The Economics of Property & Construction

Question 1

The analysis of strategic alternatives and the commitment of resources to investments involve a complex set of economic trade-offs, viewed within a competitive framework. Two of the most common methods for the assessment of financial viability are the net present value (NPV) and the internal rate of return (IRR) methods. This section compares and contrasts the nature of the NPV and the IRR investment appraisal methods.
The NPV of a flow of cash is a system proposed by many as the best for evaluating building-related options. The NPV is a direct measure of value creation as well as a screening device that indicates whether a stipulated minimum return standard, such as the cost of capital, can be met over an investment proposal’s economic life. NPV is the discounted value of cash inflows less discounted cash outflows. When NPV is negative, the minimum return standard and capital recovery cannot be achieved with the projected cash flows. When NPV is close to or exactly zero, the return standard has just been met. In this case the investment will be value neutral. When NPV is positive, there is potential for a return in excess of the standard and therefore, economic value creation (Ross et al., 2006).
The advantages of this method are that (1) it is fairly straightforward; (2) it recognises the value of cash inflows beyond the payback period; and (3) it quantifies the risk-adjusted increase in wealth from the investment. The disadvantage is that it is difficult to compare NPV to any benchmark (Vance, 2002). Additionally, while NPV is the most frequently used tool in evaluating investment alternatives, it does not answer all the questions about the economic attractiveness of capital outlays. For example, when comparing different projects, how does one evaluate the respective size of the value creation calculated with a given return standard, particularly if the investment amount differs significantly? Also, to what extent is achieving the expected economic life a factor in such comparisons? Furthermore, how does one quantify the potential errors and uncertainties inherent in the cash flow estimates, and how does the measure assist in investment choices if such deviations are significant? Finally, one can ask what specific return the project will yield if all estimates are in fact realised? Further measures and analytical methods are necessary to answer these questions.
The IRR is the discount rate at which a project will have a NPV of zero. IRR is another name for the yield on funds invested in a project. Stated another way, if cash flow estimates are achieved, the principal of an investment will be amortised over its specified economic life while earning the exact return implied by the underlying discount rate. The project’s IRR might coincide with the return standard desired, might exceed it, or might fall short of the standard. These three conditions parallel those of the NPV method. Projects with the highest IRR rank higher than projects with a lower IRR and only projects with an IRR greater than the cost of capital should be considered for funding (Ross et al., 2006).
One of the attractions of the IRR for many practitioners is its ease of comparison with the return standard, and/or the cost of capital, being stated in percentage terms. In this way, IRR can be compared to the yield of stocks and bonds, and to the yield of other investments. Naturally, the result of a given project will vary with changes in the economic life and the pattern of cash flows. In fact, the IRR is found by letting it become a variable that is dependent on cash flows and economic life. In the case of NPV and profitability index, accountants employ a specified return standard to discount the investment’s cash flows. For the IRR, the problem is switched around to find the one discount rate that makes cash inflows and outflows exactly equal.
It can also be used to determine the optimal capital budget by ranking projects in terms of their IRR and comparing them to the marginal cost of capital (Helfert, 2001). IRR can also provide an idea of the ‘cushion’ in a project. If, for example, a project has an IRR of 15% and the cost of capital is 12%, the cushion is 3%. The disadvantage of IRR is that it is complex. Another problem is that it does not always produce a unique solution (Ross et al., 2006). That is, there is the mathematical possibility that a complex project with many varied cash inflows and outflows over its economic life might in fact yield two different IRRs. Although a relatively rare occurrence, such an inconvenient outcome is caused by the specific pattern and timing of various cash inflows and outflows. More important, however, is the practical issue of choosing among alternative projects that involve widely differing net investments and that have IRRs inverse to the size of the project (the smaller investment has the higher return).
It should be apparent that the IRR, like all other measures, must be used with some caution. Because it provides the analyst with a unique rate of return inherent to each project, the IRR of an investment permits a ranking of potential alternatives by a single number and by a direct comparison to the return standard. In contrast, the NPV method builds in a specified earnings standard reflecting the company’s expectations from such investments, and the ranking is based on relative present value creation in dollar terms.
When the IRRs of different projects are compared, there is also the implied assumption that the cash flows thrown off during each project’s economic life can in fact be reinvested at their unique rates. However, a company’s earnings standard is usually an expression of the long-run earnings power of the company, even if only approximate. Thus, managers applying a 15 or even 20% return standard to investments must realise that a project with its own IRR of, say, 30%, cannot be assumed to have its cash flows reinvested at this unique higher rate. Unless the general earnings standard is quite unrealistic, funds thrown off by capital investments can only be expected to be re-employed over time at this lower average rate.

