Beruflich Dokumente
Kultur Dokumente
2006
guidelines
Project Financial Viability Studies for Property
Development in the Social Housing Sector
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
c
Contents page
purpose
Purpose and
and scope scope
of the guidelines 3
introduction
Introduction to feasibilityto feasibility
studies 4
Why should feasibility studies be done before projects are executed? 4
What is a feasibility study? 4
What is measured and against which objectives? 5
Parts of an overall feasibility study 5
Socio-economic feasibility 5
Marketing feasibility 6
Legal feasibility 6
Physical feasibility 6
Financial feasibility/viability 6
Project feasibility and institutional sustainability 7
financial
Financial viability viability
studies 8
Parts of a financial viability study 8
Steps in carrying out a financial viability study 9
compiling
Compiling various
various parts partsviability study
of the financial 10
Cover page with project details 10
Executive summary 10
Statement of the investor’s financial objectives 11
Estimated total project development cost/total capital outlay: 11
Cost of surveys and studies 13
Land costs 14
Town planning and related costs 16
Land servicing costs 16
Interim rates and taxes 17
Escalated construction costs – top structures and site services 17
Professional fees and disbursements 22
Municipal plan scrutiny fees 25
Sundry legal and administrative costs 25
Initial marketing costs 25
Development contingency 25
Finance costs 26
Interim cost of capital 26
Estimated net project operational income (gross income less operational expenses) 27
Estimated project returns 28
Development and operational cash-flow projections 31
1
S H F BP6 2006
page
Risk analysis 33
Lists of assumptions and exclusions 34
A brief outline of the specifications upon which the cost estimates are based 35
A brief outline of the outcomes of, or reference to the socio-economic, marketing,
legal and physical feasibility studies 35
woking
Worked example
example: Complete financial viability study 36
alternative
Alternative approaches
approaches to project
to doing project financial viability studies: 51
annexures
Annexures 61
Annexure A: Estimating escalations on building contracts 61
Annexure B: Calculation of interim finance costs 67
Annexure C: Estimating project time frames for use in financial viability studies 69
2
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
p
Purpose and scope of the guidelines
The purpose of the guidelines is to assist the boards, management and staff of
Social Housing Institutions in playing a more meaningful role in the compilation,
interpretation and application of financial viability studies during the property
development process.
What often happens in practice is that professionals (e.g. project managers and/or
quantity surveyors) are appointed to do the viability studies, and they work on
their own without much meaningful input from the client organisation (the Social
Housing Institution). These guidelines have been prepared to help the Social Housing
Institution to better understand the principles and process, in order to provide
meaningful input, and more importantly – to be able to interpret and question the
studies presented by specialists critically and intelligently.
These guidelines only will not be sufficient to develop the reader into a financial
viability study practitioner or expert, and attempting to do financial viability studies
without the requisite experience and insight can be dangerous.
3
S H F BP6 2006
To minimise the inherent uncertainty and risk, an investigation into the likelihood
of successfully executing a project should always be undertaken before actually
embarking on the project. This investigation is called a feasibility study. Feasibility
studies should be done very early in the life of a project, before detailed designs
and technical documentation are prepared, to ensure that time, energy and money
spent on detailed project preparations are not wasted on the wrong concept, and
to avoid irreversible commitments being made to unsuitable pieces of land.
Feasibility studies are essentially tools that are used to guide investment and
development decisions – the key “go”, “no go” (or “go back and revise”) decisions
taken at various stages in the life of the project.
For our purposes, both terms refer to the desirability or otherwise of embarking
on a project and its sustainability after completion, and both can, therefore, be
used.
The likelihood of a project being feasible is reinforced when the feasibility study
indicates that the objectives of the investor (in this case the Social Housing
Institution or SHI) should be satisfied if a specific concept or idea is executed on
a particular piece of land. Arriving at the right match between concept and land
is, of course, a process where alternative concepts are tried and refined using
a series of cost benefit comparisons (feasibility studies) until the best solution is
found. This stage of project preparation is called the pre-feasibility phase, and
corresponds with the project validation and development appraisal stages in the
Social Housing Institutions Operations Manual
Further reading
See “Social Housing Institutions Operations Manual” and www.shf.org.za
4
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
We set financial objectives to ensure the project will pay its own way and contribute
to the long-term financial independence and sustainability of the Social Housing
Institution. Financial objectives usually include:
• Realising a surplus of project income over project expenses (return on investment),
i.e. making a profit.
• Making sure project development costs don’t exceed the funding available
(subsidy, loans, grants, equity if any).
• Ensuring project pay-back within a certain time frame.
• Making sure actual cash inflows are available at the right time to meet actual
cash outflows (cash-flow projections).
The first part looks at the practical executability of a specific development proposal
on a specific site. This part of the overall study looks at the following aspects to
check their potential effect on project execution time frames, and on projected
income and expenses:
Socio-economic feasibility
This is a survey carried out to investigate demographic, socio-economic and urban
growth patterns and trends; and to see if the right target market and area for
development have been selected. In other words, is there a large enough population
with the “right” socio-economic profile to support the project?
5
S H F BP6 2006
Marketing feasibility
The target market is more specifically analysed to see if actual demand (need backed
by “purchasing power” or income) for the product exists, and if the objectives with
regard to rental and occupancy levels are realistic.
Legal feasibility
The site description, ownership details and legal status of the envisaged site are checked
for problems with the title deed and transfer of ownership, legal encumbrances such
as registered servitudes, long-term leases and other restrictions, and to ensure the
site has the necessary development rights. The purpose is to identify and quantify the
possible impact of legal issues on development time frames and costs.
Physical feasibility
The physical features of the site are checked to see if it can be built on, how much
the site cannot be built on, and what impact its features will have on development
costs. The aspects investigated include:
• Site topography and vegetation – slopes, rocky outcrops, marshes and wetlands,
water courses and flood lines, trees to be removed or conserved.
• Geotechnical features – sub-surface soil conditions and their impact on design
and costs of foundations, services and roads.
• Location and access – is it a favourable location with regard to economic opportunities,
facilities and transport, ease of access for pedestrians and cars, traffic issues, etc?.
The second part of the overall feasibility study is the financial feasibility or viability
study:
Financial feasibility/viability
This part of the feasibility study uses the information supplied by the first part of the
study, as well as assumptions based on the experience and market knowledge of the
person or team doing the study, to test and fine-tune the concept (and alternatives
if necessary) until it provides an acceptable cost benefit solution that best meets the
project financial objectives. Final investment and development decisions are based
on the financial viability study, taking into account the other parts of the overall
feasibility study.
This guide concerns itself mainly with the financial aspect of project feasibility – the
Financial Viability Study.
6
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
The Social Housing Institutions business plan must, therefore, always reflect
separately:
1. Project feasibility for each project, together with a realistic time-frame. Projects
must not be delayed for too long as their income contributions to SHI overheads
are needed to help the company break even, and break the reliance on shortfall
funding within a reasonable time – i.e. 3 to 4 years.
