Finance Question - The Economics of Property & Construction

Contents

1. Introduction

2. The nature of development 2.1 Why development takes place 2.2 Development in the private and public sectors 2.3 Function of the developer

3. Estimating demand 3.1 Single development 3.2 City centre projects Activities 1

4. Optimum construction outlay 4.1 The quality of refinements 4.2 Capital costs as opposed to maintenance costs

5. The intensity of site use 5.1 Buildings as the addition of capital to land 5.2 Combining capital with a fixed supply of land Activities 2

6. The determination of site price 6.1 Corollaries 6.2 The extensive use of land

7. The timing of redevelopment 7.1 When does redevelopment take place? 7.2 The present capital value of the site in its current use 7.3 The value of the cleared site 7.4 Redevelopment of the site

8. The rate of redevelopment 8.1 Method of approach 8.2 Changes on the demand side affecting rental income 8.3 Changes on the supply side affecting operating costs 8.4 Building costs 8.5 Relaxation of assumptions of a perfect market

9. Conclusion Activities 3

© The College of Estate Management 2009

Paper P0340V2-0

Profit in property: Development

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1 Introduction The pursuit of profit shapes behaviour in goods markets and factor markets. The marginal principle introduced in introductory economics applies to output decisions in perfect competition, imperfect competition and monopoly. It also applies to input decisions irrespective of whether the input is labour, capital or land.

We may now extend the principle to the two major areas of decision making within the property market. Firstly there is the decision whether or not to produce newly built property and secondly there is the decision whether or not to invest in existing categories of property. These are respectively:

Property development Property investment.

This paper is concerned with the former.

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2 The nature of development 2.1 Why development takes place Over time, the demand for land resources changes because of changes in: the size, income and tastes of the population; the rate of growth of economic activity; methods of transport; techniques of production and distribution. On the supply side, existing buildings wear out or become less suitable for present uses, and the cost of constructing new buildings or adapting old buildings changes. Development is the response to such changes. Indeed, the development process may itself be dynamic, one development generating development elsewhere. Thus a houseowner who gives his property a ‘facelift’ may stimulate his neighbours to do likewise.

As a result of such changes in the conditions of demand and supply, some structural change in the nature of buildings is usually necessary. This may take different forms:

modification of existing building through conversion (houses divided into flats) or refurbishment (new office or shop layouts);

redevelopment, where existing buildings are demolished and replaced by new ones;

new development on underdeveloped land (suburban housing).

All these developments usually require planning consent. We follow the definition of development contained in the Town and Country Planning Act 1971, as ‘the carrying out of building, engineering, mining or other operations in, on, over or under land, or the making of any material change in the use of any buildings or other land’ (s.22.1).

2.2 Development in the private and public sectors Private sector In the private sector development is carried out by occupiers or by specialist developers, financial institutions, property companies or construction firms working through the price system.

The advantage to the occupier of initiating his own development is that he obtains a building which is tailor-made to his individual specification; but since development requires specialist skills and knowhow, most occupiers wishing to develop their own property employ a specialist developer who endeavours to meet their requirements on agreed terms.

Irrespective of whether the development is carried out by the occupier or a specialist developer the same basic decisions and calculations have to be made.

Public sector Public sector development accounts on average for about 30% of total development in the United Kingdom, but the exact percentage varies from year to year. While decisions may be based on market prices, as, for example, in the remaining nationalised industries, most are taken on a mixture of political, social and economic grounds. Public sector development, therefore, tends to fluctuate with the politics of the government in power and the current overall requirements of the government’s stabilisation policy.

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2.3 Function of the developer The commercial developer may be defined as an entrepreneur who provides the organisation and capital required to make buildings available in anticipation of the requirements of the market in return for profit. This definition emphasises that the developer is essentially an ‘entrepreneur’ accepting the unsheddable risks of producing for an uncertain demand.

In essence this means that he has to estimate future demand for alternative uses of existing land resources, and calculate the cost of building for new uses. From among these different uses, he must choose the scheme which will produce the maximum net return subject to the constraints involved, such as planning and building restrictions, the availability of finance, etc. Thus the developer bears the uncertainty of the scheme. On the demand side, returns may be less than estimated, as a result, for example, of economic depression, increased taxation or rival projects. On the supply side, planning permission may be delayed, construction costs escalate or the cost of finance rise.