Question 2

How does one determine the optimum intensity of site development? At one extreme, a site can be ‘fully developed,’ with few, if any functional, natural ecological systems instead being dominated by high-energy land uses. At the other end of the spectrum, a site may be a natural landscape, one with no agricultural or urban development. In most parts of the world, most areas are composed of some developed areas as well as some natural ecological communities. This section explains how economic theory can be used to determine the optimum intensity of site development.
According to Lambin et al. (2000, p. 321), “intensity is usually measured in terms of output per unit of land or, as a surrogate, input variables against constant land.” They go on further to note that the intensification in land use often refers to agriculture, although not exclusively. This is likely based on the fact that in economics, optimisation techniques generally originate from the land rent theory of Ricardo and von Thünen, both of which are described briefly below.
The two of the general theories presented here arose out of an attempt to explain agricultural land values and land uses. Two eighteenth-century theorists, David Ricardo and Johann Heinrich von Thünen, are credited for having created a vast and sometimes opposing literature on land valuation. Ricardo’s economic theory was based upon the relative productivity of sites. In contrast, von Thünen’s geographic theory was focused on the locational component of land values and land use.
Ricardo’s primary argument was that the most productive land would have the highest land value, or land rent. The next most productive land would have land rent equal to the most productive land, less the value of investment that would be required to bring that land up to the most productive level. In other words, the differential in the value of productivity between the two land parcels is subtracted from the value of the more productive land to arrive at the value of the less productive land. In a Ricardian world, land value then depends on absolute and relative productivity of land.
Whereas Ricardo focused on absolute and relative productivity of land, von Thünen’s focus was on absolute location and relative spatial location. Von Thünen hypothesised that the value of land arises from the bidding process of the market. There are those who are owners of land and those who are bidding to use that land. The goal of the landowner is to maximise returns. Land users bid against one another for the right to use land.
Total revenue is how much the land user receives from the sale of their product at the central market. Total cost includes the necessary agricultural inputs as well as opportunity cost of the land user. Von Thünen is credited with being the first to use the concept of opportunity cost, which is the alternative highest return that may be received from some other available activity. Transportation cost is the total expenditure of getting the goods to market. Total revenue to the land user is the same for every land user who produces the same amount of crop. In other words, the price received at the market per unit of agricultural output will be the same regardless of where production takes place. As with Ricardo, total cost can vary with the differences in the productivity of land; but the assumption is made that land everywhere in the relevant market has the same level of productivity. The resulting assumption of an undifferentiated plain is referred to as the isotropic surface assumption.
At the market where distance is zero, the transportation cost is also zero. At the market centre, the total land rents (land values) are merely the difference between total revenues and total costs. The general message from von Thünen is that loss of accessibility, as measured by rising transportation cost, decreases land values. As distance increases from the desired place of access, that is, the market centre, the amount paid in transportation costs also increases. As transportation cost increase, and since revenues received from the sale of the agricultural product at the market are constant and therefore not dependent on the origin of the product, then land rents (land values) decline as access to the market diminishes. Overall though, Von Thünen introduced the concept of highest and best use, meaning that the market bidding process will bring about the most productive use of land becoming the prevailing land use, and that those land users outbid other uses of land at that location. In other words, the land user that is willing and able to bid the greatest amount will receive the authorisation from the landowner to produce on the land. Geographically, the market bidding process among competing uses of land gives rise to the concentric rings of land use.
Based on the above discussion, it is apparent that von Thünen’s theory of agricultural land rent is not primarily concerned with optimum intensity of site development. However, Von Thünen’s intensity theory, or the formulation of optimum intensity of land uses, is important and the ‘central-peripheral’ concept of decreases in land-use intensity due to land rent differences is still pervasively used in modelling the optimum intensity of site development. Using Ricardo’s and von Thünen’s theories, intensity is explained as depending on the economic rent achievable by the site. The economic rent is determined by: (a) market demands in the centre, (b) transportation costs, (c) production costs and degrees of perishability of goods produced for the central market (in the case of agricultural land rent). In addition, price expectations and interest rates are also important factors (Lambin et al., 2000). Thus any site, given its attributes and its location, can be modelled as being used in a manner that earns the highest economic rent, which would be the optimum intensity to which the land should be developed.

