Short term development projects – what investors should consider before investing

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We have been involved in property development for many years and follow some basic guidelines which we thought would be helpful to share with our readers. There is a general perception that the property development sector is the domain of larger institutions or special development companies and that smaller investors do not have access to it.  It is certainly true that historically, individual investors have struggled to enjoy the rewards the sector has to offer.  This is simply because of the high investment levels involved.  However, with the right structure and approach smaller investors can enjoy excellent returns from low risk projects.

When considering undertaking or investing in a development project it is worth noting the following:

The basics

  • Buy the right site
  • build it for the right amount
  • sell the units in the agreed time frame
  • for the agreed end values

Property development isn’t very complicated if the basics are followed.  The best approach is to take on a project that shows an acceptable return and then focus on producing that return.  Some people will argue that the aim should be maximise the return.  We disagree.  The aim should be to produce the profit that was deemed acceptable and not take unnecessary risks which would jeopardise achieving this.  We all want to make more money, but not at the risk of losing money.  It is all about preservation of capital with an attractive return.

The right structure

There are several ways a development project can be structured:

  • Investors buy the site with the developer acting as Project Manager on a fee/profit share arrangement.
  • Investors lend money on a secured basis to the developer, either as primary or mezzanine finance. This typically involves a set interest rate/return to the investor.

 

The suitability of the above will depend on the project and the wishes of the individual investor.
Detailed agreements should be entered into which clearly set out the obligations of the developer and protect the interests of the investor.

The location

Some developers believe there is always demand from more wealthy people so they focus on top end properties in prime locations.  Other developers argue that is always demand for standard family homes in medium income areas as this where the majority of people want to live. Developers at the low end will point out that there are always people looking to get on the property ladder and who don’t have mountains of cash to invest.  Each argument has its merits and it all comes down to individual preference.

The important issue is whether there will be buyers for the completed properties at the prices you expect in that specific location.  People live in high, medium and low income areas and the key is the demand that exists there.  If there is an over supply of properties, or vast tracts of land waiting to be developed, you may struggle to sell the properties which will affect the investment time frame and return.

The country in which the development is being undertaken should have a stable political environment, a good legal system and a transparent tax regime.  The investor is not going to live in the completed property so whether the lifestyle there appeals should not really matter.

Whether prices are rising in the location should not be the determining factor. The important thing is that prices are not expected to fall.   Any increase in property prices over the construction period should produce an enhanced return. See the danger of forward pricing below.

Forward pricing – avoid the temptation!

When compiling a feasibility study for a development project the easiest way to make it work is to inflate the prices that the completed units can be sold for.  This temptation must be avoided at all costs.  The question every investor should ask is ‘If these properties were completed and ready for occupation today, what would they sell for?’   The required return to the investor should not be dependent on prices rising over the construction period.   Of course, the properties may go up in value and be sold at a higher price and if so there should be an enhanced return.  However, they may not go up in value and the prudent approach is to base the investment return on today’s end prices. It means most projects don’t meet the expected profit requirement and therefore are not undertaken.  The good news is that the ones that do, will meet expectations.

Refurbishment or new build

It doesn’t really matter whether it is new build or refurbishment.   Some buildings need to be demolished, whilst some are structurally sound and can be refurbished.  It is less expensive to refurbish, but much depends on the specific project.  A general rule is that the more work you do on the property the greater the value you create.  Upgrading a kitchen or bathroom and adding a coat of paint won’t greatly affect the value.

A detailed budget

A detailed budget should be prepared showing ALL the costs.  This should be independently verified by an appropriately qualified person.  It should have an adequate contingency sum to allow for any unforeseen circumstances.  A fixed price building contract will reduce the risk considerably.  However,  this may prove to be more expensive as the builder will want to cover his risk by quoting an appropriately higher cost.

Independent due diligence

The following should be confirmed by an independent party before the investment is made;

  • Satisfactory planning approval
  • Construction cost and time frame
  • Professional services and fees
  • End sales values based on today’s prices

The right manager

Before you invest in a project you should confirm that the developer:

  • Has extensive experience in the sector
  • Knows the market in that location
  • Provides conservative estimates
  • Provides detailed and independent verification
  • Has formal agreements to protect the position of all parties

You will be entering into a partnership so it is important that you feel comfortable with the developer and his method of operation.

Summary

The above is just a brief note on some of the key areas an investor should consider before investing in a development project.  It is not exhaustive and each project will have its own set of issues and risks.  With the right due diligence and approach these can be minimised and the project will produce an attractive return for the investor.

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