Wanna be a developer?
Pre GFC, property developers had mythical rock star type status. The public face of the industry was full of massive egos, fast cars, illicit drugs, and self-absorbed “beautiful people.” Intelligence has never been a prerequisite to be a Property Developer.
During the last property boom, money flowed so easily out of dodgy finance companies you just needed an unhealthy dose of narcissism, and a big idea. The collapse of finance companies and developers wiped out a lot of money for Kiwis. It also led to poorer sales of essentials like Champagne, Ferrari's and high-class escorts. Of course there were always plenty of down-to-earth and hardworking investors going about their business, usually on a smaller scale and under the radar. Needless to say the “grafters” are still around whilst most of the show ponies are either bankrupt, in jail, or both. But enough flogging, it’s time to get building again!
We need more developers with the tenacity and doggedness to stand up to the council, push through the bureaucracy, and make things happen. Ideally this time around they might have some scruples too. Successfully doing a development isn't easy. I'm doing a couple of smallish projects in Auckland and have a number of clients who also dabble in development.
From my own experience, and what I observe, here is what you need to know:
Developers’ under-estimate time and cost, and make a habit of running out of cash. On my current project we’ve spent over $300,000 pursuing Land Use consent (which we don’t have yet) and its taken 9 months already. End-to-end, we are looking at 2 years from purchase to completion. It takes time, so pace yourself. If you are going to hold undeveloped land for any length of time you need to be able to service it at the same time as funding the resource consent. You never want to run out of cash. This can make for a very uncomfortable discussion with your bank. To negate these risks you might consider doing options over land, long settlements, and builder’s terms.
I like using Options. To create an Option you simply offer a non-refundable deposit upfront with a long period before you need to go unconditional. You also tend to put a higher price on the land. If you exercise the option it is because the development stacks up and you can afford to pay the landowner a bit more. Options eliminate holding costs and also reduce the risk of buying a lemon if everything hinges on getting resource consent. With builder’s terms, you simply get access to the land to start construction prior to settlement. Like any good business, make sure your return is commensurate with the risk. As a rule of thumb a good project will have a 25% margin over development cost. So a $15m project might have a margin of $3m. Not bad if you can pull it off!
For a $15m project you’ll likely need about $1m in free cash flow to fund the land and consents, about $3m of usable security and the remaining $11m can be bank funded. If you cannot find a project with a 25% margin – wait. A big mistake by developers is to accept lower margins and take more risk. Inexperienced developers (and non-residents) tend to underestimate our bureaucracy. The Auckland Council has been supportive of our plan for medium density, but ultimately it is still a lap dog. Friendly, but at the first sign of conflict it rolls on to its back.When it comes to funding, finance companies are almost extinct. There are a few small specialist Property Finance lenders. They’ll charge a 3% upfront fees and rates around 8.50%. Yes, they’re expensive (compared to cheap bank funding), but they are easy to deal with, because they focus on the security rather than on an ability to service the debt.
For a strong deal banks are prepared to fund with as little as 50% pre-sale, or even no pre-sale on smaller projects. To get into Development you’ll need to have a decent amount of cash upfront and ideally be able to service the debt through regular income. The professional developer who just moves from project to project will continue to find it tough in this market, so it might pay to do a joint venture and share the risk. Small developers may get away with doing their funding through a retail bank but unlikely. Banks have clamped down on how they define developers. As soon as construction costs go over $1m, and the project involves more than 2 houses you will find yourself in commercial banking and likely the Property Finance Unit (PFU.) Once in Commercial Banking, you can expect an upfront establishment fee of 1.00%, a line fee during construction of 1% and rates 1.50%-2.00% over cost of funds (around 5.50%-6.00%.) So on a $2m build you’ll have a fee of $20,000.
For small investors used to getting legal contributions and rate discounts, the first time you get hit with fees can come as quite a shock. Be a realist. Fees are the cost of doing business and it just needs to be factored into any feasibility study upfront. Let's face it, without the lender, there would be no development and the lender needs to make its return on capital over a short period of time. They do that through fees.
On a more complex project, consider using a specialist Broker to pull together all of the paperwork and get finance approved. That will cost around another 0.60% - 1.00% upfront. It’s well worthwhile, but I would say that! Developers know all about professional fees. On my current project we have a specialist Broker, an Urban Designer, an Architect, a Resource Management Consultant, a Traffic Engineer, an Arborist, an Acoustic Engineer, a Structural Engineer, a Civil Engineer, a Land Surveyor, an Archeologist, a Resource Management Barrister and then there are the Council fees, which have clocked up over $50,000 so far before we even get consent.
However, I don’t want to put you off. With a bit of spare cash, a great team of professionals around you, and a big dose of fortitude you too could do a development. That’s something for you to ponder over the holidays as you drive past lots of unused or poorly maintained land. There’s certainly no shortage of land if the price is right.