Keep Calm and Stick to the Fundamentals

Housing affordability and the rapidly escalating property prices are issues that are being constantly highlighted, analysed and discussed across all media over the last couple of months. Almost every other day we keep coming across reports of new price records being set for properties, especially those with “development potential”. Even properties in fringe suburbs which were considered reasonably affordable six months ago are now fetching record prices as land bankers and developers furiously bid for properties to secure “developable stock” for the future. Especially in Auckland, the unitary plan has completely changed the development landscape; today if someone has even a 400sqm section, it could potentially be developed into 2-3 new dwellings depending on the underlying zoning. As a result, there are lot of people who are either doing or planning on doing property developments as a side gig.

However, it is easy to lose sight of the inherent risks of property developments in a buoyant market. Professional and experienced developers who have encountered economic downturns will attest to the fact that property development is a risky endeavour with a number of potential pitfalls. It is an activity that should be purely based on numbers and calculations rather than emotion. It is not an enterprise for the blindly optimistic but for those who are cautiously realistic.

In light of the current market environment, I believe it is good to review some of the basic tenets of developing property:

• The Profit is in the Buying- do your due diligence: Experienced and successful developers spend a lot of time conducting exhaustive due diligence on all aspects of a development prior to buying the land. Without a high level of due diligence, the price one pays for land is a huge leap of faith into the unknown and could have very serious consequences. For example, an experienced developer will ascertain the number of dwellings that could be potentially built on the land prior to committing to the purchase. Imagine if one paid a certain price for a property on the basis that 8 units could be built to find, post purchase, that only 6 could actually be built on the site. A reduction in two units could mean the difference between a project being reasonably profitable or a loss making one.
• Preparing a project feasibility: As a developer, one has to prepare a very robust feasibility for the proposed project at the outset. Doing this exercise will provide the developer with a good indication of the likely project margin and will also allow the developer to tweak a few variables, if possible, to potentially increase the project margin. If you do not have the required experience in preparing a feasibility report, reach out to someone who does and seek their help.
• Be Realistic: In a rising market, it is very easy to succumb to the prevailing optimism. A classic mistake that people make is to assume that the market will increase another 10%-15% by the time that the development is completed. This kind of flawed logic is often forwarded by developers who know that they have “over paid” for the land on today’s market value but it doesn’t matter because the market would rise 10%-15% by the time that their development comes to fruition; hence the project would still be reasonably profitable. However, one should consider the opposite side of the coin as well- what would be the consequences if the market does not rise or even worse, actually falls 5%-10%. This is called “stress testing” the project feasibility and most experienced and prudent developers will always stress test their feasibility.
• Find the Money: Another classic mistake that a lot of newbie developers make is to approach funders after having spent a lot of time and money on a project in obtaining the various consents. Prudent developers would talk to the funders right at the outset and ensure that the project being envisaged would be one that lenders would be willing to support. Prevailing market conditions are such that finding the funds for getting a development off the ground is quite tough. The bank’s appetite for such funding is extremely limited and often comes with pretty onerous conditions. In the non-bank market, there are only a handful of players who would consider funding developments and the policies and appetite for funding developments vary significantly among those players as well. So, it is extremely critical to engage with a funder early in the development cycle and get reasonable assurance that the project being contemplated would be something that the lender would support in 6-8 months once the consents are obtained. This also ensures that the developer becomes aware of the lender’s requirements very early in the development cycle and can work towards meeting those requirements.

While we are increasingly seeing acronyms such as FOMO (Fear of missing out) being bandied about in the media, it is important to remain calm and stick to the basic principles.
Parash Sarma is Client Services Director at ASAP Property Finance Specialists based in Auckland. Phone 021-864730. Email: parash@asapfinance.co.nz