'Without development, there is no profit,
without profit, no development'
J A Schumpter, economist (1883-1950)
Professional studies
levels 4&5
Development finances
The purpose of this workshop is for you to appreciate some of
the factors in development finances. It will not give you a full
understanding
CAUTION! SIMPLIFICATION
You need to be awake for this. At the end, you will have to do
some work, so make sure you're following the explanation and
ask questions if you feel lost.
The context
Change, or die….
First: about costs
Costs in the design process (typical)
Costs in the design process (typical)
agreed budget
Costs in the design process (typical)
agreed budget
cost plan
Costs in the design process (typical)
agreed budget
check
cost plan
Costs in the design process (typical)
agreed budget
cost plan
pre-tender estimate
(PTE)
Costs in the design process (typical)
agreed budget
cost plan
pre-tender estimate
tender price
Costs in the design process (typical)
agreed budget
cost plan
pre-tender estimate
CONTRACT SUM
Costs in the design process (typical)
agreed budget
cost plan
pre-tender estimate
CONTRACT SUM
variations
Variations?
WARNING! costs may go up (though rarely down)
Buildings are complicated and usually bespoke.
There is always a trade-off
the control triangle
COST
QUALITY TIME
This is probably the most difficult area of a project and where disputes usually occur,
because money is committed at this point
Quantity surveyor
Tools: Methods / services:
BCIS Measurement:
Building Cost SMM
Information Standard Method of
System Measurement
Price books Planning
(Spons)
Estimating
Bills
Procurement advice
Typical cost plan structure (very low level of detail)
Item quantity Rate (cost per unit / area) Total £
Substructure length, area, volume £/m or £/msq
Structure or number or £/item
Services
External envelope
Internal walls and ceilings
Internal finishes
Fixtures and fittings
External works
Prelim.s site setup costs (anticipated) %
OH&P overheads and profit (anticipated) %
Contingency (client's contingency) %
£
So, in parallel with the design process, costs are estimated in
increasing detail and these are checked back against the budget
This provides a clear reporting process for those investing their
money (the client)
So, in parallel with the design process, costs are estimated in
increasing detail and these are checked back against the budget
This provides a clear reporting process for those investing their
money (the client)
As you know more about the design, you know more about the
cost. If costs go up and beyond the budget, you can make
changes to make savings
All fairly straightforward, but there's an important question that
architects often don't (or can't) ask:
All fairly straightforward, but there's an important question that
architects often don't (or can't) ask:
Where does the budget come from?
(part of the reason we’re in trouble…)
'Without development, there is no profit,
without profit, no development'
J A Schumpter, economist (1883-1950)
The world changed in the 1980s
If you want to know how, these are a good place to start
and also... Marshall Berman's All that is solid melts into air
Speculative development is the current hegemony
Most construction clients are developers
To understand where budgets come from, you need to appreciate
what developers do
Nonetheless, the state remains an important part of the construction industry. Public
sector finances have different implications from private finance and these are briefly
discussed later.
So what do developers do?
So what do developers do?
They create value
or to put it another way,
they make money out of money
(usually other people's money)
So what do developers do?
They create value
or to put it another way,
they make money out of money
(usually other people's money)
That's it.
(design? Architecture?)
Some key concepts about development finances:
Money has to earn its keep.
Unless money earns more money, it loses value.
So time and money are intrinsically linked:
Time really is money.
Some key concepts about development finances:
Banks hold a lot of money that needs to be put to use, so they will
happily loan it, at a cost (interest)
Some key concepts about development finances:
Banks hold a lot of money that needs to be put to use, so they will
happily loan it, at a cost (interest)
A developer invests the bank's money in a project that he estimates
will earn more than it costs to borrow the money.
Some key concepts about development finances:
Banks hold a lot of money that needs to be put to use, so they will
happily loan it, at a cost (interest)
A developer invests the bank's money in a project that he estimates
will earn more than it costs to borrow the money.
This difference is his profit
Some key concepts about development finances:
Essentially its a calculated gamble: the developer earns his profit
by taking risk
Risk has a value, that can be traded
(so the developer takes a greater risk than the bank, to create his
profit margin – in theory)
An illustration
A developer uses some of his own money as a basis to borrow
more money from the bank
Developer's £
Gearing or Leverage is the ratio of the developer's investment to
the bank's eg. 4:1 gives a total investment of £5
Developer's £1
Total investment
Bank's £4
The total investment is put to work to create a new value
(by the developer)
New value
eg. £7
Investment £5
Time of development
The difference between the new value and the investment is the
return
Return £2
Investment £5
Return £2
(this is called the internal return – it is not the same as the developer's return, or profit)
The return on the investment has to pay the cost of the leveraged
part of the investment, before the developer makes a profit
Profit £1
Interest £1 Developer's £1
Bank's £4 Profit as a % of original
investment
Interest charged as a
% of amount borrowed
This is the case when the bank charges a fixed rate of interest and the developer takes all
the risk for the development. There are different mechanisms for transferring risk
So, in this scenario everybody wins
The return is large enough so that the bank can earn its interest
and the developer can still make a profit
But, where is the risk?
