Risk, Uncertainty and Decision-Making in Property

P. Byrne

• Publisher: Routledge
• Year: 2002
• eBook ISBN: 9781135821258
• Edition: 2
• Topic: Business
• Subtopic: Business General
• Index: Business

Provides undergraduates in surveying and property professionals with a clear practical explanation of the various management techniques to improve their property development decisions.

1 Uncertainty, risk and the process of property development

1.1 INTRODUCTION

John Kenneth Galbraith writing in the 1970s called the latter part of the twentieth century The Age of Uncertainty (Galbraith, 1977). His theme was to ‘contrast the great certainties in economic thought in the last century with the great uncertainty with which problems are faced in our time’. Once this uncertainty is accepted as being, as it were, in the nature of things, it is easily seen that those who enter into ventures that depend upon future outcomes have to come to terms with it. One such group of people are those who control business ventures. Consequently it is not surprising to find that it is in this area of activity where attempts have been made to develop a theory of decision-making that copes with uncertainty. Decision analysis has now become a well established part of the curricula of business schools and the like, although it is fair to say that to date the basis of that theory has tended to support a mostly rational/ quantitative methodology. These ideas are only beginning to gain a more general acceptance, particularly with the development of techniques such as scenario analysis and more recently and still controversially, fuzzy analysis.

At first sight it might be supposed that this body of theory and practice would have been taken up enthusiastically by those concerned with the development of land and buildings. After all, uncertainty lies at the root of the process of property development which is essentially concerned with the manufacture of a product in anticipation of an unknown future demand. Indeed, if it were not for the constraint upon supply imposed by the system of town planning, it would rank as one of the most speculative of activities, involving as it does the investment of relatively large amounts of capital into a product that is fixed both in time and space. Yet the property development industry has largely ignored the methods of formal decision analysis adopted extensively in other industries (see for example Marshall and Kennedy, 1992).

Why is this so? It is, no doubt, due in part to the entrepreneurial nature of the business and to the fact that most development companies are, in terms of numbers employed, comparatively small. The formulation and implementation of policy does not therefore require much of a formal structure. Even the largest property companies or the property departments of financial institutions, such as insurance companies and pension funds, are small in management terms when compared with most industrial companies.

There are, however, reasons to suggest that a more formal approach to decision-making is important.

First, property markets internationally have become essentially institutionalized. The financial institutions in general and the pension funds and insurance companies in particular have come to have an overwhelming influence upon the kind of development that is undertaken and the way in which that development is carried out. For a description of the growth of financial institutions in property in the post-war period see Cadman and Catalano (1983), Cadman (1984) and Plender (1982). The informal entrepreneurial spirit of the small property company is much less suited to the perceptions of these institutions in which there is a much greater need to explain and justify particular courses of action.

Second, the collapses of property markets in 1974/5, and again at the end of the 1980s exposed a (continuing) paucity of analysis upon which investment had been made and some schemes had been carried forward, and showed that some lessons had been hardly learnt by the industry. The collapse of large and apparently well founded development companies in the latter period show at least in part the need to have a strong understanding of the factors, however diffuse, that affect the development market (see Ross Goobey, 1992).

Third, the developments in computing hardware and software have made commonplace forms of analysis that were previously both too time-consuming and cumbersome. Fourth, the growth of a body of structured and systematic data is providing decision-makers with a much improved framework of market information. Finally, as more and more people become enmeshed in investment, particularly through pension schemes, the direction of investment is being subjected to much greater internal scrutiny and fund managers increasingly have to explain and justify their own performance and have forced the same levels of scrutiny on those presenting investment opportunities. However much faith is placed in ‘the seat of the pants’, it is difficult to explain it to the outside world.

