Ripe For Development
Not every development has potential to turn a profit, but the return on a well-planned development can be huge. Joanna Jefferies investigates how to find out whether a development site is viable.
31 October 2020
With property prices on another upward swing and yields not always keeping pace, many investors are casting their eye to developing property to make a return: either subdividing land they own, or looking to purchase sites that are ripe for development.
But developing property is a very different game to investing in it, and there are some key learnings to take on board before making the leap into development. We asked the experts in the field to give us their key advice on what you need to know to ascertain whether a site is viable for development.
Know The Zoning Rules
The first thing you need to look at when assessing a particular site is the zoning that it falls under and what the rules for that zone are. Councils have District Plans on their websites, so trawl through the documents, or alternatively book an appointment with a council planner, an independent planner, or an architect.
Councils zoning rules for subdivision are vastly different. In Auckland for example, there are a range of minimum lot sizes: Single House zone is 600m2, Mixed Housing Suburban is 400m2, Mixed Housing Urban is 300m2 and Terraced Housing is 1,200m2.
Once you know what zone you’re in, there are two ways of looking at subdivision for a site: either an empty lot subdivision with no building on it (you just need a subdivision consent), or a joint land-use and subdivision consent where you’re going to show the design and location of the proposed buildings on the site.
“The biggest advantages of doing the joint version in that those minimum lot sizes (apart from Single House zone) go out the window,” says Thomas Ward, director at property development consultancy I Am Developer.
“What that means is you have to design the buildings to show how they comply with the district plan zone rules, and that they have a good level of amenity. From an investor’s point of view what could have been a twolot subdivision becomes a four-lot subdivision and that completely changes how your numbers stack up.”
Knowing The Costs
It’s crucial to know what your costs are likely to be before you sign up. Development costs are either fixed known costs that can quite easily be estimated, such as the development contribution for each new title (council websites often have a calculator that gives an estimate on your development contribution), or “un-fixed” costs.
The unknown costs require some up-front investment, such as underground services – putting in new stormwater and wastewater lines. Until you have civil engineering drawings, you can’t put a final cost on that, says Ward.
“So, it’s often a case that you have to start spending money, and the further in you get into the project the clearer your costs become. But just to give you a ballpark, usually for a simple one to two lot subdivision you’d expect to spend $120,000 to $150,000 to create one title.” However, if you then turned it into four lots, you wouldn’t expect to pay that same amount times three, because a lot of the costs (such as civil works) have to go in regardless of how many lots you put in.
Architects can do feasibility reports on a prospective development, but Ward warns it’s crucial that the architect has an understanding of maximising the potential of the site, within the client’s budget.
Designing For Profit
Understanding how to maximise a site has a lot to do with good design and you should run feasibility reports on multiple designs. But first it’s important to know your goals for the project, and that is different for each person, says Keith Hay Homes national property development manager Barry Walker.
“There is not a cookie cutter approach to every property; an investor or developer needs to take into account their short and long-term goals, their experience, finance capabilities and tax implications. Once this is understood then decisions on a development become a lot easier.”
• Locate a site
• Look at feasibility of potential number of lots and design of dwellings within zoning
• Feasibility report on costs to take to your lender or mortgage broker
• Once finance is secured: concept design
• Apply for resource consent
• Engineering plan approval
• Building consent
A developer’s timeframe for a potential design concept can also have a big impact on feasibility, says Walker. “They need to consider time, cost, value, saleability and finance. To understand these they need to review the feasibility in terms of council planning: is this going to be an easy, quick consent or will this take a longer time? To make this decision they will need to review time versus profit outcome.”
It’s also crucial to know the location as much as you would if you were simply investing there. Walker says investors should undertake extensive research into their market and partner with experienced agents to find out, “what’s selling, how much is it selling for and what are the key attributing factors to the sales price and timeframe to sell?”
The design of potential buildings is crucial to the projected return on your development. “I know of many properties that suited a six-lot subdivision, but the developer still made the same profit out of only building three houses,” says Walker.
How To Secure Development Finance
In order for a development to be viable it needs to make a return, not just for the developer’s pocket, but so that the developer can secure finance from their lender in the first place.
‘I know of many properties that suited a six-lot subdivision, but the developer still made the same profit out of only building three houses’ BARRY WALKER
Strategic Mortgages and Development Finance director Ammon Acarapi says the main banks are quite resistant to lending to inexperienced residential developers currently as their risk appetite is low, but that non-bank lenders are far more comfortable with this type of lending.
