Comments On The Spatial Planning And Land Use Management Bill, 2011 Of South Africa

The one problem I have with the wording of the Bill relates to the whole aspect of dealing with the value of property. Investors in property, which include banks through mortgage bonds, rely on property’s inherent value.  The Bill instructs that when Councils are required to make decisions, they should not allow themselves to be constrainted by the consideration that such decisions will impact negatively on the values of surrounding properties.  To me that sounds like a value-eroding instruction.

The South African economy is classified as being as being developmental in nature. In so saying, it is only logical that politicians could be expected to pursue policies that further the interest of rapid development. Property development is a highly risky endeavour in which significant sums of capital and time need to be injected in one fell swoop. Once the money is in the ground, there is no going back, as opposed to say equities, wherein investors can sell their shares or even invest small sums at a time . The exit strategy of property development is rather long term in nature. Therefore, the risk of value-erosion is a variable that needs to be managed very delicately.

The benefits that arise out of the concept of value in property assets are many and varied. Firstly, the tax base of any city based on the concept of value. Municipal rates and taxes are levied using calculations which have property value as the starting point. Government agencies such as the Revenue Services generate capital gains tax on the basis of value that has accrued to property assets over the years. Before the Treasury Department can approve a Public Private Partnership project, it is guided by value accruing to Government as one of the three, perhaps the most fundamental of considerations. Banks use the value accruing in property as collateral to extend credit to consumers. Without the confidence that value in the properties on which credit is being extended, bankers would be hard pressed to approve property loans. Very few people are wealthy enough to be able to purchase property for cash. Most people buy property on the knowledge that property is guaranteed to appreciate in value over time. An entire statutory body, called the Valuation Council is in existence, precisely for the purpose of regulating the value of property. Section 25 of the Constitution of The Republic of South Africa protects the market value of property. Even under conditions of expropriation, the State is still required by the Constitution to take value into account.

The Drafters of the Spatial Planning And Land Use Management Bill, 2011 Of South Africa should perhaps review their thinking with regards to property values and reconsider.

The Legacy Of The Development Facilitation Act 67 of 1995

The Department of Rural Development and Land Reform has marked the Development Facilitation Act No. 67 of 1995 (DFA) for repeal. This particular piece of legislation had as its main objective the acceleration of the delivery of housing to the poor of South Africa, post the first democratic elections of 1994. The DFA became necessary because the process of approving land use applications, under the control of municipal authorities across all property types, was painfully slow. Despite the promulgation of the DFA, housing delivery has not caught up with the growing population numbers of the targeted population sector. In the meantime, however commercial and high value residential developments accelerated at an unprecedented pace in one of the largest property booms in South Africa, to the dissatisfaction of the municipal managers.

During the period 1998 to 2007, South Africa experienced an unprecedented property boom. This anti-poor property boom brought about the current conflict between the DFA and the legacy legislation, this being the Townships Ordinance 15 of 1986 – anti poor because it did not assist in the provision of housing for them while diverting bulk services to these luxury developments. It did create some temporary job opportunities in the construction sector though.

When the DFA was enacted the Ordinance was not repealed. The drafters at the time hoped that for the sake of meeting the promises made to the electorate, the two pieces would co-exist harmoniously side by side. The other reason for not repealing the Ordinance was that the target areas where the accelerated development was required did not have town planning schemes, which the established suburbs had. On the other hand DFA had time frames were incorporated in its provisions within which the municipalities were forced to have reached certain milestones in the application assessment process.

The DFA however ended up being used by commercial and luxury residential developers to circumvent the townships ordinance to get approval for their developments. Clearly, the target population could not benefit from the latter’s developments. Even worse, these developments were perceived to be creating urban sprawl and bulk utility services were being rapidly depleted, to the detriment of the target communities. Such a state of affairs is not how the politicians wanted things to go, so the DFA had to go.

The municipal planners and the politicians were now of one mind in that the DFA did not meet their needs. The municipal authorities went to the law courts where they lost some major cases and the DFA stayed, if only for a while. This Act is about to be replaced by the Spatial Development Act of 2011, currently in the Draft Bill stage. Only time will tell whether this new piece of legislation will go the full distance to becoming an Act of Parliament. A very important Bill was also put through Parliament some five years ago, by the name of the Government Immovable Asset Management Act, but it was never enacted. Another important government initiative which was started but never seen through is the Urban Renewal Project in the Tshwane Central Business District.

Municipal planners and developers will always be positioned on opposite poles of human behaviour. While developers have traditionally been seen as the evildoers who have excessive profits as their only motive, at the expense of the public, municipal planners and environmentalists have been seen as the defenders of the public good. Certainly with the last property boom most developers did make superprofits, however, the ancillary costs, such as land holding costs during a lengthy low activity period, were also very high. Consumer behaviour is something very difficult, if not impossible to plan for. Developers are people who have chosen a career path of studying consumer behaviour and then planning for meeting people needs well in advance. For this, they are often required to take extreme risks, for which it is only fair that they are rewarded accordingly.  Authorities and planners can never dictate the direction of development. Their duty should be the guidance of the development process in order to create a harmonious environment for the benefit of all society, be it the end-user or the supplier. If the municipal planners were truly dynamic, then there would not have been a need for the DFA after all.

