Real estate development risk

Whenever we’ve had land buyers and developers talk to our students about development risk, they always emphasise that the major source of cost uncertainty is usually underground rather than above the surface.  There was a good piece by Hugo Cox in the FT recently outlining some of the types of problems that can occur in redeveloping old sites and historic buildings.

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The value of park life

It’s not as catchy as the Blur tune but…for anyone interested in the mysteries of valuing parks or the effects of parks on property values etc.  Fields in Trust have produced a very thorough research report that probably fails heroically to work out what financial value they contribute to the community.  I suspect that Joni Mitchell would have something to say

Don’t it always seem to go
That you don’t know what you’ve got
Till it’s gone

 

Affordable housing: increasingly blurred lines? 

The privatisation/commercialisation/marketization of the affordable/social/non-market housing sector seems to be changing gear.  As housing associations have been competing head-to-head with volume housebuilders for housing sites, private equity groups are now entering the non-market housing sector.  Aime Williams in the FT has a good piece on the shift.

Lawyers acting for the National Housing Federation have raised objections prompted by Blackstone’s acquisition of a 90 per cent stake in Sage Housing, which describes itself as a “for profit” social housing provider. The move late last year has given Blackstone a way to bid for, and then rent out, the large blocks of apartments that property developers are obliged to classify as “affordable” homes, in competition with traditional housing associations…British Land, the UK’s second-largest listed developer, set up its own “for profit” affordable housing provider about a year ago, while Legal & General, the insurance company, announced its plans to launch one in recent weeks.

These “for profit” non-market housing providers have been around since 2010.  It seems to be taking off now.   It would be interesting to know what the business model is here.  Given the growth of impacting investing, SRI etc., it could be just product creation with a view to collecting asset management fees?  With borrowing rates low and fairly secure income streams available, long term, inflation-linked geared returns could be attractive on a risk–adjusted basis?  Legal and General stated that they would be seeking returns that could be compared to those expected by a housing REIT, which have been targeting around 5 per cent.

Viability: ever increasing circles?

Following on from yesterday’s post…In it I mentioned that the High Court Judge was pretty keen on analysing and adjusting comparables (the prices for other sites that have been sold) in order to establish Benchmark Land Value.

It’s worth first re-iterating why this is so important.  The NPPF requires that in assessing whether a policy (and the application of a policy on a specific site) affects the viability of development, the proposed policy (or its application…) must allow for a competitive return to the land owner.   Typically it’s a zero sum game – the more that goes to the land owner, the less there is available for social housing and other community benefits from development.

Justice Holgate put great stress on the need to make adjustments to observed prices on other sites when using them to demonstrate what (competitive return?) other land owners were getting for their sites.  Other sites may have very low levels of social housing, have lower costs, have higher densities or be in higher value areas.  The judge seemed to be stating that adjustments needed to be made in order to take these factors into account in order to see what signal of price levels (competitive return) was being sent by these transactions – and then to estimate the BLV.

The only way that I can think of do this is to try to estimate the costs and revenue assumptions that produced the transaction price.  The next step is to change them so that they are the same as proposed scheme that is the subject of the viability appraisal and see what the resultant land value is.

This is a pretty futile exercise.  We’re basically saying that if the site that was sold was identical in expected revenue and cost terms as the site with the proposed scheme, then they would have the same value.  Basically, if we assume that the comparable site being analysed is the same as the site with the proposed scheme, they’ll have the same land value.

Let’s strip it back to basic principles.  Let’s say that we have two nice, ‘clean, serviced and developable’ greenfield sites next to each other.  Both have an Existing Use Value of £20,000 per hectare.  With planning permission etc. and 25% affordable housing, one has just sold for £3 million per hectare.  This was permitted before the local planning authority introduced a new policy requiring 40% affordable housing.  Given that development costs and house prices have been hypothetically stable, using their highly consistent appraisal techniques, valuers think that the site would have sold for £2 million per hectare if the affordable housing proportion had been 40%.  What’s a competitive return to the land owner (the Benchmark Land Value)?  £2 million per hectare?

We would have estimated £2 million per hectare if we’d ask the valuer to value the unsold site assuming 40% affordable housing.  Adjusting the comparable would be pointless.  Since the same values, costs, profit levels and planning obligations are being assumed, the sites would have the same value.  If we have two sites and then adjust sale prices of one to take into account all price, cost and policy differences, then we’ll get the same value per unit of area for each site.

Where does this leave us in terms of estimating a competitive return to the land owner?  All the acknowledged and unacknowledged circularity problems mean that prices of other sites are not useful in estimating a competitive return to the land owner.  As ever, the return to the land owner is a political decision.  It is inherently a policy choice.

We need to untie this Gordian knot.  My own view is that, if you accept the pre-eminence of private property rights in a mixed economy,  you need to incentivise land owners to release land.  I would say that they should get a similar profit level to the developer.  20% of GDV to the land owner seems a simple and flexible approach to me.  Problem solved.

Viability: complete circularity in Islington?

I’ve written before about how the Parkhurst Road application has become a seminal case in viability appraisal.  Following the dismissal of the last planning appeal, the developer took the matter to the High Court who have produced a lengthy judgement.  The High Court judgement effectively endorses the Inspector’s analysis provided in the previous appeal decision.  It’s been a long and drawn out saga.

Justice Holgate’s judgement is particularly interesting on the topic of Benchmark Land Value.  My interpretation of his interpretation is that he was particularly exercised about the circularity problem in using market transactions to estimate a competitive return to the land owner.

It does not follow that, merely because an analysis is based upon a substantial amount of market evidence, the conclusions drawn will be untainted by the circularity problem. That will depend upon whether the transactions in the data base adequately reflected, for example, the requirements of relevant planning policies and, if not, the adequacy of the steps taken, if any, to adjust that information to overcome that problem.    

