Real-world Development with propertyCEO – Part 4
Small-scale property development projects that use permitted development rights can be done in your spare time, boast six-figure returns, and have a lower cost of entry than buy-to-lets. It all sounds great on paper, but what’s it REALLY like to convert a property?
Join Ritchie Clapson CEngMIStructE, veteran developer, author, commentator, and co-founder of development training company propertyCEO, as he guides us through a real-life commercial conversion project from start to finish. Witness the highs and the lows, and learn the critical takeaways in this eye-opening, warts-and-all look at what REALLY happens where property development theory stops and the practice begins…
You can watch a video of Ritchie walking around the project. Click HERE for exclusive video content.
The story so far…
Following solid initial valuations from residential agents, the project numbers were looking promising. Ritchie had appointed his team and settled on a plan to convert the old printing works using permitted development rights (PDRs). But there were two key hurdles he needed to overcome. Could he get the construction costs to come in at a price that kept him in profit? And could he persuade his commercial finance company to lend him the funds he needed on the strength of his numbers…?
Once you own a property or piece of land you’re going to develop, you’ll incur various costs when developing the site. But by far the largest of these will be the construction cost; the value of labour and materials required to convert your site into houses or flats. Where do these prices come from? Typically, you’ll be using a main contractor. These people are something of a one-stop shop for construction. They’ll generally be a much larger business than the jobbing builder you might use on your home extension or doer-upper. They’ll have significant depth regarding their in-house capability and access to a comprehensive network of subcontractors. The advantage is that you have a single relationship with responsibility for almost all construction activity. They’ll also represent your single biggest cost on the project.
Usually, I would ask my project manager to run a tender where he would get quotes from several contractors before we made our selection.
* Top Tip: Get a minimum of three tender prices to compare. This means asking five or more contractors to quote, as invariably some won’t respond. However, don’t ask too many – word will get round, and contractors will see that they have a low % chance of winning so won’t respond – pricing up tenders costs them money!
For this project, however, I already had a name in the frame; a local contractor who had done sterling work for me on an earlier project, and I saw an advantage in having him initially quote for the job. Usually, however, a tender process would be the way to go.
* Top Tip: Get your Project Manager or Cost Consultant to run the tender for you. Be sure to include a cost schedule so you get prices against individual items rather than a lump sum. This will make it easier to compare quotes between tending contractors.
To obtain a price, I needed to give the contractor some information, and the first document he received from me was a Schedule of Works. This contained relatively high-level information about all the work required within the property. It included details of the kitchens and bathrooms that needed to be fitted and information about other required construction work that would enable him to give me an indicative price for the project. Another essential document I included was a detailed Finishes Schedule. This sets out, in detail, the specifications for every room in every flat. This information was supplemented with detailed drawings from the architect, the mechanical and electrical engineer, and the lighting contractor. I wanted the contractor to provide a formal quote, and I had my project manager handle this for me.
* Top Tip: Don’t go out to tender too early. Instead, spend time adding detail to your finishes schedule, lighting layouts, and structural and architectural drawings. You want contractors to price in as little risk as possible, so the more detail you give them, the more certain they will be of their numbers, and the less risk will be priced in.
When the contractor’s quote came in, he’d elected to give me a lower and upper price band figure, since some aspects of the construction work were still unknown. My project manager and I sat down together to revisit the numbers. Would the scheme still be profitable? The short answer was ‘yes’, but we’d need the contractor’s price to come in slightly lower than midway between his lower and upper band estimates. It gave us hope, but it was clear that we would need to negotiate if we wanted a 20% profit at the end of the project.
The next job I needed to do was to get more detailed information so that I could renegotiate with the contractor and persuade him to price up any unknowns more accurately – and hopefully less expensively. This should drive his costs down towards the lower-middle price band where I needed them to be. At this point, I reassessed the entire deal, double-checking my market pricing and exit strategy to ensure nothing had changed or been missed.
