An Insight into Property Development - Part 3
Before progressing to purchasing a development site, it's crucial to first establish that you can not only afford to buy the site, but also all associated costs of the development.
Get to know a finance broker with development funding experience to find out what your limits are. They will also be able to advise what you will need to provide from a cash input. ie what you fund and what the bank will fund. It's important to use a broker with development funding experience as its a lot more difficult than obtaining finance for a simple investment purchase. Lenders will usually allow developers to borrow up to 70-80% of the 'hard costs' of the development - not on the end value of the project. Hard costs relate to the building costs- not for things such as design fees, engineering fees, council charges, purchase cost etc which are known as 'soft costs'.
In a practical sense this will mean your loan to value ratio (LVR) is markedly less than that for a buy and hold investment property. In other words, you need quite a bit of money or other sources of equity before a bank will fund you. Even then, some banks require 100% of their debts covered before starting through pre-sales. For example, if you borrow $1,000,000, you need to have pre-sales totalling $1,000,000 before the banks will let you start. Typically, the more experience and development history you have, the more flexible the banks are with their financing restrictions.
As part of your applications for finance, one of the most valuable things you can do is a feasibility study. This determines how much profit you could make, remembering that most banks don't lend below a 20% profit margin. A feasibility study is essentially a business plan. Like any business plan you weigh up pros and cons, crunch the numbers and determine if there will be a profit. The feasibility study will include -
- Purchase Price and stamp duty
- Your equity in the project
- Borrowing costs - including interest over the period of the loan.
- Consultants costs
- Construction costs - at this stage an assumed industry standard will be enough
- Contingency - 5-10% of project costs.
- GST on sales
- Agents fees
- Income from sales or rentals.
Remember all this needs to be done in conjunction with an understanding of not just the local market, but the overall economic picture as well. This is because a development will typically have a life of 18 months and typically more. While external forces may be beyond your control, you need to have a plan B and C if the economic climate changes. If you plan for the worst, if the best happens it's a bonus.
With that in mind it definitely pays to start small and stay within your means. The biggest mistake made by developers is after 1 or 2 projects, is thinking they know it all and risk too much in the hope of the big payday. It makes much more sense to be in control of your own destiny and not be compromised by external factors, be it banks, economic uncertainty, poor sales etc. Done well, property development can be rewarding - both financially and from a sense of achievement. To take a vacant site from concept to completion, with the whole process involved is something that not many could or would undertake.