The Economics of Property and Construction - Research Paper Example

The Economics of Property and Construction Table of Contents The Economics of Property and Construction 1 Introduction 2 Factors which tend to delay the timing of Redevelopment 2 NPV and IRR Techniques of investment Appraisal Used in Cost Benefit Analysis 4 How Interaction of the Multiplier and Accelerator Relates to the Cyclical Fluctuations in Building Activity 6 Economic Factors Shaping Land Use Pattern and Rent Gradients in Mixed Economies 8 Conclusion 11 References 12 Bibliography 13 Introduction This project aims to study the economics of the property and construction sector. It deals with the areas of decision making which forms an important factor in this sector. Investors have to make a wide variety of decisions before investing in the property market. This project mainly discusses the criteria on which the decisions should be based for realizing the maximum output. Firstly, the project tries to find those factors which tend to delay the timing of redevelopment. Then it goes on to discuss the IRR and NPV techniques of investment and how it can be used in the cost benefit analysis. This method is mainly applied to measure how attractive a certain investment is. Another area which has been observed is that building activities in the markets are subject to a number of market forces. This accounts for the cyclical nature of fluctuations in these activities. At this point the multiplier and accelerator theory comes into play. This has been discussed in the context of the capital output ratio which determines the reasons for the cyclical fluctuations in this particular sector. Factors which tend to delay the timing of Redevelopment Generally, redevelopment occurs when “the present capital value of the future net returns from the existing use of the land resources becomes less than the present capital value of the cleared site” (CEM, 2009, p.21). It is necessary to calculate the present capital value of the land under the present circumstances and also the present capital value of the cleared site. Then these two need to be compared. But these two comparisons are made under the assumption that during the period there is no inflation and deflation and also the value of money remains unchanged. However, the rate of interest used to calculate the above values reflect the expected rate of inflation. It is important to note that this project is seeking to find a capital value. Since this value depends on net returns which is expected to be earned in the future, this return needs to be discounted at its present value. Then, the aggregate value is to be taken in order to calculate the present capital value. NAR or the net annual returns of the project is calculated as the difference between gross annual return and operating costs which includes costs for maintenances and repairs. Since these are dealt with in the future, GAR and operating costs are estimated at the present value. With the passage of years, GAR is likely to fall. Supernormal profits coming from initial developments encourage same kind of development and this reduces future returns. A common example is rents. Expectations remain uncertain and this also affects future returns. This effect is offset by other developments which increase rents. On the contrary, operating costs keep rising with time. This is because as the physical structure deteriorates, and as the buildings become old, they become less adaptable to the new technologies, such as the modern machineries and devices. The rate at which redevelopment occurs depends on the interrelationship between factors like the present value of land resource, present value of use of the best alternative, cost of rebuilding. It is seen that the rate of development gets accelerated if the change in the use of the best alternative is more than the change in the present value of the land. The rate of development decreases in case the situation is opposite. The rate of development is also dependent on certain other factors, such as changes in the demand side and changes in the supply side affecting operating costs. It is seen that demand side changes occur as a result of changes in tastes of customers and their income levels. The tax structure also determines the changes to an extent. High tax rate imposed on the rich people may compel them to vacate and move out of expensive centres. Presence of cheaper urban area acts as a substitute to the large and expensive centres. Certain other factors also come into play, like costs of transport and other facilities, terms of mortgage, activities like establishments of new schools and golf courses in the suburban areas. Government polices extending the security of tenure increases prolonged use of residential areas. Whereas, the implementation of “capital value rating” (CEM, 2009, p.21) increases the rate of expensive residential and decreases their usage. Certain supply side factors also come into play. Operating cost of houses may change, like the cost of maintenance and repairs. Builder’s charges might undergo a change. Certain technical improvements may take place, such as flatlets, resulting out of the partitioning system, making it economically cheaper. Finally, building costs might fall which would increase value of the cleared site and thus accelerate the timing of redevelopment. NPV and IRR Techniques of investment Appraisal Used in Cost Benefit Analysis Net Present Value (NPV) Method While calculating the net present value (NPV), the investor has to select a certain rate of discount which he considers suitable for the investment. The investor calculates this NPV as the difference between the present value of the money flowing out and the present value of the money flowing in. The investor is said to make a profit if NPV is positive. If the NPV is negative then the investor will incur a loss. If the NPV remains zero, there will be neither profit, nor loss. If the money required for starting and maintaining the investment is borrowed at the rate that is used to discount cash flows, it is to be assumed that there exists some other reason behind making the investment. For example, a firm may be ready to undertake a particular investment even if it incurs losses. Such schemes may be undertaken for the communities benefit, and other favorable purposes (CEM, 2005, p.28). If this investor provides