* Top Tip: Relationships are critical in development. Ensure you build a good rapport with your senior contracting team, including the owner or top decision-makers. You’ll invariably experience a situation later in the project where you need a favour or goodwill, and you’ll be glad you took the trouble to build a good relationship from the start.
Armed with as much information as possible, my project manager and I then attended a meeting with the contracting company’s owner, their in-house cost consultant and construction manager. We then started negotiating, going through the tender line by line and agreeing on costs. Eventually, we ended up with a number just below my walk-away number. We weren’t out of the woods yet, but both sides left the meeting hopeful that the project could move forward. And I now had a first-pass work schedule with budgets attached that I could hopefully use to persuade my commercial lender to lend me the money we needed for the project.
* Top Tip: Always know your CURRENT numbers. What are your projected costs, the maximum price you can afford, and your ‘walk away’ price?
The next day, I contacted my commercial finance broker to tell him I was looking to move from the ‘decision in principle’ we had already secured with our commercial funder to a formal funding offer.
* Top Tip: Most commercial lenders operate through a broker network, and you communicate with them via your broker. Be sure to check out other funding sources, such as peer-to-peer lending, to ensure you’re getting the best deal.
Usually, a single commercial lender would lend up to 70% of the money needed to buy the land or building, and the same lender would lend 100% of the development costs. Because I was joint venturing with the building’s owner, I didn’t need to borrow money to buy the building – but I did need my lender to fund the development costs. Now I had reworked numbers and a work schedule with budgets signed off by the contractor, it should be sufficient to secure a formal funding offer. I updated my deal analysis spreadsheets with the latest numbers and fired them off to the broker with the other paperwork, and waited.
* Top Tip: Don’t get suckered by headline interest rates when comparing finance offers. Lenders will charge all sorts of fees in addition to their interest, and you need to understand the total cost of finance when comparing deals.
As it turned out, I didn’t have to wait long. A few days later, my broker called with the good news; he’d just received a detailed funding offer and would forward it to me that morning. I quickly called my solicitor to let her know I’d be needing her input; the funding offer is a formal contract and should always be reviewed by a property lawyer.
* Top Tip: Prime your solicitor so they know you’ll be sending them documents to review. Also, be sure to hire a solicitor who is a property development specialist with experience dealing with funding offers and construction contracts rather than one who simply does conveyancing.
I now needed to review the funding offer to make sure all the details were as expected. I also reviewed the loan terms, the Personal Guarantee that the lender would need me to sign, the first charge requirement, and the fees and interest. My solicitor would also be reviewing these things but checking them yourself and getting familiar with them always pays dividends.
* Top Tip: If you’re using private lenders’ money to fund your deposit, don’t offer them a first charge on the property since your commercial lender will want to have a first charge.
The lender also requested a net asset statement for myself and my JV partner, as this would give them an idea of how solvent we were.
* Top Tip: If you are joint venturing with someone on your deal, be aware that you will both be jointly and severally liable under the Personal Guarantees you will need to give your lender. You need to make sure that you know your JV partner well and have done your due diligence on them.
They also wanted to see a cashflow projection for the project. They would be advancing funds in tranches as the project progressed and wanted to be confident that we wouldn’t encounter cashflow issues.
* Top Tip: Cashflow is a critical aspect in any business. Many successful companies have gone bankrupt because they ran out of cash, so make sure you work with your accountant to cashflow model your development.
Regarding cash flow, I could claim back VAT on costs, but I knew that VAT registration for new property development businesses could take ages, and you may not get the VAT back for months – or even until after the project has finished. I made sure I wasn’t reliant on VAT recovery when I prepared the cashflow projection.
As ever, a development project has many moving parts, but they don’t come at you all at once. By focusing on each issue at a time and leveraging your team, you can make substantial progress step by step. Getting our funding agreed was a significant win – and meant I could now move on to the next step.
Next month, Ritchie has his appointed residential agent visit the site to value the proposed units now that the layouts have been finalised. But the building is currently a wreck – will the agent be able to visualise the end product when making his valuations? And as if to prove water and electricity don’t mix, Ritchie encounters problems with both as his team attempts to sort out the all-essential utility supplies.