Why 2023 Could Be Your Best Recession Yet
As I get older, someone seems to be squishing all the Christmases closer together (I suspect it may be the same dark force that’s been shrinking my clothes every year). After all, it can only have been six months since the last one, and frankly, I’m only just past the stage of wondering if there’s any turkey left in the fridge. I can even remember where I stored the Christmas lights. Yet, for once, as we head towards the season of goodwill, I genuinely feel that Christmas has arrived early for us property types.
Now, if you’re a landlord or property investor, there’s a fair chance you’ll think I’ve gone crackers.
What exactly are these glad tidings that I had in mind? The increased regulatory burden probably wasn’t exactly top of your Christmas list, and no matter how much tinsel you throw at it, I suspect the punishing tax hikes didn’t come as a welcome present either. You’d have rather had socks. But where the traditional buy-to-let model has become all but untenable, there’s another part of the property industry where things have gone in quite the opposite direction. In fact, not only is it a sector that has recently become more accessible, but it’s also one that the government is actively encouraging property investors to participate in. Who’d have thought it? The sector in question is small-scale property development, and if you’re thinking, ‘that’s all well and good, but I’m not a property developer’, then let me enlighten you a little. You might be surprised to discover that you’re closer to being a property developer than you thought you were.
So, what exactly is a small-scale development when it’s at home? Well, these developments are effectively one step up from doing a flip or a refurb, which tends to involve taking a single property and doing it up for a profit. In contrast, a small-scale development involves building several homes on a small plot or converting an existing commercial building into residential, for example, converting a shop’s uppers into flats or turning an office building into apartments. The commercial conversion route is currently a far more attractive proposition than taking on a new-build. That’s because the government has thoughtfully introduced new permitted development rights which allow you to change the use of these buildings without requiring full planning permission. It means you can avoid the many vagaries of our broken planning system and proceed more quickly and with less risk. And you’ll have already noticed there’s a considerable volume of empty shops and commercial properties up and down the country that are ripe for conversion.
Another critical difference between a flip and a small-scale development project is the level of profits they produce. According to some Hampton’s research in 2021, the average flip completed since the start of the pandemic made a profit of £48k. However, this was in a rising market where house prices were increasing at around 10% per annum. But if house prices dip 10% while you’re doing the work, your numbers will be very different – you’ve got to try and claw back that loss before you’re into profit. And you won’t find too many people predicting that house prices will rise any time soon. Now compare these profit levels to a small-scale development, which would typically target profits of between £100k and £500k and, bizarrely, involves the developer doing less work. This is because the budget for a flip is much smaller, and, as a result, the developer usually has to project manage the project personally. With a conversion project, the budget allows the developer to hire a project manager to manage the project for them. And the commercial finance available on small-scale projects means you could be investing a lot less of your own money than you would on a flip or a buy-to-let. It sounds bizarre – more profit for less investment – but it’s true.
So, why could 2023 be a stellar year for small-scale development? Let’s start by looking at the timing. There are three critical elements that determine a property development project’s profitability, namely:
- The cost of the land or property that you’re going to develop
- The cost of physically developing the site, e.g., materials, labour, fees, and interest
- The price you sell your completed apartments or houses for
One of the recent challenges with buying commercial property is that commercial agents have woken up to the aforementioned permitted development rights.
As a result, many have been advising their clients to hold out for top dollar since developers are typically able to pay significantly over the odds compared to someone simply wanting to keep the building in commercial use. But these vendors find themselves in an increasingly tight spot. The ongoing recession will force many businesses to sell off their properties or close altogether, increasing the number of units on the market, which means more competition. In addition, the cost of maintaining commercial buildings has grown significantly and is likely to continue. There are several factors here; for those properties on a mortgage, the finance cost has increased just as it has for residential mortgages. In addition, the cost of maintaining a commercial building has also gone up. This includes overheads such as electricity and gas, keeping buildings secure and generally well-maintained, as well as the small matter of business rates which may also be payable. So, those owners holding out for a bigger payday now find themselves in a market where their property’s value is going down, and the cost of maintaining it is going up. Hardly surprising, then, that many predict that commercial property prices will take a hit in 2023. If you’re in a position to buy a commercial property next year, you should be getting a far better deal than you would today. And the adage still holds; you tend to make your money when you buy rather than when you sell.
Talking of selling, it makes sense to talk about house prices next since these affect several things. As a developer, you’re susceptible to the vagaries of the housing market and house prices specifically. On a small-scale project, it might take 18 months or so between having an offer accepted on the land or property you’re developing and putting your finished units on the market. And while 18 months is not a long time in development terms, you could certainly find your profits dented if your projected selling prices needed to come down to reflect a depressed housing market.
So, what are the current prospects for the housing market in 2023 and beyond? Individual crystal balls tend to be somewhat unreliable and something of a trip to the bookies. A quick look at the projections for house prices in 2023 from those allegedly in the know shows a spread of between a 17% reduction and a 5% increase. So what does this tell us? Well, firstly, no one really has a clue (a buying agent was recently quoted as saying, “there are only two types of expert when it comes to predicting house prices – those who don’t know and those who don’t know they don’t know”). Secondly, it probably makes sense to ignore the outliers and go with a consensus. Where does that leave us? The consensus is arguably a 5-10% reduction in 2023, followed by a rise of 1-3% in 2024 and 4-7% in 2025. To give you a flavour of some individual predictions, last month, Savills predicted a 10% house price reduction in 2023, with prices starting to increase again in 2024 and further still in 2025. They further predicted that between 2024 and 2027, prices will rise by 18%. Oxford Economics predicts a 4.4% dip in 2023, while Capital Economics reckon 12% is the number. In late November 2022, the Office for Budget Responsibility (OBR) predicted a 9% reduction between now and autumn 2024, with prices starting to rise again in 2025. In other words, they expect the market to dip in 2023, but only modestly. While the more cynical among you might reflect that the OBR has yet to get a single prediction right, their numbers don’t appear to be too out of kilter. Plus, for the less cynical, the law of averages dictates that they’ve probably got to get a prediction right sometime, and you never know; this could be the one.
