Profiting from property development

How the pros grow their wealth – and how to copy them – in 6 easy-to-follow steps …

How do the pros make money consistently? And how do they protect themselves from risks?

Property Development

Vanilla buy-to-lets are barely profitable nowadays, even before factoring in the new tax changes. So, development has become the favoured strategy within the property space. Furthermore, the government is on your side with its target of building 1 million new homes by 2020. 

But this is not about being a property developer. That’s a full time occupation with stress thrown in.

• The smarter way is to invest passively into the best projects: Select the best projects, create a portfolio, re-invest – and multiply your capital, just like the pros do

20-50%+ returns

I often look at development projects with such returns. Are these returns achievable? Absolutely – I invest in such projects and have made even higher returns. Doing it well requires proper due diligence (DD) and the right approach. Sitting through a slick presentation delivered by a smooth developer with social media presence does not equate to proper DD!

Carrying out DD is detailed in a future post but the main elements to research are: 

1. The Developer – its track record, the process it employs, the quality of its team (internal & external team), how it interacts with investors
2. The Project itself – break down the expected return into planning outcomes, costs of construction, assumed GDV (gross development value), exit strategies
3. The risks inherent in each deal (macro risks, micro risks)

Doing DD is a great first step in selecting your investments. It helps us to fundamentally understand the opportunity we are investing into.

How the pros invest – in a nutshell

The smartest investors, that generate the most wealth, play the long game. Professional investors build portfolios that consistently make money – year after year.  

I, and my fellow pros, choose £1 coins every time. This mindset is key to multiplying your wealth – and never get flattened. This is my investment approach entirely.

Sounds great – how do I start?  

We have to invest like a pro. Pros grow their wealth because they have a proper process whilst minimising risks. By following my 6-step process anyone can invest like a Pro …

1. DD the developers

It’s vital to do DD on the developers so you’re comfortable about their management of your investment. The investment opportunity might look great but it needs to be managed and executed by a competent developer and their team. The main areas to analyse are:

• Their track record: timeframes vs initial expectations, returns vs expectations, experience
• The process it employs, the way they work. What is the “edge” that makes them excel?
• The quality of its team: both internal & external: planning consultants, architects, designers, accountant, lawyers, project manager(s), the construction team and investor relations staff

Very important: don’t be swayed by slick marketing presentations or a high-profile social media presence. This means nothing. You have to do proper DD. 

• Developer due diligence is covered in more detail in a separate article

2. Appraise and analyse the project  

Double check the developer’s assumptions used for the expected return on investment. Assess each component of the project including: acquisition price, planning, costs of construction, assumed GDV (gross development value) etc. 

Next, stress test the expected returns, taking into account different scenarios around planning outcomes, cost/time overruns and market volatility. If the opportunity still stacks up after stress testing, that’s a good sign. 

Look at a range of exit strategies. Will the project be sold post-planning but before development? Or after development? If planning doesn’t come through, what are the alternative exit strategies that will still make money? 

Typical range of returns

The typical range of returns on equity investments is 20-60%. The range is wide due to several factors including: the existence of a planning permission element, profit share arrangements with the developer, and whether there is leverage (use of mortgage). 

The typical range of returns on fixed-rate debt investments is currently 8-15%, annualised.

• DD on the project is covered in more detail in a separate article
• Select the right investment – Risk & Return

After doing DD on the developer and the projects, let’s assume you made a shortlist of 5 different investments: A, B, C, X and Y. They may all have different return and risk profiles – as shown in the chart below. i.e. investment A offers the lowest returns but also the lowest risk. C offers the highest return but is the riskiest … 

• DD the developers

It’s vital to do DD on the developers so you’re comfortable about their management of your investment. The investment opportunity might look great but it needs to be managed and executed by a competent developer and their team. The main areas to analyse are: 

• Their track record: timeframes vs initial expectations, returns vs expectations, experience
• The process it employs, the way they work. What is the “edge” that makes them excel?
• The quality of its team: both internal & external: planning consultants, architects, designers, accountant, lawyers, project manager(s), the construction team and investor relations staff

Very important: don’t be swayed by slick marketing presentations or a high-profile social media presence. This means nothing. You have to do proper DD.

• Developer due diligence is covered in more detail in a separate article
• Appraise and analyse the project  

Double-check the developer’s assumptions used for the expected return on investment. Assess each component of the project including: acquisition price, planning, costs of construction, assumed GDV (gross development value) etc. Next, stress test the expected returns, taking into account different scenarios around planning outcomes, cost/time overruns and market volatility. If the opportunity still stacks up after stress testing, that’s a good sign.

