Residential property development can be very profitable, however equally costly if not approached with vigilance.
Taking the first step
Residential property development can be very profitable, however equally costly if not approached with vigilance. In this blog series over the coming weeks, we reveal our 15 key lessons that are the result of experiences in the recent past. These lessons have been learned the hard way, sharing our experiences so you don’t have to make these same mistakes. Hard work, determination and the sqft.capital deal modelling tool coupled with these rules to live by will lead to that long and profitable property development career you dreamt of.
How to Fund a Property Development. Track records; their importance, how to build one and how to start without one
Senior debt or “leverage” allows a developer to borrow money at a low interest rate in order to use it to gain a higher deal return rate. If you borrow £100 at 5% per year, it costs you £5 per year. If you can invest that £100 at 10% per year, it makes you £10 but only cost you £5 and so you have a 100% profit. Banks and other senior lenders are “last in, first out” – they get the lowest interest rate because they take the lowest risk – but their money goes in after everyone else's and comes out first (referred to as the senior portion of the capital stack). As such, they will typically only lend 60-90% of the total cost (not end value) of a development. This makes their money “safe” as the development would have to lose all profit and investors cash before they lose a penny. Senior lenders will also have first charge on the property meaning that if anything goes wrong, they take control of it.
A significant understanding in the developer’s arsenal before starting out is actually how to obtain money from financial institutions, usually through an intermediary who understands the financing market such as sqft.capital Once identified (which senior lenders have an appetite to lend on real estate development), a developer must know what lenders require in experience and capability in order that the underwriters (the actual decision makers) part with the money that the front office (sales guys) are so keen to assure you that they will.
It may be useful to know that the business development team are targeted and incentivised to bring deals in – they do not necessarily make the actual decisions to lend. Any bank or lender has a huge level of deposits or investor capital on their balance sheet and if un-invested, it makes no profits. As such, lenders are eager to deploy as much of their balance sheet as possible to the right transactions – to allow return creation.
However, any deal must gain approval from underwriters (or a credit panel) who assess the risk of lending to a scheme and determine whether you are a risk worth taking.
Typically, a lender will require from developers - Personal Guarantees, first charge (ownership) over the property / asset, and most likely first - a track record. This could create a dichotomous situation as how does anyone start being a developer (and being lent money) if they have no history of success in the field?
The answer here is to juggle, beg/borrow, don’t steal, and use some entrepreneurial creativity to get over these initial barriers - anything that can get some deal history association – even helping others in minor ways is better than zero. If this seems intimidating, perhaps this role of a developer is not entirely suited to an individual – no-one starts a business without this ability. This same individual will need to juggle many things, as long as they are in the business of property development. It never gets easier – deals rarely come to you; some just become more accustomed to it than others. If getting off the ground by juggling feels an insurmountable wall, it is certainly worth considering at least, methods of going in with someone with more core sales skills who will attack this in their stride. The reason money is made in property development is having both the vision and execution to keep climbing walls that will present themselves – this takes persistence.
It is vitally important to remember, there are no short cuts to vast cash windfalls here – to obtain a level of success, one must be patient - and patient usually means 2+ years of experience.
With no experience behind you, it is unlikely to ever present itself for your first deal. As such, better to get some experience in whatever small way possible. Each bit of experience will teach you more about the business and be a step closer to you running your own deals. Try some of the following:
- Identify deals for others and take a percentage - this one is pretty easy and highly recommended as it will cultivate experience at identifying deals (seeing value as opposed to wrecks) and it will connect future developers with potential equity investors and generate quick income (quicker than executing an entire deal). As a rule of thumb, the market will typically pay a fee to an introducer of 1% of the purchase price - if a deal works well though (perhaps yielding in excess of 20% IRR), feel free to ask for more in the form of a % of the profit over and above a certain level – for example, if it makes the buyer more than 20% on their investment, ask for a percentage of the over-and-above. To initiate this, find some potential deals and start taking them to prospective investors or other developers that don’t have the time to be at the coalface like a younger developer. Get good at modeling deals so you can quickly show the headline numbers using the sqft.capital deal modelling tool - total acquisition costs, total development costs and total disposal costs (leave debt costs out for now as how that person finances the deal is up to them).
