The Five-Year Problem for Developers

In the world of construction and property development, we cannot escape the realities that have come about from the Brexit crisis. The sphere of build costs and development appraisals have been hit by the uncertainty that has materialised from the way in which the situation has been handled. Despite the UK officially leaving the EU on 31st January 2020, a trade-deal with the EU has yet to be agreed, and this continues to have an air of unknown about it and is causing mass rises in build cost and tender pricing forecasts for the next five years.

The problem – Breakdown of RICS predictions

RICS have estimated that over the next five years, building tender prices are due to rise by 27%. Considering that the industry standard for development projects is a minimum of 20% profit on cost, a 27% rise in the building tender prices will have a significant impact upon the industry. The rate at which costs will rise is set to increase year on year; the estimated 6% growth in 2024 is set to be double the rise they expect for 2020, estimated to be 3%. RICS believe tender prices will increase by 3% in 2020, 5% in 2021, 5% in 2022, 6% in 2023, and 6% in 2024.

To break this down further, building labour costs are predicted to rise by 20%+ over the forecasted period. The estimates are set to be 3% rise in 2020, 3% rise in 2021, 4% in 2022, 5% in 2023, and 4% in 2024. Following this, it is expected that the cost of construction materials will rise at between 3-4% per annum over the next five years too.

We have already seen the Brexit impact hit the construction market. Since 2016, tender prices have risen, with the cost increasing by 15% per annum between Q1 2016 to Q1 2018, and then continued to rise at between 3-5% between Q1 2018 to Q4 2019.

Regarding the rising cost of labour, the most glaring reason for this is the lack of churn of European workers coming to the UK. The European builder has been an unsung hero of our industry for many years and played a big part in housing supply. With all the immigration/political uncertainty clouding the Brexit debate over the last few years, we are now experiencing far fewer migrant workers in the construction industry, and therefore the cost of labour has increased dramatically. Also, when looking at how Brexit has impacted the cost of materials, the strength of the British Pound has had a major effect. In recent times, far greater numbers of construction materials tend to be sourced from abroad. Couple this with the weakened pound we have experienced since 2016, and it becomes apparent that currency fluctuations have, and will continue to play, a significant impact on the cost of materials coming from abroad.

In the past, rising building costs have been accompanied by rising house prices. However, the figures show that since 2016 we have already seen a huge increase in tender price rises, with the cost increasing by 15% per annum between Q1 2016 to Q1 2018, and then continued to rise at between 3-5% between Q1 2018 to Q4 2019. During this period, the growth of house prices significantly decreased across the country and led to slimmer margins for SME developers.

What do these figures mean for SME developers?

It’s clear that the rising costs of construction, both in terms of labour and materials, is going to have a significant impact upon the margins and bottom line of SME developers and their projects. If the cost of residential houses/apartments remain somewhat stagnant as the UK continues to pave a new path for itself in the world, and make itself appealing to investment from foreign markets, the rise in build costs is going to force developers to think outside of the box if they want to continue to survive and thrive in this environment.

To make matters more difficult for the SME developer, funders are aware of the uncertainty the industry is facing over the next five years and are looking more stringently at development appraisals. They want to see margins big enough to offset the risk involved with the uncertainty. Funders are keeping a close eye on the developers’ build costs and contingency allocations to ensure that their borrowers are ready for the rise in prices. It is not uncommon for appraisals to be done several years before the conclusion of a project, and funders will want to see adequate funds allocated to build costs to withstand the uprises from today’s costs to those at being experienced at the end of the project cycle.

Additionally, these facts are only acknowledged to have a major impact by those within the industry. Developers approaching landowners are being met with unrealistic expectations as landowners outside of the construction industry disregard the fact that rising construction prices devalue their land prices. This makes negotiation more difficult and requires a significant amount of time to explain the delta between the developer and the landowner’s valuation on a particular site.

How can developers beat the cost increase, and if not, where can they find the savings to counteract?

The key question an SME developer will ask upon reading the somewhat bleak speculations on rising costs is, “how do I beat these increases?” Whilst there is no exact science, a number of measures can be taken by developers at the outset of planning and appraising to make sure they are prepared for the uncertainty of their project. The most important thing a developer needs to do is to face the challenges head on. It’s easy to live in hope and speculate that these estimates may not come to fruition. However, it goes without saying this could lead to a lot of projects failing should the costs increase in line with predictions.

