Property Development

Property development is the process by which buildings are erected for occupation or for sale/investment. Owners may build premises for their own occupation, for example major retailers may erect supermarkets; alternatively, property developers may construct the same type of buildings for lease or sale. The process may be the same although some aspects of the financial appraisal may be different. A building offered for sale or investment is driven by a profit motive, a building for owner-occupation may be related to the profitability of the enterprise within the building and thus profit motivation may be redirected or constrained.

The history of large projects is often referred back as far as the construction of the Egyptian pyramids or the Great Wall of China. They were certainly large and complex structures, built to high standards, which must have liquidated vast amounts of resources. Unfortunately, there is no documentary evidence of any project management systems.(Burke 1993, pp. 1–2)

The assessment of value and cost are dependent on a number of initial surveys and investigations; these include planning policy, planning history, statutory undertakers and the site itself.

A residual valuation is very sensitive to slight variations in its different elements such as rent, initial yield, construction costs, finance rate and building period. Because of this, the Lands Tribunal has regarded this method as one of the last resort (as in First Garden City Ltd v Letchworth Garden City Group (1966); see Butler and Richmond 1990, p. 111).

The capital value of a development site as calculated in Chapter 4 can be used in situations where the freeholder of the land retains the land interest. These arrangements are called ‘partnership arrangements’, and often the landowner is a local authority with a land bank or a statutory authority with surplus property or a major landowner wishing to efficiently manage its estate. In these cases the landowners may feel that there is not the development expertise within their organisations to carry out the development alone. The developer together with a funder thus forms one side of a partnership, with the landowner on the other. In the 1980s this was a common form of development arrangement with local authorities. In these arrangements the landowner will retain the freehold and thus retains an interest in the development together with an opportunity to share in the growth of the development. The landowner then grants a lease, usually a long lease of (say) 125 years to the developer to carry out the project. The landowner then receives an annual ground rent for the land rather than taking a capital sum on the sale. This arrangement has enabled major landowners historically to develop their lands and yet still maintain some interest, ongoing return and control. In particular this approach has advantages in town centre situations where land assembly is difficult and risky, or in new development situations where the nature of the market has not yet been established and where risks may frighten off developers, funders and investors. In these situations by partnership arrangements the balance between risk and reward can be traded-off. Partnership arrangements in this trade-off also offer the opportunity for more innovative funding arrangements as in sale and leaseback and finance leaseback situations; these aspects are investigated in Chapters 7–10 on finance, in particular project finance.

This chapter looks at cash flow methods in property development appraisals. Cash flows into the future are forecasts, but valuations and forecasts are fundamentally different. This aspect has been discussed to a degree in Chapter 4, but essentially the valuation is about market price as a snapshot in time. It may be based on assumptions as to what will happen in the future but it is not a forecast A forecast will be concerned entirely with the future. In development appraisals assumptions need to be made about project costs and future rents, and potential changes can be incorporated. Formal forecasting is used in property development, but its overall lack of use is based on the problems of risk and uncertainty in the development process (Schiller 1994, p. 4). Cash flow approaches are aided by computers and the use of spreadsheets for calculations involving cash flow statements is vital. Some texts suggest the use of bespoke computer programs (Darlow 1988). These bespoke programs can examine the answers relating to changes of inputs into the calculations, but it is difficult to examine the changes in detail as they occur; for this, a spreadsheet is more useful. The Lotus 1–2–3 spreadsheet is a useful tool for development appraisals and the examples in this book have been calculated using this software.

A property or building can be owner-occupied or rented, the latter being an investment property. In the present market (1995) it may of course be vacant, resulting from being surplus to the owner’s requirements or a poor investment! A large proportion of property is owner-occupied but most of the conventional property texts and theories are applied to an investment market. Property finance is money raised on the back of existing properties or raised for the purpose of expenditure on properties. Whether the property is owner-occupied or an investment property may alter the criteria for the raising and application of the funds, but the fundamental concepts of finance may well be the same. For instance, funds could be raised internally or externally by an organisation but the criteria for the internal loan or transfer of funds may well need to match those in the market. In this book, the presentation is mainly about the application of funds to property in the investment market and funds are considered to be private rather than public sector monies. This is to make the analysis simpler but, as has already been said, the principles and concepts of finance could well be similar.

The cash flow approach to the firm and the balance sheet model will be discussed in Chapter 10. These approaches, besides looking at the application of company funds for the purchase of assets, also differentiate between the sources of the funds, in particular the difference between long-term debt and shareholders’ equity in the firm. An understanding of the difference between equity and debt is fundamental to an understanding of how finance works. The structure of finance can analysed in two different ways:

The financial institutions consist of the insurance companies and pension funds, the two principal channels for the nation’s savings. Because of the nature and risks of the real property market and because of the larger lot size, individual investors have generally withdrawn from the market; also the channelling or collectivisation of saving into financial institutions is more tax effective than direct investment.

It has already been stressed that property finance is important in the property investment market. The costs and availability of finance will affect the cost of the provision of new investment property and therefore its supply. It is through finance that the structure of the investment interest in property may be created, so finance has an effect on the form of the interest. Whilst the costs and availability of funding are obvious in the case of the funding of development property it is important to realise that it is critical to the investment market also. The value of an investment may be driven by the opportunities or lack of opportunities to fund it and this was the main impetus of the move into the securitisation of property, a repacking of the property asset into appropriate financial packages which provide added value.

This chapter covers two important stages of the property development process, the design and construction phases. These are areas where there are a number of specialist texts. This chapter will only attempt an overview of what the project manager may need to know about aspects of design and construction.

Marketing is an important part of business strategy; Ansoff (1986) suggests that firms need a well defined scope and growth direction; the product market scope specifies the particular sector to which the firm confines its position, the growth sector indicates the direction in which the firm is moving with respect to its current market posture. Besides objectives relating to growth of turnover, market share and earnings growth, the firm needs to have additional decision rules if it is to have orderly and profitable growth. These rules and guidelines comprise a strategy, and the concept of strategy involves: