An Escalating Problem

by Justin Eslick

Have you ever worked hard on a property, done lots of research, looked at heaps of comparables, run the numbers, got it working down to the dollar, only to then get blown out of the water by another buyer paying a good $50,000 to $100,000 more than you? As a buyers' agent who refuses to pay too much for a property I certainly have! In fact, far too frequently lately. I wanted to get to the bottom of the reason why and have spoken to numerous agents and consultants and I have come up with a few conclusions.

Different price for different people

As the old adage goes, every property is worth a different price to different people. Fair call. An owner occupier would certainly be looking at a property in a different light to a developer and I can understand why, especially with the cheaper, smaller developments sites with an existing house, you could find yourself competing with an owner occupier or even first home buyer who does end up paying more than you, but what about the properties that are genuine development sites with limited or no competition from home buyers? How do we get blow out of the water with these?

Buyer types

Selling agents have filled us in on who a few of these buyers are. The main ones are: 1) people who continually miss out on deals and in desperation pay above the odds. Hard to compete with that, and not a sensible move on their part. 2) builders buying themselves a job. Us developers and investors need to make a development margin. We also employ a builder and they make a construction or builder's margin. But when the buyer IS the builder, you tend to find they are happy to make one or the other, in other words they are working on an overall margin that is less than us and that we also will have trouble competing with. 3) people who don't know what they are doing. Sad but true and again, very difficult to compete with someone who doesn't know what they are doing. For example we may know that the property has flood issues at one end and the overall potential is reduced, perhaps to the point where it becomes a three townhouse site instead of a five townhouse site. How can we ever expect to be the successful buyer when we are competing with someone who is assuming 5 townhouses? Answer: we can't, and nor do we want to. The good news is they only make that mistake once!

Speaking with consultants and enters buyer type number four. Those that use escalation rates, and this is a problem.

What is an escalation rate?

Some buyers when working their feasibility use escalation rates. What is this? It is a theoretical growth that they apply to end values. For example, they may be proposing a townhouse development in a hot market. That market is tipped to remain buoyant for some time to come and given the project will take 18 months from start to completion, they apply an escalation rate, or growth factor to their end values. So if the project could be built and completed today and each townhouse is worth $500,000, they may apply an escalation rate of 7% for an 18 month period. As a result in their feasibility they have the townhouses as worth $500k x 1.07 x 1.5=  $535,000. That is $35,000 per townhouse more. If it is a 5 townhouse project then the extra income becomes $175,000 - that will do wonders for your bottom line! Not to mention quite often the escalation rate being applied might be worked out on an annual basis.

An escalating problem

Here's where this becomes a problem. For a start, we refuse to use escalation rates for a number of reasons. The first is we don't know what the market will be like in 18 months time. Sure we can read the expert predictions, but even with the most astute of experts there is a degree of speculation. Secondly, even if there is growth we don't know what it will be. The 7% in the example above might be accurate... for houses, or it might be only 3%, or 0% for townhouses. What figure do you pick? Especially when the experts rarely break it down to 'this suburb will have 7% for townhouses over the next 18 months'. Their predictions tend to be city wide and averaged out for all product.

The issue is compounded when in a lot of cases they are applying this growth over the course of a development, yet half of the development may be sold as part of a pre-sales campaign in 6 months time, not 18 months.

There is one final issue and that is a lot of people who apply escalation rates often only ever apply them to end values. What about construction costs? Interest rates? Council charges? Technically you should consider applying an escalation rate to all of these as well. Be particularly wary of this if you are buying a site from someone who has supplied you with a feasibility. I would try and avoid one that uses escalation rates on end values, but definitely pull them up if no escalation has been applied to cost items.

What should you do?

As mentioned, I do not apply escalation rates. Is this a disservice to me and my clients? Possibly and it certainly means we would miss out on deals more frequently, however, I would much rather apply a feasibility and numbers that work TODAY, have a conservative approach, use any possible escalation as a contingency, and leave the risk in the hands of those that choose to apply escalation rates. In saying this, every project is different, every property is different and every client is different. There are times where escalation rates are justified, just make sure when applying them that you do so in a sensible and responsible manner, and don't go crying foul when that growth is not met.

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