What if the return is less than the interest?
Interest £2 Return £1
Investment £5
What if the return is less than the interest?
Developer's £1
Interest £2 Return £1
Investment £5
If the bank's interest rate is fixed, then the developer would have
to pay the difference
Then he loses: it has cost him money to do the project
So, before taking on a project, a developer needs to assess
whether it is worth doing:
a development appraisal
Is this difference big
enough?
The forecasted
All the costs new value
First, he needs to forecast all the costs
CAPITAL REVENUE
All the costs
CAPITAL REVENUE
Land costs Management
Design fees Maintenance
Management fees Servicing
Overheads Repairs
Statutory fees Marketing
All the costs
Tax
Construction
costs
Marketing
Then, forecast the return
CAPITAL REVENUE
New value Rent
(derived from the
revenue) Service charges
The return,
or the new value
In forecasting both costs and returns, time becomes important
A cashflow illustration:
income
time
cost
In a typical construction project, costs are mainly incurred at the
start:
income
Land, construction etc.
time
cost
Once the building(s) are completed, they can open for business
and operational costs are incurred (management, maintenance
etc.)
opening
income
operation costs
time
cost
At the same time, income is generated, eg. through rents
income
time
cost
operation
income
It is normal for buildings not to be fully rented, all of the time and this would be forecast
in the cashflow – known as ‘voids’
In this scenario, a lot of cost is incurred before any income is
generated
income
time
cost
Cumulative
costs
Debt peak
(minus
developer's
investment)
But at the same time, the new land and buildings have a capital
value to offset the costs (let's say the same as the costs)
Capital value
income
time
cost
Through the development, the developer is converting
investment into capital assets (land, buildings etc.)
But the value of assets are not fixed, they fluctuate according to
the market demand.
The market demand is ultimately dependent on the forecasted
revenue income in the future.
If the market falls significantly, the
value of assets falls, against the
investment
Capital value
value
time
investment
Investment
If the market falls significantly, the
value of assets falls, against the
investment
Capital value
value
time
investment
Investment
The balance becomes negative –
the developer has spent more than
he can cover with the value of the
assets
If developers have a high ratio of
debts to assets, they can become
value bankrupt very quickly
time
investment
Negative
balance of cost
to value
Whilst the developer keeps hold of the asset, he is exposed to
risk.
Development companies are vehicles for borrowing money,
generating value through assets and realising the value through
quick disposal.
They take a high level of risk, for a relatively short period of time
then sell their assets to other lower geared companies.
eg. residential developments, are sold to individuals who take out mortgages with
banks, who are not so highly geared and so can carry the risk better (in theory!)
PFI (Private Finance Initiative) or similar arrangements are different as the developer
continues to own the asset for a period of time (say 30 years), but they have a virtually
guaranteed income and value as the tenant is usually the state.
Development sold to realise
An idealised situation: new value (= investment +
internal return)
Capital value
Development Cost and income realised
risk period by new owner
income
time
cost
Investment
In order to carry out his appraisal before investment and to sell
the assets once development is complete, the developer has to
assess the value of the assets
The capital value is related to
the anticipated future income,
so the developer needs to
Capital value forecast this in his appraisal
income
time
cost
There are various methods of forecasting
Producing a time-based forecast like this one is known as the
‘cashflow’ method
income
time
cost
Different methods have different pros and cons. The cashflow method clearly shows all
the assumptions about income and expenditure during each period of time shown, but it
is detailed and cumbersome.
A common ‘shorthand’ method is the yield
The yield compares an average, stabilised year’s return to the
investment
income
time
cost
Investment
Calculating yield from the cashflow forecast:
The return for each year is simply the income minus
the costs
The income needs to account for an average
occupancy rate eg. 20% voids is 80% occupied
The Internal Rate of Return (IRR) is then calculated to find the
present value of the future income
Present value of return Return increases over
is future returns, time due to inflation
adjusted for inflation
income
time
cost
IRR Internal Rate of Return
Yt Return for year t (income – costs)
r Rate of inflation
t Total number of years of appraisal
This continues for the total
number of years, t
IRR =
( Y1
(1+r)1
+ Y2
(1+r)2
+ Y3 + ....
