Managing Risk In Property Development
To be honest, this probably wasn’t the catchiest article title I could have come up with. It all sounds a bit dull and worthy, up there with “101 Compliance Tips” or “The Hottest Hi-vis Colour For 2023”. But I can’t get away from it; it rather cuts straight to the chase. Property development is inherently risky, and managing that risk is one of the developer’s most important jobs. So, here’s an article that, in a moment of Ronseal-ness, does exactly what it says on the tin.
I should probably set a few expectations at this point. The devil is in the detail when it comes to development, so I won’t be able to steer you through every risk in the few words that I have here.
But hopefully, I’ll be able to cover some of the more important points and keep you on the straight and narrow. I want to guide you through some critical areas that combine the most significant risks and the ones I see people get wrong most often. Let me start with one of the most significant risks of them all, which is good old planning.
In case you’ve been living under a rock or have recently arrived from another galaxy (hi and welcome), I should tell you that the country’s planning system is broken. This is an immutable fact that only the brave or foolishly optimistic choose to ignore, although the path is still well-trodden by the unwary and the uneducated. Successive governments have consistently failed to grasp the nettle in fixing the problem since doing so invariably involves getting stung, at least at the ballot box, which is a singularly painful experience if you’re a politician. Everyone wants to end the housing crisis, and no one wants new houses built anywhere near them. This dichotomy logically left us with two potential courses of action; either we build some huge new towns and cities in the middle of nowhere, or the powers that be sit on their hands and kick the can down the road. I’ll let you guess which option we ended up with (clue: Milton Keynes b.1967 is still the biggest new town in the country). The required solution is to build lots of houses where people need them, but no one really fancies taking that one on politically, lest we add to the current record tally of deposed housing ministers.
So, we are where we are, at least for now. The prevailing situation is one where we have an outdated planning infrastructure that originated in the 1950s and a nation of local planning authorities that are under-resourced, over-stretched, demotivated, and where nearly all the most experienced people have long since left. And while your planning application form promises to be assessed within eight weeks (thirteen weeks for larger projects), the reality is nearly always a much longer wait. These days it’s all too common for applicants to be told seven and a half weeks down the line that they need to submit further information, e.g., by undertaking a survey of some description. When this happens, the clock is effectively reset, and you now need to spend more time and money jumping through some hoops with no guarantee of a successful outcome. Some applications have been in limbo for years. And if you’ve already bought the property in the expectation of getting planning permission, you’ll not only be racking up finance costs while you wait, your property may even go down in value if planning is eventually refused.
So, what can be done to avoid this rather challenging situation? The answer is to legitimately try and dodge as much of the planning system as possible. To that end, the government has given us a rather nifty tool for the job called Permitted Development Rights (PDRs). These rights allow us to change the use of a wide variety of commercial buildings into residential use without having to apply for planning permission. In most cases, we’ll need council approval; however, there’s a short and prescriptive list of things they can object to. So, you already know what boxes you need to tick before you apply, plus the council must determine the application within eight weeks, which means you can move relatively quickly.
You still need to get full planning permission if you’re changing the elevations of the building, but that shouldn’t be contentious – the change of use is the biggie, and with PDRs, the council’s hands are effectively tied. Not all PDRs are equally attractive; my favourite is class MA which allows us to convert most commercial property types (offices, shops, light industrial, etc.). Why do these PDRs exist? Well, the government has worked out that we have around four years’ worth of new homes that could be built on redundant brownfield sites. And given that most voters won’t object to developers turning unused commercial buildings into much-needed accommodation, they’ve been quick to encourage it. In summary, if you’re looking to de-risk your first project, I would strongly advise you to go down the Permitted Development route as it’s likely to be quicker and more certain.
On a related point, could you buy a project that already has planning permission granted and so avoid the planning risk? The problem with this approach is that the vendor will have already built the planning uplift into their asking price, meaning there’s less profit for you. As a result, the successful buyer will either be the person who can build it the cheapest or for the least profit. Or they’ve got their numbers wrong. None of these options should be attractive to you, and if you think they’ve missed a trick with their planning application (e.g., you believe there’s scope to squeeze in another bedroom), then you’re back to square one – having to submit a new planning application.
The next risk I want to talk about involves massaging. Before you whip out the baby oil, let me assure you I’m (quite literally) speaking figuratively. Because one of the biggest mistakes I see new developers make is massaging their numbers to make their deals stack up financially. Now, I know you’ll swear blind that you wouldn’t dream of doing such a thing; you’re far too sensible and pragmatic. But here’s the problem; you won’t necessarily notice that you’ve done it. Our subconscious is a potent tool, but it sometimes plays tricks on us. Let’s be honest; we WANT to find a deal that stacks up. There’s no reward in finding deals that don’t stack, so we’re pre-disposed to hope that every deal we look at will be profitable.
There are a lot of variables that determine whether a deal works financially, and you have to make a lot of assumptions, certainly at the outset. If you dial every cost assumption to the minimum, your numbers will project a substantial profit. Dial them to the maximum, and you’ll project a loss. The trick, then, is to be as pragmatic as possible. Don’t fall into the trap of being just a little optimistic here and there – it can trip you up big time.
I would also ensure you can’t see your overall profit percentage figure WHILE you input your assumptions. If you can, then as you see your profit percentage figure reduce, your pesky subconscious will make your assumptions less prudent so that you have the best possible chance of making an acceptable profit. My strong advice is to input every assumption reasonably and only enter your target sale values (GDVs) afterwards. That way, you’ll only be calculating a profit percentage AFTER you’ve input your cost assumptions, and it should be an honest one.
