Why residential property?

Why Residential Developments? 

Why do people develop residential buildings? Unless they are a government organisation, the apparent answer is money and success. History has proven that the astute have made significant profits from residential investments providing ongoing income and capital growth. Every developer will have their own financial goals, and this will be dependent on many variables such as income, age, taxation, social status and so forth, but the underlying principle in property development remains the same, and that is success and wealth.     

With almost every financial reward there is the element of risk, but with property development, these risks can be calculated and analysed. Everybody needs a home or some form of accommodation. Like a general commodity, there will always be a demand for housing. As long as there is economic stability and population growth, this demand will continuously increase. This gives the watchful entrepreneur an array of development opportunities. 

Not all developers have the same set of priorities and may focus on different areas. Some would concentrate on industrial buildings, while others will become shopping centre specialist where projects are larger and offer bigger returns. Residential developments can be equally lucrative, but the returns are relative to the scale of the project. Whether you are renovating a home or undertaking a retirement village complex, there are many financial rewards in residential property developments.     


The Demand for Housing 

Although we presently have a population of 25 million people, we still have one of the highest homes per capita compared to other countries. The demand it seems is ever increasing due to factors such as:  

Increase in population  – The demand for housing in Australia is an ever-increasing one. According to the Australian Bureau of Statistics (ABS), the natural increase for the year 2017 (147,500 people) was 0.9%, or 1,300 people higher than the natural increase recorded for the year 2016 (146,300 people).  

International immigration – Even with our low natural birth rate, our population is constantly increasing because Australia is a popular country for migrants. According to the Australian Bureau of Statistics, the net overseas migration (NOM) for the year 2017 the net overseas migration rose by 250,100 people, accounting for 63.2% of Australia’s total population growth. That was up 33,400, or 15.4%, on the level reported in the year to September 2016. 

The high rate of home ownership – According to the Australian Bureau of Statistics, in 2017 there were approximately 9.0 million private dwellings in Australia, each with, on average, 2.6 occupants with 65% of dwellings being owner-occupied, one of the largest proportions of any country. The rest were rented dwellings. However, this number is declining due to housing affordability. 

Retirement population – Between 2011 and 2030, the portion of the people born between 1946 and 1965, known as ‘baby boomers’, will turn 65 years old. With many people set to retire from Australia’s workforce over the next few decades, it will bring a shortage of retirement homes and services.    

Housing affordability – A report by the Australian Housing and Urban Research Institute (AHURI) in 2017 reveals an estimated 1.3 million households are seeking access to affordable housing whether to purchase or rent. This figure is predicted to rise to 1.7 million by 2025. 

Stable economy – Against the backdrop of international trends, Australia’s demonstrated economic resilience, adaptability, and record of steady growth has provided a safe, low-risk environment in which to do business. Now in its 26th (review) year of consecutive annual economic growth, the Australian economy is underpinned by strong institutions, an exceptional services sector and an ability to respond to global changes. This healthy situation has increased employment, household income and improved consumer demand for better housing.   

Foreign Investment – For some time now, Australia has been a favourite destination for foreign investors to invest their money. Foreign economies had a total of $3.3 trillion invested in Australia at the end of 2017. The United States and the United Kingdom are the biggest investors in Australia, followed by Belgium, Japan and Hong Kong (SAR of China). Recent investment into housing from China saw an increase in property values in the Eastern States. 

Government housing assistance – Government at all levels in Australia are involved in housing with a specific aim to encourage home ownership and investment. Some of the government programs include: 

  • First Homeowner’s Scheme (FHOS) – FHOS established since 1 July 2000. Eligible applicants are entitled to one-off grant payment for established and newly built homes. 
  • Shared Equity Scheme – This is a scheme provided by some State Governments, where the home buyer shares the capital cost of purchasing a home with the Government such as a deposit and when they sell, they share the increased equity with the Government. 
  • Private Rental Assistance – Rent Assistance gives extra help to eligible people who pay rent in the private rental market. Assistance is provided to people who are homeless due to eviction, family disputes or inability to afford to rent. 
  • Community Housing Program – Community housing is like public housing except that it is managed by a community organisation and can be initiated, planned, partly funded, developed and owned by community organisations including local government.  
  • Defence Force Loans – The Defence Service Homes (DSH) Scheme provides housing benefits to eligible veterans and their dependents of Australia’s defence force by offering benefits such as housing loans at reduced rates. 