Look at a range of exit strategies. Will the project be sold post-planning but before development? Or after development? If planning doesn’t come through, what are the alternative exit strategies that will still make money? 

Typical range of returns

The typical range of returns on equity investments is 20-60%. The range is wide due to several factors including: the existence of a planning permission element, profit share arrangements with the developer, and whether there is leverage (use of mortgage). 

The typical range of returns on fixed-rate debt investments is currently 8-15%, annualised.

• DD on the project is covered in more detail in a separate article   

3. Select the right investment – Risk & Return

After doing DD on the developer and the projects, let’s assume you made a shortlist of 5 different investments: A, B, C, X and Y. They may all have different return and risk profiles – as shown in the chart below. i.e. investment A offers the lowest returns but also the lowest risk. C offers the highest return but is the riskiest …

Financial theory tells us returns are linked to risk. Think: higher risk equals higher returns – like investments A, B and C in the chart above. Whilst this is true in general, in property it is quite possible to find opportunities where risk and return may be mispriced. Look at investments X and Y; they have the same return but different riskiness. Clearly, you would prefer to invest in Y rather than X. A real example of Y and X are shown below. The pros invest where risk is mispriced – they find the Ys. You can too. 

Mispricing – real examples of an X and Y …

At InvestlikeaPro we analysed two investments recently and they perfectly illustrate X and Y:

Project Y

This project already had planning permission and the developer was in advanced discussions with the local authority on improving the scheme which would increase GDV of the original design by 16%. With the improvement being granted, the expected ROI was 42%. We stress-tested the ROI with a) the improved scheme not being granted and b) costs to overrun by 15%. The stress-tested ROI was 28%. 

Project X

This project had no formal planning permission (it had pre-planning). The developer had used fairly punchy end-values to calculate GDV, giving an expected ROI of 38%. We stress-tested the ROI for a less ambitious GDV, a slight increase in cost contingencies, but assumed PP would be granted. Our stress tested ROI came down to 27%. And there remained risk of planning refusal. Yet, the developer (using slick marketing and investor relations) was able to attract the full investment. 

A classic case of mispricing. (Both investments had similar leverage and developer profit shares) 

4. Create a portfolio of projects and diversify

Once you’re satisfied with the developer and the specific investment opportunity, don’t just put all your eggs into that one basket. I strongly recommend creating a diversified portfolio of development investments. 

Split your pot into around 8-10 investments. So, if you’ve set aside an investment pot of £100K, you would allocate £10-12K into each project. 

Diversification is done in a number of ways: eg the range of developers with whom you invest (at least 5), by geography (don’t be exposed to just one region), by sector and by risk-type. 

An illustrative guide to a diversified portfolio

• Detailed portfolio construction will be covered in more detail in a separate post

5. Make it a PRO portfolio

So, diversifying your portfolio means you spread the risk. But how you do that makes for a really smart portfolio. This step is straightforward to implement and reduces the risk of “crash and burn” in a downturn. This approach enables the pros to carry on through a downturn and create sustainable wealth over the long term. The survivors, and winners, of the 2007/08 financial crisis were those who followed this approach … 

With typical returns ranging from 20-60%, it might be tempting to select only a handful of the highest returning investments.  I.e. loading up your portfolio with a bunch of C-type investments from the chart above. The Cs might appeal to get-rich-quick types but we invest like a pro to create sustainable wealth over the long term. 

The pros follow what is known as a ‘barbell approach’ to investing – like the portfolio on the right, below. This is much more balanced than the typical amateur portfolio full of high-return, potentially high-risk investments. 

Each blue circle represents a different investment. The one on the right is more diversified, more balanced, with risk spread evenly from lower to higher ranges. 

The pro portfolio makes great returns consistently. Most importantly, during a downturn. its owner is less likely to lose everything. This is how the pros survive to keep making money over and over again.

6. Rebalance your portfolio

To maintain your portfolio in the best shape, you have to continually rebalance. That is, when investments mature – i.e when projects complete and you get paid out – you should reinvest those proceeds back into the portfolio following steps 1-5 above. 

When you reinvest, something magical happens. Compounding. The 8th wonder of the world according to Einstein. Compounding can multiply your wealth many times over.

• More on compounding in a later post!

Return to www.investlikeapro.co.uk regularly for more insights.

Manish Kataria CFA is a professional investor with 18 years’ experience in UK real estate and equity portfolio management. He has managed money for JPMorgan and other blue chip investment houses. Within real estate, he invests in and owns a range of UK property including developments, HMOs, serviced accommodation and BTLs.