It’s also worth putting these projections into context. 2008 saw house prices drop by 15%, representing a significant market correction. Outside the national press, very few pundits are predicting a repeat of this, even though house prices have increased nearly 20% over the past 24 months alone. There are several reasons for this. The banks are in very a different position liquidity-wise than they were in 2008, when we had a historical backdrop of uncontrolled lending and self-certified mortgages. Plus, they’re doing a lot more to prevent repossessions than they did 15 years ago. There’s also a chronic under-supply of homes on the market, coupled with very strong demand. All of these would suggest that a 2008-style crash is off the cards.
In summary, while we can’t predict the exact figures, the market sentiment is for house prices to dip in 2023 and increase again later in 2024 and more robustly in 2025. Hold that thought if you would, as I’ll return to it later.
Let me now turn to the physical cost of doing the development work. One of the concerns facing the property development sector in 2022 was the cost of materials and labour. These can vary significantly over time and are influenced by numerous factors, including global events. Brexit, the COVID pandemic, the war in Ukraine, and the recession all impacted the cost of materials and labour. When the supply of materials is low (or demand high) for whatever reason, then prices increase. Similarly, when contractors, professionals, and tradespeople have lots of work, they can pick and choose their jobs. As a result, prices go up.
Major house builders are the biggest consumers of materials and labour in the construction industry. However, as soon as the housing market looks like it might cool or go backward, the housebuilders take their foot off the gas and apply the brakes. We’ve already seen this start to happen; in October 2022, house prices stuttered, and by November, several housebuilders had announced they’d cut back their new housing projections for 2023. This makes perfect sense, as they don’t want to sell new homes in a depressed market. Far better to slow things down and bring stock to the market once prices are rising and the demand is higher.
The ramifications of this for the construction industry are significant. The big players account for a large slice of the materials and labour market; when they’re not buying, prices come down as a result. So what could this mean for you as a developer? You’ll recall that the market predicts a reduction in house prices in 2023 and possibly into early 2024. Therefore it seems unlikely that the major players will be stepping back on the gas until the prospects of more buoyant house prices are in view. As a result, many contractors and tradespeople could be desperate for work in 2023. Likewise, the cost of materials will decrease since there is less demand. Assuming you bought your site in mid-2023, it’s likely to be late 2023 when you would be tendering for the contract (tendering involves having your cost consultant put together a detailed specification and having numerous contractors give you a price). If the major players are still not ramping up their production, you’ll likely secure some highly competitive labour and materials prices.
Ok, so you’ve bought a commercial property at the bottom of the market and secured the best possible prices for your materials and labour. But what about your selling prices? Assuming you started on-site in early 2024, you’d probably expect to be putting your finished units onto the market in late 2024 or early 2025. Most market commentators (including the OBR) predict that prices will rise again by that time. In other words, you’ve achieved an enviable hat trick that should allow you to make significant profits.
But hold on a second. That all sounds fine and dandy, but what if the market defies expectations and does something different? Surely you could catch a cold here if things don’t go your way? The knack for doing property development well is not only to spot great opportunities but also to minimise your risk. As someone who trains new developers for a living, I can share that high up among the raft of risk mitigants we teach students is the importance of having two exits. And once again, the market should automatically help you out. Let me explain why that is.
The two most common exits from a development project are either to sell your units and bank the proceeds or to keep them and rent them out.
Let’s imagine you’ve built your units, but the market hasn’t bounced back enough when you come to sell them. Perhaps mortgage rates and the cost of living are still high, which has impacted affordability. In this scenario, fewer people can afford to buy, so they rent instead. And this has the effect of pushing up rental demand and rental prices, something we’ve already seen in 2022. So, instead of selling your units, you can refinance them onto a buy-to-let mortgage and then rent them out in a buoyant rental market until the conditions are right for you to sell. It may not be your preferred option, but it means you’ve got a viable Plan B that still allows you to make a handsome profit when the time is right.
It’s not surprising, then, that small-scale developments are very much in the ascendency as we head into 2023. But for those currently pursuing a different property strategy, what makes me think you’d be any good at development? Well, as luck would have it, the skills you need to take on these types of development are not dissimilar to those required to be a landlord. You’re essentially playing the role of chief executive, appointing a team of people to deliver the project while you sit in a management position. And given these developments typically make more profit than a buy-to-let and require less of your own money, it’s not surprising that my business has so many landlords, flippers, and property investors on our books looking to develop their first project.
So, if buying a commercial property to convert in mid-2023 could be great timing, what should you do in the interim? Well, I’d suggest the first thing you should do is do some research. Find out what’s involved rather than jumping in (there’s a link below if you’re interested). Then if it’s for you, get yourself educated so you can avoid the pitfalls and learn where the best opportunities are. Development is neither easy nor without risk, but it’s perfectly possible for those willing to put in the effort, and it’s an excellent fit for those already in the property game. And with the stars aligning for 2023, it could turn out to be your perfect Christmas present.