px: certainty in every deal

Copyright © PSL Homes Ltd 2014 Permission granted to reproduce for personal and educational use only. Commercial copying, hiring, lending is prohibited

Residential Property Part-‐Exchange

Certainty in Every Transaction

Copyright © PSL Homes Ltd 2014

Permission granted to reproduce for personal and educational use only. Commercial copying, hiring, lending is prohibited

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Introduction Eleven out of eleven of the UK’s biggest housebui lders use part-exchange as an effective sales and marketing tool. In a recent study, we found that UK housebui lders consider part-exchange to be the second most effective tool in driving reservations after Help to Buy. While large companies have strong enough cash f low and big enough balance sheets to buy and hold used stock, the situation isn’t so straightforward for regional and local housebui lders. We’ve engaged with around 200 housebuilders of all sizes over the last 10 months. We see a playing field that isn’t level because the bigger companies are able to use size to their advantage. Smaller companies might offer part-exchange, but they rarely aggressively promote it to drive conversions. Are they missing a trick? This white paper explores using part-exchange as an effective tool to promote sales and suggests ways of mitigating the risk that buying used stock creates.

There’s a reason that 11/11 of the country’s most successful housebuilders put PX on their homepage. It works.

Dom Hawes-Fairley, PSL Homes



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Table of Contents Introduction ........................................................................................................... 2

Table of Contents ................................................................................................... 3

Executive Summary ............................................................................................... 4

Why is Part-‐Exchange Important? .......................................................................... 5

What does PX success look like? ............................................................................ 7

Establishing a Valuation Framework ...................................................................... 8

Current Valuation Strategies .................................................................................. 9

Introducing a New Valuation Strategy .................................................................. 11

Introducing the Saleability Index .......................................................................... 13

Certainty on every transaction ............................................................................. 14

Part-‐exchange & Help to Buy ............................................................................... 17

It doesn’t have to be all or nothing ...................................................................... 18

About PSL Homes ................................................................................................. 19



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Executive Summary Part-exchange is an important marketing tool for housebui lders of al l sizes because it increases reservation rates, makes customers chain-free and al lows the housebui lder to retain control of completion. Importantly, accepting a part-exchange al lows bui lders to negotiate on the price of the inbound property, rather than they one they’re sel l ing, maintaining price l ist integrity. But, property part-exchange is a risky business and measuring the success of the PX programme is only possible if one measures all of the costs associated accurately. Ideally, costs are allocated on a transaction-by-transaction basis, but in the real world this rarely happens because many companies don’t account for fixed costs in their PX transactions. Success in part-exchange is deal-by-deal. Establishing a fair PX purchase value is important to homeowners and that inevitably means using independent valuations. The established route for achieving this is through local agent valuations, but in most market conditions this only works in the interest of homeowners. We present a new framework for valuations that takes market conditions into account delivering better value for housebuilders. Resaleability is critically important to successful PX transactions and it’s not being considered in a meaningful way. A structured and impartial approach to forecasting the resaleability of a property may be more useful than just considering mortgageability or value on its own. The key to a successful PX programme is being able to achieve margin transparency on each and every transaction. Outsourcing might seem like an expensive option, but that is not always the case. Ideally, a PX programme offers housebuilders the option to buy direct where they are certain of the business case, or outsourcing where they are not. In each and every case a structured approach is needed in order to make risk-managed decisions. Help to Buy rules out PX transactions but only where housebuilders are running their own PX programmes. An outsourced PX programme offers the ability to combine both. The strategy we recommend to our cl ients is this: If you’ve got ready funds and a very high degree of certainty that you can go under offer on a PX property within 21 days of going on market, buy it with company funds. In every other case outsource the PX purchase.



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Why is Part-Exchange Important? As the property market recovers, housebuilders across the country have reported impressive reservation rates. Help to Buy has undoubtedly been the major catalyst in the housing market recovery outside the capital. It’s got homebuyers out viewing again and it’s helping them to stretch their budgets further. But, Government initiatives can only help housebuilders sell faster if their customers are chain free or have already sold.

To solve this problem, many housebuilders offer assisted sale programmes that allow reservations to be made with exchange contingent on a timely sale of the used stock. Assisted sale programmes work best in buoyant markets, with very saleable properties or where the homeowner is modest in his or her price expectations. The problem with assisted sale is that it doesn’t offer certainty and that means it’s only a partial solution.

