In this article we will depict the real estate development risks and their mitigation. Real estate development consists of land assembly, development, financing, building and the lease or sale of residential, commercial and industrial property. Real estate development is a very dynamic process with a significant average duration
2. Potential Project Risks
Each type of Real Estate has its own development risks. The following is a portrayal of the risks that may occur in the Real Estate business, along with the mitigating measures.
The risks can be grouped in the following clusters:
- Land value risk: land acquisition costs and the risk that estimation f obtained area changes because of market circumstances.
- Land exploitation risk: The risks primarily identify with environmental issues.
- Planning permit risk: The risk that no usable planning permit is received or that this process takes longer than expected. This risk also applies to other municipal approvals/permits, such as commercial licenses. Whether or not grants are obtained is also included in this risk.
- Construction risk: This regards pricing, design, quality and possible delays.
- Revenue risk: There are numerous variables that impact revenues. These include yields, rent levels, sales price levels, inflation and interest rate levels, demand and supply
- Duration risk: The duration is a consequence of other risks. It can impact interest costs, yet can likewise cause different issues, such as claims from tenants if the agreed opening date of a shopping centre is not met. A delay could also mean that the project has to face adverse market circumstances.
- Political risk: The risk that the project encounters problems due to a change in government, regulations and so forth.
- Partner risk: The risk that a partner in the project cannot meet its obligations or disagrees on the way forward.
- Legal risk: This covers a broad area of topics: possible objections against changes in zoning, liability risks or contracts which have not been drawn up correctly. It also concerns the risk of not obtaining the required permits and the risks involved with buying existing companies to acquire land positions. Tax risk is also included in the legal risk.
3. Risk mitigating Measures
To mitigate the aforementioned risks the following mitigation can be highlighted:
Research is fundamental in assessing virtually all kinds of risks. Important research areas will include:
Forecast of yield development;
Occupiers and consumer demand
- Phasing: By adequately phasing projects, the steps to be taken are smaller, the steps to be taken are more modest, with conceivable passageways after each one stage.
- Contracts: Many risks can be mitigated by carefully drawn up contracts. It is therefore essential that the legal department is involved, either directly or indirectly by instructing local lawyers. With respect to construction risk, it is crucial to use controlled pricing mechanisms when entering into construction contracts. Therefore, it is preferred to have a fixed price contract to the largest possible extent. Depending on the project, flexibility might be needed to achieve the best price possible or to allow for tenant demands, design changes etc. All projects need also to be insured in line with insurance policies. Furthermore, the quality of partner agreements ( clauses on the decision process and exit possibilities ) need to be highlighted.
- Cost calculations: A development appraisal consists of assumptions which become more certain in the course of the project. The risk of surprises and wrong assumptions made during the process need to be mitigated by meticulous calculations. These will be made during the development process as the design will evolve toward final specifications and will have to take into account inflation levels, price increases as a result of increasing demand etc. Where necessary, these should be verified externally.
- Pre-lease/-sales: In order to ‘ test ’ the market of end-users before entering into the commitment to actual starting of construction of a project, a certain rate of pre-letting or pre-selling is required. It should also have the ambition to enter other major commitments ( e.g land purchase ) conditional upon these market-tests. In addition to demonstrating the market appetite this will reduce the amount at risk as well, since pre-leasing/selling locks in part of the revenues.
- Timing payments: on account of expenses it is preferred to pay as late as could be allowed, while on account of incomes it is wanted to get these as ahead of schedule as would be prudent. Next to the obvious advantage of lower interest costs, this strategy provides control in case of possible disputes, relating to for example contracts.
Furthermore, it is preferable to keep the level of spending in the development phase to such a level that a real go/no-go decision before the start of the construction phase is still possible.