The Economics of Speculative Construction Development - Term Paper Example

Sweetwater Development Project The economics of speculative construction development Table of Contents Introduction 3 Theoretical framework 4 Risk assessment 4 Project overview 5 Company background 5 Sweetwater site analysis 7 Analysis of the plan 9 Project evaluation 9 Sensitivity analysis 11 Scenario analysis 14 Mitigation strategies 14 Conclusion 14 Reference List 16 Appendices 18 Introduction The U.K. housing sector forms a critical part of the overall economy of the nation. The housing market depends upon the banks and other financial institutions for its growth and progress. When banks increase lending, the housing sector seems to flourish. The economic crisis of 2007, which had its roots in the U.S. housing sector, has forced banks and other financial institutions to be cautious (Berry and McGreal, 2003). In order to prevent another economic meltdown, banks have steadily maintained higher rates of interest. Although the prices of houses have been gradually increasing, the number of investors therein has not reduced. The housing sector in 2010 had recorded sales of 276,000 houses in the urban and semi-urban areas. This figure in last few years has increased to approximately 454,000 (Athey, 2009). Although the housing sector has been earning steady revenues, the required rate of growth has not been satisfactory. Common people are finding it risky to invest in property by acquiring loans due to the consistent rise of interests. Post financial crisis, most of the financial institutions have established stringent policies in respect of providing housing loans. The housing sector of the U.K. however plays a major role in the development of the economy as a whole. Even though the sector has been incurring slow growths, the revenue obtained from the housing and development sector is seen to be persistently high. The demands for houses have remained high as the economy is quite prosperous. Individual in the U.K have a high level of disposable income, due to which they find it feasible to invest in property (Berry and McGreal, 2003). Research and studies in this sector have indicated that the demand for houses is expected to rise steadily. Construction companies are, hence, considering it profitable to develop sites and invest in properties of the U.K (Harrison and Leitch, 2010). In order to boost the housing and development sector, foreign investors are devising different types of schemes. Since population is consistently rising, it is essential for property developers to construct more homes. A recent survey had estimated that it is essential to build at least 150,000 new homes each year so as to be able meet housing requirements of the growing population (Haveman and Sexton, 2008). In the recent years, many real estate developers from the U.S. have increased their investments in the U.K. The positive market trends and steady growth in real estate have been successful in attracting foreign investors (Berry and McGreal, 2003). The paper provides a brief summary regarding the development project of Sweetwater in the U.K. The paper identifies the different types of risks that development company’s face and the mitigation strategies adopted by them. The analysis of the Sweetwater project encompasses reviewing the same through NPV and IRR techniques and by conducting sensitivity analysis. The NPV, IRR and sensitivity analysis are essential evaluation methods of different types of investment proposals and help in understanding the amount of revenues a given project is likely to earn and the factors that might cause changes in the same. It also helps in measuring in the extent of changes in revenue due to changes in variable factors of the economy. Theoretical framework Risk assessment Unique market risks are the most important types of risks, which are associated with property development (Byrne and Lee, 2000). The risk exposure is seen to increase if the market conditions are volatile and the investment made is speculative in nature. As a result, property development organizations must measure the variance from the expected level of profits (Crosby and Murdoch, 2000). Unique risks are mostly related to unfavourable circumstances existing in a company’s environment, including aspects such as, inability to reduce costs, difficulties in obtaining permission for construction, lack of capital availability and inadequate labour availability. Market risks are related to changes in the economic condition and their impact upon the market where a firm operates. For instance, a rise in prices may induce savings behaviour amongst consumers, thereby lowering their spending capacity. Some of the commonly associated market risks faced by the property developers are as follows (Byrne and Lee, 2000): Land value risks- The risks associated with the fluctuating values of land due to different economic and social forces (Ive, 2013b). Environmental issues- This aspect is related to exploitation of land and property in a manner that affects the environmental balance (Ive, 2013b). Construction risks- The rise in prices of the raw materials and labour may hinder the construction