2. Institutional feasibility based on the project feasibilities. This should show
clearly what contributions each project will make to the overheads of the SHI,
on a realistic cash-flow basis, until the organisation breaks even and becomes
self-sustaining. It should also clearly show what the overall operational shortfall
will be on a cumulative basis for the pre-development and development stages,
and how these shortfalls will be funded (bridging loans, grants, and donations in
money and in kind e.g. staff secondments, etc.):
Project 1:
Income R 10 000 000 Office rent R 350 000
Loan repayment R 5 000 000 Telephone R 40 000
Running costs R 4 000 000
Insurance R 10 000
Project surplus R 1 000 000
Equipment R 60 000
SHI general overheads: Salaries R 1 600 000
Consumption R 40 000
Board R 250 000
Project 2: Sundries R 50 000
Income R 12 000 000
Total overhead R 2 400 000
Loan repayment R 6 000 000
Income:
Running costs R 4 500 000
Project 1: R 1 000 00
Project surplus R 1 500 000
Project 2: R 1 500 000
SHI Surplus R 100 000
Further reading
See “Guidelines – Business Planning for Social Housing Institutions” and www.shf.org.za
7
S H F BP6 2006
f
Financial viability studies
Parts of a financial viability study
A typical financial viability study consists of the following parts:
• An outer cover with the project name, who it is for, feasibility report number
and date (optional)
• An inside cover page containing project details
• A contents page
• An executive summary showing all the critical results and conclusions, including
a statement of the investor’s financial objectives
• Summary calculations of:
• Estimated total project cost, usually referred to as Total Development Cost
(TDC), or Total Capital Outlay (TCO)
• Estimated net project operational income (gross income less operational
expenses)
• Estimated project returns (return on investment, internal rate of return or
IRR, break-even and pay-back periods)
• Detailed breakdown calculations of:
• Estimated current construction cost
• Estimated construction cost escalations
• Estimated interim cost of capital
• Estimated annual property operating costs
• Development and operational cash-flow projections
• A risk analysis
• Lists of assumptions and exclusions
• A brief project description, and the specifications the cost estimates are based
on
• A brief outline of the main outcomes of the socio-economic, marketing, legal
and physical feasibility studies that informed the assumptions (optional), or a
reference to the other studies used
8
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
2. Use experience and apply contextual and market knowledge to determine all
the main assumptions, for instance:
• Projected building cost escalation rates
• Projected loan interest rates
• Projected rentals
• Projected rental and operational expense inflation rates
• Estimated time frames for the various phases of the project. (This is crucial
as the time frame affects cost and income projections.)
3. Sit down with the professional team and agree on preliminary outline project
specifications and important design details to be used in the cost estimates (remember
that at this stage only very basic concept or sketch drawings are available to the
estimator. Also, the outline specifications are at this stage just a rough guide to assist
with construction cost estimating. The final detailed specifications will be developed
much later, but must, of course, be in line broadly with these preliminary outlines).
4. Decide on the funding structure and conditions for the project (subsidy, equity and
loans) in consultation with main stakeholders, the board and top management.
At this stage, honesty is required to make realistic recommendations, and the board
must display the wisdom and courage to “walk away” from a project if the study
shows the project to be unviable, or if the risk analysis indicates unacceptably
detrimental effects if certain parameters are changed. This is often difficult when
the organisation’s heart is set on a particular project, and when a lot of hard work
and planning has already gone into project validation and preparation. It is better to
feel the pain at this stage though than to sit with an unviable project for many years.
Remember that not too many serious contractual and/or financial commitments have
been made at this stage, and it is still possible to pull out without too much fruitless
expenditure and effort. Later, when final plans have been drawn and a contractor
has been appointed and placed on site, it may be too late to stop the project.
9
S H F BP6 2006
Note: For visual examples of the parts described below, refer to the worked
example, page 36
The inside cover page (which can also be used as the actual cover) contains the
following information
• Client details (who the study is for)
• Project description (Project number or code, name, location, street name,
stand number)
• Number and date of the study
• Name of architect
• Type and date of drawings on which building cost estimate is based
• Method used to work out building cost estimate (square metrage, elemental
analysis, rough quantities, etc.)
• Name of person or team carrying out the study (not necessary if cover is on
the letterhead of a professional firm carrying out the study)
All pages of the report must be numbered, and should carry a header or footer
with the project name or code, and the date and number of the report.
10
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
• Required rate of return: e.g. 12.5% p.a. In private sector developments for
commercial gain, the required rate of return is usually determined by looking
at the cost of capital, possible returns on alternative “safe” types of investment
(money market, blue-chip shares, government bonds), and then adding a risk
premium because property development is more risky. On the other hand, the
investor also allows for the fact that good property will show capital appreciation
or growth over time in addition to operational return. It is a complex decision.
Social Housing Institutions may be guided more by what they consider to be
a return that will cover the cost of capital and contribute sufficiently on a per
project basis to long-term institutional viability. There are also sector norms and
social housing policy guidelines to consider.
• Break-even period: This period indicates after how many years operational
income should fully cover operational expenses. Ideally this should happen in
the first year of operation, but this is rarely achieved in property development.
It is more realistic to set a break-even target of 3 to 5 years.
• Pay-back period (optional): This period indicates after how many years the project
will have paid for itself. A realistic target for social housing is 12-15 years.
Introduction
The TDC or TCO is the sum of all the “capitalised” costs incurred on the project (not
general overheads) from date of inception to the end of the development period (i.e.
the last day before commencement of the trading or operational phase. This usually
includes the costs associated with land and services installations, construction and
professional fees, but also some costs that would normally be viewed as operational
expenses during the trading phase, for example “interim” property tax and interest
on building loans during development.
11
S H F BP6 2006
Note 1: The ranges for some items can be quite wide. If you get land for free,
land cost will be a very small proportion of the total, meaning that one
or more of the other major components such as construction costs will
automatically constitute a larger percentage of the total.
Note 2: The percentages in the table above are percentages of total development
cost, and not of construction cost. Professional fees, for instance, may
only be 6.5-9.5% of TCO, but that could translate to 8.67-12.67% of
construction cost (if construction cost is 75% of TCO), or 7.65-11.18%
(if construction cost is 85% of TCO). Since professional fees are more
directly related to construction cost than to TCO, it is customary when
discussing or estimating or negotiating fees, to speak of them as a
percentage of construction cost.
In social housing projects currently, the land costs are usually close to zero, and cost
of capital is much lower because the injection of subsidies, grants, and “soft” equity
loans means that there is no, or little, loss of interest on equity.
There is no subsidy applicable, and the full project cost must be funded through
equity investment and borrowings.
12
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
In social housing projects the funding is usually in the form of government subsidy,
grants, donations, debt funding from development finance institutions, and in some
instances limited equity from own reserves. The amount of subsidies and grants is
usually deducted from the TCO, and returns are calculated on the balance only.
This calculation indicates a favourably skewed picture when compared, for instance,
with returns in private developments, which are calculated on the full project cost,
for example:
Case 1 – returns based on full project cost without the deduction of subsidies:
Total Development Cost (TDC) R 100 000 000
Net annual income (NAI) R 10 000 000
Return on investment (ROI) = NAI/TDC = R 10 000 000/R 100 000 000 = 10.0%
In reality, the above effect is lessened (or even completely negated) by the fact that
the introduction of a subsidy caps the rental income below what could be charged
in the market, while development costs are not similarly capped, for instance:
13
S H F BP6 2006
EIAs are usually required where the development requires new township
establishment or a major rezoning of land use. Township establishment is the formal
town planning procedure where “raw” farmland is converted into registered or
proclaimed urban development land via a simultaneous rezoning and sub-division
(optional) of property.
Land costs
The typical components are:
• Purchase price/market value
• Transfer cost or VAT
• Geotechnical investigations
• Legal costs related to Land Availability Agreement (if any)
An argument could be made that SHIs should follow the same principle, even
where land is donated or acquired at nominal cost, but this is usually not done,
which means that financial viability studies for social housing projects are not
done on the same basis as those in commercial developments, and returns cannot,
therefore, be compared with or benchmarked against similar developments in
the private sector.
14
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
However, SHIs have other costs that private developers may not have, such as
provision of social facilities, community development and tenant training. This may to
some extent negate the “undervaluation” of land costs in social housing projects.
The scales showing duties and fees payable, such as those in Moffat’s Improved Table
of Transfer and Bond Costs, are obtainable from any legal firm or legal publisher.
