ARGUS DEVELOPER Havard IN PRACTICE A R Real Estate Development Modeling G in the Real World U This book is a practical guide to using Argus Developer, the world’s most widely used real S estate development feasibility modeling software. Using practical examples and many case studies, it takes readers beyond basic training and provides the in-depth knowledge required to analyze potential real estate deals and help ensure a profitable development. D Argus Developer in Practice fills an important gap in the market. Argus Developer, and its predecessor Circle Developer, has long had a dominant position as the primary real E estate development appraisal tool. It is used all over the world on a variety of projects ranging from simple residential projects to huge and complex master planned, mixed- V use, commercial, residential, and leisure projects. It also shines when used to appraise “refurbs”—taking an existing building or complex and upgrading it or turning it into some- E thing entirely different. Argus Developer in Practice, the first book that concentrates on the practical appli- L cation and use of the program, goes beyond the manual that comes with it by taking you through the development/project appraisal process step by step. In addition, author O Tim Havard has over 25 years of experience in carrying out development appraisals both in practice and in teaching at the postgraduate level in UK and Australian universities. P He started using the DOS version of Circle Developer in 1990, then worked for both Circle and Argus training clients on the software in the UK, continental Europe, and the Middle E East. Besides showing you how to use the program, Havard shows you how to think like a successful real estate developer. R Using an extensive array of screenshots, Argus Developer in Practice delves deeply into practical use of the program by offering case studies of varying complexity that will help real estate professionals not just analyze development projects but also learn how the IN best minds in real estate analyze a project’s potential. You will learn: • How to model both simple projects and complex mixed-use and multi-phased P investment schemes R • How to model new uses for existing properties • How to think through real estate project problems A • How to analyze a potential development project in depth By using the program efficiently and making use of its more advanced features, you can help C ensure a profitable project without the surprises that accompany most real estate ventures. Argus Developer in Practice therefore provides something priceless—peace of mind. T IC E ISBN 978-1-4302-6262-6 54999 Companion eBook US $49.99 Shelve in: 9 781430 262626 Business/Real Estate www.apress.com For your convenience Apress has placed some of the front matter material after the index. Please use the Bookmarks and Contents at a Glance links to access them. Contents about the author                                             ix acknowledgments                                             xi preface                                                     xiii Chapter 1: appraisals: an overview                            1 Chapter 2: an overview of argus Developer                     13 Chapter 3: argus Developer: advanced Features                  35 Chapter 4: Commercial Feasibility studies                       53 Chapter 5: Residential Feasibility studies                       133 Chapter 6: more Complex projects                            163 Chapter 7: modeling project Finance                           177 Chapter 8: Understanding and modeling Risk in Feasibility studies   211 Chapter 9: Wrap–up                                        225 index                                                       237 C H A P T E R 1 Appraisals: An Overview Development Appraisals and Financial Feasibility Studies in the Development Process Before we get into the ins and outs of Argus Developer and how to use it effectively, let’s take a step back and understand the goals it is meant to help us achieve. Why Do Appraisals? Although this is not meant as a development textbook but one that concen- trates on modeling using the industry’s main software tool, it is useful to set the context and establish the roles development appraisal, sometimes known as financial feasibility studies, have in the development process. Financial feasibility studies are also known as development appraisals. They involve the gathering together of all the information on costs and values of a project. This information is incorporated into a framework and used to deter- mine the answer to some key questions. Development appraisal is one of the key aspects of assessing the viability of a development project. It is, however, used throughout the development process to fulfill a number of key tasks. 2 Chapter 1 | Appraisals: An Overview ■ Note Development appraisals, also known as financial feasibility studies, are used in part to determine the value of a piece of property based on what you want to do with it. Primarily, appraisals are used to determine the bidding price for a piece of land. This can be difficult because a piece of development land has no intrinsic or set value; it only has a value derived from the use it can be put to. The value is determined by the market and restrained by the planning and/or building restrictions on the site. Every scheme proposed for a site—residential housing, hotel, retail, and so on—will generate different values. If a piece of development land has been fully exposed to the market, then a range of appraisals based on different schemes will be made on the site by different prospective developers. The landowner will generally sell to the developer who submits the highest viable bid. Thus, the financial appraisal is a key component in determining the highest bid a potential developer can make while still meeting the target return for the project. The second major use of appraisal in the development process is to deter- mine the profit or loss the scheme will make. This is vitally important because it shows the developer whether the plan is viable or not. Appraisals can also be used to explore the impact of different variations in the project. These variations might concern design, the use or use mix that the site can support, or the different timing of elements in the project. They can also be used to determine peak profitability—that is, when it might be advantageous to sell. The financial feasibility