Notes for Mayor s Forum Sydney University April 2013

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1 Outline of Property Development Councillors and Urban Planners spend a lot of time interacting with the development sector either directly (often through the development assessment process) or indirectly through the preparation of feasibilities that have impacts on whether a development will proceed. These notes are directed at the issue and identification of risks and what might be motivating developers in their interactions with development stakeholders. It is not meant to explain the development process; there are many more detailed books in that space. One important factor in understanding Property Development is the fact that every site and every building is different because of differing location, soil conditions, local planning constraints and design issues such as orientation, relationship to adjoining sites, building requirements and project or site constraints, options and aims. The sale realisation (i.e. the value of sales) is also different for each development and each part of the development as each unit is unique due to differing location, views, design, size, desirability, access, parking, demand in the locale and the current condition of the local property market. It is crucial to understand that paradoxically as the development process progresses the developer s knowledge of the likely outcome increases but, at the same time, the room to manoeuvre and mitigate risk decreases. Thus, while at the start of the process developers have maximum uncertainty they also have maximum manoeuvrability to produce many different responses via design, quality, finishes and size. However by the end of the project the developer knows all the problems and issues which have emerged during the process but can do nothing to substantially change the end product, which is being manufactured on an essentially once and for all basis. The development process is especially susceptible to risk and uncertainty because, once started, it is relatively fixed in time and place and because it aims normally at a very narrow consumer market within what may be an uncertain economic climate (due largely to the time gap between when the developer commits to a project and the receipt of all sales revenue). The developer is at greatest risk at the end of construction while awaiting Occupation Certificate as any deposits are still held by the REA while interest is at its highest point in the process as all costs at this time have been paid however no sales revenue has yet been received. Prepared by Stewart Lawler P a g e

2 The Secret Equation In summary all the values and risks in property development can be illustrated by a simple equation which states that to produce a development profit; The cost of the land component plus the cost of construction plus the internal development costs must be less than or equal to the total sales revenue. Also inclusive in the equation is a suitable profit margin for the developer, therefore; Land cost + Build cost + development costs + margin < sales income In simple terms the cost of the land, building and other associated costs plus a developer s margin must be less than the sales income otherwise the only definitive measure of property development, monetary profit, is missing. Will increasing residential density always increase value? Increasing density will decrease the land cost per dwelling but it may also increase the construction costs of dwellings due to the height of the finished product. In lower value land areas of Australian cities high rise development is not viable because the lower land costs do not offset the additional constructions costs. Also, in these areas the finished cost of a new residential apartment is often higher than an existing separate dwelling in the same area. The cultural preference for separate dwellings makes it very difficult to sell the new apartments unless the apartments have some other benefits such as being located in a very high amenity precinct, scenic views and excellent access to transport and other facilities. The other very large constraint of density is the larger costs of development associated with developing a high rise building. This may mean it is difficult for developers to get access to finance at an affordable rate. This is a particular issue if this is the first large high rise development in an area which does not contain comparable high rise. Moreover, many small suburban developers do not have the expertise or experience to tackle these larger developments. This increase in cost is due to three main factors. Firstly the builders need to comply with stricter requirements of the Building Code of Australia (BCA) as the height increases, mainly because of fire controls and the type of construction required to comply. Prepared by Stewart Lawler P a g e

3 Secondly, the actual construction techniques become more sophisticated due to compliance and building sequencing and methodology requirements associated with high rise structures. Builders capable of such work require more expensive equipment and higher skilled workers to undertake specialist trade work. Finally Builders of larger developments will need greater cash flow and financial capability to fund large works between progress payments. Work is only paid for after approval in calculated progress payments or on completion (which is highly uncommon). Often developers will place their foot on a site by the use of an option. This is where the vendor is paid a non-refundable sum to agree to the sale of the land at a fixed sale price at some time in the future, usually 6 to 12 months. This is of benefit at most times as it allows the vender to feel as though someone is improving the value of their land, at no cost to them, from which they will receive a sale price higher than the current value. Plus the developer will know the actual price to be paid or may calculate a percentage of any uplift to the vendor in return for not having to pay holding costs. Often this may only be a small amount where a developer can convince a Vender the uplift is only minor when in fact their expected sales price is much greater than current value. Where rezonings occur local Real Estate Agents may have knowledge of such happenings where the land owners do not. At such times sales can be achieved at a much lower rate providing developers can achieve significant uplift gains prior to any further development. Such sales are the preference for those developers known as flippers as the site value is enhanced both by sale value and the possible higher density development opportunities. In Sydney building costs also affect the uplift value of property due to construction costs. Rawlinson s Construction Cost Handbook Edition 29 (2011) adjusted by an increase of 5% to anticipate Jan 2012 cost shows the following costs per square metre of gross building area; 3 storey flats with basic finish $1,705 3 storey flats with medium quality finish $1,860 Town House 2 storey high standard $2,025 Flats multi storey medium standard (4-7 levels) $2,130 Flats multi storey prestige finish (7-20 storeys) $2,965 Prepared by Stewart Lawler P a g e

