Académique Documents
Professionnel Documents
Culture Documents
C E Cloete
Department of Construction Economics
University of Pretoria
(012) 420-4545
CONTENTS Page
1. INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.1 The nature of property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2 Implications for the property market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.3 Types of property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
OBJECTIVES
To provide an overview of the nature of property, the nature of the property and
construction industry in South Africa and the major participants in these industries and the
major characteristics of the property development process.
Property has certain physical as well as economic features that distinguish it from other products.
The following four physical features of property (real estate) are important:
! Immobility
Property is fixed in location and cannot be moved. Therefore it is vulnerable to the environment
around it. One consequence of property's immobility is that property markets are primarily local,
or, to put it another way, no national market exists for property as it does for most manufactured
or farm commodities. However, for some properties, the market may be local, national, or
international, depending on the use and property rights involved. For example, interest in single-
family houses are generally traded locally, whereas investment interests in many CBD office
buildings are traded in international markets - for example, Japanese buyers of American office
buildings.
Heterogeneity implies that you do not have the perfectly competitive market situation that would
necessarily provide for an efficient allocation of resources. In addition, this heterogeneity and
the small number of sales as a proportion of the market at a given point in time imply a lack of
information by buyers and sellers. Consequently, this market requires professionals such as
! Indestructibility
The third physical feature of the property asset is that the land component, both as a physical
asset and as the object of legal interest, is viewed as indestructible. Land may be mined, eroded,
flooded, or devastated; nevertheless, the designated location on the earth's surface remains
forever.
! Three dimensionality
Fixed property includes, in addition to the surface of the earth, the areas above (air space, and
below). Legally, you may "own" any or all of these areas. Subsurface rights may be more
valuable than ownership of the surface (think of mineral or oil rights). In large cities, airspace
may be valuable as a building site, for example the Pan Am Building in New York or the Bridge
development in Johannesburg.
If we turn to the economic features of property, it can be seen that they generally parallel the
physical features.
The preference of a purchaser for a particular location is critical in determining the value of
property. One site, because of its relationship to places of employment, shopping, transport
! Modification
The economic concept of modification focuses on the impact of development on the total value
of a parcel - reflecting the fact that existing or potential future development can have a
significant impact on value. More particularly, it can often be seen that development has a
synergetic impact on property value. For example, the market or investment value of a
completed project will normally be greater than the total of the individual costs of the land,
labour, materials, and fair investment return, necessary to develop the project. Conversely,
modification (development) does not guarantee the synergetic value impact. If an incorrect or
poor decision is made, the developed value may be well below the cost.
! Situs
The fourth important economic feature of land is its situs, that is, its interaction with the uses of
surrounding land parcels. You may think of situs as another word for setting. The term also
includes in its meaning the influences of the setting on the site. The simplest illustration of situs
is shown in the street map below. The residential home located on stand B has a higher value
than a home on stand A, because of the negative interaction of the noisy street and the residential
use of stand A.
A
Side B
street
A preference to live in the northern suburbs of a city (Sandton, etc) is an example of the situs
phenomenon. The result will surely affect the economic value of the site even if identical
improvements are available in some other neighbourhood or area. As a consequence, land values
on one side of town may be twice as high as those elsewhere in the city. In such cases, the
economic difference can be attributed only to varying user tastes and preferences.
The unique features or differences in the property make the property market (or markets)
different. There tend to be a smaller number of potential buyers and sellers for any given
property type and location. Information about properties is often difficult to obtain, expensive,
and incomplete. In contrast to the stock market, financing is typically property-specific and of
greater importance in valuation. In total, these differences make the property markets less
"efficient" than their stock market counterparts in the sense that it is more likely that the price
of the property may deviate from its true value. This can be a complex and difficult concept.
For now, you need remember that the tendency toward inefficiency can create wonderful
opportunities for the player who is "better at the game".
The following exhibit illustrates the factors influencing the space and capital market equilibrium.
While the exhibit applies to the USA, the principles involved are also applicable to the South
African property market.
Other Producers
Fixed Investment by
Type of Asset
Transfer Costs
Availability
Costs
Materials
Plant
Immigration
Price of existing
Capital Housing stock houses
DEMAND Prices of Substitutes
Rent levels
Conversions
Profit
Expectations
Availability
of Land
SUPPLY DEMAND
Comment: The above framework is extremely useful when forecasting building activity and/or costs in the private non-residential sector, whether
econometrically or intuitively.