Because assembling the site and construction take time, the developer incurs costs over and above those of acquiring the land and rebuilding. These additional costs may be labelled ripening costs and waiting costs.

Ripening costs. Ripening costs arise through holding land in anticipation of profitable future development. They cover the interest on capital tied up, plus any speculative element paid for the land in excess of its current use value in the hope that eventually planning permission for a higher use will be forthcoming.

Waiting costs. Waiting costs are incurred, even when the land already has planning permission, because construction takes time and it is necessary to span the period before revenue from the development is received. Such costs, therefore, include professional fees and interest on stage payments.

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3 Estimating demand The net present value (NPV) of a development indicates to the developer the likely value of the completed project. Since the NPV depends upon the stream of future net annual returns (NARs), demand for the type of building and its operating costs, both now and in the future, have to be estimated.

The problem of estimating demand for a small, single development differs somewhat from that of a city centre project. We can illustrate by concentrating on shop developments, although the same principles apply to other categories of development.

3.1 Single development With a single development, a guide to the likely selling price can be obtained from current market information. If, for instance, enquiries from estate agents reveal that, in the same shopping area, a prime shop unit with vacant possession sells for £200,000, the developer has a yardstick for his own project since this price has been arrived at in a market where buyers and sellers have taken into account present and estimated NARs. Similarly, a recently agreed market rent of £14 a square foot would reflect the current NAR.

The developer would adjust this selling price or rent to his own particular project by allowing for differences in location, nearness to multiples, complementarity with similar shops, occupation rates and such features as layout, storage facilities and staff accommodation. Some consideration would also have to be given to the possibility of competition from similar developments in the near future. Other adjustments might cover how quickly the type of shop sells or lets and the adaptability of the layout to selling different goods as demand changes or to new techniques of retailing being introduced.

3.2 City centre projects In the past, shopping areas have developed along high streets on a shop-by-shop basis. But post-war New Town projects, comprehensive redevelopment of city centres and suburban growth of the more prosperous towns have necessitated planning in advance the size and layout of shopping areas.

The shopping space The size of the shopping space must be related to the overall demand for shopping facilities. The latter is usually expressed in terms of the total value of retail turnover. From turnover in existing shopping centres, a floorspace ratio (FSR) for each particular type of shop can be obtained, using the formula:

This known FSR can then be applied to the forecast retail sales of the new shopping centre: floorspace required = FSR × forecast retail sales. Since each type of retail shop will have a different FSR (jewellery, for example, with its low physical turnover will have a higher FSR than groceries), the total floorspace required will be the aggregate of the floorspace requirements of all shops in the shopping area calculated according to their individual FSRs.

FSR = units of floorspace turnover at current prices.

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This crude application of central place theory has two main weaknesses. First, the ‘units of floorspace’ in the formula will themselves be dependent on shop rents. If these are high, increased turnover may be met by more intensive use of existing floorspace rather than by adding to it. Second, the method ignores the power of a shopping centre to attract customers from a rival centre.

Reilly’s Law of Retail Gravitation Reilly’s Law of Retail Gravitation covers this latter problem. W J Reilly, examining shopping habits in the USA in the 1920s, concluded that, as a general rule, two cities will attract retail spending from the area between them in direct proportion to the size of the city’s population and in inverse proportion to the square of the distance to the city from any point in the area between. Thus a city of 320,000 population located four miles from the intermediate area will attract 20 times as much trade from it as a rival city of 49,000 located seven miles away; that is:

While this crude formulation illustrates the basic technique for evaluating shopping development, refinements are necessary. Because the attractive power of a city rests on spending power rather than just its population size, consideration has to be given to the composition of the population (say by age group and working proportion), its earning capacity (for example, proportion of skilled workers), government subsidy policy within the district and the spending habits of different income groups. Ease of transport between the intermediate area and the centre is also relevant.

