How to Develop Property minus the Pitfalls = International Best Practice Models
Valuation errors and misconceptions in the Real Estate Industry when planning a development.
Historical sales statistics are commonly and incorrectly used as a valuation mechanism of choice amongst the majority of practitioners, and this can lead to incorrect CURRENT MARKET VALUATIONS. Historical sales stats, whether it be for Commercial or Residential Properties come about in a different economic climate to that of today. These stats also come about in a different interest rate cycle and there are countless internal sales between owners and their entities which skew the figures produced as they re-position or alter their gearing arrangements. Historical sales stats simply cannot account for the supply and demand of stock at that historical date.
How Buyers Value Property - you must be competitive with all other properties on the market currently!
Buyers view all the available stock on the market currently, in the areas or locations that they have an interest. With the amount of data that they have available, the buyer will quickly reduce the current properties on the market to a “per square meter” or “square foot” pricing, and weed out the overpriced stock. The buyers of today are probably, in most instances more informed than sellers because they are about to make an investment. A CURRENT MARKET VALUATION is equal to how your property stacks up against all other CURRENT PROPERTY on the market today. If you are not competitive with current listings, then you are ON the market and not IN the market. our message is to avoid historical stats when performing a current market valuation because you are not competing with history, you are competing with all the other listings on the market today!
Types of Developments have different risk factors:
There are many different types of development. Some of which will produce cash flows sooner than others. The time that it takes to produce cash flows or become an income-generating asset can vary between development types. The longer it takes, naturally your risk will go up as you become more exposed to the unknown factors and possible changes to the market conditions presently. You may also benefit, however, it would be foolhardy to not recognise time as a factor that you need to be aware of and make more provision for swings and roundabouts.
Time Value of Money - can be costly!
We find the most common and avoidable error when evaluating a development proposition is the overreliance on Gross Profit predictions without making proper use of (TVM) time value of money. There are International accredited formulas which are a must when evaluating real returns and in a nutshell, developments, in particular, should make use of XIRR and XNPV which are easy formulas that consider future dates of cash flow and the time value. These formulas are technically the equivalent of IRR and NPV respectively, but they are able to account for different cash flow amounts on different timelines. The standard IRR, MIRR and NPV all require consistent cash flows on consistent timelines. A gross profit of 10 000 000 over a 3-year period is vastly different to a gross profit of 9 000 00 over a 12-month period. The sensitivity of delays should also be considered with sufficient margin to absorb the interest over an extended period. Funders of any kind will always look at how many times your XIRR will beat the hurdle rate to provide sufficient cover for cost and time overruns.
Always Use Financial Models to consider the Capital Gains Tax effect when holding Residential or Commercial Property for long-term lease or rent.
Developers, Individuals and Investors that transact on a “buy or develop to hold and lease” should always make use of a financial model that considers and factors in the CGT liability that comes with the exit value. Most states, and countries have Capital gains Tax at various levels for Investment Property and when you consider the effects on your exit values, it changes your IRR, MIRR and NPV enormously. We find that many private and individual investors will perform some type of valuation as to how the investment property will perform over the next few years, but again, the IRR and MIRR must beat the hurdle rate sufficiently, and not have a model that predicts the CGT liability has a profound effect on the exit value and consequent IRR and MIRR results.