Question 3

In capitalist cities, land is continuously being reconverted to other uses. However, this reconversion is not always because of calculated urban planning decisions but is often due to market forces (Bertaud, 2004). Economic development officials are often concerned with land use within a metropolitan area. Economic development decisions frequently include alterations in land use. This section discusses the economic forces shape that the land use patterns in a typical capitalist city.
According to Blair (1995), if population is held constant, four factors normally affect the density in cities:

• Newer cities developed around the automobile tend to use central locations less intensively than older ‘trolley car’ cities.
• Higher-income groups are more likely to decentralise. Thus cities with high-income populations will have less concentrated populations.
• Low-quality central city housing leads to lower intensity in the core of the city.
• Low manufacturing employment contributes to lower density in cities.

European central cities have higher population densities than their American counterparts for many of the reasons given above, especially the first point.
An understanding of urban form and urban morphology requires a general descriptive study of the forces that shape a city. The market forces that shape urban form and urban morphology can be grouped into the following nine descriptive qualitative categories: geodemographic, transportation, interdependence and externalities, spatial equilibrium, population change and relocation, government, economic base, real estate cycles, and information technology (Thrall, 2002). Together, the above categories of market forces bring about the spatial patterns of urban land use and land values. A change of the parameters within any of these categories will lead to the creation of and changes to urban submarkets. In this section, geodemographics, interdependence and externalities, spatial equilibrium, the economic base, and real estate cycles are examined briefly.
Demographic measurements are the wide array of descriptive characteristics of a population. The most commonly used demographic measurements by market analysts are population count and a measurement of wealth such as median household income. Geodemographic measurements are descriptive characteristics of a population, arranged and ordered by a scale of geography that is meaningful to the analysis. The most important geodemographic measurements that contribute to shaping the market forces of most urban areas are: population distribution, race, income, and vintage. These four geodemographic measurements significantly contribute to urban form and urban morphology, that is, the spatial patterns of land use and housing values) and how they change over time (Thrall, 2002).
Concentrating on income, several themes are apparent. First, households with similar incomes tend to agglomerate. Urban form is not random, but instead shows high spatial regularity and is highly predictable. Second, households with like characteristics are spatially distributed within sectors radiating outward from the central urban core. Cities have sectorial patterns of land use, and geodemographic patterns of population that conform to those sectors. Sectors of households of similar incomes arise in large measure because, through time, the trend has been for households to move outward. Also, as population subgroups increase in numbers, new development occurs that is adjacent to the prevailing geographic concentration of that population subgroup. The adjacent new development usually extends the radial pattern outward from the market core. Therefore, the income distribution contributes to the geographic shape of the city.
The single word that best describes a city is interdependence. Without interdependencies, cities would be just a random occurrence. Instead, the benefits of interdependence greater the geographic proximity, the greater the impact one individual, or group of individuals, will have on others. One of the conditions that must hold for a perfectly competitive market to exist is for there to be independence between all the actors participating in the market. In other words, the actions of one person cannot and do not affect any others. However, the city exists because of interdependence, and the city creates interdependencies. A city, and the market land values and land uses within the city, does not conform to strict principles of perfect competition. The force, either positive or negative, which emanates from the many interdependencies and contributes to land prices or land uses, is referred to as an externality. Examples of negative externalities that affect housing land use include noise from traffic along a highway, congestion on a highway, smog, and crime against people and against property that may originate from a neighbourhood.
To understand geographic or spatial equilibrium, consider those market forces that pull households away from places that they frequently access versus pushing them closer. Geographic or spatial equilibrium occurs when there is a balance of centripetal and centrifugal forces, namely the forces to move away are balanced by the forces to move closer in. The market is then in spatial equilibrium when households have no incentive to relocate (Fugita et al., 1999, Papageorgiou and Casetti, 1971).
Finally, Thrall (2001) notes that the most important market force that drives the local real estate market is that market’s economic base. The amount of GDP produced at a particular location can have multiplier effects in that community, thereby stimulating further wealth and more GDP. Part of that increase and flow of GDP goes into real estate. However, the increase in GDP is not smooth or continuous. Fluctuations in GDP can be quite high, leading to rapid urban development as well as downward spirals.
In conclusion, there are several economic forces that shape the land use patterns in a typical capitalist city. Additionally, there are several other factors which impact land use patterns in cities, some of which have been mentioned here. Important among these are modes of transportation, which has a dramatic effect on the population density and on the willingness of the population to move away from their favoured nodes. Also important in recent times is the distributed work environment, where the workforce is connected electronically, which has the potential to dramatically change office markets. Bertaud (2004) notes that these information and communication technologies that allow having production, design and management in different locations further encourage the land intensive production functions, such as industrial land use, to move further out of the city centre where land is cheaper.