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Identifying Profitable Housing Development Opportunities with Risk Analysis

Aug 8, 2022

Real estate investment opportunities come in all shapes and sizes – from new developments that traditionally provide reliable, predictable income, to troubled properties that could have significant financial potential if developed and managed properly. The key to success with these opportunities – particularly when dealing with dilapidated properties or Fannie Mae foreclosures – is identifying the viable financial rewards given the costs and challenges to a specific property.

Wright Homes, a real estate development and property management company, has used Palisade’s @RISK software to account for traditional uncertain variables in housing development for years.

“Palisade’s @RISK solves the problem of generating a risk-adjusted offer amount for a real estate development effort, based on the requisite analysis. It also provides visibility into making appropriate cost and risk trade-offs, which is ‘must have’ information before investing in any new properties,” said Jim Goebel, Principal Developer for Wright Homes.

While the housing industry is often fraught with risk, clogged supply chains and new data signaling a market slowdown in the U.S. have thrown new uncertain variables into the mix.

Sales of new single-family houses in June 2022 were down 8.1% (±15.0%) from May 2022 and were 17.4% (±11.6 percent) below the June 2021 sales, according to the U.S. Census Bureau and the Department of Housing and Urban Development.

“The current change in the housing market is partly due to the economy at large and consumer sentiment. And right now, the economy is on shifting sands—on one hand, there are signs of a weakening economy as the gross domestic product (GDP) has declined for two consecutive quarters, which some economists say indicates a recession. But on the other hand, the job market and consumer spending is still strong,” explained Natalie Campisi in the Forbes Advisor article Housing Market Predictions 2022: When Will Prices Drop?

The unknown trajectory of the market poses a challenge for developers as housing development often requires years of advance planning.

“Housing is a hugely fragmented industry of mostly independent companies that includes developers that spend decades turning raw land into parcels that can be built upon and subcontractors that hire laborers by the hour. The system works fine when demand is strong, but deteriorates with even a modest sign of trouble and can take years to restart, creating a backlog that gets deeper each time building slows,” wrote Conor Dougherty and Ben Casselman in the New York Times article We Need to Keep Building Houses, Even if No One Wants to Buy.

Instead of making development decisions based solely on intuition, developers must leverage risk analysis software to help account for the new uncertainties in the market. With @RISK, Wright Homes created a model to facilitate their residential property housing re-development activities while minimizing the financial risks.

“We needed a system that would help us select the right properties to engage in, know what to offer on them, and do so in a way that ensured we wouldn’t expose ourselves to too much risk,” said Goebel. Palisade’s software provided a solution that was both effective and profitable.

One of Wright Homes’ recent developments – the McKinley project – posed a particular challenge as there was significant uncertainty regarding the property’s expected redevelopment costs. The company initially did qualitative research to better understand the area which included analyzing the demographics, geographical qualities, and neighborhoods.

“Approximately 1 out of every 10 properties we review ‘qualifies’ and makes it past the first part of our prospecting process,” explained Goebel.

Once the McKinley project passed this first step, Wright Homes used @RISK to model a wide range of factors of uncertainty including line-item costs for redevelopment efforts, vacancy and maintenance allowances, future rental income, taxes and insurance, and assessed value or rebate programs. The resulting distributions, coupled with Monte Carlo simulation, provided a final output – the total cost figures for redevelopment. These figures helped guide Wright Homes on what to offer for the property based on their desired return on investment.

By using a probabilistic approach to decision making, housing developers are taking the guesswork out of the equation, account for unknown variables, and make better decisions that maximize their profit.

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