Proposal Financial Appraisal
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RISK AND UNCERTAINTY Introduction The simple residual valuation, covered earlier in the course, takes a single value for each input to produce a single estimate of financial viability. However, each input is a variable and, clearly, changes in their values will affect the profitability of the scheme. The significance of changes in variables for the developer will depend upon:
• the amount of change; • the frequency of change; • the predictability of change; • the controllability of change; • the impact of change in any variable upon profitability.
It is the combination of the character of any change and its impact on profitability that determines its true importance to the developer. Developers can adopt tactics to control/reduce risk and uncertainty. For example, they might pre-let/pre-sell schemes at agreed rents/prices; negotiate short term finance at fixed rates of interest; offer fixed price contracts to builders for the construction and so on. However, each approach has its cost: pre-lets/pre-sales would normally be at a discount on (expected) market rents/prices upon completion; fixed interest rates and fixed price construction contracts would normally be at rates/prices higher than market rates at the time of the agreement and so on. These discounts or premiums reflect the fact that a part of the project risk has been transferred from the developer to another party (in the above example, the occupier/investor, the lender or the contractor, respectively). Sensitivity Analysis The impact of changes in each variable upon the profitability of a scheme is crucial from the developer’s point of view. We will examine the sensitivity of the profit rate on the example scheme to changes in the main cost and value variables: rent/price, yield, construction costs, finance rate and disposal period. Using change in rents/prices as an example, the calculation is undertaken by entering the required change in the relevant cells of the table in the ANALYSIS page of the spreadsheet. In this case we explore the effect of increasing (column B) and decreasing (column C) rents/prices by 10% (see Figure 14; try this yourself to see how the spreadsheet changes). The results are presented in the APPRAISAL 2 page of the spreadsheet (see Figure 15; Valuation A is the original appraisal). If the calculation is examined in detail, it is evident that change in a specific variable has knock-on effects on other elements of the appraisal. These need to be traced in order to appreciate the full implications of the original change.
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Figure 14: Changing the Variables (Rent/Price)
Figure 15: The Impact of Rent/Price Changes on Developer’s Profit
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Pursuing the example of a 10% increase in rents/prices, by comparing the respective detailed elements of Valuation B with Valuation A in Figure 15 (a 10% decrease, described in Valuation C, would have a similar but opposite effect), we can see that:
• The initial impact of the change is upon GROSS DEVELOPMENT VALUE, which has increased
This has also fed through into some costs that are dependent on aspects of the scheme’s value; these are:
• The letting fee, based on the estimated rental value; • The investment sales fee, based on the GDV of the rented accommodation; and • The occupier sales fee, based on the price achieved for the owner-occupied
accommodation. Consequently, the change in the RESIDUAL is the net result of gross changes in value and cost. The analysis may easily be repeated for the other main variables, using the ANALYSIS page of the spreadsheet. Try it yourself. Trace the impacts of changes in each variable through the appraisal by comparing each row in Valuations A, B and C, as appropriate. The least obvious ‘impact trail’ is that relating to Yield. Why does a change in yield have less impact on value and profitability than a change in rents/prices? If each variable is subject to a 10% change in the direction that will reduce profit (that is, values are decreased and costs increased), while the other variables are held constant (that is, all the other cells in the ANALYSIS page have a value of ‘0’), the results are as described in Table 1 (try this yourself to check that you understand how to undertake sensitivity analysis).
As Table 1 makes clear, the developer’s profit rate is more sensitive to changes in some variables than others. All the variables have been changed by the same proportion, but a change in rents/prices of + 10% has increased the profit rate by almost five times that proportion. In contrast, a change in the disposal period of +10% has very little effect on the profit rate, which is reduced proportionately by only - 2.56%. The developer’s profit is most significantly affected by rents/prices, construction costs, yields, the finance rate and the disposal period, in that order.
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An alternative way of undertaking a sensitivity analysis is to estimate the proportionate change that must be made to each variable in isolation to reduce the profit rate to 0%. The results of applying this approach to the specimen scheme are described in Table 2 (again, you can try this yourself). Note that they are a mirror image of the results in Table 1. The variables that, when they change, have a big impact on profit (Table 1) do not need to be changed by very much to reduce the profit to 0% (Table 2). The variables that have little impact on profit must be changed a great deal to reduce the profit to 0%.
The above results relate to the specimen residential and office scheme. Developments have distinctive characteristics and associated value and cost structures: their sensitivity to change will be similarly varied. Development Scenarios So far the impact of changes in individual variables has been considered. In the real world, changes in the various factors do not take place in isolation, they occur simultaneously and their impact is cumulative. One way of considering a combination of changes is to construct development scenarios. These can be made to reflect many different circumstances: for example, a delay in obtaining planning permission, changes in property market trends during the development period and so on. To illustrate how scenarios may be used, a general approach is pursued here. It is based on two possible trajectories for the economy. Optimistic scenario: economic growth. Economic activity grows faster than its current rate. The demand for accommodation increases and, consequently, rents/prices increase. The risk of property developments and investments being unsuccessful is reduced, so yields fall. Contractors increase building tender prices in the face of increased demand for their services from developers. Interest rates are raised to dampen potential inflation. Property can be let/sold more quickly in the face of increased occupier demand. Pessimistic scenario: recession. Economic activity slows and then contracts. The demand for accommodation decreases and, consequently, rents/prices stabilise and then fall. Property development and
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investment becomes more risky, so yields rise. Contractors decrease building tender prices in the face of decreased demand for their services from developers. Interest rates are lowered to encourage investment and economic growth. Property takes longer to let/sell in the face of decreased occupier demand. The impacts that these scenarios might have on the viability of the specimen scheme are assessed by:
(i) estimating the magnitude of the changes in each variable (based on an analysis of past trends and current position and outlook); and
(ii) entering the changes simultaneously into the table on the ANALYSIS page of the spreadsheet.
Figure 16 and Table 3 illustrate the kind of results that are obtained for the above scenarios (where B is the optimistic scenario and C is the pessimistic scenario). Three important points may be made about the scenarios. First, every variable does not improve in the optimistic scenario or get worse in the pessimistic scenario. In the former, changes in rents/prices, yields and the disposal period add to profitability by raising values or reducing costs. However, changes in tender prices and finance rates add to costs and reduce profitability. In the latter, changes in rents/prices, yields and the disposal period erode profitability by reducing values or raising costs. However, changes in tender prices and finance rates lower costs and increase profitability. It is just that in periods of economic growth the good outweighs the bad and, in recession, the opposite occurs. The second point is that the scenarios are not mirror images of each other. For example, rental/price growth is +25% in the optimistic scenario and -5% (not -25%) in the pessimistic scenario. Similarly, the disposal period is 50% shorter in the optimistic scenario and 100% longer (not 50%) in the pessimistic scenario. The final point is that, for this example, the development is less affected by recession than it is by growth. In the optimistic scenario, the profit increases proportionately by 27.56%. In the pessimistic scenario, the proportionate decrease in profit is -14.68%. Even in recession, the developer’s profit remains positive, at 21.04%, and is above the 15-20% viability threshold.
Figure 16: Undertaking Scenario Analysis
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Again, it must be stressed that these results relate to the specimen office and residential scheme and to the particular scenarios. Other schemes with different characteristics and different value and cost structures will be affected quite differently by similar scenarios. Conversely, different scenarios may affect the specimen scheme quite differently. Its performance might not be so robust in the face of other circumstances.