BLV should also be informed by market value, having regard to the extent to which it is possible to achieve sufficient comparability and the need for proper and transparent adjustments to render any comparisons valid and to accord with paragraph 023 of the PPG and RICS guidance…

Such data should be adjusted (subject to any issues about reliability and cross-checking). A failure to obtain adequate information about comparables relied upon (including the planning context and circumstances influencing bids and the transacted price) would not be acceptable where development appraisal or viability is dealt with in the Lands Chamber or in an arbitration, and it is difficult to see why the position should be different where the same type of issue arises in the present type of case.

“Adjusting the information“ raises interesting methodological challenges about the interpretation of comparable evidence from land transactions.  Sites will vary in terms of abnormal costs, sale values per unit of space, density and planning obligations – nevermind timing of sale.  Working out a, let’s call it, “effective land value” would not be easy.  It would require the valuer to estimate the price that the sold site would have sold for if it had been in the same location as the proposed scheme with the same density, same costs and same planning obligations at the current date.  I’ll work on it…but I suspect that there may be some intractable issues.

Usually in order to criticise the evidence of the appellant’s valuer, Robert Fourt (the appellant’s valuer) was mentioned several times by Justice Holgate.  The RICS’ guidance on viability (a draft of a new, updated version has been argued about within the discreet, deliberative arenas of the RICS for several years) was supported by the judge but its application by Fourt was implicitly critiqued.  Justice Holgate concluded that

It might be thought that an opportune moment has arrived for the RICS to consider revisiting the 2012 Guidance Note, perhaps in conjunction with MHCLG and the RTPI, in order to address any misunderstandings about market valuation concepts and techniques, the “circularity” issue and any other problems encountered in practice over the last 6 years, so as to help avoid protracted disputes of the kind we have seen in the present case and achieve more efficient decision-making. (Actually – this has been happening). The High Court is not the appropriate forum for resolving issues of the kind which the Inspectors dealing with the Parkhurst Road site had to consider. It is very much to be hoped that the court is not asked in future to look at detailed valuation material as happened in these proceedings.

You could write a PhD on the role of Fourt and the RICS in the viability guidance issue.  Fourt has been closely involved on the various committees involved in producing viability guidance (RICS and Harman), has appeared to give expert evidence to government bodies like the GLA (he has often literally been the right-hand man of the RICS’ officer – Tony Mulhall), has appeared at numerous events promoting the guidance that he has been instrumental in drafting and been using that very same guidance to justify the approach taken by him in viability appraisals for the firm that he is a senior partner in – Gerald Eve.  It raises lots of interesting issues in terms of institutional governance and personal ethics.

The RICS are faced with a dilemma in drafting new guidance of this kind which can have commercially (and socially) significant consequences.  Their members tend to have the technical expertise required to produce appropriate technical guidance but they also may have vested financial interests in the nature of the guidance given.   How to ensure that professional guidance is independent?

My long-held, personal view is that, with its various vested interests and biases, the RICS should never have been let near the question of what a “competitive return” to a land owner should be – and nor should any other professional institution.   Inherent in this issue is the distribution between land owners and the community of the land value uplifts ‘released’ by a planning permission.  This is essentially a political choice rather than a technical valuation issue.

Sustainable real estate: dirty laundry

John Authers in the FT highlights a fairly old piece of work that I was unaware of.  It’s a study by a group at London Business School that finds a widespread and long term outperformance of sin stocks.  It takes a very long term horizon and looks across a wide range of countries.  They investigate, measure and try to explain this sometimes huge outperformance

…if a large enough proportion of investors avoids “vice” businesses, their share prices will be depressed…offer a buying opportunity to investors who are relatively untroubled by ethical considerations…The paradox, then, is that depressed share prices for what some regard as noxious and nasty businesses may demonstrate that responsible and ethical investors are having an impact on the value of a company whose activities conflict with social norms. If so, the shares will ultimately sell at a lower price relative to fundamentals. For example, they may trade at a lower price/earnings or lower price/dividend ratio. Buying them would then offer a superior expected financial return which, for some investors, compensates for the emotional “cost” of exposure to offensive companies.

Interestingly and with a more recent perspective, they go on to investigate a strategy of active asset management.  They focus on three potential strategies:

  1. Invest in vice and virtue stocks and hold them passively
  2. Do not invest in sin stocks and only invest in virtue stocks
  3. Invest in vice stocks and try to make them more virtuous

They find that there is a lot of potential investment performance gains in a ‘washing machine’ model – Model 3.

This could well be a strategy that could be the most effective in improving the environmental performance of the commercial real estate stock.  An active asset management model could involve acquiring ‘dirty’ real estate at (appropriately) discounted prices and ‘repositioning’ them (change the building structures, the hard services, the soft services, the leases, the operational management, the behaviour of the users etc.).

Could this be a more responsible and profitable investment strategy than simple selling or screening out ‘dirty’ assets?

Regulators captured?

The Guardian is persisting with their work on the issue of involvement of current and ex-councillors are lobbyists in the development and planning sector.  They seem to be putting some serious research and resources into the topic.

Almost one in 10 councillors in London either work for property businesses or have received gifts or hospitality from them, a Guardian investigation into the depth of links between town halls and the property industry has revealed.

Nearly 100 councillors in the capital work for property companies or lobbying and communications consultancies involved in planning, according to declarations of interest made by elected representatives. Some of them also sit on planning committees making decisions over major developments, including volumes of affordable housing.

With so much potential financial gain from fairly discretionary and subjective political judgements, some with specialist knowledge, information and expertise in this decision-making process are going to find a way to monetise it (ugly phrase, I know) in some way.