Keeping Your Eyes On The Prize
Last week, I had a lunch meeting in London and, since it was one of those all-too-rare sunny days, I decided to unhitch Shanks’s Pony and took the not-unpleasant stroll from Waterloo Station, past the London Eye and out across Westminster Bridge. The recently de-grimed Big Ben was positively gleaming in the sunshine, and all manner of folk were milling about, enjoying the uncharacteristically warm weather. As I crossed the bridge, I noticed several groups of people huddled around at the side of the pavement, dotted at various points across its span. My curiosity piqued and knowing that my lunch guest was so habitually tardy he’d be late for his own funeral, I decided to hang around on the fringes of one of these huddles to see exactly what was going on.
As it turned out, it was that oldest of gambling games known as the ‘shell game’. I’m sure you’ll have seen it before. I and a small throng of others watched as a man with a rather grubby green baseball cap knelt in front of three cups and very deliberately placed a ball under one of them. He then shuffled the cups around and invited one of the tourists in front of him, an excitable-looking Japanese lady in sunglasses wearing a polka dot hairband, to guess which cup concealed the ball. She confidently pointed to the centre cup, which he duly lifted to reveal the ball. Having complimented her on her skill, he suggested she do it again, this time for a wager of ten pounds. Having handed him a freshly minted tenner, he replaced the ball and repeated the shuffle. This time, as anyone watching would have spotted, the ball was surely under the left-hand cup. But the Japanese lady looked rather unsure. She nervously stroked her lip and then turned to the crowd as if to get their assurance. Eventually, she pointed anxiously to the left-hand cup, and the man slowly lifted it to reveal… the ball! The Japanese lady looked delighted and relieved in equal measure, and the man dug out a well-thumbed tenner, handing both notes to her. He then suggested that she go double or quits, which she duly did and, seemingly filled with more confidence this time, she picked out the correct cup once again. This time, the man scowled and rather grudgingly handed her the four notes, imploring her to double down once more. But the Japanese lady was having none of it. She deftly trousered her winnings and left to spontaneous applause while about half a dozen other tourists waved tenners at the man, imploring him to choose them next. All involved were thinking about taking candy from babies.
You probably know exactly where this is going. Unsurprisingly, the next few tourists didn’t fare quite as well as the Japanese lady. They won at first, but as soon as they had a couple of wins under their belts, the ball mysteriously failed to appear under the cup where everyone could have sworn blind it would be. Eventually, each one reluctantly agreed to cut their losses, having lost a few brown notes to the now not-so-scowly man with the cups. Having successfully fleeced a few sheep, he upped his sticks and walked back the way I had just come, towards the old County Hall building. As I headed on to my lunch date, I had to smile with grudging respect. £100 for twenty minutes work isn’t a bad rate of pay, even in the capital.
Being able to keep your eyes on the prize leads me neatly on to one of the biggest newbie mistakes that I see in property development. To reinforce the importance of it, I should begin at the beginning and ask why people develop property in the first place. It’s not a trick question – the answer is obvious. While there will undoubtedly be a small number of developers doing it as a hobby, most do it because it can generate a lot of capital in relatively short timescales. In short, they’re in it for the money. Profit is the prize, and there’s absolutely no embarrassment in that. The problem occurs when developers start taking expected profit for granted. In my book, there are five essential rules you need to follow if you want to stay in the black.
Development has many moving parts, and getting distracted by the various noises and issues that crop up along the journey is all too easy. It can often feel like a surreal game of whack-a-mole, where, just as you manage to put one issue to bed, another completely different issue springs up somewhere else. Right at the start of a project – in fact, before it even becomes a project – a developer will analyse the ‘deal’. And at a high level, the maths is simple. Work out what you can build on the site and what value you could sell it for. Then deduct the costs of developing the site and acquiring the land or host property. What you’ve got left is your profit. Simples.
And it’s a calculation that every developer does, admittedly to varying degrees of accuracy and skill, before they commit to a deal. The problem, particularly with less experienced developers, is that they fail to refine their numbers sufficiently. They may only have high-level numbers available at the time they put an offer in. But these initial numbers are often only assumptions, and they need to be backed up with quotes or at least firm pricing indications before the deal is committed to. So, Rule 1 is to constantly refine your initial numbers as the deal progresses so that as many assumptions as possible are minimised by the time you reach the point of no return.
When the offer goes in, and it’s duly accepted, it’s at this point where the whack-a-mole machine kicks into life. Until then, the developer was largely in control of their daily activity. They were the ones that dictated what their routine would look like on any given day. But once an offer is made, other people get involved, and things start taking on a life of their own. Suddenly, there are legals to do, finances to sort, and contracts to review. All these things are the stock-in-trade of any developer, but now the developer’s focus is forced to wander from their bottom line. And this whack-a-mole experience continues long after the project is secured. There’s often a hiatus after the developer has purchased the project and before work commences on site. But as soon as the contractor breaks ground, the moles start popping up again all over the place, and the developer is forced to look repeatedly from one way to the other to stay on top of things. And this is where Rule 2 comes in.
