Mitigating the key risk element to property investment

One of the best check-and balances before making a buying or investment decision is to make sure the asset has been acquired at or below replacement cost.

Base Land Value.

Replacement cost can be assessed using a few different methodologies; it can be assessed down to residual base land value in the most conservative fashion.

Assessing Upside Future Value.

For example, if you invest in a development site or funding future development, the value will often be assessed on its upside value. On the amount of NLA (Net Lettable Area) or GFA (Gross Floor Area), you can notionally achieve under the council code or local authority plan permissions on that site. A notional value – a rate per sqm or rate per unit site if the site is residential – will be applied to that notional GFA or NLA of the future Floor space area.

Real Value.

Yet, without approval on that site, the land is only really worth the base land value. The notional rate per square metre on NLA or GFA - or the rate per unit site - is only relevant if the site is approved for the specified amount of built floor space AND if the market is absorbing the completed stock at the specified value – be it commercial or residential.

Incoming Acquisition Price Makes A Deal.

An investment is made or broken by the incoming price paid for the land or underlying asset base.

An Upswinging Market.

So, in an up swinging strong market, the end value of the completed conceptual development will also increase, which will increase the underlying value of the land.

Swings & Roundabouts.

However, if the market turns, changes the cycle or takes a pause, that notional upside value can dissipate quickly and reduce back down to the base residual land value of what that land was originally used for, be it a car park or farming land or otherwise.

Land Leverage.

This is where you will often see developers buying up raw farming land on the outskirts of established CBD and suburban areas, which don’t yet have the correct zoning. Yet, there will be a longer-term planning vision at, say a state government level to rezone the precinct for growth and to add infrastructure, which can increase the value of the land.

Shared Upside for Planning Outcome.

The developer will usually negotiate an option with the owner of the land, which is reflective of current use, with additional amounts payable to the incumbent landowner on various upside outcomes being achieved from a use and floor space ratio perspective.

More Floor Space Higher Value.

In other words, the more floor area that the developer can achieve on the site via a development approval process - and or rezone - the higher the value of the underlying land site.

Ultimately Supply-Demand Drives Value.

Regardless of the floor space achieved, the commercial outcome and value of that site will still depend on the market – and how much an occupier of the finished space is willing to pay. This is usually based on recent market comparable sales and leasing transactions at the time.

The Key Risk Element is Timing.

The main variant in this will be overall economic conditions and the supply-demand fundamentals at the time that the completed development is marketed for commitments from end occupiers. And this timing element is where the critical risk lies.

Replacement Value: An Existing Asset

The other methodology when looking at an existing asset – say completed residual residential apartment stock, or commercial office, or even a retail shopping centre – which is ready to occupy now is: “Can the land and building be replaced today for less than what I am buying for?”

Replacement Value Assessment

From this perspective, adding up the current market land value, the DA costs, and the consultant and construction costs for the completed building is one methodology. Ideally, the outcome should be that the subject asset is being acquired for less than what it would cost to construct a competing product in today’s market.

Replacement Value: Asset & Income

In a more opaque market like the current post-COVID low-interest rate economy, where there is a likelihood that we are nearing the end of – OR - entering into a new economic cycle, and where longer-dated and defensible income is the most valued type of investment, assessing the replacement of the land, building and the income stream is also relevant.

Replacement of Income Assessment

In this case, the replacement value assessment would include the sum of the land acquisition value, the consultant costs and DA costs in obtaining a DA, building the building, any downtime to leasing or selling that building, as well as agents fees, marketing fees and leasing incentives paid to a prospective tenant.

Illiquid Nature of Unlisted Real Estate

Like anything, when assessing an investment or making a buying decision in the investment-grade real estate markets, the decision needs to take into consideration the longer-term aspect of the asset class, given its more illiquid nature.  

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Mandi Prager
Founder and CEO
MP Group

MP Funds Management has executed more than 28 investment-grade real estate deals, an aggregate value of over 1.3 billion dollars in assets, producing an average investment return of 22 percent annually (IRR), with the lowest returning investment...

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