Redevelopment economics and associated value capture opportunities

Understanding the basics of redevelopment economics and associated value capture opportunities has become critically important. Alex Hrelja, Principal of HillPDA Melbourne discusses this in Planning News March 2015 edition.

Urban renewal has been given prominence in metropolitan and local planning strategies around Australia for at least a decade. The general desire of many plans is now being realised, driven in particular by strong growth in medium and high density housing projects (albeit concentrated in selected regions at this time). The growth has been so strong in some locations that the scale of demand has arguably caught some authorities off guard in terms of having sufficient infrastructure contribution and value capture mechanisms in place to help deliver public realm works and community facilities to support liveability. Understanding the basics of redevelopment economics and associated value capture opportunities has become critically important.

The economics of redevelopment in a location is generally explained by three variables:

• demand for property in the market area, which sets the value for different property types
• the attributes of a particular site and its improvements and use, which sets the value of the subject property in its current state
• planning frameworks that apply to the site, which determine potential use and development of the subject site via redevelopment.

In most cases, a site can be redeveloped when land value of the site under a redevelopment scheme from a developer’s perspective is greater than the site’s value in its existing condition. For example, assume a shop has a value of $2m if put to the market for sale as a going concern (existing condition).
The shop could be bought by an owner-occupier or investor both seeking to use it in its current form and both would pay market value of $2m.

From the perspective of a developer, the acquisition value of the site is based on market demand (point 1 above) and what can be done with the site (point 3 above). The combination of those variables gives the land a residual land value from a redevelopment perspective. This value changes based on
shifts to the two factors (demand and planning).

For example, say a two storey height limit applies to the subject site under the existing planning framework. A developer may generate a scheme which estimates an end-value for the property at $4m. Assuming costs (construction, profit, other costs) are $2.8m, the residual land value is $1.2m. Hence the developer would be outbid to acquire the site because its existing value to others in its current state is $2m. The planning framework sterilises redevelopment.

If however the planning framework is changed and a four storey height limit applies, the end value of finished redevelopment might be $9m. Assuming costs are $6.5m, the residual land value would be $2.5m. Hence the developer would be the highest bidder (and the property redeveloped) if the property was put to the market.

This simple example highlights the impact planning can have on land value, and the likelihood of existing development or redevelopment occurring. In the simple example, the shift in the planning framework has increased the value of the property by $500,000. A nice free kick to the land owner.

In some planning jurisdictions, estimates of such potential value change are made before planning frameworks are changed and a model established to return some of the associated value uplift to community facilities in the area of redevelopment. This is an increasingly common practice in NSW in redevelopment precincts where significant changes to density are proposed.

Before planning changes are made, a negotiated agreement is struck between prospective developers and the planning authority. The agreement generally seeks to retain a portion of the assessed value uplift (say up to 50% in some cases) for public benefit relating to the development area in question.

In the above example, $250,000 would be paid to authority as a contribution to the redevelopment area’s public domain and community facility development. This can be in addition to infrastructure contribution charges that are factored into the cost of development. The other $250,000 is retained by the land owner.

Simple in theory, but tricky in practice. Keys to making such schemes work effectively include:

• timing and communication
• legal mechanisms
• valuation accuracy and transparency
• funds collection and spend ing.

It is important to foreshadow the application of value capture schemes in tandem with announcements regarding proposed planning changes. Developers will factor into their land purchase price the prospect of a changed planning framework (to some extent) even before the statutory framework has changed (taking into account the level of certainty and risk in the process). This valuation should include the concept of a value capture contribution at that time if one is to eventually apply. It is generally unfair to introduce a value capture arrangement later in the planning process, which could render some projects unviable.

The legal mechanism is obviously critical. The mechanism needs to be simple and promote transparency. In NSW for example value capture schemes are executed by Voluntary Planning Agreements (VPAs). This is similar to section 173 agreements in the Local Government Act in Victoria.

A third element of importance is accuracy and transparency in the valuation process and uplift calculation. A black box or generalised calculation of value is not sufficient, as it would be open to dispute. The use of development feasibility and valuation software such as via Estate Master OF has been successful in making the valuation calculation clear and assessable for all parties. This is essential in being able to negotiate an outcome effectively.

Another element of importance is use of the funds collected. A fair approach is to spend the funds for the purpose they were collected – to support liveability in the area that paid the contributions. Confidence in value capture schemes can be eroded when used as a general taxation tool. Another element that supports use of such tools is timing of payment. Payment at the end of development projects, when income is received by developers, is a preferable approach.

The end result can be a process that delivers urban renewal efficiently, with all parties in the process being treated fairly and able to share in the gains from the process. Agencies can move forward with confidence of knowing a fair share allocation will be made for facilities and developers can move forward with certainty.

Planning News Volume 41 NO.2 March 2015

Alex Hrelja, Principal at HillPDA, can be.contacted at Alex.Hrelja@hillpda.com