AbstractThe current practice of real estate companies engaged in property development is to employ industry‐accepted heuristics as target rates of return based on benchmarks commonly expressed as hurdle rates of return (Crosby et al., 2018a).Hurdle rates are a minimum financial metric and are intended to include the developer’s cost of capital and a premium commensurate with a subjective assessment of a project’s unsystematic risk and are used to measure a potential project’s viability through conducting a feasibility analysis and inform decision-making during the early stages of the undertaking. For a project and/or site acquisition to proceed, the forecasted profitability determined through a feasibility analysis must meet or exceed a firm’s minimum requirements. Longer-term investment holding periods introduce new risks and uncertainties and require change management mechanisms which are often unidentifiable at the preliminary stages of a project. This is particularly the case with staged developments in many sectors, newly listed assets and infrastructure.
There were three primary aims of this research which are:Firstly, to complete an examination of the decision‐making practices used in determining project viability through conducting a feasibility analysis by real estate development firms in Australia and also to obtain information regarding hurdle rate selection and techniques commonly utilised to determine project viability. This research investigated the drivers and decision‐making processes of property developers in Australia and touches on the global practices of the industry as property development becomes increasingly internationalised.Findings indicate the majority of Australian property development organisations do utilise specific go/no‐go hurdle rate mechanisms as a decision basis for proceeding beyond the pre‐commitment stages of the development process.Furthermore, few differences were found between property developers with differing primary property types in the use of specific go/no‐go decision processes, with the majority using a margin on development cost (MDC) or an internal rate of return (IRR) as a minimum financial metric. Property developers whose preferred project size is large (> AUD 50 million end value) utilise more sophisticated methods of feasibility analysis and have a higher number of specific hurdle rates to guide decision‐making.
Additionally, property developers who primarily undertake small project sizes(<= AUD 5 million end value) use less sophisticated quantitative methods of analysis but require a higher return on equity (ROE) as a basis for project selection. The results indicate the structure of many development projects are complex, and the boundaries between traditional speculative development and property investment through the use of securitisation methods have become more difficult to distinguish. The majority of development organisations surveyed do not rely purely on quantitative metrics for determining project viability through feasibility analysis, but also use qualitative methods and organisational specific structural checks as a method of managing the organisation’s risk.
Differences were also found in the selection and use of hurdle rates based on developer typologies; multi‐national property development organisations operating in multiple geographic regions demonstrated a higher use of qualitative frameworks as a decision‐making process. In terms of developer feasibility analysis practices and the use of feasibility analysis programs, the two most frequently used tools included Microsoft Excel and Argus Estate Master DF. The two most frequent methods of determining site value prior to acquisition were the residual land value and DCF methods.
Secondly, this research aimed to examine the relationship between bounded rationality, heuristic bias and management decision‐making by property development organisations. Findings indicate the majority of developers in Australia do not have a predetermined process and method for altering or adapting the chosen hurdle rates and benchmarks, even in the presence of an expected change in uncertainty and risk to a potential project. Those developers that do alter hurdle rates do so based on three primary themes which are;altering hurdle rates on the basis of risk analysis and forecasted market conditions; altering hurdle rates based on qualitative frameworks or intuition;and altering hurdle rates based on the project’s status of planning approval.Additionally, it was found that the property developers surveyed exhibited bounded rationality and place a heavy reliance on industry‐accepted heuristics when both selecting and setting the specific level of hurdle rate metric and determining a potential project’s viability.
Thirdly, this research examined the risk analysis methods used to determine a potential project’s viability through the use of feasibility analysis. This aim included an investigation into the use of specific techniques including MonteCarlo simulations, Bayesian models and real option theory, finding few development organisations surveyed used sophisticated quantitative risk analysis methods at the pre‐commitment stages of the property development process. Additional findings indicate property development organisations possess a high level of confidence in their organisation’s ability in both the identification and management of risks which may be encountered in a potential property development project. However, this confidence is not supported in the actual risk management processes used.
Recommendations were formulated in three principle areas by synthesising the results of the analysis of the empirical survey and the literature review. The first area considered the selection and use of hurdle rate metrics that form a go/no-go decision basis for potential projects and site acquisition. The second area dealt with the feasibility analysis practices and methodologies adopted in determining project viability. The final area of recommendation involved the risk analysis techniques used by decision‐makers in property development organisations during the pre‐commitment stages of the development process.
Consequently, the results of this study have highlighted areas which would benefit from further research. Themes identified include the linking of decision‐making practices and hurdle rate selection with project outcomes and developer success ratings; the selection and use of time value of money hurdle rate financial metrics and the use of sophisticated risk analysis methods.Additionally, the results of this study found financial metrics were being used by decision‐makers in a manner different than those anticipated, and the usefulness of specific metrics in the application to decision‐making concerning potential projects should be further investigated.
|Date of Award
|12 Oct 2019
|Michael Regan (Supervisor), Lynne Armitage (Supervisor), Craig Ashley Langston (Supervisor) & William Earl (Supervisor)