study will also be used by commercial lenders to deter- mine whether they will lend you money to carry out your plans. Commercial lenders will look at the financial appraisal very carefully before advancing any funds. In essence they look at two things: 1. Assumptions. Lenders check to see whether the assumptions relating to the development values are sound. Lenders will carefully examine all of the compo- nents of the completed project. They will look at the rental values and the yields that have been projected by the developer for realism. They will also scrutinize the selling or leasing program to determine whether goals can be achieved. Then they will examine the construc- tion costs and all the other elements of the project. The appraisal lays these factors completely open to scrutiny. In short, the developer and lenders will use the develop- ment appraisal to prove whether the assumptions in the development project are based on sound projections. Argus Developer in Practice 3 2. Profit margin. If the financiers are satisfied with these factors, they will then look closely at the profit margin on the project by the appraisal. The financiers want to be satisfied that the developer will achieve a sufficient profit margin. It may surprise some that the financiers are inter- ested in the developer’s profit, but the lenders are primar- ily concerned about the developer's financial stability. The profit margin reflects the risk margin on development. Basically, the larger the profit margin is, the less risk the lender will assume by advancing funds on the scheme. There are no set margins as to what lenders will look for in terms of returns. The normal rules of thumb call for a 20% profit margin on costs for speculative commercial schemes, 10% to 20% returns on cost for commercial projects with leasing precommitments, and 10% to 15% on residential projects. ■ Note Lenders do not look for set profit margins on real estate development projects. Typical returns range from 10% to 20% based on the type of development. These are the primary initial uses of development feasibility. There are other uses as well. As noted above, developers will explore the effects of altering, reworking, and changing the timings in the scheme. Projects often require rethinking during the project lifetime. This may involve changing the mix of property that will be developed to suit market requirements. The appraisal will be used to see what the effect of these changes is on developer profitability. Above all, the baseline appraisal allows you to explore all the options and assess the greatest possible profit on the development you are considering. Common Appraisal Elements The process of development analysis involves many disciplines of knowledge, including structural and services engineering, architecture, project planning and management, marketing, and urban economics. The feasibility report should communicate the facts, assumptions, figures, and recommendations gained dur- ing the analysis process. The person preparing this report does not need to have direct knowledge of all details required, but he or she should at least understand the impact of each critical factor and how and where this information can be accurately determined. This process of information management requires inves- tigative skills, mathematical application of data, and intuitive thought. In short, anyone setting out to do a development appraisal in today’s world will not be able to use traditional approaches using a simplified manual calcula- tion. You will need a sophisticated spreadsheet (and the skills to go with it) or a proprietary software system such as Argus Developer. 4 Chapter 1 | Appraisals: An Overview The process of carrying out the full feasibility study is beyond the scope of this book. But before we look at models in Argus Developer in detail, it is important to reflect on the basics of development appraisal. The basic equations for a development appraisal are simple. To calculate devel- opment land value (or rather a land bid), the following equation is used: Value of the buildings on completion Minus: The development costs (construction, all fees, all ancillary costs, and all the costs of finance) Less: An allowance for developer’s profit Equals Land Value (maximum sum available to buy land) An alternative equation is used when developers know their likely input costs for land and construction and want to discover whether the scheme is viable— in other words, whether it produces sufficient profit for them to proceed: Value of the buildings on completion Less: The development costs (construction, all fees, all ancillary costs, and all the costs of finance) Less: Land cost (including fees) Equals Development Profitability Note that the appraisal is always looking to solve for the unknown element in the equation, either land value or profitability. All of the elements mentioned in the formula will have to be established or estimated. This is breaking feasibility studies down to their very basic components. If things were as simple as this in practice, we wouldn't need expensive software models! The complexity in appraisal comes from the sheer number of components involved—ensuring that everything has been accounted for, calculating the all the components’ correct values, and allowing for when these items will take place, which in itself will have an impact on their values. This process is further complicated by the fact that everything occurs in the future with the developer/appraiser often dealing with a scheme that exists only in outline. Argus Developer in Practice 5 ■ Note Keep in mind that a development appraisal is always no more than a forecast of a series of future, uncertain events. Appraisal Challenges I used to run a master’s program in real estate development at one of the top universities in the UK. We had a weekly guest lecture spot for people from industry, and one of my favorite speakers was a grizzled 30-year veteran of commercial real estate. He frequently used the same phrase over and over again: “Development is not rocket science.” He was, of course, absolutely right. The fundamentals of real estate develop- ment, as we saw in the last section, are very simple: Build something that you can sell for more than it costs you and bank the profit. The components of building are themselves simple; we have been doing it for thousands upon thousands of years. Bring a Roman surveyor or craftsman back from the past and