money required for the investment using his own resources, and if he gets a return and feels satisfies with getting a return on his money which equals the rate of discount, then he may go for the investment even without making any profits. The NPV method is used while making comparison between the various investments. The one with the maximum NPV value is chosen. Internal Rate of Return (IRR) Method The NPV method has certain shortcomings which are overcome by the IRR method. A number of investors are more concerned about the actual interest rate which they can earn on capital. The IRR method is used to determine that rate of interest at which the value of expenditure equals the value of receipts. This is the rate at which the NPV equals to zero. This rate of interest is called IRR or DCF (Discounted Cash Flow) rate. In most cases of investment, “if the rate of interest used to discount the cash flow is very high, then the present value of the outflow will exceed the present value of the inflow” (CEM, 2005, p.31) and vice versa. Between the extreme high and low rates of interest, there is a certain value at which the value of output equals the value of input. This interest rate can be found by the method of trial and error. IRR is said to be the interest rate which the investor earns on his investment. At this same rate the “discounted cash flow” (CEM, 2005, p.33) does not show any profit or loss. This method is the most convenient method to measure how attractive an investment is financially. The IRR of more than one scheme can be compared with each other. How Interaction of the Multiplier and Accelerator Relates to the Cyclical Fluctuations in Building Activity In order to explain the reasons behind cyclical fluctuations in building activities, the multiplier and accelerator theory needs to be discussed. Business cycles follow as a result of the interaction between the multiplier and the accelerators. According to multiplier theory, with every increase in the level of aggregate spending, there is an expansion in the income and output level of the economy. The income and output level increases by a multiple of the aggregate spending. As spending increases, it leads to the rise in income level. This increases the spending further, which again raises the income level. Thus, it is seen that the effect of a small change keeps multiplying and hence the name, ‘multiplier theory’. The accelerator theory suggests that with the rise in demand or income in an economy the investment made by firms also increases. Firms either raise the price of products or increase their investment to match the increased demand. Most companies increase their production resulting in increased profits. This attracts more number of investors which adds to the growth even further. The same applies for the property and construction industry. In the context of the construction industry, it can be assumed that firms will have a “capital output ratio” (CEM, 2009, p.10). Firms try to ensure that their stock of capital, which comprises of machineries and buildings are enough to meet the demands of their output. Thus, they maintain a specific ratio between the value of capital stock and the value of output. The following expression determines the capital output ratio in a firm. Desired Capital Output Ratio (Dcor) = Desired Capital Stock (K) / Output Flow (Q) Thus, K = Dcor * Q, What applies for actual levels of K and Q, also applies for changes in those levels. Hence, Δ K = Dcor * Δ Q, The change in stock of capital can be referred as the change in investment. Thus, it can be said that, Investment (I) = Dcor * Δ Q So, the desired investment made by an organisation is the multiple of the rate at which its output changes. This theory may be applied to every firm that the economy comprises of. I = a * Δ Y, where, Δ Y is the weighted average of all the Dcor values; ‘a’ is the ‘accelerator coefficient’. The building activities are largely influenced by accelerator and multiplier effects. Studies show that building activities, especially residential buildings are marked by frequent and violent fluctuations which have a cyclical character. The economic conditions affect the regional economies. Investment made in the housing and construction sector accounts for a significant investment in the economy because it creates a high multiplier and accelerator effect. Activities taking place in the construction industry is very responsive to periodic fluctuations happening in the economy. A change in the aggregate demand in the housing and construction sector can have a significant impact on the national income of a country. This accounts for the multiplier effect on the economy. It is initiated by demand injection in the construction sector. This stimulates big investments in this sector which consequently leads to greater output and creation of more employment opportunities. The multiplier effect becomes prominent when new investments and jobs are attracted to the building and construction sector. The final increase in output and employment is found to be much greater than the initial demand injection because of the multiplier and accelerator effects. A considerable amount of research and study has been conducted to study the causes of cyclical fluctuations in the buildings and construction sector during the nineteenth century. Statistics for both Britain and USA show the existence of long periods of fluctuations in this sector. Economic Factors Shaping Land Use Pattern and Rent Gradients in Mixed Economies A number of factors determine the pattern of land usage in mixed economies. A number of models have come up to explain the same. The most prominent factors include accessibility of land and transportation cost. General Accessibility of Land Accessibility of land refers to the advantage that a particular location offers in terms of transportation costs, the capacity to earn revenue and other conveniences it offers. Thus, the profitability and value of a piece of land depends on its accessibility. Markets and factors of production should be made accessible to firms. Markets are comprised of shoppers and the factors of production include labour, in particular. Household’s accessibility to their workplace, shops and markets, schools, colleges and recreational facilities also account for the price of a piece of land. In both cases i.e. for residential