11 Apr Managing Risk in Property Development
Whether we realise it or not, managing risk is something we all deal with every day. For example, the simple process of crossing a street involves a certain degree of risk which we manage without even blinking an eyelid. Imagine for a moment crossing a busy street without looking left and right, without gauging the direction and speed of traffic, and without gauging the distance of the street we are crossing. Thankfully most of us are very good at managing these everyday risks effectively.
But what about managing the risks of something as complex as a property development project? Well, whilst the risks are more numerous and greater in complexity there are still certain measures you can take to manage them effectively. Let’s take a look at some of the more notable risks in performing a property development project and how you can manage them effectively.
Risk #1 – Not Having Enough Knowledge
By far and away the greatest risk in property development is the risk of undertaking a project with insufficient knowledge. I have seen it many times before where individuals undertake their first project with sugar coated expectations of how easy property development is only to find themselves in strife half way down the track because they were not willing to invest in knowledge. How can you manage this risk and become more knowledgeable in property development? Well, there are two main options available to you.
Firstly, you can pay a project manager to manage your project. Project managers typically don’t become involved until the site is already purchased (so they aren’t generally helpful in the due diligence and financial feasibility stages) and they generally don’t get involved with development finance and marketing so you’ll have to be competent in these areas. Secondly, rather than pay a consultant a portion of your profit to manage the project, you could invest once in your own knowledge and reap the rewards project after project. After all, no one else is as committed to the project’s success as you are so it makes sense for you to be the one in the driver’s seat.
Risk # 2 Interest Rate Rises
As developers, roughly 75% to 80% of the costs of doing a property development are supplied by the financier. And obviously there is an interest levied on that finance.
While falling interest rates have a positive effect on the bottom line of a development project, rising interest rates have the reverse effect. Interest rates are not something we can control but in fact they have only a minor effect on the bottom line.
If you have a feasibility software program you can check the effect for yourself but if interest rates went up 1% over a 12-month project by rising 0.25% each three months the loss of profit on each townhouse is roughly $2,500. So instead of making say $100,000 per townhouse you would make $97,500. Hardly noticeable.
Risk #3 – Paying Too Much for Your Development Site
How do you manage this risk and ensure that you do not pay too much for your development site? Well, it all comes back to the number crunching prior to purchasing the development site. It is critical that a comprehensive financial feasibility is performed prior to purchasing a development site.
Given that a financial feasibility is only as good as the assumptions made in it, it is critical that you do your homework to ensure the accuracy of your assumptions.
As part of your financial feasibility you can calculate what’s called a residual land value. A residual land value is simply determined by estimating the project’s gross revenue then subtracting the various expenses (excluding the development site) and an adequate profit margin to leave the residual value of the development site. A residual land value will provide you with the maximum amount that you can afford to pay for a development site therefore ensuring you never pay too much.
Risk #4 – Purchasing a Lemon Development Site
Whilst we all understand the risk of purchasing a lemon car, few people realise that it is possible to purchase a lemon development site.
So how do you manage this risk and ensure that you do not purchase a lemon development site. Well, it all comes back to performing a thorough investigation of the development issues of the site, better known as a due diligence analysis. The due diligence analysis may be performed either prior to purchasing the site or as a condition of the contract. Either way, the performance of a thorough due diligence analysis should incorporate each of the following issues:
- environmental and heritage issues (e.g. presence of vegetation protection orders, heritage listed buildings etc.)
- flood issues (e.g. presence of a flood regulation line)
- geotechnical issues (e.g. presence of acid sulphate soil, contaminated soil, underground rocks, underground water, unstable fill etc.)
- service issues (e.g. proximity of services to site, capacity of services for the proposed development etc.)
- stormwater issues (is there a legal point of discharge, if not are adjoining owners amenable etc.)
- title related issues (e.g. presence of caveats, covenants, easements, encumbrances, interest details, administrative advices, unregistered dealings etc.)
- zoning issues (compatibility of current zoning to the proposed use)
Whilst a development site with the necessary local authority permits in place will have overcome most of these issues, it is nonetheless advisable to investigate the various issues as a matter of course.
Risk #5 – Construction Costs Blow Out
Construction costs are generally the greatest expense component in a property development project. As such, it only takes a slight proportional change in its cost to have a significant impact on the projects bottom line. So how do you manage this risk and ensure that a blow out in construction costs does not destroy your bottom line?
Well, the best way is to ensure that you use a lump sum fixed price and time contract. A lump sum fixed price and time contract is where the price is determined by the building contractor which includes all associated costs such as materials, labour and profit margin. As the name suggests, the contract price is fixed from the day the contract is signed.
If you have detailed plans and specifications the only things that will vary the price are variations to the contract such as wet weather etc.
Most financiers will insist on a contingency amount, often 5% of the construction price to be build into the price to cover variations.
Risk #6 – Building Contractor Goes Bust
By this point in a project most of the hard work has been done and you could certainly be forgiven for having your eyes fixed on completing construction and banking the settlement funds. However, all of this can change in an instant if your building contractor hits financial difficulty and cannot proceed with the works.
So how do you manage a risk such as this? Well, whilst circumstances can change quickly in the construction industry there is certainly a lot to be said for using a building contractor with a good reputation and a proven track record. As a developer you should feel free to make enquiries into the building contractor’s project history and financials. After all it is your money in the deal and your name as guarantor on the loan so there should be no reason to feel shy about asking for this sort of information.
On small projects building contractors take out warranty insurance. During construction warranty insurance covers against the building contractor becoming bankrupt or placed into liquidation and against the building contractor failing to complete the works under the contract.
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