Property Development Study Guide - Module 05

Feasibility Studies – Part II

INTRODUCTION
This module is a continuation of Module 4 on feasibility studies. The following areas will be
covered:
• Hypothetical development method
• Discounted cash flow (DCF) method
• A comparison between hypothetical development method and DCF method
• Sensitivity and scenario analysis, and simulation
• Real estate project life cycle
• Valuation of incomplete property development

Most of the materials are taken from the text book and Property Valuation and Analysis
(Whipple 2006).

HYPOTHETICAL DEVELOPMENT METHOD (TRADITIONAL RESIDUE METHOD)

This method is also known as the traditional residual method, or the static model of
valuation of development property. The equation used in this method is:

“value” = land + development cost + finance cost + profit

As pointed out by Whipple (2006), the above method continues from the days when there
were virtually no delays in obtaining development approvals, inflation was largely unknown,
and the development was not as capital intensive as now. The most significant difference
that we are facing now is property development takes much longer to prepare for sale, for
example a longer time to obtain development approval. Therefore, time factor has become
far more important than before. As the time value of money could be ignored due to the
relatively much shorter development period, the above equation gave more reasonable
results then.

To illustrate the hypothetical development method, an example of a 70-lot residential

subdivision will be used (Whipple 2006, p. 428). The descriptions below are based on the
calculations shown in Figure 5.1 – Application of static valuation method to 70-lot
subdivision.

Page 1 of 17
Figure 5.1 Static valuation for a 70-lot subdivision
Source: Whipple 2006, p. 428
Page 2 of 17
Estimating the lot yield
The first step is to draw up a plan of subdivision showing the lot yield and other details such
as the length of road to be constructed, sewer and drains to be laid, power lines, etc. The
plan must comply with the relevant regulations and market requirements. Based on market
data or comparables, the price of the developed site is estimated.

Selling expenses
Selling costs are deducted from the selling price to give an estimate of net realisations.
These selling costs are derived from local practice. They usually include advertising,
commission and legal fees.

Profit and risk factor

The margin for profit and risk is a function of total outlay. As shown in Figure 5.1, a margin
of 20 per cent is allowed. Total cost includes the cost of raw land.

Development cost
Development cost should be estimated based on current costing, it should not be escalated
to allow for price inflation. Reference can be made to contractors, quantity surveyors, and
other professionals in the property development industry to ascertain development cost
and professional fees.

Other costs
These include overhead costs, open space levy and other charges. Public garden and
recreation space contribution may be in cash or by the dedication of land as agreed by the
planning authority. It is therefore, required to ascertain local practices and requirements to
make appropriate allowance in this regard.

In addition, contingency allowance needs to be included and the percentage is usually

depending on local practices.

Interest and property taxes

Interest is calculated at the rate applicable to the funding of the development project. The
usual assumption is that the development money will be outstanding for an average of half
the period during which the estate is being developed and sold. Assuming for a two-year
development period, the interest will be based on one year period.

Rate and taxes will be allowed over the project life period. Interest on land cost is assumed
to accrue over the duration of the project as shown in Figure 5.1. Acquisition costs include
stamp duty, legal fees and others on purchase, allowed for at 3 per cent. And, finally, the
land value is estimated at $2,056,357.

DISCOUNTED CASH FLOW (DCF) METHOD

In principle, discounted cash flow (DCF) analysis for property development is no different
from DCF for any other purpose. It is important that you understand the principles, the
terms and the practicalities of using DCF analysis, as well as being comfortable with using an
Excel spreadsheet. For most of you, that will not be a problem. If you are not on top of the

Page 3 of 17
concepts, you should get hold of an appropriate text, and sit down with a spreadsheet and
practise.

While DCF analysis is not the only method of determining whether a development is
financially viable, it is the only method that is practical for analysis of major developments
that extend over reasonably long time periods.

Your course coordinator has a personal preference for using NPV, not IRR for the following
reason: You, as the analyst, are calculating whether a development being carried out by a
particular developer will be successful. Thus, the discount rate is simply the return expected
by the developer on the money that is being put into the project - the developer's hurdle
rate. This is a case of a specific analysis of a specific project for a specific developer, not a
general market analysis. It is very important to distinguish between using DCF for
development analysis and using it for determining land value, as you did in Real Estate
Valuation.

