Developing and Mistakes?

[whitt]

Have you developed or built spec homes? Made mistakes?

Many forum members have been around in investment property game for several cycles. Kierans Book on the Property cycle mentions to look at purchasing property from developers whom may have come into difficulty at the turn of the cycle.


Out of all of these members who has built or developed Spec homes to sell off?

What mistakes have you seen or made in the past?

Have you lost $$ at the turn of the cycle?

Any suggestions on how to stay safe?


I have a few ideas but would like to hear from anybody who has been there done that first hand.

Thanks

[Muffin]

Whitt,

Started this last night before an ADSL crash, so will try again. A friend and I built a semi major development in 2002 in Sydney at the height of the market, we got out before the crash, but not before making a host of mistakes. And yes we made a profit, a good one at that but there was a lot of dumb luck involved.

For background I inherited the site no.22 (a four bedroom house) in a good suburb of Sydney in 1995, it had been rented while I went through uni and started my working career. A good friend of mine owned the house at no. 28 (inherited from his grandmother), basically we met when we were very young and stayed friends. In 1999 the no. 24 came up for sale on the death of the owner, we bought it at auction (and paid over the odds at the time). In 2001 no. 22 came up for auction, we purchased prior and then we offered no. 26 an above market rate to complete the five blocks.

The five blocks all have dual access, all the houses were on a significant slope. Both streets are cul-de-sacs.

We submitted plans to council. First mistake... We put the application together with the architect. The council rejected them flat out for a number of reasons. We went back to the drawing board, but hired a development consultant (basically an ex-planning officer), for a cost of $20,000 the new plans sailed through. We had to provide a lot of parking (the area is notorious for parking) and we needed to make the design match the area (most houses were built in the 1930s, were brick and very spacious).

Second mistake, the bank, there are two prongs to this mistake. Combined we had an excellent asset position, cashflow was reasonable, but the first bank wanted 75% pre sales and wanted a say in the choice of builder. We wasted three months in negotiation before being essentially forced to change banks. We changed tack from going to the bank cap in hand to being aggressive with the bank, we ended up with 50% pre sale requirement and the choice of builder. The mistake with this was that the bank took significantly more security than the initial bank, and when we had some delaying problems, the cost of funds blew out significantly.

The builder. Finding a builder in a booming market is a problem, especially for a smaller project. We were robbed blind by the first builder, the materials all had mark ups and then were significant delays, also he commenced another two projects during ours. The sub contractors were being paid late and in some cases not at all, the work they were doing was slipping badly. After six months, the excavation was completed and very little progress was being made. I spoke with our solicitor and he used one of the get out clauses in the contract (a strong recommendation, get a solicitor who has strong experience in developments - not someone who is a generalist, a proper specialist!!!). This saved us a lot of grief as thee builder has subsequently gone broke.

I spoke with a friend who is a large developer in Sydney, he agreed to allow us to use his 'team' providing that we paid the contractors direct and he was entitled to a portion of the profits. In hindsight this would have been a better option from the start, a good builder is willing to put some hurt money into the project. By paying the subbies direct, it meant that we were their site of choice, they did excellent jobs because they knew they would get paid on time and in full (this is the most important lesson).

Presales was a massive problem. We had 50% sold off the plan, with the majority being secured by deposit bonds. Two weeks ago the final one of these settled (the development was finalised three years ago), the purchaser has essentially paid for the property and the decline in the property market since. We found that of the deposit bonds that 40% of these had problems settling and we re-took possession. The deposit bond provider was difficult to get money from and it severely stuffed the cashflow.

Final problem was the bank and the delay of the project, in the end the project took a year longer than initially expected with the bank, we breached one of the rules of the loan, the interest rate rose by 5% for the final year of the development. Because they had tied up all the security I couldn't renegotiate the loan to another provider (as I was unable to get additional cash for the deal).

The deal was exceptionally profitable, but if we had kept the five sites and sold them at the top of the market we would have almost as much as the profit from the development. However while the process was painful, it was a valuable lesson as well. At the moment sites are still expensive, however we are starting to see some price breaks at the top of the market which will hopefully translate into some more reasonably priced sites coming onto the market.

Final advice on staying safe... Keep some assets away from the bank...

