Research Report in Construction Management
Table of Contents
Introduction 3
Finance and economic conditions 4
Development proposal and site selection 7
Regional and Local Context 7
Planning Environment 8
Site valuation 16
Investment market and cash flow projections 17
Taxation implications on cash flow schedules 19
Conclusion 20
Bibliography 22
Introduction
The financial, taxation, and operating implications of owning a retail investment property in any location required detailed and extensive analysis. This report focuses on the Target Shopping Centre Development in the Leopold neighborhood (Australian Bureau of Statistics 2016). It endeavors to provide insights on the positive and negative impacts of the development, provide sound valuations of the development, and demonstrate the approaches that both developers and purchasers of retail properties should look into when seeking to invest in the retail investment property in Leopold. In presentation, the analysis appreciates the complexity of developing large retail properties hence the report is broken down to the following parts and sections:
The report is structured to contain two parts; the first part is the development part and contains sections one, two, and three. The second part is the investment part which provides details of the valuation of the project at ten years and contains sections four and five.
Section one provides the finance and economic conditions of both the development and the neighborhood. This section provides details on equity and loan financing as well as the market place conditions that can be used to determine whether or not the development will be financially feasible.
Section two focuses on development proposal and site selection. The targeted project is Target Shopping Centre Development in the Leopold neighborhood. The development will be a largescale capital project for shopping center that will be constructed from the ground. In this section the cost of development are discussed at a high level analysis.
Section three will focus on site valuation and appraisals. The goal is to determine how much the client should be prepared to pay under the residual analysis method. The section also provides details of the development program sequence from land purchase through to the completion stage.
Section four will focus on the investment market and cash flow projections which will entail analysis of the value created in the project and the valuation of the development at 10 years. The goal is to demonstrate how much the project would fetch at the end of the ten years period.
The last section, section five, will focus on tax implications of the cash flow schedules recognizing the impact of cash flows on the valuation of the project at the end of the term of ten years. These factors are critical in determining the correct valuation and viability of investing in the project and selling at ten years.
Finance and economic conditions
Economic conditions in Leopold would be best demonstrated by the economic conditions in Melbourne. In the CBD the average yields in the 2016 financial year were 5.00%, dropping to 4.71% in 2017. The regional average yields were at 5.63% in 2016 but dropped to 5.22% in 2017. In sub regional yields, the average yield for 2016 was 6.50 before dropping to 6.35% in 2017. The Leopold neighborhood this remains to be one of the best in yields considering an average rate of 6.50% and 6.49% in 2016 and 2017. Further, the case is even better in large format retail investment with returns at 8.50% and 7.93% in 2016 and 2017 respectively (Deloitte, 2018).
The average yield rates shown above indicate that Leopold remains to be among the best areas for development and investment based on the expected returns. The investment landscape in the region is quickly changing with investments moving from the CBD where the average yields are lower than in the sub regional areas (Real Estate Investar, 2019).
Figure 1: Yield Records
The gross rent per square meter are lower in the sub regional neighborhoods as compared to the CBD. Understandably, the costs of development as well as the cost of land is similarly skewed. While in Melbourne CBD the gross rent per square meter was $7500 in 2016, in the neighborhood it was $760. However, the rent recorded a decrease to $7736 while in the neighborhood it increased to $779. For large format retail space the increase was from $265 to $272 per square meter (Deloitte, 2018).
These properties demonstrate the shifting balance in the regional returns and average yields hence demonstrating why it is essential to start moving from the CBD to the sub regional markets (Okunev, Wilson and Zurbruegg, 2002, pp. 89). It also makes sense to invest more in large format retail centers in places such as Leopold where none exist yet the returns are above the regional averages. The various trends in different regions of Australia are also shown in the chart below which details the trends over a few years (Real Estate Investar, 2019).
Figure 2: various trends in different regions of Australia (Real Estate Investar, 2019)
Based on the economic data and the yields demonstrated above, it is recommended that an equity position of 60% is held in the project with the remaining 40% being financed through debt. This would push the cost of capital lower and also result in reductions in tax liability as discussed elsewhere in this report. All other metrics are held as presented in the rest of this report.
Development proposal and site selection
Regional and Local Context
Leopold, Victoria is a residential eastern suburb of Geelong. Leopold is located 86 km South West of Melbourne 11 km East of Geelong 14 km North West of Ocean Grove 11 km West of Drysdale. It is served by two major highways that include the Bellarine Highway to the south and Portarlington Highway to the North. According to a 2016 census, Leopold has a population of 12,814 (Australian Bureau of Statistics, 2016).
