Presale losses & high build costs: A possible solution for developers

This article will require you to invest 7 minutes of your time to make a 7-figure return, either in savings from lessons learnt or negotiating terms that are in your favour! Many years of my experience and the experience of my clients have been spent to put this series of articles together.

As with all things, the devil is in the detail, and this is especially true when it comes to property development / construction funding / private lending. Other parts of this series will cover different aspects.

The purpose of this article is to bring to light certain economic factors with respect to the broader economy but also its direct impact on property development funding! My job is to provide possible solutions, but ultimately your own DD will determine what is best for you.

Problem 1: Bank presales in an increasing material cost environment.

With the 12 months to the March quarter reporting a CPI figure of 5.1%, and with the recent RBA Governor Dr Philip Lowe stating that construction costs had increased by 10%, we fundamentally do not feel these data sets reflect what our clients are facing! We believe the cost increases are much higher, especially in construction! Our clients are reporting that in the last 12 months, they have seen a 20% to 40% rise in construction costs!

Dr Philip Lowe did state that he expected interest rates to normalise at 2.5%, but he did not specify the time in which he expected that to occur (it could be 12 months or 36). This will most likely come as a shock to a generation of home buyers that never experienced an interest rate rise!

There are no free lunches in life, and the past decade of QE, stimulus upon stimulus, has, in some respects, created a false economy. We are pragmatic by nature, and therefore for both our investor and business clients, we fundamentally believe we need to plan and mitigate downside risks.

For anyone doing property development, including our clients, this inflationary period causes a number of headaches for anyone who has engaged a bank that is requesting a high number of presales to facilitate funding!

This causes developers an issue of having to sell stock at a discount or at market price before construction has commenced. In an environment of rising costs during the construction period, this can erode project margins or puts the project greatly at risk.

The solution

“We can only manage what we measure” were the famous words of one of my MBA lecturers who originally was a hardcore engineer. Therefore, we first need to test the feasibility of the project using different scenarios to make an evidence-based decision. Below are just some of the main factors you need to consider for!

Scenario 1 (with bank funding).

Revenue from the presale sale price of the properties that are sold to enable bank funding and the expected revenue on completion of remaining stock.

And

The cost of capital sourced from a bank.

And

The extra cost of holding the site and servicing the debt during presales.

And

The expected rise in construction prices.

Vs

Scenario 2 (with private development funding).

Revenue from selling all properties at the end of the construction period (or a reduced number at presale prices) at the market price at the time or a higher price (to facilitate higher build costs).

And

The higher cost of capital from a private lender.

And

The expected rise in prices for construction.

Testing the feasibility of both scenarios will quickly tell you whether you should use a bank or private capital. Remember, your decision is based on numbers and logic, not necessarily what you are comfortable with!

Vs

Scenario 3 (joint ventures)

Joint ventures can serve as another way to mitigate risk. There are two options here.

1. A joint venture between the developer and builder, where both the downside risks and upside profits are shared between the two.
2. A joint venture between a private financier and a builder-developer (typically, this works better with a builder-developer than just a developer as there are greater margins). Once again, downside risks are shared by both parties, but also the profits. Typically, a financier will provide a component as debt and then a second component as preferred equity.

Testing the feasibility of all scenarios will quickly tell you whether you should use a bank or private capital and or JV. Remember, your decision is based on numbers and logic, not necessarily what you are comfortable with!

Opportunity Cost

However, there is also an opportunity cost involved when taking bank funding. If, for example, you had to wait six months to achieve all presales, then you must consider the following

1. Holding costs of the site and finance costs.
2. The benefit of not waiting six months for presales to be achieved.
3. The reinvestment of funds and the ability to catch market momentum for the next project, which will be lost during the presale period, and the flow on effect of reinvestment.

Problem 2: Rising material & labour costs

Inflation, high transportation costs, delays in supplies, material shortages and labour shortages are all adding to the cost of building. This is causing builders and developers to lose margins and sleep.

The solution

There is no silver bullet here, but our builder and developer clients have started doing the following things.

1. They are ordering materials in advance and storing them in their own warehouses. A cost-benefit analysis needs to be done of whether ordering, paying and storing materials now is better than buying materials later at a higher price! Contractual obligations also need to be considered. For a number of our clients, this has been their saving grace. Typically these clients have worked with the end client, or if they are the end client, they have worked with the builder to ensure more funds can be secured upfront to facilitate this process.
2. Another option may be to work with your suppliers, pay them and ask them to store the materials for you for a period of time until you need them.