Where do developers get it wrong typically every decade or so and what should they have done differently?
This article is mainly based on developers that are providing new residential units through conversion and new build. Many of the points do also relate to those that are refurbing and/or adding value through extending individual homes. Property development is a largely speculative activity with most of us being traders and historically only holding property when the market was/is slow. This is changing with many developers now building for the private rented sector through build to rent schemes. This is most definitely an expanding part of the sector and for many of us a great way to potentially mitigate the financial risk of development. More about that later.
Property development is an extremely risky business with both new and more experienced developers going out of business, even in strong markets. The numbers rise dramatically during softer markets which result from major political or economic changes and the repeating economic cycles. We have lost many £’000s in tough markets and fortunately made more in strong markets. We did not make money by being clever and lose money by being unlucky. Understanding what, how and when to buy and sell takes an element of economic understanding, courage and the ability to minimise risk whilst maximising margins.
Liquidation statistics are often 12 months or more out of date with many developers and developments subject to lengthy processes of land & project ‘step-in’ with fixed charge receivers. This leads to a false sense of the reality of current performance within the sector. We often find developers, investors and funders taking a very optimistic view over their projects and investments listening to and sometimes promoting an unrealistic picture. With so much information available to us and more sector experts and commentators than ever before its not difficult to find articles, stats and opinion that’ll support every view regardless of the reality. Hindsight is as they say a wonderful thing and many developers like me look back and say, “if only….”.
The market for homes is not driven by supply and demand which makes property unlike many other markets and seemingly unpredictable. In order to protect ourselves from whatever the future may bring then it is the past we should look, anything else is someone’s opinion based often on their wishes or agenda sometimes described as a ‘gut feeling’.
For some it’s believed that there is an 18-year cycle in the property sector with boom, decline, bust, growth, mid-term peak, small decline then growth back to boom. There are plenty of statistics that support this thinking however it’s not something that we should rely on as its only happened 3 times and even that is debated by some experts. House prices doubling approx. every 10 years is another belief that can be supported if you are selective with the statistics. Regardless of cycle frequencies it is clear that they do not prevent many developers, both new and experienced from judging the market poorly.
So how should we protect ourselves from market uncertainty and ourselves? Bear in mind that much of what I say and that said by leading developers like Tony Pidgeley (Berkeley Homes) and Mike Ingall (Allied London) is based on the mistakes that we have made over many decades. It is with great confidence that I say from all the successful projects I’ve been involved in I learnt very little, from the ok projects I took a few nuggets however it’s from the disasters that we build solid foundations for sustainable businesses.
So, what are the big mistakes that developers make which often lead to losses and quite frequently bankruptcy and how do we avoid making them?
1. Brand
Let’s start with something, possibly a little controversial which is more relevant now than in previous softer markets. That said developments by unknown smaller developers have taken longer to sell in all market conditions in many cases over the last decades.
Sometimes described as ‘packaged ego’ and in these days of increased presence through social media it’s the person behind the brand that is often promoted rather than the brand. We see a lot of focus on brand building and can all probably think of examples where a brand/person has achieved great reach and been able to gain financial and personal support for a business which has struggled and ultimately failed or is failing. Before social media neither success or failure received much exposure, people could be virtually anonymous. We are aware of dozens of investors & funders that have lost or will be collectively losing £millions from buying in to “brand”. In no cases that we are aware of is this significantly due to the soft market, it’s down to inexperience and overreach. I fully get the benefits of brand, what doesn’t work in property development is brand without substance.
How to avoid?
Less focus on brand building, concentrating more on the product which will become the brand. The company will have a name and associated brand identity and the marketing should be professional using modern tools such as CGIs. It may be changing however homebuyers rarely buy a brand, they buy based on price, location and available choice.
2. Scaling a business too quickly.
We seen developers both experienced and many new to the sector take on projects beyond their core team experience which may be thought to be achievable by the “you can achieve anything” mindset. Ambition is a wonderful thing unfortunately in many cases people want to achieve their goals really quickly through accelerating growth. We’ve seen people taking on 100 units plus for their first project which for most of us doesn’t make sense and ultimately hasn’t worked out well for those involved. The continual message of the UKs shortage of homes has led some developers to believe that wherever they build homes they will sell, and some have taken on multiple sites which have stretched their resources, so projects become poorly managed and issues are not identified early enough.
Of course, we all know of brands/businesses that have grown turnover exponentially, question is are they profitable?
AMAZON has made less than $8b in 20 years after becoming a public company and it took them 18 years (1995 – 2003) to make a profit. In the same 20-year period Apple made $327 billion and was profitable from year 1.
UBER reached bookings of $50 billion in 2018 with a $1.8 billion loss on $11.3 billion revenue. In its short history since 2009 its never posted a profit however is valued at $120 billion.
TWITTER eventually reached a profit, c$100 million after 12 years, just as growth peaked so profit could be a temporary situation.
SPOTIFY finally posted a quarterly profit in 2018, after 12 years. Forecasted to still make a loss over the year of between $227 million to $409 million.
TESLA has only been profitable in 4 quarters during its 15-year history and following its 2019 first quarter loss of $702 million and second quarter loss of $408 million is forecasted to continue losing money through 2019 and early 2020.
Whilst turnover in tech companies has been of greater interest to investors than their value it’s not the same for property development investment. What about companies operating within the property sector?