Leopold and the larger Bellarine Peninsula is a bubbly tourist destination, majorly receiving local tourists from Melbourne over the weekends as well as during summer. It is home to two listed heritage sites that include Melaleuka and St Marks on the Hill (City of Greater Geelong 2018). The strategic location of Leopold is attracting growth in housing and population. The number of schools in the neighborhood is increasing and growth is expected in the near future in line with the growth in the neighboring regions especially within the City of Greater Geelong (Australian Bureau of Statistics, 2016).
On location in Leopold are major hotel brands including Leopold Sportsman’s Club. There are schools including and Leopold Primary School, Leopold Kindergarten, and Allan Vale Preschool Centre among other upcoming centers. However, a noteworthy shopping center or supermarket is conspicuously missing in the picture thereby making the Target Shopping Centre Development an icon in the region (Victoria Places, 2015).
Figure 3: The neighborhood of Leopold, Victoria (City of Greater Geelong, 2018)
Planning Environment
The development of the proposed Target Shopping Centre is in line with the planning of the neighborhood as presented in the Leopold Structure Plan which was adopted by the City of Greater Geelong. Leopold Structure Plan provides details of the targeted infrastructure and structure planning in the region while at the same time demonstrating the need for the development of a modern shopping center (City of Greater Geelong, 2018).
The development will contribute immensely to the growth of the local economy of Leopold. This includes creating employment for the population of Leopold, providing the opportunity for the development of a sub-regional retail hub around which a town center will rise and contribute to the development of the retail strategy of the City of Greater Geelong. In whole, the development of Target Shopping Center in Leopold will not just be for the people of Leopold but also for the greater good of the Bellarine Peninsula (Real Estate Investar, 2019).
The development is a large format retail mall meant to host different brands. The anchor tenant will be Target supermarkets. Clothing line brands, the luxury and high end categories, will be available in the mall. This is meant to attract huge numbers of customers to the shopping mall as one of the key performance indicators of the mall. The development plan and floor area of the mall was as shown below. The overall income generating area of the building is colored.
Figure 4: development plan and floor area of the mall
There will be five large format retail shop areas on the building. The retail shop areas can host multiple tenants as the trading area will be provided and made available per square meter basis. Retail shop 1 will have a trading floor area of 240 square meters. The second retail shop will have a trading floor area of 158 square meters. The third retail shop area will have a 117 square meters while the fourth will have 100 square meters in trading area. The last retail shop area is 75 square meters. The foyer area is 790 square meters while the target country is 1550 square meters. The net lettable area is 2230 square meters. In total, the development will cover an area of 3030 square meters. The design is as shown in the figure above while the breakdown of the floor area by shops is as shown in the table below.
Table 1: Breakdown of the floor area by shops
Building Zone Area
Retail Shop 1 240
Retail shop 2 158
Retail shop 3 117
Retail shop 4 100
Retail shop 5 75
Foyer area 790
Target Country 1550
Total Building Development Area 3030
Development Cost per square metre – $1,485
Total Building Development Cost $4,499,550
The estimated total cost of the entire development project is $4,499,550. This is a high level estimated cost based on projects of nearly the same magnitude and size at the sub region level. The development cost per meter was placed at $1,485. The cost estimate is comprehensive and puts into consideration all the development costs except the costs of land and the financing costs.
The project will be developed over a period of 18 months according to the project program and schedule expressed in the following table. The schedule is broken down to three stages that include project initiation/preconstruction period, construction period, and the sales and letting period. The preconstruction period will take a total of 5 months in accordance with the breakdown schedule shown below (Real Estate Investar, 2019). The construction phase will take ten months while the sales and letting period is estimated to be three months. All high level activities towards the development are as shown in the table below.
Table 2: List of high level activities towards the development
Project Initiation / Pre-Construction 5 months
Land purchase 2 weeks
Finance negotiation 1 month
Project Admin 1 month
Design documentation 1 month
Authority Approvals / Building Permits 1 month
Pre-construction work 2 weeks
Construction 10 months
Building works, Enabling, fittings and fixtures 10 months
Sales and Letting period 3 months
Sales and Marketing 2 months
Waiting / Letting period 1 month
Total Development Programme 18 month
Focusing on development cost analysis, the estimated total cost of development including site costs, legal and surveyors fees on site purchase, building costs, and design fees the costs is estimated at $5,061,993.75. On adding the financing costs the total development cost adds up to $6,265,671 as shown in the table below.