Certainty Part-exchange offers total certainty once a deal is agreed. Because it removes the need for homeowners to market their own properties, the deal’s progress is fast, efficient and predictable. To the customer, certainty is about more than knowing their old home is sold without hassle or estate agents traipsing through the house. It’s also about certainty of timing, moving and getting on with their lives. That’s a powerful sales tool. But, if development schedules should slip a little “chain free” also means that customers complete at the convenience of the housebuilder, not the other way round.

“Chain free” means that customers complete at the

convenience of the housebuilder, not the other

way around



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Price control A customer with no property to sell is in a strong position to negotiate because they are immediately proceedable, but housebuilders don’t like discounting because they know it can set a precedent for future sales. Part-exchange customers are also immediately proceedable, but instead of negotiating on the price of the property they’re selling, housebuilders can negotiate exclusively on the price of the property they’re buying. This allows them to maintain the integrity of their price list and still give the customer a good deal.

Increased reservation rates There’s a very good reason that 11/11 of the biggest housebuilders in the UK promote PX so aggressively. It works. Barratt Homes reported a 42 per cent rise in PX reservations in a six-month period in 2012.



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What does PX success look like? It seems simple to buy a used house, but it’s very hard to do it in a way that manages risk in a consistent way, delivering measurable and transparent profit every time. There are just too many variables at play. Some companies choose to define success by the number of part-exchange deals they execute and they measure PX performance purely as an aid to reservations. Put another way, they don’t measure the profit and loss on each deal and, in our opinion, leak profit as a result.

In fact, our experience is that the great majority of companies don’t get too deeply involved in the financial efficacy of their PX programme. They see part-exchange as a necessary evil to be competitive and, because the true costs

of running a part-exchange programme are spread across the P&L sheet, they don’t measure them. We may look at PX on the P&L in a future white paper as it’s a highly specialized subject. In summary, we believe that PX costs should appear “above the line” not below it. That’s to say PX is a cost of sale, not an overhead.

• If you have a full-time part-exchange manager, how do you allocate that overhead to individual deals? You probably don’t. You probably mark it down to fixed overhead and get on with building. But that doesn’t mean it’s not a real cost.

• If you buy a property and have to hold it for a year before completing on its resale, how are you accounting for that?

Our model for PX success is about transparency and certainty; knowing exactly what each PX will cost you and managing risk so that you profit from the better deals and offload risk on the rest. Success in part-exchange is deal-by-deal. Because no two properties are the same and local markets operate differently we don’t think the old approach works effectively. Ideally housebuilders should be working a PX programme that offers flexibility, minimal risk and maximum effectiveness. The starting point to effective PX is effective valuations.

PX is a cost of sale, not an overhead… Success in part-‐exchange is deal-‐by-‐deal



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Establishing a Valuation Framework PX must offer customers a “fair” price for their old home to be a successful sales and marketing tool. “Fairness” is an important concept to homeowners because when it comes to one’s own home, decisions are often more emotional than rational. Fair matters. The PX price of a property is almost never going to be as much as the property could sell for on the open market. Vendors choose to part-exchange their properties for a number of reasons, but generally accept that they will achieve a lower price in PX than they could on-market. Thus, demonstrating fairness is an important part of gaining trust and achieving reservations. The starting point for establishing a PX price is identifying a realistic open market valuation (OMV). As we all know, the OMV of a property is simply what someone will actually pay for it, but how accurately can the established industry predict that in advance? Not very accurately at all and here’s the rub. People think of open market value as a price point, but in reality, it’s a price range. Estate agents tend towards the optimistic to win listings. It’s their valuations that fuel your customers’ expectations and if you buy at their price, you’ll almost certainly lose out. RICS surveyors’ red book valuations are often seen as the benchmark, but they can sometimes value down and sometimes value up. More often than not, they value down to err on the prudent side. Both the agent and the RICS surveyor are probably “right” in their valuations. If someone walks through the door and falls in love with the property, it could well sell at the agent’s price. Equally, it could sell at or below the RICS valuation if it’s been exposed to the market for too long. This is why open market value works better as a range than a price point. What’s key is that to be seen as fair, an independent reference point is needed and there are a few ways to achieve that.

