Profiting from property development
We’ve been asked a few times lately why, if we are focused on social outcomes, do we also need to show a profit on our development appraisals.
The answer to this is tied up with how projects get funded.
If someone asked you to lend them some money for a property development project, what kind of return would you expect?
“Well, that depends”, you might say. And you might go on to ask “When will I get my money back and what are the risks?”. And you’d be right to ask.
“Well”, might come the response from your trusty developer friend, “We will pay you back from the surplus we make once we have got planning permission, knocked down the existing building, built a new one and sold the new development.”
“Right”, you might say. “And I suppose you can’t know exactly what you will get permission for, what it will cost to build or exactly what you will sell them for”. “Correct”, they say. “But we’ve got a good team with decent experience and have got the measure of all these things. We’ll be co-investing with you too. Side by side”.
“Can’t you borrow from a bank?” you ask. “Yes, we have…” they say, “But they will only lend up to 60% of the cost. We have to find the rest”.
“And how long might all this take?” you ask. “Realistically, three to five years perhaps”. “Hmm”, you murmur. “And if it all goes wrong, like you don’t get planning permission, or build costs go up or the market goes down, what protection do I have?” you ask. “Erm, some” comes the response. “But the bank will have first charge, you would come after. Think of it a bit like me borrowing on a credit card. Unsecured. You’re the credit card company”. “A credit card?” you say. After a little thought you might say, well “If it is kind of like borrowing on a credit card, I’m faced with the greatest risk, I think I would like credit-card like returns. But I’d also want a share in the performance of the project too. If you do better than expected, I want to share in that.”
And there we have it. The cost of equity investment in property development projects.
And this is the generally unspoken truth about the need for profit from property development. The project’s ‘profit’ is the source of the returns for equity investors. If the development makes no profit at all, the investors get no return on their investment. And, in investing, there is an opportunity cost of that money and its only right that there should be a premium for the risk being taken. If the investor can’t see a route to a fairly priced return then they won’t invest and the development won’t take place.
So when you see a development company making what seem like eye watering returns on a development project, remember that someone has had to stick up eye watering sums in the first place and has sat first in line for any losses over a number of years.
And it's this balance of the need for returns on investment and the risks inherent in development that drives the need for a profit margin in any given project. The fewer certainties at the outset, the higher the profit needs to be in order to cope with the unexpected and deliver a risk adjusted return to investors.
We at Stories are continually focused on how we balance the need for equity and how risk is carried through a development and by whom. A common approach we adopt across all the projects we are working on is to identify and actively mitigate risks at the very earliest stages. We then set about designing the projects' delivery (funding, legals and contracts etc) to enable us to price the profit margins accordingly. This works to all parties' advantage and supports us in our mission to create and leave behind enhanced social and environmental value. At the heart of this approach is a close working relationship between landowners, funders, investors, designers, construction partners and ourselves – collaborating and being open about how and when risk is transferred, managed and ultimately mitigated.