Geotechnical investigations
Problem soils (heaving clay, collapsible sands, dolomite) are common in South Africa,
and it is always prudent to carry out geotechnical investigations of a prospective
building site. They are done by specialists (some civil engineering firms also have
geotechnical divisions), and usually involve:
• Digging test pits over the site to expose the underlying strata for inspection
• Taking soil cores for analysis in a laboratory
• Preparing a report with diagrams showing the underground soil profile, and
recommendations with regard to foundation types and bedding, and jointing
of service pipes below ground
The cost of these investigations varies according to the size of the site and the
number of pits dug and core samples taken, and can be substantial on large or
problematic sites.
15
S H F BP6 2006
No further costs except that the boundary beacons may have disappeared, and a
land surveyor will have to be paid to re-establish them.
16
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
Municipalities are responsible for providing bulk and link service infrastructure and
connections to the new township. They usually obtain funding for this from national
government via the Municipal Infrastructure Grant (MIG), the Department of Water
Affairs and Forestry, the Development Bank of South-Africa (DBSA), and where
applicable, a combination of grants and loans from district councils.
Property tax paid up to the end of the development period is capitalised, i.e. added
up and included in TDC/TCO. According to new property rates legislation, rates
are levied as a percentage of the total market value of land and improvements per
year.
Some councils levy additional penalties on undeveloped land (applicable where the
land is acquired and then delays in the development process occur).
There may also be charges for grass cutting and keeping sites clean before and
during construction. Always check carefully with your local council which of the
above charges apply.
17
S H F BP6 2006
At first, the construction cost is estimated as at the present time and under prevailing
construction market conditions (Estimated Current Construction Cost). It is possible,
however, to determine the estimated cost of a building at any time in the future by
making assumptions about the rate of escalation of construction costs due to inflation,
and the likely prevailing market conditions at that time, and then compounding the
estimated current cost by the necessary factors. Building cost estimates are usually
prepared for the employer by a professional quantity surveyor (QS or PQS) who must
have an up-to-date knowledge of building market conditions, trends and prices,
and of how contractors’ rates and prices are made up.
There are different ways of drawing up an estimate. Each method serves a particu-
lar purpose and requires different kinds of information. Where, for example, only
a rough indication is required, the “cost per unit” method of estimating could be
used. At the other end of the spectrum, a highly accurate estimate of cost can be
obtained by pricing out a detailed Bill of Quantities. The most reliable method is
the Elemental Building Cost Analysis, a method that is both quick and accurate.
Elemental estimates must cover the following main cost sections:
• Work carried out under separate contracts before the main contract starts (e.g.
bulk earthworks, piled foundations)
• Contract preliminaries
• Demolitions (if any)
• Alterations (if any)
• Primary elements (structure, shell and finishes)
• Internal service installations (plumbing and electrical)
• Special installations (including main contractor’s profit and attendance)
• External works and services
• Service connections
• Construction contingencies
• VAT
Some of the above are more troublesome than others, and additional guidelines
are given below:
18
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
Pay special attention to stormwater disposal, landscaping (hard and soft) and planting,
garden furniture, etc.
Check with the local authority for an idea of their service connection fees. These
can be substantial. Where additional work is done at existing premises, it is often
necessary to allow for substantial and costly upgrades to services and connections.
Contingency allowances
This is one of the most misunderstood and abused aspects of estimating. Some
consultants (and their clients) see it as a simple case of “adding an extra 10% so we
have a bit of fat in the estimate”.
19
S H F BP6 2006
1. “Design and detail development” – to allow for lack of detail at sketch plan at
estimating stage. This allowance should be high in the preliminary stages, and
reduce with each subsequent estimate as more detail becomes available from
the design team. Once tenders are in and construction is ready to start, this
could be reduced to a very small allowance, unless parts of the design are still
incomplete. It is usual to allow 2.5% to 5.0% of estimated final building cost in
the early stages of the pre-feasibility phase when designs are still basic, reducing to
around 1.0% when detail design development and technical documentation are
complete, and 0-0.5% when tenders are in. (For refurbishment and conversion,
the initial contingency should be increased to 7.5-10.0%). This allowance is part
of the construction cost, and has nothing to do with the architect’s fees.
The total contingency allowance (sum of the above) could vary from 5.0%-10.0%
initially (15.0%-20.0% for refurbishments and conversions), to around 2.0%-3.0%
once tenders are in.
However, to estimate only the current building cost is not realistic. Financial feasibility
studies (of which the estimate of construction cost is an important part) first have
to be carried out, tender documentation must be prepared, tenders called for and
adjudicated, plans submitted for scrutiny, and permission to start building granted
by the local authority, etc. This can take from 4 to12 months, or longer on large
and complex projects.
During this time, construction costs will fluctuate in response to both macro-
economic and local construction market factors. Recently, these fluctuations have
almost always been upwards as a result of continued inflation, and it is expected to
remain that way for the foreseeable future. (For a brief period In the 1980s, building
costs went down slightly.)
20
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
The future tender price will always be higher than the estimated current construction
cost, which must therefore be escalated in full for the estimated total planning period
at a projected rate based on construction market trends.
The project planning and construction periods (time) have an important effect on
time-related cost aspects such as:
• Preliminaries (especially salaries, plant and other time-related items)
• Pre- and post-tender construction cost escalations
• Financing cost (interim interest)
The effects of time on final building costs as outlined above must always be taken
into account in building cost estimates. This requires the highly specialised knowledge
and skill of a competent professional Quantity Surveyor.
Note: More detailed guidelines on how to estimate project time frames are
given in Annexure C.
21
S H F BP6 2006
On projects with simple buildings, a lot of design repetition, and limited involvement
of the independent professionals in the post-contract administration and supervision,
such as low-cost housing schemes for government, professional fees may be as low
as 6% to 9% of the final building costs.
For social housing, professional fees are generally between 8.5% and 12.5% of final
building costs.
The correct way to estimate fees is to estimate the value of work in a project that each
consultant is responsible for, and then to estimate the fee for that consultant on the
basis of the recommended scale of fees and tariffs for that profession. For practical
purposes, some of the general principles behind fee-scales are as follows:
• They are based on percentages of construction cost (usually the final cost).
• These percentages work on a sliding scale – high percentages on small contracts,
or on the first parts of larger projects, and lower percentages on larger projects
or the remaining parts of these projects.
• Multipliers are applied for more complex or risky work.
22
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
SHIs should take care when structuring their professional teams to avoid duplication
of fees on the one hand, and gaps in responsibility on the other. This is especially
true of two key positions on project teams, namely the principal agent (PA) and
the project manager (PM). The PA is the leader of the professional design team and
takes prime responsibility for administering the building contract, assisted by the
various other professional consultants in terms of their appointments and briefs. The
PA does not necessarily provide overall project management. The project manager
is responsible for the overall management of the project or contract.
The roles and responsibilities of the PA and the PM must be clearly spelt out in the
different briefs and agreements. The customary way is for the PM to take on the
additional role of PA, or else have an overall PM, with the PA directly in charge of
building operations, and reporting to the PM on aspects pertaining to the building
contract. The PA would, for example, exercise cost control on the building contract,
with the PM assuming overall responsibility for cost control and reporting on all
aspects of the project. The PA’s building contract cost report would then be an input
into the PM’s overall project cost report. Special attention must be paid, however, to
the “grey” areas where responsibilities could be seen to overlap. This could lead to
important issues being neglected because the one party thinks the other is looking
after them. For instance, it should be made clear who is responsible for making
sure the boundary pegs of the property are in place prior to site handover, who
is responsible for chasing up service connections, and whose responsibility it is to
ensure that occupation and compliance certificates are obtained.
The principal agent can be any of the professionals on the team and there are two
streams of thought:
1. Architect as principal agent
As the main design agent and leader of the design team, it makes sense to
appoint the architect as principal agent because he or she has the best overall
grasp of the required end product, and best understands what is expected from
each member of the team.