People think of open market value as a price point, but in reality, it’s a price range

Figure 1: Open market value



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Current Valuation Strategies

Estate agent valuations Housebuilders that operate their own PX programmes generally use the average of two or three local agents’ valuations as their purchase price. In our experience, most estate agents use “on market comparable pricing”. If all of the properties on market were valued correctly, this would be a good approach, but very few are. On market comparable pricing is an appropriate methodology to use when prices are not appreciating and there’s palpable under supply, because lack of supply will help to compensate for over-valuation. But, it’s not a good approach to use in other market conditions if the objective is to convert PX enquiries into profitable sales. It is also commonly accepted that agents routinely over-value properties in order to win instructions. We very strongly advise our clients not to rely solely on agent valuations. Here’s a good example of how it can go wrong.



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Case Study In June 2013, we encountered a property that we valued at £65,000 in Middlesborough. It had been valued by local agents at £89,850 (open market price) with a fast sale price of £76,000. Over-valuing is bad if you’re a homeowner trying to sell, but it’s disastrous if you’re a housebuilder trying to buy in a PX. In this case, the housebuilder was faced with taking an immediate loss £11,000 or hanging on and hoping. They hung on and hoped. The property finally sold for £64,000 in December 2013. With council tax, cost of capital, salaries, legal and agent fees on the final sale, this a case study for what PX success does NOT look like.

RICS red book valuations The RICS red book valuation is the ultimate independent reference for a property’s value. But, as any professional involved in buying and selling property knows, RICS valuations are also somewhat slanted because they’re designed to manage risk for mortgagors not pinpoint value for other purposes. RICS valuations perform best when used as part of a managed risk process because they are often on the bearish side.

3rd party valuations Housebuilders that outsource some or all of their PX programme will typically be provided with a report offering more analytical and in-depth valuation methodologies combining both on-market and sold comparables. This is an improvement on the majority of agent-only valuations, but we believe that over-analysis of comparables can produce bearish valuations in some markets and bullish valuations in others.



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Introducing a New Valuation Strategy The right PX value is one that ensures the profit on your sales transaction once all of the associated costs have been allocated and which leaves the customer feeling they’ve been well and professionally treated. We advocate identifying PX value by taking a structured approach to valuations depending on market conditions as illustrated in figure X. Saleability plays an important part in the offer price too and this is a factor that’s generally overlooked in current valuation models. We’ll look at saleability next.

Figure 2: Valuat ion strategies



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On market comparable pricing Where prices are stable but stock is selling through quickly (4-6 weeks), the best strategy to use for valuations is on market comparables. This is the market condition that we’re currently seeing in smaller market towns and villages in the Midlands and parts of East Anglia. Prices aren’t genuinely rising because demand isn’t increasing, but well priced stock is selling quickly. Selling quickly in such markets means being better priced than nearest on market comparable properties.

Vendor-‐led pricing Where prices are rising AND properties are moving quickly because of an increase in demand but insufficient increase in supply, the best strategy to use for valuations is vendor-led. This is the market condition found in prime markets like London, Cambridge and Oxford.

Vendor-led pricing doesn’t mean always over paying to secure deals, but it does mean that your ability to negotiate a purchase price will be reduced. In such instances the best strategy may be to offer to underwrite the sale at sold comparable prices, but advise the purchaser to sell on the open market to test for a higher price.

Buyer-‐led pricing Where prices are either static or deflating and the market is slow, taking properties in part-exchange is risky. While these market conditions are usually associated with general downturns, they are still prevalent in certain areas of the UK, even as we power out of the recession caused by the global credit crisis. Buyer-led pricing will rarely offer vendors anything near market value, but when nothing else is selling, it does allow a move to be made. We see these conditions in parts of Wales, the North East of England and in certain parts of the West Country.

Sold comparable pricing Where asking prices are rising, but sales are slow the best gauge to use for value is what has actually sold. These conditions are often prevalent where agents are driving market values or in locations adjacent to more prime markets where values are anticipated to rise, but they haven’t yet. Sold comparable pricing offers vendors a very easy reference point for value.