The above schemes may vary from State to State and could change at short notice. Therefore, the schemes should be verified with the State Government office.  


Favourable Tax Laws 

There are several tax incentives for the private sector to invest in residential property. These laws provide for: 

  • Negative Gearing – under the current Australian Income Tax Law, Negative Gearing of investment property in Australia refers to a situation whereby the interest and the other costs incurred to acquire that property are more than the rental income received. This cash loss is offset against other sources of income, reducing the amount of income tax payable.  
  • Depreciation Allowance – Under the Income Tax Assessment Act, property investors are entitled to capital works taxation deductions. This is a proportion of the cost, which can be deducted annually as a legitimate expense. A depreciation of 2.5% per annum is allowed on a newly built rental home or improvement over a 40-year period. The allowance is also transferable to another investor who may buy the building.  
  • Capital Gains Tax (CGT) – CGT is a tax charged on capital gains that arise as the result of the sale or disposal of assets (such as investment property and shares) acquired after 19 September 1985. The tax is levied on the real or inflation-adjusted profit realised from the sale. In the housing market, family homes are exempt from such taxes. The tax is calculated on the difference between the asset cost base indexed to the Consumer Price Index (CPI) and the resale price. Any gains determined are added to the investor’s other taxable income and taxed at the marginal rate.    

The Pros and Cons of Developing 

There are many books written about the benefits of investing in established properties, but what about investing your time developing your own investment properties? What are the advantages, and will it benefit you financially? The decision for most people will depend predominantly on personal choice but could involve several other factors such as the availability of personal time, personal financial situation, timing, and location. Below, we will analyse the benefits and disadvantages between these two options.     

PROS OF DEVELOPING

Free equity – If you have done your research and you are a good negotiator, there is always an opportunity to purchase land and negotiate a building contract at discounted rates when undertaking a development project. If you are an experienced developer, you can save money by putting in your own sweat and undertake a portion of the project yourself. In each situation, you are creating “free equity”. Free equity is the difference in value between the total cost of the land plus building cost and the bank value at the completion of the home. For example, if the total capital cost for your development is $750,000.00 and the valuation at the completion of the project is $950,000.00, your free equity is $200,000.00.  

Design to suit the market trends – Depending on the age of the building some investment properties may be too old or will outlive the market needs, in terms of accommodation and architectural style. For example, the rooms may be too small, and there is no family room, the kitchen looks tired and is not well planned, the colours of the bathrooms are over the top.  With a new development, you can plan and design the building to suit present market trends associated with today’s lifestyle.  

Exciting – Watching your development plans unfold as the Architect/Designer presents your design, selecting your own finishes and watching the various stages of construction while seeing your dreams being created can be exhilarating and stimulating. Added to this, when the public is overwhelmingly receptive to your product, and your development is quickly sold or leased. The same cannot be said of purchasing an established building. The excitement is limited, and there is always the thought of renovating and adding new rooms to suit the present market.  

New design and materials – Like the fashion industry, architectural trends and building materials are constantly changing to adapt to consumer taste. Lifestyles are also continually evolving. For example, in new home plans, we now see a computer room, games room, home theatre, alfresco area and open plan living presented as the typical Australian lifestyle. Most established homes reflect the period in which they were built in their elevation, planning, colours, and building materials. Only with substantial cost and alterations can an older home be brought up to date with the latest trends.  