process. When a given project takes a longer duration to be completed, it increases the cost of production (Ive, 2013b). Revenue risks- Revenue risks arise from multiple factors such as, inflation, savings behaviour, lack of investment availability and lack of returns from the market (Claessens and Laeven, 2003). Political risks- Changes in the government regulations may impact business either positively or negatively. An increase in corporate taxes or delay in sanctioning projects may affect the development projects in a negative manner (Claessens and Laeven, 2003). Project overview Company background Wates Construction Limited is one of the largest construction companies operating in the U.K. The company has been successful in maintaining its reputation and expanding operations over years. Wates is known as one of the best real estate companies for developing residential buildings. The company was witnessed to overcome several financial difficulties during the economic crisis of 2007 (Shucksmith, 2000). The internal financial strength of the firm is high. One of the primary reasons behind the company’s success is its superior management strategies and well-established system of working. The company strategically establishes its supply chain network so as to lower cost without impacting quality. Wates largely focuses upon urban development. The key financial aspects of the company over last five years have been shown below. Figure1: Financial of Wates Key financials of Wates Construction Limited         31/12/2013 31/12/2012 31/12/2011 31/12/2010 31/12/2009 Turnover 830232 1070876 1032302 887861 899285 Return on Shareholders’ Funds 13.73892835 16.85658205 41.22820231 49.13178647 55.7379361 Return on Capital Employed 12.03906697 14.08181008 36.40474729 29.63524793 31.7832761 Current ratio (x) 1.274506747 1.216129762 1.22134781 1.416475346 1.40970749 Working Capital 108498 118982 113714 -33386 70511 EBITDA 12001 11713 27284 34181 36385 Construction companies usually have a high requirement of working capital. Hence, liquidity becomes an important aspect to consider. Wates has a stable level of liquidity as its current ratios are adequate and depict a rising trend. The company had negative working capital in 2010 due to declining revenue. However, Wates could effectively redeem the same in the forthcoming years (Schiellerup and Gwilliam, 2009). The above table shows the important financial figures of the company during the last five years. It can be observed that the revenue earned by Wates has remained to be quite high. It is also seen that the revenue of the firm had slightly declined during the fiscal years 2011 and 2012. This was due to the poor economic condition providing lack of scope to grow. Figure 2: Current ratio of Wates (Source: Authors creation) Figure 3: Turnover of Wates for last five financial years (Source: Authors creation) The above graphs depict the trend of the company’s turnover and current ratio over the last five years. The overall financials of the company are seen to be positive and has a steady pace of growth. The X axis depicts the years for which the analysis has been conducted for both the above figures. The Y axis depicts the revenue levels for figure 3 and ratios for figure 2. Sweetwater site analysis Sweetwater is located in East London and is a site for the development of Queen Elizabeth II Olympic Park. The area chiefly consists of residential houses and buildings. There are also a number of schools and colleges in the locality. Wates has decided to develop a residential complex with 2 residential buildings, a primary school and a shopping mall. The residential complex will have state-of-the-art facilities and will be built near the West Flagler Street. The Sweetwater project is set be built at the existing site of the Queen Elizabeth Olympic Park in London E20 2ST. The residential complex will be built on an area of 250 acres. Wates has strategically chosen this site for the development of this project (Sweetwater, 2012). The project, being majorly residential in nature, requires to be built in an area comprising large number of households. A site map for development of the complex is presented below. Figure 4: Sweetwater site The residential complex will have close proximity to the commercial areas, which will benefit the working population. The area is closely located to metro railway and is equipped with suitable number of road networks, thereby facilitating bus and car transport. The site currently consists of an unused factory and a few under-used residential complexes. The company is, therefore, required to take permission from the local and state authorities in order to demolish the existing construction work and set up the new project plan. The proposed site is one of the most expensive residential areas of the city. The proposed residential complex plan will consist of both expensive as well as low priced flats (Sweetwater, 2014). Wates proposes to undertake development of the residential complexes at first. Once they are completed, construction of the shopping mall and the primary school will begin. Since demand for the residential complex has been rising in the city, Wates aims to