Nov 6, 2017 in Economics

The Economics of Speculative Property Development

Questions on Economics of Speculative Property Development

Question A

Formally a police hostel – the old building that has stood empty for over eleven years – has been earmarked for demolition to pave way for a new project – Trenchard House. Due to the increasing housing needs of the residents, as well as the need to provide world-class facilities to meet business needs, Barrett Developments PLC has undertaken to build a building along Broadwick Street to meet these demands. The new building is planned to house about 65 affordable rent apartments for the middle-class individuals who are looking for cheaper but world-class homes and a further thirteen apartment house developed exclusively for private persons. It will also contain retail on its ground floor for business purposes and an underground floor space, as well (Deakin 2004). 

With its strategic location, at the heart of Soho and close to Berwick Street Market, the building will provide excellent features to its beneficiaries. Accessibility is one of the key features incorporated in the design and development of the project since it is conveniently located within a short distance from the underground stations. Its residents will also benefit from the anticipated Crossrail project which will be ready by 2017. Trenchard House is expected to be underway in autumn 2012 and be taken up by potential occupants in autumn 2014 – a period of two years.  It is expected to reach a market value of over £4,000,000. Moreover, it is estimated to generate revenue streams of £1,320,000 annually in terms of collected rents. The location of the project is Broadwick Street where property houses cost an average £589,000 per flat, and the average cost of a property according to figures from the last five sold houses in the area stands at £3,850,000. The project is poised to fetch about £4,120,000 from market sales (Zhu 1999).

To arrive at these figures, the amount of funds used to purchase the land on which the project is to be constructed was considered. The land, on which the old police hostel stands, will cost £1,512,000 including demolition expenses. The construction of Trenchard House is projected to be expenses amounting to £3,492,824 which include construction expenses totalling to £1,680,800, and other costs such as administration costs of about £200,024. Upon completion, tenants will occupy the building which will generate an NPV amount of £1,320,000 up to thirty years. After completing repayments of the funds invested in the building, it can be sold to any buyer: for instance, a pension fund, at a market value of £4,120,000. This will generate a discounted surplus amount of £732,176, (£5,440,000-£4,707,824).

Question B

Trenchard Houses expected cash flows are given in the table below. It is assumed that the cash flows for management as well as those of maintenance will assume a rising trend a little higher than the current inflation rate. Main repairs on the project will be financed by a measured start system of fund allowance that is provided in the cash flows. The system is presented as being financed by a mortgage to be repaid at a rate of 5.2 percent interest for a period of thirty years with annual instalments of £84176. The following table shows all the cash flows from 65 affordable 1 bed flats and 13 private apartments financed by:

CAPITAL EXPENSES

 

FINANCED BY

Acquisition

£1,512,000

 

Grant

£2,227,796

Works

£1,680,800

 

Private finance

£1,265,028

On Costs

£300,024

     

Total Costs

£3,492,824

 

Total Receipts

£3,492,824

         