(1+r)3 )
t
Investment %
The period of time, t can be chosen, but inflation and income rates will fluctuate over
time, so longer periods are not necessarily more accurate.
Year 1 should be the first year that income and costs have stabilised.
Let’s say that on an initial investment of £10m over 4
consecutive years, the income is estimated to be:
£960,000, £1,000,000, £1,100,000 and £1,120,000.
Inflation is taken to be fixed at 3%
( )
IRR = 960,000 + 1,000,000 + 1,100,000 + 1,120,000
(1+0.03)1 (1+0.03)2 (1+0.03)3 (1+0.03)4
4
10,000,000
(%)
IRR = 9.7%
The maths are fairly straightforward, but there are a lot of steps. Work out each step
and write them down as you go. Don’t forget to convert between decimals and
percentages. A calculator with a 1/x is very helpful.
This is the yield of the investment: it provides a simple method
for developers to compare one investment against another
6% yield 9% yield 12% yield
The yield is not transparent in the same way as cashflow and so the assumptions
behind any yield need to be considered when comparing it with investments.
The yield is the relationship between the rate of return from the
project, and the total investment (why it is called internal)
If the investment is geared, the developer still has to pay
interest out of the return, so he can compare the yield and the
interest rate, to make sure the return is greater and so generate
a profit.
Discount rate method:
A further appraisal method is to ‘benchmark’ the development
against other investments with a similar risk.
In this case, you take the yield of a benchmark investment (eg.
from the stockmarket) and ‘discount’ the development appraisal
by this amount. This essentially cancels out the two yields if
they are equal.
If the answer is negative, then the development is less
attractive, if its positive then more attractive. If they’re equal, its
equal.
Developers or banks might do this if inflation is too volatile to
accurately predict.
Factors affecting development:
Cost of development:
If costs increase beyond the costs allowed in the appraisal, this
comes directly off the profit
Factors affecting development:
Time:
The longer the period of the development, the greater the
exposure
The longer the period of the development, the longer the period
of interest payments on any loan, so the greater the cost
The greater the risk, the greater the cost of borrowing.
‘Phasing’ a project can help to reduce borrowing rates, by
reducing the exposure.
Inflation means that costs and income increase, but developers
usually incur a lot of cost before they realise any income.
Time:
Capital value
The longer the period of risk, the
greater the cost of borrowing
nb. cost of borrowing is external
so doesn’t appear in the yield
directly
income
time
cost
Phasing reduces the peak debt
and may allow income from
earlier phases to pay for later
phases so less borrowing
Investment
Factors affecting development:
The market:
If demand drops unexpectedly, rent drops and so yields drop. If
this happens during the period of development, the
development loses money.
If the development can attract higher rent than its competitors,
at no extra cost it will have a higher yield
If cost inflation changes differently to income inflation, the yield
will change
Factors affecting development:
Sensitivity:
A good way of assessing the sensitivity of a development to
these factors is to run the assessment several times, changing
one factor at a time. The bigger percentage change to the
outcome, the more sensitive.
This is called sensitivity analysis
Summary:
Developers invest money to create value.
The (potential) value has to be realised at some point in the future
The potential of each investment is usually measured by
comparing yields
Developers usually sell their assets after development to realise a
profit. The value is related to the yield.
Profit may be quite high: typically 20%
But they take a lot of risk: risk costs money and if the risk is
reduced, the cost is reduced
Development is sensitive to all factors that affect cost and income
and therefore yield
Public sector finances:
Any development that directly involves public money and
sometimes public assets, is different mainly as follows:
There are specific rules, to ensure transparency, fairness and
competitiveness. These rules are mainly governed by the
European Union
Generally, ‘best value’ must be demonstrated, in a way that can
be measured.
Non-financial concerns can be considered as part of the
appraisal: eg. improvements in health or education can count
instead of financial gain (known as benefits).
Public finance rules are quite complicated and it is worth taking
time to understand the basics if you are involved in a public
project. Government bodies publish advice.
Now your turn….
A prize for the most correct answers
Scenarios:
1. Draw a graph to show how phasing a project reduces the
level of borrowing.
How will this affect the yield?
Scenarios:
2. Explain all the ways that a shorter construction period will
reduce the cost of a development
How will this affect the yield?
Scenarios:
3. As part of a planning permission, a retail development is
required to include a public gallery. This adds cost to the
project, but it means there will be more customers for the
shops.
How will this affect the yield?
Scenarios:
4. The cost of borrowing suddenly increases, but rents stay the
same. What does this mean for developments?
How will this affect the yield?
And finally: assignment
Brief on UELplus, 50% of marks, deadline 26.04.11