High levels of interest rates account for a significant proportion of the total development costs of a typical commercial development. When professional fees are added, often over one-third of the total costs are represented by “invisibles”. Or, to put it another way, less than two-thirds of the costs of carrying out a project are attributable to land, bricks and mortar.
Any change in borrowing costs can therefore have a profound effect on the feasibility of a proposed project, or the profitability of a current development.
The frequency and magnitude of changes in the London clearing banks’ base rate during the recent past is illustrated by the graph. Just how volatile interest rates can be is demonstrated by the 100% increase (from 7.5% to 15%) over the 16 months between May 1988 and October 1989. The forecast of three months’ Interbank rates by City analysts range from 10.5% to 13% (average 11.2%) for the fourth quarter of this year and 9% to 12% (average 10.8%) for the fourth quarter of 1992.
Of course, not all loans are priced by reference to a margin over base rate. The choice of the benchmark used is a matter of prior agreement between the parties. Other typical benchmarks included a selected gilt stock, LIBOR or Treasury bills.
The frequency with which the borrowing rate is related to the underlying index and the interval between “rests” are also negotiable.
On the other hand, should the developer be using his own resources to fund (or partly fund) the development, he will imply his own appropriate cost of money. This may be based on the opportunity cost, or an internal target rate of return, on the money invested. The rate selected will, in turn, be influenced by money market rates.
In any event, as interest rates alter, this will affect development costs and hence the amount which can be afforded for site purchase or, where a site has already been acquired, the amount of profit expected to be released on completion of development.
But how significant are finance charges as a proportion of total costs, and how significant are changes in interest rates in affecting total finance charges? Are residual site values or profits materially affected by changes in interest rates?
The following examples help to answer these important questions:
(1) Effect of different interest rates on the price bid for a site, assuming a constant “fixed” profit at 20% of total costs.
Site A. Central London office development Assumptions Rent: £50 psf; Investment yield: 6%; Building cost: £150 psf; Development period: 2 1/2 yrs.
Assuming a total development period of 30 months (pre-building period of six months, building period of 18 months and a letting period of six months) it can be clearly seen that finance charges are a significant proportion of total costs, amounting to 25.6% of costs at borrowing rates current at the start of 1991. As interest rates fall so the amount available for site purchase increases, as the percentage figures in the above table show.
If a longer void of 12 months was assumed, reflecting a difficult letting climate, this would further depress the price bid for the site but increase the amount of interest charges and their proportion of total costs.
At a borrowing rate of 16% finance as a proportion of total costs would increase from 25.6% to 30.5%. Similarly, if the building period was increased from 18 months to 24 months, but the letting void remained at six months, finance charges would increase to 29.5% of total costs.
For office development outside central London, where rents are lower and land values consequently much lower, finance charges are still significant, but less so than in central London.
Site B. Suburban/provincial office development Assumptions Rent: £25 psf; Investment yield: 8%; Building cost: £110 psf.
Assuming a total development period of 30 months (as in the previous example of Site A) finance charges at current borrowing rates fall from 25.6% to 20% of total costs. As previously, if a longer letting period of 12 months is assumed finance charges as a proportion of total costs would increase from 20% to 25%. An increase in building period to 24 months would similarly increase the importance of the level of interest charges.
(2) Effect of different interest rates on profit assuming a constant, fixed, site cost.
Of equal importance to the above analysis is an examination of how profit is affected by changing interest rates (assuming the site has already been acquired). Clearly, as the site has been purchased in the open market at its full development value, reflecting current high interest levels, any reduction in those interest rates will improve viability and increase profit, other things being equal. But how significant will this effect be? As above, two different types of development are examined, reflecting a different composition of total costs.
Site A. Central London office development
If borrowing rates were to fall overnight by 6% (from 16% to 10%) finance charges would obviously decrease dramatically, and realisable profit would increase from 20% to 34.1% of costs — an increase of 70%. However, this attractive scenario is not likely for obvious reasons. While it is possible that, during the duration of a development now started, interest rates will fall — possibly, though unlikely, by 6% — this will happen gradually, and the full benefit shown in the table would not be achieved.
If there were a gradual fall of, say, 3% from a base rate of 14% to 11% over the next 12 months, this would have the effect of increasing profit 25% or more by completion of development.
If the site were acquired today, but assuming a 12-month letting void (ie resulting in a lower site cost), the effect of interest rate changes would be slightly more marked. If finance rates were to decrease overnight to 10%, profit would increase from 20% to 37.5% of costs — an increase of 87.5%.
For lower-value schemes outside central London the effect on profit of interest rate changes is less dramatic.
Site C. Suburban/provincial office development
The effect of an overnight fall in interest rates of 6% would in this situation increase profit by about 50% from 20% to 30.5% of costs. A lower site acquisition cost, reflecting the assumption of a longer letting period of 12 months, increases the figures slightly, as before, showing a maximum increase in profit of 68%.
Taxation
Tax relief on loan costs is another complication, as this can be subject to somewhat complex rules depending on whether the interest is “short” or “yearly”. Care should be exercised when a UK-based developer is borrowing from a foreign-based lender, or where the whole appraisal is being carried out on an after-tax basis.
Foreign exchange
Equally important can be the effect of adverse movements in foreign exchange rates where loans are expressed in foreign currencies. Although sterling’s recent entry into the ERM should contain potential losses (or gains) to a maximum of 12% (assuming we remain in the 6% rather than 2.5% band), losses (or gains) on loans priced in non-EC currencies can be far more significant, as the following table for last year shows.
However, a range of sophisticated risk limitation devices are now available which can contain interest, or exchange, rate movements to predetermined levels. But these have to be paid for, usually “up front” and therefore — at least initially — may reduce profitability. However, over the period of cover, the expense may prove to be well justified.
Future movements of rates are a matter of conjecture, but the table below summarises the forecasts of various experts:
The conclusions from the above analysis are, first, that at current high levels of interest rates finance charges are a significant proportion of total costs, particularly for schemes located in high-value areas where sites are correspondingly expensive (as a proportion of capital value or total costs). In such high-value areas finance charges can account for between a quarter and a third of total costs. Second — and as a consequence of the first conclusion — a fall in interest rates should significantly increase viability for these developments where site value forms a high proportion of total costs or capital value. Clearly the greater and quicker the decrease in interest costs the more significant the effects. It is therefore surprising that more developers do not cover themselves by arranging appropriate interest-rate protection.