If the developer wants to see a bunch of IRRs before picking one, you would have to ask
questions – if the developer does not have a reasonable idea of the return they should be
expecting, you the property analyst should provide guidance from your market investigation
of what other developers in that market are seeking by way of return. There are three
methods of doing this which will be discussed in the following:

Developing the Discount Rate

The expected rate of return of a proposed project is predominantly affected by two factors:
“(1) the perceived riskiness or volatility of the cash flows from the real estate investment;
and (2) the investment alternatives available” (Miles et al. 2007, 2004). The most important
thing to be aware of when obtaining the discount rate is to compare apples with apples.
You need to be very sure that the discount rate you are given was that applying to the same
type of analysis that you are contemplating. When you ask for the discount rate that you
intend to apply to a preliminary feasibility analysis, you might be given one that applied to a
fully worked up feasibility study, including taxation and borrowing. You must ask enough
questions to establish the provenance of the figure you are given – in the same way that you
would find out whether a rental rate per square metre was gross, net, or whatever. This
advice applies whether you are trying to work out a discount rate from the market, or are
obtaining the preferred “hurdle rate” from a developer client.

The Discount Rate is the major causes of anxiety in using DCF, with very good reason. The
Discount Rate is not divorced from considerations and forecasts of income and expense
growth, inflation, vacancy allowances etc. - they are correlated because they are part of the
same economic scene. Regard must be given to the rate structure of the entire capital
market - the opportunity cost of alternative investments. Mathematically, the Discount
Rate discounts the value of future expenditure and receivables into Net Present
Value - almost invariably the desired measure.

Page 4 of 17
 i. Rate Selection by Abstraction
This means finding enough pertinent information about relatively similar investment
properties to find each of those properties' Internal Rates of Return. The IRRs are resolved
by essentially the same (objective or subjective) reasoning process used to resolve differing
capitalisation rates or net income multipliers. The resolved rate is then applied to the
subject property's forecast net cash flows as a discount rate.

The abstraction process applies to estimated future earnings of the comparable properties,
as opposed to actual current earnings of the property when using the various
current-earnings ratios. It is therefore necessary, if objective and significant results are to be
achieved, to consult with the buyers, and preferably the sellers as well, to ascertain and
understand the criteria involved in the process of price formation. Obviously, if the buyer
used DCF analysis to decide on a purchase price, the discount rate evidence is there and the
use of DCF is very sensible. In the absence of this direct evidence, a second best method is
to use the same criteria in analysis of both comparables and subject. This is the equivalent
of using the capitalisation method without interviewing the participants, and is justifiable or
not, depending on your point of view. Because discount rates, projected future earnings,
and estimated net reversion are linked, the whole of the events which triggered the
transaction must be understood before an intelligent, as opposed to a simply mathematical,
analysis of the transaction can take place.

ii. Rate selection by market inquiry

This relies on some knowledge of capital markets' current attitudes and preferences,
because real estate is simply another investment. Interviews with investors/developers
active in the particular market sector to which the property would appeal are the common
method. Such interviews should be with people who are familiar with the concept of DCF
and with the particular market. Clearly, a developer looking for a discount rate to apply to a
calculation of a suitable purchase price for development land will not be keen to interview
potential rivals. This is where the property analyst comes in.

The interviewer needs to be prepared to give all the details of the subject property and its
circumstances, particularly the growth prospects. If you give someone misleading data, why
should you expect them to process that into a useful answer? Such interviews may, of
course, be helpful in arriving at appropriate predictions for inflation and market rentals. The
interviewee may suggest a discount rate appropriate to certain forecasts. They may suggest
current market preferences of establishing the forecast period, the reversion and other
criteria.

iii. Synthesising the discount rate

This really tends to be a last resort, and is generally inferior to market inquiry. However, it
can be a useful check method, as it causes the analyst to question assumptions relating to
the risks of property development or investment. The full summation method, which may
be used if the benchmark rate is unobtainable through market inquiry, involves synthesising
the benchmark rate and then adjusting it by a series of secondary adjustments. Some of
the literature suggests using the long-term bond rate as a base for the investment discount
rate, in which case it is important to choose the bond term coinciding with the projected
holding period of the property. In the case of a property development, the bond rate would

Page 5 of 17
need a major adjustment for the risk of development – if the analyst does not have a feel for
what that adjustment should be at the time, then the bond rate is not a good starting point.
It might be preferable for property development to use the overall yield on development
company equities or some such yield that accounts for development risk.