[kickingbird]

WOW! Thats quite the experience..chockablocka full of character development. My first development is finalising now. I cleared a large site and cut up townhouse size sections. I removed the buildings from the site and secured another section to put them on. That then became an additional asset useful down the track. We secured a private investor for $100,000 which we used to secure the section and pay for the moving of the buildings. So it was mortgage free and fullly usable against the bank as security.

The original site was presold to a building company who bought all of the sections prior to completion. Their deposit finished the development and left our cash in hand. They will settle in about 2 weeks and begin building. We now have the other property to onsell and it will be on the market in 2 weeks as well. All around a good deal with good personal profit margins even with a partner involved.

We used outside assets to borrow against but used a personal guarantee in place of a 1st security over other assets for some of the deal. had to play hard ball with the bank for a lower interest rate and better terms but they dished them out in the end when we started talking about a mortgage broker...

Now we're into the next one. 60 acres to be cut up into 8 lifestyle blocks and all vendor financed on special terms and conditions. Interest free. pay off on sale. next to no money down..I tell ya the deals are out there if you can be a bit creative with your terms!

I'll post as we go on that one...should be fun but had to really play hardball to get it together..still have to put on my game face for a month or so yet but we;re on the home stretch!

This was a very good experience but alot of homework time was put in and even then we found the budget popped in places. We took calculated risk and made sure the margin was flexible enough to cater for it in the end...it paid off.

[Muffin]

The last part of the chapter is about to be written, the driveway has started lifted and we are going to get a claim for it...

I will keep everyone posted.

[whitt]

Just out of interest what sort of profit margins are you all getting?

Taking into account all expenses , holding costs etc.
10,20,30%????

[Muffin]

Whitt,

I will qualify by saving we made over 100% on the development, in round terms the development netted a touch over $6m, after the distribution to the developer we walked away with $5.5m (and before the little problem with the driveway, which will cost about $300K). This was due to the following;

- Land content rose by 300% during the period of development, the development is in Greenwich in Sydney, the average house price there has risen from $300K to $1.2m over the last six years (our five blocks of land were worth $6m by the end of the project on their own);
- Price of materials rising on average by 50% over the period;
- Labour rising by 25% (bricklayers went through the roof);

Effectively we were getting retail margins on the building. Meaning that we paid the lesser prices and still charged the prevailing prices.

I would not consider the performance as normal.

Realistically I target 15% after everything, including interest, holding costs, land, all payments and salaries for the developers (a big expense but necessary to fairly value it). From there expect to make 10% overall as there are always overruns and some units invariably are sold for less than expected (or there are problems with presales). I also generally will not look at project under $5m to completion (this is due to having the capital to be able to commit to this scale project). Less than this is a lot of work (there is as much council hassle with a subdivision of one block as there is with 30 apartments). For smaller projects I would be targeting 25% as a base (and expected 20%). I have been looking at some projects for a while now and generally the process takes six to twelve months of research before jumping (anyone who tells you they can develop with hardly any research is full of it).

If this is an avenue you are thinking of pursuing I would suggest costing it on the worst case scenario and then doubling it. It is not for the faint hearted, I was very, very, very, very lucky, the market peaked at the right time and we had an exceptional starting point and everything feel into place.

Another thing is to make economic analysis of the project (my background), examining who would buy it, why would they buy it, how many cars will they have, how will they be impacted by rates, petrol, school fees etc... Think of it like playing the Sims, you have to develop for the right people to inhibit it. You need to look at the suburb, is it gentrifying, who is moving into the area, where will they be employed, what will happen in an economic downturn etc...

Just my thoughts.

[whitt]

Thanks Muffin
I am just running figues now and trying to touch base with a few hands on developers. It was interesting to see the profit margins you quoted for small projects. Do you account for Taxes ( if any) in the expenses and your profit margin?

I am defentiely reasearching area and property type to suit the project.
Thanks

[Muffin]

I work everything pre income tax, makes it a lot easier. GST is an expense which I consider (and in Australia stamp duty).

The higher rates for the smaller projects are for a few reasons;

- Greater risk, suprising small issues become serious for a smaller project, for example the driveway in Greenwich would cost the same if it was one or twenty units;
- Usually the LVR is greater for bigger projects;
- At the moment I have research six projects over the last two years and am six months from the next (if lucky), I expect a dollar return for the time expended.

Hope this helps

[Muffin]

Another thought / warning

When doing your timings add another month for every two you expect it to take, if the numbers stack up, then you should not encounter any problems.

