Property development guide part 9 — Common risks related to development
Many investors approach property development with rose coloured glasses, but in order to minimise your risks and maximise your chances of turning a good profit (remember you want at least 15 per cent on the development cost), as a developer you must understand the potential risks associated with the development process.
Whilst we’ve already considered problems associated with reducing acceptable profit margins and taking on too much too soon, here are some other common dilemmas developers can face on any given project.
Increases in interest rates which result in increased holding expenses.
It is all well and good to be able to service a loan and make repayments when interest rates are at an all time low, but you must always factor in the possibility of rate rises over the life of your development.
After all, it may be two to four years before you complete your project and realise enough profit to be able to refinance and pay out your development loan.
Even large, seasoned developers have been caught out when they have borrowed too much money on lower interest rates and then as rates started to increase substantially, they could no longer meet their loan commitments.
Increases in construction costs due to increases in the cost of building materials or labour.
This is another common trap developers fall into.
They account for set construction costs in their budget at the time of commencing their project, without having any contingency in place for a potential rise in these costs, which commonly occur annually in the construction industry.
They are then forced to either borrow more money (if the bank will allow them to — any this rarely happens), or sell their unfinished project and cop a loss in doing so.
You must always have a contingency fund to allow for things like an increase in the cost of building materials and labour.
A downturn in the property market…
For reasons such as increases in interest rates, cyclical movement in the real estate market and depressed or unstable general economic conditions resulting in lowered property values or increased holding costs until properties are sold.
We are all too familiar with this in recent times, yet it never ceases to amaze me that people who have worked within the industry for decades still do not allow for this natural occurrence.
The most important thing to remember as a developer is that property markets move in cycles and you really need to understand all of the fundamentals that drive booms and busts in order to time the start and finish of your projects accordingly.
Ideally, you want to be looking at acquiring sites during quieter times and marketing your completed project during times of heightened buyer activity and demand.
Variations occurring in the real estate market between supply and demand causing adverse fluctuations in real estate prices.
As most property investors know, the different fundamentals that drive the property market determine the varying levels of supply and demand at any given time.
When consumer confidence is high and interest rates favourably low for instance, there is often increased buyer activity, creating heightened demand and pushing prices up as purchasers compete for sought after real estate.
Furthermore, social changes such as immigration of new residents, baby booms and decreasing household sizes all mean we need more housing to accommodate a growing and changing population.
So what does this mean to developers and how can it make or break the success of a project?
Essentially, if you complete your development at a time when demand is drying up for certain economic and social reasons, you risk making a small profit or none at all if on-selling, or having very little equity to release if refinancing.
This is because at times of low demand within the property market, prices tighten as more stock sits on the market for extended periods and motivated vendors start selling up for “bargain basement” prices.
This is why I suggest you need to know what drives supply and demand in the property market and the various economic and social fundamentals that cause prices to rise and fall.
When you understand what influences market movements up and down, you will have more chance of getting the timing of your projects right, to coincide with periods of increased demand and rising values.
This is critical when chasing that minimum 15 per cent profit margin as having your completed project languishing on the market indefinitely will eat away at your profit.
Disputes with building and other trade contractors.
This is one dilemma that poses obvious risks to any development for a number of reasons.
Firstly, such conflict with your builders can result in lengthy delays which in turn, mean budget blowouts as you must account for increased holding costs.
Additionally, having tradespeople walk off the job half way through necessitates finding an alternative builder.
Oftentimes builders brought into a project midstream will charge more to complete a job and the reality is, you will have very little bargaining power as they know you are caught between a rock and a hard place.
You must establish good communication between yourself and you builder and/or tradespeople right form the beginning and document all deals in a formal contract to minimise the risk of such disputes occurring.
Should any disagreements arise during construction, be diplomatic in your management of them and try to resolve them as quickly and cleanly as possible.
This is an area where a good project manager can really be of valuable assistance.
Changes to the laws relating to property development, including laws relating to zoning and town planning, restrictions on land use, environmental controls, landlord and tenancy controls, user restrictions, stamp duty, land tax, income taxation and capital gains tax.
In between acquiring your development site and obtaining planning permission, legislation can change and throw a spanner in the proverbial works.
It’s not unusual for local and state government to amend planning regulations at the drop of a hat so as a developer, you need to be prepared for almost anything!
Having a good understanding of the laws relating to property development at the outset can save you a lot of drama in the long run and speaking with your local council in the beginning to find out whether changes might be in the pipeline is highly recommended to minimise any nasty surprises.
When town planning approval is required for a development, unexpected delays and increased holding costs may be encountered whilst the application is proceeding through the council maze.
It is also possible that approval will not be granted or will be granted on unfavourable terms.
When it comes to getting your plans across the bureaucratic line, the best approach is to hope for the best but expect the worst.
Having a strategy in place to address any issues that may arise during the planning stage is critical; this includes having an exit strategy.
Account for possible delays in your project’s feasibility analysis and make sure you can cover your holding costs should the planning approval stage blowout indefinitely.
By taking these cautionary steps, you will be less likely to find yourself in a messy situation.
Additionally, make sure you have the right professionals on board who can assist you in addressing any town planning issues that arise.
Improvements you undertake may not necessarily result in significant increases in value of your property.
The most effective way to ensure you minimise the chance of this occurring is to do your homework!
Understand what sells and what doesn’t when it comes to design and quality in the area you choose for your development project.
Know your target market and what they want before you begin and if doing a renovation, avoid costly structural improvements and go for aesthetic changes that actually add real value.
Speak to local agents to gauge what buyers in the area are looking for so you know what you have to deliver.
Unexpected structural defects or building deficiencies that may be encountered resulting in unexpected expenses being incurred for repairs or refurbishment.
This one applies more to renovation projects but can mean big losses in profit margins.
In order to minimise this risk it is essential that you fork out a bit of money upfront for building and/or pest inspections from qualified, independent professionals before you sign any contract of sale.
They will be able to forewarn you of any issues with the building and you can then make an informed decision as to whether you go ahead with the deal or not.
Such issues don’t have to mean walking away from a potential project entirely as you may be able to use a building report to negotiate a cheaper purchase price.
Again, it all comes down to the numbers and whether at the end of the day, you can collect on that 15 per cent profit margin.
The risk conscious approach
The bottom line that you must keep in mind is that when buying any type of property, you should always look for the downside.
For instance, when calculating potential returns from rentals always take a pessimistic view.
Test your ability to finance the property under the worst possible conditions.
Assume that interest rates will rise substantially and that rental values will hold or even drop.
Also, don’t forget that you are required to pay tax on any rental income, so factor this into your cash flows.
If after these pessimistic calculations, you can still make a good return on a prospective property development, you can proceed knowing that even in a worst-case scenario, where the bottom falls out of the market, you will not lose money.
A good property developer learns to be risk conscious rather than risk adverse because the truth is if you never take a risk you will never make a gain.
The difference between successful and unsuccessful developers is that successful people take risks whilst constantly looking to minimise them.
In the next article of our small development series, Bryce will take a closer look at how to minimise risk by undertaking a detailed feasibility study.
If you want to learn more about the property development process you may be interested in How To Get Started in Property Development.
Originally published at https://propertyupdate.com.au on September 6, 2019.