2. QS as principal agent
It makes sense to appoint the QS as principal agent because he or she controls
the purse strings, has a better knowledge of contractual matters, and is generally
better at routine paperwork and administration than the more “creatively-
minded” architect.
23
S H F BP6 2006
Both instances work, and the SHI’s decision should be based on an assessment of
leadership qualities and experience of the people involved, rather than the profession
they represent.
Another option is to appoint the PM as the PA as well, and have all the professionals
report to him or her. In this case, the architect and engineers will be responsible
for design only, while the PM/PA will run the building contract and supervise the
contractor. The design consultants may be consulted by the PM/PA on technical
or contractual matters on an ad-hoc basis. The QS will perform his normal duties
under the direction and control of the PA.
Model two (for larger and more complex projects where specialised input from
a variety of consultants and service providers is required):
• The SHI assumes overall development function.
• The SHI appoints an external professional PM.
• The PM is also given the role of PA.
• Various professionals are appointed for design and limited consultation by the PM
on technical and contractual matters during the contract administration phase.
24
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
• Plan-printing costs (on large and complex projects there may be hundreds or
even thousands of drawings of which copies must be distributed to the client,
the quantity surveyor, other consultants, contractors and sub-contractors, etc.
• Typing, printing and copying of specifications, bills of quantities, minutes of site
meetings, etc.
• Travelling and sustenance for projects located out of town.
The above must be allowed for in the estimate, usually as a percentage of building
cost based on previous experience (usually 0.25% to 1.5% of building cost).
The local authority usually charges for this service at a rate per square metre of
building area, for example:
The costs could take the form of fees and expenses to do promotions and advertising,
spotting and recruitment commissions to “runners” who bring successful applicants,
etc. Allowance should be made for initial marketing costs, even if the SHI believes
that the outcomes of the socio-economic survey and market-survey will automatically
lead to signing up of tenants without having to market the product.
Development contingency
In addition to the design and detail and building contract contingencies allowed
under escalated construction costs, an overall development contingency should be
included. This may range from 0.5% to 2.5% of TDC/TCO.
25
S H F BP6 2006
Finance costs
In the process of securing project finance, there will be administrative and legal
costs such as:
• Raising fees/originator fees (sometimes “hidden” and paid off in the loan
repayments)
• Valuation fees
• Mortgage registration fees and duties (lawyer’s fee and deeds office)
• Structuring fees where one financial institution acts as main lender in a consortium,
and undertakes to “structure” the total financing package in collaboration with
other institutions.
Interest charges apply to all “normal” loans obtained from financial institutions such
as the National Housing Finance Corporation (NHFC), Mpumalanga Housing Finance
Company, and any of the commercial banks.
Note: Examples of how to calculate interim cost of capital with both methods
are given in Annexure B.
26
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
Gross operating income is the “theoretical” total income that could be derived
from renting out full-time, without vacancy or bad debt, all residential units, facility
spaces (e.g. child-care facility), commercial spaces, and parking bays, together with
any recovery of operating expenses through levies (only in certain types of leases),
and sale of electricity, where the SHI is buying it in bulk from the municipality and
distributing to individual tenants.
In practice, the theoretical gross income is never fully collected. Some vacancies
always occur (for instance, when units are vacated from time to time, and need
repair, or when a replacement tenant is not immediately available). In addition,
some tenants will default on rental payments, and leave without the arrears being
collected, resulting in some bad debt write-off. Usual practice is to target around
2.5% of theoretical gross income for each of the above (5.0% total), and the result
gives gross collectible income. Many SHIs allow for only 90% collection in
their projections, but this sets too low a target, and leads to complacency and
inefficiency in collection. In the risk analysis at the end of the feasibility study, the
effect of a 90% collection rate can be illustrated in the “pessimistic” scenario.
Property operating expenses which are not recoverable through levies must be
deducted from gross collectible income to give net operating income before loan
repayments and taxes if applicable.
27
S H F BP6 2006
• Insurances:
• Property insurance
• Public liability insurance
• Loss of income insurance (if applicable)
Note: Project returns on investment are calculated by using net income before
repayment of loans and income tax (where applicable). Loan repayments
are, however, taken into account when cash-flows (and budgets!) are
compiled. The reason for this is simple: Returns are estimated in order
to compare investment opportunities. Whether the money (which you
don’t have anyway) is invested in shares, the bank, or in the property
development project, it would have to be borrowed in all cases at same
cost of capital. Loan repayments would therefore be common to all
alternatives, and it is not necessary to complicate the calculations with
that factor.
28
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
Gross rental income, two-bed units: 100 flats @ R 1 000 p.m. R 100 000
X12 = R 1 200 000 p.a.
Less: Provision for bad debt and vacancy 5% R 60 000
Gross collectible income p.a. R 1 140 000
Less:Property operating costs R 280 000
NET INCOME FOR FIRST YEAR R 860 000
Initial (first-year) return = R860 000/R9 000 000 x 100 = 9.56% p.a.
The major advantage of this measure is that income and expenses do not have to be
escalated too far into the future. This makes the projections more accurate (than say
a 20-year projection), and more easily understood in terms of the current value of
money. (Remember that even if it is acceptable for the calculation of estimated
return to assume an ideal situation from day one, the reality of lower initial
uptake [reduced initial income], and possible additional expenses in ironing
out early snags must be reflected in cash-flow and budget projections.
If assumptions are realistic, and estimates of both time frames and costs are done
properly, the initial return is often a better indicator of the health of a project than
the more sophisticated long-term cash-flow analyses used in financial modelling.
Long-term projections usually ignore possible cyclical fluctuations in inflation and
interest rates (i.e. assuming fixed or average rates over the period of study).
29
S H F BP6 2006
are spread over the year for each year, and not incurred or collected in one
go at the end of the year, but it is a slight improvement on the initial return
method, as the realities of first year(s) of operation could be accounted for in
the averages.
• Discounted cash-flow (DCF) measures of return
• Net Present Value (NPV): The sum of net annual incomes over the pre-
determined operational life-span of the project is discounted to its present
value, using the desired rate of return as the discount rate. If the NPV is
equal to or more than the TCO, then the desired rate of return has been
achieved. If the NPV is less than TCO, then the rate has not been achieved.
For example:
• CO on a project is R10 000 000
• Desired rate of return is 12% p.a.
In this case, the NPV of future net incomes is more than the TCO if discounted
at the desired rate of return, meaning that the actual rate of return achieved is
far better than the discount rate of 12%.
• Internal Rate of Return (IRR): The IRR is the rate at which the total net cash-
flows on the project during both the development and operational periods
has an NPV of zero. Where the NPV method works with a pre-determined
discount rate to see if it is achieved or exceeded, the IRR provides the rate
at the end of the calculation. (The IRR method assumes that all positive cash
flows are re-invested in the project at the discount rate). For the example
above, you would have to feed all cash-flows into the formula (or financial
calculator), and compute the rate.
For both DCF methods, the cash-flow must assume an end-value. Usual practice is
to take an operational life of 20 years and an end value equal to 100% of TCO
Working out these returns manually is an extremely laborious task. Detailed monthly
cash-flows for the whole 20-year period first need to be estimated, followed by
a compound interest calculation with different factors for each of the individual
monthly cash-flow entries. It is easier to use a financial calculator with DCF functions.
You will still have to do the cash-flow projection though, as that is part of the input
of variables into the calculator. Different makes of calculator have different key-
strokes for entering variables and computing answers, but they all come with good
instruction booklets that also explain the concepts and principles underpinning the
various calculations.