The DFA is a very effective piece of legislation. It has helped to facilitate one of the strongest property booms in South Africa. It did a good of exposing the weaknesses inherent in the Ordinance. It remains to be seen how the new Bill will consolidate the strengths of and minimise the weaknesses of the DFA and the Ordinance to take advantage of worthwhile development opportunities.

Real Options And Property Development Decision Making

Real options are increasingly being promoted in the academic world for use by developers to make more informed decisions on the timing of property development and the valuation of development land. The proponents of the theory propose that property development investments provide developers with several options that can increase value through flexibility of decision-making.

Decision-making under conditions of uncertainty requires managers to make financial decisions that affect the future, whilst they are unable to predict future events with absolute certainty. Any decisions that are being made now assume a certain amount of inefficiencies arising from the risk of making a partially incorrect decision due to the inability of managers to predict the future with absolute certainty. The converse statement to this is that one can wait a bit longer for more information to make better decisions, which delay gives rise to an option. Real options theory claims to be able to value the option contained in this delay.

Various decision-making methods, like the discounted cash flows (DCF) are used extensively to forecast the future. One of the most common DCF techniques is the net present value (NPV) technique. This technique holds that an NPV calculation that returns only a positive result means that a development should go ahead. An NPV calculation only uses information that is known at the time of the calculation, whereas property development is an at-least 50-year decision. NPV evaluates a development project as if it will be completed, regardless of whether they it still makes sense mid way through the project or not. Cash flow and discount rate variables change over time and as a result the NPV should also change. A project that may look positive now may not be attractive a few months later and vice versa, thereby increasing the chance that the wrong decision can still be made.

Property development is an extremely complex activity which involves significant numbers of people and skills, utilising extensive resources over an extended period, for the provision of physical buildings in the future. It all starts with the provision of development land. The most popular method of valuing the land component in a development is the residual valuation method. Briefly, this method works by calculating the development’s NPV and confirming that the project should be embarked upon. Thereafter the building cost must be subtracted from the total investment outlay, thereby arriving at the residual value of the land. It therefore not scientific in that it works in reverse logic.

Other questions arise when the DCF is used, for example: what discount rate should be used on the future cash flows? What are the variables used to build up the discount rate? What time period must the calculation be done over? How is the risk premium to be calculated? Practitioners often do away with the complexities of the NPV and dispense with the investment decision by capitalising the first year’s projected net income with an appropriate rate to arrive at a value estimate.

NPV gives no indication as to when the decision should be implemented, whereas real options can help with such a determination. The decision as to when to proceed with a particular development has generally been based on the position of the rental growth curve in relation to the building cost growth curve, as observed over a period of time. However, the exact timing as to when this condition will be reached and for how long it will last can never be predicted accurately. Another trigger used to to time hotel development is to observe what is called the hurdle rate, and again, as with NPV, once discount rates get used then the chance exists that an incorrect decision could be made. The hurdle rate is tied to to the company’s cost of capital.

Real options mean various things to various people. The synthesis below explains what they say about real options as they could be applied to property development. In finance, an option is a contract between a buyer and a seller that gives the buyer of the option the right, but not the obligation, to buy or to sell a specified asset (underlying) on or before the option’s expiration time, at an agreed price, the strike price. Real options are an off-shoot of financial options, and can be defined thus: A situation in which an investor is able to choose between two different decision options where both choices involve tangible assets, such as real estate. Real options allow developers the ability to treat vacant lots of land as options to wait to develop. By considering developments which provide the ability to react accordingly to the uncertainty of future forces, developers can better manage the risk associated with a potential weak market while also gaining the potential to benefit in a strong one. Flexibility of this type in real estate is generally known as a real option. Real options add value to a project by providing developers with flexibility to minimize downside risk or take advantage of upside potential as conditions change from deterministic expectations. The model proposed values these managerial flexibilities and shows improved risk management, identifying the optimal strategy and timing for the construction phases.

The assumption with NPV is that the investment decision must be made now or never. However, many projects create future opportunities or threats, which may be a significant source of value or loss. These opportunities can be modelled as real options. With this view, an investment decision can be considered as a call option. The value of the project is just the value of the option to invest. The exercise price is the cost of the investment, and the gross option return is the discounted expected value of the investment returns. This option is exercised when the gross return is high enough. The DCF method fails to evaluate this option correctly.

Short term land speculators also use options extensively whereby they pay a fixed sum to a seller of a prime parcel of land, subject to a higher, final payment should a development be proceeded with on the land. If the development does not go ahead then the option lapses and the land reverts to the seller, together with the initial payment.  This is a powerful example of how options can be used in property development. However if the entire development decision is treated as an option, even better land-banking decisions can be made. Banks have, much less now than in the past, used financial options to facilitate loans to their blue chip corporate clients for property developments. Real options are different in that the option is integral to the entire development and the valuation methods used to value the options do not rely on discounted cash flow analyses.

