When repositioning is not enough, and the project you have
inherited simply has no profitable (or sufficiently loss minimized) way forward
then you may have to replan it. That means a completely new start. Replanning
for a completely different use, throwing out the current consents and
demolishing what has been built might be the most profitable strategy. Blue sky
thinking.
There could be dozens of options
and hundreds of permutations if you decide to replan the project. Two critical
features will dictate the range of options available to you: 1) planning
constraints, and 2) the current real estate market.
If you plan to rezone the property
to make allowance for an alternative use, then all the luck of the Irish to you
— I’m not about to embark on the limitless opportunities your project site may
have. However, if you are going to plan within the current planning rules
(perhaps with a few infringements) consider the following first three steps
that often have the most impact on profitability:
Can you increase density, or floor area and put more of the same or similar product on the site? This will reduce your land cost per unit. It can be especially effective if you are not significantly increasing per unit construction costs at the same time.
On less expensive land where construction costs are increasing, can you do less density and lower height to take advantage of comparably cheaper rates? There is typically a reasonable difference in dollars per square foot construction costs for five-story condos (high) versus two-level terrace homes (lower).
Does your planning and zoning allow what is in hot demand in the current real estate market? For example, residential may no longer be profitable but the office market is. You can then concentrate on this use.
That concludes our series on Restarting Failed Property Development Projects.
The property development project has flaws preventing it from working in the current market, but they are not terminal if it can be suitably repositioned. Repositioning often includes some redesign and a new approach to sales and marketing. There is no 11 herbs and spices recipe to reposition a development project in trouble. The idea is to find a more profitable feasibility and action its delivery without throwing everything out and starting again. Probably the best way to explain repositioning is to give some examples that I am familiar with across the real estate spectrum:
Residential
Down spec’ing (reducing specification of mainly
fittings and fixtures to a less expensive alternative) to reduce cost to appeal
to a lower price point.
Up-specifying to increase desirability for those
at a higher price point.
Decreasing home or apartment size to appeal to a lower price point and/or a
higher investment yield (a smaller unit could cost much less to build than the
corresponding drop in rental).
Increasing home or apartment size to appeal to a
higher price point.
Joining homes together by duplexing or terracing
to reduce cost or add homes.[1]
Combining or splitting apartment units to create
dual key opportunities (live in one, rent the other).
Selling groups of sections or super-lots rather
than individual sections, appealing to larger developers and builders.
Joining sections to make suitable for larger
homes.
Subdividing sections into smaller ones, to make
more affordable.
Selling sections rather that house and land
packages to appeal to owner builders and small-time spec builders.
Reconfiguring homes or units to have more
bedrooms in the same space, increasing rental income.
Converting garage space into liveable area or
vice versa.
Adding commercial opportunities to residential developments. Include a home
office. Make the ground floor of a multi-level home suitable to lease for
retail or office. Create a gym space that can be leased. Include a valet and
carwash service in the parking garage.
Converting part of the residential to a hotel or
serviced apartments, for example the top floors
of an apartment building, with a separate lobby on the ground floor.
Conversely, converting a hotel or serviced apartments to residential units for
sale or long-term rental.
Converting residential to student accommodation, student accommodation to a
hotel, and vice versa.
Industrial
Cutting larger industrial premises into smaller
sellable or leasable areas.
Turning industrial premises into managed
self-storage facilities.
Joining smaller areas to create larger premises.
Increasing or reducing the office space provided
with the industrial.
Adding a residential use to the industrial
premises, such as an apartment over light industrial units.[2]
Partially converting to retail use; for example,
on a main road frontage.
Lifting the roof to increase stud height — effectively
repositioning to a larger tenant market.
Office
Decreasing or increasing contiguous areas to
attract a larger or smaller (or more varied mix) of office tenants.
Convert to serviced office space, rent by desk
and business incubator type office space.
Install exclusive stairs to join levels of a
prime office internally — to reposition to larger multi-level tenants.
Adding a retail presence to the ground floor of
an office building either because it attracts a higher rent, or it helps to
provide additional amenity to office tenants.
Adding naming rights and signage opportunities
to increase revenue.
Adding a residential use to the office premises,
such as an apartment over office units or making the upper levels of the office
into apartments.
Increasing common area spend (lobbies, elevators,
toilets lighting, artwork, furniture, size space, luxuriousness of materials) and
amenities (onsite gym, showers, roof deck) to attract higher class (higher
paying) office tenants.
Decreasing common area spend and amenities to
decrease operating expenses to attract more cost sensitive tenants.
Spending more capital upfront on low maintenance
plant and equipment to lower ongoing tenant expenses.
Embracing latest ‘hot issue’ for specialist or socially
conscious tenants; sustainability, high technology or alternative transport.
Retail
Decrease per unit size to allow for smaller
tenancies at higher rents.
Include different sized spaces to attract a varied
tenant mix.
Adding a residential use to the retail premises,
such as apartments above, or live-work combination terrace home.
Converting space to an office use to absorb
areas where retail does not lease well (like the second level of most suburban
retail centers). Offices, for example, can add retail patronage.
