Talking about mistakes is often uncomfortable. Yet, learning from experience is arguably the best way of outperforming in the future.
It is obvious that developers must present deals in the best light to attract investment, but there always needs to be a balance. In the long term, no one benefits from unrealistic or inaccurate appraisals. To the objective observer, many development appraisal mistakes may seem obvious, but, with viability pressures higher than ever, it is remarkable how often issues repeat themselves.
As someone who has spent much of the last 20 years developing real estate, and now acting as a funding adviser, I have tried in this article to balance both the developer and funder (debt and equity) perspectives. The initial aim was to cover the whole development process but, as I started writing, I realised just how many pitfalls I was able to remember! So, this first article focuses on the beginning of the development process – the development appraisal (aka the business plan).
So, without naming names or dropping myself in it too much, here are my top 3 appraisal pitfalls to avoid:
1. The overly optimistic development appraisal
Every developer has faced this temptation. The truth is, this one is a question of degree. Everyone expects a developer (who speculates considerable time and money to pull a deal together) to be positive about the financial prospects of an opportunity. However, there is a line to be drawn between healthy optimism and unhealthy optimism.
Whilst many funders will focus on the exit price per sqft, where things can really go wrong is a material underestimation of delivery costs, which can be open to more debate. The arguments are numerous, ranging from “we know the best contractors and suppliers” to “inflation is easing and costs will come down over the next 12 months”. There are some exceptions (for example where a developer is also a contractor and can demonstrate high levels of cost certainty) but, generally speaking, if the costs look too low, they are.
An additional pitfall to mention is assuming unrealistic debt terms. When you’re trying to raise equity and your viability is under pressure, one easy option for a developer is to increase the leverage and squeeze the interest rate on the debt funding. All this does is delay bad news – as the debt won’t be available on the identified terms and the deal may therefore not close. Identifying realistic debt terms is even more important where there is an evolving funding strategy, like an initial land bridge, followed by one or more refinances. We have seen recent examples where this has not been the case and developers are at risk of losing all their equity.
2. Being bad at maths
As someone whose maths career peaked at GCSE (unlike my expert colleagues at Voltaire Financial) I am not well qualified to wax lyrical about maths. However, in the context of a development appraisal, where you are expecting funders to part with substantial sums of money, being bad at maths is a problem.
It is remarkable how many development appraisals are inaccurate. Common issues range from something as simple as columns not summing correctly, to the interest rate on a mezzanine loan not being calculated properly, to incorrectly indexed affordable housing calculations. Such mistakes tend to have one thing in common – they produce higher not lower returns.
We don’t have time in this article to go into all the reasons why development appraisals might be inaccurate, but, a lack of effective standardisation within the industry is a clear issue. Proforma software like Argus has limitations on bespoke analysis and Excel is a fantastic tool but in the wrong hands it can be a car crash. With more than 130,0001 real estate businesses in the UK, and no standard approach to appraisals, it is easy to see the challenges.
The take-away for funders is to ensure that development appraisals are not just taken at face value. Most funders are good at this. It is probably more important from the developer’s perspective to get the maths right first time because, if you don’t, when mistakes are highlighted later on, it either (a) completely undermines your negotiating position or, worst case, (b) means you spend many years labouring under a misapprehension of what you’re going to get at the back end. Indeed, some of the more ruthless private equity funders might exploit this latter point from the beginning of the funding negotiation. A well-known London residential developer once said to me “you can only personally deliver 10 substantial projects in a 20 year career so you need to make them count”. Ambitious developers may disagree over the number of projects, but these are wise words.
3. Deal closed, development appraisal in the desk drawer
We can be so focussed on getting a deal closed, and closing that chapter of the development story, that the original appraisal (i.e. the business plan) gets put in a drawer and largely forgotten.
Part of the issue is that, often, one team works on the deal origination and funding and then another team works on the delivery. Once the origination and finance team have closed a deal it usually gets passed over to the delivery team who weren’t necessarily closely involved in the appraisal process. It is then all too easy for the delivery team to forge ahead with negotiating contracts and ordering materials with little reference to the business plan.
When a deal is funded, it is imperative that there is a development appraisal included within the deal documentation that all parties are committed to following. This ‘business plan’ must then be the bible for all subsequent development team meetings – each month the delivery team must report against the cashflow set out in the business plan – noting any movement vs the previous month and comparing back to the original appraisal. This necessitates the finance team having constant communication with the delivery team so that any material changes (for better or worse) are spotted as early as possible and reflected accurately. Doing this accurately and consistently over 36 + months is not easy, particularly if there are personnel changes along the way.
The most successful developers are great at implementing and monitoring the agreed business plan. And vice versa. During the course of our advisory work, we have seen substantial development businesses (no longer existing) that lumped all their various sites together, without any deal specific financial monitoring whatsoever.
Funders rightly focus on this monitoring process so that they have confidence in the developer’s ability to deal with bumps in the road and present them with an accurate picture at any moment in time.
The observations in this article are not ground-breaking. But, if developers can present reasonable development assumptions, remain focussed on accurate numbers and ensure proper monitoring, and funders can double check that these approaches are in place, everyone will be in for a more enjoyable and profitable ride.