More important, dynamic factors must be taken into account. Thus some allowance would have to be made for future population growth. Above all, a new large shopping centre may generate its own growth, with specialist shops enhancing the reputation of such a centre which thus grows over time relative to smaller centres.

The layout of a new shopping centre Not only the size but also the layout of a new shopping centre must be planned carefully. With a single shop development, the subsequent provision of a municipal car park nearby or the opening of a supermarket or a major department store next door would increase revenue-earning capacity. These events create external economies since they cannot be planned for by the developer. In contrast, with a comprehensive city centre development such externalities are under the developer’s control. That is, externalities can be ‘internalised’ to maximise the value of the total area. This means relating the shopping area to public transport and car parks, and then siting shops in order to secure complementarities. Such ‘merchandising’ involves planning the sizes, shapes, and locations of shops to maximise the value of aggregate turnover, which in turn should maximise rentals.

The developer is likely to start from the key outlet, such as the department store or supermarket. Secondary ‘magnets’, such as banks and the post office, are then located, and multiples positioned between them. The object is to generate movement of shoppers around the whole centre by avoiding the creation of dead spots through the concentration of too many important magnets in one area. The remaining space is then allocated to the specialist shops, such as jewellery, shoes, cameras and clothing, having regard to their complementarity preferences. Thus food stores prefer to be located together, with the specialist shops, such as delicatessen and patisserie, being close to the supermarket. Other trades, such as stationers, hairdressers, florists, restaurants and toy shops, are less demanding, but they add colour and variety to the centre and so have to be carefully located in order to secure the overall objective.

320,000 : 49,000 = 20:1 16 49

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Since different types of shop have different requirements with regard to window space (for example, dealers in cameras prefer corner shops), show space (furniture), customer-circulating space (clothiers) and storage space (ironmongers), merchandising demands detailed planning in advance, especially if provision is made for flexibility to meet future changes in requirements.

ACTIVITIES 1

1. Section 1 refers to the marginal principle (also called the principle of marginal equivalence). Review your undertanding of this. See, for instance, Paper 3407 The toolkit, available in the online study paper library.

2. Development as a production activity differs from manufacturing. List the differences.

3. Largetown (L) has a population of 200,000 and Mediumville (M) a population of 50,000. Smallham is located on the straight route between L and M, six miles from M and 18 miles from L. Calculate the relative attractiveness of shopping in L and in M for the residents of Smallham according to Reilly’s Law.

4. List the weaknesses of Reilly’s theory in the case above.

5. Outline how demand estimation techniques might allow for the cyclical nature of economic activity.

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4 Optimum construction outlay Revenues are determined not only by the use to which a site is put but also by the capital outlay on the building erected. Questions to be answered are:

What refinements should be incorporated in the building?

To what extent should higher initial capital costs be incurred in order to save future maintenance costs?

How intensively should the site be developed?

As we shall see, the answers to these questions all hinge on the principle of equating marginal revenue and marginal cost. More specifically, any addition to construction outlay must be at least covered by the addition to NPV from the resulting higher net revenue. We discuss the first two questions in this section; the third, and most important, in the next section.

4.1 The quality of refinements When deciding on refinements such as lifts and air conditioning in offices, the basic question is: how much will refinements add to revenue? If the enhanced NPV exceeds the cost of installation, such refinements should be incorporated.

4.2 Capital costs as opposed to maintenance costs For most buildings there will be some possibility of trading off higher initial construction costs against reduced maintenance costs. Here again the same marginal principle applies.

If higher initial building costs lead to lower future maintenance costs, net annual revenues will be greater than for a building costing less. We therefore have to choose that combination of construction costs and discounted NARs which will yield the highest NPV. Here the rate of interest and expectations of future wage rate levels would be major determinants. A high rate of interest penalises projects whose returns are received further in the future, such as a building with high initial capital costs. Thus a high rate of interest operates in favour of a low capital/high maintenance cost building. On the other hand, maintenance costs tend to be labour-intensive, and if wage rates are expected to increase more than other factor rewards it would give an advantage to the dearer, low-maintenance-cost building.

However, over and above these considerations, the availability of capital may impose a budget restraint so that a cheaper building has to be erected.

