Dynamics of development
ALL the talk now is of a shortage of prime office buildings, especially in Dublin, hampering the IDA's efforts to land new overseas companies. Budget 2014 allocated another €2bn through NAMA to fund new development over the next two years.
With rents rising and good enquiries in the market, developers are tweaking planning permissions and weighing up a return to building. But what are the issues facing developers and NAMA in deciding whether or not to dive back into speculative development?
Developing multi-storey office buildings is risky because with offices, it's "all or nothing." To acquire a site, design a building and construct it can take two to three years, by which time market conditions can change.
But there is no option to stop halfway with an office building – you must finish it to be on the market, whereas housing, industrial and some retail schemes can be built in phases, reducing risk.
So is office development viable now in Dublin? I've taken a broad look at a notional site in Dublin 2 with planning permission for a building of 10,000sqm. My figures are for illustration only and you must take independent advice.
Our planning permission for 10,000sqm is "gross space", including common areas which tenants don't pay rent for. Hopefully our architects have done a good job in minimising the amount of common space and we'll assume a loss of 17pc, leaving us with a net lettable floor area of 8,300sqm.
Our design should allow us to let to a single tenant or on a "floor by floor" basis and we will assess offers as they arise. Our next decision is what level of finishes will we provide on a speculative basis and the best practice is to provide ceilings, lighting, raised floors, plastered and painted walls and fully finished common areas.
The next big item is our building cost and quantity surveyor estimates for our chosen specification are €2,000 per sqm, giving us a gross building cost of €20m.
We also need to add in estimated costs for marketing, professional fees and a contingency fund.
We must put in the value of our site as a "cost" and the current value of the site is about €750 per gross sqm of buildable space, ie €7.5m. In broad terms, the total cost of our scheme is say €30m.
The big question is whether any bank will provide finance, but assuming that a bank or NAMA will, enquiries indicate that an interest rate of 7pc will arise.
Now we turn to income and the developer will rely on his agent for advice.
The most recent large letting is to Facebook at €350 per sqm. Facebook committed to a 10-year term but are understood to have secured a two-year rent free period. We'll use the same rent for our appraisal and assume that the rent free period will be six months and that the tenant will commit for ten years minimum.
Putting these assumptions into our model and assuming that we can sell our completed development at the current net yield of 6pc, our model produces a profit of almost €10m, which at 20pc of our Gross Development Value, is healthily viable.
A developer should carry out a "sensitivity analysis" of an appraisal, to assess risk.
In our appraisal the biggest risk will be a change in the yield and if the yield softens by a half percent by the time we are selling, our profit reduces by over €3m. Our next biggest risks are time delays (e.g. bad weather) and a rise in building costs. Conversely, if yields harden, as I expect they will, our profit level soars.
On the face of it prime office development is already viable. A conundrum is that a bank which could invest funds in buying our completed investment at a yield of 6pc, won't be rushing to fund its speculative development for a return of 7pc.
That's why I expect to see NAMA funding the first few schemes. The banks will want to see low loan to value ratios, rents of €400 per sqm and sub 6pc yields before leaping back into speculative development.
Our appraisal suggests that site values will rise. Another interesting conclusion is the irony that with supply restricted by a lack of finance and profitability thus enhanced, NAMA debtors with finance from there, have a competitive advantage in being first into a profitable market.