The assessment of risk in property development is often very basic. The best case ‘evidence based’ scenario is presented to funders with a project contingency and margin to cover known risks.
In residential property development, for a lender to fund 80% of development costs they may expect to see a 5% contingency, a robust construction contract, a 20% return on cost profit margin and 50% pre-sales before releasing funds to start construction. This obviously varies depending on a range of factors including the market, the developer and who is providing guarantees and equity.
‘Megaprojects and Risk: An Anatomy of Ambition’ provides a detailed insight into how poorly risk is treated on some of the worlds largest infrastructure projects.
[Flyvbjerg, Bent, Nils Bruzelius and Werner Rothengatter, ‘Megaprojects and Risk: An Anatomy of Ambition‘, Cambridge University Press, 2003]
The authors pull no punches in their critique but also offer solutions to how risk should really be treated. Their research covers a number of projects from the Eurotunnel, to bridges and tunnels connecting Denmark and Sweden to metro subways, high speed rail and airports around the world.
The reason for their research is simple: many megaprojects experience a double whammy of cost overruns and missed revenue forecasts in a very public forum.
Effectively risk has not been correctly identified, publicised or managed, as the authors describe:
“We will show in terns of risk, most appraisals of of megaprojects assume, or pretend to assume, that infrastructure policies and projects exist in a predictable Newtonian world of cause and effect where things go according to plan. In reality the world of megaproject preparation and implementation is a highly risky one where things happen only with a certain probability and rarely turn out as originally intended.” [page 6]
“Megaprojects are increasingly becoming highly public and intensely politicised ventures drawing substantial international attention with much potential for generating negative publicity.” [page 9]
“A first step in reducing cost overrun is to acknowledge that a substantial risk for overrun exists and cannot be completely eliminated; but it can be moderated.” [page 11]
“A next step is to allocate the risk of overrun to those best able to manage it.” [page 12]
There are lots of examples with massive cost overruns and revenues never getting close to initial expectations – the Chunnel for example only had 18% of of forecast traffic in its first year of operation, beaten by Calcutta’s metro which had a measly 5% ! [page 25].
The discussion is also very critical of the lack of accountability and optimism bias of political and private promoters of such projects.
I know very little about large infrastructure projects, let alone megaprojects. I once developed software that was used on motorways (freeways), wastewater upgrades, hospitals, prisons, airport and rail projects in New Zealand for document and consultant collaboration. The software’s objective was to improve communication, variation management and indirectly reduce risk but I had little knowledge of how feasibility and initial assessment of risk was treated on those projects.
However, after reading this book you could quite easily substitute the words ‘property development’ for megaproject. Except for the most basic, short term and complying projects, property developments are susceptible to many of the same risk causes as the authors describe in megaprojects. This is especially so in publically funded projects but even private developments have many political and public risk factors.
Large scale property developments take time. The longer the programme the more likely you are susceptible to (changing) property market risk, capital market risk and policy risk [page 77 for associated discussion].
The larger the property development project the greater the potential implication on project costs, negative publicity and political decisions.
What the authors found is that a mechanical approach to risk analysis (static +- sensitivity analysis) often led to an incorrect belief that the course charted is the most likely [page 77]. They describe the problems when looking from what the World bank describes as the EGAP approach ‘everything goes according to plan’ [page 80].
“…in reality in the world of megaproject planning an implementation is a highly stochastic one where things happen only with a certain probability and rarely turn out as originally intended.” [page 73]
“…what people may think is the mean of all possible outcomes it actually the very unlikely best possible outcome” [page 77]
” …the result is that the real costs and real risks do not surface until construction is well underway” [page 44].
The authors describe a better mechanism for risk analysis where you assign probabilities to potential outcomes and provide a more realistic assessment of what could happen and the effects on project investors and stakeholders. This helps remove some optimism bias (politicians like to make promises, builders like to build, developers like going for high profits) and to uncover the all important worst case scenario [page 81].
Whilst determining probabilities itself can be very subjective and montecarlo simulation analysis may appear overkill in property development, merely looking to apply the principles can create a more rigorous risk assessment. With the risk assessed, alternative scenarios can be formulated or contingency plans produced to mitigate that risk should it arise.
If the worse case is beyond your speculative inclination you can drop the project altogether. If the worse case isn’t actually that bad, then that may influence your decision to proceed even if there are significant risks (yes I run the ‘risk’ of sounding contradictory!).
Private business, undertaking work for public entities often miscalculate policy and stakeholder risk. One important way to reduce that risk is to get as much upfront agreement and clarity around objectives and decision making processes as possible – ideally binding contracts. It is also important to monitor those risks in line with the agreements in place. This works both ways; it protects the private interest from expending resource in anticipation of a successful outcome only to face policy change down the line; and it reduces overall cost to the public entity because clarity (especially when contracted) reduces the margin a prudent private business needs to place on policy and stakeholder risk.
The book has many lessons applicable to large scale property development and I recommend it as essential reading, especially for any organisation involved in private-public development initiatives.
Andrew Crosby
For my own take on managing project risk visit www.developmentrisk.com and read more in Turnaround Success: How to Resurrect Failed Real Estate Developments.
