Apartment developers must rethink their business model: RiskWise's Doron Peleg

Staff reporterApril 5, 20200 min read


Developers must change their business strategies and pricing for off-the-plan units to avoid insolvency, according to RiskWise Property Research. 

RiskWise CEO Doron Peleg said the selling price of most off-the-plan units should be far more attractive to investors, the majority of off-the-plan buyers, and developers should not expect high property prices.

“In the past three years a few big events have had a major impact on developers and have resulted in bankruptcy,” Mr Peleg said.

“These events include oversupply, credit restrictions, the potential introduction of changes to negative gearing and capital gains tax, construction defects and now coronavirus. The entire business model of developers is based on meeting pre-sales and sales targets and for that they simply need buyers. Therefore, the risk assessment for each project should also address the potential events with a material impact on home buyers and particularly investors.”

He said the best case scenario in areas of oversupply was they simply underperformed the market, but the worst case scenario was they were actually losing money. And these days investors are well aware of these risks.

“For example, while Domain’s House Price Report shows in the 2019 December quarter prices rose 4.3 per cent, this was not the case in suburbs with high oversupply and particularly those affected by construction defects, such as Mascot where prices fell 4.6 per cent to $880,000. In Homebush West, where the Centenary Park building is located, prices also fell 9.3 per cent to $565,000.

“These areas not only have the risk of being in the Danger Zone due to oversupply but also the construction defect risk – and the reputational damage from the construction defects has also carried through to high-rise towers across Australia.

“The number of transactions, which is a key factor when assessing the risk of not meeting pre-sales and sales targets, is often very low. For example, the number of apartment sales in Sydney Olympic Park fell dramatically by 75 per cent following the defects identified in Opal Tower with buyers showing little interest for apartments across the suburb.

“What we are seeing is that new units in high-supply suburbs either resulted in a loss or underperformed the market, even during periods of strong price increases. This has an adverse impact on investor confidence and particularly their expectations regarding the potential price increases of these dwellings.”

Mr Peleg said the introduction of credit restrictions in 2017 completely altered the landscape of the housing market with investors demonstrating their responsiveness to the changes.

Overall investor market share in Sydney decreased between January 2017 to March 2018 from 50.4 per cent to 43 per cent. A similar trend was witnessed in Melbourne with a reduction in investor activity from 39.1 per cent to 34.9 per cent during that period.

“In addition, the potential introduction of the changes to negative gearing and capital gains tax, as RiskWise projected in June 2018, also increased uncertainty and fears due to the creation of two markets (a primary and secondary market) and this led to a major reduction in the sales of units.

“According to the ABS, the number of new homes approved for construction in the month of November 2018, dropped by 2.2 per cent from the previous month and 18.3 per cent from November 2017. Westpac break reported in August 2018 that sales volumes had dropped to a 28-year low.

“The Brisbane unit market is a case study in poor risk management. When a developer pays inflated prices for the land, the risk will be realised, and you will have loss. Even as early as June 2016 in Statistical Area Level 4 (SA4) Brisbane Inner-City, price growth was -1.8 per cent with a massive oversupply of units (17,417 in the pipeline - an addition of 24.5 per cent to the current stock).

“As a developer when you are paying for a piece of land based on the potential selling price of the end product, you must factor in the risks rather than base it on optimistic scenarios. If you do factor in very tangible financial risks, you will see that the fair-value of the lot is lower in comparison to an optimistic scenario. In a vast majority of developments, the lot price is the major variable on the selling price.”

He said the risks included not meeting presales or that sales targets have a major impact on the financial results. Even if the targets are eventually met, the funding costs associated with those targets increase and add up to material amounts. However, even after meeting the presales and sales targets, there’s still a settlement risk that buyers who paid very low deposits could back away from the deal completely if there was a significant reduction in the pre-settlement valuation, and cash flow issues.

Mr Peleg said Covid-19 added another layer of complexity as its significant impact is yet be fully determined.

Meanwhile, there has already been a sharp reduction in auction clearance rates over the past couple of weekends falling to a preliminary rate of 61.3 per cent as of March 22 across the combined capital cities with the final result expected to be in the 50s within a couple of weeks.

The Westpac-Melbourne Institute Index of House Price Expectations Index fell 6.6 per cent in March, the largest monthly decline since February last year.

Risk identification and assessment

“We need to identify and assess the key risks. There are some very obvious and common risks that must be addressed by developers and these are oversupply and inflated selling prices that are included in the financial models of the developers when they make their decision to develop the property,” Mr Peleg said.

“On top of that there are other risks that should be identified by implementing proper risk-management practices. In addition, there are obviously other risks that cannot be foreseen, such as the coronavirus, which create major and unexpected economic shocks.

“The point is that we don’t know and do not expect to know all the potential major events that could occur in the period of at least two years or more (until a developer meets their financial obligations). Many things can happen and what developers need to do is to factor that in and improve risk-management practices to include them in the prices they are proposing.

“Then if they see the discounted pricing, including the risk aspects, is too low – and that others are willing to pay more inflated prices for a lot – they should move on.

“The decision should be very structured, risk based and non-emotional. The first step is risk management, where we need to assess the obvious risks (e.g. oversupply) and the potential risks that are less obvious (e.g. a major economic downturn) and then, based on that, we need to set the price taking into consideration the results of the risk assessment."

Mitigating the risks – develop in the ‘missing middle’

Mr Peleg stressed the importance of risk mitigation by developing properties in popular areas in the middle rings of Sydney and Melbourne, i.e the ‘missing middle’.

“Due to lower supply for house-and-land packages in the missing middle, even when there are some negative shocks, due to limited supply and generally good demand, these shocks are better absorbed with lower price reductions. Another development option in the missing middle is family-suitable units that are more attractive to owner-occupiers looking for larger floor space, lower price per square metre and in smaller building blocks generally close to transport hubs, employment and schools.

“There are actually many areas that have great potential and carry a low risk, it is only a matter of business strategy and proper risk-management practices.”

“Marketing expenses are, in many cases, materially lower for development in the missing middle in high-demand areas where they can be done through the local real estate agents with the standard, up to, 2 per cent commission (as opposed to high commissions required for intrastate and international property marketers).

“And usually in the missing middle, the scale of the development is far smaller which makes them easier to sell.

“The point is developers are at risk of insolvencies and this means they need to mitigate this risk by ensuring they have a sustainable business model, focus on the missing middle ring and address imbalances in the property market.

“Focusing on the missing middle is by far more of a solution than taking the risk of off-the-plan high-rise development.”

DORON PELEG is the CEO of RiskWise

Staff reporter

Off the plan
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