[spaceman]

Muffin ... a man barely alive...

...but we can rebuild him ... make him better, stronger faster .....the six million dollar man.

$6,000,000 nice one ...... can i be your friend.

But seriously I have a question.

15% - 25% strikes me as a bit low... not that I've done any developing..... but I sold computer equipment for a while and the minimum mark-up on that was 25% ...my girlfriend worked in a clothing store and their mark-up was 80%.

Lets say I had $6,000,000 ..... I'd take a fair bit of convincing to shift it from a nice safe bank account earning say 7% to something with a higher risk and only a further 8% return (granted 15% is more than double 7% so you could say you've doubled your return)

Shouldn't you be shooting for bigger margins?

Cheers
Spaceman

[kolzee]

spaceman - are you not confusing a gross margin percentage with a contribution percentage??

what i mean by this that the sale price mark up on the cost of the clothing may be 80% but the % return after all costs on selling that item of clothing will be a lot lower... It's the percentage return after all costs which is comparable to muffin's 15%...

[spaceman]

Fair enough on the gross vs net

But I still think 15% -25 % net still sounds a bit bit low ....especially after hearing muffins tale of woe ... that happily seems to have turned out OK.

Cheers
Spaceman

[Muffin]

A little more background

For the deal I am currently examining the breakdown of costs is;

- Land content $4m
- Building (@$200K per unit) $8m
- Stamp Duty and GST $1.5m
- Approval, architectual and development planning $200k
- Other (which includes levy contributions, council costs, water, electricity, communications) $400K (the site is a bit of a mongrel.

Total cost to completion $14,100,000

The total project value at completion is $18,000,000 net. (effectively 21.7%)

The funding for this comprises of;

- Bank Funding at 60% of completion value (for this one we need 75% pre sales) or $10,800,000, this is in stages of course, the apportioned cost of interest is $1,000,000;
- Mez Funding of 25% of completion value or $4,500,000, the interest cost is $750,000;

Our contribution is therefore;

- $14,100,000 in costs;
- $1,750,000 in interest;

less funding

- $15,300,000 total;

- $555,000 contribution.

If everything goes to plan our return on equity is $2,700,000 or 486% pre tax.

However, we generally budget for additional costs of another $1,500,000 (a good 10% buffer), this time we are confident on the sale because of the high presale condition, so the return will be $1,200,000 or 218% on equity.

The number are high, but so are the risks, the margins are very thin in the developing game especially where land content is so expensive and materials are still above normal averages.

Think of the return on development as;

- Marking up the land, smaller pieces sell for more per square metre, but there is a finite amount you can mark them up;
- Building is not profitable unless you are the builder, in most cases we aim for break even with a little profit generated on the cosmetic improvements (for example we estimated that having a different coloured feature wall in each apartment last time increased the price by $12,000 per apartment), most builder developers do it to keep their staff employed;
- For each development there is a lot of time that is not compensated, for the last project we spent two full years prior preparing it and two years involved in it, the return after time is a lot less, for example if this project goes ahead I will book a further 500 hours in time into the project for myself.

These result assume everything goes to plan, but it never does...

[Muffin]

I should note that the additional contribution is generally funded on a mez basis, with cross securitisation.

[Muffin]

Back from the lawyer

The body corporate has requested that we replace the driveway and provide temporary parking in the interim (essentially paying for everyone to park in St.Leonards station complex or at the RNS hospital at about $1,000 per car per month), his suggested options;

- fight it - claim that it was normal wear and tear and see how long they want to fight it for, fee bonanza for him, but in his own words a waste or time (at least he is honest);

- negotiate - pay for the driveway (which will take about a month to do), let them pay for their own parking, his reasoning is that the residences will happily allow for Saturday and Sunday work if it means that they stop parking on the street more quickly. The work could be started this weekend and be out of the way soon. His preferred option

- agree - pay for the driveway and the parking for a period of time (i.e. a month), but if it overruns it is going to be nasty as they will expect the parking to continue.

- bankrupt the entity - walk away clapping our hands, simplest option.

The result, we are putting forward options two, we will pay for the driveway and commenc immediately, we will not pay for the parking.

For reference the development doesn't finish at the sale of the last property, it is a bit like a pelican, there is always a bill in front of you. The banks especially are not keen on developers who disappear from their responsibilities. Funny that the banks can be act however they like, and generally do but expect a higher standard from others...