The easy pickings are over. Increasing competition for good deals in the Spanish real estate sector mean that international funds need to turn to development in search of high returns, writes property expert Mikel Echavarren in an article for Idealista.com, a property portal.
Over the last two years the number of sales of mortgage debt, repossessed property, and equity asset portfolios, in which investment funds were the main players on the buying side has multiplied.
Almost all these transactions have been an auction, meaning the funds have had to make a considerable investment in advisors, resources, and time. Since “many are called, but few are chosen”, it’s obvious that many of these funds are considering diversifying their investment strategies in Spain, more so when it’s increasingly difficult to obtain two-digit returns because of the current huge competition among buyers.
Among these strategies, one worth highlighting is the property development business of buying building plots or unfinished developments where returns, in accordance with the risks in this business, should fulfil these investors’ expectations.
The key to this strategy is access to investment opportunities on plots that are interesting both because of their price and potential demand for projects tailored to a particular target market.
Apart from this important point, which means that these funds need active management and an ability to choose opportunities based on risk, market, project and cash-flow assessments, there are numerous possibilities for structuring these business.
Unless a fund wants to reinvent the property development business by setting up a development company with its own structure and teams of professionals, the most common form of management is through local partners for development, technical, sales, and even financial partners.
That said, setting up a new development company could make sense at the moment, as it would be free from the baggage of previous projects, refinancing problems, and potential contingent liabilities. Nowadays, it’s possible to find excellent professionals and experts in property development who are available for work as a result of the property market disaster, and early retirements in the financial sector.
By building up a property development company from scratch, or transforming a company with experience in the business, a fund could gain all the value from this activity at a time when competition has been reduced to a very small number of developers with access to capital, and when it’s reasonable to believe that property prices have bottomed out.
The most important point is the exit strategy – how the fund cashes in when it exits the development company’s capital after five years. Leading up to the crisis, stock market listings of developers were excellent for owners who sold but disastrous for those who bought. This experience, and the rarity of stock market trading of residential property development businesses are uncertainties that, in our opinion, make it advisable to focus investment strategies on alternative structures.
Those that, as far as possible, allow funds to detach themselves from 10-year technical risks through the creation of joint ventures with developers, participative loans, or delegated development.
This focus opens up plenty of business possibilities to developers who simultaneously combine experience in the product, specifically in the local area where the project is being developed, who can contribute capital as proof of their commitment to the fund, who are not an obstacle to obtaining finance from banks and whose reputations do not present a risk.
These are not easy factors to bring together in the property development sector, particularly the ability to contribute capital to each project, between 5 and 10 per cent of its total. However, this joint-investment requirement can be overlooked if the developer offers added value from the beginning, such as an option to buy the plot at below market price, a prior commitment to a bank loan for a percentage of the plot cost, or a project with exceptional returns.
These intangible assets that developers might contribute can be put into practice via formulae in which the fund capital is structured through a participative loan whose conditions are adapted to the ‘capital’ contributed at the beginning.
Given the rapid changes in the Spanish property market, and the way funds adapt their investment strategies to it, we believe that it will be increasingly common for the investors to focus their attention on different locations, beyond their initial focus on Madrid, Barcelona and the main tourist areas.
One of the key aspects needed to reach this sort of agreement or alliance with developers, apart from the project being profitable and reasonable, is the ability to anticipate these funds’ requirements for returns, liquidity, multiples, and control, in order to be able to present a good enough logical structure for joint-investment, management, and financial and technical supervision of the joint project.
To find sufficient capital to convert development opportunities into viable projects requires a large dose of pragmatism and financial analysis. And in this case too, many are called, but few are chosen.
Source: Spanish Property Insight