Start with a Feasibility Study

A feasibility study is an analysis of how a property development project can be successfully completed. It is done when searching for opportunities. The aim is to get yourself in a position to appoint the right team, to deliver the right product, in the right location.

A.        Real Estate Cycles

We live in a world of booms and busts – see them as changing financial seasons. The economic seasons of spring and summer are phases characterised by business expansion. It is followed with the cold winds of autumn and winter recessions. It is important to identify which stage of the cycle you are operating in and the supply and demand cycle for real estate assets.  

B.        Competitive Market Position

The aim is to understand what makes the area distinctive, what are the sources of dynamism in the economy and the accessibility of the location. In our student housing developments, the first money we spent was to instruct a demand report. This detailed the characteristics of the universities around the site. The number of students and whether these numbers were growing. It provided an analysis of the supply of bedrooms that would be the competition to our scheme being fully occupied. 

C.         Political and Regulatory Environment 

There are controls on building activity by the public sector. These controls are acts of law such as the UK’s Town and Country Planning Act. This established the need for planning permission to be granted before development begin. The government require local authorities to prepare a comprehensive local plan, showing how it wants the land to be used. The USA has less national-level land use legislation with greater focus on State controls. It is the concept of zoning which is the main form of land use control.

A thorough knowledge of local government planning policy is needed. It is very difficult to make a scheme work which is in conflict with their strategy or even law. These policies are updated periodically. The skill of being able to anticipating which areas, your project may fall in, or out of favour, is key in obtaining political support and approval.

D.        Development Appraisal

Then the math. You need a cash flow projection to assess the viability of the scheme. It will estimate the amount and timing of the financial return. It will need to include a breakdown of the development and construction costs to complete the project. The projections should be tested under different scenarios. Such as the construction cost increasing by 10% or values/revenue falling by 5%. The aim is to have a robust business plan.

E.         Think like a Banker

You need an outline plan to fund the project, and focus on the downside protection. Have a strategy that increases certainty for a funder. A bank is concerned about available cash and payment of debt service cost. How extreme are your assumptions to make the project reach this breaking point? Have a plan to restructure the deal if it starts to go wrong. For our student housing developments, we focussed on an alternative use valuation. This involved remodelling the rooms into family apartments and selling them to pay back the debt.

F.         Write the Report

There are many templates to follow when writing a feasibility study, such as SWOT. This reviews the internal strengths and weaknesses and the external threats and opportunities.  

Making the Investment Decision

Valuations of assets are subjective and when making an investment decision, you need to escape merely the financial. You need to use your own judgment, to find what is scarce and valuable to you, and suitable to your ends.

A.        Setting Strategy

An investor outlays capital to produce an income. For an investment to be worthwhile it must meet strategic goals. An investor need decide on its focus by asking:

·         What it is good at?

·         How the market might change?

·         How customer satisfaction can be delivered?

·         What is the risk-return goals?

·         Are the risks the kind that tend to result in a permanent loss of capital?

B.        Rate of Return

There are different types of professional investor. Each investor will establish their required rate of return on an investment given their risk appetite. The more uncertain a project. The longer it ties up your money. The more it should deliver superior returns.   

Risk Appetite | Investor Category | Rate of Return | Holding Period

Low | Pension Funds | 5% Yield/10% IRR | 20+ years

Balanced | Investment Managers | 10% Yield/15% IRR | 10+ years

High | Private Equity | 15%+ Yield/20%+ IRR | 5 to 10 years

 C.         Cost of Capital

Value is created by earning a return on the investment that is higher than the cost of capital. The cost is calculated by a weighted average, expressed as a percentage of the mix of equity and debt. In this scenario and ignoring tax it is 9%:

          WACC = (cost of equity * % equity funding) + (cost of debt * % debt funding)

          WACC = (15.0% x 40%) + (5.0% x 60%)

          WACC = 9.00%.

Cost of Equity

The cost of equity is calculated by the Capital Asset Pricing Formula: 

          CoE = Risk Free Rate + Beta (Market Rate of Return - Risk-Free Rate)

          CoE = 2.00% + 1.4 (11.00% - 2.00%)

          CoE = 15.00%

The formula takes the risk-free rate of return. This is the return on an investment with zero risk, which is considered to be short term government debt. I have assumed here that if you owned government debt it would pay 2% per annum.