Longer life span – All older buildings have a certain amount of wear and tear and require maintenance over their lifespan. Before buying an older building, engage the services of a building consultant to examine and uncover any structural defects, electrical faults, roof leaks etc. With a newer building constructed to quality standards, it is less likely that it would require maintenance over a short period.  

Tax benefits – The depreciation allowance mentioned earlier is the proportion of the cost or the book value of a building, which may be deducted annually as a legitimate expense and is usually determined by the original cost of the construction set against the life of the building. The present allowance is 2.5% p.a. over 40 years. As a developer of a new project, you will receive the benefit of the full 40 years.  

All new properties for sale are subject to the Goods and Services Tax (GST).If you are a developer that embarks on a new project every year or if your income on developments exceeds $100,000 per annum you will be liable to register as a GST vendor and add the GST amount on the sale of your building(s). However, all goods or services with GST supplied to the development can be offset against the project.      

Less upfront capital required – With most property transactions that are financed a deposit or similar equity is required, and this is generally around 20 per cent. With a new development, the deposit is needed mainly when purchasing the land, which is lower in price than an established building that includes both the land and buildings. Below is an example showing that 60 per cent more equity or upfront cash is required on an established unit investment. In addition, there are related cost such as stamp duty, conveyancing fees etc., which are usually higher in a completed development.    

CONS OF DEVELOPING

Budget blowouts – When a completed building is offered for sale, there is usually a bottom-line price that the seller is prepared to accept. This gives a degree of comfort to the investor, as he or she is only liable for additional costs such as stamp duty and conveyancing fees. When building new, you know the fixed price for the land, but you can find yourself in the situation where the final cost of the building has blown out beyond your budget. With a new building, there are always additional costs such as landscaping, fencing, floor coverings, curtains and so on, that a builder does not usually include in his price. In addition, you can get carried away and over-capitalise on the building so when it comes to selling, you find yourself in a situation where you cannot get a buyer to match the amount of real money you spent on the building. 

You cannot see what you are building – Unless you are building a replica of another development, most new buildings are developed from an idea or concept and finally into a set of working plans. To most people reading and visualising the completed development from architectural drawings is a difficult task. With an established building, you can walk through and obtain the exact feel of the plan layout and see the exact room sizes.  

Disputes with contractors – ‘Dodgy’ builders are constantly making media headlines, which make us aware of unscrupulous practices and creates a degree of scepticism about the building industry. Disputes with builders could delay the completion of the project, which increases your holding cost thus reducing your profit. These reports are enough to make most people shy away from tackling new developments but fortunately, not all builders are dishonest, and most have a credible reputation for quality work and excellent client relationships.   

No immediate return – When you invest in an established property, especially if it is already tenanted with a long lease you will be able to assess the value of your return immediately. On the other hand, when you develop a new property the value of your return can only be evaluated when the building or buildings are completed and fully leased, and this could take several months.  


Comparing developing versus buying established

Let us now compare the two hypothetical cases from a financial point of view. The example shown below is 3 Unit development, versus a group of 3 units on a single site.  

From the above analysis, one can see that there is an opportunity to create “tax-free” or “sweat” equity, which can be used as a deposit for future investments.   

The Decision    

The financial decision whether to invest in a completed building or to develop your own will be based on a personal choice, and the factors pointed out above. If you are prepared to go through the process of negotiating land deals,  design with your Architect or Designer, select and negotiate with a Builder and face a certain amount of challenges during construction, there is nothing to beat the excitement and stimulation of having a new development.  


Residential versus Commercial Developments 

All property developments whether residential, retail, industrial or offices are always subject to a diverse range of variable factors. These include the changing neighbourhood character, demographic fluctuations, varying levels of development activity, the condition of an area’s public services and the unpredictability of local economies. However well-selected residential areas for development allows for the most effective management and control of these variables. Compared to other forms of property development, residential property is less likely to suffer from the extreme variables that can trouble commercial developments. This comparison can be evaluated under the following headings: 

Low initial investment – Most residential developments require a smaller amount of capital to get started. Depending on one’s financial position some lending institutions would not require a deposit, and at times only 10% to 25% deposit is required to start. This allows the developer to leverage his financial position. 