30
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
• Pay-back period
The TCO is divided by the annual net income to show how many years it takes for
the project to pay for itself. For example:
TCO = R10 000 000; net annual income = R100 000
Pay-back period = R10 000 000/R100 000 = 10 years
A cash-flow projection is a table of actual cash receipts and payments for every month,
or quarter, or year, as the case may be. It should not be confused with a budget (forward
financial planning) or an income statement (retrospective financial reporting). The purpose
is to be forewarned of any cash crises that may arise, and to help the SHI plan for and
overcome these.
Cash-flow tables are compiled by taking into account predictable or known events (e.g.
paying for land against transfer, paying a certain percentage of professional fees when tenders
are in, and so on), and by projecting expenditure spreads such as construction cost with the
use of predictive techniques such as so-called “S-curves”, and “Californian envelopes”.
For an “S-curve”, real expenditure patterns on past similar building contracts are analysed,
corrections made for out-of-the-ordinary events, and the results plotted on a graph.
The horizontal axis represents cumulative time (usually in months), and the vertical axis
represents cumulative expenditure. The plots are then averaged out to give a single trend
line. The result may look as follows:
R 5.5
R 5.0
R 4.5
Cumulative expenditure (million rands)
R 4.0
R 3.5
R 3.0
R 2.5
R 2.0
R 1.5
R 1.0
R 0.5
R 0.0
0 1 2 3 4 5 6 7 8
Time (months)
31
S H F BP6 2006
Although these curves are commonly referred to as S-curves (if you look very carefully
you may see a flat S in the shape of the curve), they often do not show any marked
flattening out at the end of the contract period, and are more like a “C” lying on
its back at an angle.
From the above, a cash-flow table for an 8-month building contract with a value of
R5 300 000 can be read off as follows:
Compiling the base S-curves from historical data is a difficult task, and requires
some knowledge of statistical mathematics. A more practical method is to compile
a simpler table, using actual expenditure tables from previous similar projects as a
rough guide.
Let us say a R9m contract is spread over 9 months. The average expenditure should
be R1m per month, but the actual pattern would look different, with amounts smaller
than the project average being spent in the first two or three months (low turnover
work such as site preparation, foundations, structural frame); amounts larger than
average spent in the middle months as the tempo picks up (high turnover work such
as brickwork, plastering, roofs), and the curve levelling off again towards the end
as final finishing is done.
The actual expenditure table on the previous similar building contract may have
looked as follows:
32
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
Let us say the current project for which the estimate (and feasibility study) is being
done is an estimated R9.9m building contract, also spread over 9 months. The
average is now R1.1m per month, and the table above can be used to guide us in
compiling a projected cash-flow for the current contract as follows:
In this case, the estimator decided that because the current project has a larger
value, but still has to be completed in the same time as the previous one, a quicker
start is required. The percentages in the first few months were adjusted to be closer
to the average. In the end it becomes a balancing game where the percentages are
tweaked according to experience, data available and intuition.
Risk analysis
Financial viability studies are projections into an uncertain future, based on past
and current trends and assumptions. The question needs to be asked: how will
changes in variables or assumptions used in the calculations affect project returns
and sustainability? These questions are often called the “what if?” type questions,
e.g.: “What if, for loan-repayment purposes, the average interest rate over the term
is 12% p.a. rather than the 11% used in the calculations”; and “What if the rental
for a two-bedroom unsubsidised unit is only R1 400 per month, rather than the R1
600 per month used in the calculations?”
33
S H F BP6 2006
It is usual to present three types of scenarios for each variable in sensitivity analyses:
• Optimistic (better than the assumptions used in the presentation of the viability
study)
• Realistic (the same figures used in the study)
• Pessimistic (worse than the figures used in the study)
34
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
35
S H F BP6 2006
w
Worked example:
complete financial viability study
Notes to the reader (not part of the viability report):
1. Only one measure of return has been estimated below, namely the simple
initial or first-year return. The more sophisticated cash-flow analyses
(NPV, IRR) requires more detailed figure work such as long-term cash-
flow projections, and including these would unnecessarily burden the
reader without really enhancing the illustrative value of the guidelines
and examples.
2. For the same reason as above, less detail than would often be included
in real reports was provided in the following sections:
• Detail breakdown calculations
• Risk analysis
• Project specifications
36
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
GOODHOMES PROJECT
for the
KOPANONG
HOUSING COMPANY
15 August 2006
37
S H F BP6 2006
CLIENT:
Kopanong Housing Company
PROJECT:
Project name: GOODHOMES FLATS, BIGTOWN x 17
Project no.: GHFBT 17/1
Erf no.: 2305/2 Bigtown Extension 17
Description: 180 two- and three-bedroom flats in three-storey walk-ups
ARCHITECT:
Nicedraw and Associates
QUANTITY SURVEYOR:
Fightwitharchitect and Partners
38
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
Contents
Executive summary
Brief project description
Estimated project time frame
Project funding structure and conditions
Statement of financial objectives
Estimated project costs and rates
Estimated project income
Estimated project returns, and how they compare with the stated objectives
Conclusions and recommendations
Summary calculations
Estimated total capital outlay
Estimated net annual operating income
Estimated return on investment
Risk analysis
39
S H F BP6 2006
Executive summary
Brief project description:
The project comprises 180 two- and three-bedroom flats for rental in six three-storey walk-ups on erf number
2305/2, Bigtown Extension 17, distributed as follows:
40
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
Estimated project returns, and how they compare with the stated
objectives:
Initial return = 7.7% p.a.
All possible savings in construction cost and operational expenses have already been considered in the
calculations below. Alternative funding structures with the incorporation of institutional subsidies have been
analysed, but because of the limiting effect of this on rental incomes, the situation actually looked worse. In
order for break-even between income and expenses to be achieved from year one, equity grants to the value
of R9 580 000 plus VAT would have to be injected into the capital funding for the project.
The recommendation to the board, therefore, should be that the project is not to be proceeded with in
its current form, but that it be re-conceptualised for a different target market, with different affordability
parameters. This will require a re-analysis of the social and marketing surveys, and possibly a new
demand study.
41
S H F BP6 2006
Summary calculations
ESTIMATED TOTAL CAPITAL OUTLAY (EXCL. VAT) R 34 879 938
VAT (@14%) ON TCO EXCL INTEREST (R33 197 773) R 4 647 688
ESTIMATED TOTAL CAPITAL OUTLAY (INCL. VAT) R 39 527 626
42
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
43
S H F BP6 2006
Estimated net annual income (before loans and tax) R 3 042 994
Estimated gross annual collectible income R 4 339 844
Estimated annual operating costs (R 1 296 850)
Estimated net annual income R 3 042 994
44
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
Notes:
1. No escalation during tender adjudication period – assumed immediate go-ahead.
2. Pre-tender escalation based on BER tender price indices.
3. Contract escalation based on projected Haylett-formula CPA indices.
4. Cash-flow factor for construction cost expenditure taken as 0.6.
45
S H F BP6 2006
46
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
Sheet 2:
Item Total Apr 07 May 07 Jun 07 Jul 07 Aug 07 Sept 07 Oct 07 Nov 07 Dec 07 Jan 08 Feb 08 Mar 08
Total constr
R 30 685 122 1 476 668 1 664 836 1 853 009 2 041 172 2 511 592 2 699 760 2 720 013 2 839 713 3 527 792 3 243 713 3 144 534 2 962 320
period
Construction R 28 225 212 1 317 176 1 505 344 1 693 517 1 881 680 2 352 100 2 540 268 2 560 521 2 680 221 2 822 300 3 084 221 2 985 042 2 802 822
Professional
R 1 241 910 103 492 103 492 103 492 103 492 103 492 103 492 103 492 103 492 103 492 103 492 103 492 103 498
fees
Sundry costs R 20 000 1 667 1 667 1 667 1 667 1 667 1 667 1 667 1 667 1 667 1 667 1 667 1 663
Marketing
R 172 000 14 333 14 333 14 333 14 333 14 333 14 333 14 333 14 333 14 333 14 333 14 333 14 337
costs
Dev
R 480 000 40 000 40 000 40 000 40 000 40 000 40 000 40 000 40 000 40 000 40 000 40 000 40 000
contingency
Notes to reader:
1. Professional fees were split into a once-off 60% payment at tender completion, with the balance paid in equal monthly payments
spread over the construction period. In reality there will probably be stage payments during the planning phase as different “work
stages” are completed.
