Risk is an inevitable part of developing property. But there are several different types of risks that can affect your project, each with their own causes and implications. Understanding your potential risks is key to mitigating them and maximising returns. Â
While the many risks faced by property developers and investors throughout a project’s lifecycle are largely dependent on an array of situational factors, the most common tend to relate to market conditions, financing, construction, leasing and exiting.Â
We delve further into each of these particular risks to provide some insight into why they are prevalent and how gaining a better understanding of each of them may be helpful when assessing a real estate opportunity or entering into a new project.
Market risk
The property market is cyclical – real estate prices can and often do rise but they can also flatten or fall. Market risk refers to changes in demand or supply that can affect property prices. Understanding what can cause a boom or bust market can be the difference between realising high profits or lacklustre returns.Â
There are several factors that can affect the demand for real estate including consumer confidence, the level of interest rates, the need for housing driven by increased immigration or a baby boom. Recently, many have been caught out by interest rates rising, creating uncertainty in the property market and increasing the level of market risk.Â
When buyers factor in market risk into their purchasing decisions, the demand for property may reduce, resulting in lower returns for an investment. If you choose not to sell during a downturn, you will incur higher holding costs as you see out the cycle.Â
Other factors that may contribute to market risk include changing social trends that impact demand over the long-term. For example, the trend towards smaller household sizes may mean more housing will be required in the future but the type of housing that is required may change.
Financing risk
The ability to secure financing for a project can exist across the life of the project, not just at the beginning. As circumstances change you may need to refinance or seek additional funds but your ability to obtain financing may also have changed – this is financing risk.Â
Financing risk is often closely related to other risks. For example, credit markets may tighten for developers if interest rates rise or rental incomes reduce as financiers factor the same risks into their lending decisions. If credit markets tighten you may need to look further afield beyond traditional banks to obtain financing. Often, non-traditional financing can be more flexible in its terms, like requiring a lower cost to value ratio, but this may come with additional costs and conditions that could impact your cashflow. You can read more about how property development financing can be structured here.
Construction risk
At the time your budget is developed, you will no doubt plan for construction costs. But when you consider the long time period of many development projects, a lot of things can change and many of these may impact the cost of construction. We have recently seen the impact of construction risk with high inflation and supply chains impacted by political unrest overseas. As a result, the cost of raw materials have increased leading to the possibility of cost overruns.
Construction risk can also involve the availability of labour, as we saw during and following the pandemic, where labour shortages increased costs and led to lengthy delays. Other factors impacting the availability of labour can include immigration policy and the quality of skilled labour. Â
As a development progresses, additional risks may arise including the quality of the work produced by the builders, contractors or suppliers. If there is an issue with quality, what starts as a difference of opinion can quickly escalate into a costly dispute that leads to lengthy delays and budget blowouts.
Leasing risk
If a development property is intended for residential or commercial tenants, consideration of leasing risk must also be made. A project’s profitability will be dependent on three main factors – the occupancy rate, amount of rental income and quality of tenant. Â
Occupancy rate refers to how much of the property is able to be leased out. This can change depending on a range of market factors including the availability of similar types of property and market demand. Similarly, the amount of rental income investors may earn from your development will be affected by market risks such as consumer confidence, property demand and amount of similar properties available.Â
These factors can also impact the quality of tenants that are attracted to your property. High quality tenants with long-term lease agreements and stable income are more attractive to investors but may be difficult to find during a period of economic downturn. Social changes can also impact the quality of tenants your development may attract – for example, as more businesses move to hybrid working arrangements the demand for commercial tenancies may decline long-term.
Exit risk
Timing is everything in property. If you sell at a time where demand is low due to economic uncertainty or social factors, you risk failing to meet your profit expectations. In turn, this can have knock-on effects to future projects, from limiting your ability to purchase your next development site or impacting the amount of equity you can release by refinancing. Â
Many market factors can impact the price of your property, including consumer demand, interest rates and leasing risks. In addition, changes to government policy can also influence demand over time, from capital projects planned near your development to the level of immigration impacting consumer demand. These risks may swing in your favour and lead to higher returns or can result in your property taking longer to sell and increasing your capital holding costs.Â
If your development has taken longer than anticipated to build and/or sell, there is also the risk that legislative requirements have changed impacting your ability to exit at the desired time or price. Some factors that could change include environment controls, tenancy laws and taxation laws. Depending on the change it could make it more costly for you to sell, require revisions to the property or make the property less attractive to investors.
Managing risks
How risks are managed can make the difference between a successful project or not. While not every risk can be mitigated, it is prudent to test your project against worst case scenarios and plan for these, ensure you have contingency funds in place (or are at least familiar with the avenues available to access them), and protect yourself with robust contractual obligations.Â
The team at Madison Branson Lawyers have decades of experience helping developers and investors manage their risks in complex and high-value deals across the property development, construction and infrastructure sectors.
We understand that every development project is different and your requirements may vary between each stage of the development process from purchase through to construction and exiting. Our experienced lawyers work with you to ensure your interests are protected.
No matter what stage you are in your development project, our Property, Construction and Conveyancing team are available to help. For a confidential discussion, contact us today.
The information provided in this article does not, and is not intended to, constitute legal advice; instead, all information is for general informational purposes only.