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5 The intensity of site use 5.1 Buildings as the addition of capital to land As well as determining the highest and best use of a site, the developer has to decide how intensively it shall be developed. If, for instance, the most profitable use of a large suburban site is for housing, to what density shall the houses be built? Or, if an office block is to be built in a city centre, how many storeys upwards, given no government restrictions, shall it go? In economic terms, how much capital shall be combined with the site?

Although the two decisions, most profitable use and capital intensity of development, are arrived at simultaneously, we shall simplify the analysis by assuming that the best use has already been determined, confining the immediate discussion to capital spending on the actual building.

5.2 Combining capital with a fixed supply of land Since we are dealing with a particular site, we can regard land as a fixed factor. To simplify the explanation, we shall assume that the project has a life of one year and that all returns are received at the end of the first year. (An obvious example of this in practice would be where a non-renewable one-year lease is held on a vacant site.)

The problem now resolves itself into one of applying units of a variable factor, which we shall term ‘capital’, to a fixed factor, land, subject to the following assumptions:

1. All costs of developing the site – material and labour costs, ripening and waiting costs, legal fees and normal profits – are capital costs.

2. The capital unit is an unspecified physical amalgam of materials and labour with the return and cost likewise unspecified.

3. There is perfect competition in both the capital and product markets. Thus all the capital the developer requires can be obtained at a given price, and the product sells at a constant price per unit. Therefore, marginal cost (MC) is constant, and the marginal revenue product (MRP) curve equals the marginal physical product (MPP) of capital times the price per product unit whatever the output. The MRP is net, operating costs having been deducted.

4. A site is being developed for offices, with one suite of offices occupying one storey. It is assumed that the height of the office suite makes no difference to the rent obtained, and so, following from (3), each suite lets at the same rent.

5. There are no government controls on height, and developers are free to bid for the site.

As extra units of capital are applied to the fixed site, the law of diminishing returns eventually comes into operation, and the MPP of capital falls. This is because building upwards incurs extra costs as a more expensive substructure is necessary, labour costs per unit rise with height, and lifts and fire escapes have to be provided. Thus the return on given additions to capital eventually decreases, giving a downward-sloping MRP curve in Figure 1. The MC curve, of course, is horizontal.

Development of the site will take place up to the point where marginal revenue equals marginal cost; that is, to where the MRP of a unit of capital equals the marginal cost of a unit of capital (OB in Figure 1). The building reaches its optimum height, that is the development is complete, when OM units of capital have been applied to the site.

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6 The determination of site price In Figure 1 total proceeds from the development will be AOMC, and the total capital cost BOMC. In practice, the developer will have plans of the optimum building to be constructed, and he can obtain preliminary cost estimates based on these plans. In addition, he will have to cover waiting and ripening costs, extra cost arising from the activation of escape clauses, overheads and normal profit. All costs will be included in BOMC. Thus the maximum which he can pay for the land is the residual, ABC, the shaded area.

6.1 Corollaries Certain corollaries follow from our assumptions and analysis:

If offices were the most profitable use for the site, ABC would represent the demand price for the site. Competition among developers would ensure that this price was in fact bid.

Suppose, however, there was an alternative use (e.g. for a departmental store) yielding a higher return. This would be shown by a higher MRP curve (MRP Figure 2) giving a larger residual surplus. The developer who recognised this use could bid more for the site. Thus competition ensures that the site goes to the most profitable use for this has the largest residual surplus.

Competition also ensures that the site is developed upwards until MR = MC where the bid for the site (ABC in Figure 1) is a maximum. Thus, not only does the site go to its most profitable use, but the type of building upon it is the one which secures the highest possible return.

A higher building and a higher site price will result either from a rise in the MRP of capital or from a fall in the rate of interest. A rise in the marginal revenue productivity of capital from MRP to MRP (Figure 2) could occur through:

an increase in the marginal physical product as a result of improved techniques (self-service selling) or increased productivity of the construction industry; higher revenue, for example from increased prices of the existing product supplied by the building or from a new higher use as the demand for another good increases or planning permission is granted. The height of the building increases, as indicated by the increase in units of capital applied, from OM to OM .