Client
Financial
Adviser (Q.S.)
Tender Q.S.
Documents Architect
Engineers
Subcontractors
Tender Main Contractor Merchants
Tender Q.S.
Evaluation Architect
Supervision:
Main contractor Architect
Construction Subcontractors Engineers
Merchants Clerk of works
Inspectors
Completed
Building
Clients Financiers
Contractors Professional consultants
Subcontractors Local & other authorities
Suppliers
About 60% of all construction (by value) is being done by the eight largest contractors. There
is a large number of medium-sized contractors and an even larger number (thousands) of small
contractors.
Property development is the process directed at the increase in value of an existing property
(undeveloped or developed) by the application of resources (material human and capital).
Development is not limited to erecting buildings. It also includes installing streets, water
facilities, sewers, electrical lines and performing the necessary survey work to create building
lots for single family residences. Property development is concerned with the creation of space:
space in which to play, live, work, and build. Development also includes the redevelopment of
existing buildings as well as the erection of new ones.
There are basically two types of developers: the Public sector and the Private sector.
Public sector development can be distinguished from private sector development according to
the nature of the expected yield. Public sector development will take place if the value (yield)
for the community is higher than the development cost. For example, authorities may build a
dam or a road because the value of the dam or the road to the community is greater than the cost
of building the dam or road. Private sector development, on the other hand, is normally mainly
concerned with profit: profit is the primary motivator of private sector developers. They seek
to make a profit producing a product and selling it for more that it cost to produce. That is, a
developer who estimates that an office building development will cost a total of R4 million
hopes to make a profit by selling the project for more than R4 million. The amount above R4
million is profit and an addition to the developer's wealth. In other words, developers seek to
create wealth. If the expected wealth added by the project is not great enough, the developer will
not undertake the project. In this regard, a developer attempts to produce the type, quality, and
quantity of space on a particular site that maximizes profits. A developer realizes that the cost
of producing space increase with the size and the quality of the space. Furthermore, different
The economic value curve (the straight line) reflects the assumption that each square metre of
additional space adds the same amount of value. This simplifying assumption may not always
be true, but is helpful here to illustrate the concept without doing any damage. The lower graph
maps the difference between value and cost, which is profit. In this example, profit is greatest
at point C. Thus, C is the optimum developmental intensity for this use.
Not all developers plan on selling their projects as soon as they are completed. Some may want
to assume the role of equity investor and may also decide to operate (manage) the property.
Nevertheless, while the project was being translated from idea to reality, they acted as developer.
Not all developers plan on selling their projects as soon as they are completed. Some may want
to assume the role of equity investor and operate the property. Nevertheless, while the project
was being translated from idea to reality, they act as developer.
Profit is not the only motivator for developers; many are also motivated by the desire to improve
their community, prestige, etc.
For the developer interested in selling the project when it is completed, development is usually
a shorter term situation than equity investment. The word usually is used because some equity
investments are very short-term while some large development projects require a rather long
Exhibit Relationship between development costs, economic value and developer’s profit.
4.3.1 Introduction
Development requires a number of steps: a developer does not simply decide to develop and
instantly produce a finished product. The major steps in the development process are illustrated
in the following diagram. Each step requires the developer to make a decision about whether
to continue the project, with or without any changes to be made. The developer does not have
the luxury of performing each step in isolation: many things are going on at the same time. So
in looking at the diagram keep in mind that the steps are not as distinct and orderly as they may
appear. The process is a spiral with many feedback loops, rather than a strictly linear sequence.
IDEA
PRELIMINARY FEASIBILITY
FINANCING
CONSTRUCTION
MARKETING
The development process does not, of course, always start with an idea. Sometimes the
AVAILABLE SITE
PRELIMINARY FEASIBILITY
FINANCING
CONSTRUCTION
MARKETING
Next, the developer will make a "rough-cut" analysis of whether the project is feasible.
Feasibility is generally measured in economic terms: Is the project worth a sufficient amount
more than it costs to produce? At this point, the developer must settle for rough estimates of the
cost of development, the rental income it can produce, and the resulting market value. A
developer interested in selling a project when it is completed may estimate the cost of
construction, the rental income it will produce, and what investors will pay for those rental
income (the market value of the project).