- Before taking any deals to someone though - be sure to get some form of agreement in place that they will actually pay you a fee for bringing a deal to them - this can be as simple as a one page document or email saying something along the lines of “if I (name) identify a property that you (name) or any company or individual that you are connected with later purchases, you agree to pay me a fee of 1% of the purchase price, payable on completion of purchase”. Have them sign and date it and you counter-sign it and give them a copy (by email). This may be an awkward and slender piece of legal compliance and honestly, you will at sometime get screwed over by someone not paying you and even if you had a lengthy contract, they have more money than you so it is unlikely that you will sue them. This is a vital bit of experience as every developer will encounter it at some point - accept it and move on knowing you have just bought a valuable lesson. Should anyone delay or resist signing this agreement – don’t even bother with them. No seriously, do not bother. If they want a deal, they need to be happy to pay you.
- A final word of warning - when you do take a deal to someone you have an agreement with, its better to not disclose the address until they have agreed that they like it - giving too much information out too early can allow greedier types to confirm internally that this deal was born of their enormous capability.
- Take a management fee - if you are able to identify a deal, it is worth suggesting that you also manage certain aspects of the deal. There is a lot of running around with many deals that many an investor would happily pass over for a small monthly fee. Don’t be afraid to ask - be upfront, you don’t have the funds to do this yourself so are aiming to make money by bringing deals to others and managing them - most honest people will recognise your determination and probably see you as a younger version of themselves and take pleasure out of mentoring you as you should keep bringing more deals to make them money. The experience you will gain in running deals like this will be invaluable - just remember to be honest and never be afraid to ask questions.
- Offer to help project manage for other developers – similar to above, there are many developers out there with deals already running. They will be happy to pass on their experience and delegate any jobs they can. If you offer to do this for free - many ears will prick and gates will precipitously swing open. This may not be an option for you financially but if at all possible, this kind of work experience is the best available. It certainly should not be performed as working for free; this is huge learning opportunity and chance to impress. Work diligently, go beyond expectations and it would be a lycra-clad developer that did not give some form of reward. Very many developers prefer to give way more reward at the back end (when sold) instead of loading their front-end budget so a bonus is likely for a good job (which means good profit, not just hard work).
- Take a mortgage - before development finance is available to a developer - a mortgage might be. This may also award the freedom to run a first development concurrent with your existing employment (which will definitely be needed to obtain that mortgage). Also, mortgage debt is very cheap compared to development debt, and the biggest bonus, if this is your primary residence; it avoids the greasy hands of the tax man. These two factors will become a glorious thing of the past when a career as an experienced developer begins; so make the most of them. Many a developer has started to build up their pot by moonlighting (literally) their first property - you will also never feel as rich as when you sell the first one for a profit. One negative aspect here is that mortgage will not lend on the development of a project, only a percentage of the purchase costs so you will have to find that money elsewhere. Can you get a loan?
- Borrow from family - not everyone may be in this lucky position but if you are able to borrow money from a family member, offer them a decent return on their investment and make very sure they completely understand the deal you are doing – the potential upside and possible downsides. This practice will help hugely later in life when pitching to a financial institution that does not possess a will to see your success like a family member does. Parents may be interested in getting involved and they will perform significantly less due diligence than a bank but if they are unaware exactly how the project has been modeled, the site may have unexpected daily visitors, and this is to be avoided at all costs – you do not need people checking up on you daily. Anyone lending money is putting a huge amount of trust in the promoter and so it is only diligent to entirely explain their risk in doing so and their potential (note “potential”) upside. Do not promote overt optimism, as people will actually lend money a lot easier if aware of all potential downsides and risks as this displays clear understanding of the downside. Many a passive / amateur investor is far more focused on their risk (downside) than their potential upside - remember that and raising money in future will become a lot easier.
- Full equity deals - this is probably the toughest but, saying that, not impossible... There are bored individuals who have buckets, and buckets of cash - some are clever, some not so much - the former usually made it and the latter commonly not. Either way, idle funds adore a property deal due to their high risk / reward but they are also tangible assets that (unlike stocks) are physical. If you are able to meet those who have enough money to risk a portion of it without it affecting their lifestyle - ask the question. It is possible to massively promote the deal in their favour - give a primary return on cash (i.e. if they put £1,000,000 in, give them a priority hurdle – interest on their cash - which could be 5% per annum on the money they put in before anyone takes any profit) and offer a larger part of the profit share. What you negotiate is debatable but try asking for 30% of the profit (perhaps with a monthly management fee to cover your cash flow - that will be taken against your profit) as this should offer an enticing opportunity to an investor.
All of the above are ideas about bootstrapping the way it into the game - it will not be comfortable and it will not be easy, but if later rewards are sought, hardships of getting off the ground are necessary as with any entrepreneur. Do not lie, do not be over-optimistic and above all, never take risks beyond your level of tolerance. This may vary for some but for one to abide by is never being in a position whereby risks would stop you sleeping at night.