Table 3: Development cost
Pre – Construction Costs
Cost of site acquisition
Site costs $700,000
Legal and Surveyors Fees on Site Purchase @ 2.75% $19,250
Total Site Fees ($719,250)
Building Costs – building area in sq.m @ $1,485 per sq.m $4,499,500
Design team fees @ 12.5% of Building costs $562,443.75
Sub-total Building costs ($5,061,993.75)
Finance cost
Total interest / accumulated debt on site purchase and fees @ 7.00% $76,827.84
Finance cost on Total cost of completing building work (S-Curve) $183,152
Finance fees on Legal and Surveyors fees @ 1.5% of NDV $116,928
Finance fees on Agents Letting Fees and Marketing (20% of Annual income) $107,520
Total Cost Including Site Finance and Fees $6,265,671
The last key element of analysis in this section is the gross development value. As shown in the table that follows, the gross development value of the project is $ 8,270,769.23, before the deduction of the purchaser’s costs, and $7,795,200 after purchaser’s cost. Considering the gross and net development value are higher than the gross development cost estimates, the analysis considers the development financially feasible. Note that all revenue estimations were made at a rental rate per square meter of $240 whereas the sub regional average is between $265 and $272. The valuation is therefore based on a most likely case scenario and meant to attract high clientele.
Table 5: Valuation details
Gross and Net Development Value
Net lettable area 2230
Rental Rate per sq.m 240
Annual Rental Income 537,600
Years’ Purchase (6.5%) 15.3846
Gross Development Value (GDV) $ 8,270,769.23
GDV less purchasers costs (5.75%) $7,795,200
One of the most important tools in investment appraisal is the net present value technique. The tool is used to determine the net present value of the project after the determination of all projected revenues and all the relevant costs for the project. A project should be accepted only if the net present value of the project is positive (Real Estate Investar, 2019).
The net present value is computed based on the estimated rental income as well as the prevailing yields in the sub regional locations. This ensures that the valuation captures the time value of money concept (Brueggeman and Fisher, 2011, p. 5-6).
The analysis of cash flows returned a positive net present value for the development project discussed in these documents (Clauretie and Sirmans, 1999, p. 34). As a result, it is recommended that the client invests in the development of the project. The findings were as demonstrated in the table below.
Table 6: findings made
Quarter 0 Q1 Q2 Q3 Q4 Q5 Q6
Revenue ($m) 7.795
Land cost ($m) (0.897)
Building cost
with prof. fees ($m) (0.530) (1.590) (1.590) (1.590)
Finance cost ($m) (0.225) (0.145)
Letting cost ($m) (0.224)
Equivalent cash flow ($m) (0.897) (0.755) (1.590) (1.590) (1.735) 7.570
Cumulative NPV ($m) (0.897) (1.652) (3.242) (4.833) (6.568) 1.002
There are a few considerations in the development of the project. The first concern relates to the trend in the rental income per square meter. In the sub regional areas such as Leopold the rental income is estimated to be between $260 and $272 with the expectation of an upward trend. An increase in the rental income would mean a higher valuation of the project. The need for caution however arises from the observation that the rental income per square meter in all other areas has been reducing (Williams, 1991, p. 96). The trend has the potential to hit the project in a similar. This created the need to provide the valuation following a lower rental income per square meter, at the rate of $240 which is the estimated lowest rental income per square meter that should be expected from the development.
There are considerations on occupancy levels and how they may impact the revenues and valuation of the business (Ling and Archer, 2013, p. 12). From the analysis, the Leopold region does not have any other shopping complex of the magnitude of Target Shopping Center. Together with the fact that Target will be the anchor tenant, it is expected that the shopping complex will have occupancy levels averaging 95% or more. The design creates room for the attraction of high profile brands targeting the Leopold populace as well as the tourist population that quite often graces the neighborhood. Seeing that there are hardly any vacant business premises in Leopold is also an encouraging factor with respect to the expected occupancy levels in the neighborhood of the proposed Target Shopping Center. These factors have been duly considered in the valuation of the project for development hence the valuations provided herein adequately capture the most crucial information.
In summary, the analysis recommends investment in the development of Target Shopping Center in Leopold based on the valuations as well as the expected returns form the project. The analyses provided in this section demonstrate how the project creates value for the investors and the developers in particular.
Site valuation
This section focuses on valuing the project post-development. The section uses residual valuation with a ten-year focus to determine how much a prospective buyer should be ready to spend in order to get the real estate property.
