Ritchie Clapson CEng MIStructE, co-founder of propertyCEO looks at how smaller firms can reduce their risks when turning property developer.
Anyone can develop property by buying a property or some land and then hiring various professionals to get to work. But it can be a risky business, even if you have years of experience in the building sector. So, if you are thinking of turning developer, here are a few thoughts on the five biggest risks.
Planning
Our current planning infrastructure originated in the 1950s, and today we are faced with local planning authorities that are under-resourced, over-stretched and demotivated. Planning applications that supposedly should be assessed within eight weeks (thirteen weeks for larger projects), nearly always take much longer.
The smart move is to avoid as much of the planning system as possible, and the Government has given us a tool for the job called Permitted Development Rights (PDRs). These rights allow us to change a wide variety of commercial buildings into residential use without having to apply for full planning permission. In most cases, we’ll still need council approval. However, with PDR’s there is a short and prescriptive list of things they can object to.
The council must determine the application within eight weeks – otherwise it is automatically approved. You will still need full planning permission if you are changing the elevations of the building, but that should not be contentious – the change of use is the important one, and with PDRs, the council’s hands are effectively tied.
Assumptions
There are a lot of variables that determine whether a deal works financially, and you need to make a lot of assumptions, especially at the outset. If you dial every cost assumption to the minimum, your numbers will project a hefty profit. Dial costs to the maximum, and you will show a loss. The trick, then, is to be as pragmatic as possible.
A good tip is when you are putting together your spread sheets, ensure you can’t see your overall profit percentage figure when you input your assumptions. If you can, then as you see your profit percentage figure reduce, there is a high risk that your subconscious will make your assumptions less prudent – it’s human nature. The solution is to input every assumption reasonably and only enter your target sale values (GDVs) afterwards. That way, you’ll only see your profit percentage AFTER inputting your cost assumptions.
Margins
An important piece of de-risking advice is always to target a 20% profit margin based on GDV (gross development value, i.e., your selling prices). So, if your units are expected to sell for a total of £500k, you want to target a £100k profit at the outset. You should also include a contingency budget of 10-15% of the construction costs. You won’t be able to predict the additional costs that will crop up as your project progresses, so you need to build in enough fat to ride out a few storms. And there will be bumps in the road; the trick is to ensure you are still left with a decent profit once you have crossed the finish line.
Also, don’t be tempted to target a fixed profit figure rather than a percentage. For example, you might think that targeting a £200k profit sounds pretty good. But if the GDV were £5million, you’d only make a 4% profit margin. It doesn’t take too many unexpected costs to wipe out 4%, so make sure that you stick to 20%, not simply a fixed amount of money you would like to make.
On-site
Risk can also crop up while your team is on-site. The most common problem occurs when developers fail to specify precisely what they want. A developer may have specified ‘a dozen internal doors’ in the tender, imagining (but not stipulating) nice oak ones with brushed aluminium handles. The builder can’t be blamed for installing cheaper doors, and while the doors can be changed, that involves extra expense. The lesson? If you don’t indicate what you want exactly, your contractor will likely install the cheapest available, so be very specific.
Exit
Always have more than one exit for your project at the outset. You may want to sell your finished units, but what if the market has tanked when you come to sell? The logical thing to do could be to refinance the project onto a buy-to-let mortgage and then let the units out until the market rebounds. On the other hand, if you were planning to rent out the units but the rental market bombed, then your plan B could be to sell. Either way, ensure you have worked out a Plan B at the start and that you know the numbers involved.
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