My next piece of advice is to make sure you always target a 20% profit margin based on GDV (gross development value, i.e., your selling prices) and to include a contingency budget of 10-15% of the construction costs. So, if your units are expected to sell for a total of £500k, you want to target a £100k profit at the outset. This lies at the heart of development risk management. You cannot predict all the issues that could crop up during your project and impact your profitability, so you must build enough fat to ride out a few storms. And trust me; there will be some bumps in the road. The trick is to ensure you’re still left with a decent profit once you’ve ridden them out and crossed the finish line.
Also, please don’t be tempted to target a specific £ profit figure rather than a percentage. I remember a developer who once targeted a £200k profit because they thought that was a nice amount of money to make. The problem was their GDV was £4m, which meant they were only making a 5% margin. The mathematicians among you will have already worked out that a 5% margin can be eroded a lot more easily than a 20% one, so stick to percentages rather than values.
On the subject of numbers, there’s another key thing you need to do BEFORE you commit to purchasing a project, and that is to make sure you’ve firmed up as many of your numbers as possible. You won’t be able to nail them down completely, but a common mistake is to leave too many figures as ‘reasonable assumptions’.
And this can catch you out. The problem occurs because development doesn’t involve doing a deep dive into every potential deal. You don’t want to spend ages firming up numbers only to find that the deal doesn’t work. Far better to put in some reasonable assumptions initially and then only firm up numbers if the deal stacks. As a result, there can be a tendency for a developer to get lazy and assume that some of their initial assumptions will be just about right. Big mistake. Go through the exercise of nailing down as many of your numbers as possible, and you’ll reduce the risk of seeing nasty surprises down the line.
You must consider risk throughout your project, not just at the deal sourcing stage. A problem crops up when developers do a poor job of specifying what they want when tendering for pricing. They’ll approve a schedule that requires the contractor to quote for a certain number of doors, door furniture, power sockets, and the like, but they don’t make it clear exactly which door make and model or type, etc., they want. Then, when the bid-winning contractor installs doors so thin they blow open when someone sneezes, the developer pushes back, saying, ‘that’s not what I wanted.’ But a door’s a door, and the contractor has delivered what was on the finishes schedule. Of course, the same contractor is happy to change them for those lovely oak doors you wanted, but that will be an extra £5k on the bill; thanks very much. You can avoid the problem to a great degree by being ultra-prescriptive on the specification from the outset.
My final piece of advice surrounding risk mitigation is about having multiple exits. Every airline under the sun will explain to its passengers how to get out of the plane in the event of an emergency. Experience has taught them that it’s more effective to do this BEFORE they’ve taken off when there’s no emergency rather than try and explain the finer points of safe aircraft evacuation when the engines are on fire and the cabin’s full of smoke. You need to adopt the same approach – ensure you have a Plan B (and maybe a Plan C) right from the outset. The most obvious scenario occurs when you plan to sell your units, having built them, but something has made that route less profitable. Perhaps the market has tanked at the wrong moment, and you want to wait until prices rebound before you sell them. In this case, the obvious solution is to switch (at least in the short-term) to a build-to-let strategy. Simply refinance the properties onto a buy-to-let mortgage and pay back the development finance company and any investors. You can then rent out the units while you wait for house prices to bounce back. Conversely, if you were building to rent and the rental market proved challenging, you could flip to a build-to-sell model. The critical point is that you want to nail these potential solutions at the start, and your commercial lender will likely insist that you’ve got a Plan B worked through before they’ll lend.
There, that wasn’t so painful, was it? Hopefully, you didn’t find it too dull. Given that I’ve mentioned massages, baby oil, extra-terrestrial visitors, and a possible air crash, it was probably a bit more exciting than you’d expected, in which case I hope I’ve over-delivered. And if you’re still in the market for some new PPE and are wondering which colour hi-vis jacket to go for this year, be sure to tune in next month.
My final piece of advice surrounding risk mitigation is about having multiple exits. Every airline under the sun will explain to its passengers how to get out of the plane in the event of an emergency. Experience has taught them that it’s more effective to do this BEFORE they’ve taken off when there’s no emergency rather than try and explain the finer points of safe aircraft evacuation when the engines are on fire and the cabin’s full of smoke. You need to adopt the same approach – ensure you have a Plan B (and maybe a Plan C) right from the outset. The most obvious scenario occurs when you plan to sell your units, having built them, but something has made that route less profitable. Perhaps the market has tanked at the wrong moment, and you want to wait until prices rebound before you sell them. In this case, the obvious solution is to switch (at least in the short-term) to a build-to-let strategy. Simply refinance the properties onto a buy-to-let mortgage and pay back the development finance company and any investors. You can then rent out the units while you wait for house prices to bounce back. Conversely, if you were building to rent and the rental market proved challenging, you could flip to a build-to-sell model. The critical point is that you want to nail these potential solutions at the start, and your commercial lender will likely insist that you’ve got a Plan B worked through before they’ll lend.
There, that wasn’t so painful, was it? Hopefully, you didn’t find it too dull. Given that I’ve mentioned massages, baby oil, extra-terrestrial visitors, and a possible air crash, it was probably a bit more exciting than you’d expected, in which case I hope I’ve over-delivered. And if you’re still in the market for some new PPE and are wondering which colour hi-vis jacket to go for this year, be sure to tune in next month.