WeWork continues to lose money, 2017 net loss of $933 million followed by a net loss in 2018 of $1.9 billion.
Property development companies need to show decent returns from an early stage, early projects will often see lower profits due to inexperience however to keep attracting funding profits are key. Scaling a property development company can be achieved quickly particularly in a strong market where value increases mask the problems.
How to avoid?
Any business needs a solid foundation especially before scaling so ensuring that there is a full understanding of the development business from acquisition to exit within or accessible to the developer. Taking on projects within the teams’ capabilities both in understanding and available time. Larger projects should be capable of phasing so we can slow down or even stop if sales are slow. Avoid large scale (20-30 units max) conversion projects as phasing is virtually impossible and they are generally heavier on cashflow/borrowings. Interesting that many new to the industry favour conversions as its seen as an easier route in.
3. Cashflow
The underestimation of cash required to fund a project and how cash flows through a project from pre-acquisition to post completion causes many new and experienced developers to struggle and ultimately spending much of their time raising additional cash. When applying for development funding experienced funders will look at cash flow projections with great interest generally this tells how experienced the applicant/developer is and where the risk may be. The upfront cash required to fund a project is often underestimated as the simple method that many use for assessing deals allows for maximum borrowings and these to fund the project month by month. There are some costs that funders do not pay, and project valuations can often cause issues between developer and contractor/s. When the market softens the biggest impact on cashflow is the sales rates and amounts.
How to avoid?
Know what the unknowns are and make a budget allowance. Do not accept that there are unknown unknowns this is simply incorrect, we always know what they could be for every project. Confused by the last 2 sentences? Then you need someone with experience to explain, no apologies for this as the unknowns are very different between projects and without someone experienced with the size, type and location onboard they will be missed.
Overpaying for a site, underestimating the costs and end values is something that many developers experience, some through naivety and some through arrogance. Residual land valuation identifies a range of values that a site can be worth, the valuation contains many variables so a site can be worth different amounts to different developers/buyers. A huge topic to be discussed in a future edition.
Avoid developing high value units (values vary between areas e.g. in Shrewsbury anything over £400k is very hard to sell currently and in Norwich that value rises to £500k) as they are always the first to feel the softening market with time to sell often moving form weeks to months and in some case years. Higher value units generally provide a low rental yield so financing them away from development funding is difficult without leaving large amounts of cash in.
The biggest unknown is how much and when the revenue will come in. For projected unit values use a mixture of actual statistics and trends. Land registry data on prices paid is available by house type, location and period which gives a very accurate picture of prices, price movement and trend. Other market data is available on www.home.co.uk which we use for year on year data for house type, and location, this provides a great indication of volume of sales, availability and time to sale.
Having agreed exits for some or all the units upfront will largely derisk this. Building to rent for yourselves or others is a great option for some sites. Working with end funders to understand how many units you may be able to keep and at what cost is part of a project development appraisal. Keeping all units with no money left in may be theoretically possible however few projects actually achieve this. Build to rent could be considered counter cyclical. Forward selling larger sites to funds for rental is also becoming an option, funds are often looking at £20 million minimum value purchases. Selling a whole site or numbers of units to Housing Associations is another great way to derisk a project and accurately predict cashflow.
4. Inexperienced team
In their naivety and sometimes rush to grow, new and scaling developers are guilty of taking on inexperienced consultants, contractors and team members for their projects. Its fair to say that ‘streetwise’ consultants and contractors are often found exploiting the naivety and lack of interest with high fees and costs. This is a lot more common than is openly spoken about and in some cases a project becomes consultant led which inevitably increases costs and timelines.
How to avoid?
Become a lead developer or as we often say the “conductor of the orchestra”, you don’t have to play all the instruments. Learn what to ask, when to ask, who to ask and why you are asking. Do not over leverage your time, stay interested and involved throughout, if you leave too much to others results will suffer.
Adding value, reducing costs and creating margin are essentially the key skills of a developer.
5. A few other tips
The size of project should relate to the strength of your team and partners, doesn't have to be small. Most importantly you need to 'feel' ok about the project.
If you are a 'positive' person then make sure you have someone to keep you grounded, positivity is fantastic providing it is channelled in the right direction. Be very careful of who you listen to and who you get involved with.
Do not get involved in a JV without fully understanding what it could mean.
Don’t become a motivated buyer.
Be clear on funding costs and any through funding issues.
Make sure that your projects are at different stages at any one time.
Don’t assume people are doing what you want, be clear with expectation from all sides.
Consider the ‘what-ifs’. Do your sensitivity analysis.
Learn to appraise an opportunity properly, not just at high level.
Don't specify stuff because it's what you like without gauging opinion, we use agents and interior designers. You should view show units to get ideas too.
Pay attention to the exterior especially the front. Remember regardless of what 'wow factors' on the inside prospective purchasers first and last view is of the outside.
Don't get 'sold' expensive kitchens & bathrooms, generally they will be too good for your development. Match the spec with the price/end user.
Buy the skills/services/products in at the appropriate prices. Procurement is an area where 'most' think they get great prices which generally equates to a great sale by the supplier.
Don't dress the property yourself unless you genuinely are talented, not wanting to be rude however lots of people think they can do this and often don't really have the skills. Leave it to the pros.
Property development is a get rich slowly, get poor quickly business.
Be prepared to work very hard and long.
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