put him on a modern construction site and, after a little acclimatization, he would soon be very much at home. We have some sophisticated tools now that make our lives easier but, fundamentally, things have not changed that much. The developer was also slightly wrong. Although fundamentally simple, the process of modeling is complex. As noted above, not only do you need to account for everything required to complete a project, but you also have to put the components into the correct time framework. Although some time elements are predictable, key components, including the critical ones of when something will sell or lease, are very uncertain. The models have to incorpo- rate often-sophisticated assumptions about financing, how money flows in and out of the scheme from a variety of sources, and how to apply differing cost, drawdown, and repayment possibilities. To complicate things further, these timing assumptions may need to change either prior to the project starting or, often, during it, as circumstances change. An appraisal model has to take these things and many more into account. An obvious question that must be asked at this point is the following: Why use a proprietary software system such as Developer and not a self-constructed Excel spreadsheet? Excel is, after all, a wonderfully flexible and powerful tool that can and is used globally for complex tasks—and, in fact, is used in rocket science! So, why not use it here? I used to be a strong proponent of Excel spreadsheets, frequently using and creating them, and applying them widely in both practice and in the classroom. I am now more wary of them, even though they are still probably the most widely used tool in the industry. In early 2012, I found myself embroiled in a debate on an Internet real estate discussion site about the merits of proprietary software vs. Excel. 6 Chapter 1 | Appraisals: An Overview I came across the site accidentally while checking a reference. I was interested in the debate that had clearly been going backward and forward for some weeks and, always enjoying an argument, decided I would join in. Having been heavily involved in this area for a dozen years or so and having originally been a great advocate of Excel, I found it odd to be on the other side of the fence arguing with the site owner. He did make some excellent points, some of which I quote here: I have a good friend who is an engineer for a leading aerospace-component design and manufacturing facil- ity here in southern California. They produce nacelles mostly, but that’s beside the point. Their parts are used by both Boeing and Airbus. Their work requires mod- eling the physics acting on their parts, and extensive and sophisticated testing is required by regulators and for simply quality control purposes. What do they use? Microsoft Excel with Visual Basic. The planes you and I ride in were in part designed and tested with Excel. I have a colleague who works on Wall Street creating and trading financial derivatives for a leading invest- ment bank. His whole firm (and industry) use Excel. Why? Because of its power and breadth and because they—like every other MBA from a top university— used Excel for their finance and statistics classes. All the leading texts (particularly Bodie/Kane/Marcus) in finance go through examples in Excel. And this isn't simple dis- counting we're talking about but CAPM, linear regres- sion, options pricing, and so on. Excel is the standard. As much as I like to think that real estate analysis and valuation demands brilliance and a firm grasp of com- plicated and arcane mathematics/statistics (and good looks to boot!), it simply doesn’t. Beyond logic (if this, then this . . .) and high school math (but not even as advanced as calculus), commercial real estate analysis requires only an understanding of Present Value (mathematically speaking). The modeling we do for real estate is child’s play compared to the capabilities of Excel, as evidenced by its much more rigorous applications.1 1Landon M. Scott http://incomepropertyanalytics.com/alternative-to-argus/ #comment-896. Accessed 7th May 2012, reprinted with permission. Argus Developer in Practice 7 These are very good and valid points. It is natural, then, to apply Excel to property development. It looks like the ideal tool for the job and, indeed, many practitioners pride themselves on their Excel abilities and the sophistication of the models they use. But I no longer would use it and the reason simply comes down to the risks of error involved and the high stakes involved. Real estate development is a high-stakes poker game; you can win a lot, but you can also lose huge amounts. That is a huge part of the appeal. However, there are enough risks involved with the sector in general without adding to it elements of risk that come from using self-constructed models. These errors can arise from a whole host of sources: 1. Errors due to time pressure. Many workplaces are high- pressure environments, with appraisers having to do complex work within a short time frame. 2. Failure to properly audit the spreadsheet. Auditing can eliminate errors from the spreadsheet, but each time you create a spreadsheet item or make a change to a spreadsheet model requires you to follow an audit trail. That costs you time. Standardized models such as Argus Developer do not need the same audit and, therefore, save you considerable time in checking the mechanics of the calculations. 3. Incorrect modification of an existing spreadsheet model (and a presumed failure to audit). This is a common set of circumstances. Development projects are not static; there are always many changes from the initial appraisal, where many assumptions have to be made, up to the final appraisal immediately prior to commencing work on-site. 4. Application of an existing model to new development projects. It is a natural thing when considerable time effort has been invested in the creation of a spreadsheet model to spread the cost (and save time) by applying and adapt- ing the model for different projects. This not only opens up the possibility of modification errors as in number 3 above, but also in the perpetuation of errors from ear- lier projects. That’s because people will assume that the applied model will have been audited and is error-free on the earlier projects. So, in summary, the challenges of doing a development feasibility study is producing a reasonable and logical forecast of expenditure (money out) and