Residual method of valuation incorporates depreciation in the valuation model to determine the value of the property. Beginning with a valuation of $5,301,571 in year zero, depreciation of the project over the ten years would result in a building value of $4,115,767. However, depreciation is not the only factor of concern in the valuation considering that there is the chance that the building will attract higher rental income per square meter in the coming years. All these factors must be incorporated into the analysis in the determination of the value of the property at the end of the ten-year period.
Figure 5: Determination of value of the property
The recommended sale price for the project after ten years is $8,686,447. In this period the project would attract sales cost at 1% of the sale value hence the cash flows from the sale would be $8,599,583. If the project is purchased at completion then the purchase price would be $7,795,200 thereby providing a capital gain of 414,623 after incurring the purchase costs of $389,760. The capital gains would attract a capital gains tax of $124,387.
Investment market and cash flow projections
A valuation of $7,795,200 was generated from the cash flow analysis of the project upon completion as well as expected economic conditions and how they would impact both the revenues generated by the project and the rates of return in the market. The valuation was considered in all means reflective of the present value of the project upon completion and it allows the investors and developers of the project to generate a return from the project.
Figure 6: Valuation values
The valuations presented above are based on a best case valuation. This is the most likely scenario with the expected annual revenues from the project. However, depending on the economic conditions a maximum swing of 10% in either direction should be considered a possibility. Consequently, it is appropriate to determine the sensitivity of the project valuation to changes in the economic conditions. The analysis was as demonstrated in the table that follows.
Figure 7: Valuation analysis
The base case valuation places the value of the project at $8,686,447. The worst case scenario would result in a lower valuation of $7,817,803 if the revenues fell by 10% while the best case scenario places the valuation of the project at $9,555,083 if the revenues rise by 10%. The latter would change the sale price identified above by +9.9%.
The economic impact on the project may also result from reversionary yield. A reduction of 10% in the yield would result in an upward change in pricing of the project by 11.08%. Considering the economic environment it is considered that the best case scenarios are a live opportunity considering that the rental incomes in the sub regional locations in the neighborhood of the project are estimated higher than the rate at which the project valued the revenues and there are also expectations of higher revenues from the project. These considerations are important in making a decision on valuation of the project at ten years and the most likely price for the sale of the project.
This section posits that the minimum price that the project should sell for is the price of $8,686,447. This price best captures the prevailing economic conditions at the most likely scenario or base level. There is however the possibility of an upward swing in the price of the project by about 10% depending on the economic conditions within the ten years of the project.
Taxation implications on cash flow schedules
Australian law allows for capital allowance at the rate of 2.5% per annum. The law also demands 30% tax on income also capital gains tax at a rate of 30%. The implications of cost were included in the determination of the free cash flows as demonstrated in sections above. The impact of taxes is the reduction of the free cash flows.
One of the ways in which tax liability is reduced is by following Modigliani and Miller principles on debt capital (Grenadier, 1996, pp. 56; Locke, 1986, pp. 103). Interest on debt is tax deductible hence having interest capita is considered an important way of reducing tax liability.
The study recommended an equity position of 60% and debt capital at 40%. Debt helps in lowering the weighted average cost of capital and at the same time ensures that the businesses reduces its tax liability. The weighting of equity and debt in the proportions above also ensure that the developer has controlling interest in the project. Notably, the use of debt in this case is not just as part of raising capital but also as a strategy in lowering the tax liability. Debt financing would be acquired at rates lower than or equal to the proportions shown in the schedule of yields.
Conclusion
In concluding, this document contains a report on the development of a large format retail center in Leopold. The name of the project was identified as Target Shopping Center. Leopold is a residential area with a population slightly above 12,804 persons and which has no major shopping malls. The implications are that Target Shopping Center will be a game changer in the sub-region. Target supermarket will be the tenant anchor in the shopping complex.
The rental income per square meter is estimated at $240 which is lower than the average for the sub region neighborhoods in Melbourne where the rent per square meter is between $260 and $272. At this rental income, the valuation of the project was placed at $ 8,270,769.23 while the cost of developing was placed at $6,265,671 inclusive of all site finance and fees. If the project is sold at ten years, a residual valuation of $8,686,447 would be obtained after consideration of all costs including capital allowance, income taxes, and capital gains taxes on sale.
Based on all the analyses provided, the project is considered viable and financially visible at development and the point of selling the project at ten years. The net present value was found to be positive and the internal rate of return at 2.15% at the end of the ten year period. This creates the basis for development, holding for ten years, and selling the project at ten years in order to attract a high return on investment.
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