With the benefit of this analysis it is possible to isolate those factors that are crucial to the decision-making process. Obviously with variables such as site development costs and professional fees, although their movement improves or disimproves the relative feasibility of the project, their effect is not the most critical. Similarly, items such as agents’ fees and advertising costs do not form a significant element of costs or revenues. For large-scale commercial developments small movements in land prices also are not significant and
Chapter3 Partnership Negotiations Using Property Development Appraisal Techniques 63
savings in this area, while welcome, would not swing major development decisions. It is when rentals, investors yield, construction costs and finance costs are analysed that the greatest levels of uncertainties and risk are encountered.
Rental income is the developer’s forecast of what rent will be achieved when the development is completed. This forecast is shaped by considerations of location and supply and demand in the market at a future point in time.
Specialist advice from leading chartered surveyors or estate agents will often be sought regarding expected levels at completion date. Normally, appraisals are based on today’s levels of rentals and cost. Expected rentals are difficult to predict as they are dependent on both supply and demand with the intentions of other potential suppliers of development space unknown. Consequently, it is common practice to include a series of rental levels in feasibility studies.
This assessment is crucial as it determines the expected capital value of the property from which the developer expects to derive the profits. Investor yields are similarly crucial in their role in determining the expected capital value of the property developed. As a multiple of the rental in assessment of gross development value (GDV) the smallest change in yields significantly influences GDV and development profits. The sensitivity of these two factors combined produces the crucial estimate as to what revenues can be expected from a project.
Construction cost constitutes a major fixed cost on the development. If variation is allowed in this factor due to inflation, wage increases, demand for building services or costs of raw materials, the effect is immediately to reduce development profits. Developers can attempt to ensure that construction costs are contained through maximising the tendering competition between potential building contractors seeking work on the project. Cost savings are also often sought through delaying payment as much as possible to the contractor commonly through phasing arrangements. During periods of low construction activity, this process of cost reductions and competition is at its most intense, involving both initial tender price and phasing arrangements.
Boom periods allow contractors to increase their prices and profits in the knowledge that competition is less pressing.
The cost of finance is often the most difficult to predict. The ready availability of finance from 2000 to 2007 contrasts with previous high costs, based on historically high real interest rates in the 1980s and 1990s, which made finance prohibitively expensive on many projects. Movement on finance cost is potentially more complex and more damaging than changes in other cost factors. Changes with major impact can occur either in time or interest rates, which significantly affect profitability.
Timing of the development is crucial to profitability in many respects.
With the cyclical movement of the property market, letting or sale of the property may prove more difficult than expected. Rentals and yields, as previously discussed, if underachieved, result in immediate losses. However, delay in the project, even with a successful disposal, has similar results. This occurs because property development is normally carried out with high costs of borrowed money overhanging the development. Delays at relatively high interest rates immediately involve financial costs, which seriously damage
Chapter3
viability. Small rises in interest rates alone may be covered by developers in the short term in terms of the project remaining viable or profitable.
However, if such rises are combined with delays on completion or disposal of the property, the effect has most serious implications. Reductions in interest rates conversely increase the profitability of projects. It is clear therefore that time and interest rates for the completion and disposal of a development represent a major risk at all stages of the process.
With such a high degree of sensitivity to change present in factors that are at best only reasoned assumptions, the scale of risk involved is often great. Variations of only 10% can potentially double or entirely remove profits. Great care and attention must therefore be taken in arriving at such estimates. While architects or quantity surveyors can with a reasonable degree of confidence predict building costs, the estimates of rentals and yields must be regarded as less certain. The cost of finance, based as it is on time factors pertaining to the development as well as general economic considerations and government policy, is obviously out of the control and expertise of developers and property markets. Best estimates of the input figures included must therefore be based on probability analysis.
No matter how detailed the study of probability, models can never overcome the fundamental dynamic nature of the inputs involved in the development process. It is therefore necessary to treat all major inputs as flexible and revisions on the feasibility of the project would be common as the project proceeds. Even construction cost can be significantly affected by a design change made necessary at the planning stage. To a large degree, however, risks based on costs are within the experience of major develop-ment interests and with the exception of a major redesign, construction costs can be expected to be reasonably accurate. Similarly, funding arrangements secured in advance at fixed rates can help contain the cost of finance. How-ever, unless the building is pre-let or pre-sold, the investment yield and rental and eventual time taken for disposal remain beyond control. It is therefore on these factors that most risk is concentrated. The variation resulting from changes to both these inputs can be calculated over a series of scenarios and the results compared in order to assess results on profitability. Timing of development remains the greatest imponderable since developments will only be coming onto uncertain markets within 2 years. The final decision on development, type of development and timing is therefore based on a series of crucial assessments and estimates. Based on the analysis of these figures, any development interest must use decision-making processes to evaluate what result is most probable and finally decide whether that crucial element timing is correct.
References
Ball M (2006) Markets and Institutions in Real Estate and Construction, Wiley Blackwell, Oxford.
Cadman D and Topping O (1995) Property Development, E and F Spon Press, London.
Chapter3 Partnership Negotiations Using Property Development Appraisal Techniques 65
Darlow C (1990) Valuation and Development Appraisal, Estates Gazette, London.
Guy S and Henneberry J (eds) (2002) Development and Developers, Wiley Blackwell, Oxford.
Hayward R (2008) Valuation: Principles into Practice, Estates Gazette, London.
Isaac D and Steley T (1999) Property Valuation Techniques, 2nd edn. Macmillan, London.
Ratcliffe J and Williams B (2000) Development Properties in Valuations Principles into Practice, (eds WH Rees and REH Hayward), Estates Gazette, London.