What lenders are looking for is a feasibility analysis that makes commercial sense, but that also shows the applicant either has experience in development, or has employed a team of advisers mortgage advisers, engineers, planners, architects who know their way around developing land, says Acarapi.
Engaging these advisers to run feasibility on the project may cost around $5,000 – and that’s before you know that the project is viable. In addition, lenders are looking at a combination of the borrower’s equity position in the project and the profit margin (development finance is not income-tested).
“You would have to question anyone who would want to build a project for less than say 20% return on the work that they are doing,” says Acarapi. “That’s not to say that they only need to have 20% in the whole deal. If we were trying to get funding on a development that was only going to have 20% in it at the end, then it’s not very attractive to a funder.”
The advantage with getting funding through a non-bank lender is that they are so familiar with this type of project that they won’t require pre-sales like many main banks do, and they often won’t require valuations or quantity surveyor involvement, which is a huge cost saving, says Acarapi.
But if you think you’ll get retail banking rates, think again. Even a small development is considered commercial in nature and commercial rates generally apply. That means 8-12% per annum. “You’ve got to remember this is not long-term money, it’s money required for a specific use over the short term it could be 12 months.”
It’s crucial before purchasing a development site to be aware of both GST and income tax law, and how they will impact on the viability of your acquisition. When you are developing property for the purpose of disposal, the first thing to understand is that all gains are fully taxable and where the processes are continuous and regular, they are also subject to GST.
In fact, there has been case law that suggests that a subdivision as small as the division of one lot into three is sufficient to require GST registration for a continuous and regular activity, says Withers Tsang chartered accountant Mark Withers.
“So, the bar is quite low in terms of people having to be registered.” The important thing to understand about GST is that all land transactions between two registered parties are generally subject to compulsory zerorating.
That’s determined by three criteria:
1) both parties are registered,
2) the purchaser gives warranties that they are using the land in their taxable activity and
3) that it won’t be land that will be their principal place of residence.
“So, if those criteria are met, the land transaction is dealt with on a zero-rated basis, where the vendor doesn’t pay and the purchaser doesn’t claim. “The advice I always give is that you are not in a position to make an offer until you know what the vendor’s GST status is. Because if you make an offer that is inclusive of GST, but the transaction is zero-rated, it’s inclusive at zero and you won’t get a claim,” says Withers.
That differs from land where if an unregistered person is selling it, there is a GST claim available under the secondhand good rules of 15%, “so it’s critically important that people understand the GST position of all parties before they start firing in offers”.
The standard form sale and purchase agreement now has Schedule 1 GST warranties at the back and warranties should always be completed properly to ensure that everyone is clear on GST position.
Income Tax Trap
Section CB 15 is an anti-avoidance provision in the Income Tax Act and is a constant source of work for accountants and can be a real trap for those new to developing land.
It basically says that if someone is in the business of developing land, the land they hold is known as being on revenue account, which means that when it’s sold it’s subject to tax, as opposed to capital account which is what property investors hold their rental properties on.
So, if you’re a registered developer and you’re holding your land on revenue account and you transfer some of that land to an associated person, like a family trust or a member of your extended family, then under CB 15 they inherit the revenue account status of the land, which means that they can never sell it without it being taxable.
“Basically, if you are developing land for sale, then you never want to retain any of that land for the purposes of investment, because what would normally be a 10-year hold to get clear of tax is perpetual when it’s your own revenue account land that you’re trying to retain.”
“Because of that rule, if people come to see us with the proposition: ‘I’m doing a subdivision, I want to keep some and I want to sell some’ then that requires a very specific strategy to be able to be navigated without there being a tax outcome on the retained land, which involves partitioning the ownership of the property right from the outset between a ‘hold’ entity and a ‘sell’ entity.” Withers says it’s a common pitfall for aspiring developers and it’s too late to rectify once the land is settled.
Dealer Or Developer?
There are three sections in the Income Tax Act that deal with people that are dealers of land, developers of land or people in the business of erecting buildings.
If you’re in the business of doing any of those three things, then all your other land acquisitions are tainted by that activity. That means if you buy land to keep, then that’s tainted land that must be held for 10 years or there’s full income tax payable on it. “It’s not generally possible to structure around these rules,” says Withers, “because the associated persons rules are cast so widely.”
If you’re not in the business of developing, you’ve only got to worry about the bright-line rule. But if you are, then you have a 10-year hold rule. However, it’s not perpetual, like many assume. “You’re only tainted while you’re in the business of developing, so if you have a company that is doing a land development and you finish and you liquidate it and have stopped that activity, you won’t then be tainted for future acquisitions.” ■