To reach an appropriate benchmark discount rate, adjustments must be made for relative
illiquidity of property (commonly .25 to 1 %), management intensity (up to 1 %?) and
relative appeal of real estate at the time of analysis (if real estate is somewhat more
appetising than shares at the time, perhaps a negative adjustment may be appropriate).
Secondary adjustments are sometimes made for other general considerations, leaving
specific factors relating to the subject property to be accounted for in the cash flow. General
adjustments would be made for the particular category of property (seldom > 1 %?), relative
location, such as state and city (0 to 3%?), type and quality of tenancy, lease structure,
management competency, onerous existing financing structure (up to 1% in total?) and
quality of the information in the cash flow.

There are rules of thumb around for estimating discount rates, like adding 6 to 10% to the
estimated inflation rate. The trouble with rules of thumb is that if there are major paradigm
shifts, and these occur with surprising frequency in the information age, the "rules" lose
their applicability. The main disadvantage of rules of thumb is that they tend to discourage
thought.

Forecasting
This was fairly comprehensively covered in Module 2, but there are some practical
implications well worth noting. The analyst must understand the link between economic
activity and property development. This is most often expressed in the so-called real estate
cycle, shown in Figure 5.2. The term “cycle” can be misleading, for it implies that there is a
regular pattern that can be predicted.

Figure 5.2: The real estate cycle

Source: RREEF Research, cited in O’Roarty, 2009, p. 91

Page 6 of 17
The real message of the real estate cycle is the cause and effect link between economic
activity and real estate development. If businesses are expanding and taking on more staff,
they need more space. The increased demand for a supply of space that is fixed in the
short-term, results in an increase in rentals, which leads to an increase in income for
property owners. When rentals look as if they will rise to the point where property income
will provide a good return on new property development, developers start to get interested
in new development. With planning, approval and building processes being what they are,
there are usually a good couple of years between the dawn of this realisation and the
completion of the first of the new stock. During this time, of course, things can go wrong.

Business expansion may cease, or even turn into a contraction (hence the need to pay
attention to forecasts about the general economy). More common is that many developers
start working to satisfy the demand, so that where one building might supply the required
space, ten are built. Sometimes this is because developers don’t pay attention to possible
competing supply; more often it is because they know about it and assume that their
particular building will attract all the tenants, while the other nine remain vacant.

If lenders and investors are keen on the property market at the same time (perhaps because
the returns in the share market are not good), then the problem is multiplied. Of course, all
ten developers compete like mad for the tenants, offering rental concessions etc., and all 10
buildings end up with 10% occupancy and bankrupt developers and lenders. The buildings
are bought by investors at prices that make sense given the new lower rental levels and that
enable them to hold the buildings over a fairly long letting up period.

The next time the cycle occurs, developers tend to be a bit more cautious, and will not start
a new development without a substantial pre-commitment from intending tenants. If
developers are all aware of what goes on, then the supply might match the demand and the
real estate cycle will be in a stable situation. However, corporate memories do not last
terribly long, and we can confidently predict that fools will rush in and repeat the same
mistakes at some time in the future. Hopefully, having taken this course, you will not be
among them, and perhaps you might, as a consultant, be able to save some developers from
themselves!

