The impacts of a real estate crisis on development projects

Development projects last for more than a year and such kind of duration brings a significant portion of risk with. Although any risk decreases the probability of overall project feasibility, most of them are easily manageable. However, crises regularly happening in the real estate markets all over the world takes together much dangerous and harder manageable than others. Even if such kind of crisis is not occurring very often, its consequences usually change the market completely. The goal of this research paper is to analyze the impacts of the real estate crisis on development projects and to provide recommendations on how such impacts could be reduced either before they occurred or once they raised to reality. All literature and supporting documents named in references are focused on development projects and financial crisis mostly dealt with consequences caused by the financial crisis of 2008. On the other hand, it is important to mention that such a crisis has not been solitary in the history and for that reason, every investor should be able to face to the similar situation well prepared.

Development projects in the real estate business consist of several direct inputs in various business sub-spheres. General public perception of such kind of projects is often connected with construction, mostly because the final product is a building and it is something tangible. However, there are other sub-spheres like leasing, financing or design, to name just a few and each of them is more or less intangible abstract products. Without them, this kind of business would not exist at all. Although development projects are a crucial element for any entrepreneurs on the way to generate profit, they need a kind of financial space where they can be traded. Such space is called a real estate market and its role in generating profit is inevitable. This market, similarly to others, goes through own peaks and falls, and behavior of this market affects principally a performance of every single project. From the peak point of view, it has always a positive effect on project results. However, what about falls and crisis regarding project result? Those periods of market performance can kill any project.  Are there any possibilities of how to reduce the volume of impact attacking development projects?

Development project

A development project is a process consisting of several single stages going either one after the other or intersecting each other. A principle of such kind of project, based on the name, is to create any meaningful idea and bring it into the reality. The main goal of development projects in real estate business is to make a product, any kind of building, which brings a profit to the investor at the end of a project. The way of generating profit, either through selling or leasing, does not care. Only a positive number at the bottom of P&L in the project evidence is, once is the project finished, what counts from the financial point of view. Any development project can be basically divided into the following stages (Archipreneur, The 4 Phases of Real Estate Development):

1. Project Initiation: Broadly, an investor seeks an idea, location, and capital during this stage. There are several alternatives how this stage can finally look, all that is truly dependent on the current investor financial and property situation.

2. Project Conception: Once the initiation stage is done, a core of project successful foundations are built in this stage. Creation of future concept design, collection, and evaluation of all risks, costs estimation, and other prediction must be done, otherwise, the project should not continue, as it could be too risky.

3. Project Management: Although a great conceptual phase can be done, the poor performance of project management can end in an unsuccessful project. Therefore, this stage is mostly about planning, controlling, milestones evaluating or coordinating. Leading skills of a project leader are crucial for meeting project expectations.

4. Project Marketing: If the first three stages are over, the product is delivered and the last stage can start. No matter how predictions were made during abovementioned stages, only the reality depicts a real value of products to the investor. For this reason, no matter whether it is going to be sold or leased, profit or loss is generated in this phase.

Based on these facts in parallel with a duration of a common project lasted over a period of one year, the project lifecycle provides many weak areas for making mistakes within the project. However, there exist many rules and control mechanisms, which can help a project team in order to avoid making plenty of project mistakes. The majority of such rules are covered by plenty of managing structures, for instance following principles of practically-proven methodology like Prince2, which provides 7 such principles (PRINCE2, 2014, s.11):

1. Continued business justification
2. Learn from experience
3. Define roles and responsibilities
4. Manage by stages
5. Manage by exception
6. Focus on products
7. Tailor to suit the project environment

As can be seen, most project threats are manageable as they are often not hard to predict. What can be much worse predictable is a real estate market performance.