FIGURE 1 Applying capital to a fixed site

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1

1

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A fall in the rate of interest would lower the cost of each capital unit, for example from OB to OB , again increasing the height of the building by extending the use of capital from OM to OM (as indicated by the MRP curve).

Similarly, the price of the site will rise from ABC to A BC when MRP rises to MRP or from ABC to AB C when the rate of interest falls to Oi .

From the viewpoint of the individual developer, land is a cost; he has to pay the competitive market price in order to obtain it. His argument therefore may run as follows: ‘The higher the price of land, the more I have to economise in its use. Thus a site has to be used more intensively by applying more capital per square metre. High land prices have caused high buildings’.

Now while this may be quite true from the viewpoint of the individual, our analysis of the land market as a whole turns the argument on its head:

where demand is high, the use-capacity of land is high; this means that a highly intensive use of land is profitable; because high building is profitable, land values are likely to be high.

If we now relax the assumption that the project has a life of only one year, then, provided that we assume that the price of capital and the price of the output produced in the building do not change over time, the model still applies since incomes can be discounted back to the present value according to the year in which they are obtained, and then added together. The area AOMC will now represent the value of the aggregated discounted income stream throughout the estimated life of the project.

6.2 The extensive use of land By building higher, the developer is in effect saving on the cost of land. But diminishing returns mean that the cost of obtaining a given addition to revenue increases. Thus the developer will only build an extra storey so long as this is cheaper than acquiring extra land. In other words, there is a ‘margin of building’ in terms of both intensive use (adding an extra floor) and extensive use (adding extra land).

Suppose the demand for office suites in a district increased. A developer could respond either by adding a storey to a building or by building a ground-floor suite on undeveloped land. The alternative adopted would be that which cost less to produce a given addition to revenue.

FIGURE 2 The effect of a change in the productivity of capital or in the rate of interest

on the height of a building and site value

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1

1 1

1 1 11 1

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In practice, competition in an efficient land market would ensure that, in the long run, development everywhere will be pushed to the point where the marginal return to capital is equal to the marginal cost of capital for every site. Thus, suppose plots of land of the same size are being developed for (i) a city centre site by the use of OMa units of capital and for (ii) a suburban site by the use of OMb units of capital. The developer has equated MC with MRP in each case. In the first case the rent is ABC and in the second, A B C (Figure 3).

Where only one project is possible on a given site, the developer should choose the one which is most profitable – that which yields the highest net present value (NPV). Having done their calculations, developers compete with each other to obtain the site. The developer who can recognise the most profitable use can make the highest bid. As a result, given perfect knowledge, a competitive price system and no external costs or benefits, the site would be used in the most efficient way.

ACTIVITIES 2

1. Section 4.2 makes reference to applying the marginal principle to the choice between construction costs and maintenance costs. Draw a diagram showing this idea.

2. Outline the relevance of DCF to the model in 1).

3. If units of capital (in Figures 1–3) were measured in £1million units, then the MC line would be at £1million (OB in Figure 1). Optimal intensity of development would therefore require MRP to be at £1million also. Explain how that might be the case even if the marginal unit of capital only boosted rent-earning capacity by £125,000 p.a.

4. The development intensity model also provides an interesting model of land value. Using the model demonstrate the impact on site value of:

a. a new rapid transit station opening nearby; b. a change of planning policy.

FIGURE 3 The intensive and extensive use of land

1 1 1

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7 The timing of redevelopment 7.1 When does redevelopment take place? In general terms redevelopment takes place when the present capital value of the expected flow of future net returns from the existing use of the land resources becomes less than the present capital value of the cleared site. Therefore we have to calculate the present capital value of the site in its current use and compare this with the present capital value of the cleared site. It is assumed that during the period under consideration there is no inflation or deflation and therefore no change in the value of money. Note, however, that the rate of interest used in finding present values will reflect expected inflation.

7.2 The present capital value of the site in its current use It must be emphasised that we are seeking to establish a capital value. Since this depends on the net returns (gross annual returns less operating costs) expected to be earned in future years, such returns must first be estimated and discounted to the present and then aggregated in order to arrive at the present capital value.