This is the manifestation of the consumer of space as the drive-wheel. If the space
producers (including property investors) do the driving, then the market gets into trouble. It
is interesting to observe the Adelaide CBD office market during mid-2003. There was very
little vacancy in prime office space. The novice analyst might conclude that this meant that
there was strong demand for some new, prime, office buildings. The experienced analyst
would look at the tenant composition of the prime space. How many tenants were in there
on long leases at cheap rents, entered into when there were 30% vacancy rates? What sort
of rental increases would their businesses be able to afford when the honeymoon was over?
Was there A and B grade space (used or refurbished) that would satisfy their business
needs? Our experienced analyst would also look at rental movements in prime space (not
being fooled by any hidden rental concessions). Are real rental rates approaching the level
where it would pay a developer to construct a new prime office building? The key is
effective demand – both requiring the particular class of space for the business operation
and being willing and able to pay the level of rental that will secure it.

Page 7 of 17
The Excel spreadsheet
You should be able to construct a proper Excel spreadsheet for a DCF analysis of a property
development proposal. Once you understand the principles, then even the most complex
development analysis is just a question of more headings and more data. It is useful for
sensitivity and scenario analysis if you construct a data table by using Excel spreadsheet;
you only need to change one figure, not whole rows of them. You should most definitely
acquire the skills to use relational formulae.

There are other softwares available such as Estate Master, Feastudy and @once, which are
very user friendly in working out these analyses. However, it is important that you to have a
general understanding of how they work by using Excel and a good "feel" for the quality of
the output before using ‘black-box’ approach.

The DCF analysis used in this course is the basic analysis used to compare potential
developments or to compare various permutations of a given development. It is therefore
assumed that there are no borrowings and no taxation implications. This is done for
reasons of simplicity – if you are ranking developments, then the same taxation and interest
rate regimes would apply to each, and the relative position in the rankings would be
unaffected. The other reason they are omitted is to enable us to focus on the real estate
deal as such. A bad real estate deal might be improved by taxation concessions and a
favourable borrowing rate, but it will still be a bad real estate deal. Why not use taxation
and borrowing to improve a good real estate deal instead? There is also a minimal amount
of detail shown in the income and expenditure on the spreadsheet. Again, this is to keep it
simple in recognition of the fact that this is only a preliminary feasibility analysis. Please
refer to the Excel file (part of Module 5’s study materials), Copy of Excel Development
Sample [Link]. A copy of which is shown in Page 17.

Once the preliminary feasibility of a particular development idea has been established, then
the full feasibility study is prepared, as described in Module 4. This certainly involves the
financing and taxation implications and contains much more detailed cost and income
information than the preliminary analysis. The information is obtained and prepared by
specialists, such as quantity surveyors and market research firms. It is beyond the resources
of the average property analyst, which is why you are not asked to perform such analyses.
However, given the right information, you should be perfectly able to perform such detailed
analysis, because the DCF and principles are exactly the same.

One very important aspect of setting out your development spreadsheet is to avoid the
mistake of doing a combined development/investment analysis. If you allow your
development time period to extend into the leasing and income producing period, which a
lot of newcomers to the game tend to do, you will be discounting the investment income at
the development rate, thus badly understating the viability of the project. Your
development spreadsheet, unless it is a staged development, should have only one income -
the value of the completed development at the end of the development period. All the
other cash flows should be development outgoings. The calculation of the value at the end
of the development period will depend on your assumptions about letting up periods, rental
growth, capitalisation or investment discount rates. It is common to capitalise the imputed
stabilised annual rental income (assuming the long-term vacancy rate), and then deduct the

Page 8 of 17
present value of any rental shortfalls over the letting up period. You have learned, or will
learn about these in your valuation courses.

Note that some of the books include borrowing and taxation in the DCF calculation. That is
the appropriate thing to do once you have determined that one particular development
scenario is better than the other possibilities that you were comparing it with, and meets
the developer's hurdle rate requirements. We do not go that far, because we are only doing
preliminary feasibility analysis. Once the developer has decided to go ahead, put in all the
figures relating to the developer's personal financial situation by all means - it is not difficult
if you understand the basic principles.

Sensitivity and scenario analysis, and simulation

Sensitivity and scenario analysis are especially important to know about, and to know the
difference between.

Sensitivity analysis looks at the sensitivity of the IRR to changes in individual variables in the
development analysis spreadsheet. If you alter the building costs by 10% and the IRR
changes by more than 10% (of itself), then the project is sensitive to changes in that
variable, and it might want further research to reduce the risk of that variable value
changing. It is important to note that the items are varied singly in sensitivity analysis.

