There is an awful lot to take into account when it comes to budgeting for a development project. You need to know how much it’s going to cost you, how much you’re likely to make, and how much the banks will be willing to lend you to finance the project.
Peter Hutchinson, Founder of Master Capital Group, explains some of the considerations for any potential developers.
Calculating ROI and IRR
One of the most important numbers in any project is the return on investment (ROI) or initial rate of return (IRR). After all, if your project isn’t going to make any money then it isn’t worth doing.
To work out your return you need to take into account all costs, including capital employed, interest payments, and all project fees, and offset them against the total end revenue. The ROI looks at this figure as a whole, whereas the IRR takes into account the time needed to complete the project and achieve the projected profit.
For example, if a project cost is $1 million with a profit of $500,000 then the ROI is 50 percent. But if it takes two years to complete then the IRR is 25 percent; three years would be 16.6 percent, and so on.
When it comes to obtaining development funding, banks will require a minimum ROI of around 20 percent, says Peter. Second tier banks may drop slightly lower to around 18 percent, depending on how the loan is secured.
Banks will also look at the level of debt coverage a project provides. In the past the standard was set at 0.8 – meaning 80 percent of the loan value had to be covered by pre-sales – but they are now setting the bar higher and looking for full debt coverage, and in some cases the rate is as high as 1.4.
Peter explains the reason for this shift: “Some investors, particularly overseas investors, have been putting down a deposit of five percent or less and then failing to complete the sale. To allow for a certain percentage of sales to fall through, banks are starting to push for a higher rate of debt coverage than is actually required.”
Peter says that in his experience, the maximum ROI a developer can expect from a project is around 35% for a particularly high-end venture. The main determining factor is the yield; sites with height restrictions will limit your return, whereas developments with the potential to build higher will offer a greater yield.
However, Peter warns of the risks of building to the maximum height permitted just for the sake of increasing your yield.
“The risk you have with going down that track is that if you’ve got 50 stories and you don’t have pre-sales, or you just have pre-sales up to debt coverage, you may not be able to complete them,” he says.
“In a rising market that’s all fine but if it’s a softening market, which we’re heading into now, maybe you will end up with some of the units still in your possession because you haven’t been able to sell them, and you’re not going to sell them at a below-cost rate.”
When running the numbers for your project, the value of the land should be between 25 and 30 percent of the overall cost.
But Peter explains that land prices are rising, and he puts this down in part to people having access to a wealth of information via the internet.
“People are now seeing what developers potentially can make, and they’re increasing the value or they’re selling their land at a higher percentage.”
The result of this greed is that increasing numbers of projects are simply not feasible. Higher land prices mean there is not enough left over for all the people involved – including the investor, the developer, and the vendor – to turn a decent profit.
Despite this, Peter believes that most projects carry enough money to offer a good return to property investors. Although there is always a risk involved if a project doesn’t complete as planned, investors stand to gain a fair profit without needing to be involved in the details of the development.
Calculating project fees
There is a myriad of project fees that need to be factored into ROI calculations in order to work out an accurate figure.
Most of these, Peter explains, can be estimated as a percentage of construction costs. For example, development management fees are between three and five percent, and architectural fees are between two and three percent of the construction value.
Banks will, of course, apply lending fees in addition to charging interest on the amount borrowed, and Peter says that the tightening of the banks’ lending regulations is pushing developers to obtain funding from alternative sources.
“Mezzanine funding is becoming more and more required by the developer to make sure they’ve got enough equity in the total property,” he says, adding that the typical rate for this kind of funding is between 15 and 20 percent per annum, but it usually only accounts for a small percentage of the total equity.
One of the major costs to factor in is, of course, for construction. This can be worked out relatively accurately on a per square metre rate, says Peter, and it usually comes out at around $3000 per square metre. However, there are all kinds of variables that will affect this, such as balconies, number of stories, internal spaces, and carparks.
Carparks in themselves can be a complicated matter; on a small development, carparks take up a relatively large proportion of the space – particularly if they’re underground and space is needed for ramps. The entry and exit points can affect how much turning space is required, says Peter, and you also need to consider the demand for bike racks.
Once you start thinking about it, you realise just how much thought needs to go into every little detail of a development – even at the planning and cost estimation stage. This is just one of the many areas where Master Capital Group can lend their expertise to a project.
Some quantity surveyors offer online feasibility study tools, which allow you to plug in all your numbers to calculate approximate costs for a project. But these should only be treated as a rough guide; everything is still subject to approval by your bank.
“Once you’ve completed your feasibility study, you have to submit that to the bank and then they’ll have a separate QS report, which will identify all the various areas within a project,” says Peter.
Understandably, the bank’s assessment is incredibly thorough because they want to make sure that they are funding the right amount and the project is viable. They will include the head works and holding costs (which are often overlooked), and will conduct a complete valuation of the project, making sure all costs are accounted for.
Allowing for the unexpected
If everything goes according to plan with your development, you stand to make a good return. But Peter warns that it’s unusual for everything to happen exactly as planned. Even the best developers in the world have occasional blowouts, he says.
The things most likely to trip a project up are time and cost of funds. Time is money, and so even a small delay could push costs up beyond what you’ve allowed for.
There are many factors developers have no control over. For example, heavy rain can cause flooding when you’re digging down to sub-basement level; the council can receive objections to the development after work has commenced; or you might find Aboriginal artefacts buried at the site.
It’s important to have contingency funds that will cover your holding costs during delays like these. Any extra money you need to borrow unexpectedly will be at the higher mezzanine funding rates of 15 to 20 percent, impacting a project’s profitability.
The GFC’s effect on funding
It hasn’t always been so difficult to obtain funding from banks. Pre-GFC, some banks were lending up to 80 percent of the gross realisation value on a development.
But the crisis brought to light a serious problem with over-funding projects that held very little equity.
“A lot of developers went under during the GFC; they were leveraged too highly and they didn’t have enough equity in the projects and when they came to try and complete them, they just simply ran out of funds,” explains Peter.
At this point the banks would take over the development and sell it on for the highest value possible in order to recover some of their investment, but this would not come close to the gross realisation value if the project was incomplete.
These days, banks will only lend 65 or perhaps 70 percent of the total construction value. That’s a big drop down from 80 percent of the gross realisation value. Even second tier banks won’t lend on “soft costs” such as architectural fees, town planning fees, finance fees, and interest.
This means that a significant amount of equity is required in order to fund a project, and that’s where companies like Master Capital Group can help get a project off the ground – matching investors with projects that require funding.
“We can help you find that equity partner” says Peter.