Broader market – Depending on its location, residential developments can cater to a broader market. Not only can they provide for most people looking for a home with convenient facilities in proximity, but they can also attract a larger group of investors looking for a long-term investment in a good location and a building with very little maintenance.  

Ease of financing – Most lending institutions have the infrastructure and systems to make home loans more accessible for the consumer to apply for. With more banks and new mortgage companies entering the market, finance for a home is a lot easier than other forms of development. 

Superior liquidity – With finance more readily available, housing developments are a lot easier to sell than other forms of development. In addition, there are generally not as many conditions attached, therefore making settlement and sales procedure a lot quicker. 

Market not as sophisticated – Purchasers entering this market are not as sophisticated, compared to seasoned investors found in commercial properties. These experienced investors will generally negotiate strongly on several issues, therefore, delaying the settlement that in turns affects the developer’s profit. 

Competition – Housing prices fluctuate according to supply and demand. Quite often during a boom period, housing prices peak and set the benchmark for future prices. The capital growth in this instance can be quite significant. Prices on commercial buildings, on the other hand, are governed by the leases they have in place and only increase in value relative to the escalation clause in the lease. This escalation in a lease is generally linked to the consumer price index (CPI).  

Buy-in-prices – Commercial buildings in the right location, such as a well-established inner-suburban area with a consistent quality can be very good developments, but developers will often pay a premium to acquire such properties. Buy-in-prices for commercial properties are substantial when compared to residential and are usually purchased by wealthier groups or corporations. In addition, the returns from commercial developments, particularly during times of strong capital growth, can be relatively low and move slower than rents from residential premises where leases are renewed more regularly. 

Tenants and leases – Residential properties can often be subject to periods of vacancy, but on the other hand commercial properties can be challenging to lease due to the specific requirements of business tenants. Business tenant’s demands are greater, and they tend to lose interest in a property for reasons that are beyond the control of the developer. This can include insufficient parking, strong business competition, local government restrictions etc. During tough economic times or with stiff competition, developers will have difficulty in finding commercial tenants and will offer generous lease terms. This can be in the form of rent-free periods or significant expenditure to meet the tenant’s specific planning requirements. This rarely occurs with residences where location and local amenity are at the forefront of tenants’ minds. Even if rent for a high-quality residential property is low, the investor will be compensated by good capital growth. 

There are indeed several top-quality commercial developments within most capital city’s diverse suburbs. However residential properties offer developers far greater levels of control over the performance of their assets. Developers of residential property in established inner-suburban locations can anticipate stable tenancies and solid capital growth. 


Types of Residential Developments 

Any developer’s management and marketing skills should help determine the properties to purchase. Although this material is written for the novice investor, who may only want to develop small income-producing properties, the following is a list of all the types of development that are available for investment: 

Renovation – Some older suburbs in capital cities can offer exceptional opportunities by way of renovation to older homes and can be rewarded with good returns. These renovations may require some alterations or additional rooms or just adding some paint to bring the building up to the present market standards.  

Speculative homes – The speculative new home, which is usually built on a single lot in a new land sub-division or on an older block that has been sub-divided into a smaller lot generally found in older suburbs. 

Small units – These smaller unit developments are commonly found in suburban areas of both new and old sub-divisions and can be defined as duplexes, triplexes etc. They can be developed as strata type units or small green title lots. 

Group housing – Under this category, one would find group dwellings such as Villas, Townhouses and Retirement Villages. Each development will have their own architectural theme defined by a similar use of materials, scale and building style. Residences are accessed at ground level.  

Multi-density  – These buildings are defined as apartments found mainly in the inner-city areas of most capital cities. This building form is described as those dwellings in a group of more than one where any part of a dwelling is built vertically above the part of any other.  

