The Economics of Property & Construction

© The College of Estate Management 2009

Paper P0340V2-0

Profit in property: Development

Contents

· Introduction

· The nature of development

Why development takes place

Development in the private and public sectors

Function of the developer

· 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

Buildings as the addition of capital to land

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

h The rate of redevelopment

§ Method of approach

§ Changes on the demand side affecting rental income

§ Changes on the supply side affecting operating costs

§ Building costs

§ Relaxation of assumptions of a perfect market

i Conclusion

Activities 3

Profit in property: Development Paper 0340 Page 3

1 Introduction

The pursuit of profit shapes behaviour in goods markets and factor markets. The marginal principleintroduced in introductory economics applies to output decisionsin 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.

Profit in property: Development Paper 0340 Page 4

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.

Profit in property: Development Paper 0340 Page 5

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 ofprofitable 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 hasplanning 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:

FSR =

units of floorspace

turnover at current prices.

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.

Profit in property: Development Paper 0340 Page 7

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:

320,000

:

49,000

= 20:1

16

49

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.

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