Financial theory tells us risk and return are positively correlated.
This is true if you compare investments in different asset classes. If you invest or shall I say speculate in Derivates you definitely want a higher return than in 10 Year Government Bonds.
However, investing in the same underlying asset class like into stocks or property one can receive extra returns for equal risk. Especially in the property market which is a less efficient market, as all relevant information is not processed quickly and efficiently. There definitely are rewards in such markets for the one who does a proper analysis of the risk-return trade off on investments.
Admittedly, there are also other social and environmental factors to a property development project which could be beneficial to the developer and the community in an indirect way if the whole life cycle of the project, from site acquisition to demolition is assessed. However, this is more the case in a build and hold investment.
Putting aside these less intrinsic factors for discussion on another day, lets focus on what the normally drives the investment decision of a person who exposes his capital to risk, namely the required return – measured and benchmarked by the Development Margin (DM) or the Internal Rate of Return (IRR) for longer projects.
In the typical process of build, sell and claim your GST back, a property development’s financial success is built like a building on its foundations, in this case, the land acquisition price.
To address the risk of the site acquisition price, we suggest the use of a sensitivity analysis which focuses on either the DM or the IRR subjected to two variables which usually move in tandem.
For example, assuming 100% debt financing, apartment developments in some areas have seen reduced values for the end product or gross realisations (GR). If a GR is reduced due to a weaker market by say 10% during the construction period, depending on the project costs, to achieve the required DM the capital outlay for the site may need to be reduced by approximately 35%.
If due to weaker demand the sales period increases by 10% as well, to achieve the required return the site acquisition price needs to be approximately 40% lower.
To exacerbate the situation, the above scenario may also be in tandem with interest rate increases and a more restrictive overall lending environment. Therefore, weaker demand for the completed units and longer sales periods could be accompanied by increasing interest rates, resulting in increasing construction and other costs.
Factoring all these into the equation might require more than a 50% reduction in the price of the site to receive the required return.
Also, a sensitivity analysis of at least two variables has become a more recognised risk assessment tool, now recommended under International Valuation Standards (IVS).
IVS 140 states that a valuer should report on how potentially disproportionate effects of possible changes in either the construction cost or end value impact on the profitability of the project (DM and IRR).
The moral of the story:
“Buy your stocks (or sites) like your socks, quality at a discount”.