Government housing  – Also known as Public Housing and provided by the State Government. Each State has their own housing program, and in some states, these bodies get involved in joint venture housing developments with private sector Developers or offer these Developers opportunity to tender on a specific housing project.  

Seniors Housing – There is a variety of senior’s housing that can be referred to as retirement villages, manufactured home villages, rental villages, over 55’s villages, lifestyle villages, lifestyle communities, lifestyle estates, retirement resorts, retirement communities, retirement estates or retirement homes and residential aged care or nursing homes.  

Residential land – These developments can vary in scale from small backyard sub-divisions to larger scale suburban community land developments. The latter requires intensive town planning in conjunction with the local Councils Planning Department and the State Planning Commission.  

Niche residential developments – In addition to the above residential developments, there are several developments, which we can consider as niche markets and this includes: Holiday homes, timeshare apartments, cooperative housing, student accommodation, transportable homes, and caravan parks 

The size of your bank balance will usually dictate the size of your development. If you have limited equity resources, the size of your development will be relatively small. In most residential developments, developers are usually required to put in from 10 to 25 per cent equity. In some cases, that will be discussed in later chapters, one can reduce this equity contribution by using creative negotiating and financing techniques. 

In deciding the class of property to develop, determine the range as well as the type of construction that you will be comfortable with. Many developers will want to build in urban areas only, while others focus on suburban areas. 


Risks in Residential Developments 

Risk is inherent in any business venture, but if you speak to financially successful people they are very ‘risk aware’ as opposed to ‘risk averse’. They accept that risk is part of the business but are focused on continually minimising their risk. People contemplating entering property development should adopt a similar approach. Compared to other forms of investment, risk in property development can be calculated through a feasibility study before making a financial commitment. 

When calculating the risk-reward equation, weigh all the positives against the negatives. A common analogy is that higher potential returns are accompanied by higher degrees of risk; conversely, lower returns afford less potential risk. Although there are several risks associated property developments, the ones listed below are most common. 

Financial risk – In property development, there is the possibility of losing one’s initial investment due to several factors. The developer may have to sell at a loss or even face bankruptcy, which can be very stressful and embarrassing. Some reasons for development losses can be attributed to poor assumptions in the feasibility study, budget overruns, lower than anticipated sale prices, an increase in interest rates, high vacancy rates, and inaccurate operating cost.   

Risk of liquidity – Property unlike other commodities, such as shares, or bonds cannot be traded on a daily basis. A developer may plan to develop a property for a quick sale but may become stuck with the property if the market is in a downward spiral. Property is generally sold with conditions, and this could delay the flow of funds and hence the cash flow of the developer. 

Risk of equity – In most property developments, the developer must supply some form of equity. The equity required can be made up of the deposit on the purchase of a development site including stamp duty and conveyancing costs, the payment of bank fees and government taxes, the money to develop the property or funds to carry the property when the property is not sold or generating sufficient cash flow to cover all operating expenses. Any development suffering from a negative cash flow will eventually be lost to the mortgage lender, and the developer could end up losing the original and ongoing equity investment. 

Risk of missing an opportunity – A developer who does not get the projected cash flow returns from a current development may lose another opportunity for a more profitable development as he or she now does not have the capital to invest in the other development. On the other hand, some developers would use the “cash flow” rather than “real profits” from their current developments. I have seen too many developers going bankrupt doing this and would strongly advise against this method.  

Risk of a bad purchase – There is always a risk facing a developer who may pay too much for a property or buy in the wrong location. This can happen if the developer is impatient and does not obtain the correct market information or is influenced by an overzealous real estate sales consultant. The risk of a bad purchase can be reduced by better-negotiating skills and more extensive market research. 

Business failure – All forms of businesses are subject to the risk of business failure and property development is no different. Failure can be the result of bad management, a decline in the local economy, change in consumer taste, bad timing etc. Good management, careful market research, and creative marketing can help to reduce this type of failure.  

