Positive or Negative Development

Dear all,

I have found conflicting views so far on what I term margin on development cost (as in the value of what you are building/have versus the development costs). I want to give you an example scenario of what I mean & see what people's thoughts are. I will keep it simplistic deliberately.

I want to stress that this is a buy, develop & HOLD question, NOT a buy, develop & sell.
Times are based off a market I am familiar with.

Imagine a scenario involving buying a block with the intention of putting a new dwelling in its backyard.
Block Purchase Price: $400,000 = WILL HAVE NEGATIVE CASHFLOW (cost you money to own/not pay for itself)
Additional Costs Involved With Purchase: $50,000

Cost To Create New Dwelling: $300,000 (inclusive of everything from construction, town planning etc.)

Value of New Dwelling: $350,000 = WILL HAVE POSITIVE CASHFLOW DUE LARGELY FROM DEPRECIATION BENEFITS
Value of Existing Dwelling: $350,000 (it is now on a smaller land area hence the reduction) = WILL HAVE NEGATIVE CASHFLOW

Total Value Now: $350,000+$350,000=$700,000
Total Costs/Loans: $400,000+$50,000+$300,000=$750,000

Margin on Development Cost=$700,000-$750,000
=-$50,000

Team A argues this is a bad strategy:

• It is too risky, if something went wrong you have put yourself in an even worse position.
• You are smarter to wait for 5-10 years of capital growth until there is say a 10% positive margin & then do the development as there will be much less risk.

Team B argues this is a fine strategy based on the time periods involved & what could go wrong:

• If the property market in the area or economy were to go down, you will be in a negative position anyway.
• For the first few months at least you will likely be in a negative position anyway, with the purchase costs outweighing any capital growth. Therefore any crisis that happens here with or without a development plan will still lead to a negative outcome.
• By ideally the 8th or so month you might have permits. Ideally this would improve any forced selling position & easily outweigh the costs involved with getting said permits.
• Once construction commences, any unforeseen issues/costs (striking rock etc.) shouldn't matter too much as they will merely reduce the amount of positive cashflow you gain from the investment.
• If the builder goes broke partway through/absconds, you are in a bad position regardless of which Team you are one=likely swallow your losses & find another builder.
• What about if you lose your job during any stage? The finishing the development makes even more sense as the positive versus negative cashflows should either negate each other or at the very least reduce the burden.

WHY BUILD FOR A LOSS-THE CAPITAL GAIN REASON
If you hold the initial $400,000 block and it grows at a conservative 6% per annum:
After 5 years=$535,000=$135,000 gain
After 10 years=$715,000=$315,000 gain

If you do the development and the two combined grow at a conservative 6% per annum (remember costs are $750,000):
After 5 years=$935,000=$185,000 gain
After 10 years=$1,250,000=$500,000 gain

i.e. the development produces a greater capital growth gain.

Let me know your thoughts.
Cheers.

 

IMO you need to go into a deal (any deal, or development, or buy reno hold, anything) with the intention to make an immediate profit. Don't enter deals to make a loss. You don't buy shares or trade options that way, so don't buy property that way either.

 

Wait. I think I misread.

You developed for a loss? Why?

I thought it was, you were making a loss during purchase to then build and uplift.

As for bringing on a second builder to finish off first builders work.

From what I've seen, second builder either hesitates to take on unknown works, or charges an arm and a leg to complete.

 

See the new line I added about capital gain.

 

Why would you develop..... using numbers above
If you go in it to break even or make a loss ??

Just buy an established dual property in a falling/distressed market, save time around 12 months and make money. No risk

Seriously ...... not logical to develop property if there will be a capital loss. Cash flow is not exciting either

Assumption of growth in current environment is high risk, chances are your development may go backwards and your capital erodes further

When I read this thread thought it was a joke

 

I see.
I would strongly suggest not doing that.

1. Less land component than using funds to buy 2nd property.
2. Development should be 1+1=3

Development for me is. Buy site, build 4, sell 3, keep 1 now positive cashflow property, cash in bank, can move on-to next deal.

Waiting for external market forces for my future financial security occurs to me as too much of an extreme sport.

 

I think he mentions positive cash flow post development and long term hold .

 

Regardless, a paper loss is a loss

 

No one is doubting that it is a loss upfront on paper, but true loss/gain only occurs when you sell & from your cashflow=that is what changes the dollar amounts in a bank account.

Actually plenty of people 'top up' on shares when the price is down to make a later profit-think BHP when the price of iron went down.

 

Some developers ger stuck and start building in a rising market and then the market turns and they have no choice but to hold

Developers are at the mercy of market conditions, that is the risk

However to start a development when the numbers are in the red is nuts, easiest way to go broke

I know all my development projects have cost me perhaps 5% above feaso, that is why it is important to have plenty of fat in the deal

 

But you aren't selling the development immediately. You only need two tenants.

 

OK. Goodluck with that one

 

I can't see that.
How positive? Maybe if it was 20% cashflow-positive. Maybe.

And only if I had a large income and capital to keep moving forward. Otherwise you're stuck. Gta think 5 moves ahead.

The above scenario sounds like the perfect chess move... to loose.

 

But after 5 years time (or actually 3 & a bit if you take out the physical construction/permit times), you are well ahead-not only have you made a much greater gain, but you also haven't had the 5 years of negative cashflow. The capital growth difference is over 30% anyway.
Define 20% cashflow positive please.

Also as to what MTR said about buying a dual property in a falling market:

• You are now buying two properties & likely both negative cashflow
• You might not have the lending funds to do that

 

@Perthguy thoughts?

 

After 5 years. The cashflow + capital gains development will also go up. Now you're even BETTER off.

If you're buying a duplex. I'd hope you're getting something highly cashflow positive from day one.

I see this all the time here. Can't wrap my head around it. Justification for terrible investment choices.

If one wishes to persue your above stated scenario. I wish them all the best in their investing endeavours.

 

All sorts of alarm bells for me.

Developing to make a capital loss. Counting depreciation in as part of cashflow calculations. Relying on future above average capital growth as a justification for the deal.

It's a "no" for me. I agree with @NHG - the other financial benefits would have to be truly obscene, like 20% yield or something.

 

I have a better idea find a development project that makes a profit on completion where the numbers stack up.... and icing on cake is cash flow positive

Refinance on completion..... rinse and repeat

 

If your budget was $400,000 though I reckon you would struggle to find one in Aus..

 

I have no idea not looking

Markets are softening, IR rising, credit squeeze.... Whats the rush???

Be patient, and wait for the right deal to come along