Scenario analysis is typically shown as best-case (optimistic), worst-case (pessimistic), most-

likely-case (hopefully the one you started out with), where all variables are
changed appropriately. Note that even the pessimistic case has to be realistically
pessimistic and the optimistic case realistically optimistic. In other words, there has to
be a fair chance that either could happen.
The optimistic and pessimistic scenarios define the limits which the outcome of the
investment is deemed to fall.

The scenarios should not be chosen without any reason, they are assessments of likely
future events that will influence the investment. You determine your figures from your
understanding of the behaviour of the variables in the particular market. You do not just
make a wild guess at a low or high figure, or arbitrarily select 10% either way! For example,
if your worst-case scenario includes the economy being in recession, then it would be
unrealistic to assume high building price inflation.

The analyst must present reasons for the various assumptions used in the three scenarios.
Three important sources of influences are: macro influences affecting the market,
consequences arising out of actions in the real estate market, and factors arising from
within the building itself, or some combinations.

Simulation is really running a whole lot of scenarios, selected by a computer program such
as @Risk, on the basis of predetermined statistical probability modified for correlation
between variables and for serial correlation within variables. The result is a distribution of
IRRs or NPVs that give a probability of the development having various positive and negative
returns. The tricky part about simulation is that you need lots of past cost and income

Page 9 of 17
information to determine what the inter- and intra-variable correlations are, as well as what
distributions to use. This is a very serious limitation, as most organisations would not have
such a database, while setting one up would be very expensive. You are not asked to run
simulations in this course, because many students lack access to simulation programs, while
others have had no training in their use.

DCF and spreadsheet principles

This section is included for the benefit of those who do not have the knowledge of DCF and
Excel assumed in the course, or who wish to brush up on some basic principles.

Discounted Cash Flow (DCF) Analysis is a technique for assessing the return on capital
employed in a project over its economic life, with a view to prioritising alternative courses of
action that exceed established profitability thresholds.

In the case of a Property Development Project, the Economic Life of the project is the time
between the first cash outlay and the receipt of the proceeds of sale of the development
even if this is only by way of internal book transfer

Development projects typically span more than one year and hence involve costs and
benefits arising well into the future. Since payments or receipts arising at different times
have different worth per unit, their discounted values for a common date must be
expressed in equivalent dollars before they are comparable. The term cash flow represents
transactions involving liquid assets generated by a particular development project. Cash
inflows relate to benefits that are received and which can theoretically be deposited in a
bank account. Cash outflows are expenses incurred in obtaining those benefits. The net
cash flow is simply the difference between cash inflows and outflows and is essentially a
function of cost and return.

Setting out a spreadsheet can be as simple or as complex as you wish to make it. Remember
that you are discounting the NET CASH FLOW for each period - it is up to you how much
detail you wish to include. A very detailed cash flow is usually unnecessary for a preliminary
feasibility analysis - for instance, you would show total development costs, rather than the
cost of each component of the building – but you need to strike a balance between
providing information and overcomplicating the presentation with excess detail.

DCF principles
The Discounted Cash Flow technique focuses on the overall cost consequences of an
investment, considering the amount and timing of cash inflows and outflows and envisaged
rates of return. The underlying principle is to determine the value of future cash flows
generated by a project over its economic life. This can preferably be done by applying an
appropriate discount rate to reduce the present value of future costs and benefits to a value
that reflects their investment potential today - i.e. present value.

