Paul McNeive: 'So just how profitable is it to develop office buildings?'
The right moves
The Dublin office market is red-hot. Concerns a couple of years ago, about a possible oversupply, were blown out of the water by a staggering 364,000 sq m of take-up in 2018. Over a third of the deals last year were pre-lettings.
The vacancy rate now in Dublin's CBD is 5pc, effectively full-occupancy.
Of the 165,000 sq m due for completion this year, 94,000 sq m is reserved.
Prime CBD rents have now risen to €700 per square metre.
It's interesting to look at the viability of office development, and at the risks involved, so I carried out an appraisal of a fictional office development in Dublin 2. The figures I used are comparable to actual deals done and my development costs are as indicated by quantity surveyors. Figures have been rounded-up for simplicity.
For the purposes of this exercise, I assumed that the 0.4 hectare (one acre) site had been acquired in 2015 at a cost of €72m, including stamp duty and legal and agents' fees. Over the next 18 months our developer designs the building and secures planning permission for an eight-storey building, with a total net lettable floor area of 23,205 sq m. Thus, the price paid for the site represents €3,100 per buildable square metre.
Building work begins in 2017 and construction costs are €3,670 per square metre, into which we incorporate an allowance for inflation at the rate of 7pc per annum.
The specification provided at this cost is what agents call a 'CAT A' finish, i.e., including ceilings, lighting, raised floors, air-conditioning, and fully finished lobbies and toilets. Our total construction cost is €134m.
In early 2018 a top-quality tenant is identified for the entire building and we agree a pre-letting at a total rent of €14.5m per annum, which is €580 per sq m overall. The tenant is granted a six-month rent-free period.
The developer decides to take advantage of the strong demand for office investments and he sells the building in late 2018 at a net yield to the purchaser of 4.5pc, which means a net sale price of €299m. Our joint investment agents earn a further €3m between them.
The overall result is that the developer makes a profit of €39m. This represents a profit on cost of 15pc, which is in line with the traditional assumptions on required returns.
It's a big profit, and everything went well, but it's interesting to look at the risks involved, because if any of the variables go wrong, the effects on profit are significant.
For example, if demand dries up and our building is vacant for more than two years and four months, we will lose money. If the rent we achieve is 10pc lower, our profit reduces by €3.5m. If the yield at which we sell the investment moves out by 0.5pc, our profit reduces by €3.8m.
I assumed that we financed the development at an interest rate of 6pc, but if our interest rate was 1pc higher, our profit on cost reduces to 11.5pc.
In reality, the major problem is that when the market turns, most of these factors worsen together, and a viable project can quickly become loss-making.
The other big lesson is that our financing costs are in excess of €30m, the equivalent of most of our potential profit, and which underlines the advantage that funds and institutions have, with their lower financing costs.
Raising the profile of the credit industry
I am honoured to be keynote speaker at an event organised by the new Ireland branch of the Chartered Institute of Credit Management (CICM) next Thursday (21st), from 7.30am, at the Spencer Hotel, IFSC, Dublin 1.
Entry is free to credit managers and credit professionals, but places must be reserved in advance via the website, firstname.lastname@example.org
Glyn Powell, President of CICM Ireland, said that this networking event was to introduce the organisation to professionals in the credit industry and further raise the profile of credit in Irish business.
Further information is available from email@example.com.