Real options use some intricate mathematical tools, which are not the subject matter of this article, to value the subject land and the development. Suffice it to say that the list includes decision-tree analysis with probability theory, binomial theory, derivatives and stochastic processes and others. However the techniques seem to cover most of the abstract mathematical concepts that DCF does not cover. Perhaps in a later article I will attempt to explain the mechanics of the proposed theory works in practice.

The flexibility inherent in real options is the cornerstone of this theory in that it allows developers to make better decisions as they have the option to delay making a decision. The abandonment option is a problem because most construction contracts do not allow for abandonment, especially when the contract is of the fast-track kind. The disadvantages of real options at the moment are that developers are still content to use the NPV. South African developers are not quick at adopting new methods of doing things, as evidenced by the slow adoption of the NEC construction contract documents.

Real options theory has been written about extensively in property development journals. Some reputable Universities are teaching real options as part of their property education curricula. Through the way that real options promise to deal with the problems inherent in NPV analysis, developers should at least look to see if its applicability in their projects can be justified.

Property Investment 101 – The Property Syndication Lesson

The recent reports and comments involving a very prominent property syndication company provide a case in point. Due to the inability of this company to make a mandatory distribution to its investors recently, various commentators have not lost the opportunity to criticise the property syndication investment model as being bad for investors. The main critics blame the lack of liquidity in the model for the said company’s problems. I do not believe that is a fair criticism for many reasons, some of which I will attempt to outline below.

Wikipedia defines liquidity as follows: “A liquid asset has some or more of the following features. It can be sold rapidly, with minimal loss of value, any time within market hours”. Property by its very nature is very illiquid. Bricks and mortar, unlike equities, cannot be turned over a short space of time. Too many variables enter the equation here. Timing is one of the most important of these. Entering and exiting the market has to be timed perfectly. It is said that a property investment cycle unfolds over seven-year periods. So it takes quite a long time for investors to start realising any serious benefits. Or, as some would say, property is a long term investment.

During this time, investors can either leave their returns in the investment or withdraw them every month. If they choose to withdraw their distributions, then they forfeit the capital growth that accrues to the investment as a result of compounded growth. In such a case then at the end of their investment period they can withdraw their capital subject to the ravages of inflation, or the time value of money. Over a period more than seven years, an investor who has left their funds in the investment are typically rewarded with a positive balance. So, such an investor would have enjoyed a monthly “dividend” plus capital growth.

Investors who are in property investments for the long haul by and large come out as winners. Advisors who direct their retired clients towards property investments when the latter cannot afford the time required to realise full benefits are doing the industry a disservice.

Long term investments, such as property syndications, do not as a rule generate “superprofits” from the annuity income from the property. However, in the long term, investors do realise very good returns. One of the reasons is that most urban environments do become attractive for other investors and they also inject their capital into the area. Those who entered the market earlier at a lower price can then sell their holdings at the appreciated price.

The liquidity argument sounds like a contradiction in terms because the long term nature of property investments is that your capital is tied down in the property for a long time. So, there is no point in looking for liquidity where it is not likely to exist. The problem with leaving capital tied down for long periods of time in any asset class is that risk also increases correspondingly. However, property is generally considered to be a “safe bet”, or as they say, property is as “safe as houses”. So, in theory, the timing risk should be adequately mitigated by the safety factor.

Property Unit Trusts were set up specifically to counter the problem of lack of liquidity in property investments. Legally, PUT operators are required to distribute their properties’ income minus expenses to investors every month. Also, investors purchase shares or linked units in the fund rather an indivisible share in the property, as in the case of property syndications. So, if an investor was to require immediate cash, then they could easily sell their shares at the ruling price on the Stock Exchange, just like they always do with equities. In contrast, investors who are interested in the physical asset would put their capital into a property syndication rather than in shares. The syndication brings together people who want to invest in commercial and retail property but cannot afford exclusive ownership in their individual right because of the large amounts involved.

Property syndications are likely to be successful when investments are made into an existing property, as opposed to when a company develops a brand new building. This is because with an existing building, the majority of costs that are payable upfront in any building have already been dispensed with. In a new development, most tenants have to invest large amounts of capital expenditure upfront, on which they have to pay financing costs and earn a quick return. Every cent that the landlord gets from the tenant has to be fought for with others. This puts pressure on rental negotiations, including turnover rentals.

When it comes to property developments, timing is of the essence too. The development profit equation is quite easy to follow – development income less development cost gives development profit. The most difficult thing in attaining maximum profit is to conduct proper research. If a developer starts a multimillion Rand development when building costs are very high, probably the highest in recent history, then the projected profits are not likely to materialise. On the other hand, when the tenant market is depressed, as most recent reports have highlighted, profits are likely to be squeezed even further.

Existing buildings are also far more preferable to new developments due to the certainty that a firmly established property management regime brings about. The process of running a management operation on a large property is a daunting task. The level of uncertainty that is brought about by forecasting the running costs of a new building can rattle even some of the most seasoned property management companies.

As with all other investment classes, the standing rules of investing in property have to be followed meticulously, otherwise the investment is likely to fail. To blame the property syndication model for failed investments when the rules were not followed properly is not fair.