Using Discounted Cash Flow analysis ideally requires knowledge of the operation of the
discounting formula, which is:

Page 10 of 17
 PV = 1/(1+i)n

Where PV = Present Value

i = Discount Rate
n = Period of time in which cash flow occurs

The result is a number (the discount factor) between 1 and 0, which is multiplied by the cash
flow in that period to give its Present Value. The Present Values are added to give the Net
Present Value. The discount factor cannot be greater than 1, because that would imply that
$1 in the future is worth more than $1 now. Using this formula for the Present Value of $1, a
table of discount rates can be established (such tables were used before financial calculators
and computers). For Example:

Cash Flow in Period 0 (Start of the project) = -$120,000

Discount Rate = 5%
PV of $1 in period 0 at 5% Discount = 1/(1 + 0.05)0
Any number to the power of 0 =1, so the discount factor =1
-$120,000 x 1 = -$120,000

Cash Flow in Period 1 (end of First Period) = -$27,000

Discount Rate = 5%
PV of $1 in Period 1 at 5% Discount Rate = 1/ (1 + .05)1
Any number to the power of 1 is equal to itself
The Discount Factor = 1/1.05 = 0.952381
-$27,000 x 0.952381 = -$25,714

Cash Flow in Period 2 (end of second period) = $150,000

Discount Rate = 5%
PV of $1 in Period 2 at 5% Discount Rate = 1/(1 + .05)2
The Discount Factor = 1/1.052 = 1/1.1025 = 0.9070
$150,000 x .9070 = $136,054

Page 11 of 17
 The Net Present Value of the development can be assessed by summing
the individual Present Values:
Period 0 PV = -$120,000
Period 1 PV = -$ 25,714
Period 2 PV = $136,054
Total= NPV = -$ 9,660

The NPV is negative, so the project is not viable under the conditions of
the calculation

Computer spread-sheet programs, such as Microsoft Excel, have their own Net Present
Value functions, which make it unnecessary to use the PV Formula, but they do contain a
trap:

• The cash flow in period 0 is not discounted using the PV Formula, because the
Discount Rate is equal to 1
• The Spreadsheet Formulae do discount period 0 at the period 1 rate, giving an
erroneous result
• The trick is to obtain the NPV for periods 1 to n, then add the undiscounted cash
flow in period 0 to that NPV to give the true NPV
• It is recommended that you generate a discount rate for each period, because it is
easy to do on a spreadsheet, lends itself to sensitivity and scenario analysis, and can
be visually checked for errors

Another trap to be wary of in setting out a spread-sheet is adjusting the discount rate for
time periods of less than one year. Discount rates are normally quoted annually. To simply
adjust the rate for a lesser period, divide the figure by the number of periods in a year.
e.g. if the discount rate is 20% per annum, and the period is quarterly, divide it by 4 (giving
5% per quarter). If monthly, divide the annual discount rate by 12 (giving 1.667% per
month). The mathematically accurate way to do this is:

Effective Rate = ( 1 + Nominal Rate/Periods per Year)(periods per year) - 1

For Example, Nominal Rate = 20%, Periods = 12
Effective Rate = (1 + 0.2/12)12 - 1 = 21.94% p.a.
=1.83% per month
Quarterly Equivalent is 5.39%
There is a significant difference from the 5% using the simple formula, but it is
probably within the error margin for the whole DCF Calculation

Page 12 of 17
You may use financial calculator to work out the above calculations.

A COMPARISON BETWEEN HYPOTHETICAL DEVELOPMENT METHOD AND DCF METHOD

Hypothetical development method does not take time factor into consideration as DCF
analysis. As most development take a much longer period to complete, normally more than
1 year from planning to realization of value, thus, hypothetical development method
presents a poor basis in this regard.

DCF analysis is much more detailed compared to hypothetical development method. The
assumptions embedded in the latter method are not easily discovered thus constitute a
major source of risk in its use.

The timing and magnitude of cash flows are clearly demonstrated in DCF analysis. It is the
most useful management tool as correction actions can be taken when actual performance
deviates from the planned performance. As emphasized earlier, a DCF analysis should be
prepared for a number of possible scenarios to derive a range of likely values from which
the most probable value is selected.

Apparently, the questions of accuracy of the estimates of the timing and magnitude of
individual cash flows cause disadvantages to DCF method. This underscores the need to
conduct in-depth market analysis in the early stages of work in DCF analysis.

Despite the shortcomings of hypothetical development method, it is still widely used by

practitioners in assessing potential development site.

REAL ESTATE PROJECT LIFE CYCLE

Figure 5.3 depicts the stages of real estate project life cycle (Miles et al 2007, p. 518). The
first stage is the project development period; it is the shortest period in the project life
cycle. The income and value of the project would be expected to grow as space is leased to
tenants as the risk of vacancy is decreasing.

