Why undertake financial feasibility studies for property development proposals?

You can have a wonderful dream for a development concept for a piece of real estate but if that concept is actually financially unfeasible to implement, then you could lose a great deal of time and money by pursuing that idea. In other words, implementing your gut feeling about the viability of a property development proposal, without having comprehensive, objective and corroborating evidence for the validity of your intestinal opinion, could be dangerous for your financial and mental well-being!

Before we make a decision on whether or not we should attempt to purchase a certain property to develop and sell it for a profit, it would be very prudent for us to undertake all relevant and appropriate financial feasibility studies (“crunch the numbers”) for various development proposals for that property after gathering all of the important data for these studies in a logical and systematic way with all due diligence. To help us work out what is the “best bang for our buck”, we should try to determine what is the “highest and best” economic use of the property because we should avoid pursuing proposals that undercapitalise or overcapitalise the land but find out what is the optimum capital development for it. For example, if the existing use of the property is already the highest and best economic use of the land, then it is not financially viable to develop the property and we should dismiss the idea of buying the land for development purposes.

Of course, before we crunch all of the relevant and appropriate numbers, we should have, among many other things, a sound knowledge of all of the critically important aspects of the laws that relate to what we can develop on the property, such as the pertinent planning and/or zoning laws. For example, we should not be wanting to develop: a restaurant on a property while it is zoned for residential land uses only; or housing on land that is zoned for residential use if the relevant local government’s planning laws for the site include a maximum building gross floor area to site area ratio that is too restrictive for our purposes. We should also know all the important physical aspects of the site of the development property; and be conversant with the current and likely future market demand and supply for what we propose to develop.

Appropriate feasibility studies help us determine, among other things:

• Whether we should spend more time and/or money on the development proposal(s) that we are considering,
• Whether the opportunity to carry out the best development proposal for the property will make a sufficient profit, given the risks involved,
• What we should pay for the property, if anything,
• How important it is to keep certain costs to a minimum and achieve a certain level of income, and
• What level of external debt funds we need if we can’t or don’t want to finance the development partly or entirely ourselves.

Usually, the most important pieces of cost and income data that we need for each of our financial feasibility studies are:

• The maximum price we should pay for the property for the relevant development scenario,
• The construction cost and the period over which that cost is spread, and
• The market prices for the components of the development on their completion and the period over which that income is spread.

Other significant but less important development costs commonly include: conveyancing fees, legal costs, planning and building approval fees, professional consultants’ costs, property rates and taxes, contingency costs, marketing costs, selling fees, and borrowing costs.

Although we should have reliable information on the market value of the development property on a direct comparison basis if that data is available, the price we should pay for the property for its development potential should not be greater than the residual land value for the highest and best economic use of the site for us. Hopefully we can buy the land for less than both of these values. The “residual land value” is the maximum amount that a developer should pay for the land for a particular proposal, after duly taking into account the minimum level of returns that the developer should require for the development proposal and the amount and timing of all relevant development costs and incomes for that proposal. It is the residual land value because it is the (maximum) residual amount that is left to pay for the land purchase price after we have properly considered all relevant costs, incomes and return criteria for that proposal.

It is important for us to bear in mind that the residual land value 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 our development sales income 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.

These are some of the common pitfalls of undertaking financial feasibility studies for property development proposals, which we must avoid in our feasibility studies:

• Not doing enough research (due diligence), including the research of alternative, legal proposals.
• Not engaging the right professional consultants for obtaining the relevant feasibility data.
• Not using suitable financial feasibility study software/technology for undertaking the number crunching.
• Not spending enough time understanding the results of the number crunching (e.g. not knowing the basis of calculations of the technology that has been used for this).

Another important thing to remember is that, when we submit an application to obtain external finance from a bank or finance company to help fund our development project, a well-presented and detailed set of financial feasibility reports provides an important component of our credibility as a potential user of the lender’s funds.

If you want to undertake financial feasibility studies for property development projects to help you perform the type of analyses we have discussed above, and potentially create and submit such reports to a potential lender, one of our Feastudy products can assist you. You can learn more about our products from here or contact us for more information.

Mark Andrews
Managing Director
Devfeas Pty Ltd
29/10/2020