Managing Risk In Property Development

Managing Risk In Property Development

Author: Luke Andersen

Whether we realise it or not, managing risk is something we all deal witheveryday. For example, the simple process of crossing a street involves acertain degree of risk which we manage without even blinking an eyelid. Imaginefor a moment crossing a busy street without looking left and right, withoutgauging the direction and speed of traffic, and without gauging the distance ofthe street we are crossing. Thankfully most of us are very good at managingthese everyday risks effectively.

But what about managing the risks of something as complex as a propertydevelopment project? Well, whilst the risks are more numerous and greater incomplexity there are still certain measures you can take to manage themeffectively. Let´s take a look at some of the more notable risks in performing aproperty development project and how you can manage them effectively.

Risk #1 - Not Having Enough Knowledge
By far and away the greatestrisk in property development is the risk of undertaking a project withinsufficient knowledge. I have seen it many times before where individualsundertake their first project with sugar coated expectations of how easyproperty development is only to find themselves in strife half way down thetrack because they were not willing to invest in knowledge. Many people willtell you that ignorance is bliss but when it is your money in the deal and yourname as guarantor on the loan ignorance can be a very costly thing! So, how canyou manage this risk and become more knowledgeable in property development?Well, there are three main options available to you.

Firstly, track down some quality property development books and acquire acomprehensive knowledge of the property development process. Secondly, with thisknowledge you should then attend a quality property development workshop tosharpen up the practical application of your knowledge. Thirdly, having readsome books and attended a workshop you should then be equipped with thenecessary knowledge to undertake your own property development project. Forthose that lack the necessary confidence to undertake their own project it ispossible to team up with an experienced property development manager to manageyour first project. This way you can learn ‘on the job´ under the guidance of anexperienced property developer and progressively graduate yourself into managingyour own projects.

Risk #2 - Paying too Much for Your Development Site
There are fewthings worse than paying over the odds for a development site and being leftwith the prospect of bearing all of the risk and performing all of the worknecessary to complete the project only to break even or make a tiny profit.

So how do you manage this risk and ensure that you do not pay too much foryour development site? Well, it all comes back to the number crunching prior topurchasing the development site. It is absolutely critical that a comprehensivefinancial feasibility is performed prior to purchasing a development site. Giventhat a financial feasibility is only as good as the assumptions made in it, itis absolutely critical that you do your homework to ensure the accuracy of yourassumptions.

As part of your financial feasibility you can calculate what´s called aresidual land value. A residual land value is simply determined by estimatingthe project´s gross revenue then subtracting the various expenses (excluding thedevelopment site) and an adequate profit margin to leave the residual value ofthe development site. A residual land value will provide you with the maximumamount that you can afford to pay for a development site therefore ensuring younever pay too much.

Risk #3 - Purchasing a Lemon Development Site
Whilst we allunderstand the risk of purchasing a lemon car, few people realise that it ispossible to purchase a lemon development site.

So how do you manage this risk and ensure that you do not purchase a lemondevelopment site. Well, it all comes back to performing a thorough investigationof the development issues of the site, better known as a due diligence analysis.The due diligence analysis may be performed either prior to purchasing the siteor as a condition of the contract. Either way, the performance of a thorough duediligence analysis should incorporate each of the following issues:

• environmental and heritage issues (e.g. presence of vegetation protectionorders, heritage listed buildings etc.)
• flood issues (e.g. presence of a flood regulation line)
• geotechnical issues (e.g. presence of acid sulphate soil, contaminated soil,underground rocks, underground water, unstable fill etc.)
• mining issues (e.g. impact of mining subsidence)
• service issues (e.g. proximity of services to site, capacity of services forthe proposed development etc.)
• stormwater issues (is there a legal point of discharge, if not are adjoiningowners amenable etc.)
• title related issues (e.g. presence of caveats, covenants, easements,encumbrances, interest details, administrative advices, unregistered dealingsetc.)
• zoning issues (compatibility of current zoning to the proposeduse)

Whilst a development site with the necessary local authority permits in placewill have overcome most of these issues, it is nonetheless advisable toinvestigate the various issues as a matter of course. A thorough due diligenceanalysis can be a rather time consuming process but given the cost involved ingetting it wrong it is time very well spent!

Risk #4 - Construction Costs Blow Out
Construction costs aregenerally the greatest expense component in a property development project. Assuch, it only takes a slight proportional change in its cost to have asignificant impact on the projects bottom line.

