Why and how we develop
We have embarked on a large development programme – early in the recovery cycle. We led the London market by being the first to restart developments in January 2010. This year we also became the first company to restart large-scale retail development with the start of construction at our £350m Trinity Leeds scheme.
To put our development opportunities into perspective, in the last 18 months we have started work on over 150,000m2 of developments in London. Meanwhile, our Trinity Leeds scheme is the largest single development commitment by a REIT in the UK since the downturn and when completed will represent 15% of our shopping centre portfolio.
Why is development attractive?
When undertaken at the right stage in the cycle, property development has the potential to deliver new buildings at attractive rental income yields and to generate valuation surpluses materially ahead of general market movements.
In the London office market, there has been a hiatus in development activity with virtually no new schemes being initiated during the financial downturn. This means that very few new buildings will be completed in 2011, 2012 and 2013. As a consequence we expect rental levels will grow as blue chip companies chase the good quality office space that is available. We see development as an effective and profitable way of capturing these rising rents. At a time when debt finance is not generally available for development projects, we are able to fund our development activity using finance raised centrally on our balance sheet. This is a source of significant competitive advantage.
In retail, 2012 is predicted to be the first year in a generation that no major new shopping centre development is completed in the UK. However, through our relationships with retailers we know there is still strong demand for good space in the right locations. Leeds is such an example. It is one of the biggest cities in the UK and has seen no major development in the city centre for over 25 years. That means its retail space offer is out of step with modern retailing demands. Retailers recognise this, are keen to support the scheme and are willing to commit to pre-lettings and pay appropriate rents to see the scheme go ahead.
How do you manage the risks associated with development?
On individual projects, we apply our planning, construction and leasing skills, to manage risk. We also have an in-house research capability to help us determine the appropriate timing of our projects relative to the cycle.
We also have a number of Group level risk controls on the amount of development we will undertake. These are covered in detail in Our risks and how we manage them.
What about construction risk?
We manage this carefully through the agreements we reach with our principal contractors. Depending on the scheme, we may take control of the management of the project or appoint a contractor capable of taking responsibility. We have used our early mover advantage to secure low construction prices, which has helped to make the schemes even more profitable.
How do you manage the planning process?
The planning process differs with each and every scheme. To give an example, our Cabot Circus development in Bristol took around nine years to move from the start of the planning process to completion, while One New Change, EC4 – which is in the City of London – took four years. The key to our success in planning is to ensure that we take account of local concerns as we design the scheme.
What is the cost of all this development?
We calculate total development cost as being the value of the land we put into the scheme at the start of the project and the estimated construction cost plus capitalised interest. Currently, the total development cost of our programme is £1,715m and outstanding capital expenditure to complete the programme is £496m.
What returns will these developments create for shareholders?
We believe that developments offer a good way to contribute to earnings growth for shareholders particularly in current market conditions where achieving rental income growth from existing assets can be challenging. All of the developments we have started since 2010 are expected to deliver an attractive gross yield on cost of approximately 7-8%. Even after spreading of rent-free periods over the lease length (for accounting purposes), this yield would boost earnings through the margin over our average cost of debt of 4.9%.
This high yield does reflect the higher risk associated with constructing and letting-up a new building, but we work to mitigate risk through our skills in construction and leasing.
Another way to analyse returns from developments is to compare the return on cost to the end yield of the development. For example, if a completed development delivers a 7.5% yield on cost, and is then valued in the market at a 6.25% initial yield, that represents a profit on cost of approximately 20%.
Not all property companies have the balance sheet or skills to deliver a large-scale development programme. Land Securities does, and we believe it is the right strategy to adopt for the Company and for shareholders at the present time.