Topic 5 – Economics of Property Development

1. Topic 5 – Economics of Property Development

2. Learning Objectives After studying this topic you will: • be able to explain the properties characteristics • be able to explain the essence of development • know the methods of valuation • Understand the possible causes of loss to developers • be able to prepare the developer’s budget of feasibility study

3. Property Characteristics • Property market is fragmented and dispersed • Heterogeneous, indivisible • Difficult to ascertain realistic value • Relative durable; an element of protection against inflation

4. The Essence of Development • The most economic development – the greatest return to the community for the minimum capital invested • Phasing development – give an early return to pay for the less remunerative items • Integrate the planning of large scale redevelopment • Minimize the time between capital expenditure and completion of project • To know the cost implications at the outset

5. Methods of Evaluation • The investment method • The comparison method • The residual method • The profit or accounts method • The reinstatement method • The contractor’s method (Richmond D. (1994) Introduction to Valuation: Chapter 8 Methods of Valuation), Macmillan)

6. Residual Methods Value of site when developed for the most profitable permitted use (GDV) RM1,200,000 Less Estimated cost of development and allowance for risk and developer’s profit RM860,000 Estimated value of existing property RM860,000

7. Possible Causes of Loss to Developer • Payment of an exorbitant price for the land • Unexpected capital expenditure stemming from such matters as problems with underground services or contaminated land, extra cost of work needed to satisfy building regulations or town planning requirements, or to comply with easements or restrictive covenants • Unattractive layouts or provision of dwellings of types for which demand is limited, resulting in selling problems; • Organisational weaknesses, such as in adequate or ineffective advertising, poor supervision and execution of work in the wrong sequence.

8. Developer’s Budget/Feasibility Study Developer need advice on • A fair price of the land • The probable building costs • The probable rent or selling price of completed buildings

9. Developer’s Budget/Feasibility Study The feasibility study will involve: • Identifying the basic aims of the projects; • Preparing the outline designs of various alternative options • Identifying the initial capital and operational costs of the various schemes • Preparing an outline programme covering the design, construction and commissioning phases including and period of public consultations • Preparing a budget for the project • Identifying sources of funding, grants and taxation provisions • Recommending an appropriate course of action

10. Developer’s Budget/Feasibility Study Gross Development Value (GDV) • Net annual Income = Estimated total annual rent - Outgoings, (such as maintenance, repairs and management) • GDV = Net annual income x years’ purchase. • Rental values of properties vary widely as • between the same class of building in different situations • between different classes of building in similar locations

12. Valuer Advises the developer on site values and future valued of the development Quantity Surveyor Possess far more cost data than the valuer Developer’s Budget/Feasibility Study

13. Main headings of expenditure • Estimated building cost • Fees payable to architect, quantity surveyor and other consultants • Legal charges for letting of completed building • Agent’s commission on letting the accommodation • Advertising costs • Contingencies to cover increased building costs and unforeseen problems • Interest on finance to cover cost of money invested in the building during the construction period

14. Developer’s Budget/Feasibility Study Costs of Buildings • Approximate Estimating • Unit Method • Cube Method • Superficial or Floor Area Method • Storey-Enclosure Method • Approximate Quantities • Elemental Cost Analyses • Comparative Estimates • Interpolation Method

16. Developer’s Budget/Feasibility Study Cost of Buildings • Cost Analyses • Standard Form of Cost Analysis • Building Cost/Price Indices • Cost Data • Cost Research

17. r=28.2m 50m 100m 25m 25m 50m Perimeter length enclosing 2500m2 Perimeter = 177m Perimeter = 200m Perimeter = 250m Perimeter = 250m

18. 50m 25m Area of Perimeter length 200m Area = 1875m2 Area = 2500m2

19. Developer’s Budget/Feasibility Study Architect’s and Surveyor’s Fees • 10-15% of Building Cost • Covers the preparation of all contract documents and supervision of and financial arrangement for the contract.

20. Developer’s Budget/Feasibility Study Legal and Agency Fees • 2½ to 3% of GDV. • Covers legal costs on purchase of site, including • stamp duty • preparation and agreement of leases • agent’s fees on letting the property • advertising costs.

21. Developer’s Budget/Feasibility Study Developer’s Profit • 10-20% of GDV. • Covers risks in • rising costs, • falling rents • inability to lease the property on completion.

22. Developer’s Budget/Feasibility Study Cost of Finance • Borrow or use own capital to purchase a building site • Cover the period from date of purchase to the time when the completed building is let or sold • Usually calculated at an agreed rate of interest on half the building cost for the full contract period

23. Example 1 A prime commercial development was completed at a total cost of $4.9m. The market value of the property was $7m and it was fully let for a net rental income of $490,000 per annum. Mortgage finance amounting to 70 % of the market value was repayable on an annuity basis over 25 years at a fixed rate of interest of 6.5%. Determine the income surplus.

24. Example 1

25. Example 2 Planning consent has been given for the erection of an office block of 10,000 m2 on a vacant building site. It is estimated that the building will produce a net income of RM1,400,000 pa and will cost RM680/ m2 to build. Assuming it will take 18 months to build, determine the present market value of site.

26. Solution 2 Gross Development Value RM1,400,000 pa Net income from offices 12.5 YP in perpetuity at 8% RM17,500,000

27. Solution 2 Building Cost Building 10,000 m2 at RM680/m2 RM6,800,000 RM1,088,000 Architect’s, surveyor’s and consultant fees 16% RM7,888,000 One-and-a-half years building finance on half cost RM7,888,000 x ½ at 11% RM433,840 Legal and agency fees and advertising costs (3% of GDV) RM525,000 Developer’s profit (10% of GDV) RM1,750,000 RM10,596,840 Residual = RM17,500,000 – RM 10,596,840 = RM 6,903,160

28. Solution 2 Residual = RM17,500,000 – RM 10,596,840 = RM 6,903,160 • The residue represents three items: • Value of the land • Acquisition cost (4% of value) • Cost of borrowing for 2 years @ 11% pa on land value and costs Let x = Land value Then RM6,903,160 = (x + 0.4x) x 1.112 1.2814x = RM6,903,160 Site value = RM6,903,160 / 1.2814 = RM 5,387,200

29. Solution 2 Cost Building, including fees RM7,888,000 Building finance RM433,840 RM525,000 Legal, agency and advertising costs Land cost RM5,387,200 Site finance and acquisition RM1,515,960 RM15,750,000 The net income of RM1,400,000 gives a 8.89% return on the development costs of RM15,750,000.