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Introducing the Saleability Index Many housebui lders use mortgageabi l i ty as their sole criter ia for purchasing part-exchange propert ies. While this certainly keeps things simple, we don’t bel ieve that mortgageabi l i ty on its own is an effective r isk management strategy. We believe that using mortgageability as sole criteria for PX appropriateness can lead directly to very poor PX decisions. A better approach is to consider the saleability of a property, of which mortgageability is a contributing factor. A purchased PX property that is not saleable can rapidly reduce the margin made on a new house sale and in extreme cases, eradicate all meaningful profit.

We maintain that saleability is the single most important factor in establishing the true potential of a property for PX purposes. What happens when a property is mortgageable but not saleable? Either the price has to be dropped in order to secure a sale or the owner has to wait for the market to catch up. This can take years in a static market and many smaller housebuilders need cash to build, not to hold existing stock. On-market stock doesn’t get more valuable over time. At the same time, one of the key reasons that homeowners seek PX deals is that they can’t sell or can’t wait to sell on the open market. Thus, a house with low saleability can’t be ignored for PX purposes, it just has to be factored in the purchase price, resale price or both. Most estate agents and surveyors factor in saleability to their valuations but their assumptions are subjective, non-specific and un-measureable. We use saleability scale that is objective, highly specific and measurable to validate the valuations that we issue. We may address this in more detail in a future white paper.

Figure 3: Saleabi l i ty factors



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Certainty on every transaction Why does certainty matter? Certainty of sale is crit ical to customers buying a new house, just as certainty of margin is to housebui lders when sel l ing one. From the customer’s point of view, certainty and simplicity make buying a new home very attractive and a wel l-run PX programme can serve as a very strong incentive to choose one housebui lder over another. From the builder’s point of view, certainty of margin enables commercially sound decision-making. Some housebuilders see PX as either cost neutral or as a potential profit centre in a rising market. In many cases, this is because the true costs of the transaction are being obfuscated at the accounting stage. We’ve already seen that valuations are subjective at best and an educated guess at worst which makes managing risk and achieving certainty on a transaction difficult if the risk is being taken by the housebuilder.

Outsource purchasing to achieve complete certainty One option to achieve certainty is to work with an outsourced PX specialist and let them take the price risk by buying the property for you. In flat or recessive markets, this is a popular option, but when the market turns, or perhaps more realistically, is perceived to have turned, attitudes change. Outsourcing the purchase of PX properties certainly reduces balance sheet risk, but it doesn’t come for free. Existing providers offer to buy for a fee, at a discount to the PX value or a combination of both. Many of the transactional costs incurred by the outsourcing company are also incurred by housebuilders who buy direct, so the full cost of outsourcing is less than it may at first seem. Let’s look at an example. A property has a PX value of £100,000 against a reservation of a new 3-bed semi worth £179,995 with a GDV of £53,000. A PX company offers £87,000 for the property meaning the housebuilder has to contribute £13,000 to deliver full PX value to the customer. At first sight, outsourcing looks like it will erode almost 25% of the margin, but PX doesn’t come free even if you buy direct. Please see Figure 4 on page 15.



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Scenario 1: Ideal circumstances The property sells for full asking price within six weeks of going on market and completes six weeks later.

Transactional costs for a 3 month sale at £100,000 Purchase Legal costs £800 Searches £300 Surveyors fees £175 Inventory costs Finance or cost of capital at 75% LTV for 3 months 8% p.a. £1,500 Insurance £50/month £150 Council tax £150/month £450 Utilities £30/month £90 Sale Legal costs £500 Agency fees (VAT inc) 1.5% £1,800

Total £5,765 Figure 4: 3 month sale

Note: no allowance has been made for the human capital cost of managing the transaction or maintenance work that may be needed to the property such as draining heating systems etc

Scenario 2: Not uncommon circumstances The property doesn’t sell quickly and after a price reduction sells for £95,000 after four months on market and completes after six months on finance.

