Why do some property developers fail?

Why do some property developers fail?

Property development is a complex, lengthy process – get it right and you can reap significant rewards. But when things go wrong, the consequences can be serious, involving multiple stakeholders, bureaucracy and huge sums of capital. Navigating these waters is a serious challenge, to the extent that some property developers are at risk of going under when things don’t go to plan.

Gary Cleaver explains the particular nature of the property business, the key challenges facing developers and how the right structures and advice can mitigate risk.

 

What challenges do property developers face?

Property development can yield impressive rewards and lead to the creation of healthy, longstanding businesses, but like any form of investment, property development contains an element of risk. Each project is conceived based on the expectation of a future demand which will create the returns on the project. The challenge for property developers is twofold.

Firstly, every project involves multiple stages, skills and variables, with the potential for issues to arise at any stage. The business model will involve managing:

• legal requirements
• local authority permissions
• neighbour and resident concerns
• consultants and contracts
• investors and prospective buyers.

Each of these can present challenges, and each needs careful attention and planning over the life cycle of the project. Property development ventures are relatively long term by nature. The process of site identification, acquisition, planning, development and marketing can run to years. The potential market identified at the outset may change significantly during that process – see more under “Market Risk” below.

Secondly, the nature of these projects makes diversifying risk very challenging for any but the largest developers. Given the huge sums of capital involved, larger projects could have the nature of effectively ‘betting the house’ - it just takes one investment to not work out (for any of the reasons mentioned above) and the developer can find themselves making major losses.

Meanwhile, each deal has its own unique characteristics, making it difficult to standardise approaches or systematise risk, since each will involve a host of different factors.

 

What are the key risks for property developers?

Third-party dependency

Unless you have significant resources in-house, most property developers act as middlemen, connecting capital and contractors to take a project from site selection, through planning, construction and, eventually, lease or sale.

Many of these stages will involve engaging a third-party to take on specialised tasks – such as planning permission consultants or marketing agencies – but the largest exposure comes from building contractors. Builders themselves are subject to a host of risk factors in their market, from labour to raw materials availability to health and safety and environmental concerns.

If you lose your contractor while a development is in progress, either from the developer going out of business or being unable to deliver as agreed, there’s a real risk of the project as a whole failing. Finding a new contractor is possible, but it will often involve extra costs beyond the budget, or they may want to pursue the development in a different way to their predecessor.

This can lead to the project stalling or stopping completely, with the developer left holding all the debt, and with nothing to sell.

 

Cash flow issues

Given the long term nature of property development projects, managing cash flow is essential to ensure that milestones remain on track, on time and on budget. While capital can be raised at multiple stages of the development process, the consequences of doing so can be onerous.

Projects generally start with raising capital, through joint ventures or specialised investors and lenders. This may be spread out among the initial stages – buying the land, obtaining necessary permissions, creating a business plan – but once the project is conceived, all cash levels are built around the returns planned from the project.

That means that any increase in costs – and extra borrowing – risks eating into your eventual returns. If new costs arise, from increases in materials, planning difficulties or legal issues, then developers may find they haven’t sufficient cash to finish the project. Raising capital late in the day can come with punishing interest rates and strict terms, further reducing project returns.

 

Market risk

Over the years it takes to take a project to completion, the conditions that determine the value of that project can change dramatically. Increases in interest rates, movement in the property market and depressed or unstable general economic conditions can result in lowered property values or increased holding costs until properties are sold.

When consumer confidence is high and interest rates are low for instance, there is often increased buyer activity, creating heightened demand and pushing prices up. However, by the time a project comes to fruition, conditions may change and market values not be what they were.

At best, this eats into returns, at worst it could leave developers with an unsellable property.

 

How to reduce risk for property developers

 

While a lot of the above factors are out of developers’ direct control, there are measures that businesses can take to protect themselves against some of these risks and to mitigate their consequences.

• Silo risk within corporate structures: Avoid the “all your eggs in one basket” scenario, A corporate group structure, with Single Purpose Vehicles (SPVs) incorporated for specific projects, will isolate the individual project risk into one legal entity. In the unfortunate event of a failed venture the overall group exposure is mitigated and the risk of a tainted brand substantially reduced.
• Buffering cash reserves: While cost volatility is out of a developer’s control, risk can be reduced by building in a margin for unforeseen costs and not over extending on original cash raised, in case of delays or fluctuations.
• Pre-construction risk management: In the event of a longer project, developers can guard against market changes by forward contract selling, or obtaining an agreement to lease with potential tenants to ensure that the property will find use on completion.

 

How we can help you building a stronger future

In the ever changing world of property development, it pays to have the right support on your side. Our teams work with a range of national and international businesses, from local leaders to major brands. We help guide projects to completion with the right advice, structures and data to help you make the best choice for your business.

 

To find out how you could benefit from our wide experience, get in touch with our team.