Eliminating the 11 Big Risks of Real Estate Development
Let’s take a look at some of the risks of real estate development. Undertaking your first real estate development project is more demanding and involves more risk than buying your first investment property. But while there’s more that can go wrong, there’s also the opportunity for bigger rewards. I think the biggest risk for the first time developer is inexperience or lack of knowledge.
The good news, however, is that with the help of experts and specialist advice, you can overcome the risk of inexperience or ignorance and avoid the usual pitfalls.
This will speed you on the path to becoming a successful developer. Now let’s take a deeper look at what I call the 11 Big Risks.
Risk 1 – Inexperience
The key to eliminating this risk is to always ensure that you have the input of a professional real estate development specialist, especially on your first projects. Not having this assistance could affect your ability to borrow funds. My company has helped many real estate developers start their careers, getting them on the right path from the start and helping them become great.
Risk 2 – Loan risks and interest rate risks
When you borrow funds, you should take into account the possibility that interest rates will increase during the term of your development or the long-term holding of your investment. This can result in higher development and maintenance costs. However, this should not be a cause for concern as the actual increase may not be too high. Of course, at the other end of the scale, you could also increase your profits if interest rates go down.
Risk 3 – Market value risks
Based on the fact that property values can go down as well as up, you can have no guarantee of the value of your project upon completion, or even how much demand there will be if you decide to sell. Smaller, faster changes will be less risky and there will be less time for values to fall. But in general, property values go up more often than they go down, and in the long run, if you hold onto some of your property, you’ll make money. Property values would have to drop about 15% before it tends to lose money.
Risk 4 – Risks during Construction
There are several reasons why construction costs can increase. Disputes, unexpected delays caused by labor or material shortages, and bad weather can delay the construction period and lead to increased maintenance expenses. Using a lump sum fixed price and time contract can help lower the risk of skyrocketing construction costs, as well as making sure you do extensive due diligence with the builder before hiring.
Risk 5 – Financial risk factors
The main risk here is not having enough additional capital as a reserve or contingency fund, in case costs increase more than anticipated. I think it’s important that you allow and keep a contingency fund for when this happens. Real estate development involves financial risks and the sooner you realize and understand these risks, the sooner you will be successful as a real estate developer. As a general rule of thumb, I work with a 5% contingency margin on all my projects. As I mentioned, you’re going to run into trouble as it’s part of the beast’s nature, but a buffer will help ensure you don’t get undone.
Risk 6 – Risk of not performing thorough due diligence
A complete due diligence checklist is essential. The proper due diligence must be carried out before purchasing your property. To avoid buying a property that will cause you problems in the long run, you should review your listing thoroughly, including all details related to planning, engineering, builder and financial analysis with the local Council.
Risk 7 – Paying too much for the Site
It is true to say in the property business that ‘you make your profit when you buy the site’. Market knowledge, especially in the area of land values, along with the ability to negotiate a good deal are important assets when it comes to making sure you buy well. Study your market and area wisely; keep your ears to the ground and keep your head above the clouds. It will save you from burning your cash.
Risk 8 – Underestimating costs
Getting an idea of the costs involved relative to the revenue side of the feasibility study (the sales), from real estate agents and appraisal specialists is reasonably easy. However, controlling the expense side is much more difficult, especially if you are new to the game. You should be very aware of all the costs associated with the income and expenses of the development and how much to allow for each. If you are well informed about your costs, you will be less likely to underestimate them.
Risk 9 – Setting your loan limit
Don’t make the mistake of borrowing at full capacity, as this leaves you no room to move in the event of unforeseen circumstances such as interest rate increases, slow sales, or construction delays. Know your borrowing limit and stick to it.
Risk 10 – Hiring the wrong consultants
Increasingly, clients are calling me to see plans that have been poorly designed. Approximately 95% of these plans were designed by drafters, and almost always the money the client saved by using less qualified designers was doubled and sometimes tripled in additional costs associated with construction problems and delays. If you pay qualified people to do your work, the result will be satisfying, and ultimately, you’ll spend less money and make more profit. It takes an average of five years for an architect to complete a degree and two more years to register, as opposed to three years total for a draftsman.
Risk 11 – Disputes with commercial and construction contractors
Disputes with construction and commercial contractors can cause lengthy delays, which exceed budget as the developer has to cover delay costs. When contractors quit before completion, a replacement contractor must be found, and in most cases, contractors that are called in the middle are more expensive. This is because the developer’s bargaining power is weak and the contractors know they are in a tough spot.
Resume
• I think the biggest risk for the first time developer is inexperience or lack of knowledge.
• If you pay qualified people to do your work, the result will be satisfactory and, ultimately, you will spend less money and make more profit.
• Know your borrowing limit and stick to it.