Transactional costs for a 6 month sale at £95,000 Purchase Legal costs £800 Searches £300 Surveyors fees £175 Inventory costs Finance or cost of capital at 75% LTV for 6 months 8% p.a. £2,850 Insurance £50/month £300 Council tax £150/month £900 Utilities £30/month £180 Loss on sale £5,000 Sale Legal costs £500 Agency fees (VAT inc) 1.5% £1,710

Total £12,715 Figure 5: 6 month sale



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Certainty of risk When a housebuilder buys a part-exchange property direct, they take on 100 percent of the risk. Many companies that we speak to focus purely on price risk – the amount they can sell the property for after purchasing it, but there are more risks than that in each deal.

Price risk Price risk is the most common risk used to measure and to manage PX transactions by housebuilders. It works like this: if house bought for £160,000 has buying and selling costs (SDLT, legal fees and agency fees) of around £6,000, it must sell at £166,000 or more to break even. This is a fairly simplistic approach to take because it doesn’t take account of the cost of finance, internal salaries etc etc. Managing price risk to deliver certainty is about being confident in the property valuation. This subject has been covered in some detail earlier in this paper. We maintain that the valuation methodology most companies use it flawed and therefore, risk is not being managed effectively.

Property risk Property risk is the most overlooked of all risks in the PX process. Few companies commission anything but valuation surveys prior to completing on PX deals and, thus, expose themselves to something being wrong with the structure of the building. The most common issues we encounter are damp, electrical and heating issues.

Margin risk Margin risk is the risk that the PX transaction erodes the margin on the new property sale.

The simplest way to manage all of these risks is to outsource the PX process to a third party. While this will almost certainly reduce the margin slightly on each deal, it avoids the penurious instance of getting either the price or the property risk assessment wrong. Risk Direct Purchase Outsourced purchase Price risk Yes No Property risk Yes No Margin risk Yes No Figure 6: PX r isk management



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Part-exchange & Help to Buy I f Help to Buy is the best marketing tool avai lable to housebui lders in the UK and part-exchange is the second best tool, what happens when they’re combined? According to the regulat ions, Help to Buy is not avai lable on houses that are being part exchanged, but there is a way of combining both to real ly superboost sales. As a housebuilder, the Help to Buy rules prevent you from accepting a property in part-exchange and approving a Help to Buy application. The rules don’t prevent your customer from working with an independent part-exchange company, however. You can even refer them, but the PX company will have to

pay SDLT on the transaction as the exemption will no longer apply. Strictly speaking, such a transaction is not a part-exchange, but it looks, feels and works that way for a customer. Using an independent PX partner is a totally legal way of being able to offer Help to Buy to your customers while giving them all the benefits of a

part-exchange. You will need to contribute financially to the deal, but you’ll achieve certainty and guarantee your margin or be able to refuse the deal.

Strictly speaking, such transactions are not part-‐exchange, but they look, feel and work that way for a customer.

Figure 7: Help to buy



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It doesn’t have to be all or nothing I f every property were to achieve a fast sale, outsourcing some or al l of the part-exchange process wouldn’t make sense. But, that’s not the way the market works. Some propert ies sel l very quickly at the price you want and others don’t. Those that don’t l inger and end up gett ing discounted and discounted.

The optimal part-exchange strategy uses both direct purchase and outsourced part-exchange to manage risk and maximize profitability across the phases of a development. As long as the property appraisal methodology is consistently applied, decisions about who actually buys the PX property can be left until quite late in the process.

The strategy we recommend to our cl ients is this: If you’ve got ready funds and a very high degree of certainty that you can go under offer on a PX property within 21 days of going on market, buy it with own funds. In every other case outsource the PX purchase.

If you’ve got ready funds and a very high degree of certainty that you can go under offer on a PX property within 21 days of going on market, buy it with own funds



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About PSL Homes PSL Homes is a privately funded property services company. We work on both an ad-hoc and retained basis with national and regional housebui lders, housing associat ions, property investors and other professional property owners. We buy propert ies direct to l iquidate assets quickly and we operate part exchange programmes for housebui lders under our PrepackPX brand. PrepackPX offers a unique approach to PX that offers total risk management, detailed analysis and insight, certainty of margin on every deal and multiple funding options for purchased properties. PSL Homes 2nd Floor, King’s Hall Parson’s Green St Ives Cambridgeshire PE27 4WY Tel: 01480 877 330 Web: www.pslhomes.co.uk Web: www.prepackpx.co.uk @pslhomesuk @prepackpx

px: certainty in every deal

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