Buy well

The most obvious way to combat this is to “buy better”. The age old saying that “you make your money on the way in, rather than on the way out” is more important than ever. Whilst it’s easier said than done, developers will have to remain more focused on securing parcels of land and sites at a price that can support the more expensive costs they will inevitably face during the construction period of their projects.

Land traders who buy unconditional sites, gain planning, and look to flip it on, will find their pool of SME housebuilders diminish over this period and will find they will not be able to sell at the same premiums they were previously able to.

Developers need to be thinking about the bottom the line right from the start of the project, more so now than ever. In years past, developers would sometimes overpay for a site and look to value engineer it throughout the planning and construction process to find hidden profits to make the scheme work by the end. What was previously a risky tactic, but somewhat considered possible, is a dangerous way to proceed over the next few years. Dealing with landowners from the outset to communicate the market conditions and your interpretation of the valuation on the site/land will be imperative to getting good deals over the line. The land buying process can be extremely long and arduous, but giving in to purchasing for a higher cost and hoping to find hidden profits in the construction process is a path that should be tread with extreme caution.

Partner with other stakeholders to limit your downside

Another way in which developers can exercise caution over the next five years is to consider limiting their downside by partnering with others. Joint ventures are a popular term these days, and whilst they come with their own challenges, they can be utilised to mitigate risk for the developer. Ultimately, if you have the opportunity to negotiate a joint venture with a landowner/construction partner/professional consultant etc., you can limit the amount of funding required during the acquisition and construction phase of projects and allow for more space in the capital stack for unexpected cost rises.

To take this approach, a developer needs to be comfortable in the knowledge that they may not be milking as much money out of a deal as they possibly could have, as it often leads to a profit-share upon exit of the project, but equally they are keeping themselves safer and more secure in these uncertain times.

A common example of a development joint venture is when a landowner has a site that they have not recognised the development potential on. In this scenario, a developer can negotiate a deal in which they would secure planning on the landowners site, and either trade this on, or build it out and split the profits with the landowner in a pre-arranged way that would usually mean the landowner receives a sum greater than the existing use value of the land.

Communicate and work closely with your contractor

Moving further along the process, if you’re working with a traditional procurement model, communication with a main contractor is key. It is imperative that a developer works with a contractor that they feel understands the risks and is ready for the rise in construction costs. A terrible outcome for a developer is to work with a contractor that hasn’t prepared for the fast rise in prices, and eventually goes bust because of this. Once a developer is confident that the contractors are prepared for this, during the tender process, a developer may choose to work with a contractor on a Design & Build basis. This means their price to deliver the project is somewhat fixed. It’s worth noting that a Design & Build agreement will have a main contractor already pricing in the cost of uncertainty for the duration of the project. However, if it fits within a development appraisal, a developer could choose this approach as it provides them with more security against the swings of the labour and materials market.

Create good products

Whilst beating the costs on the way in and during the project is extremely important, it’s upon exit that a developer see’s the revenue coming in. To put it simply, if construction costs are rising, developers have the license to go out and create better, bolder, and more “affordable luxury” units that can increase their overall GDV/value of a site on the way out of a project. This can be done in a number of ways throughout the project lifecycle, from innovative design ideas at the outset, to the incorporation of smart-home technology during the construction phase of a project. All the little things that may cost more during the project can add a significant value on the way out and can help to beat the slimming margins the project may face. Create homes that stand-out from the norm, and not only can you generate more profit from sales, but you will also find your sales time decrease and allowing you the ability to pay back funders quicker and keep decrease the cost of finance.

Summary

In summary, it is clear the next five-year period is going to pose challenges to SME developers, but equally, for those who are able to act swiftly and come up with solutions to adapt to the new climates, it can pose a great deal of opportunity. Disappointingly, we may be seeing fewer numbers of SME developers in the market, but for those who can manage to solve the five-year problem, they have the licence to grow and scale their business exponentially.

Image credit: iStock.com/Leonid studio

About Nikhil Patel

Nikhil Patel is the Managing Director of Flamingo Investment Group. Flamingo Investment Group is a boutique real estate group, specialising in residential property developments in and around London and the United Kingdom.