2. Construction cost escalations are included in the monthly payments as if they are calculated and paid in the month to which they
apply. In reality there is a lag time of 3-6 months in the publication of indices needed for calculating each month’s applicable
escalation, which means that there will still be escalation and maybe other final account payments up to 6 months after contract
completion. The liability is, however, incurred in the month in question, and it is therefore prudent to portray it as such so that the
provision can be made timeously.
3. The interim cost of capital is reflected as a cost in the estimated TCO elsewhere, but is not included in the cash-flow above. This
is because the usual practice is for it to be capitalised at the end of the development period, added to the loan amount, and
amortised (paid off) over the term of the loan as part of the monthly instalment. It is therefore not a cash expense in the development
period.
4. If there were some equity investment, the table above would show the cash-flow demand (and maximum requirement) on equity
and loans separately, so that the SHI could plan for the availability and release of own funds which may be tied up in investments,
or may have to be diverted from other provisions on a temporary or permanent basis.
47
S H F BP6 2006
Gross income 4 568 256 4 796 669 5 036 502 5 288 327 5 552 744 5 830 381 6 121 900 6 427 995
Vacancy and bad debt 228 406 239 833 251 825 264 416 277 637 291 519 306 095 321 400
Collectible income 4 339 844 4 556 836 4 784 677 5 023 911 5 275 107 5 538 862 5 815 805 6 106 595
Operating expenses 1 296 850 1 361 693 1 429 777 1 501 266 1 576 329 1 655 146 1 737 903 1 824 798
Net income 3 042 994 3 195 143 3 354 900 3 522 645 3 698 778 3 883 716 4 077 902 4 281 797
Less: Loan repayments 4 178 808 4 178 808 4 178 808 4 178 808 4 178 808 4 178 808 4 178 808 4178808
Annual surplus/(shortfall) (1 135 814) (983 665) (823 908) (656 163) (483 030) (295 092) (100 906) 102 989
Expenses 1 296 850 1 361 693 1 429 777 1 501 266 1 576 329 1 655 146 1 737 903 1 824 798
Security 84 000
General 6 000
Notes to reader:
1. The operational cash flow can be done for 5, 10, 15 or 20 years. In the example above it was done up to the point where there is a
surplus after expenses and loan repayments. It shows that net income will be able to meet expenses and loan repayments only in
the 8th year of trading, with an accumulated shortfall of almost R4.5m (plus interest). The project in its current form is therefore not
sustainable from a cash–flow perspective, and should be re-conceptualised.
2. Both income and expenses were escalated by 5% p.a., while loan repayments were kept static at the initial rate of interest. More accurately,
the anticipated average interest rate over the term should be used for calculation of loan repayments, but the approach is that if loan
rates were to change, it would generally be accompanied by related changes in inflation rates, meaning that income and expenses would
change as well.
48
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
Risk analysis
Parameter changed Amount of change and its effect on initial return
Optimistic Realistic Pessimistic
Escalated construction -5% As is 7.7% +5%
cost (see note 1 below) 8.08% 7.36%
Interest rate Change to 10% p.a.: As is (11% p.a.): Change to 12% p.a.:
(see note 2 below) 7.74% 7.7% 7.67%
Rentals +10% As is 7.7% -10%
(see note 3 below) 9.44% 7.13%
Vacancies and bad debt Change to 2.5%: As is (5%):7.7% Change to 10%:
(see note 4 below) 7.99% 7.13%
49
S H F BP6 2006
Outline specifications
Item Description
Foundations 600 x 200mm strip footings under walls; 800 x 800 x 400mm reinforced pads
under columns
Structural frame Reinforced concrete columns 230 x 230mm, and 200mm thick flat slabs (150mm
for walkways and balconies)
External walls and finishes 220mm brick walls faced outside (Prime cost (P.C.) for supply of face bricks =
R1 800/1000)
Internal walls 110mm brick
Internal wall finishes Cement plaster and washable acrylic paint; ceramic tiles in showers and splashbacks
(P.C. for supply of tiles = R50/m2)
Roofs Concrete tiles on timber trusses at 26 degrees, with plastic underlay; fascias and verges,
but no gutters or downpipes
Ceilings Slab soffits externally: Off-shutter concrete unfinished
Slab soffits internally: cement plaster and PVA
Under trusses: 6mm Gypsum board, painted and with 40mm mineral wool insulation
Floor finishes Balconies and external walkways: Untinted granolithic
Stairs: Untinted granolithic with reeded treads
Bedrooms and living rooms: carpet tiles (P.C. supply and lay = R70/m2)
Kitchens and bathrooms: 2mm vinyl tiles on screed
Fittings 1500mm double bowl kitchen sink on white steel cabinet
1800mm melamine wardrobe in main bedroom
1200mm ditto in other bedrooms
Plumbing 3-bedroom flat: Bath, whb, WC, sink and 150l geyser per flat
2-bedroom flat: Shower, whb, WC, sink and 100l geyser per flat
Electrical Pre-paid metering unit in each flat
1 light and I 15 amp power socket per room
Isolator for stove and geyser
Fire service Fire hose reel and 2 extinguishers per floor
2 hydrants for fire engine connection on site
Access control Swipe card system for tenants
Security guard and intercom at entrance gate
Boundary walls 1800mm high steel palisade fence between face-brick piers at 3m centres
Gates 3m and 1m motorised remote-controlled motor and pedestrian gates
Roads and parking Bevelled concrete block paving
Sport and recreation facilities 1 basket ball court, playground equipment, tennis practice wall
Garden works Instant lawn, shrubs, trees and flower beds as plan
50
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
a
Alternative approaches to doing
project financial viability studies
Income capitalisation method of
determining financial viability
The way investors and their consultants often go about doing financial viability
studies is as follows:
1. Determine demand for product type and mix (one-/two-bedroom flats, etc.).
2. Develop concept design and work out development cost estimates.
3. Determine what the rentals should be to justify the cost.
4. Find out too late that the projected rentals were too optimistic, and that the
detail design and documentation are based on unaffordably high product
specifications.
A more prudent approach involves first determining realistic rental levels affordable
to the target market, and then “forcing” the design to result in a development cost
that is viable within the constraints of realisable income. This technique is commonly
used in commercial developments, and is called the income capitalisation method
of setting development cost targets or limits. In simple terms, it works as follows:
1. From the social and market surveys, determine the product demand as before,
and then set realistic rentals for the different products.
2. Calculate the estimated total net income that could be realised on the basis of
those rentals.
3. Divide the net income by a capitalisation rate (cap rate for short) acceptable to the
investor (in other words, the investor’s desired rate of return on the project).
4. The result of the calculation in 3 above is the total allowable amount of total
development cost (TDC) or total capital outlay (TCO) that must be adhered to
if the desired rate of return is to be achieved at the determined rental levels.
5. From this amount, deduct the known cost of land, and then do a residual value
calculation to eliminate interim finance costs and professional fees, leaving a
balance that could be spent on actual building cost. This then becomes the cost
parameter for design purposes.
51
S H F BP6 2006
For this exercise let us assume that the investor’s desired rate of return is 10% p.a.,
and that it decides on this figure as a cap rate. Now divide the net annual income by
the cap rate factor: 10% = 0.1:
The allowable TDC is R8 400 000.00 (Check the reverse calculation: R840 000.00
net income over R8 400 000.00 TDC gives an initial return of 10% p.a.)
