
- Funds set aside in the construction loan to cover interest payments during the construction and lease-up period (Correct answer)
- A deposit held by the lender to cover potential cost overruns on the project
- Cash reserves maintained by the developer to fund equity shortfalls
- A portion of permanent loan proceeds withheld until the property reaches stabilized occupancy
Correct answer: Funds set aside in the construction loan to cover interest payments during the construction and lease-up period
An interest reserve is built into the construction loan budget to fund interest payments during the construction period when the property generates no income.
Question 5: What is a 'ground lease' structure and how does it affect development economics?
- A long-term lease of land where the developer builds improvements but pays rent to the land owner (Correct answer)
- A lease of the first floor or ground level of a commercial building to retail tenants
- A land purchase agreement contingent on obtaining development entitlements
- A subordinated mortgage on land used to reduce equity requirements in development
Correct answer: A long-term lease of land where the developer builds improvements but pays rent to the land owner
In a ground lease, the developer builds and operates improvements while making lease payments to the landowner, reducing upfront capital needs but creating a subordinate rent obligation.
Question 6: What is 'construction contingency' in a development budget?
- A reserve percentage added to hard costs to cover unforeseen construction expenses (Correct answer)
- The developer's fee for managing the construction process on behalf of investors
- The amount by which construction costs can increase before triggering loan default
- A lender-required reserve funded at closing to cover future capital expenditure needs
Correct answer: A reserve percentage added to hard costs to cover unforeseen construction expenses
Construction contingency (typically 5–10% of hard costs) is a budgeted reserve for unforeseen costs such as design changes, subsurface conditions, or material price increases.
REA Development & Feasibility Analysis 2
What is a 'guaranteed maximum price' (GMP) contract in real estate construction?