It’s no secret that Build to Rent (BtR) is on the rise. Driven by a number of factors – including the growth in population, the increasing cost of housing and the ever-growing rental market – BtR is now one of the most promising opportunities in real estate.
But with so much at stake, how do you ensure that you’re getting the most out of your BtR development? By carrying out a simple financial analysis, you can make sure that you’re maximizing your returns and delivering the best possible outcome for your project.
In this article, we review 3 simple steps an investor can take ahead of committing to a development to maximise returns
Feasibility and the three levels
A financial feasibility study evaluates the rate of return for any real estate development. It can give you confidence in your decisions and determine whether the development project will be a financial success or not.
With a detailed appraisal of the potential risks and returns, you’ll be able to test every assumption, make intelligent decisions and maximise every opportunity.
The most common levels of feasibility are:
a) High-level feasibility
The very first feasibility step – ‘back-of-the-envelope calculation’ – explores ideas and considers pluses and minuses of the development site. You may make assumptions based on attributes and constraints and make some estimates about local supply and demand.
b) Static feasibility
The assumptions you made during the high-level feasibility study will become grounded in more solid facts, and you’ll have a clear understanding of the highest and best use for the site. There is still a bit of guesswork – particularly relating to revenue, time, and cost – at this stage of feasibility, so you shouldn’t make a purchasing decision just yet.
c) Cash flow feasibility
Finally, at this stage, you get down to the granular detail, especially around project financing and funding requirements. As you negotiate a price, you need to understand how much money will go out and how much will come in. Check and challenge all your assumptions. Do the revenue, time and cost numbers still stack up?
Consider all the costs
A high quality feasibility study will consider these main costs:
- Acquisition cost: Costs associated with acquiring the development, including legal costs, stamp duty and rates.
- Construction costs: Usually calculated based on the design or size of the development at a per square metre rate. If you receive a fixed price construction cost from a builder, this is a massive advantage.
- Planning costs: Local regulatory bodies and councils will charge different amounts for different certifications. Be sure to consider development approval applications, building permit fees, zoning, strata titles and subdivision costs.
- Professional fees: This should include all fees charged by consultants and professionals such as lawyers, town planners or architects, quantity surveyors or engineers, and is typically a percentage of construction.
- Marketing: Any fees hired to help market or sell the property. From brochures to immersive virtual reality experience to commission-based real estate agents selling your property.
- Tax: Taxes may vary depending on the jurisdiction, but they are an inevitable and fundamental part of the development process.
- Contingency: Few property developments go exactly to plan, and a contingency helps you stay on track when costs exceed your budget. Typically, 5-10% of the budget should be allocated to cover additional or unexpected costs during the construction project. Leaving out the buffer can easily cause budget blowouts. Conversely, an over-inflated contingency may mask a project’s viability.
Assess risk and uncover opportunities
A BtR development must manage the competing forces of risk and return. There’s a very simple mantra which remains fundamentally true in property development: the greater the risk, the greater the return.
The simplest form of risk analysis is sensitivity analysis, which should be used to understand how changes to individual inputs (such as construction cost or sales values) might affect the feasibility of your project. Ie. What happens if construction costs rise by 10% or fall by 5%?
Scenario modelling can be used to evaluate highest and best use. Every feasibility study should consider whether or not the proposed development is the highest and best use, and whether another type of asset would maximise the value.
Choose the right feasibility model
Determining whether a project “stacks up” can take considerable time and effort – but a BtR development feasibility study gives you confidence in your decisions and determines whether your development dream will be a financial success or a failure. There are many different feasibility models, but there are two commonly used in the property development game: the development margin approach and discounted cash flow analysis. We’ll take a deeper dive into these below.
Discounted cash flow analysis (DCF)
The development margin approach’s disadvantages often lead developers to the discounted cash flow method, also known as DCF. DCF estimates the value of an investment based on its future cash flows. DCF analysis attempts to determine the value of an investment today, based on projections of how much money it will generate in the future.
Development margin approach
When you know the exact price paid for land or can estimate its value, you can use the development margin approach to determine the proposed profit on your development project. Using this traditional model, you estimate the total development cost in current, not inflated, dollars (including interest on 100% borrowings). The simple formula below is known as the ‘back-of-the-envelope’ approach.
Development margin = Net profit / Total development cost
The anticipated revenue is calculated based on the project sale values, and the costs (including land but not the developer’s margin) are subtracted to estimate the net profit. You then calculate the development margin by dividing profit by total development cost.
Final thoughts
Property development is a complex process, and it’s more important than ever to understand the risks and opportunities involved in any project. By using sensitivity analysis and scenario modelling, you can get a clear picture of how changes in different factors might affect your bottom line.
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