Captain’s Blog – Art v Science

Property development used to be an art practised by legends such as Gerald Ronson or Tony Pidgley. Ronson used to drive around his petrol filling stations on a Saturday morning to see how they were performing, watching people fill up and make purchases at the desk. Tony similarly used to visit his housing developments chatting to the general foreman and the sales teams getting a ‘feel’ for his business. They would both make decisions on gut instinct but that instinct was honed by years of observing their businesses, what made them tick, what was good versus what was bad, what attracted customers, what was costing too much and what efficiencies they could introduce. Not a laptop, spreadsheet or IRR calculation is sight. 

Today’s developers and investors are different. Many only visit a site under sufferance. They never talk to the contractor – at least not without lawyers present – and they don’t know or care about the end customer, the person who will occupy and use the building they have developed. For them development is painting by numbers. They approach a development through a spreadsheet and worship at the altar of the IRR or internal rate of return. Greater than 15 good, less than 15 bad. Good means go, bad means no.

Now that’s all well and good, property development is all about profit so a scheme must stack up but it’s the lack of human empathy that’s missing. The magical IRR is a construct of many inputs into the economic model. Some are obvious and fixed like the site price or (to a lesser extent) the construction cost. However some are completely arbitrary. Consider a development of 600 apartments built for the BTR (build to rent) market. The developer needs the IRR god to say yes so requires a number north of 15. He inputs the site cost, construction cost, fees and interest and arrives at the total project cost. Next he needs to figure out the return. Sounds simple – 600 flats at £1200 a month gives an annual rent of £8.64m and then apply a yield which he can sell at – hey presto he has a project value. But – and it’s a big but – over what period do those flats rent out. Do we assume that on completion of construction, 600 tenants arrive and all sign a rental agreement and move in the next week? Unlikely. How about half of the flats have been reserved thanks to the efforts of the sales team so on completion the scheme is half full? That sounds OK. Now, how quickly will the other 300 rent out. 10 each month? 20, 30, 40? The answer is nobody knows because no one can see three years into the future. If they don’t rent out (lease up in property business jargon) quickly the investor sees his return suffer because he has shelled out £150m and expects a return from 600 flats but he’s only getting half that return from 300 flats. 

The investors have no clue. They have only been to the site once, they don’t know the city, have no ‘feel’ for the scheme or the people who will occupy it and can’t use any gut instinct to guide them because they haven’t been trained to do that. All they can do is guess. Press the button on the laptop which says 10, 20, 30 or some other figure. 

In our example (which is based on a true story as they say) the numbers guy hits the 20 button, the spreadsheet does its thing and – computer says no. IRR 13.9% so under the magical 15% is a no go. Had he guessed at 30 the hey presto the IRR is 15.1% and champagne all round and when do we start on site. 

It’s not just our industry which has been hijacked this way. A friend of the Captain used to run a successful chain of multiplex cinemas which he built up from scratch. The Captain developed one of the first for him in a deal agreed over lunch without any laptop present. Eventually our man was approached by a venture capital outfit who wanted to buy him out. He was perplexed when he attended the first meeting expecting to meet the principal on the other side. Instead he found a room full of (his words) kids with laptops saying very little but hitting buttons every time he spoke. The deal went through and the number crunchers took over the company (lunatics, asylum spring to mind?) Fast forward 10 years that business doesn’t exist because it went bust. Seems you can’t run a cinema chain via spreadsheet any more that you can run a property business.