So how do you manage this risk and ensure that a blow out in constructioncosts does not destroy your bottom line? Well, the best way is to ensure thatyou use a lump sum fixed price contract. A lump sum fixed price contract is acontract where the price is determined by the building contractor which includesall associated costs such as materials, labour and profit margin. As the namesuggests, the contract price is fixed from the day the contract is signed. Theonly things that will vary the price are variations to the contract orfluctuations in provisional or prime cost items. As such you should try to limitthe number of variations made to the contract, and whilst nothing can be done tocontrol fluctuations in provisional or prime cost items, it is possible to keepthese items to a bare minimum when detailing the contract.

Risk #5 - Building Contractor Goes Bust
Perhaps every developer´sworst nightmare! By this point in a project most of the hard work has been doneand you could certainly be forgiven for having your eyes fixed on completingconstruction and banking the settlement funds. However, all of this can changein an instant if your building contractor hits financial difficulty and cannotproceed with the works.

So how do you manage a risk such as this? Well, whilst circumstances canchange quickly in the construction industry there is certainly a lot to be saidfor using a building contractor with a good reputation and a proven trackrecord. As a developer you should feel free to make enquiries into the buildingcontractor´s project history and financials. After all it is your money in thedeal and your name as guarantor on the loan so there should be no reason to feelshy about asking for this sort of information.

Whilst there is no substitute for using a proven reputable buildingcontractor, we are fortunate in Australia in that it is a requirement forbuilding contractors to take out warranty insurance. During constructionwarranty insurance covers against the building contractor becoming bankrupt orplaced into liquidation and against the building contractor failing to completethe works under the contract. After construction it covers against the buildingcontractor failing to fix any defects and against the building suffering fromthe effects of subsidence or settlement. It is usual practice for buildingsurveyors or local authorities not to issue a building permit until evidencethat the building contractor has taken out warranty insurance is provided.Nonetheless, it is prudent that you ensure for yourself that warranty insurancehas been taken out.

Risk #6 - Shoddy Construction Work
We have all seen the stories on‘A Current Affair´ where the hard working Australian family put all of theirmoney into building their dream home only to arrive on handover to somethingthat is not only displeasing to the eye, but a danger to live in. Whilst thesestories are very extremist they do demonstrate a very significant risk that ifleft unmanaged can be potentially disastrous.

So how do you manage this risk and ensure that you are not met at handoverwith shoddy construction work? Well, once again there is no substitute for usinga proven reputable building contractor. For all of the work that goes into aproperty development project it is the quality of the construction on which yourreputation as a developer can live or die. It is therefore absolutely criticalthat you do your homework on your building contractor. Always insist on gettingthe building contractor´s project history including contact details for refereesfrom previous projects. This way you can visit the projects and make contactwith the previous developers to satisfy yourself as to the whether or not theirworkmanship meets your standards.

Whilst engaging a proven reputable builder can mitigate this risk to a largeextent, you should not simply sit back on your laurels waiting for a phone callwhen construction is finished. I´m sure you would agree that it is betterknowing if something is progressively going wrong and be able to rectify it thanto find out at the end that it is beyond rectification. This same rationaleapplies to construction work and the process of performing regular buildinginspections.

Throughout the course of a property development project a number ofinspections should be performed by various individuals. The structural engineerwill need to perform inspections at a few key stages of construction (e.g.footings, slab, framing etc.) to ensure that the approved plans and buildingregulations are being followed. It is also advisable that you engage yourarchitect or building designer to perform regular inspections to ensure that theworks are being performed in accordance with the plans. Once practicalcompletion has been reached you will need to perform a final inspection. By thispoint, the final inspection will be concerned with minor defects that will becovered under the defects liability period. Generally, the developer and eitherthe development manager, architect or building designer will perform the finalinspection.

Whilst the before mentioned risks are by no means an exhaustive list, itshould however give you a feel for the more notable risks in propertydevelopment and how you can manage them effectively. Given the high stakesinvolved in property development any mismanagement of these risks can prove verycostly indeed. If you are not experienced in managing property developmentprojects and do not want to learn the hard way than engage an experienceddevelopment manager to act on your behalf. This way you can reap the rewards ofbeing a property developer without becoming another causality to poor riskmanagement.

By Luke Andersen
Partner of Positive Property Strategies andco-author of ‘Residential Real Estate Development: A Practical Guide ForBeginners To Experts.´

Positive Property Strategies is an innovative property development businessoffering property development management, property development advice andproperty development education. To find out more please visit http://www.propertystrategies.net