Valuing Developable Land at Canary Wharf
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Valuing Developable Land at Canary Wharf
In valuing the developable land at Canary Wharf, there are several factors to take into account. Namely, it is crucial to decide on an appropriate rate at which to discount the projected cash flows for the property. The developable properties of Canary Wharf come with considerable risk. For example, the London office market downturn, as well as significant market hits for the large financial services tenants of Canary Wharf, presents serious tenant lease up and lease covenant negotiation risks. How long will it take to attract quality tenants to the buildings, especially as financial services tenants are currently stressed? Additionally, the requirement for further planning consent on the buildings indicates that construction on three of the sites can not commence for a number of years. How can one accurately predict the market in the future? Will the London Office market significantly improve or continue to decline? What will interest rates look like? Songbird must consider the risk of valuing such sites several years into the future. Further, Songbird must consider the weighty transportation risk. If the Crossrail project does not come to fruition in a timely manner with necessary approvals, development will not proceed as planned, causing cost overruns and heavy construction delays. Assuming that Canary Wharf is able to get the necessary transportation approvals, Canary Wharfs projected cash flows should be discounted at 12.5% in order to mitigate risks to be faced. Given this discount rate, as well as considering all taxes, debt obligations, rents and rent-free periods, and all construction costs, an appropriate bid on the developable sites at Canary Wharf is ₤809,000 (the Net Present Value of the cash flows, discounted at 12.5%). Please see Exhibit 1 for a detailed pro forma of all projected cash flows.
It is important to clarify some key assumptions that were made in valuing the properties to this NPV. First, the project yields a high IRR of 73 %, due largely in part to the sale of each building upon lease up. For the cash flow projections, it was assumed that all buildings are sold 18 months after construction completion. Therefore, with the exception of the last building to be sold, Heron Quay, the buildings are sold toward the end of their free-rent periods and no rent is collected. However, it is assumed that the subsequent purchasers value the buildings at aggregate annual rental income over the prevailing capitalization rate at the time of sale. This timing allows the purchasers to value the buildings on appropriate rental income streams and optimizes the purchase prices that Songbird can receive upon sale. The model assumes that North Quay will be requisitions as a staging area for the Crossrail construction for 2.5 years and that it will be sold immediately upon lease up in early 2014. To reflect the office market downturn and the need to be increasingly more aggressive to attract tenants, the properties initially have free rent periods of 20 months but as the market improves, the free rent periods decrease to 15 months by 2008.
Additional Necessary Information
Aside from known facts regarding development and valuation, central indefinite assumptions involve vacancy rates, the property tax rate, rent growth post-2007, capitalization rates, construction costs, and debt repayments. Vacancy was assumed to be 10%, an appropriate measure to reflect predicted state of improvement in the London office market as well as Canary Wharfs pre-leasing policy before construction begins. The property is assumed to pay no taxes since the government has assigned a special “deprived status” to the Canary Wharf area. Rent growth forecasts through 2007 have been provided and post-2007, rent growth was assumed to grow at 5%, as it seems that rents have already hit a trough in 2004 and is on the rise again. Cap rates in the model begin at 6.00%, decrease to as low as 4% during the market recovery period and rise again to 6% upon market stabilization. It is assumed that construction for all properties lasts 18 months, same as the estimated construction for Churchill Place. For each building, 25% of infrastructure costs and 75% of shell and core costs are assumed to be incurred in the first year. 25% of shell and core costs, 25% of full fit out costs, and 75% of all infrastructure costs are incurred in the final 6 months of construction. For the purpose of conservatism, infrastructure costs include an additional contingency of ₤30 m for potential additional Crossrail payments. Construction for Churchill, Riverside South, North Quay, and Heron Quay commences on 1/1/05, 1/1/08, 1/1/10, and 1/1/11, respectively. (North Quay is assumed to be requisitioned for a period of 2.5 years due to its use as a staging facility for Crossrail construction; therefore, North Quay does not begin its lease up until 1/1/14.) Principal and interest payments on the debt are assumed to be rolling; to that extent, funds are drawn down as construction occurs, but each time a building is sold, the collateral goes away, and the loan amount allocated toward that building is paid off.
Projected Cash Flow Timeline
In total, it is reasonable to assume that the entirety of developable land at Canary Wharf can be constructed, leased up, occupied, and sold off at the end of 10 years (by the end of December 2014). On average, therefore, a realistic period of 2.5 years per developable property has been allotted. Considering some construction is already relatively near completion, this assumption proves logical.
Pre-Leasing Estimations
Traditionally, the London office market has been fractionalized in that large financial services institutions have leased multiple small office locations throughout the city, which many believe to be an inefficient way to run a business. Canary Wharf is in demand because it provides a convenient solution to this problem–namely large office towers with spacious floor plates. Due to this, a pre-lease up demand of 70% can be reasonably expected and at this level, the company should feel comfortable commencing construction. If, however, rent contingency negotiation was able to lock in above-market rent rates for a tenant who was anxious to relocate into the space, the company may be inclined to reduce this tolerance level to as low as 60%. The remainder of leasing is assumed to occur during construction for each building site to bring occupancy rates to 90% occupancy at the time of construction completion. Upon performing sensitivity analysis on vacancy, it is found that if the vacancy rate is increased