Assessing the financial risks of undertaking a development proposal

Picture this scenario: you have spent a considerable amount of time looking for and finding a suitable residential property to develop. You then enter into your development feasibility software all the data that are relevant to what you believe is the most financially feasible development proposal for the property. From studying your software’s Profit and Loss report, you find that there is possibly a sufficient level of profit from undertaking that proposal. What other considerations need to be satisfied before making an offer to buy the property?

In the scenario described above, we opine that one of the most important things that the developer should conduct, with all due diligence, is the proper assessment of the most significant risks of not achieving the level of profit that is indicated by the most likely financially feasible development proposal for the property before making a decision on whether or not to attempt to purchase that property for developing the relevant proposal. This blog article has a focus on the types of data inputs that we believe can have a very significant effect on development profitability.

We believe it is important to bear in mind that the financial returns of a development can vary significantly in the results for our financial feasibility studies when we vary the size of our most significant inputs such as: construction costs, construction period, the sale value of the developed components, and the period of time to sell these components. For example, a reduction of 10% in development sales income for the proposal might reduce our developer’s margin by 60%. Therefore, in a suitable financial feasibility software application, it is important for us to test variations in these significant inputs to help us determine the returns that we should require for our proposal, given the risks that we would face by undertaking that proposition.

Based on the experience of more than 30 years of developing and marketing software for property feasibility studies and from having feedback from developers who use our software, we have come to the view that the most critical variables (data) for development feasibility studies for Australian residential developments (not necessarily in order of importance) are the following:

1. Land Cost(s)
2. Construction Cost(s)
3. Construction Period
4. Sell-On Income (Development Sales)
5. Sell-On Income Period (Development Sales Period)
6. Borrowing Interest Rate(s)

In the case of commercial developments, Capitalisation Rate and Rent Income variables can also be important critical variables in addition to the above list of six variables.

In our software, Feastudy Professional, each of the Variations reports for all of the abovementioned critical variables are modelled within the range and increments for that report in the Sensitivity Range Settings window for a Development file when relevant data are entered for that file.

• The Land Cost Variations report shows the effect on profitability from variations in Land Cost(s) (purchase price[s]).
  
• The Construction Cost Variations report shows the effect on profitability when Construction Costs are varied.
  
• The Construction Period Variations report provides feasibility metrics for various scenarios of earlier and later cashflows for Construction Costs.
• The Sell-On Income Variations report generates feasibility results based on the variation of Sell-On Income values.
• If Sell-On Income data are entered in a Development file, the Sell-On Period Variations report provides feasibility metrics for various scenarios of early and late receipts of Sell-On Income.
• The Borrowing Interest Rate Variations report produces feasibility results for during the whole of the cashflow for a Development file, if at least one Borrowing Interest Rate, which has a rate greater than zero, is entered for Primary Debt Funds.
• The Capitalisation Rate Variations report shows the effect on profitability of a change in capitalisation rate (which is a weighted average rate, if more than one rate is entered), if one or more capitalisation rate(s) and Rent Income data are linked for calculations of rent-capitalised sell-on values.
• The Rent Income Variations report shows the effect on profitability from variations of Rent Income, if Rent Income data and at least one capitalisation rate for a Sell-On Income item are entered.

The Sensitivity Range Settings option from the File menu opens the Sensitivity Range Settings window which enables the adjustment of the range and increments for Feastudy’s Variations (sensitivity analysis) reports for your feasibility data file.

(The discussion of Feastudy’s Variations reports for Development files ends here.)

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Mark Andrews
Managing Director
Devfeas Pty Ltd
03/10/2023