4 Major Risks of Developing Property
Over the past 30 years I have dealt and worked with some fantastic property developers who have created tremendous wealth from very humble beginnings. I have also seen some people get ‘lucky’ and confuse their luck for skill and, unfortunately, I have seen many others fail badly.
Property developing can be the most exciting and positive form of real estate investment if approached positively and with a full understanding of the risks involved. Unusually, the higher the risk the higher the return. Some developers achieve 100%ROE (Return on Equity employed) and can keep assets 100% financed because they utilise the profit earnt which becomes the equity and generates significant tax benefits as well.
Why is developing property risky?
What makes property developing risky are the things you can’t control. Namely property is:
- Long term – most projects can take 2-3 years, and larger projects even longer.
- Illiquid Asset – it’s worth more at the start and end of the project (unless the market has moved). There is a very small market for half completed projects, which usually results in the market buying them at a big discount.
- Economy – factors can change and impact your initial assumptions i.e. general conditions, interest rate movement, demand for property, changed banking requirements, competition etc.
- Speculative – there is no certainty. Just like a business you are making an educated guess at best, there are no guarantees when you start.
These factors make property development a complex business that requires a unique blend of skills to put together the best team to deliver a successful development.
The 4 Major Risks of Developing Property
When it comes to developing property, I believe the major risks that can be controlled are as follows:
- Permit Risk. Depending on the current zoning of the property and the proposed development you are considering, the time required to get the various planning approvals can be considerable. As a minimum you would expect simply permits to take from 6-12 months, and up to 2-3 years. Adequate due diligence before the property is even purchased is vital to a successful development.
- Finance Risk. How are you going to finance the project? How much money do you need to settle the land, pay development costs and commence construction? Have the banks lending criteria changed? What are the lending ratios, interest covers and, are pre-sales or pre-leases required? I have seen many new inexperienced developers get in trouble because they weren’t prepared for the changing circumstances.
- Selling Risk. The profit of your development is determined by the sales achieved before or after the development is actually finished. The ability to sell your development is subject to the markets condition at the time. You must understand at what stage of the economic clock your project will be when you sell it. Do you have a ‘back up’ plan if it doesn’t sell?
- Construction Risk. Your construction costs have a major impact on your developments profit; therefore it is vital that these costs are controlled. An underestimation of construction costs and/or variations, unidentified ground conditions, unnecessary time delays all have an impact on your construction and holding costs, which impact your project. A due diligence on your builder and his contract is vital.
As you can see, the property developer is the mastermind behind a property project; all of their activities should focus on reducing all the risks associated with the process. A property developer starts with a property or raw land and then has to de-risk the development process enough before the bank lends them the money.
A property developer must ‘expect the unexpected’ and plan for almost every contingency, or at least… that’s what successful property developers do.
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