Period in Years

Gross Revenue from Rent

Voids

Administration

Maintenance

Main Repairs

Net Revenue from Rent

Interest

Closing Loan Due

1

87,956

-3,518

-7,612

-9,882

0

66942

-65,782

-1,263,866

2

91,898

-3,676

-7,840

-10,178

0

70204

-65,722

-1,259,384

3

95,960

-3,838

-8,076

-10,484

0

73562

-65,488

-1,251,310

4

100,144

-4,006

-8,318

-10,798

0

77022

-65,068

-1,239,356

5

104,452

-4,178

-8,568

-11,122

0

80584

-64,446

-1,223,220

6

108,890

-4,356

-8,824

-11,456

-5,836

78418

-63,608

-1,208,408

7

112,670

-4,506

-9,090

-11,800

-6,010

81264

-62,838

-1,189,980

8

116,050

-4,642

-9,362

-12,154

-6,190

83702

-61,878

-1,168,158

9

119,532

-4,782

-9,642

-12,518

-6,376

86214

-60,744

-1,142,688

10

123,118

-4,924

-9,932

-12,894

-6,568

88800

-59,420

-1,113,308

11

126,812

-5,072

-10,230

-13,280

-13,528

84700

-57,892

-1,086,500

12

130,616

-5,224

-10,536

-13,680

-13,934

87240

-56,498

-1,055,758

13

134,534

-5,382

-10,852

-14,090

-14,352

89858

-54,900

-1,020,800

14

138,570

-5,542

-11,178

-14,512

-14,784

92554

-53,082

-981,328

15

142,728

-5,710

-11,514

-14,948

-15,226

95330

-51,030

-937,028

16

147,010

-5,880

-11,860

-15,396

-23,526

90348

-48,726

-895,406

17

151,420

-6,056

-12,214

-15,858

-24,232

93058

-46,562

-848,908

18

155,962

-6,238

-12,582

-16,334

-24,958

95850

-44,144

-797,202

19

160,640

-6,426

-12,958

-16,824

-25,706

98726

-41,454

-739,930

20

165,460

-6,618

-13,348

-17,328

-26,478

101688

-38,476

-676,720

21

170,424

-6,816

-13,748

-17,848

-36,364

95648

-35,190

-616,262

22

175,536

-7,022

-14,160

-18,384

-37,454

98516

-32,046

-549,792

23

180,802

-7,232

-14,586

-18,936

-38,578

101472

-28,590

-476,908

24

186,226

-7,450

-15,022

-19,504

-39,736

104516

-24,800

-397,192

25

191,814

-7,672

-15,474

-20,088

-40,928

107652

-20,654

-310,194

26

197,568

-7,902

-15,938

-20,692

-42,156

110882

-16,130

-215,442

27

203,496

-8,140

-16,416

-21,312

-43,420

114208

-11,204

-112,438

28

209,600

-8,384

-16,908

-21,952

-44,722

117634

-5,846

-650

29

215,888

-8,636

-17,416

-22,610

-46,064

121162

-34

120,478

30

222,364

-8,894

-17,938

-23,288

-47,446

124798

6,264

251,540

NET PRESENT VALUE

Using the net present value method, the viability of investing in Trenchard House is obtained as follows:

Surplus revenue= NPV on net revenue from rent and sales – the funds invested in the project.

The NPV of net revenue collected from rents from Trenchard house is arrived at by discounting the values for net revenues at a given discount factor: say 5.2 percent for a period of 30 years. The amount obtained is £1320000. The amount of private funds contributed to the project is £1265028.

Surplus revenue=£1320000-£1265028=£54972.

This figure of Net Present Value shows the amount of money the project will generate to repay the funds invested in it. NPV is preferred as a method of evaluating viability because it is suitable for large-scale projects, as well as its inclusiveness of the cost incurred in borrowing funds for investment by the use of a discount factor. The amount obtained – £54972 – demonstrates that the project’s financial requirements can be met sufficiently by the returns generated from the same project (Risebero 1985).

The surplus is an indicator that the grant amount will be reduced by £54972 and the project will still remain viable. If it had been a negative figure, it could mean that additional amount of money in form of subsidy would have been required to ensure that the scheme remains viable.

Question C

There is every chance that the project might not collect enough money from rent revenues to offset the money borrowed for its construction. If a property is not built by a reputable builder, it does not make a name and ends up losing its image and appeal to the tenants. This impacts negatively on the rate at which it generates revenue used to cover interest charges and loan repayments. If the project records a lot of voids in its lifetime, it will be under producing; thus its efficiency in utilizing the resources invested in the project would be poor. The financial appraisal should be thoroughly done to insure that the project is on course to effectively and efficiently utilize the resources invested in it (Boyes 2011).

The location of the building is a major factor in determining the success of the project as projected by the investors. For the project to yield returns maximally, its location must be in an area where there is a demand for the features that the house is offering. It should be convenient to such facilities as social amenities and accessibility by good road networks. The investment must focus on the long-term and not short-term side of the investment to ensure that overall returns exceed the amount used in the project. There is a need to set the rent amount carefully so as not to overcharge clients, as well as avoid generating lesser than the projected amounts. A high amount of rent means a lot of voids; while charging a fair amount could lead to less voids and a more stable income.

Basically, a project faces risks that mainly emanate from the ability or failure of its management to deliver. If the management becomes corrupt and misappropriate funds meant for the completion of the project, it will definitely collapse. The management must utilize the allocated funds wisely and according to the pre-planned schedule in order to accomplish the project. Furthermore, it is paramount to consider the availability and use of quality materials to avoid developing a substandard project that might lead to losses in case it collapses. This will also ensure that the project is durable and therefore will guarantee the customers a return on their money as well as boost the image and reputation of the company (Kant 2005).

In addition, the builder-company needs to avoid the risk of shoddy work by ensuring that it hires qualified personnel to oversee the development of the project from its inception till completion to make it appealing to the potential customers. The management needs to plan the construction well in advance to avoid the risk of losing revenue due the incremental costs that arise from the delay of the completion of the project. One of the main causes of delay in project completion is the time it takes liaising with the authorities during the project development and execution. Advance planning allows enough time to fulfil all the requirements imposed by the authorities, especially the government.

Question D

One of the risks faced by this project is the threat posed by the sharp increase in overseas investments making the housing market in London distorted. Extremely rich individuals are rapidly raising their housing investments abroad thus crowding out locals by driving up house prices to unaffordable levels that the locals can not manage to compete. Even with the high stamp duty rates, most new homes are mainly bought by the foreign investors. About three-fifths of sold houses in London are now in the hands of investors from outside of the UK who mostly keep the houses empty.

With this trend expected to continue, the risk of another ‘housing bubble’ is likely to occur. Investors are increasingly being attracted to the London property market in spite of the high rate of stamp duty being high causing the likelihood of a dysfunctional market in housing. The local people find it more difficult with each passing day to find a house to buy since the outside buyers are increasing. As a result, this might create a soaring demand which will, in turn, push the prices of houses high. Such a situation is very risky since it causes disequilibrium in the market. A high-price market for homes will lead to a fall in the proportion of homes owned by the locals, making a bad situation grow worse. Consequently, the current home ownership figures show a significant dropping trend in the number on houses bought by locals. Most buyers are overseas investors who mainly buy houses for the sole motive of business. The authorities should re-evaluate the policies surrounding the way business is conducted to ensure the fundamental principle of shelter comes first in housing since treating houses like trade commodities denies the people the basic need of shelter (Frank 2005).