If the expected profit, the difference between the project's value and its cost, is big enough, i.e.
the developer feels the profits provide enough cushion for possible cost overruns or lower than
expected rents and market values, then the project will continue if the developer has adequate
resources to do so. If not, it will be dropped.
If the developer does not yet control the site, it must be obtained at this stage. Control is
necessary, because the same improvements at a different site may not be feasible and the
feasibility would have to be redone because of the new economics of the different site. The word
control is used because the developer will not necessarily purchase the site. The site may be
leased on a long-term ground lease. If the developer needs more time either for analysis or to
Once control of the site has been obtained, a more detailed feasibility study can be undertaken.
How detailed the feasibility study is, depends on the project and the developer. A complete
feasibility study will analyze the legal, site, market, and financial aspects of the proposed
development. Legal analysis will tell the developer how much and what kind of space can
legally be developed. Site analysis will provide information about, among others, the ability of
the soil to support structures and any special problems for construction. Market research will
help answer questions about the size and type of space to be developed, what rental income can
be expected, and what features tenants want. Architectural and design work provide alternative
designs on the site, as well as cost estimates. Financial analysis is then used to determine
profitability of various alternatives. If these more detailed analyses indicate the project should
not be undertaken, the project can be abandoned at this point.
What constitutes an acceptable or unacceptable project, at this point, depends on the objectives
of the developer and the ability of the project to satisfy them. That is, the same result from a
feasibility study may lead one developer to consider the project acceptable while another would
find it unacceptable. One cannot say that a proposed project is acceptable without considering
the specific developer. The developer provides the context within which a certain set of findings
is judged to be feasible or not.
During the feasibility analysis and design phase, preliminary discussions are started with
construction and permanent lenders. Once the plans are completed and the project has been
determined to be feasible, negotiations on financing will be finalized. First, permanent financing
While the activities described earlier are going on, the developer also considers the construction
of the improvements. Construction is critical to the success of the entire project. If actual costs
exceed the estimates used in the feasibility study, the project may turn from a winner to a loser.
If the project is not completed on schedule, extra interest costs and lost rental income could hurt
profitability. If any of the parties involved in construction run into financial difficulties, the
project could be held up by legal proceedings. The developer must decide who is to implement
the architectural plans and under what conditions. The person or firm actually performing this
task is either the general contractor or the construction manager.
Some developers may act as their own general contractor, or have someone on their staff who
can do so. Other developers will hire construction firms to act as the general contractor. In either
case, the general contractor may or may not perform all of the construction tasks. In most cases,
the general contractor will use subcontractors to perform certain tasks. For example, an
electrical company may be used to perform all of the electrical work on a project, a plumbing
company for all the plumbing, and a heating company for all the air conditioning and heating
work. General contractors use subcontractors because it is not economical for them to have the
large number of skilled workers and expensive equipment necessary to perform all facets of
construction jobs. The general contractor acts as the overall coordinator of the project,
scheduling the subcontractors and making sure their work conforms to the plans and
specifications of the developer. Subcontractors look to the general contractor for payment. The
general contractor, in turn, looks to the developer for payment. Since the developer usually does
not have either the time or the ability to supervise the actual construction, he or she will usually
depend on either the architect or a construction management firm to act as construction manager
General contractors should be selected with care. The contractor should be financially sound,
have a good track record in projects similar to the one planned, and be credit worthy. Insurance
companies, financial institutions, etc. issue performance guarantees for a fee, guaranteeing that
should the developer have financial difficulties the project will be completed for the agreed-upon
price. However this performance guarantee is normally limited to an amount equal to a
percentage of the construction cost (normally 10%). Obviously, these companies issue
guarantees only on contractors they feel are good risks. Construction lenders often require that
the general contractor obtain a performance guarantee.
The ultimate success of a development project depends on its marketability. Two types of
marketing may accompany a development project. First, the space in the development must be
leased. Second, it the project is to be sold, a buyer must be found. These two areas of marketing
activity are closely related to one another since the ability to lease the space being produced is
a prime determinant of the ability to find a buyer and the price that the buyer is willing to pay.
A project that has been leased to good tenants at competitive rental rates is attractive to potential
equity investors and can command a top rand price.
! Leasing
Leasing activity begins as early in the life of the project as possible in an attempt to get tenants
into the building and paying rent as soon as the project is completed. Generating cash as early
as possible is critical to the success of a project because the entire construction period is one of
cash outflows. Often developers underestimate or simply fail to consider the cash necessary to
operate the property after construction is completed and before the project is producing enough
rental income to cover costs. Some projects require years to reach this breakeven point. Many
projects ultimately fail during this period, making the rent-up period one of the most dangerous
periods in development.
