for the developer who creates a striking architectural building or complex.
When calculating the risk–reward equation, developers should weigh up all the positives against the negatives. A common analogy is that higher potential returns call for higher degrees of risk, and conversely lower returns require less potential risk. Although there are a number of risks associated property developments, the following lists include the most universal.
Despite economic changes, property development and real estate in general retain many unique benefits compared with other investments. Real estate offers tax and leverage advantages that are not easy to obtain with routine stock and bond investments. The following are a range of possible benefits with property development that should be balanced against the potential risks.
Entrepreneurial opportunities
Compared with other investments such as shares, property development can offer a number of entrepreneurial business opportunities. By providing their own labour and limited capital input, developers can realise a vision to improve or renovate existing buildings, or rezone and subdivide land, resulting in healthy profits. Many real estate millionaires started with small-scale residential or renovation developments. Today these entrepreneurs are building our cities and creating job opportunities.
Cash flow
Cash flow can be generated by sales of residential units or strata commercial office or industrial units that have been completed or sold off plan. Alternatively, units can be rented at market value, thereby generating cash flow and further capital growth. The rental income should exceed the interest cost to ensure a positive cash flow.
Financial leveraging
Most property developments are made using borrowed funds from financial institutions, otherwise known as leveraging (or gearing). A small amount of personal equity is used to borrow the total capital cost of the development in order to realise a larger return than the initial deposit invested.
Tax benefits
To assist the various housing and infrastructure needs of our increasing population, governments offer a number of tax incentives for the private sector to invest in property development. In addition to depreciation, a number of other expenditures involving property development can also be deducted as expenses. It is often possible to deduct the development costs, property rates and taxes and any payable interest as expenses, ultimately reducing taxable income.
Creative financing
Yields from property development can be greatly improved by creative financing techniques and clever negotiating strategies. Astute developers with a strong understanding of financing have launched developments with minimal personal financial input. Some creative developers have managed to secure 100 per cent financing without any security excepting the property they are developing.
Manufactured equity
Instead of buying a newly completed building at market value, a property developer can develop a similar building at 15 to 20 per cent below market value. This is generally known as the developer's margin, with the agent's commission, marketing and other costs usually included in the price of the sale. By holding property as an investment the developer has automatically created a manufactured equity. This means the rental yields will be higher than for someone who bought their property at market value.
Equity build-up
Apart from the manufactured equity, developers can hold properties as long-term investments to improve their equity position as inflation is constantly increasing the value of their equity. This equity can be used to provide a deposit for another development or sold and leveraged for a larger project.
Pooled equity
Developers working on larger projects can establish a syndicate of investors to provide additional equity. This pooled equity allows access to investment in larger development opportunities, markets and diversity that might not be available to individual investors. A developer can also enter a joint venture or partnership with landowners to share the required equity for a new development.
Easier refinance
Once the development is complete, the developer can approach lenders to refinance their property. If an 80 per cent loan can be secured based on the retail value when completed, then the 20 per cent is close to the manufactured equity, which allows the developer to take out their initial equity. Banks are usually comfortable with this as they are not financing development risk and the loan will always be underpinned by the security of real estate.
All these benefits allow the developer to grow their property portfolio faster than by investing in established properties. Developers can be owners of high-growth properties that cost them less to own and at the same time provide generous returns on the initial equity plus tax benefits.
All investments are subject to risks. They may go down in value as well as up, and investors can experience investment losses as well as gains. Different types of investments perform differently at different times, having different risk characteristics and volatility.
There are many risks (of varying degrees) associated with property development, including market risk, leasing risk and construction risk. It is imperative that a developer understand all these elements and mitigate the risks by applying certain strategies and targeting a return relative to such risks.
General risks
General risks that can affect a development include:
• Economic risk: Returns are affected by a range of economic factors, such as changes in interest rates, exchange rates, inflation, general share market conditions or government policies, fluctuations in general market prices for property, and the general state of the domestic and world economies.
• Taxation risk: Tax returns from any development may be influenced by changes in taxation laws or their interpretation.
• Terrorism risk: The unpredictable nature and social and physical destructiveness of terrorist events may affect the earnings and attractiveness of investments, resulting in losses.
Market risk
Any change in property market sentiment during the construction of a project may influence the price and the targeted return. This can affect the profitability of the project and/or the developer's ability to repay the construction loan. To mitigate this risk the developer should undertake thorough market research and analysis into the type of property and the market needs in the area.
Development risk
Risks associated with any property development may include:
• Planning approval risk: Planning approvals for a project may be delayed or denied for a variety of reasons. This can affect the time it takes to commence or complete a project.
• Interest rate risk: Upward movement in interest rates may affect the profitability of projects.
• Legal and regulatory risk: A project may be affected by changes in government policy and/or legislation.
As part of a project's due diligence, the developer should review the project feasibility report prepared by experienced consultants in the planning and approval process.
