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Short term development projects: Do you need to like the location?

A remark often made to us by investors is that they have no interest in investing in, or may not like, a particular market.  Quite naturally, there are sometimes valid reasons for this. Just as some people won’t invest in pharmaceutical or technology shares because they think the sectors will under perform, some people will think the same of certain property markets.  If prices are not going to rise within an acceptable time frame, or the rental income is not attractive, having a passive, capital growth investment property make little financial sense.

Should the same thinking apply to a short term development project where the return is not determined by capital growth?  Of course, if prices are falling then it makes little sense to develop a property as the downside risk may too great.  The eventual return is likely to fall over the construction period and there is no way of evaluating this properly.   However, if prices are stagnant then as long as there is sufficient demand for the finished product at the prices the developer needs to make a profit, and the project is costed and run properly, capital growth is not a factor. If there is any, it will only enhance the return. Under these circumstances there is every reason to undertake a low risk development project in that market.

The Costa del Sol is certainly an example of a property market that has seen a major correction.    As a result of the property crash prices fell by over 40% and whilst the market is now slowly recovering general property prices are not set to leap forward and show staggering returns in the short term.  The good news from a development point of view is that few, if any, analysts and commentators are forecasting the market to fall further.  For example, the Sociedad de Tasación’s new housing market bulletin for 2015 reports that the average price of new housing increased by 2.9% last year, reaching a price level equivalent, in real terms, to those registered in the month of June 2002.   In November 2015, the General Council of Notaries reported that the number of housing transactions carried out reached a total of 34,918, which represents an increase of 7.3% over the same month of the previous year.  This meant 18 months of continuous growth.

Some investors will argue that there is still a lot of property available on the secondary market so it makes no sense to build new properties.  In certain locations and price points this is certainly the case.  According to a study carried out by Idealista, 59% of the advertised homes are priced at lower than €100,000, while 23% cost between €100,000 and €150,000.   The homes with prices between €150,000 and €200,000 account for 10% of those advertised, and those between €200,000 and €300,000 account for 6% of the total. Importantly, just 2% of these properties are priced at over €300,000.   So if you develop properties that are priced at over this figure there is certainly no oversupply.

As Mark Twain is commonly quoted as saying, ‘Lies, damned lies and statistics’. It is easy to be selective and use statistics to support a point of view.  The fact is, some months the figures (and hence the headlines) are good, some months they are not. This is what happens when the market bounces along the bottom of the price cycle.  However, with the general economy improving and demand from overseas buyers picking up, the worst is behind the Spanish market.

So what sort of investment returns should an investor expect from developing in Spain?  This will depend on the location, the sector and the risk involved. Securing a change of use for land to be developed may produce an excellent return, but the risks will be too high for most investors.  Refurbishing an existing building will involve much less risk.   It is all about doing the right due diligence, working with the right professionals and adopting a conservative approach.  With an investment period of two years or less, and double digit annualised returns on invested funds, the financial rewards can be attractive.

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Short term development projects – what investors should consider before investing

We have been involved in property development for many years and follow some basic guidelines which we thought would be helpful to share with our readers. There is a general perception that the property development sector is the domain of larger institutions or special development companies and that smaller investors do not have access to it.  It is certainly true that historically, individual investors have struggled to enjoy the rewards the sector has to offer.  This is simply because of the high investment levels involved.  However, with the right structure and approach smaller investors can enjoy excellent returns from low risk projects.

When considering undertaking or investing in a development project it is worth noting the following:

The basics

  • Buy the right site
  • build it for the right amount
  • sell the units in the agreed time frame
  • for the agreed end values

Property development isn’t very complicated if the basics are followed.  The best approach is to take on a project that shows an acceptable return and then focus on producing that return.  Some people will argue that the aim should be maximise the return.  We disagree.  The aim should be to produce the profit that was deemed acceptable and not take unnecessary risks which would jeopardise achieving this.  We all want to make more money, but not at the risk of losing money.  It is all about preservation of capital with an attractive return.

The right structure

There are several ways a development project can be structured:

  • Investors buy the site with the developer acting as Project Manager on a fee/profit share arrangement.
  • Investors lend money on a secured basis to the developer, either as primary or mezzanine finance. This typically involves a set interest rate/return to the investor.

 

The suitability of the above will depend on the project and the wishes of the individual investor.
Detailed agreements should be entered into which clearly set out the obligations of the developer and protect the interests of the investor.

The location

Some developers believe there is always demand from more wealthy people so they focus on top end properties in prime locations.  Other developers argue that is always demand for standard family homes in medium income areas as this where the majority of people want to live. Developers at the low end will point out that there are always people looking to get on the property ladder and who don’t have mountains of cash to invest.  Each argument has its merits and it all comes down to individual preference.

The important issue is whether there will be buyers for the completed properties at the prices you expect in that specific location.  People live in high, medium and low income areas and the key is the demand that exists there.  If there is an over supply of properties, or vast tracts of land waiting to be developed, you may struggle to sell the properties which will affect the investment time frame and return.

The country in which the development is being undertaken should have a stable political environment, a good legal system and a transparent tax regime.  The investor is not going to live in the completed property so whether the lifestyle there appeals should not really matter.

Whether prices are rising in the location should not be the determining factor. The important thing is that prices are not expected to fall.   Any increase in property prices over the construction period should produce an enhanced return. See the danger of forward pricing below.

Forward pricing – avoid the temptation!

When compiling a feasibility study for a development project the easiest way to make it work is to inflate the prices that the completed units can be sold for.  This temptation must be avoided at all costs.  The question every investor should ask is ‘If these properties were completed and ready for occupation today, what would they sell for?’   The required return to the investor should not be dependent on prices rising over the construction period.   Of course, the properties may go up in value and be sold at a higher price and if so there should be an enhanced return.  However, they may not go up in value and the prudent approach is to base the investment return on today’s end prices. It means most projects don’t meet the expected profit requirement and therefore are not undertaken.  The good news is that the ones that do, will meet expectations.

Refurbishment or new build

It doesn’t really matter whether it is new build or refurbishment.   Some buildings need to be demolished, whilst some are structurally sound and can be refurbished.  It is less expensive to refurbish, but much depends on the specific project.  A general rule is that the more work you do on the property the greater the value you create.  Upgrading a kitchen or bathroom and adding a coat of paint won’t greatly affect the value.

A detailed budget

A detailed budget should be prepared showing ALL the costs.  This should be independently verified by an appropriately qualified person.  It should have an adequate contingency sum to allow for any unforeseen circumstances.  A fixed price building contract will reduce the risk considerably.  However,  this may prove to be more expensive as the builder will want to cover his risk by quoting an appropriately higher cost.

Independent due diligence

The following should be confirmed by an independent party before the investment is made;

  • Satisfactory planning approval
  • Construction cost and time frame
  • Professional services and fees
  • End sales values based on today’s prices

The right manager

Before you invest in a project you should confirm that the developer:

  • Has extensive experience in the sector
  • Knows the market in that location
  • Provides conservative estimates
  • Provides detailed and independent verification
  • Has formal agreements to protect the position of all parties

You will be entering into a partnership so it is important that you feel comfortable with the developer and his method of operation.

Summary

The above is just a brief note on some of the key areas an investor should consider before investing in a development project.  It is not exhaustive and each project will have its own set of issues and risks.  With the right due diligence and approach these can be minimised and the project will produce an attractive return for the investor.