DAFRES (URBAN5115)

The Economics of Development Decisions

Dr Tunbosun Oyedokun
 Main ILOs

▪ Explain the economic rationale and the theoretical basis for real estate
development decisions.

▪ Apply relevant models to evaluate the viability of real estate developments and
value of development sites.
 What is property development?

▪ …creation of new buildings as well as the

substantial conversion, alteration, expansion
or modernisation of existing buildings.

▪ …the process of improving the productivity of

land through the reallocation of land to its most
profitable use
 Owner occupied vs. commercial property dev.

Owner occupied Commercial

▪ Also called bespoke building ▪ Purpose-built for profit-making
▪ Built and occupied by the owner ▪ Initiated by trader-developers as short-term

▪ Not for direct rent or capital income, investment for capital return or investor-

although owners can let portion developers as long-term investment for

▪ Mainly to enhance asset base rental income

▪ Contribute to corporate business ▪ Involves outright sale, letting or ‘lease-back’

performance after completion

▪ Development process is similar to ▪ Financial appraisal considers real estate

commercial, but no letting or market and impact of local economic

investment sale conditions

 Owner-occupied development

▪ Gogarburn, Edinburgh
▪ Commissioned by RBS as their new Headquarters
▪ Completed in 2006
 Commercial developments

▪ Example of a speculative
development
▪ Comprising of 10 buildings
▪ Totalling 756,000 ft2
▪ BREEAM Very Good
▪ UK’s largest speculative office
park development
▪ Commercial developments will
be our focus on this course

Maxim Office Park Motherwell, ML1 4WQ


Real property market factors
▪ Private sector property development
activity depends on current real estate
market condition
▪ Increment in demand from the
investment and occupier markets
▪ Increasing net absorption and rental rate
▪ Contrasting yields and rising prices
Drivers of development
Exogenous factors
▪ Macroeconomic environment e.g., GDP,
interest, exchange and inflation rates,
employment, size and nature of local
economy, income level, etc.
▪ Demographic structure e.g., population,
age and family size, etc.
▪ Political decisions e.g. tax policies,
planning and housing policies, political
uncertainties, etc.
▪ Change in user requirement and
obsolescence (which can be economic,
functional or physical)
 Questions facing developers

▪ The main questions developers want to answer are:

✓ Should we develop?
✓ What is the profit margin?
✓ How much can we safely spend on construction?
✓ How much should we offer to buy the site?
▪ Financial feasibility study helps to ascertain cost and revenue prospects of proposed
commercial real estate developments
▪ If appraisal says YES, go ahead and develop, if NO, abandon or delay development
Feasibility in the development process
 Economic rationale for private-sector development activity

When should a developer build?

n
Rt − Ct
The value (or net present value of property n (Pn) Pn = 
t =1 (1+ r) t

where R is annual rental income and C annual building operating cost

This applies to the valuation of all completed income-producing developments

Greenfield development site
 Economic rationale for greenfield development site

n
Rt − Ct
▪ Using the completed value equation Pn =  (1+ r) t
t=1

▪ Then it would be viable to develop a greenfield site when the value of the proposed
development (while allowing for development/building costs (Bo)) > 0

n
Rt −Ct

t=0 (1 +r) t
− B0  0
Brownfield development
 Economic rationale for brownfield development or
derelict buildings

Redevelopment of brownfield site is viable when NPV of the proposed new use (while
allowing for development costs (Bn) and demolition of existing structures (Dn) at time
point n) > NPV of old/existing use.

Rt' − Ct'
x
Rt − C t

x'

 (1+ r) t −n
−B'n − Dn 
'

t=n
(1+ r) t −n
t=n
 Using comparison method to estimate yield

▪ This involves three stages:

▪ Finding a comparable investment or property

▪ Estimating the rate of return on the comparable property

▪ Adjust upward or downward to reflect risks

E.g. A shop recently let on a lease at £20,000 p.a. (net of outgoings) was sold to an
investor for £210,000.

In appraising a similar property, a discount rate of return of 9.5% (plus/minus) will be

adopted.
 Estimating development value

▪ Valuation is the art and science of determining the

“amount for which a property should exchange on the
valuation date between a willing buyer and a willing
seller in an arm’s length transaction after proper
marketing and where the parties had acted
knowledgeably, prudently and without compulsion”

▪ Valuation usually applies to existing use value,

different from appraisal which applies to properties
with development potential

▪ In development appraisal, value is calculated as

though the property has been built
 Comparison method

▪ Considered as the simplest and most reliable

▪ The method entails making a valuation by directly comparing the property
under consideration with similar properties which have been sold or let
▪ The three main requirements of property comparables are:
✓ Similar type or use to the subject property
✓ Similar location to the subject; and
✓ Evidence obtained is recent and reflects current market conditions
▪ Each property is unique, and allowances must be made for the differences
between the subject and the comparable properties to reflect the differences
▪ Differences (e.g. in size, quality, street, etc.) may lead to upward or downward
review
Profits (Revenue) method
 Investment method

▪ Used when properties generate a rental income for the landlord, and sometimes the
tenant

▪ It is typically used to value shops, offices, factories and warehouses

▪ When the rental income paid by the tenant to the landlord is at the current Market
Rent (MR) we say this property is “fully let” or “rack-rented”

▪ Method:

Market Rent (MR)

less Outgoings (% of MR)

equals Net Income

times YP perp (Present Value of £1 p.a. @ k% in perpetuity)

equals Capital Value = Market Value

(where k = investment yield)