#SQFT 12: Have you got the best deal? How to increase profit in property development.

Guest post for our partner, Squarefoot Capital – Where property developers raise debt and equity funding.

 

With every deal appraisal, we break down each element in the following methods to assess firstly if it is viable. Secondly, how we can financially engineer it to increase profitability before raising debt and equity as required for the developer.

Here are the steps we use:

Summary and Story. We get an understanding of the deal – plans, location, demand, difficulty – the story behind a deal is just as important as the numbers when going out for investment. Anyone investing in your scheme wants to know how you have worked to find value in a project that others haven’t. If it’s too easy, red flags start to pop up.

Headline Costs. We summarise the 5 headline costs of the deal. These are the Land price, the associated acquisition costs (SDLT, professional fees etc.). The development cost (build, including VAT), the professional fees (architects, surveyor etc.) and finally the disposal costs (legal, agents fees). We know have a clear picture of the expected costs before finance – on which we base the optimum debt loan.

Debt percentage and cost / fees. We model the debt – decide whether the developer prefers a low leverage (say 50-60% of deal costs) or a high level of debt – upto about 90% of the costs of the deal. The cost of debt is then modelled based on drawdowns of the build facility over the period of build and the duration of sales of the units. We now have a very accurate expectation of the cost of the debt on the scheme which we can tailor to suit a developer.

Debt lenders. Now we know the amount of debt to be raised, we can look at the most appropriate lender currently and their fees – to ensure this is the most competetive in the market at that time. Many are suprised how much they have been paying in the past compared to what is on offer.

Profitability. After tweaking the debt amounts and costs of it, we have a clear picture of the strength of the deal by the profit as a percentage of the total cost of the deal. As ever we are looking for the minimum magic 20% return on cost – preferably 25%+ though to show some flexibility. If the deal is more than 12 months in duration, we must then consider the Internal Rate of Return of the deal as this will half if the deal length goes from one to 2 years – this is more specific to the equity lender though.

Type / level of Equity. Now we have a picture of the deal, we look for the best equity option (if required). Typically, we will look at either:

A preferred equity coupon (where the equity investor takes a fixed return on thier investment (typically 20 – 40%) before the developer taks any profit, or

A hurdle / coupon (5-10% of the equity amount) to be paid to the investor before profit, followed by a straight profit split.

At this point we can focus with the developer as to what they would prefer – if they have a highly profitable scheme, they make not wish to give away too much profit and so are willing to put a little more cash in at the start. However, if they have little cash to put in, they may prefer a fixed profit split in the hopes of repeat business with the investor. Either way, we can then go to our black book of equity partners and negotiate the best deal for the developer.

Finally, we use a metric test – by summarising the main metrics of the deal such as the build cost/SQFT, the sale price/SQFT, the average sale price etc., we can see then if any key indicators will stand out and affect the developers ability to raise funding in any way. An example that many developers try is including a very high management fee for carrying out the development. This can typically put off a lot of equity investors s they see is as guaranteeing too much return to the developer before profits.

This story is listed in: Investment, London Property market, Property development, Property Investment

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£20,308,750

GDV to date

£970,308

Average acquisition

£1,562,212

Average GDV

£351,115

Average Equity raise per deal

£343,558

Average profit per deal

97.75%

Average ROI on equity

11

Deals completed

8

Currently units in progress