construct the property within a short time scale (Sweetwater, 2014). Analysis of the plan Project evaluation The Sweetwater property development project is one of the most important projects of Wates. Apart from contributing towards urban development, the project will also provide the company with huge turnover. Below shown are the estimates relating to construction of the complex in the Sweetwater area. Figure 5: Initial investment in the project The major expense in relation to the project arises out of construction of the shopping mall and the school. The shopping mall and the school have been built with the view to attract citizens residing in the nearby areas. The number of shopping malls in the Sweetwater area is low, which has been a driving factor in attracting several retail brands so as to invest in development of the mall (Sing and Patel, 2001). Wates is anticipating a huge amount of investment for developing the site, which would accelerate the overall development process. The expected revenue from the site has been analyzed to be as follows. Figure 6: Sales forecast The above sales forecast has been calculated from the year of completion of construction. The construction is expected to be completed within three years. Additional three years are required for selling off the entire property. Since a major portion of the property will be sold on the basis of instalment, the principle sales amount will not be obtained immediately after sales. The construction cost shown above encompasses that of demolition of the existing building, construction of the new buildings and developing suitable interiors and parking areas. The entire process of development and sales is supposed to last for five years. The project expects to attain break even in the second year of sales, post completing the development work. As per policies of the government, it is essential that every housing project to provide affordable units of property. A minimum of 10% of the net property is required to be lowly priced. Wates has considered this requirement and consequently, included less expensive flats in the construction plan. Below shown are the NPV and IRR analysis of the project (Durnev, Morck and Yeung, 2004). Figure 7: NPV and IRR The NPV analysis reveals that Wates is expected to obtain a positive return by investing in the project. NPV can be described as the difference between present value of the future cash inflows and the initial investment. NPV is an important capital budgeting technique, which assists in determining whether a project is worth investing or not (Winch, 2010). The technique takes into consideration the aspect that a unit of money is worth less in the future than it is at present. The money invested today, therefore, cannot be analyzed or compared with the returns available in future. In order to decide whether or not a given project is worth investing, it becomes essential to discount the expected future revenue so as to align it with the net investments made today (Bierman and Smidt, 2012). Since NPV technique considers the time value of money, it is regarded as one of the most effective ways of analyzing a given investment proposal. In order to bring the future cash inflows at par with the initial investment, an appropriate rate of discounting is used. The project has been analyzed by taking into perspective a discount rate of 10%. The discount rates are calculated on the basis of the weighted average cost of capital and are adjusted upward or downward on grounds of risk element in the project. The method also takes into perspective the cash flows over entire life span of a project (Miller and O’leary, 2007). A project is generally approved if the NPV value is positive. In case of mutually exclusive projects, the one that yields a higher NPV is usually selected. In order to obtain adequate results using the NPV technique, discounting rates must be set accurately. The weighted average cost of capital represents the cost accrued to an organization in respect of obtaining fund from different sources such as, equity or debt. The minimum requirement of the company is to generate that amount of revenue from the investment, which is equal to the initial investments made (Kahraman, Ruan and Tolga, 2002). Internal rate of return can be described as the one at which discounted future cash inflows become equal to the initial investments made. Projects with a higher rate of return are selected by the management. The IRR for the project undertaken by Wates in Sweetwater is expected to generate a return of 50%. This indicates that the project shall provide investors with twice the returns. The high rate of return on the project is due to the fact that the cost of investment appears relatively low (Ive, 2013a). The property for the residential complex was purchased by Wates few years back. Since the property was involved in legal disputes, other construction firms were not interested in acquiring it. Wates took advantage of the situation and purchased the property. Few years from the acquisition, value of the land in Sweetwater area increased tremendously. Wates had then decided to set up a residential complex in the area. The high IRR