When planning your development project, the bottom line should be the return on your investment, regardless of what the market might be doing at the time.
A good target to aim for is a 15 to 20 per cent return on your development costs, which is the net profit you make after selling the finished property or properties.
WHY A TARGET OF AT LEAST 15 PERCENT RETURN?
A 15 percent margin is a good compromise between providing a safety cushion in case of sudden changes in the market, and being an achievable and maintainable target.
If you work on a 15 percent margin, you will simply:
- Make good money in a good market.
- Make sufficient money in a bad market.
Obviously, if you firmly believe the property market is about to slump, you won’t get involved in a development at all.
However, if you stick to the 15 percent rule you’ll learn to be highly disciplined and effective in your negotiations.
Crucially, you will learn to walk away from a deal when it’s too risky.
If the market is overheating and the opportunity of a safe 15 percent return is not available, simply walk away. Wait until the market is in a better condition before you purchase your property.
HOW THE BANKS PROTECT THEIR RISK
If you think about it, banks use 15 to 20 percent of a property’s value as a buffer against their risk. We can see this clearly in the terms for standard mortgages.
In order for you to get a mortgage, a lender usually requires that you put up 15 to 20 percent of the property’s value.
This is based on their assumption that the market is highly unlikely to drop more than 20 percent, so that even if the mortgage holder, that’s you, went bust, the lender would still get their money back by selling the property and keeping the deposit.
If financial institutions use 20 percent as the level at which there’s no real risk, then so should you.
If you also apply this principle – aiming for a 15 to 20 percent return – you will be drastically reducing your risk exposure.
MINIMISE YOUR RISK WITH A GLASS HALF EMPTY APPROACH
To minimise your risks when doing your financial feasibility on a potential development site, always look at the potential downside. When you’re calculating potential returns of your development, always take a pessimistic view.
Test your ability to finance the property under the worst possible conditions.
Assume that interest rates will rise substantially and that end values and rental values will hold or even.
What will the end values be on completion of your project?
If you are planning to develop and hold rather than sell your property, when you’re calculating potential returns from rentals take a similarly pessimistic view.
If after these realistic calculations you can still make a good return, you can go ahead with your development knowing that even in a worst-case scenario where the bottom falls out of the market, you won’t lose money.
The crucial thing is that this level of security will enable you to hold on to a property until the market corrects itself as it always does.
Essentially, holding the property as a long-term rental will buy you time.