Development activity has slowed as liquidity has dried up. But for those that continue to invest at this end of the spectrum assessing risks has never been more important, says Daniel Henn
Philosophers and motivators will tell you that you cannot succeed in life without taking risks and that the more you risk the greater you stand to gain.
This may well be true, but in the words of the great American general, George Patton: "Take calculated risks. That is quite different from being rash." For those investing in and financing the commercial property sector, there has never been a greater need for prudent risk management.In the current economic climate there is even greater pressure on investors to demonstrate that, where possible, they are calculating and managing all recognisable or potential risks.
It is important for the future of the market and the overall economy that heightened risk does not prevent investment at a time when it is most needed, especially at the lower end of the market. What is therefore required is a cautious approach to due diligence that ensures that risks are carefully managed at every stage of the process, from assessing potential investment, right through and beyond the completion of the development project.
Before entering into an agreement to invest in a development there are a number of steps that investors should be taking to weigh up the risk. The findings can be used to evaluate the viability of the venture and the level of involvement and sum of investment that is committed to the development should the decision be taken to proceed.
When assessing risk, consideration should be made to issues such as the track record and financial standing of the developer, contractor and team; programme constraints and who is responsible for delays; what insurance is available and what the third-party liabilities are; how advanced statutory applications are; how watertight and appropriate the specifications and design information is; what power does the investor have; and what existing record and survey information is available for the building or site. In fact, every element of the design, construction, contractual and other due diligence information should be inspected.
To avoid expensive surprises, investors should make sure they review all third-party reports and, where they feel there may be gaps in the information, have their own inspections carried out.
On one occasion, prior to committing to a joint venture on a major development in London's Regent Street, a survey inspection on behalf of the investor identified corrosion in the metal framework. A review of the project information showed that no allowance had been made for this and the £500,000 (€630,000) needed to address this defect had not been included in the developer's costs.
Had the investor not carried out stringent risk management prior to committing to this project, it would have been faced with the situation of budgeting return on investment based on unrealistic targets.
In the current market, one of the biggest risks facing investors is that developers, contractors, sub-contractors and consultants can go in to liquidation mid-project. It is therefore more critical than ever to ensure that all the right mechanisms are in place for protecting the investment in such situations.
For example, it is important to make sure that performance and guarantee bonds are in place between the developer, contractor and sub-contractors. Additionally, investors should consider step-in right provision in case the developer's business is wound up.
Sub-contractor collateral warranties should also be checked when agreeing initial terms.
The investor may need to rely on these as the first line of defence if something goes wrong with the sub-contractors' work and after the main contractor has gone bust. Equally important is the range of insurance available to investors, such as key-man policies and protection for late completion.
It is impossible to know exactly how inflation will continue growing and what impact this will have on the overall cost of a development, but this must be taken in to account in the assessment of risk. Investors need to ensure that cost plans are robust, contractor prices are sufficiently fixed and that appropriate procurement methodologies are in place to get the best possible prices.
With the market as it is, many projects may be put on hold and while contractors may state that material prices are rising, there will also be a definite keenness on the part of the sub-contractors to offer competitive sub-contract prices.
Investors are not simply there to provide finance, invest in or acquire a development; they should have a right to get involved in a project to ensure that their interests are being managed in the most productive and efficient manner.Before committing to a scheme, an investor should be checking to see what powers of representation they, or their advisers, will have within the development agreement.
It is also important to address the key issues and identify any risks prior to contracts being signed and then continue assessing risks during the course of the project itself and at completion. As an extension to the overall project team, where required, the investor's project monitor is in a position to influence decisions relating to the construction in a way that a ‘money man' or lawyer may not.
An initial project appraisal will ensure that every detail of the available project information is reviewed and will, for example, provide a snapshot of the quality and status of design information; the progress of statutory consents; how realistic cost plans are; whether the contract is appropriate and what third-party protection is available. This technical due diligence is very much dovetailed with the lawyers' advice.
Throughout the project, progress should be monitored with particular attention paid to commercial issues such as cost increases, timing and the quality of delivery, as well as keeping abreast of contractual, statutory and legal matters. And on completion of the development it is important to identify all the matters that need to be dealt with without leaving anything open for come-back at a later date.
Before final completion is accepted the investor should be checking that legal matters such as agreements for lease have been complied with; warranties are in place; party-wall awards have been settled; all planning conditions have been discharged and building control completion certificates obtained; the services have been properly commissioned and snagging has been completed; and final accounts with contractors have been agreed. This, unfortunately, is by no means an exhaustive list.
There has never been room for rashness in commercial property investment; today there is, without doubt, a greater need for being calculated with your risks and keeping a close eye and an active hand on the development you have invested in.
Daniel Henn is head of project consultancy at building and property consultants Tuffin Ferraby Taylor