Viability Matters: A Long Post

I attended a presentation on development viability on Tuesday this week at the RICS. The event was framed around some research that Peter Wyatt and Neil Crosby have done at the University of Reading. There was a strong panel of discussants and a well-informed and sometimes fiery audience. A lot of the issues that I’ve written about before in this blog or elsewhere came out. However, they often came out loudly and clearly. Whilst some of the points merit much more substantial discussion on their own, here’s my list of ten takeaways. I don’t think that it’s me but few of them are positive.

  1. It’s not working! See below.  It was surprising to hear such a pessimistic analysis of the use of viability models from many of those who actually get paid for producing them. One of the reasons why it isn’t working is the inherent uncertainty in the models that then ‘permits’ lots of other undesirable behaviour.  However, whilst it’s hard to argue with many of the criticisms made, I’m not convinced that the problem lies with viability modelling itself. I recently heard Duncan Bowie outline how he pioneered over a decade ago the use of viability modelling at the GLA to show how developers could easily afford to provide 50% affordable housing in central London. (He’s now regretting it.) As I’ve written before, many developers were aghast at having to ‘open their books’.  I would interpret the viability model as an instrument rather than a cause. The cause is government ‘policy’ to favour the interests of land owners and private house builders. The system of viability modelling has been shaped to reflect this ‘policy’. It could easily have been shaped differently and some local authorities are trying to do this – but they don’t have the same power.
  2. Viability has become a bit of a monster and is popping up throughout the planning system – appeals, plan-testing, CIL setting, development management etc. There was concern that it is starting to override other planning considerations and undermine “good planning”.
  3. It was generally agreed that development appraisals are prone to too much uncertainty. It’s not exactly new news. From nearly half a century ago, I often quote the Lands Tribunal decision that stated that “it is a feature of the residual valuation that comparatively minor adjustments to the constituent figures can have a major effect on results …” and “once valuers are let loose on residual valuations, however honest the valuers and however reasoned their argument they can prove almost anything”, First Garden City Ltd v Letchworth Garden City Corporation (1966) 200 EG 123, 460. Accordingly, the residual valuation would be accepted by the Lands Tribunal as a method of ‘last resort’.
  4. Facilitated by this uncertainty, the whole process of viability modelling is prone to bias. Fraud was mentioned at one stage! I’d agree that it is extremely unlikely that viability appraisals are objective. Nearly all inputs into a development viability appraisal can be estimated within a reasonable range. If the choice of inputs were objective, we would expect that some estimates of individual inputs would be at the upper end of the ‘reasonable’ limits; others would be at the lower end. However, given the financial incentives involved, it is likely that developers will systematically opt for pessimistic but reasonable and defensible assumptions in the development viability appraisals submitted in support of planning applications. With the result that, whilst every individual assumption may be reasonable, collectively the model inputs will be systematically biased. Given that the output of such models – estimated land values – can be very sensitive to relatively small changes in major inputs such as construction costs or sale prices, the implications for estimated planning obligations can be substantial.
  5. It was strongly felt that such bias was undermining the credibility of real estate professionals. Whilst some proclaimed that professionals SHOULD behave professionally, I’d argue that this is naïve and complacent. It is well-established in appraisal and throughout the professional services that the outcomes of professional activities can be biased by incentives. Just think of equity analysts during the dot.com boom and auditors, accountants, rating agencies etc. during various financial crises.   As Upton Sinclair stated “It is difficult to get a man to understand something, when his salary depends on his not understanding it.”
  6. I tend to agree with Bob Colenutt who suggested that, if viability is to be a basis for making planning decisions, then the viability studies should be produced by independent bodies.

Given the sheer number of local authorities that are dealing with these problems, an independent national viability organisation that collects, provides and evaluates data on development costs and timescales, land prices and values is probably the best way to solve the bias problem. Both local authorities and especially developers have too much ‘skin in the game’ to be disinterested.

As an academic, I’ve been directly involved in very few of these cases. On one – a really tiny scheme for a couple of flats in Reading – I genuinely tried to be objective and fair but the local authority estates officer then proceeded to try to chip a bit off nearly every single assumption that I (or the cost consultants) made – mostly on pretty spurious grounds. It was disheartening stuff. No surprise – he didn’t suggest that I’d got anything wrong that suited the interests of the local authority to be wrong.   After all, he was working for the local authority.

7    For one planning lawyer, clawback was a “no-brainer” and would solve lots of problems. The idea is that when projects were able to be non-compliant with planning policies, they’d be re-examined at the end of development (or a phase of development) and planning obligations could be recouped from “windfall” profits.  In effect, this is deferring planning obligations until the scheme is complete.   It also helps de-risk the project from the developer’s perspective. However, on the other hand, the local authority can’t put affordable units into a project after it has been completed. Overall, I’d agree that a clawback provision should be standard for projects that are non-compliant but it isn’t a panacea.

8   As is pretty well-accepted in the academic community, there are a number of technical weaknesses in mainstream development appraisal models.

Profit is incorporated into the development viability appraisal as a cash margin. Typically, this will be expressed as a proportion of Gross Development Value or as a proportion of Gross Development Cost. This is generally regarded as a fairly crude method of evaluating a project. This is because it does not reflect the effects of time. A project that generates a £1,000,000 profit in two years is assumed to be as viable as a project that generates in profit of £1,000,000 in ten years. In reality, the former will be far more attractive to a developer than the latter.

It is a particular anomaly that in many conventional development appraisal models it is assumed that the developer is able to borrow all development costs i.e. the developer is assumed not use any of their own money at all! Like profit, finance is often treated in a crude and simplistic manner that is often divorced from the real-world approaches of market participants.

The obvious solution is to use a standard project appraisal technique and discount the project cash flows at the appropriate target internal rate of return. It’s worth bearing in mind that one method is no more complex than the other. The cash flows for the different methods are almost identical. A target cash margin has implied target IRR and vice versa. The main difficulty is estimating an appropriate target IRR.

9    There was a near consensus that transparency was critical for moral and practical reasons. In terms of democratic accountability and community support, openness was regarded as critical to generating trust and transparency. There were a few dissenting voices who took the rather patronising view that these things were too technical for common people who, bless their cotton socks, didn’t really understand such sophisticated things and should leave it to the experts (I paraphrase).

In terms of concern about loss of commercial advantage arising from disclosure, developers/landowners were stated to be very concerned about the release of information on build costs and benchmark land values. However, as the speaker pointed, she couldn’t really understand why. Me neither.

10          There’s little agreement on the appropriate return to the land owner. The vexed issue of Benchmark Land Value remains very vexing.

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