First, market research is critical in the leasing process. Knowledge of the market is valuable in
determining what features are most important to potential tenants and what pricing structure
should be established for the space.
Second, you should realize that deciding when to lease space is sometimes not an easy one. If
space is leased too early in the development process, it may be leased for rates that are below the
going market rate when the project is completed. The opposite situation may also occur and the
developer may be able to secure prime lease rates because of a shortage of space at the time the
space was originally leased. Once again, knowledge of the market is of great value in this
decision. Another factor affecting the implementation of a leasing program is the phase in the
development when the project is to be leased.
! Sale of project
If the developer does not wish to retain ownership of the property after completion, a buyer must
be found. The developer must make some important decisions relating to the sale, such as when
to sell and at what price. The developer realizes that the project is worth more when finished and
fully leased than when it is simply an idea and a set of blueprints. The choice is not so simple
as whether to sell for less now or more later. It is complicated by uncertainty about future market
conditions for leasing the space and the availability and cost of capital now versus later.
Developers play a risky game in which many of the factors affecting the ultimate profitability
of a project are beyond their control. However, just because these factors are out of the
developer's control doesn't mean the developer should simply ignore them. It is imperative that
the developer closely monitor them and incorporate this information into the many decisions that
must be made throughout the life of a project. A good feasibility study will identify these critical
variables and provide some initial information about how sensitive the returns from the project
are to changes in these variables.
The developer can, to a certain extent, control some of the different factors influencing the
success of a development.
The different requirements for a successful property development can be summarized as follows:
a) Sufficient market demand for the product at a price which would make the investment
viable.
b) The identification of the cost structure which will ensure the optimum net profit.
c) The ability of the architect to design a product which will satisfy the parameters of the
cost structure as well as the maximum market demand.
Risk is the potential of not realizing the expected return. Development always carries with it the
risk of loss.
Because of the expense involved, estimating the legal risk for a project is an important aspect
of the developer's feasibility analysis. Public opinion, especially the sentiment of those near the
project, should be carefully evaluated to determine what objections may be raised to the project.
Research should be conducted into recent decisions on similar projects to see whether precedents
exist. Finally, the availability of utilities should be explored to determine whether they represent
a potential problem for the development.
There are two general types of markets: rental and equity. These two markets are interrelated
and conditions in them are constantly changing. These markets are of prime interest to the
developer, since the value of the development is determined, among others, by the rental income
it will produce.
Even if a developer correctly assesses demand, and the market value of the space being
produced, making a profit is dependent on the cost of producing the space. Estimating this cost
is no small matter. In times of inflation, costs frequently change during the course of
development. The longer the development period, the greater this risk.
Rather than measure potential variance, most lenders attempt to provide capacity to absorb
foreseeable shifts of income, occupancy and expectations. The two typical measures of cushion
for variance in creditor realizations are the default ratio and the debt coverage ratio.
The default ratio is the ratio of all foreseeable expenses plus real estate taxes plus interest and
principal payments to the gross cash rent schedule.
A default ratio of 80% in effect means that vacancies may increase 20% or rental prices can be
cut by the same amount to achieve 100% occupancy or the 20% cushion may be split between
increased vacancies and expenses.
The debt coverage ratio is the ratio of net income available for debt service to required debt
1. What are the physical and economic features that distinguish property (real estate) from
other kinds of products?
6. Name and briefly discuss three types of risk that the property developer are exposed to.
Fisher, P & Collins, T 1999. “The commercial property development process”. Property
Management 17(3):219-230.
Pisani, R R & R L Pisani 1989. Investing in Land. How to Be a Successful Developer. New
York: Wiley.
West, Staniland 1999. “A guide to success in property development. Parts 1,2,3". ProjectPro
July: 29-31; Sep: 14-17; Nov: 11-13.
Ratcliffe, John 2000. “Scenario building: a suitable method for strategic property planning?”
Property Management 18(2)127-144.
Roulac, Stephen E 1996. “The strategic real estate framework: Processes, linkages, decisions”.
The Journal of Real Estate Research 12(3):323-346.
Wurzebach, C H & Miles. M E 1994. Modern Real Estate (5th ed). New York: Wiley.