The First Loss is the Best Loss – Signs that all might not be well
In this second article, Chris Price looks at the current property lending environment and considers common pitfalls and indicators that all might not be well with a property development scheme
As with all economic cycles the good times of rising prices are full of optimism, after all, “What could possibly go wrong?” when the value of the finished product is rising at around 1% per month
In most circumstances the answer might be nothing but that all changes when markets start to slow down or move into negative territory.
Property recessions over the last 50 years have tended to follow a 15 year pattern so possibly we are due one soon.
EVERYONE’S A DEVELOPER!
On the back of the good times all sorts of people believe that they can be developers, whether qualified or not, with some being less than completely honest about their intentions. So the first and probably most crucial step for lenders to take when considering a loan application is to know your customer and understand the scheme.
Asking searching questions which focus on the structure of the scheme will identify indicators of potential problems later in the build program.
- Who is the development team?
- Are they independent and do they have the technical knowhow?
- What projects have they undertaken to date?
- Will they protect my interest?
- Are planning, 106 agreements, and building regulations all in place?
- Has all possible due diligence been undertaken?
- Is the market for the product clearly identified?
- Would I put my personal money into this scheme?
If all the above have been considered and are in place, then all should be well, however, when instructed on ‘distressed’ development projects I have noticed common problems starting to appear. I have seen many situations where the “profits”, taken out of the build contract, quickly exceed the value of the work undertaken and the cost of the site combined.
RELATED PARTIES – A COMMON THEME
A typical way for developers to extract quick profits from a scheme is to set up a separate entity/company whose single asset is the site (Special Purpose Vehicle ‘SPV’) for which the developer often seeks finance for the site purchase as well as the ongoing development work. In distressed situations I have regularly come across these types of arrangements which include a number of common factors within the operational structures,
1) The development works are undertaken by a principle contractor that is linked to the developer, with the site being monitored by a surveyor working for the developer as well as reporting to the lender, creating a potential conflict of interest.
2) Generally, there is not a competitive bidding process for the contract with the principle contractor managing the build using multiple subcontractors without formal contracts or agreeing fixed prices for each construction phase.
3) Phased loan payments in respect of ongoing work are provided based on valuations of work completed and approved by the monitoring surveyor – in such situations the surveyor may see his responsibility as being to the developer and not the lender.
4) Such valuations often include general site overheads and set up costs that are recovered early in the build rather than spreading these costs throughout the build phase, thus staged funding can exceed the value of the work completed. If an element of profit is also built into the payments the gap between funding and works completed can widen further.
With the absence of formal contracts and a lack of accountability,planning and preparation problems start to appear in the project such as
- Cost overruns
- Projects timetables falling behind
- Problems with planning or building control, for example wrong materials used or planning conditions not satisfied
- Issues with rights of drainage or the provision of utilities where access over third party land is needed but not secured prior
- Sub-contractors not being paid
As cost pressures mount short cuts are taken which can quickly make matters worse; subcontractors refuse to attend as they have not been paid, suppliers refuse credit, with the developer getting ever more desperate to receive funding. In many cases this is down to a lack of skill and knowledge however the greater risk can quickly pass to the lender, who now has security over a part completed site, with the developer having recovered his costs from the build.
In the worst cases sites get abandoned, vandalism takes place while all the time the value of the lender’s security is diminishing.
While most developments proceed satisfactorily static or negative property prices will inevitably lead to an increase in the number of problem schemes. When this happens, early intervention is always the best course of action if losses are to be minimised.
CALL TO ACTION
Having identified that there is a problem the lender should commission an independent review, or options report, of the development from an experienced surveyor who will report on all aspects of the development and provide the lender with a variety of options which best protect his interest.
If you think you would benefit from a 30 minute Complimentary Consultation contact Chris Price, Lead Director, Property Debt Advisory
(t) 0117 456 8775, (e) firstname.lastname@example.org
Chris Price is lead director at PACT Property & Assets Ltd with more than 30 years experience in the property sector.
An MRICS registered property valuer and fellow member of NARA (Non-Administrative Receivers Association), Chris has
been appointed LPA /Fixed-Charger Receiver on numerous properties throughout his career.
T: 0117 456 8775
M: 07979 541215
CHRIS PRICE BSc. (Hons) MRICS, NARA