As I settle into a pleasant one hour drive to inspect two properties in the growing township of Warragul, once a township in regional Victoria but now an outer eastern suburb, I start to solidify my thoughts on the topic of this blog, that is – how to assess the nature of risk and reward in the typically dynamic real estate development sector.
I think back to the old-school developers I knew in my younger years as a property valuer and bank manager when back of the cigarette packet calculations were the norm through to current versus modern software models where all assumptions can be clearly documented and sensitivity of those assumptions applied.
We would typically use a software package such as Estate Master in the value assessment of master-planned properties such as new residential sub-divisions where there are typically dozens if not several hundred sub-divided plots to construct.
Over time, I have heard criticism of these software models as being a ‘blackbox’ (black as in opaque) in which the criticism implies that the inputs and outputs are often being applied without any knowledge of its internal workings, inferring its implementation is often of limited worth.
However, my experience tells me that in fact these inputs and calculations are just a more advanced and computerised version of the typical Excel calculations that Valuers and financiers would typically utilise on a day-to-day basis.
Regarding valuation methodologies and techniques to be utilised, they can be broadly characterised as Direct Comparison, the Turner (or hypothetical subdivision/feasibility) and Discounted Cashflow (DCF) approaches.
Armed with the benefit of research and experience the valuer can then determine which approach is best suited depending on the size and complexity of the proposed development, summarised broadly as follows;
- As development potential becomes more remote and speculative, greater weight will normally be put on the Direct Comparison approach.
- As projects become larger, longer and more complex, grater weight will be put on Discounted Cash Flow.
- For smaller, more straight-forward projects, grater weigh will be put on the Turner and Feasibility approaches.
- In cases where the subject property and sales are very comparable, Direct Comparison is usually preferred.
As a rule of thumb the complexity of a project will be dependent, for example, upon the state of the market, the size, length and type of development, the degree of competition for the site and whether it is to be pre-let or forward sold.
For smaller, more straight-forward projects, as a generalisation, typically banks like to see a profit margin on gross realisation of 20%, with 16% considered to be at the lower end of the acceptable range and 17.5% representing a typical margin.
Often in these developments the developer will also be the contractor/builder and will attempt to make a gain through two sources; namely, a profit on the construction business undertaken, and also an entrepreneurial return for the risk of undertaking the project.
In this regard, what I have often found over the years is that a financier will approach me and ask that a set of individual circumstances regarding a potential client be taken into consideration. For example, that the client is an owner-builder or in some cases that they may have access to cheaper rates of capital than the market is offering.
The key aspect to remember here is that in our role as Valuers we must value according to a defined definition of Market Value, in which we would, critically, only consider the typical market participant.
Therefore, in the case of an owner builder hoping to use lower construction costs what we would be assessing is Estimation of Worth rather than a Market Value, with the word Market being critical here.
We as a profession have actually renamed this as Project Related Site Value to better reflect the mechanics of arriving at the resultant figure.
In the case of larger and more complex projects, in which the developer contracts out the construction works, the calculation of the risk and reward inclines to move towards a Discounted Cash Flow calculation rather than a return on gross realisation or costs inputted.
Typically, these rates vary greatly depending upon the assessed risk and time scale of the project, with a broad variance of discount rates utilised, between as low as 8 percent to over 20 percent.
As a small deviation from this point, it is important to understand the difference between appreciation and improvement in the overall real estate market. Often one may see media articles revealing significant gains in real estate prices.
What these articles often fail to inform is that statistics flounder in proving a breakdown in which elements of these apparent gains were realised through what could be termed appreciation – typically understood to be caused by a single factor or in combination, a number of inflationary factors driven by population growth, wage growth, overseas buyers entering the market, or re-zoning value enhancements.
On the flip side is capital values gained caused by improvement – that is development of new buildings, homes and units, whether through new construction or renovation, contrasted with the previous depreciated stock.
Typically, the developer plays a key role in the growth of capital values as it is she or he that is providing the new build, which as we know is most often likely to achieve higher values.
For example newly constructed townhouses versus 1960’s units being developed in a suburb, whereby it might appear that capital values for units have undergone extraordinary growth, while in reality the wealth effect is being caused mostly by the addition of new stock to the pool.
When we discuss risk there are several major points to consider.
Firstly, has the development model been sufficiently de-risked so that any potential shortfalls in income are not burdened back onto the developer’s profit margin, making it act as an all-in-risk rate? Rather, we must attempt to individually categorise as many of the costs, known and likely as possible.
Key examples include statutory cost imposed by Councils, inflationary risks and holding costs. Further, that sufficient marketing and sales allowances are assessed.
Critically, the Valuer’s assumptions may prove to be materially different from those assumed by the developer. To explore this risk idea further, let’s consider the case of a proposed master-planned subdivision of 100 residential lots in a new out of town location with limited sales evidence, which is now viable due to changes in zoning or the planned implementation of new major infrastructure.
On assessing the limited sales evidence at hand, the valuer may observe that 400 square allotments have been realising $300,000 each. However, will 100 lots entering a new and immature market be able to realise the same levels? This is the key question to assess.
The ability of that sub-market to absorb a high quantity of new stock is a major risk to observe and the time-scale required to achieve sales of these units is of concern, especially if the values assigned to these lots is set at the higher end of the expected range.
The point being that you can’t expect to burn the candle at both ends without often dramatically increasing risk; either the expected realisations are set at the higher end of the indicated range and a longer sale realisation period is adopted, or a more realistic price range is set in combination with a shorter sales period.
This is often to the benefit of the financier who would typically judge their risk in such a situation by how long their capital is exposed to the market. Interestingly, in a Bell-Curve Development Risk Model, risk can be broken down to three categories of risk level – lowest, medium and highest – whereby at the commencement of a new development, we find a medium level of risk, whereby the effect of both key and more minor assumptions are anticipated and expected to be appropriate.
However, the highest level of risk is most often found during the construction phase. Why? Well, market conditions may materially change.
This is where losses may be realised as experience tells us that incomplete developments are typically shunned by the market, can fall into disrepair, and are then sold at a major discount to the costs inputted to date.
However, and perhaps not surprisingly the lowest risk is typically found at the completion of a development, whereby sales and leasing activity reaches its peak, settlements occur, cashflow increases and in general the market yields associated with the development transition from the higher levels to those more commonly found with established properties.
In conclusion it can be observed that urban growth has been an ongoing phenomenon associated with Australia’s major cities for well over 100 years.
Given the likelihood of a continuation of at least a modest level of population growth in the future and the finite limit to population increases which can be housed by the existing housing stock, the process of conversion of both land on the fringe of major urban centres to residential allotments, as well as the redevelopment of existing improved sites to encompass new higher density apartments and townhouses will continue.
So a strong understanding of the various methodologies and characteristics underlying these developments is a must for any Valuer working in this field.