In consulting on risk, its nose in, fingers out!1st Jun 2019
Nose in, fingers out! This is how I was taught to approach risk detection in property development consultancy. In other words, ask lots of questions, look, learn and observe everything, and yes, sniff around. But don’t interfere.
The real estate development industry assembles and applies the financial and physical resources to construct new built space in its role as a converter of financial capital into physical capital. In meeting these objectives, a developer has to focus on the satisfaction of the needs of both target and client groups, e.g. the users of the property and the investors.
As a company we are careful not to interfere with the work of the executives, but sometimes it’s hard – especially when considering the results of a recent study conducted by the Internal Audit Authority, which found that 78% of respondents said they turn to management to identify risk. But management noted they are surprised by risk more than 60% of the time, so how can they be the source of your mitigation?
A risky business?
Real estate development is considered to be one of the riskiest corporate activities there is. As the creation of real estate products is in many cases speculative and therefore in anticipation of an unknown future demand, risk and uncertainty are key elements of real estate development. The risks are omnipresent – a vicious triangle of space, money and time.
Successful development depends, inter alia, on bringing the adequate real estate product to the market at the right time at the right price. The development profit depends on achieving all that while balancing costs and value.
Real estate development is fixed both in time and space; involves relatively large amounts of capital; and demands a dedicated team of people with different skill sets and expertise.
It also requires the co-ordination of a wide range of interrelated activities. Local authorities, legal requirements, residents and neighbours are to be satisfied; design teams and contractors must be managed; time scales, costs and contingencies have to be monitored; and lenders and other stakeholders – especially prospective tenants and investors – need to be satisfied. In addition, real estate developers are often faced with considerable changes in their environment, and new challenges driven by economic, social, urban planning, political, legal, environmental and technological conditions.
The most prominent risks associated with real estate are that it is tied to its location, it is heterogeneous, it is scarce, and it has limited substitutability. This has far-reaching economic, legal and factual implications. Heterogeneity leads to both scarcity and limited substitutability.
- Land has limited substitutability. It cannot be reproduced, and any structures built or developed on a specific piece of land are characterised by a high degree of uniqueness.
- The geographic location alone frequently determines the most likely use as well as the physical and/or structural possibilities, and the value of real estate is largely determined by external factors such as the condition and possible uses of adjacent properties, as well as public-sector infrastructural facilities.
- The heterogeneity of real estate can be derived from its immobility. A low level of heterogeneity results in the creation of material and regional sub-markets, thereby restricting the comparability of real estate. Yet we often take data and compare developments based on their use alone – that is if you are not an expert at understanding the complexities. Be warned that no two developments are the same in any way.
- Real estate development is a highly complex, dynamic and multidisciplinary challenge. The duration and complexity of the development process involves a considerable amount of time and, as a consequence, real estate developers lack the relative flexibility to respond and adjust quickly to any fluctuations in tenant and investment markets. This results in increased economic risk.
- Real estate is also characterised by its long life cycle and useful life. Depending on the purpose of real estate, its capability of being used by third parties and its usage concept, the economic life of real estate ranges between 20 and 100+ years. During this long period of time properties have to be maintained, refurbished or repositioned.
How to avoid surprises?
Emerging risk has the potential to create the biggest surprises, so managing emerging risk is the single most important function of risk management. This is anticipating risk rather than managing it once it arrives.
- Firstly, acknowledge the increase in change velocity, which is a great compounder of risk and associated costs. The speed of risk has increased tenfold. Gone are the days where we could be metaphorical meteorologists who stand on a hill and see a storm coming from far. Storms now arrive a lot quicker, and in some instances they hide themselves from view until it’s too late.
- Be objective, or get external objective opinions. It is easy to implement hard controls, check the boxes, and be legally compliant, but that does not really mean much. The soft issues are the dangerous ones. The single biggest contributor to risk mitigation is getting external professional opinions for evaluating the development process, and identifying the best exit point for the developer. If the developer is too emotionally involved, or too attached to invested capital, objectivity is lost. So invest in an objective opinion you can trust. Knowing what risks lie in each period of development enables a developer to gauge the expected returns on exit.
- Risk in property is tied to movability. Just as the development is immovable in terms of its location, the movability of a developer during the project’s timeframe is directly related to the risk. The fewer options you have, the higher the risk –and the higher the probability of being impacted by factors outside your control.
- As a project progresses, types and extent of risks may change. New risks may emerge, and existing risks may change in their importance. Of particular importance is the relationship between time and flexibility. During the course of the project, the developer’s knowledge of the likely outcome increases, but at the same time options decrease, and there is less room to manoeuvre. So developers start out with maximum uncertainty and manoeuvrability, both of which decrease until – towards the end of the process – complexity has decreased, but so too has the developer’s ability to influence the project, especially with respect to the commitment of capital or tied-up costs. And this declining manoeuvrability leads to increased risk.
- Understand the phases of development. Knowing the pitfalls in each phase and how to free yourself from the project at the right time is the most important tool in a successful developer’s arsenal. And, when exiting, ensures a smooth, open and fair transition.
- Be guided by failed or struggling developments, and be aware of your limitations. Seek the guidance of experts to best mitigate the unforeseen, and learn from the past mistakes of others.
Francois Schoeman’s professional experience lies in driving business growth through strategic marketing and business development initiatives including core competencies in management, planning and directing launches for diverse sectors and turnaround strategists.
Francois holds qualifications in Property Development and Investment and Facilities Management through UCT. He also holds a CMCA and AMS through the American CAI and is a Certified Director through the Institute of Directors of SA. Currently COO of GEMS Property, consulting to more than 65 developments in diverse sectors.