You see, once you’ve committed to a deal, it can be very easy to mentally tick a box that says that your numbers are baked in. You’ve got quotes from people, had inputs from your cost consultant, and spoken to local agents about the selling price. In short, you’ve done everything you can to nail down your figures. And so your brain subconsciously removes the whole numbers thing from your to-do list. They are what they are, and there’s no more work for you to do. Instead, your focus turns to keeping the moles at bay. The problem with this approach is that a project’s numbers have a shelf life. What may be reasonably accurate today will be slightly less accurate next week and even more so next month. And, of course, development projects don’t happen overnight. Even a smaller development will likely take 18-24 months or longer from when an offer is accepted to when the finished units are finally sold. And a lot can happen over that period, both good and bad, from a numbers perspective. Most developers worth their salt are well aware of this. After all, until they’ve signed a contract with their contractor, they know that labour and materials costs could fluctuate from those in the business plan. Similarly, until a finance deal is agreed with a commercial lender, the cost of borrowing won’t be nailed on. So, they make sure that the business plan is updated constantly during the development process to ensure they’re totally on top of their numbers at any given time. That’s Rule 2, and it’s a critical one. As a developer, you don’t want to discover that your original business plan was miles off two years down the line. By tracking it throughout, if you spot that profitability is heading in the wrong direction, you’ll get a chance to do something about it.
Rule 3 is linked to Rule 2; however, it’s often forgotten about. And that’s very simple: to stay on top of your GDVs. GDV, or gross development value, is what you estimate the finished units will sell for in total. The problem all developers have is that estimating accurate GDVs requires the application of a crystal ball, which nobody owns. Does anyone know what will happen in two years’ time when the properties eventually go on the market? What’s going to happen to house prices? Perhaps there could be an unexpected slump or boom. Or maybe GDVs could be affected by more local issues.
Perhaps the local council will announce a massive investment in rejuvenating the local area (yay!) or that they’ll be building a new household waste recycling facility next door (not-so-yay!). The point is that staying on top of your costs during a project is only half of the requirement. The price you ultimately get for your development is the other extremely important half, and you need to recalculate it regularly throughout the project to truly stay on top of your numbers.
All this talk about what can happen to GDVs over time prompts an obvious question: what on earth can a developer do about it? They can’t single-handedly persuade the council to change the proposed location of their new local waste recycling facility any more than they can influence house prices or the housing market. So, if you recalculate your GDVs and find a problem, is there anything you can do? This is where Rule 4 kicks in, which states that you should ruthlessly value engineer your project to always try to end up with the required profit margin.
Value engineering sounds complicated, but the process is very simple. It involves the developer calling a meeting of their core professional team, namely the contractor, architect, structural engineer, mechanical and electrical engineer, and cost consultant, and telling them exactly how much money needs to be saved. Block out at least half a day and get them to look at design, construction, and materials changes that could shave project costs without materially impacting the overall GDV figure. You’ll be amazed at the savings that can be made when you get subject matter experts to really start using their brains. They’ll often compete against each other to see who can generate the most significant savings. Usually, it’s not one big change that moves the needle – it can be several smaller items. Just be sure to check with your residential agent that any specification changes won’t impact GDV values or saleability. Of course, the good news with GDVs is that they can go up as well as down. You may find that the market has moved in your favour or that, once the project is near completion, your agent is bowled over by your stunning development and thinks the units could command a higher price.
My fifth and final rule is more straightforward than all the others, and it’s something that no developer can afford to do without. I’m talking here about factoring in contingency funding into your numbers. While it’s effectively the first rule to be implemented (since you should be factoring a contingency cost into your very first deal analysis), its purpose is to save your bacon, even after the other four rules have been exhausted. Put simply, it’s 100% guaranteed that a project will encounter unexpected costs. Or at least, in my forty years in development, I’ve not heard of a project that didn’t. It’s simply the nature of the beast. The problem comes when the developer thinks the contingency fund is a nice-to-have rather than a cost.
Because they don’t know what the fund will be used to pay for yet, they mistakenly think that it can be reduced or removed altogether, particularly if this helps get their numbers to stack. It’s the equivalent of removing the braking system from your car in order to save weight and go faster. It will definitely work, but the consequences can be undesirable. Your contingency is there to ensure as far as possible that you walk away from a deal with the shirt on your back, and you should never consider it as optional.
So, there you have five rules which, if you follow them rigorously, will go a long way to help ensuring that your development projects will remain profitable. There’s a brief epitaph to this story if you’ll permit me. Having lunched rather well at my tardy friend’s favourite London restaurant, I made my way back to Waterloo Station, past Big Ben and across Westminster Bridge, where the thinning crowds were still enjoying the late afternoon sunshine. Only a couple of hustlers were left hawking the shell game to passing tourists, and I wondered whether they ever made a loss, given that they needed the crowd to witness someone winning money before other punters wanted to join in.
As it turned out, I had my answer five minutes later. Just before I headed up the Waterloo steps, I decided to grab a bottle of water from the nearby coffee kiosk. I couldn’t help noticing that the man in front of me in the queue was sporting a green baseball hat – and sure enough, as he turned, I could see it was our ‘cups’ man from Westminster Bridge. I watched as he left the counter sporting two large cappuccinos and went to sit on one of the nearby tables. He handed one of the drinks to his companion, a Japanese lady in dark glasses wearing a polka dot hairband, and gave her a peck on the cheek as he did so.
I have to say, it rather made my day.