It then calculates the premium for making an investment in a risker market asset (credit risk). This is the stock market return less the 2% which gives a 9% premium.

The risk is evaluated with the Beta coefficient. This measure the volatility of the investment compared with the overall stock market. A value of 1 indicates it would move identically with the market.

For alternative investments, a public benchmark is found in the same sector such as a listed construction company, and a premium is added. For this evaluation the construction company ‘Sterling Construction Company Inc’ has a Beta of 1.36. In our our example we add a premium to get 1.4 and will require a 15.00% return.

Cost of Debt

The cost of debt is the interest rate on bank loans.

Debt is cheaper as it is secured against assets of a company and is a tax-deductible expense. Therefore, maximising the amount of debt should reduce the cost of capital and increase shareholder value. Too much debt however, increases the financial risk.

D.        Evaluating the Investment  

The owners of UPP, Barclays Capital, had two return metrics in evaluating their investment decisions.  

Internal Rate of Return

The IRR evaluated the returns over the investment’s holding period. It indicates the effective ‘interest rate’ earned on the equity. It takes into account the timing and amounts of payments to the investor until all the funds are withdrawn.

The IRR at Reading was 14%. It required a detailed financial model showing the cash flow each year for 50 years.

The rationale behind IRR is if it is greater than WACC (IRR>WACC). The project’s rate of return will exceed its costs, and as a result should be accepted.

Cash Yield

Barclays also evaluated the cash return on the investment in its first year, with a net initial yield (NIY) calculation. This deducts all expenses from the annual rent in the first year. This net income is then divided by the property’s purchase price. For the University of Reading acquisition, the NIY was 6.5%.

Raising the Funds

There are three main ways to finance a real estate development:

 A.        Traditional Development Structure 

A traditional approach involves a mix of equity and debt funding. The developer approaches a bank for a loan. If the bank is interested in the project, it will instruct an independent valuation. The value will be based on the building’s expected rents at completion. It determines how much the bank will lend on the project. As banks are usually not willing to lend more than the 60-80% of the expected value, the developer will need to provide upfront equity injection for the 40-20% balance.

A new special purpose company (SPV) will be set up for the project. The loan will ideally be structured as non-recourse. This means that if the project goes wrong, the loss for the developer is limited to the money they invested. The bank cannot come after other personal assets. If this is not achievable, the developer may have to provide personal guarantee putting everything on the line for the deal!

The SPV will buy the land, pay for the development and construction work. For a speculative build there is no formal commitment from a tenant to rent the space. Instead during construction, a tenant will be secured. The SPV will own the building at completion and refinance the development loan. This new business loan interest payments will be covered by the rental income from the tenant.

B.        Forward Funding Structure

Under this structure, the developer does not borrow money or own the building. It is trading not investing in property. It sells the project to a long-term investor, who provides the short-term financing. To secure an investor, a developer needs an Agreement to Lease from a tenant to lease space in the building before the construction has started. This reduces the risk on the rental income at completion. 

The deal is structured as two contracts. The first is a land contract. The investor will buy the site directly from the landowner. The investor will then sign a Development Agreement with the developer. This contains the obligations on the developer to deliver the building. In return the investor provides the funding based on milestones payments and at completion the developer walks away with the development profit.

Milestone Payments by Investor Amount

Exchange of Contract 10.0%

Start on Site 10.0%

Golden Brick 10.0%

Structural Roof Completion 20.0%

Water Tight 15.0%

Weather Tight 15.0%

Practical Completion 18.5%

Completion of making good defects (12 months) 1.5%

Total 100.0%

The main concern for an investor is the safety of the rental income upon completion. Not all of the space (especially in office construction) will have been pre let to tenants at the start of construction. The investor will therefore look for security from the developer. There are two principal methods. The ‘profit erosion’ method whereby the investor can claw back money. The second is the ‘priority yield method’ whereby the developer guarantees to pay the difference in the expected rent in the first year.

C.         Forward Purchase Structure 

Another trading rather than investing solution, but the developer takes out bank financing. A developer enters into an agreement with an investor or prospective owner-occupier to buy the building who puts up 10% deposit and the remaining 90% at completion. The developer borrows the money to fund the development and construction costs. The developer has ownership of title. The bank has a guarantee from the purchaser, that their short-term finance will be taken out on completion.