Real Estate Market

A real estate market usually constitutes one of the biggest shares of the economy of every single country. For instance, in the USA real estate market outputs generated $1.34 trillion. Such amount of money produced 7 percent of U.S. gross domestic product. (Amadeo, Real Estate's Impact on the US Economy: Why Buying a Home Helps Build the Nation). This and a similar level of shares are important to see from several points of view. Generally, a real estate market consists of several, called “components”, however, the two most valuable are residential and commercial real estate components. For example, the commercial property produces money not only directly, as an employer and money earner, however also indirectly, as a creator and executor of places for retailers, to name just one. The UK commercial sector generated 3.2% of GDP in 2011, what was worth of 41billion pounds. (Investment Property Forum, The Role of Commercial Property in the UK Economy).

There are various manners how to look at the real estate market current situation through a property value. Among others, two of those are gross rental yields and buy-to-let rating. The first indication, a gross rental yields (GRY), takes into consideration annual rent and current property value. The number presented GRY is usually calculated as following (Mortgage choice, How to calculate rental yield):

Gross rental yield = (Annual rental income / Property value) x 100

where Annual rental income is weekly rent x 52

Property value could be purchased or market value (depend on preferences of outputs)

The second indication, buy-to-let rating, represents a power of buyer to buy and let immediately property out for rent in order to make a profit.

Table 1: Comparison of Gross rental yield and Buy-to-let rating of selected countries

Source: Global Property Guide

The more stars a country has, the higher the potential of bigger return on investment could be achieved. Table 1 represents a comparison of those two indicators of selected countries from the world.

Both columns of outputs from table 1 show quite interesting results, as there exists no mutual dependency of countries on a region or continent.  Due to the fact that so many inputs affect the final numbers like low capital gain taxes, pro-landlord rental system or strong economic growth, it can be said a real estate market of every single country is a special one.

Typical causes of a crisis on real estate markets

A probably worst concern in every business for entrepreneurs is a crisis. On one hand, a crisis can also bring some positives for business and customers like product prices of products go down (good for customers) or weak competitors or suppliers are not good enough to survive (good for business). On the other hand, crisis mostly brings negatives with and in many cases has been devastated for plenty of entrepreneurs. 

Table 2: Real estate market crashes in the USA over the last 200 years

Source: The Depression of 2008 (Foldvary, The Depression of 2008)

In the history of humankind, there has been plenty of reasons for a crisis in countries, regions or continents. Each reason could be analyzed from a different point of view. Providing a better overview of the crisis, it is convenient to look at one real estate market. The U.S. economy has been affected several times by such a crisis. In 2007, a book devoted to a possible crisis by Mr. Foldvary was published. In his book, Mr. Foldvary came to interesting conclusions presented in table 2 (Foldvary, The Depression of 2008).

Based on table 2, the most significant evidence is, apart from a few exceptions, the crisis in the USA has been repeating in the period of 18 years. The biggest exception was caused by World War II when the timing of happening as well as its consequences changed almost everything. Although the time period of 18 years is more than a quite interesting, crucial reasons of crisis occurrences are others and can be described following:

• Property prices – As it can be shown in table 2, peaks in land value, as well as property price peaks, have been reached only for a short time (usually less than two years), before the crisis happened.
• Interest rates – Based on the historical records, real estate interest rates hit own peak almost immediately once land values were peaked. (Lulich, Red Flags That Indicate A Real Estate Market Crash)
• Mortgage rates - Mortgage rates in the USA have been permanently under 5% for more than 6 years. Based on the last crisis happened in 2008, it is generally known that mortgage bubbles were one of the main triggers of the 2008 crisis. Even more, the significant indicator is also foreclosure, which dropped to a 12-year low in 2017 in the USA. (Lulich, Red Flags That Indicate A Real Estate Market Crash)
• Construction work – Construction work – Based on table 2, construction work indicator is pretty much similar to property prices, as there is a clear fact of had reached the peaks in construction volume of work and prices just a year or two before the crisis occurred. 
• Property inventory – The indicator is just a natural consequence of pricing strategy. After the peak of prices is reached, people start being reluctant to pay as much as before as well as demand is getting decreased.

