In this series article, I talk us through managing the risks associated with property development to increase the chances of success.
I’ve found that once many property investors who’ve collected a few properties in their portfolio become keen to “dabble” in property development.
They see this as the next phase in their career and determine that with the bit of knowledge they have gained buying and selling real estate, they’re all set for a successful transition into the world of planning, design and construction.
The fact is, getting involved in property development means entering a very challenging adventure.
There are many ups and downs.
It’s a bit like riding a roller coaster that leaves you wondering when the next highs and lows are coming.
In this section of our series on property development, I will explain some of the more common dilemmas that can plague even the most seasoned developer and discuss ways you can reduce such risks.
In giving you this knowledge, hopefully, you can be prepared for the bumps in the undeniably challenging road that you will face along the development journey.
Tenacity – the tool of successful developers
Most successful developers have one common characteristic that stands out above all else; they are tenacious.
Rather than give up at the first sign of a problem, they focus on solutions and dig their heels in to get the job done.
Without this type of conviction, you can lose heart very quickly in the development game.
Tenacious people succeed because they are driven by their goals.
They know that success doesn’t come instantly; it requires focus and determination.
Just imagine the pride you will feel when you find a way to get past obstacles such as:
- Looking at 50 potential development sites that are all too expensive and unsuitable, only to find the perfect property that has been snapped up before you even get the chance to look at it.
- Employing an architect who fails to follow your brief and instead constantly presents you with his own ideas, before you have to take control of the situation.
- Jumping through numerous hoops to get finance because you’re an inexperienced property developer.
- Starting to pour the foundations for your property, only to have the weather turn on you so that flooding rain causes the foundations to collapse.
You must stay positive and remain focused on your goals, even when everything seems to be going wrong.
Your hard work and tenacity will truly pay off when you finish your project and reap the financial rewards.
Crawl before you can walk
Property development has the potential to provide great long-term returns when the outcome is successful.
However, as with any new venture you intend to have a go at though, you need to crawl before you can walk.
Tips: If you are new to property development, the key is to start small and build your way up.
As you grow in experience and benefit from the profits of your early projects, you will be able to take on more ambitious challenges.
Tackling a small renovation, to begin with, is the best way to cut your teeth and determine if developing property is really a path you wish to pursue.
Importantly, starting small allows you to make mistakes that won’t send you bankrupt!
All developers make mistakes and being able to learn from small errors is just as valuable as learning the hard way – from the big ones.
How to make money whatever the market does
One of the most common questions I am asked by budding developers, particularly in recent times, is; what sort of profit can I make from a development project and how do I guarantee a profit in any type of market?
Realistically, as with any type of investment, the end has to justify the means when it comes to making money through property development.
In other words, the higher the risk, the higher the reward you should expect to gain.
As a general rule of thumb, with any development project, you should always aim for a 17 per cent return on your total development cost ( which translates to a much larger return on your invested capital) in order to maximise potential profits and minimise the risk of losing money.
A 15 per cent return gives you leeway to make a few mistakes and still come out with a reasonable profit margin upon completion of your development.
When planning your project and determining whether the risk will be worth the reward, quite logically it will always come down to the numbers and projected return on investment.
That is, the profit you make after you have sold the property or refinanced the property before tax.
This is typically called net profit.
A 15 per cent return means your (net) profit will be 15 per cent of the total development cost of your project, as in the following example:
Total Costs of project (including all fees, commissions etc) $1,700,000
Sale Price $2 million
Net Profit $300,000
Therefore the return on the total development cost is 15 per cent (300/2,000,000), although the return on your invested funds, which may only be $500,000 (assuming you borrowed the balance) could be up to 60 per cent.
Why should you always look for at least a 15 per cent return?
I suggest this rate of return based on my experience in property markets over the years.
Property markets falter and even crash!
They always have done and will continue to do so – it is just the nature of the cyclical manner in which they move.
With this in mind, a 15 per cent margin is a good compromise between providing a safety cushion in case of sudden fluctuations in the market, and being an achievable and maintainable target.
If you work on a 15 per cent margin you will:
• Make good money in a good market
• Make sufficient money in a bad market
Obviously, if you firmly believe that the property market is about to crash, you wouldn’t enter into development.
The risk would simply be too great for any potential reward.
However, if you stick to the 15 per cent rule, you will learn to be highly disciplined and effective in your negotiations.
Crucially, you will learn to walk away from a deal when it is too risky.
Managing risk
One of the biggest mistakes you can make as a beginning developer is to assume you know everything there is to know.
Even though I have been involved in development professionally for years, I still consider myself a learner in many respects.
I have seen many a developer – both new to the game and old pros, take some very big tumbles that have lost them a lot of money.
Let’s take a closer look at how the mighty can fall.
Developers nearly all start with one small property; they invest in that property and make a profit – based on a 15 per cent margin.
They then take that profit and buy a bigger property, again to which they make improvements and gain a further 1 per cent margin.
Next, they take the profit from this second property and perhaps buy an even bigger property or perhaps a further two and so on.
Five years later they’re worth $4 million; all of which is invested in property.
However, when they started they demanded a 15 per cent return, whereas they now have to accept 10 per cent because the market is booming and they can no longer acquire properties at a price that will allow for that 15 per cent profit margin.
The double-edged sword is that if they stop buying property they could realise their total profit, but they would also be out of business.
So in desperation, they break their golden rule and buy at smaller and smaller margins and when the market inevitably drops once more, they lose everything.
In order to protect yourself from this common trap, I suggest that you adopt the following two key principles of successful property development:
• Always aim for at least a 15 per cent return on investment and if that return is not achievable within any potential project, walk away and wait for the next opportunity;
• Your development must always work financially regardless of whether you choose to on-sell the completed project or retain it in a long-term hold and rent scenario.
On the second point, as I have already mentioned previously in this series, in today’s property climate it’s advisable to hold property for the long term and refinance in order to use your profits to move into further investments and developments.
If you do intend to buy, develop and on-sell, you should always ask yourself; “if the market crashed tomorrow, what rental income could I expect from this property and will that cover my financial costs – even if interest rates rise?”
In the next segment of this ongoing series, I will consider the common development dilemmas a property developer is likely to face.
If you want to learn more about the property development process you may be interested in How To Get Started in Property Development.
You may also be interested in reading our Team Series or check out our graphic guide to the Property Development Process.