Page 13 of 17
 Income Appreciation in Dollar

Period of Highest
Growth

Development Stabilization Time Decline Time

Time

Figure 5.3 Real Estate Project Life Cycle

Source: Miles et. al 2007, p. 518
When the project is physically complete and the building has considerably rented out, the
project is considered as ‘stabilized’. The length of period to stabilize varies according to
property type, market conditions, the quality of the building as well as the quality of the
management team. Some buildings take many years to reach stabilization, and in a
stabilized state for a long period of time. On the contrary, some poorly conceived and
constructed buildings go into the decline stage immediately after completion, i.e. they never
achieve stabilization. It is the full responsibility of asset and management manager to ensure
the building operates optimally when it attains stabilization.

The developer’s profit is calculated at the end of the development period as the difference
between the project’s market value and the developer’s total development cost.
Development companies are usually capital-constrained and work to recover their capital
profit from a project as early as possible. The asset and property manager is interested in
the value of the completed project as it provides the baseline for measuring the future
property performance.

Ideally, the asset and property managers are active during property development period in
providing input into project design and the marketing strategy. However, in reality, a project
rarely follows its pro forma exactly during the development period. These could be due to
changing market conditions affecting the project.

VALUATION OF INCOMPLETE PROPERTY DEVELOPMENT

The valuation of an incomplete project will depend on the definition of value relevant to the
problem. For valuation for accounting purpose, the value will be defined as one of the two
as below (Whipple 2006):

• Realisable value in the ordinary course of business; or

Page 14 of 17
 (i.e. the expected selling price of the completed project less all costs still to be
incurred to develop and sell the project)

• Realisable value in its existing state

This is the property value to another developer. That is the price which another
developer would pay for the property, less selling expenses. It can also be regarded
as wholesale price as opposed to the retail price used in realisable value in the
ordinary course of business.

To take over a partly completed project is very complicated which an investor would only be
attracted to if the return offered was quite high. As pointed by Whipple (2006, p. 445),

“The current status of all contracts, payments made thereunder and yet
to be made, planning and other consents, labour relations, perceptions
by potential buyers of the finished product and the difficulty in identifying
contingencies are all problematical.”

It is of utmost importance for a valuer to have extensive knowledge about local real estate
in valuing an incomplete project. A valuer has to look into various aspects such as the
physical conditions of the projects and its surroundings, the contracts and agreements with
the contractors, tenants, financials, and various consultants, as well as the market
conditions. Highest and best use analysis is conducted to ascertain what went wrong with
the project, thus a good understanding of the real estate market is a must. The business
experience and knowledge of a valuer are critical to assess the project’s worth.

ACTIVITIES

1. Revise your studies on DCF analysis and Excel spreadsheets. If you find that your
skills and/or understanding are lacking, set yourself the task of becoming a skilled
practitioner – you will be more employable in the property industry and in business
generally.

2. Practice designing your own spreadsheet using hypothetical data, then conduct
sensitivity and scenario analysis until you are confident about what you are doing.

READING FOR MODULE 5

Chapter 10 of text book (Real Estate Finance: Background )

Chapter 11 of text book (Real Estate Finance: The Basic Tools.)

Chapter 13 of text book (Stage Three: The Feasibility Study)

Page 15 of 17
REFERENCE

Whipple, RTM 2006, Property valuation and analysis, Thomson Lawbook Co. NSW, Australia.

Miles ME, Berens G, Eppli MJ & Weiss MA 2007, Real Estate Development, Principles and
Process, 4th edn, Urban Land Institute. Washington

O’Roarty, B 2009, ‘European value added investing: leveraging structural and cyclical real
estate opportunities’, Journal of European Real Estate Research, vol. 2, no.1, ,pp. 79-104.

BIBLIOGRAPHY

Stansa RC 1997, ‘Distressed property analysis, in Maurice Squirrell’, Readings in property

economics, Australian Institute of Valuers and land Economists, Deakin, Australia.

Page 16 of 17