Providing internal access to link harder to
lease upper or basement space to ground floor retail.
Adding naming rights and signage opportunities
to increase revenue.
Turning every surface and opportunity into an
advertising revenue stream.
Increasing common area spend and amenities to
attract higher class retail tenants.
Decreasing common area spend and amenities to
decrease operating expenses to attract more cost sensitive tenants.
It’s all about repositioning the project
in line with current demand and supply.
[1] This overlaps with the re-planning option we
discuss in the next chapter.
[2] This will more than likely be constrained by
planning rules when placing a residential use into an industrial zone.
The existing property development project doesn’t work in its current structure, but there is an opportunity to make it work if ownership is restructured. The intention is to keep the design, consents and construction works predominantly as-is, complete only what is absolutely necessary and restructure future ownership. Here are some examples of restructuring projects:[1]
Convert sales
into leasing. Assume a 100-unit condominium project has
contracted sale prices that do not cover the cost to complete construction. The
lender now controls the project and you have been brought in to assess how to resurrect
it through restructure. Selling a half-completed project will mean a
substantial loss to the lender so they are prepared to work it through. The condominium
market has deteriorated below original list prices so there is no opportunity
to ask buyers for more money. All contracts will need to be terminated. However,
there is no point trying a new marketing campaign to sell condos as market
prices do not support the remaining construction costs. The best course of
action you determine (at least the lesser hit to the lender’s wallet) is to complete
the project and lease the units in the rental market. You would continue to
rent until the ‘for sale’ market appreciates, and you can sell down units or
until a suitable long-term investor is found to purchase the completed
development. Taking it further down the ‘for rent’ spectrum would be a conversion
into short stay serviced apartments.
Convert
leasing into sales. Typically, this type of restructure occurs
mid-cycle in an appreciating residential real estate market.[2] As the market improves,
yields generated by for rent units generally get surpassed by the effective
yields home buyers are prepared to pay. The arbitrage gap allows a developer to
purchase a block of residential units at say 10% yield, undertake cosmetic
renovations, create separate ownership titles and sell to individual buyers at
an effective 5% yield.
To
illustrate, assume a 10-unit apartment project, when complete, is worth
$5,000,000 with a gross rental of $500,000 (10% yield). Unfortunately, the
‘for-rent’ developer has defaulted on the loan and you are looking to purchase
the half-finished opportunity from the bank. You determine that if you
restructure future ownership to individual home buyers, they will pay $750,000
per unit. The total income you receive is $7,500,000. The rental remains
at $500,000 but dividing it by the for-sale price represents an effective yield
of 6.67%. There are costs — $500,000 in legal, utility separation, marketing
and some redesign. But you have created two million dollars by magic!
Another example is converting a for-lease building to for-sale office, retail
or industrial condominiums. Rather than continuing to
try and lease a large space you sell off individual units (like floors or adjacent
spaces). This restructure is viable when the market to smaller investors and
owner operators is superior to the general leasing market or selling to larger
investors.
Sales or
leasing into hold. Selling the project is only feasible
with a heavy discount. Leasing it on completion carries too higher operating cost
and low rentals and detracts from a more profitable use in the future. In this
case you complete construction to a certain point and restructure to hold until
a better time to sell or lease eventuates. An example is where you have created
a residential subdivision but take the sections off the market and move
it from an expensive debt leveraged position to a long-term hold and equity
position. Or it may be farmland originally to be developed, where the market
has changed, and you decide to continue to hold as farmland. Or it might be
leaving the expensive internal fitout of the penthouse in an apartment building unfinished
until the market improves.
[1] You see restructures all the time post the
peak of a market cycle.
[2] Americans know all about the condo-conversion craze!
This is where you continue part of the property development project as-is to a satisfactory stage and segment the remaining parts. Each segment will have its own restart. For example, you could finish the first stage of a residential development and sell of the remaining parcels to another developer. Or in a mixed-use development you could concentrate on the retail side of development (if that is your expertise) and sell or joint venture with others to complete apartments and offices.
This is where in the property development project you inherited you wipe the slate clean of current contracts and relationships to restart free from historical baggage and constraints. The premise being there is no value continuing with existing contracts.
This is progressively more
difficult to do (or at least carries more risks), the further developed the
project already is. Let’s look at cleaning the slate at various stages:
Conceptual
design. At this stage there isn’t much to lose if you want to ditch the
existing architect and consultants and start fresh. If this project has been
one with a poor payment performance record, the existing team may be low on
motivation. Their emotions may not change with new owners (you). You will lose
some intellectual property and knowledge by abandoning them. But it shouldn’t
be too much of a problem for new consultants to get up to speed. Just check
whomever you replace is not the only expert in their field for your type of
project or has political connections where you may find yourself embarrassingly
having to go back to them in the future. At this stage you won’t have buyers or
contractors involved, so no problems there.
Developed
design and planning consent. Before cleaning slate, get copies of all delivered reports, plans and
specifications from consultants and where possible the raw electronic file
formats used (CAD/BIM for example) so your new team does not have to recreate
all the work previously done. Town planning involves relationships with
authorities so think carefully before changing. Ensure you have all
correspondence from local planning authorities, especially where the town
planning consultant had authorisation on the previous developer’s behalf.
