Property development - lumps, bumps and slumps

Here's a sector that's relatively easy to understand, but there are still some factors to watch out for

Sat, May 19, 2018

Alan Lok
Eunice Chu
Guruprasad Jambunathan

IN a complex and fast-moving financial world, it's comforting to know that some sectors remain relatively easy to understand. A case in point is property development. The property developer acquires land, an architect then designs the building and obtains planning approval before passing the baton to the construction team.

At this stage, the developer could choose to undertake marketing and sales before construction is complete or wait until the last brick falls into place. Either way, you can then calculate the gross development value (GDV) of a project or profit from the project, of which the sum of GDV, excluding the developer's liabilities, will yield the value of the development.

Lumpy revenue generation

So far, so simple. There are, however, a few variations that you should note. We shall begin with the lumpy nature of revenue generation.

It can take years to complete a project, and if the developer has only one development, then the profit-and-loss account will not record any revenue during the planning and construction phase - something that can stretch for many financial reporting quarters. Upon completion, and the subsequent sale of residential or commercial units, revenue will spike before declining when all units are sold. Investors and analysts are somewhat uneasy with this "erratic" performance.

That said, revenue volatility is not a pertinent issue for big developers, as they usually have multiple projects running with different completion dates.

For companies that do not fall into this category, the need to smooth out their income stream is far stronger. The following steps may stabilise the variations:

Develop the land in phases. The first tranche is completed and sold, often at a lower entry price to generate interest in the project. When word gets out that the initial stage was well-received, work will start on phase two. By adopting this approach, the smaller developer's revenue will appear more fluid.

For developers that lack the financial resources to take on multiple enterprises, there is the option of running numerous projects through joint ventures. The landowner supplies the land while the property developer does the rest, which evens out revenue reporting numbers and reduces risk exposure to a project.

Generate money from property investment. Developers may hold on to units for rental purposes, forming a revenue base and providing earnings stability. Alternatively, they may spin off the property investment portfolio to a Reit, where dividends are declared on a quarterly or half-yearly basis.

Is it also important to point out that any assessment of a property developer should consider the geographical distribution of its revenue sources - diversification reduces the risks associated with revenue concentration. Nevertheless, embodied in the points above are the all-important reputation and track record of the company.

Different demand factors for developers

For residential property developers, key statistics include demographics: population, age, and net migration, as well as movement from the countryside to the city. Changes in income statistics should also be observed. Other areas to investigate include issues relating to single-occupancy city-centre apartments and suburban family houses. It also pays to understand the culture of each market - is home ownership seen as a measure of success, or is perpetual renting the norm?

In the wake of near-zero interest rates, property prices have accelerated in many countries, including those in Asia-Pacific where the price-to-income ratio (a measure of affordability) has soared. Governments may therefore offer subsidies to first-time buyers, which can bode well for developers in the lower-end space.

When examining the more cyclical commercial property developers, begin by looking at economic data. Stronger growth and expansionary monetary policies usually suggest an increase in business activity. Therefore, warehouses, factories, and retail assets will be highly sought after. The expansion in the service industry will also propel demand for office space.

After that, drill down and explore the factors unique to each industry and the location of the property. For example, when researching hotels, you should examine the growth in tourist arrivals. Another significant factor is the expansion of e-commerce, with demand for retail space suffering in favour of high-tech warehousing space in Asia-Pacific.

Land - the crucial raw material

Most developers possess a land bank, but this is an asset that can be depleted if not replenished promptly. Companies do participate in public auctions of land released by governments - in Singapore, this is known as the Government Land Sales Programme. Developers can also choose to buy land from private owners. The key to land parcels is location, location and location.

Alternatively, developers may acquire old buildings. While this can be less expensive than participating in auctions, such activity raises questions about the time and cost-effectiveness of renovating or converting an existing asset. In some areas, they may also "land bank" through the conversion of one use of land to another, subject to the jurisdiction of the local authority.

Study the developer

There are key performance metrics you can employ in the study of developers. Sell-through rates for recently launched projects can be an indication of company performance, track record and reputation. Observe changes in overall transaction volume, also known as transaction velocity, as there is a strong correlation between share prices and property transaction prices (as measured by Property Price Index) and volume.

Changes in unsold inventory can indicate cyclical upswings and downswings. As a value measure, share price to Revalued Net Asset Value, (RNAV - which is the book value of development property plus revaluation surplus) is a useful metric. During an up cycle, this ratio may range from around 0.9 to 1.5. On the other hand, a bear market can see this ratio range from 0.3 to 0.6.

A study of how a developer manages its working capital (WC) requirement is helpful. Such an assessment should begin by analysing how it raises WC and its implications on the cost of capital and risk. At the same time, find out if the developer requires a higher level of WC in different areas of its operations, such as projects in other countries. Investors also need to note the developer's capital-allocation strategy in apportioning money to acquiring land parcels, developing properties and other competing uses.

Another variation on the straightforward business model is the outsourcing of construction to contractors, as well as sub-contractors. A developer's essential competency rests on having a keen eye for acquiring reasonably priced land parcels and developing these into coveted real estate trophies. While doing this, its management may decide to focus on what generates value for the business and outsource the construction segment. When extracting value from construction, the core competency differs - in this case, execution and cost control form the recipe for success. If this is the variation, then capital and WC requirements will be lower.

Sources of capital

Funding is critical for property development projects. External sources of money may come from bank loans, bond financing, share-rights issuance, or some other form of equity financing. Where a property developer has obtained funding, do take the time to understand its structure because this can impact returns, especially if the company is highly geared.

Risks - analyse these under a microscope

A developer may successfully bid for land during a boom only to experience a subsequent market correction. Alternatively, it may pay too much for land plots.

There may also be a supply shock with too many projects being completed all at once. This oversupply can be exacerbated by macroeconomic downturns, depressing both prices and take-up rates. Highly leveraged developers are acutely exposed when there is a double whammy of falling prices and risk-averse buyers.

Government intervention in the market is a further source of risk. Developers may experience the adverse consequence arising from regulatory policy changes designed to curb a perceived bubble.

Alan Lok, CFA, is the Director, Society Advocacy Engagement of CFA Institute. Mr Lok researches and writes on investor protection issues and capital-market structure.

Eunice Chu is an ACCA-qualified finance professional. She was a regional finance director of a Fortune 500 multinational corporation and at present heads the policy function of ACCA Hong Kong.

Guruprasad Jambunathan, FRM, is a Director for Financial Research at CRISIL, a global analytical company. He has over 12 years of experience in equity research and works closely with a broad clientele of buy-side and sell-side firms, as well as with academic think-tanks across various continents.