Market acceptance – A new development concept or trend may be very successful in a specific city or country but may be a complete failure in another. It may take time to be accepted by a new market as traditions and trends can vary from locality to locality. By the time interest is shown, the developer may have lost a considerable amount of capital. Thorough market research and correct planning to the local market needs will help to alleviate this risk. 

Variations to laws and regulations – Property development is subject to several laws and any changes to government laws or local authority regulations can alter the expected returns from a development. These include laws such as environmental protection acts, new building by-laws, building moratoriums etc. Careful attention to any possible changes in political and social movements can help the developer to plan strategies around these changes. 

Delays in the development process – In most developments, there is always a possibility of delays. For example, most purchasers of new developments do so with borrowed funds or buy conditional upon a sale of an existing property. This process can take a considerable amount of time before the sold property is settled and in the interim, the developer is left holding the property forcing him to pay the interest on the money borrowed. Another example is where a development may not be able to be built in phases such as an apartment block. This could cost the developer a considerable commitment of funds if only half the development is sold. Allowing for this factor in your feasibility study and good negotiating skills will help to alleviate any losses due to delays.  


Rewards in Residential Developments 

Whilst there are several risks in residential developments there is an equal balance of rewards as demonstrated below.  

Rewards in entrepreneurial opportunities – Compared to other investments such as shares, property development can offer several entrepreneurial business opportunities. Through one’s own labour and limited capital, one can make a vision come to fruition by improving or renovating existing buildings, rezoning and subdividing land to realise healthy profits. Many property millionaires started with small-scale residential or renovation developments. Today these entrepreneurs are now building our cities and creating job opportunities.  

Rewards in cash flow – Cash flow can be generated by sales of smaller units that have been completed or sold “off plan”. If not sold, such units could be rented at market values, therefore, generating cash flow. Each developer should aim to obtain cash flow that is commensurate with the risk involved in the development. 

Rewards in leveraging – Generally, most property developments are made with the use of borrowed funds otherwise known as leveraging. With a small amount of equity, a developer can raise the total capital cost of the development and realise a significant return on the initial deposit invested, when the property is sold.   

Rewards with tax laws – In order to assist the various housing and infrastructure needs of our increasing population, there are several tax incentives (including those mentioned earlier in the chapter) for the private sector to invest in property development. These laws provide for: 

  • The deduction of expenses associated with the development 
  • The deduction of interest charges 
  • The deduction to any property taxes related to the development 

Rewards in creative financing – Yields from property development can be greatly improved by creative financing techniques and smart negotiating strategies. Astute developers, who have a strong understanding of finance, have started developments with minimal personal financial input. Some creative developers I know of have managed to secure 100% financing without any security accepting the property they are developing.   

Rewards in equity build-up – If you decide to retain your development as a long-term investment, the increase in inflationary capital gain is continually increasing the value of your equity. This equity can be used to provide a deposit for another development and leveraged for a larger project. 

Rewards in growing markets – There is a continuous demand for new shelter and infrastructure needs due to the constant increase in population. In every new residential suburb development, there are ancillary needs such as schools, shopping centres, medical centres etc. In addition, there are thousands of real estate sales consultants and brokers advocating the qualities of property as an investment. The effect of these beliefs and claims provide a continuous flow of buyers and helps improve property prices.  


Summary

  • New residential developments will always be required as the constant demand for housing is still there, due to factors such as increasing population. 
  • When compared to investing in established property, residential property development can be more profitable relative to personal capital (equity) invested.  
  • There are more risks involved in commercial property developments when compared to residential as the latter offer Developers far higher levels of control over the performance of their assets. 
  • There are many choices in residential development, but to choose a specific class will depend on the developer’s expertise, financial resources, and business strategy.   
  • There is a risk in any venture, but one should be ‘risk aware’ as opposed to ‘risk averse’. Accept that risk is part of business but focus on continually minimising your risk. 
  • While there are several risks in residential developments, there are just as many rewards in residential property development.