Building
consent. Not only do you want all files, preferably in their raw format,
but also copies of all design statements, producer statements and
certifications. Check that the consent documentation submitted does not
implicitly require that same consultant to undertake inspections or sign-offs
later in the project. If it does, ensure your new consultants can do those
signoffs or make provisions for the existing consultant on a limited scope.
This is very important if building consent has been granted and extremely
important if the element has already been built. I have been in the situation
where an engineer in a legal dispute did everything possible (contrary to
professional ethics) to frustrate us by refusing to hand over a certificate for
an item of infrastructure already built and inspected (with no problems). No
other consultant wanted to sign off this item. It ended up a very costly
exercise to ‘extract’ the certification. Intellectual property and liability
collide at this point though. Ensure any new consultant will take on the
responsibility of previous drawn plans.
Under
construction. Ensure there are no certification or liability issues with the consultants you are
terminating, before you terminate. For contractors, the issues are further
compounded, especially with responsibility over warranties and guarantees. If you are considering
terminating a contractor then you need to plan to get all warranties, guarantees,
certifications and as-built documentation for work in place. Many of these will
come from subcontractors and suppliers and you may have to negotiate with each
separately. If the subcontractor has experienced payment problems, then it may
be difficult to get these certificates. Although you are terminating a main
contractor, there could be key subcontractors who you need to retain just because
it is easier to keep them on to avoid problems gaining final approvals from the
local authority. If subcontractor continuity[1]
agreements exist it will be much easier to deal direct. For
work that is partially complete, or where your audit finds it may have not been
done correctly, be especially careful. Subcontractors may have an incentive not
to help if they have played a part in the project’s failure in the first place.
They may have cut corners as a project deteriorated (lack of payment or lack of
competent inspections) and will no longer want to take any responsibility. Others
may just be holding out for a payment. If the existing subcontractors do not
want to assist you, or you are forced to terminate them because of their
incompetence, then you will need to specifically address how you are going to
complete the works and get the appropriate certifications. You may need to
discuss the circumstances with the local authority, so they will accept a new
contractor’s certification. This could include retrospective inspections, or
unfortunately, rework. Sort all this out before you restart construction in
earnest. Review every official certification or signoff you need in relation to
what has been built and tick off exactly what you need and have a plan to deal
with what may create difficulties. If you don’t do this at the start, and only
find out from the local authority that you need a certificate for this item
many months later, the amount of rework could increase significantly. As an
example, think of the situation where you don’t have certification for waterproofing at the base of building but
now you have built an entire building on top of it. Catch-all guarantees, such as weather-tightness or multi-year warranties
provided by the main contractor, will be difficult to retain if you are
terminating them. Ensure you can get your new contractor to provide this or at
least provide a limited one that excludes work already done. Obtaining an
insurance policy to cover the same risk may be an option. Don’t
forget to cross reference what has been promised to purchasers and lessees in
their contracts as well.
Sales or
Leasing. Assuming you have the control and right to cancel,the formula is straightforward. If the
value of contracts in place is greater than the current market value, then
retain them. If they are less, then you renegotiate or terminate. Although it
may be more difficult than that. Some buyers or lessees could have been given so
many broken promises that their existing relationship with the project is
fractious (and litigious). The pain to continue with them may just be too much.
Illustrating some of the complexities that need to be thought through:
Say you have taken over a commercial project, 50% complete, where one of
the tenants signed up is a medical laboratory. Substantial work has been
undertaken to customize the base building for this tenant. There are no
potential replacement tenants, and a lot of work (money and time) would be
required to reconfigure the space to attract alternative tenants. Canceling
this tenant may simply be too costly. This tenant likely has strong negotiating
power in this situation, even if they have signed up at below market rates. Your position will be stronger if this tenant
has no alternative options or are under pressure to occupy the premises.
Suppose you have existing agreements to lease on a retail shopping center
development. All the minor tenants are
signed up at above current market value rates. However, the large anchor
department store tenant has been signed at a rate so ridiculously low with such
large incentives they are the main reason this project has failed. You want to
terminate the anchor but keep the minor tenants. The only problem is the minor
tenants have clauses linking them to the anchor’s presence, and in the current floundering
market you definitely don’t want to terminate all those minor tenants.
Or
consider the scenario where you have taken over a 50-unit terrace home
development that is completely presold. Construction costs
have ballooned out and there is not enough revenue to cover the required
development budget to complete the project. Given your high opportunity
acquisition price, canceling sales contracts is necessary; however, some
contracts are below market value, some are at market and some are above market.
Do you just cancel some or do you cancel all contracts? The residential market
is also slowing down so resales at the price required will take some time. The
project is high profile and canceling agreements is likely to generate
consequential negative publicity that could put off resale buyers. Plenty to
think through!
[1] A subcontractor continuity agreement is
typically put in place between developer, funder and main contractor within a
tripartite agreement. It allows the developer or financier to step in and
manage subcontractors directly if there is a default by the main contractor.
