Identifying and pricing risk in residential development

Property impacts the livelihood of so many Australians both in terms of home ownership rates and business activity. It is Victoria's biggest industry, accounting for 11.9% of the state's economic activity. It is also Victoria's second largest employer, employing more people than mining and manufacturing combined (Urban Development Institute of Australia, 2014). It is evident, therefore, that the development, building and construction industry underpin a relatively significant portion of the Australian economic growth platform. It accounts for jobs, spending and the macroeconomic multiplier effect of general activity and prosperity. There are many hurdles to overcome during the development lifecycle and these hurdles inevitably include an assessment of risk and return. As Loosemore (2006, p2) states, 'the challenge (for enterprise) is not to avoid risk, but to take calculated risks by recognising and managing them effectively.' Of interest was that there is relatively little evidence-based research available regarding 'appropriate' industry capital investment return methodology. The understanding of risk and return in the residential property development market was the focus of this research which used a grounded approach and mixed methods research methodology to identify '...how a developer measures the uncertainty involved in a scheme and... how much profit is required to balance the resultant risk' (Wilkinson et al, 2008, p120). In developing this research, it was desirable to ultimately add to the body of knowledge by producing a best practice, applied process for risk pricing in residential property development. Initially, it was necessary to understand how development risk was identified for a site opportunity. Subsequently, it was necessary to understand the risk profile of residential development over the development lifecycle. If risk measureably diminished over the life of the project, then there may be an opportunity to standardise the measurement of residential development risk and uncover how to price it appropriately. This research, would therefore serve to enhance the body of knowledge in a number of ways, including deciphering the risk profile for residential development, and producing research into the methods for pricing risk as it is understood by the industry. Given the grounded nature of the research deliverables, a mixed methods approach was applied and developed for the study, which includes applying both quantitative and qualitative aspects. 'Its central premise is that the use of quantitative and qualitative approaches, in combination, provides a better understanding of research problems than either approach alone' (Creswell & Plano Clark, 2011, p5). The research data involved forty (40) 'Stakeholder Surveys', followed by fifteen (15) 'Semi-structured Interviews.' The analysis related to the surveys involved approaches including: descriptive statistics, correlation, weighting of consequence by probability and examining recorded interviews outlining participants attitudes towards the dominant factors which influence residential development risk. Interestingly, four main themes became repetitive, including; i. Experience ii. Capability iii. Financial capacity iv. User bias. It became apparent from the quantitative research that development risk was not linear, nor did it necessarily reduce, by consequence, from start to finish. The participants' outcomes identified what can be identified as 'risk spiking', being numerous moments throughout the residential property development lifecycle where risk escalates to a milestone or deliverable and then falls, only to spike again at a subsequent risk event. The analysis of data related to the interview process was recorded and dictated, then filtered through the NVivo data analysis software. Following the NVivo entries, the relationships and themes were systematically highlighted from each of the interviews until seven key content headings emerged from the data. The content headings were: i. Risk mitigation actions are not necessarily absolute (x124) i . Competing priorities exist at enterprise level (x44) iii. Timing of entry of investment impacts return (x48) iv. Minimal scientific basis for standardised required returns or pricing of risk elements (x122) v. Risks are segregated and interrelated (x61) vi. Risk pricing challenges (x94) vii. Probability might change, consequence less so (x72). The research identified a number of headings, some more frequently than others, including one specifically which speaks to our initial inquiry objective: that in residential property development there is minimal scientific basis for standardised required returns or pricing of risk elements. In practice, the user/development practitioner decides if the return metrics are acceptable according to its own internal decision making, the basis for which can vary immensely. Loosemore (2006, p9) explains that '...the concept of risk a very personal thing since an event, which is a risk to one organisation might not represent a risk to another. Indeed, an event, which is a risk to one organisation, might represent an opportunity (possibility of gain) to another.' Key to the results was the emergence of a clear differentiation between two interpretations of what 'risk pricing' meant to the research participants. The concept of risk pricing had been defined in the early research as the assessment and calculation of risk in relation to the development's profitability or return metrics. During the research period, it evolved to include a development assumptions-based definition. This involved the estimation of the allocation to financial or time contingencies to each of the cost and revenue items in the feasibility that were at risk of diluting the outcome of the risk/return profitability metrics. Importantly, we understand that standardised returns on a specific residential development project is difficult to calculate, for various reasons. However, based on practitioner led research data, it is posited that it is possible to produce, what has been titled, an 'Applied Process for Risk Pricing.' This provides for an initial development feasibility and ongoing monitoring approach which chronologically and often iteratively analyses 7 key stages in the process, outlined in Chapter 6. The research further identifies a 'Circular Evaluation' process between valuer, financier and developer whereby the market-based conversations between these property sector participants appear to be the determinant of the accepted risk-based profit input for a subject development, for the purpose of determining residual land valuation. This thesis identifies that there are key risk pricing stages and evaluation practices which are important determinants when assessing risk-based pricing in residential development.