Part 6 of an eight-part series written by Ian and Ritchie for Property Investor News, featuring some of the key aspects of small-scale property development covered by propertyCEO’s ‘8-Pillars’ system. This article appeared in the January 2022 edition of the magazine.

In part 6, Ritchie shares some thoughts on how to analyse deals before you make an offer.

Analysing deals can be a little daunting for new developers, mainly because getting something wrong could prove alarmingly costly. How will you know you’ve not missed something vital in your calculations? Or what if your spreadsheet skills are a little outdated, and you’re struggling to get Lotus 123 loaded back onto your ZX Spectrum? After all, one small slip for man could surely lead to one giant leap backward for profitability? All too true, but never fear; with a game plan, some common sense, and a few dating analogies, I hope to demonstrate that you can crack it very successfully.

As with many things in life, deal analysis is easier if you approach it as a system. The first thing to point out is that you don’t want to do an in-depth analysis of every deal you look at because you won’t have enough time.

Deal analysis should operate as a sales funnel (or a dating app, if you’re allowed to use such things). You start with everything that meets your high-level requirements for location, property/plot type, and value, then quickly swipe left for the obvious no-hopers. Then you dive down a further level and cull anything that doesn’t bear closer scrutiny. And you keep diving down in stages until you’re left with a much smaller number that are worth putting some time into. Similarly, when running some numbers, you want to get to a ball-park profitability figure first. That’s because it’s not worth spending time firming up accurate numbers if it’s evident from a high-level analysis that the deal won’t stack. Again, it’s about spending the most time on what will give you the biggest return.

A big part of systemising your deal analysis involves using a deal analyser – a generic spreadsheet that allows you to enter all the relevant parameters for build cost, professional fees, and finance and arrive at a bottom-right-hand-corner profitability figure. You can build your own analyser from scratch, or use an off-the-shelf version, however a few words of warning on the latter. Firstly, make sure it’s comprehensive enough to give you a reasonable ball-park profitability figure but not so complex that it takes you hours to complete on a first pass. I’ve seen some analysers which promise that just three numbers will tell you whether a deal is profitable, yet I guarantee you’ll be throwing out babies with bathwater left, right, and centre if you use it. Conversely, I’ve seen some forensic deal analysers which take hours to complete and so won’t give you a quick high-level indication. A happy medium is what you’re after for your first pass – you can get forensic once you know the deal has a good chance of stacking up. If you’re using someone else’s deal analyser, make sure you understand it inside out, and you know precisely what number goes in which cell and what downstream calculations link to it. Also, make sure that you don’t overwrite formulas by always starting each new analysis using your ‘template’ spreadsheet rather than re-using the previous deal’s workbook.

Now, I know I mentioned the dreaded ‘S-word’ in the last paragraph, and this may have struck fear (or at least a mild sinking feeling) into the hearts of many. Spreadsheets are a marvel of not-so-modern technology, and they’re a necessary evil when it comes to deal analysis. Some people love them while others loathe them, or perhaps more accurately, they may feel that they’re not a ‘numbers person’. If this is you, then you have my sympathy. And now we’ve got that out of the way; let me tell you that you MUST be able to operate a spreadsheet to analyse deals and that there’s no such thing as not being a numbers person. There’s only a person who hasn’t bothered to learn how to use a spreadsheet. Harsh but true. Luckily, deal analysis involves basic maths and precisely zero rocket science, and spreadsheets are routinely used by six-year-olds.

If I’ve not yet alienated you completely, I’d strongly urge you to learn some spreadsheet basics. It will change your life (and allow you to analyse development deals).

The first rule of deal analysis is to target a minimum 20% profit on the gross development value (GDV) of a project. For example, if the target sales price of your finished units is £1 million, then you need to be projecting a return of at least £200,000. If you’re using commercial lenders, they will usually insist that your deal returns 20%+ on GDV before they’ll agree to lend you any money. Now, you might be thinking, let’s not be greedy; I’d be happy to make £150k profit on a £1m deal. But that misses the point. Think of your margin as a safety buffer designed to prevent you from losing money. As an extreme example, if you were doing a £100m deal, then you’ll appreciate that your £150k target profit could evaporate in an instant if the price of bricks went up by a few pence. The principle is that you must focus on the percentage return and not the physical amount, and 20% of GDV is the minimum you should aim for.

The second rule of deal analyses is to factor in some contingency, typically 10-15% of the build cost. Never view this as a nice-to-have that can be stripped out if your numbers don’t quite stack, as you WILL almost certainly need that money. Unexpected costs tend to be a ‘when’, not an ‘if’ in development, and you should assume the contingency will be spent. You just don’t quite know yet on what it will be spent.

Like dating, property development occasionally requires the head to have a few strong words with the heart. New developers can be prone to falling in love with projects, and we all know that love can be blind. In deal analysis, this usually manifests itself as a somewhat optimistic approach to pricing assumptions to get the numbers to produce an acceptable return. But here’s the rub; I can get ANY deal to stack if I dial all my assumptions to ‘optimistic’, simply because there are so many variables. The trick is to enter all the numbers using prudent assumptions WITHOUT taking a sneaky peek at the profitability until you’ve finished. That way, you end up with a number that hasn’t been subconsciously ‘optimised’ as a result of your passionate longings for 24 Acacia Avenue. The best way of avoiding this problem is to enter in the sales values of your units last of all; that way, you won’t know the profitability figure until after you’ve entered all the costs.

You’re likely to encounter one of several outcomes with your first pass numbers. If the deal returns north of 20% profit, it’s a clear swipe right – and straight through to the next round. If it produces less than 8-10% profit, it’s swipe left. But anything between these two figures may still turn out to be viable once you’ve refined your numbers, so I would still put it through to round two.