Expected net annual returns (NARs) from current use The NAR of the project during any given year is the difference between the gross annual return (such as the rental received) and the operating costs (including repairs and maintenance). Since we are dealing with the future, the gross annual returns (GARs) and the operating costs are estimates; these are shown digrammatically in Figure 4. XY shows the NAR at Year N.

As the years go by GARs are likely to decrease because:

supernormal profits accruing to the initial development will encourage similar developments, which reduce future returns, for example from rents;

expectations are subject to greater uncertainty the further one looks ahead. However, these effects may be partially offset by complementary developments (externalities) which raise rents.

In contrast, operating costs rise as the years go by because (i) the structure deteriorates physically, and (ii) the older the building, the less adaptable it is to new technical requirements such as modern office machinery.

FIGURE 4 GARs and operating costs over time

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Discounting and aggregating NARs to obtain present capital value The NARs for the whole of the future life of the building have to be discounted to the present and then aggregated in order to obtain the present capital value of the land resource in its current use (see Figure 5).

In Figures 4 and 5 the NAR and the present capital value both become zero after OZ years. If no redevelopment has taken place by then, the land resources are left derelict. OZ represents the age at which the building becomes physically obsolescent.

7.3 The value of the cleared site The present capital value of the cleared site is equal to the present capital value of the most profitable alternative use less the cost of clearing the site and rebuilding to the new highest and best use.

The present capital value of the most profitable alternative use is calculated as already explained by discounting expected future NARs to the present and then aggregating them. Thus, in Figure 6, DD shows what, at any particular year, the discounted expected future NARs thereafter would be.

It will be deduced from Figures 5 and 6 that in Year 0, when the existing building in Figure 5 was constructed, its present value (OP) was greater than that of the new alternative best use (OD) in Figure 6. It was for this reason that the land went to its current use. From then on, however, the value of the alternative use (DD ) rises. This occurs for two main reasons. First, changes in the conditions of demand and supply (discussed later) mean that a new building, being specifically designed for new use, will earn higher NARs. Thus an old office building will give way to one that is air- conditioned and has the structure and space suitable for modern office equipment. Second, any new building would probably have a longer time horizon than the old building (which has already run a part of its life) so that there would be more future NARs to aggregate to obtain its present value.

From the present capital value of the next alternative use at any one time, we deduct:

a. the cost of demolishing and clearing the site (AB) b. the costs of rebuilding for the new use (OA).

For simplicity, we have assumed that costs (a) and (b) both remain constant over time. OB represents the sum of (a) and (b).

FIGURE 5 The present value of a land resource in its existing use

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1

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The present value of the cleared site is thus shown by CC, the difference between DD and BB at any given year. Once a site has been allocated to a given use and has had a building erected upon it, any new use has the additional handicap of demolition and rebuilding. Thus until Year R the present value of the cleared site is negative.

7.4 Redevelopment of the site By combining Figures 5 and 6 in Figure 7 we can show when redevelopment takes place. From Year R the present value of the cleared site is positive and increasing and eventually in Year T exceeds the present value of the building in its current use. Thus redevelopment should take place in Year T. It is in this year that the current use becomes economically obsolescent.

FIGURE 6 The value of the cleared site

FIGURE 7 The timing of redevelopment

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8 The rate of redevelopment 8.1 Method of approach The diagrammatic model can be used to analyse all redevelopment situations. By way of illustration we will examine the rate of redevelopment.

The rate of redevelopment will depend upon changes which occur over time in the relationship between:

1. the present value of the existing use of the land resources; 2. the present value of the best alternative use; 3. the cost of rebuilding.

It will be accelerated if (2) increases relative to (1), or if the cost of rebuilding falls. It will be retarded if opposite changes occur. What we have to consider, therefore, are the factors affecting (1), (2) and (3).

Present capital value depends upon expected future NARs and the rate at which they are discounted to the present. This rate will be common to both existing and alternative uses. We can thus concentrate on the NARs of each; that is, the difference between GARs (rentals) and operating costs. Rentals are concerned largely with changes on the demand side, operating costs with changes on the supply side.

