To go back to our first principles, we’ve got three components: time value money, opportunity cost and risk. Those are all in our desired discount rate of return which is then applied to the series of cash flows which reflects the design, permitting the cost: the debt and the equity. In order to evaluate what it is and to come up with a value, a sub component of that is the risk, which comes back to design.
Can you design this thing? Can you build it? Well you can build anything you want if you can get a permit for it… but will there be a market to lease it to? If you’re building a vacant office building, will there be tenants? Everyone is price motivated, so what would be the rents that you would have to achieve in order for this to be attractive to tenants and to also generate a return to you on the purchase value, plus the cost, plus the discount rate on the future? In other words, what are the total costs so you can calculate how to generate a profit.
You are doing market feasibility, design permit feasibility, costs and financing feasibility to assess the risk component of the rate of return. To use an example, let’s say that you’re buying a piece of land that’s been completely permitted and designed for a building that is very much in need for that market. This would be a hundred units of apartments in an area that is lacking housing. The land is right across the street from a large tech firm who have a young employee base.
A lot of money goes into designing and building and it’s already been approved. So that removes a lot of uncertainty. Well, what does that do to your discount rate or required return? Would that bring it down or up versus buying some raw land and having to start from scratch? A reduction in uncertainty would bring down your rate of return, because from the lower risk, you don’t need as much return. It’s very much in demand, and so you could pay more for that building and land and accept a lower rate of return because it’s more design-feasible, permit-feasible and you only have to address your construction costs in the rate of return. So every time you’re building up your rate of return, this equates to risk, where risk can be broken down by market, financial cost, design and permitting pieces.
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