Failure: The Primary Risks in Development

By: Mason McDonald

In last month's newsletter, we examined several opportunities that are currently available in the world of development–specifically those that exist due to inventory shortages and lending regulations. To the savvy investor or developer, reading that article could have been exciting and shown where there is significant opportunity, but to the also savvy investor, it could have drawn up concerns about the risk-profile of investment opportunities in the development space. Both are appropriate responses.

This month, I will attempt to examine several of the common pitfalls that happen in new housing developments and how we can turn those failures into opportunities for our companies and more importantly, avoid that risk for ourselves and our current and future investors. I will primarily focus on three pitfalls that are controllable within development rather than the ever-present natural disaster/pandemic/act of God risks that are always something we keep on the radar. The three risks that we’ll examine will be operations, financing, and market analysis.

Failure #1: The Bad Operator

This particular cause for failure in development is probably one of the more complex pitfalls to appropriately label or define, but you’ll know it when you know it: and that’s The Bad Operator. Within business, operations is the lifeblood of any organization and typically when you look at an org chart, just about every aspect of the business lines will flow through the head of operations. For housing development, the need for an experienced operator is absolutely critical due to the amount of stakeholders involved, the amount of phases in the project, and the necessity of all plans being executed correctly the first time.

The reason that I said that this is one of the more complex pitfalls to define is because of the sheer amount of stakeholders that are involved in any development project. From the initial site evaluation of the piece of land to the finishing touches on the homes that are built, there are dozens of stakeholders that can significantly affect the success of a project with many of those stakeholders being government offices/officials. Since there are so many phases and moving parts involved, the operator of the development has the opportunity to pass blame onto anyone they see fit (“well, you know how the county is”, “well, you know how subcontractors are”, “well, you know how _____ is”...[you get the point]).

Since it’s seemingly impossible to label to whom the blame lies in some of these projects, the only person that the investor can fault for their lost money or delay in timeline in receiving their returns is the operator. However, if you are unfamiliar with the industry and have difficulty distinguishing between who is an effective operator versus who is someone that is going to lose your money, here are some potential ways you can analyze who it is you’re investing your money with.

Evaluation of Their Business Track Record

If the project entails completing a massive development project (large apartment complex, large single family subdivision, etc.), the operator should have experience being involved in massive development projects. The level of complexity with a project like this requires prior experience in order to be successful. However, the definition of prior experience is something that can be a little bit more nuanced and will ultimately come down to the investor’s opinion of whether the prior experience is applicable to whatever project it is they are looking at investing in.

Look for Experience with Similar Projects

Don't just settle for experience in development in general. The ideal operator will have a proven track record of success in projects similar to the one you're considering. This demonstrates their understanding of the specific challenges and opportunities associated with that type of development.

Assess the Depth of Their Team

A strong operator is surrounded by a strong team. Look for a development company with experienced professionals in areas like construction management, architecture, finance, and legal affairs. A well-rounded team is essential for navigating the complexities of a development project.

Reference Checks and Due Diligence

Don't be afraid to ask for references and conduct thorough due diligence. Speak with past investors and partners about their experience working with the operator. Research any legal or financial issues the company may have faced. The more you know, the better equipped you'll be to make an informed decision.

By taking the time to evaluate the operator's experience and team, you can significantly reduce the risk of partnering with someone who will lead your project down the path of failure.

Failure #2: Poor Debt Structuring

Just like a poorly built house can crumble under pressure, a development project with a weak financial foundation is destined to fail. This brings us to our second major pitfall: Poor Debt Structuring.

Debt, when used strategically, can be a powerful tool for developers. It allows them to leverage their capital and maximize returns. However, if the debt is structured incorrectly, it can quickly become a suffocating burden, leading to missed payments, defaults, and ultimately, project failure.

Here's how poor debt structuring can derail a development project:

Mismatched Loan Terms

Imagine taking out a short-term loan to finance a long-term project. The pressure to repay the loan quickly would restrict your ability to invest in the project's ongoing needs, potentially stalling construction or forcing cost-cutting measures that compromise quality.

High Interest Rates 

Excessive interest payments can eat significantly into your profits. In a worst-case scenario, they could even make it impossible to generate a positive return on your investment.

Inflexible Covenants

Loan covenants are restrictions placed on borrowers by lenders. They can limit your ability to make strategic decisions, such as acquiring additional land or changing the project design. Rigid covenants can hinder your ability to adapt to unforeseen circumstances.

Here are some ways to avoid the pitfalls of poor debt structuring:

Work with Experienced Financial Advisors

Securing the right financing is crucial. A skilled financial advisor can help you understand different loan options, negotiate favorable terms, and ensure the debt structure aligns with your project's timeline and budget.

• Stress Test Your Plan: Don't just plan for the best-case scenario. Factor in potential delays, cost overruns, and market downturns. Run simulations to see how your project would fare under financial stress.

• Maintain Open Communication with Lenders: Keep your lenders informed about the project's progress and any potential challenges. Building trust and transparency can give you more flexibility if unforeseen circumstances arise.

By carefully considering your debt structure and working with experienced professionals, you can ensure your project has the financial foundation it needs to weather any storm and achieve success.

Failure #3: An Oversaturated Market

Even the most experienced operator with the most ironclad financial backing can be sunk by a simple fact: there just might not be enough buyers for what they're building. This is the danger of an Oversaturated Market.

A market saturation occurs when there is an excess supply of a particular type of housing unit available for purchase or rent. This can happen for a number of reasons, such as:

• A Sudden Increase in Development: If multiple developers all decide to build luxury condos in a specific neighborhood at the same time, there's a good chance they'll all end up struggling to sell their units.

• A Shift in Demographics: Maybe your development is geared towards young families, but the neighborhood is experiencing an outflow of young families and an influx of retirees. This mismatch between supply and demand can lead to vacancies and falling prices.

• Economic Downturn: During an economic recession, people are less likely to buy homes. This can put a damper on the market for even the most well-designed developments.

So how can you avoid the pitfalls of an oversaturated market? Here are a few key strategies:

• Market Research is Key: Conduct thorough market research before you break ground. Analyze existing housing stock, demographics, and economic trends to understand the true demand for the type of housing you plan to build.

• Find a Niche: Don't try to be all things to all people. Identify a specific niche market with unmet needs and tailor your development to cater to that niche.

• Location, Location, Location: The location of your development is crucial. Look for areas with strong job growth, good schools, and amenities that are desirable to your target market.

By carefully considering market conditions and strategically positioning your development, you can significantly reduce the risk of getting caught in an oversaturated market.

In conclusion, the development world is full of opportunities, but it's also fraught with risks. By understanding the three major pitfalls we've discussed – a bad operator, poor debt structuring, and an oversaturated market – you can increase your chances of success and turn potential failures into learning experiences that propel your development ventures forward.