Stephen Flanagan, Knight Frank Middle East’s Head of Valuation & Advisory explores why development valuations even in stable market conditions, have a degree of subjectivity, inherently due to the number of assumptions and inputs that need to be made by the valuer.
In the current global situation and present market conditions, there are some significant key points to consider when advising on the value of a proposed or partly completed development.
Construction Lead-in Period and Timing
For ready sites where construction has not yet started, it is prudent to allow for an extended lead-in time prior to commencement of construction on site. This could be an additional three or even six months, depending on the project nature and location. In many cases, contractors will not be willing or able to commence work on site and comply with the rules on social distancing in the workplace.
Supply chains for materials are likely to be subject to some disruption, which could mean that an extended construction period is required, with the nature of the scheme having a significant bearing on this and the construction materials being utilised.
In times of heightened risk, an investor or developer will typically seek a greater reward to reflect that proposed risk, but accordingly there is an argument to add a risk premium over and above the level of the development return that would have applied immediately prior to the global Covid-19 outbreak arising.
It is acutely important to establish the actual cost of borrowing on the project if it has already commenced, as this may provide a good indication of the cost of borrowing levels in the market, as well as speaking to a selection of lenders to gauge current appetite. Despite the historically low interest rates currently in place, lenders, if they have any current appetite for new development finance at all, are likely to be seeking an additional risk premium for new lending to developers.
Normal finance rates are probably only available only to blue chip / strong covenant borrowers, with balance sheet lending rather than project based finance. Therefore, a smaller developer could have great difficulty raising finance at anything approaching reasonable rates and lower LTV and higher rates may therefore render some developments impossible to fund at all.
Partially Completed Developments
Valuations of partially completed developments need very careful review in the current market conditions. Scenario examples include:
This is where the lender is requesting an update to assess progress of the scheme and to gauge whether the gross development value (GDV) remains in the same ball park as at the outset of the project. In these cases (subject to any specific client instructions) a valuer would normally assume that the construction contract / developer, remain in place and that the project will broadly continue as originally proposed, although we may of course factor in any cost over-runs, extended construction periods, as well as any changes to the GDV and sales timings.
In the UAE, the practice of off-plan sales and revenues from pre-sales being held in an escrow account to fund construction, will warrant careful consideration going forward from a valuation perspective. Where a residential development is partially complete, consideration must be given to the timing of outstanding sales collections due from buyers. The probability of strong collections is now likely to be impacted and thus it is important to engage closely with the developer to understand how many requests have been received for cancellation or payment deferment. Other key questions to consider in this process are:
– How advanced is the construction progress and what % of due collections have been received to date?
– How well funded is the escrow account and what is the price point of the units under development?
– What is the current value of units in the development versus the contracted value, as well as ascertaining what the likelihood of buyers defaulting is?
In addition, the marketing period for any unsold units in the development, together with the sales price point and any revenue growth assumptions needs careful review. These will need to be carefully examined on a project-by-project basis in close discussion with the developer.
For a commercial project developed for lease, similar careful assumptions need to be made on pre-letting %’s, marketing / leasing up periods for vacant space, and rental levels / payment incentives being offered for the same.
It is more important than ever to highlight to clients within the property risks section of the valuation report, the key property risks in the current market. The inclusion of a sensitivity analysis in all cases is considered best practice and will no doubt be requested by all informed lenders going forward.
*Written by Stephen Flanagan, Partner and Head of Valuation & Advisory at Knight Frank Middle East.