Manufactured equity
Instead of buying a newly completed building at market value, a property developer can develop a similar building at 15 to 20 per cent below market value. This is generally known as the developer's margin, with the agent's commission, marketing and other costs usually included in the price of the sale. By holding property as an investment the developer has automatically created a manufactured equity. This means the rental yields will be higher than for someone who bought their property at market value.
Equity build-up
Apart from the manufactured equity, developers can hold properties as long-term investments to improve their equity position as inflation is constantly increasing the value of their equity. This equity can be used to provide a deposit for another development or sold and leveraged for a larger project.
Pooled equity
Developers working on larger projects can establish a syndicate of investors to provide additional equity. This pooled equity allows access to investment in larger development opportunities, markets and diversity that might not be available to individual investors. A developer can also enter a joint venture or partnership with landowners to share the required equity for a new development.
Easier refinance
Once the development is complete, the developer can approach lenders to refinance their property. If an 80 per cent loan can be secured based on the retail value when completed, then the 20 per cent is close to the manufactured equity, which allows the developer to take out their initial equity. Banks are usually comfortable with this as they are not financing development risk and the loan will always be underpinned by the security of real estate.
All these benefits allow the developer to grow their property portfolio faster than by investing in established properties. Developers can be owners of high-growth properties that cost them less to own and at the same time provide generous returns on the initial equity plus tax benefits.
All investments are subject to risks. They may go down in value as well as up, and investors can experience investment losses as well as gains. Different types of investments perform differently at different times, having different risk characteristics and volatility.
There are many risks (of varying degrees) associated with property development, including market risk, leasing risk and construction risk. It is imperative that a developer understand all these elements and mitigate the risks by applying certain strategies and targeting a return relative to such risks.
General risks
General risks that can affect a development include:
• Economic risk: Returns are affected by a range of economic factors, such as changes in interest rates, exchange rates, inflation, general share market conditions or government policies, fluctuations in general market prices for property, and the general state of the domestic and world economies.
• Taxation risk: Tax returns from any development may be influenced by changes in taxation laws or their interpretation.
• Terrorism risk: The unpredictable nature and social and physical destructiveness of terrorist events may affect the earnings and attractiveness of investments, resulting in losses.
Market risk
Any change in property market sentiment during the construction of a project may influence the price and the targeted return. This can affect the profitability of the project and/or the developer's ability to repay the construction loan. To mitigate this risk the developer should undertake thorough market research and analysis into the type of property and the market needs in the area.
Development risk
Risks associated with any property development may include:
• Planning approval risk: Planning approvals for a project may be delayed or denied for a variety of reasons. This can affect the time it takes to commence or complete a project.
• Interest rate risk: Upward movement in interest rates may affect the profitability of projects.
• Legal and regulatory risk: A project may be affected by changes in government policy and/or legislation.
As part of a project's due diligence, the developer should review the project feasibility report prepared by experienced consultants in the planning and approval process. Depending on the risk profile of the project, these risks may be mitigated by fixing interest rates, imposing pre-sale requirements or investing only after development approval has been obtained.
Liquidity risk
Unlike other commodities such as shares or bonds, property cannot be traded on a daily basis. A developer may plan to develop a property for a quick sale but may be stuck with the property if the market is in a downward trend. Property is generally sold with conditions and these could delay the flow of funds and hence the developer's cash flow. To mitigate this risk, it is advisable that the developer has a contingency cash reserve for this eventuality.
Borrowing risk
Borrowings will magnify gains or losses and increase the volatility of returns. Volatility will result from fluctuations in interest rates and risks associated with refinancing loans once the terms expire. A way of mitigating this risk is for the developer not to leverage or gear too highly. Depending on the project's risk profile, the developer should aim not to exceed debt levels of 65 per cent of the final asset value or 70 per cent of the total development cost.
Risk of bad purchase
A developer will always face the risk of paying too much for a development site, buying in the wrong location or failing to obtain the development approval (DA) for the type of building they envisaged. This can happen if the developer is impatient and does not obtain the correct market information or is influenced by an overzealous real estate sales consultant. The risk of a bad purchase can be reduced by better negotiating skills, more extensive market research and making settlement conditional on securing a DA.
Construction risk
During the construction phase of a development potential risks can include the following:
• The construction costs for a project may exceed the budget, which will reduce the potential profit from the project.
• The construction period may exceed the projected building schedule, delaying settlement of sales and/or leasing of the building.
• The builder may run into financial problems and may not be able to complete the building, requiring the developer to employ another builder, which could ultimately increase costs.
To reduce these potential risks, the developer should appoint reputable and experienced contractors who have adequate insurance cover and sufficient financial resources for the type of works for which they are engaged.
Business failure
All types of business are subject to the risk of business failure and property development is no different. It can be a result of bad management, a decline in the local economy, change in consumer tastes or bad timing, for example. Good management, careful market research and creative marketing can help to reduce this type of failure.
Minimising risk
The aim of the developer is to minimise these risks as far as possible. Some additional strategies that can be applied are listed here.
• Allow for contingencies: To protect against financial risk during the purchasing stage, prepare for various contingencies in the contract.
• Diversify investments: Diversification of development and investment activity into different building