indicated that the project is profitable. However, future unexpected costs and sudden rise in prices may affect the IRR. The IRR may fluctuate between 45 to 49% under unexpected circumstances. Nevertheless, the IRR are anticipated to remain high (Nanthakumaran, Watkins and Orr, 2000). Sensitivity analysis Sensitivity analysis helps in understanding ways in which risks and unexpected circumstances may affect the project. In context of the Sweetwater project, sensitivity analysis has been carried out in respect of the NPV, considering changes in various variable factors. Figure 8: Cash inflow sensitivity The above figure presents the sensitivity analysis related to the variable factor of cash inflows. Cash inflows may vary due to aspects such as, increase in prices as well as savings behaviour of individuals or other such unexpected scenarios. The sensitivity analysis of cash inflows has been considered varying the predicted cash inflows by +10% and -10%. Under both the circumstances, the project exhibits positive NPV. Figure 9: Duration sensitivity The duration of a project may be considered as a highly variable factor. It might be possible that a project exceeds the expected time required for completion. The project has been analyzed by increasing the duration by 1 year and lowering the same by 10%. Under both the scenarios, the NPV has remained positive. Figure 10: cost of production sensitivity The project has also been evaluated considering the aspect that initial investment may vary. The discounted cash inflows have, however, been kept the same. The percentage of change has been 10%. Under both positive and negative scenarios, the NPV has remained positive. Figure 11: Discount rate sensitivity Discounting rates are highly variable due to changing economic forces. As per the sensitivity analysis conducted on discounting rates, the project indicates a positive NPV when the rates fall to 8% and rise to 12%. Scenario analysis The analysis of the project using capital budgeting techniques and sensitivity analysis reveals that the project is profitable. Even when the risk aspects are high, the project is expected to generate positive revenues. The project requires generating adequate returns in order to attract more number of investors. The sensitivity analysis of the project points out that even in negative circumstances such as, increase in the discounting rates, reduction in inflow of cash and delay in completing the project, the project yields positive NPV. The impact of risk upon the project is seen to be less drastic. Consequently, investors will not have to suffer losses. The analysis has mainly been conducted by taking into consideration unique risks and their impact upon the project returns. Market risks cannot accurately be predicted, which is why studying their impact is not highly feasible. Nevertheless, deviations in discounting rates and changes in cash inflow, which has been studied in the above section, may arise out of market risks. Mitigation strategies It is essential for the developers to research on the investment proposal. Research aspects include forecasting yields, allocation of resources, demands of investors and demand of the consumers. Once a proper research has been conducted, the company is required to phase out the entire project. After completion of each phase, the end results should be analyzed. It also becomes essential to analyze the external environmental conditions before investments are made. Changes in the government policies or political conditions may adversely impact the project (Ive, 2013c). Additionally, the company may also consider entering into different types of hedging and speculative agreements with other firms in order to mitigate the impact of risks and earn higher returns (Morley, Guy and Hanneberry, 2002). Conclusion The Sweetwater development project undertaken by Wates has been analyzed by considering different risk aspects. The impact of risks upon the business was evaluated by performing a sensitivity analysis upon NPV of the project by changing different variable factors such as, duration, cash inflows and rate of discounting. Under each of these scenarios, the NPV yield from the project remained positive. The company has also developed suitable plans for eliminating unexpected risks. Market uncertainties cannot be effectively controlled by a firm. As a result, the organization should examine a given project from different probable scenarios before investing. Reference List Athey, G. (2009). Economic development in the UK: challenges during and after the recession. Local Economy, 24(6-7), pp. 604-611. Berry, J. N. and McGreal, W. S., 2003. European cities, planning systems and property markets. London: Routledge. Bierman Jr, H. and Smidt, S., 2012. The capital budgeting decision: economic analysis of investment projects. London: Routledge. Byrne, P. and Lee, S., 2000. Risk reduction in the United Kingdom property market. Journal of Property Research, 17(1), pp. 23-46. Claessens, S. and Laeven, L., 2003. Financial development, property rights, and growth. The Journal of Finance, 58(6), pp. 2401-2436. Crosby, N. and Murdoch, S., 2000. The influence of procedure on rent