Business

Evaluating the risks of a real estate development

Learn how risk evaluation in the early phase of a project can help develop a sustainable commercial strategy, identify red flags, and prevent cost overruns.

R

eal estate projects always start from an optimistic point of view, otherwise they would probably never start. Problems occur when optimism clouds reality and the financial returns end up proving you wrong.

The most common issues we encounter with real estate developments fall into one of the following three categories:

  1. Projected sales are below target because the market was not well studied or not based on wrong assumptions.
  2. The operating and construction costs overrun the initial budget.
  3. The clients are about to sue for breach of contract and lack of compliance.

Can the risk of failure be prevented? We believe so, as long as the origin of the problem is well understood and the right corrective actions are taken promptly.

Why are we failing to sell?

All real estate projects are born from an Excel spreadsheet, where the price of land, and the costs of construction and operations define the type of product to be designed. The final sales price is almost always determined by local competition. To achieving better sales results in terms of revenues some developers position their product more competitively by lowering the price or adding more amenities. Few developers take the time to study and analyze in details their niche market based on realistic market data.

A couple of years ago, a developer in the north of Mexico decided to buy a piece of land in the Riviera Maya and build 12 high end luxury houses. Without previous market research, he began construction, and once halfway through the construction he had only sold 1 house to one of his relatives. Despite the optimal location of the land, there was no market for houses that didn't meet the needs and expectations of local clients. Currently the project has been discontinued and is abandoned, as no bank wants to re-finance a product that doesn't sell.

Investing in a market study that analyses demographic and psychographic data and identifies niches and competitive opportunities makes conceptual design and marketing easier while avoiding the race to the bottom that consists in competing on price. The first rule should be to know what we don't know.

How to control costs?

Effective planning and supervision are the key to success when it comes to building a real estate development. Only with a construction management team who understands quality control and operational processes, and has experience and technical expertise, can you manage to deliver high quality projects without making costly mistakes.

In 2016 we had the opportunity to work with an experienced developer in middle-income housing who decided to switch gears and dedicate himself to the hotel industry. He managed to sign with a well-known American hotel chain, bought land on the beach, and hired an architect to design a project for 119 business-level keys. When we were called to execute the work planned, the land had already been acquired without having had a study of soil mechanics (or Geotechnical Engineering). The excavation should have been 8 meters deeper, and subsequent land modifications tripled the cost of the foundations. These costs could have been avoided if the preliminary studies had been done.

Investing in a construction management team with specific experience in the type of development that is being built is essential to meet deadlines and cost targets.

Post-sale is just as important as sales

One of the biggest mistakes that real estate developers make is thinking that their commitment to the client ends once the units have been delivered.

Five years ago we worked with a middle-income home builder who achieved first-stage sales on target and was confident that subsequent commercial stages would achieve equally well. They never anticipated that the residents who acquired the first homes were demanding the resolution of basic problems such as security, green areas, access, finished roads and guarantees of hidden defects. Units were purchased on the basis of brand promises that were never met. After a year they were still no resolutions. Despite the action plan that we proposed to the developer in order to address the issues of his clients, the construction company ignored the directives and continued with its previous work plan. Months later sales plummeted, and the development became a ghost town that is still not fully sold out despite several price cuts.

The ability to solve problems effectively and with professionalism in the post sales phase largely determines the credibility and reputation of a developer.

Do you want to know how successful your development company is? Ask your clients what the experience of living in one of your developments has been like.

You build credibility and a lasting reputation once your customers become your brand ambassadors. Developers need to start by understanding how to meet client expectations, listening to their feedback, and focusing on meeting the brand promises that were made.

No matter how many developments and projects you have built over the years, you should never assume that you know enough to skip market studies, build quality processes and hire experienced staff.

Article in Spanish Version

ASSESS YOUR RISK SCORE TO IDENTIFY ANY RED FLAGS

ARES is a risk assessment method developed by Archetika to evaluate risk.

Our proprietary risk score algorithm computes risk factors based on benchmark data from hundreds of real estate developments.