1.2 THE PROCESS OF PROPERTY DEVELOPMENT

Even when related specifically to property, ‘the development process’ means different things to different people. To some it is simply the construction of buildings, a physical process of production. To others it is essentially a part of a social and political process, involving the distribution and control of resources. We do not seek to deny either of these interpretations and indeed accept that there are others that, while valid in themselves, are not appropriate to our purpose. In answering the question ‘What is development’?, the Pilcher Report (HMSO Report, 1975) gave the following reply:

Development comprises the following tasks:

1. The perception and estimation of demand for new buildings of different types;
2. The identification and securing of sites on which buildings might be constructed to meet that demand;
3. The design of accommodation to meet the demand on the sites identified;
4. The arrangement of short- and long-term finance to fund site acquisition and construction;
5. The management of design and construction; and
6. The letting and management of the completed buildings.

This definition is close to the one that we need for our study. Our own definition is as follows:

The process by which development agencies, together or on their own, seek to secure their social and economic objectives by the improvement of land and the construction or refurbishment of buildings for occupation by themselves or others.

Acquisition, production and disposal

Although there is no model of the development process that can be applied universally, for the purpose of our study, which is principally the investigation of uncertainty and risk, we can divide the process into three parts as follows:

1. Acquisition
2. Production
3. Disposal

The first part of the process comprises the acquisition of the land upon which the development is to take place and the acquisition of the appropriate planning permission. The second part comprises the construction of the building or buildings and the third part comprises their disposal both for occupation and investment. As the process takes place, the developer’s knowledge of the likely outcome increases but, at the same time, the room for manoeuvre decreases. Thus, while at the start of the process developers have maximum uncertainty and manoeuvrability, at the end they know all but can do nothing to change their product, which has been manufactured on an essentially once and for all basis. The process is especially susceptible to risk and uncertainty because, once started, it is relatively fixed in time and place and because it aims at a very narrow consumer market.

During the first part of the process, the period of acquisition, the uncertainties are of three main types: the physical characteristics of the land, the characteristics of tenure, including restrictive covenants and easements both in favour of and against the land, and the nature and extent of use that the local planning authority will permit. Most developers will attempt to identify and determine all these factors before committing themselves to the purchase of the land. Land acquisition cost is often the first major commitment of capital and as it comes at the start of the development process it is then like a snowball, accumulating interest throughout the remainder of the development.

During the second part of the process, the period of production, the main element of uncertainty is the cost of construction. This factor, which represents the second major capital commitment, is substantially determined at the start of the building contract with the builder. However, in nearly all cases there will be some element of fluctuation allowed for in the contract and, in any event, the phasing of the construction and the length of the building period can never be fully determined at the outset.

The third part of the process, the period of disposal, can be seen as comprising both the disposal of the building to one or more occupiers and its disposal as an investment. Where the occupier is also the owner, as in the case of the residential owner-occupier or where a commercial or industrial building is sold to a company for its own use, the two forms of disposal are fused together. In most commercial and industrial developments, however, the buildings are let to one or more occupiers on full repairing and insuring leases and the consequential stream of net income can then be sold as a property investment. The uncertain factors that lie within the disposal phase are, therefore, rent and investment yield or, in the case of residential property, capital price. Because it is physically fixed to a precise location, and because it has to be manufactured well in advance, the eventual product of property development is trapped within a particular social and economic framework which is largely beyond the developer’s control. No developer of a speculative development project can be sure of the market conditions that will prevail as and when the development is completed.

Some of these uncertain...

Table of contents

• Cover Page
• Half Title Page
• Other Titles from E & FN Spon
• Title Page
• Copyright Page
• Copyright Page
• Copyright Page
• Preface
• Preface to the first edition
• Chapter 1 Uncertainty, risk and the process of property development
• Chapter 2 Decisions and decision-making
• Chapter 3 Assessing risk and uncertainty
• Chapter 4 Decision methods in development appraisal
• Chapter 5 Development appraisal the Monte Carlo way
• Chapter 6 Advances in development appraisal simulation
• Postscript
• Appendix: The characteristics of the normal distribution
• Bibliography
• Index