52
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
If we know that the current building cost for two-bedroom units in a walk-up is say
R1 800/m2, our allowable size is R55 000/R1 800 = 30.55m2. Now the question is
whether or not 30.55m2 for a two-bedroom unit is a marketable size for a rental of
R1 150 p.m. The answer is probably no, so we must look at it from the marketing
side and say that the units must be at least 42m2, meaning that the allowable current
building cost rate is R55 000/42 = R1 310/m2. Is this feasible or will it result in too
low a specification and quality? We have to reach a workable compromise between
realistic income, and a marketable but affordable product. We will have to try
different product and tenant mixes, where some units can be let at market-related
rentals to non-subsidised tenants in order to make the scheme work.
This means there needs to be constant interaction between the design team
on the one hand, and the marketing and property management teams on the
other, and it is up to the development manager and/or project manager to
ensure this happens!
4. The design team prepares a preliminary concept or sketch design, and the QS
does a cost estimate and preliminary viability study. If the estimate falls within
the cost parameter, OK, if not – it is back to drawing board. Savings could be
achieved through:
• Reducing unit size and specifications (but not below marketable levels, and
not in a way that will result in maintenance problems).
• Simplifying complicated building shapes and details, improving layouts to
shorten service pipe runs, improving design efficiency i.e. achieving the
optimal ratio between lettable and common spaces respectively.
• Consulting with property and marketing managers to see if certain facilities
and amenities could be provided in rudimentary form initially (or even left
out), and gradually introduced or upgraded in a phased manner as income
improves or additional donor funding is obtained.
53
S H F BP6 2006
In the above examples, we worked on the premise that the land cost was known
and fixed. This is not always the case. Sometimes we need to check the asking price
against what we can afford, to enable us to negotiate the price on a realistic basis.
Sometimes we will still need to search for suitable land. In that case we could do
a hypothetical calculation (say 500 units at a certain density and price, and for a
certain target market as identified in our social/market survey). We could also do
an estimate of what the total development cost should be, in order to render an
acceptable return by using the income capitalisation method as above.
The same principles as above can then be applied to determine what the maximum
price is that can be paid for a piece of land, and the search for suitable land will
then narrowed down to properties that fall within that price range.
54
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
Unless we change one of the other variables (building costs, time-frame, income,
etc.), we can only afford R149 523 for the land. The cost of the land in the previous
exercise – R320 000 – is therefore too high for this project.
55
S H F BP6 2006
Information with regard to size, development rights, etc. of the site is obtained
from the town planning office of the local authority, and is used to calculate gross
construction or floor areas of the different types of buildings that are permitted on
the site in terms of the “Town Planning Scheme” of the local authority.
56
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
Other assumptions:
• Time required for project validation and appraisal: 2 months
• Time required for purchase and transfer of the property: 2 months
• Design development, and documentation: 4 months
• Plan approval: 2 months
• Tenders: 2 months (but overlaps for 1 month with plan approval)
• Total planning period: 11 months
• Construction period: 13 months
• Total development period: 24 months
• Bond registered in month 4
The project will be 100% loan financed (this of course not realistic, but is assumed
just to simplify the calculations below)
57
S H F BP6 2006
With the information above, the estimator can now do the following calculations:
Total area of site that may be covered with buildings – 40% x 10 000m2 = 4 000m2
Total permissible floor area of buildings at all levels – 1.2 x 10 000m2 =12 000m2
We will also assume that, from our general market knowledge, we know that the
most popular accommodation is 2-bedroom flats of 40m2. We also know from past
experience that design efficiency for this type of building is 90% (meaning that 90% of
our 12 000m2 or 10 800m2 is available for flats, with the remaining 10% being used
for stairways and other circulation areas). We can therefore, fit 10 800 m2/40 = 270
units on the site.
The next critical aspect is parking. Available on site is an area of 5 400m2 after deduction
of ground floor built area of 4 600m2. Of this, about 600m2 is unsuitable (rocky outcrop
and wetland in SE corner), leaving 4 000m2. We estimate that another 1 300m2 is
needed for garden and recreational areas, refuse yards, walkways, etc., leaving only
2 700m2 for parking on site. At 30m2 per car, this gives us space for 90 parking bays
on site. The total parking requirement as laid down by the local authority is 0.25 bays
per unit = 270 x 0.25 = 68 bays (2 040m2 of paving). (In practice, it is usually a lot
harder to satisfy the parking requirement.)
We can now do a quick financial viability calculation as follows (or preferably using
the income capitalisation approach illustrated earlier):
58
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
59
S H F BP6 2006
It is now possible to do the rest of the financial viability study from the information
above. Lettable areas of buildings and, therefore, projected income and returns on
investment can be estimated.
60
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
ANNEXURE A
Estimating escalations on building
contracts
Contract Price Adjustment Provisions Of The JBCC
(Formerly Known As The Biac (Haylett) Formula)
Introduction
A Manual and Reference Guide for practical application of the formula is published by and available from
the Joint Building Contracts Committee (JBCC), with revisions and interpretations issued from time to time.
Students are advised to obtain a copy of this manual, and to continually keep up to date with new revisions
and interpretations.
61
S H F BP6 2006
Calculation of adjustment
• The principal agent will calculate an amount of adjustment for each valuation period in respect of each
work group using the formula:
Xe
A = 0.85 V ( Xo - 1)
Where:
At present there are two bodies that provide the building industry with contract price indices together with other
relevant statistics on a continuous basis, namely:
Starting and completing construction on the very same day is, of course, not possible. Feasibility studies (of
which the estimate of construction cost is an important part) first have to be carried out, tender documentation
62
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
must be prepared, tenders called for and adjudicated, plans submitted for scrutiny, and permission received
from the local authority to start building, etc. This can take from 4-12 months or even longer on large and
complex projects.
During this time, construction costs will fluctuate in response to both macro-economic and local construction
market factors. Recently, these fluctuations have almost always been upwards as a result of continued inflation,
and are expected to remain that way for the foreseeable future.
The anticipated future tender price for the work will invariably be higher than the estimated current construction
cost. The estimated current construction cost must therefore be escalated for the estimated total planning period
at a projected rate based on construction market trends.
In this case, the interest or accumulation factor is 1.07738, and the future value or estimated tender sum is
1.07738 x R 10 000 000 = R 10 773 800. The pre-tender escalation is therefore the difference of R 773 800.
63
S H F BP6 2006
A different type of index is now applicable in accordance with the contract conditions for civil engineering and
building projects.
The compounded future value as calculated or read from the tables is then: 1.005 x R 9 157 730 = R 9 203 519.
In other words, while the tender was being adjudicated, the building cost escalated by R 45 789
(R 9 203 519–R 9 157 730)!
The building cost has therefore gone up in this time by R45 789, from R 10 773 800 to R 10 819 589.
This means that by the time the builder gets the go-ahead to go onto site and start work, the building
cost has already gone up to R10 819 589 from the tender price of R 10 773 800.
64
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
Basic information:
i = 0.5%
n=4
K (“Vtotal” x 0.85 x 0.6) = R 10 819 589 x 0.85 x 0.6 = R5 517 990
Estimated final escalated building cost in accordance with the short method:
1. Estimated current building cost R 10 000 000
2. Estimated pre-tender escalation R 773 800
3. Estimated tender sum R 10 773 800
4. Estimated post-tender escalation:
4.1 During tender adjudication: R 45 789
4.2 During construction: R 111 187 R 156 976
Estimated final escalated building cost R 10 930 776
From the end of the first month of construction activity, the contractor will receive progress payments. An amount
of 0.85 of the value of each progress payment will only escalate from the base date to the date of certification,
and no further.
To estimate the escalation on each payment, a construction cash-flow or payment projection must first be made.