4 These costs would be likely to be 5-10% higher than above due to increases in the marketplace. This has been running for the past few years in the order of 5% per annum. To the above rates for construction there needs to be added an allowance for professional fees for the Architect, Engineers (including Structural, Mechanical, Electrical, Civil, Lift, and Hydraulics) plus any other specialist consultants. This is usually costs an additional around 11-13% of the construction value for residential type construction. Other associated costs such a site assessment and development advisory services will also need to be added to these costs as part of the development costs. Risks in property development Property development is amongst the riskiest forms of (legal) economic endeavour. Some factors which can attribute to an unviable development project include; The land price being too high; therefore sales cannot produce the predicted profit. The architectural concept is based on incorrect urban planning information which produces a lower density causing the yield to drop in area or number of units. As a consequence the development may not produce sufficient revenue from sales to justify the project. Stalled approvals which cause holding costs to exceed the budget due to additional costs accrued prior to completing the construction or sale. Unreasonable or stringent development approval conditions cause both cost and time escalation due to works which need to be completed. Disputes with the consultants or builder add cost and time. An increase in interest rates could force holding and financing costs to escalate markedly. Construction costs could increase due to inflation or higher demand for construction. Union disputes in industry may spread to the development site. Council requirements and planning instruments change. Building code or industry requirements change. A downturn in the market results in a reduction in property values across the market, sector or area. Consequently, the project will not produce the expected sales returns and therefore anticipated margins. Prepared by Stewart Lawler P a g e

5 Should the construction period extend beyond the program, the cost will balloon and as a consequence sales may not produce a profit, if the market moves negatively particularly during the delay period. Inclement weather and recovery time delay project completion. Dealing with latent site conditions may delay project completion (see Figure 1 ). The selection of an incorrect design or end product may mean the development will not sell in a timely manner. There is also the failure of project management to deal with the project in a correct and timely manner which requires the head, the heart and years of experience in order to embed the necessary essential engaging elements into one s bones Campbell (2007, p xv). In summary, many failures are due to factors, some of which are out of the control of the developer. Some are within the control of the developer but may affect the end result due to either poor judgement, inexperience in the particular development product or inability to control construction or development costs. Detailed and experienced planning is one method of assisting in delivering a successful development. Consideration also needs to be made when deciding on the finishes level of a building. A basic finish in a high rise building is not likely to induce high sales returns due to the final cost of development which will increase the end value significantly and as a result put the building into a higher sales bracket, which will require a higher sales return in what may be a falling or over supplied market. There are also internal factors such as inexperience in development, latent site conditions such as asbestos or indeed a boat being found in the foundations and other unknowns (see Figure 1 over page). Such risk reduction will allow staff to operate in enhanced conditions due to the avoidance of difficult situations and possible financial losses caused by unforeseen or unmanaged risks. The most important part of the process is risk management within the organisation where all operatives should be proactive rather than reactive. That is, to keep vigilant to all risk in whatever form it may exist, or whichever form it may become present in an activity. Prepared by Stewart Lawler P a g e

6 Figure 1: Boat found in a development site Photograph courtesy of Mr Derek Bebbington, City West Development Manager Property development is a highly interconnected process with all parts interdependent on all other parts and should any part fail the entire project is at risk. It is important to note there is no return from a development until completion and at that point the maximum amount of funds are at risk, as all the costs have been paid to complete the project and the interest on holding costs is at its greatest and continuing until all funds are repaid Risk management is the process of first being able to recognise risk and then being able to allocate or manage such risks. This requires the development of tools which initially identify risks, then allow prioritisation of the risk, management or dealing with the risk and finally to control, mitigate and monitor the results of such risk management or intervention into the overall process. By effectively managing risk, organisations will achieve superior results and avoid the difficult circumstances when matters waver from the established plan. Risk management also assists in delivering better yields in terms of the amount of housing which can be provided by the organisation to its clients. Prepared by Stewart Lawler P a g e