land usage and for business purposes, some users place special emphasis on the land accessibility than others. In general, land users for business purposes prefer the centre of the city. They are known as CBDs or “central business district” (CEM, 2008, p.10). These districts are greatly accessible and are increasingly becoming popular. But, since such sites are limited, rents remain high. Thus shops, such as ladies jewelleries and cameras are required to attract customers from distant areas so that they can outbid users from these districts. In the very same way, offices where the use of manpower is more than capital are required to outbid warehouses and factories from accessing the central sites. Moreover, hotels, restaurants, leisure pursuits like theatre and cinemas tend to concentrate near these districts. Households and residential demand for ‘accessibility’ seems to be more complicated. It depends on a number of factors, like the time and costs which relates to the distance from schools, shops, workplace, etc. Certain non monetary factors also require attention, like the environmental space, kind of neighbours, and how quiet and peaceful the place is (CEM, 2008, p.10). Special Accessibility of Land External economies arise from certain activities. Concentration of shops in close proximities helps to tap each other’s market. Thus each one gets an advantage of knowing the others’ markets. Firms make adjustments accordingly, like altering their offerings to customers, increasing attractiveness of their products. With regard to offices also, they enjoy certain advantages of being in close proximity. Availing labour supply and common services are a few of these advantages. These are termed as “agglomeration economies” (CEM, 2008, p.11). Agglomeration economies or external economies refer to the benefits derived from the outputs and housing located in a particular area. Agglomeration of economies results from increasing returns to scale, development of externalities and the existence of imperfect competitive markets. These markets remain strategically interdependent to each other. Agglomeration results from the spatial pattern of firms and their economic activities. This configuration then results in certain combination of forces that help to attract or repel customers. Blanche, the famous geographer in France has said that every society, irrespective of whether they are in their developed or rudimentary state faces the very same dilemma (Fujita, 2002. p.10). Externalities remain crucial in the development of agglomeration economies. When an industry chooses a certain location, it is expected that it will continue to operate in that place for a long time. So certain advantages are enjoyed by people who are following the same trade with similar skills. Due to the existence of agglomeration economies, people and firms tend to concentrate in particular areas. People tend to move to cities where there are greater choice of jobs, specialist activities and social activities. Other Factors Influencing Use of Land Apart from accessibility, certain other factors also influence land usage in areas. Factors like growth in area size, the existence of metropolis which attracts specialised activities like the opera, ballet, medical and legal specialists seek for central sites. Imperfections prevailing in the capital market prevent firms from establishing itself in that area. This is the reason why institutional funds for the development of offices, trigger the process of development of cities. Development of transport, like radial roads and motorways favour commuting in residential areas. Advanced building techniques complemented with developments like lift, air conditioners favours establishment of offices in labour intensive places like warehouses and factories. Rent Gradients in Mixed Economies Generally, high accessibility of centres by public transport and roads shoots up the price of land. It is the responsibility of urban planners to reduce some amount of pressure in the market by increasing the attractiveness of areas which are less sensitive. The decision to develop a plant ultimately depends on how it can decompose its profitability into revenues and cost variables. The interaction between demand and supply is a prominent determinant of the pattern of land usage. This pattern further determines travel patterns like shopping and commuting. “Mixed use areas” (Jones & McDonalds, 2004, p.8) is said to encourage more use of public transport and less use of private cars. Negative externalities arise out of overuse of transport above the optimal level. This happens because of the inadequate availability of infrastructures and public transport and too many “single use area” (Jones & McDonalds, 2004, p.8). Conclusion Thus, it is seen that the allocation of resources to a certain business is a critical factor and is dependent on a number of reasons. Analysis of these factors and careful study of the market conditions help to make the task of investing in a business easier. Regarding land usage also, it is seen that a number of economic factors shape the land use pattern and thus determines rents in economies. It has been concluded that the most prominent factor which makes a piece of land attractive is its ‘accessibility’. Certain other factors like the existence of a favorable transports system, medical and legal facilities and sources of entertainments also add to the popularity of the region. Finally, it is seen how interaction between a numbers of factors delay the timing of redevelopment. References Fujita, M. 2002. Economics of Agglomeration. Cities, Industrial Locations, and Regional Growth. Available at: http://assets.cambridge.org/97805218/01386/sample/9780521801386ws.pdf [Pdf]. [Accessed on August 6, 2010]. Jones, C. & McDonalds, C. 2004. Sustainable Urban Form and Real Estate Markets. [Pdf]. Available at: http://www.city-form.org/uk/pdfs/Pubs_JonesMacDonald04.pdf [Accessed on August 6, 2010]. The College of Estate Management. 2009. Growth and Cycles Revisited. Paper P0162V2-0. The College of Estate Management. 2008. Land Use and Location. Paper 0342V2-0. The College of Estate Management. 2005. Introduction to the Discounted Cash Flow (DCF). Paper 2497V5-0. Bibliography Harvey, J. 1981. The economics of real property. Macmillan Myers, D. 2004. Construction economics: a new approach. Taylor & Francis Read More