Estimated escalation for each monthly payment must then be calculated, using the relevant contract adjustment
formula and the projected escalation rates for the construction period.
Basic information:
1. Projected contract escalation rate during construction: 0.5% per month
65
S H F BP6 2006
Note: that n for the first payment = 2 (one month tender adjudication before construction starts! – first payment
only two months after tender closing: this takes care of the escalation taking place during the adjudication
period).
Estimated final escalated building cost in accordance with the long method:
1. Estimated current building cost R 10 000 000
2. Estimated pre-tender escalation R 773 800
3. Estimated tender sum R 10 773 800
4. Estimated post-tender escalation:
4.1 During tender adjudication: (incl below)
4.2 During construction: R 165 973 R 165 973
Note: In this example, the figure calculated using the long method differs by only R8 997 from the short method,
but the differences can be far greater if the “cash-flow factor” is chosen differently for the short method.
If in the above example, for instance, a factor of 0.5 was used in the short method, the calculation would
have looked as follows:
Basic information:
i = 0.5%
n=4
K (“Vtotal” x 0.85 x 0.5) = R10 819 589 x 0.85 x 0.5 = R4 598 325
R4 598 325 x 0.02015 = R92 656 instead of the R111 187 for a factor of 0.6.
66
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
ANNEXURE B
Calculation of interim cost of capital during development
period
Introduction
The SHI can obtain capital required for construction or property development projects from different sources,
such as:
• Equity or own capital (from own accumulated cash reserves/investments) – this is currently rare as most
SHIs are struggling just to meet operational expenses, let alone put away surpluses
• Government subsidies and grants, and donor grants
• Loans from financial institutions and aid agencies
In theory, all project capital comes at a cost. If it is borrowed, there is usually an interest charge. Equity invested
in a project is withdrawn or withheld from being invested elsewhere, thus losing out on the opportunity to be
earning interest, capital appreciation, dividends or operating profit depending on the alternative (investment in
bank, property, stocks and bonds, or stock for trading). This loss of potential interest or other form of return or
yield is referred to as the opportunity cost of equity. In practice, subsidies and grants, and interest-free loans
are considered to be “free money” that comes at no cost to the property developer (SHI).
Capital is invested in a project in varying amounts from time to time during both the planning and execution
phases. As soon as a certain amount is spent (invested), it either loses interest or the opportunity to provide
yield (equity), or it attracts interest charges (borrowed capital). Both opportunity costs on equity, and interest on
amounts borrowed (to pay for land, professional fees, construction and so on) during the development period
must be calculated up to the end of the development period and “capitalised” or included in the total capital
outlay or project development cost. The sum of these constitutes the interim cost of capital.
For purposes of estimating and feasibility studies, interim cost of capital can be calculated in one of two
ways:
• Using the so-called long method – done on the basis of a detailed project cash-flow, and therefore, more
accurate (but also quite time-consuming)
• Using the so-called short method – done without a detailed cash-flow of expenditure, and therefore, less
accurate
67
S H F BP6 2006
The total estimated cost of capital during the 6-month development period (2 months’ planning, 4 months’
construction) is R 23 689.00.
As seen in the cash-flow table above (and in Annexure B), expenditure curves on construction contracts
usually show that more money is spent during the second half of the contract period (because of slow starts,
site establishment, high volume/low value work in the early stages, etc.) The effect of this is that less than 50%
(usually around 40%) of the contract value is subject to interest accumulation for half the time. In the example
above, 40% of construction contract value (R 120 000 + R 180 000 = R 300 000 out of R 750 000) is spent when
50% of the contract time (2 out of 4 months) has elapsed. The cash-flow factor is therefore 0.4. (We would not,
of course, have done the cash-flow for this particular project, but we would know the expenditure pattern from
analysis of previous projects, and from experience).
Using this factor of 0.4 for our example, the estimated cost of capital during construction would be as below.
We would still have to do separate calculations for lone-standing major expenditures such as land cost, fees
payable at tender stage and so on. For practical purposes, the balance of fees and other small expenditures
can be lumped together with construction cost and adjusted by the cash-flow or spread factor of 0.4:
This is less than the amount calculated via the long method (which is more accurate).
68
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
ANNEXURE C
Estimating project time frames for use in financial viability
studies
Key agreements that need to be put in place
A useful framework for guiding the drawing up of a critical path programme is to identify and arrange in critical
sequence all the key administrative approvals and project governing agreements needed, as these usually
take up the most time. The technical work taking place in between approvals and go-aheads is not normally
the problem. Some of these agreements and approvals are shown in the table below more or less in critical
sequence (you can think of more that apply to your specific case):
69
S H F BP6 2006
Some of the questions the programmer now needs to ask him/herself are:
• What work needs to be done by the technical project team before an application for approval can be made, or
a key agreement drafted, and how long will it take, including the research or information gathering stage? (e.g.
How long for management to prepare a proposal to council requesting a land availability agreement?)
• At what level are internal approvals required, and how long will it take? (e.g. The proposal for LAA must first
get board approval for the selection of land as well as proposed terms – how long to convene board, must
it first go through technical/legal/finance sub-committees, and allow for come-back and re-submission?)
• How long does the external approval process take? (e.g. The request for land will first have to be investigated
and agreed to by various technical departments within the council. Is the land available, is it developable
in terms of geotech, availability of services, etc. – then it must be submitted to council for a resolution in
principle, then given to legal for drafting of the actual agreement, and finally accepted by both parties, and
then the board’s and the town manager and/or mayor’s signature/s must be obtained).
Next, the programmer needs to decide in consultation with the board, the PM and key stakeholders on a high-,
medium- or low-risk approach to how long administrative processes should take, and the degree of overlapping
that is prudent.
Programming techniques/tools
Programming tools vary from simple charts where activities are listed in sequence from top to bottom along
the vertical axis, and the time an activity takes and where it belongs in the sequence are depicted graphically
by lines or bars on the horizontal axis time-scale (bar chart or Gannt chart), to complex computerised network
techniques.
Programming requires a good understanding of the development process, and how changes in the duration
and/or sequence of activities in the process impact on each other and affect the completion date.
70
G U I D E L I N E S PROJECT FINANCIAL VIABILITY STUDIES
The above are indications only. Real times will be affected by the degree to which the SHI is willing to take the
risks involved in overlapping some activities, the availability of money to fund land acquisition, rezoning costs,
professional fees for documentation, etc., and administrative delays in getting land availability agreements set
up, etc.
Realistically, the shortest time between project initiation and getting a builder on site is probably 12-16 months
for straightforward cases, and 20-24 months where complications such as rezoning are involved. These periods
will vary considerably according to individual circumstances and the degree of overlapping the SHI is willing
to risk (for instance initiating land acquisition before preliminary studies are complete, proceeding with town
planning procedures on risk before the property is transferred, preparing full tender documentation before plans
are approved, etc.)
Township establishment could take slightly longer than rezoning in simple cases (where a single piece of land
is owned by council), or could add anything from 12 to 24 months to the normal process in cases where, for
instance, a new estate has to be planned on previously unproclaimed land. This is because new land-use layouts
will have to be prepared and submitted to various government departments for input.
71
S H F BP6 2006
This would be far too time-consuming at the time of estimating, and a quicker method is required at this stage.
A simplified version of the critical element method is therefore probably the most appropriate estimating tool. It
is based on the observation that the concrete frame in the case of multi-storey buildings, and the walls, slabs
and roofs in the case of walk-ups are usually the main critical elements. The method is to first estimate the time
needed for the structure, and then to add time for start-up and finishing off.
Further reading
See “Guidelines - Construction Management Good Practice” and www.shf.org.za
72
Ground floor, Milner Place
32 Princess of Wales Terrace
Parktown, Johannesburg
www.shf.org.za