What exactly is round two? This is where we look to firm up the numbers a little more. Necessarily all deal analysers start with some sensible ball-park assumptions; otherwise, you’d be calling your cost consultant every five minutes. These assumptions are enough to weed out the no-hopers, but we need to get a bit more granular for the more profitable deals. The first step is to sense-check each assumption yourself. You may find an area where your initial assumptions don’t look reasonable for this specific project. For example, your deal may require some major structural work that will incur greater cost, or perhaps there’s a significant amount of hard landscaping that needs to be factored in. You need to make sure that you’re happy that the assumptions look reasonable from your perspective at a high level.

And don’t worry if you think there’s still a considerable margin of error here – that’s perfectly normal.

The next step is to speak to your professional team. You’re looking to bring them up to speed on the project so that they can give you a steer on pricing assumptions, and in some cases, receive an estimate or quote for their fees or costs. Here you’re going to be talking to your architect, planning consultant, contractor, project manager, and structural engineer. You may need to bring in additional professionals if there are some specific issues with the project that need pricing up, e.g., demolition. A common mistake is to forget that the generic assumptions in your analyser are still assumptions. No matter how reasonable you think they are, they will still need validating. This can be a particular challenge with construction costs. Your contractor may have given you a quote just a few weeks ago, and so you thought things couldn’t possibly have changed much. These can prove to be famous last words, so please always double-check.

When it comes to the construction costs specifically, you’ll want to get the input of a cost consultant (a.k.a. a quantity surveyor). They’ll be able to give you an estimate of the lump sum cost or at least an indication of a cost range based on the building type and its geographical location. This needs to be a staged refinement process, where you start with high-level estimates, which you then stress test. If the deal stacks initially, you can move to the next stage before testing again. This second stage may involve sharing the agent’s particulars, site measurements, floorplans, etc., allowing the cost consultant to refine their estimate. This refinement process happens throughout the life of a project, and it should apply to every figure in your analyser. The critical point is that by firming up numbers in stages, you get a chance to veto bad deals as early as possible, i.e., before you, your cost consultant, and others in your team have done a load of work only to find the numbers don’t stack.

Another element to factor into your numbers is the freehold value, assuming you’re building leasehold flats. There’s been a lot of media coverage about freeholds, but as I write, they are still worth money and, in many cases, could boost your profits by a healthy five figures. Don’t make the rookie mistake of giving away the freehold with your units without first checking that it wouldn’t be more profitable to sell it separately.

One thing you should always do before making an offer is sense check your numbers by doing a separate manual calculation. Take a blank sheet of paper and write down four headings: fees, construction costs, finance costs, and sales values (GDVs). Then in pencil, write in the approximate, rounded values for all elements within each section without referencing your earlier calculations. Compare these new numbers to your spreadsheet. If they’re close, then great. But if there’s an anomaly, you can instantly see which section it’s in and whether your manual calculation is off beam or if it’s your spreadsheet that has the error. Not exactly high-tech, but a good way of making sure there aren’t any obvious errors in your spreadsheet.

I’m often asked about the most common mistakes people make when analysing deals. There are quite a few to choose from. Not systemising things is a big one, as is spending too much or too little time on the numbers. Here are some other common bloopers:

  • Tweaking numbers to make the deal work or purposefully optimising or leaving costs out – in other words kidding yourself it’s a good deal
  • Being subconsciously optimistic by looking at the profitability as you add costs
  • Failing to stress test the analysis. Will the deal still work if the construction costs are higher or the sales values lower?
  • Not reaching out to professionals to get indicative costs and instead assuming your baseline assumptions will be reasonable
  • Asking a contractor for indicative pricing instead of a cost consultant (you may get an over-optimistic assessment)
  • Not challenging the assessments of estate agents. Agents, bless them, may tell you what you want to hear. Do your own market analysis so you can critique what they tell you, and always ask for evidence
  • Not checking whether a CIL or Section 106 payment is payable
  • Not factoring in accounting and bookkeeping costs for your development company (SPV)
  • Not fully understanding finance costs

Some estate agents still believe that the financials for a development project are one-third asset cost, one-third development cost, and one-third profit. Don’t fall into the same trap since this lazy maths is often far from the truth.

If relying on your own numbers sounds rather scary despite getting input from your professional team and a cost consultant, then I have some good news for you, assuming you’re planning to secure commercial lending on your project. You see, when it comes to lending you money, commercial lenders are not going to assume your deal stacks up without first checking it for themselves. And they’re very good at it – better than you – because critiquing development deals is their day job. They’ll pull the legs off every aspect of the deal and factor in numerous what-if scenarios. What if the contractor goes pop, what if the market turns, and what if the cost of materials goes up? Only when they’re completely satisfied that the numbers stack will they lend you the cash. It sounds harsh, but it’s a huge tick in the box. You know that if a commercial lender offers you money, your deal has promise.

My final word of advice could equally have come from the Ladybird book of dating, and that is not to be frightened of making an offer. New developers often think that making an offer is a massive commitment that requires them to quadruple-check every figure in their deal analysis first, and as a result, they often miss the boat. You don’t want to be offering on every opportunity, but when a deal is starting to look promising, an offer shows that you’re serious and will open a more meaningful dialogue with the vendor/agent. Any offer will always be subject to your due diligence, and you can withdraw it at any time. After all, if you don’t enjoy a first date, you’re certainly not obliged to go on a second.

I don’t have the space to dive into the individual components of a deal analyser in this article, but I hope you now at least have a steer on the best way to approach things. Next month, I’ll be looking at the technical aspects of development and also how to master the planning side – an area where many see pain, yet they could be seeing opportunity.