8.2 Changes on the demand side affecting rental income Let us assume that the current use of a site in the city centre is for large residential houses and that the best alternative use is for offices.

A change in the demand for large city centre houses can arise through changes in:

tastes (a switch in preferences towards flats or smaller suburban houses);

real income (people tend to move outwards as their real income increases);

the distribution of income (higher taxation of the rich may force them to vacate expensive city centre houses);

the prices of substitutes (cheaper suburban houses);

transport costs or facilities (the building of a motorway or electrification of a railway);

mortgage terms;

complementary activities (new schools or golf courses in the suburbs);

government policy (the extension of security of tenure to furnished lettings may prolong residential use, while the introduction of capital value rating which shifts the rate burden towards expensive houses would tend to shorten it).

Similarly, rents from offices, the alternative use, would be affected by changes in both occupation and investment demand. Thus a rise in occupation demand (because of, for example, a rise in demand for professional services or for offices in city centre positions) would increase rents, while government dispersal policy would tend to decrease them. But since NARs depend largely on expected future rentals, a rise in investment demand would increase present capital value if such rentals were expected to increase with inflation.

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8.3 Changes on the supply side affecting operating costs Basically the same considerations apply to both houses and offices, but we shall illustrate for the former. With houses, operating costs may change because:

Maintenance costs and repairs change. For example, builders’ charges may rise, or repairs may be curtailed (as for instance, in the twilight zones of towns).

Technical improvements may allow conversions to a more intensive use. For example, flatlets may become economically viable as a result of cheaper partitioning and the development of compact units incorporating a sink, refrigerator and electric cooking facilities.

Government policy may alter. For example, improvement grants for conversion will reduce costs, whereas more stringent fire precaution regulations will increase them.

8.4 Building costs Redevelopment will be accelerated by a fall in real building costs because this will increase the value of the cleared site. Such a fall may occur through increased productivity in the construction industry or improved technology, for example in the building of high-rise office blocks. In contrast, an increase in building costs will retard redevelopment.

8.5 Relaxation of the assumptions of a perfect market Conditions in the real world may affect the pace of redevelopment:

Imperfect knowledge, immobility of factors, or just inertia may mean that it takes time for profitable redevelopment to get under way.

Imperfections of the capital market may affect the type of development. For instance, houses may be built instead of a block of flats because selling the former on completion gives the developer an earlier cash flow.

Legal restrictions, such as a covenant prohibiting a shop from selling certain goods, may postpone redevelopment until another type of shop becomes competitive with the current use.

There may not be perfect competition in the supply of sites; for example publicly owned land is not commonly offered for sale, while some owners of sites, essential to the complete development, exercise their monopoly power in the price they demand.

Government policy may affect the rate of development. Thus planning regulations may prevent redevelopment for certain uses; the exercise of compulsory purchase powers may make it easier to combine interests and so accelerate development, for instance for slum clearance; taxation policy (for example regarding depreciation allowances) may affect development; and improvement grants may encourage the modernisation of owner-occupied or rented older residential properties.

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9 Conclusion Development may take several forms, but private sector new-build involves a predictable process beginning with some form of demand estimation.

The marginality principle that we have encountered in our study of both the product and factor markets applies to many aspects of planned construction: refinements, maintenance-saving, site intensity, number of units, etc.

Redevelopment depends upon a comparison of the balance of revenues and costs in existing uses and in alternative uses. The time dimension enters the calculation by using present value calculations.

ACTIVITIES 3

1. Outline why Figure 5 shows a steady decline in the value of buildings yet experience suggests that building value rises over time.

2. The model of redevelopment timing is in essence comparing current site use with the best redevelopment option. Explain therefore why the latter is referred to merely as ‘site value’.

3. State in your own words the difference between physical and economic obsolescence.

4. Name three distinct government policy changes that would be expected to accelerate the rate of redevelopment.

5. Demonstrate, using the redevelopment diagram:

a. how a historic building may be saved from redevelopment; b. why a historic building should be saved from redevelopment.

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