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Risk and Uncertainty in Development Projects

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Property development is a risky activity. We can tell that from the level of return (i.e. the ‘standard’ 20% profit margin used in commercial project appraisal) that is assumed. These returns can be obtained, indeed returns in excess of this are quite possible but, similarly, it is almost equally possible to see heavy losses from a development project.

Why is this the case? Well, to start with, development projects tend to be over relatively long timescales and, therefore, the decision to go ahead and/or the amount to bid for the development site requires judgments to be made about cost and values which are going to occur in the future, frequently indeed 2 – 5 years in the future. These factors are very hard to predict over these timeframes.

A second problem is that the development appraisal itself is highly sensitive to the key input data, i.e. the assumptions which are themselves uncertain. The reason for this is that the outcome of the development appraisal is actually the marginal difference of the ratio between costs and value. A slight change in this ratio can cause a major percentage difference in this marginal outcome. The key variables are anything to do with value – rents, yields and sale prices. A fairly small reduction in value (say 5%) has a disproportionate effect on Land Value or Development profitability – sometimes 50% or more.

Risk has two aspects. Something can have a low risk of happening (such as being involved in an aircraft crash) but severe consequences (death, serious injury or long term trauma). Other things can have a high risk of occurrence (e.g. the risk of catching a cold) but insignificant consequences for most (minor discomfort). Property development is subject to factors that have a high risk of variance (rents, yields and sale values are rarely static) and huge stakes and potential consequences because of the high capital sums involved. 

Successful developers have to be risk takers. They also have to be optimists – if you are too pessimistic and too cautious the nature of the development appraisal means that you would never have a scheme projected to make a profit nor be able to outbid the market for a piece of land. This does not mean, however, that developers and developer advisers should blindly ignore risk; risk needs to be identified, understood and managed right from the start.

I believe that there are three components to this in the appraisal process.

Firstly, it must be accepted that the outcome of a single development appraisal is just one possible answer. It is up to the person or body constructing it to test and retest the assumptions made for soundness and reasonableness wherever possible. The more sound the underlying assumptions are the more reliable the outcome will be.

Secondly, the tools used to carry out the development appraisal should have mechanisms to test the sensitivity of the appraisal to variations in the input variable.

Finally, the person carrying out the feasibility study should have the skills and knowledge to use this sensitivity analysis properly. All too often there is a temptation to simply carry out a ‘standard’ sensitivity analysis – varying the rent and yield by 10% and recording the results. I would argue that this is just going through the motions, it is not truly ‘analysis’. The skill in sensitivity analysis is knowing what questions to ask to ensure that the risk that the development (and the developer) is fully appreciated and explored.

The first of these components is down to developer/appraiser in an individual project. They must understand the market, understand the forces that act on it, understand the product they are intending to produce, and can only really come from both experience and good research.

The latter two components are different because they are concerned with the tools and methodology, i.e. how the tools are used, and this is the area we can examine and where skills can be learnt. Fortunately, the main software products used by practitioners in the market place have good sensitivity analysis modules.

EstateMaster’s product in particular has an outstanding sensitivity analysis module, well developed, well thought out and potentially very powerful, particularly as you can test both single variables and paired variables, but it goes way beyond this because you can also explore the probabilities of variance occurring. This makes it the market leader in this area.

Date Published: 21 Feb 2012
Category: White Papers

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