Impacts of crises on development projects

The main objective of development projects, similarly to most of the other business projects, is their profitability. From the initial stage of the project, entrepreneurs invest own or borrowed money into projects under a condition of reaching feasibility. This measurable value of the project is several times verified in every stage. The sooner is in the project any issue discovered, the better for investors, otherwise, a risk of losing money could be noticeable. An impact of any crisis can emerge in various forms and its intensity is mostly dependent on the following:

• current stage of the project
• the volume of already invested capital
• package of already contracted suppliers
• percentage of already signed agreement with future customers

Although the intensity of impacts has significant importance, it is only a secondary effect. The primary effect is caused by the impact itself. The most notable impacts appeared during crises are listed below:

• Financing of the project – During the last financial crisis in the Czech Republic, financial institutes defined the maximal amount of investment, which banks were able to provide at the level of 150-200 million Czech crowns (Financnynoviny.cz, Financial crises impacted on development projects).
• Changes in land use plans – Based on hard times not only for investors but customers as well, a common future tenant is being much more careful in signing contracts and he must be absolutely convinced about its decision. For example, it happened in Pilsner, the Czech Republic in 2008 (Financnynoviny.cz, Financial crises impacted on development projects).
• Loan agreement conditions – During the crisis, banks usually start to re-evaluate loan agreement conditions and take much longer time for negotiating and signing the agreement. In the end, it is not unusual to not sign it at all.  Investors, who preferred to lead to project speculatively and did not sign not enough leasing or selling contracts, are almost in an insoluble situation, but to sell or postpone that project (Ekonomika, Developers is getting to sleep own projects, the financial crisis can clean up the market).
• Procurement of the projects – Construction industry, in general, is a core element of development projects. The financial crisis influences and highly increases the rate of unemployment. A construction industry can be called as a huge employer. Although such fact can bring also some negatives (Asgari, The Effect of the 2008 Economic Crisis on Construction Procurements), in terms of development projects, it has brought mostly positive effects. Suppliers have been fiercely competing and such kind of competition usually save not inconsiderable financial resources.
• Sustainability of the projects – During a crisis, every investor thoroughly thinks about costs and exerts a great deal of effort on reducing it. Contrary to this, most governments strengthen legislative and norms in order to force investors to implement as much greenery and other sustainable components as possible. Such action pushes many times investors into insoluble position (Umar & Co., Impact of recession on green building and sustainability over the residential and non-residential building in the United Arab Emirates).

Recommendations on reducing impacts

As was already mentioned above, an average of development project duration is more than one year, and that is not unusual to meet the project lasts for more than 5 years. Such huge time baseline is highly incoherent to any unnatural occurrence on the real estate market. For this and other reasons should investors plan their development projects very precisely and in detail in order to reduce impacts induced by crises of the real estate markets?

Recommendations on such reductions are the following:

• Strategy preparation – The duration of development projects can bring investors into financial problems. In order to avoid them, a strategy must be prepared in every possible detail with likely scenarios how the project could develop.
• Financing – Based on history, it is absolutely impropriated to rely only on loan kind of financing, because banks are highly reluctant to provide the full amount of capital for projects. Every financing structure should consist of compound financing.
• Project management – The project can dispose of with huge amount of financial resources, however, without non-functional project management is probably impossible to meet investor expectations. There should be implemented all project management tools, which can be used.
• Leasing – One of the mistakes made in early stages by investors is to start later with leasing or selling a property. Owning lists of agreements is not only good for internal financial resources, but for external too. Banks are satisfied with providing money for projects, which are mostly leased or sold to clients in advance.
• Broader portfolio of development projects – On the way to reduce the risks of unsuccessful projects, investors should not forget about keeping a sufficient broad development project portfolio. Despite the fact that managing several projects in the same time is, from the financial point of view, not so easy, with properly structured projects and in different stages, a financial burden can be significantly reduced.

All things considered, there are several ways how to reduce the impacts of a crisis on development projects. The key is in preparation and project management in every single detail.

Author: Tomas Juricek, DBA student at LIGS University

References

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