determination in the commercial property market of England and Wales. Journal of Property Investment & Finance, 18(4), pp. 420-444. Durnev, A., Morck, R. and Yeung, B., 2004. Value‐enhancing capital budgeting and firm‐specific stock return variation. The Journal of Finance, 59(1), pp. 65-105. Harrison, R. T. and Leitch, C., 2010. Voodoo institution or entrepreneurial university? Spin-off companies, the entrepreneurial system and regional development in the UK. Regional Studies, 44(9), pp. 1241-1262. Haveman, M. and Sexton, T. A., 2008. Property tax assessment limits: Lessons from thirty years of experience. Cambridge: Lincoln Institute of Land Policy. Ive, G., 2013a. Principles of project investment appraisal using NPV. London: UCL  Ive, G., 2013b. Economy of Risk 1: market risk and unique risk. London: UCL  Ive, G., 2013c. Risk (2): An example-NPV for a property project- Methods, Costs, and benefits of risk transfer. London: UCL  Kahraman, C., Ruan, D. and Tolga, E., 2002. Capital budgeting techniques using discounted fuzzy versus probabilistic cash flows. Information Sciences, 142(1), pp. 57-76. Miller, P. and O’leary, T., 2007. Mediating instruments and making markets: Capital budgeting, science and the economy. Accounting, Organizations and Society, 32(7), pp. 701-734. Morley, S., Guy, S. and Hanneberry, J., 2002. Development and Developers: Perspective on Properties. West Sussex: Wiley-Blackwell. Nanthakumaran, N., Watkins, C. and Orr, A., 2000. Understanding property market dynamics: insights from modelling the supply-side adjustment mechanism. Environment and Planning A, 32(4), pp. 655-672. Schiellerup, P. and Gwilliam, J., 2009. Social production of desirable space: an exploration of the practice and role of property agents in the UK commercial property market. Environment and Planning C: Government and Policy, 27(5), pp. 801-814. Shucksmith, M., 2000. Endogenous development, social capital and social inclusion: perspectives from LEADER in the UK. Sociologia ruralis, 40(2), pp. 208-218. Sing, T. F. and Patel, K., 2001. Evidence of irreversibility in the UK property market. The Quarterly Review of Economics and Finance, 41(3), pp. 313-334. Sweetwater, 2012. London Legacy development Corporation. [online] Available at: [Accessed 14 July 2014]. Sweetwater, 2014. Queen Elizabeth Olympic park. [online] Available at: [Accessed 14 July 2014]. Winch, G.M., 2010. Managing Construction Projects, 2nd Edition, West Sussex: Wiley-Blackwell. Appendices 1) NPV calculation NPV Year Cash inflow P.V factor at 10% Discounted cash inflow Cumulative cash inflow 1 250000000 0.909090909 227272727.3 227272727.3 2 350000000 0.826446281 289256198.3 516528925.6 3 370000000 0.751314801 277986476.3 794515402 Total discounted cumulative cash inflow 794515402 Total cost of production 433300000 NPV 361215402 2) IRR calculation IRR Year Discounting factor at 50% 1 250000000 0.666666667 166666666.7 2 350000000 0.444444444 155555555.6 3 370000000 0.296296296 109629629.6 431851851.9 3) Cash flow sensitivity analysis Rate of increase 10.00% Year Cash inflow 10% of cash flow Revised cash flow P.V factor at 10% Discounted cash inflow Cumulative cash inflow 1 250000000 25000000 275000000 0.909090909 250000000 250000000 2 350000000 35000000 385000000 0.826446281 318181818.2 568181818.2 3 370000000 37000000 407000000 0.751314801 305785124 873966942.1 Total discounted cumulative cash inflow 873966942.1 Total cost of production 433300000 NPV 440666942.1 Rate of decrease -10% Year Cash inflow 10% of cash flow Revised cash flow P.V factor at 10% Discounted cash inflow Cumulative cash inflow 1 250000000 -25000000 225000000 0.909090909 204545454.5 204545454.5 2 350000000 -35000000 315000000 0.826446281 260330578.5 464876033.1 3 370000000 -37000000 333000000 0.751314801 250187828.7 715063861.8 Total discounted cumulative cash inflow 715063861.8 Total cost of production 433300000 NPV 281763861.8 4) Duration sensitivity analysis Increase by 1 year P.V factor at 10% Discounted cash inflow 1 150000000 0.909090909 136363636.4 2 350000000 0.826446281 289256198.3 3 370000000 0.751314801 277986476.3 4 100000000 0.683013455 68301345.54 771907656.6 Total discounted cumulative cash inflow 771907656.6 Initial cost of production 433300000 NPV 338607656.6 Decrease by 1 year P.V factor at 10% Discounted cash inflow 1 485000000 0.909090909 440909090.9 2 485000000 0.826446281 400826446.3 841735537.2 Total discounted cumulative cash inflow 841735537.2 Initial cost of production 433300000 NPV 408435537.2 5) Discount rate sensitivity analysis Year Cash inflow P.V factor at 8% Discounted cash inflow Cumulative cash inflow 1 250000000 0.925925926 231481481.5 231481481.5 2 350000000 0.85733882 300068587.1 531550068.6 3 370000000 0.793832241 293717929.2 825267997.8 Total discounted cumulative cash inflow 825267997.8 Total cost of production 433300000 NPV 391967997.8 Year Cash inflow P.V factor at 12% Discounted cash inflow Cumulative cash inflow 1 250000000 0.892857143 223214285.7 223214285.7 2 350000000 0.797193878 279017857.1 502232142.9 3 370000000 0.711780248 263358691.7 765590834.5 Total discounted cumulative cash inflow 765590834.5 Total cost of production 433300000 NPV 332290834.5 Read More