Increased investing in the house market by overseas investors has far-reaching effects on the industry. They cause a distortion of the demand and supply forces that run the economy. If house prices continue growing, they pull along with them the rest of the sectors in the economy such as food prices. The overall effect would be an economy with high inflation rates, unstable exchange rates manipulated by speculators and high prices, which will totally ruin business in the country.

A research on the pricing of homes indicates that London has the highest prices in the country which are set to rise even more. This trend is worrying since the demand created by the increasing foreign investors is set to push these prices to the level even higher beyond the rich of most common citizens who are after affordable housing. In contrast with England, house prices in London have continually risen in the past forty years and affordability is increasingly eluding most people.

The presence of speculators in the housing markets has made the situation worse because they create a virtual demand and supply of homes leading to disequilibrium. Unless this is arrested by the authorities, the market will continue being dysfunctional. There is a necessity to put mechanisms in place to gather information and data more efficiently, and analyze it to produce the best policies on how to manage the market. The authorities also need to analyze the effect of the overseas investors on the market carefully and keep these effects under control to ensure a fair and competitive market by the use of regulation and taxation (Frank 2005).

Some of the external factors affecting the project include the political climate in the country, the level and stability of industry, and the economic conditions in the country. In recent years, just like in many countries, developers have had to deal with the risk of terrorist attacks targeting their buildings, especially those that house government departments or NGO offices. Such attacks pose a great risk since they might destroy a building completely or affect its reputation, and hence reduce the amount of revenue it can generate. The environment assumed by the industry during the timing of the project as it will affect labour and material costs which will have a major weight on the entire project, particularly its returns. The costs of bringing up the project will adversely be affected by the prevailing economic conditions. If the project is undertaken during a period of high inflation or recession, it is likely to give a wrong impression to stakeholders regarding its true worth and cost.

Recently, there have been a lot of riots and protests in the streets of London as more and more groups of people turn to the streets to demonstrate against various issues. The violence and harassment that these protesters use to pass their massage has always portrayed the city as bad for business. The police have to use a significant amount of force to contain the crowds. It is risky to do business whenever there is no calm and peace.

Question E

This project is financed by a grant of £2,227,796 and private fundsamounted of £1,265,028. By use of accurate appraisal schemes, the effectiveness of the invested funds in producing returns is revealed. The effects of the scheme in both the short and long term are adequately predicted. This project’s estimated cash flows show that it is likely to produce initial stream of gradual revenue from the onset of the project, which will be expected to contribute to the firm’s profitability, though the loan amount needs to be paid by this revenue.

Whilst the amount to be used in financing this project will decrease the volume of resources held by the company, the revenues generated from the project will go a long way in increasing the net worth of the company, as well as generate attractive returns on the shareholders’ funds. The shareholders are looking for returns on their funds, and so they will want to know how much the stand to gain form this investment relative to the opportunity cost foregone in not purchasing financial assets in the form of bonds and shares (Dawson 2009).

The NPV calculated for this project proves that the investment will be able to repay the amount of funds invested in it in the long run and still generate positive revenues which will add up to the firms’ overall portfolio.

Question F

Barratt Developments PLC is regarded as the best builder in the UK by most of the people. It is a company that deals with activities mainly revolved around the acquisition as well as the development of land into a particular project. It also designs and develops business premises and residential homes which it sells to individuals and firms. It operates under markets that range from flats, family houses and urban premises for business purposes. It mainly deals with two segments: building houses for families and developing commercial buildings. Trencherd House cuts across these two segments because it doubles up as a commercial project and a provision of homes for families (Edwards 2004).

The building of Trenchard House is one of many projects undertaken by Barratt Developments PLC. In the company’s portfolio, Trenchard House is among the projects that are currently underway with its completion scheduled to 2014. The company lists many underway projects as completed as the ones planned to be undertaken in the future.

Question G

Instead of investing in this project, the amount can be given back to the company shareholders who, in turn, will use it to invest for themselves. The company’s undertaking to invest in this project is based on the projection that the project will yield a return of 5.2 percent or more. If the project produces a return of less than this amount, the shareholders will lose the opportunity to invest in a different firm that would give them a return equivalent to 5.2 percent thus this will be their opportunity cost. The shareholders will want to invest in a project generating 5.2 percent or higher, and so they will either invest in our firm or take the money and invest for themselves in financial assets such as bonds or shares.

The organisation can as well opt to invest within the firm by purchasing a tangible asset other than Trenchard House that would generate the same streams of incomes. This will enable the company to generate enough revenue to sustain it in its daily operations. In conclusion, the building will not only be beneficial to the internal but also to the external management. Furthermore, it will be a strategic point for many stakeholders (McKinney 2005).

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