Joseph Wainaina

PROJECT COST AND BENEFIT ANALYSIS INTO THE CONSTRUCTION OF A RESIDENTIAL DEVELOPMENT IN RIDGEWAYS, NAIROBI Introduction The cost benefit prepared below investigates the economic feasibility towards the development of a 5.05 acre parcel of land in Nairobi’s Ridgeway’s area. The proposal study’s various variables including the development concept and various financing strategies to be adopted. Approach Towards the analysis of the financial viability 4 options have been studied to provide a clear direction to the project developer on the most feasible path to be taken in the improvement of the parcel of land. In the analysis the project cost excludes the value of land which is an already financed cost. It calculates the debt limit based on unfinanced costs. The costs include construction, professional fees, survey and approvals. The options have been summarized as shown below; Option Strategy Scenario Option 1 Development and sale or rental of 22 No. 4 bed town houses Option 2 Development and sale or rental of 10 No. 5 bed villas Option 3 Development and sale of 22 No. 4 bed townhouses through a joint venture structure Limit Financing using 70% debt funding Financing using 100% debt funding of total project cost Financing using 70% debt funding Financing using 100% debt funding of total project cost Scenario 1 Scenario 2 Scenario 1 Scenario 2 Financing funding Scenario 1 using 70% debt The development is expected to be complete within a period of two and a half years after construction and including the sales period as shown below; Development schedule 6 18 6 6 - Start - Pre-con Construction - Defects - Month Harvest 5 10 15 20 25 30 35 40 1 OPTION 1: DEVELOPMENT OF 4 BED VILLAS From the concept paper developed the first option analyses viability of developing 22 no. 4 bedroom townhouses on a 5.05 acre piece of land. Each of the units will have a total area of 400 sqm. Type of unit 4 Bed townhouse Total/Average Project scale Land size in square meters Land size in acres Land size in hectares Land density Number of units Unit area m2 Units 22 22 Unit m2 acres hectares Units/hectare units 400 400 Value 20,- SCENARIO 1: 70% OF PROJECT COST AS DEBT FINANCE This scenario examines the impact of leveraging the project cost up to 65% with debt financing. The results of the analysis are shown below. Average costs per unit Unit Value Land cost per unit Kshs/unit 13,772,727 Construction cost (incl. 5% contingency) per unit Kshs/unit 15,663,024 Kshs/unit 2,511,907 Kshs/unit 9,859,533 Kshs/unit 41,807,192 Professional fees per unit Other costs per unit Total development cost ("TDC") per unit 2 Project development cost Uses of funds % Land (incl. transaction costs) 29.28% Construction cost (incl. 5% contingency) 40.45% Professional fees 5.34% Other costs 0.81% Senior debt cost 16.96% Construction VAT 7.16% Total uses of funds ("TDC") 100.00% Kshs/m2 34,432 47,574 6,-,947 8,416 117,601 KSHS (000) 303,000 418,651 55,262 8,373 175,537 74,065 1,034,888 Project finance Sources of funds Developer land Developer cash Senior debt Total sources of funds % 29.28% 23.32% 47.40% 100.00% KSH ('000) 303,000 241,315 490,572 1,034,887 KSH ('000) 303,000 241,315 490,572 1,034,887 The total project finance amounting to Kshs 1.03 billion will be secured through a debt infusion of Kshs 490 million and an equity injection of Kshs 544 million. The debt amount will be financed at a rate of 18% p.a during construction. The principal amount depending on the financing methodology will either be fully retired upon completion of sales or converted into a permanent mortgage to be repaid over a 10 year period. Further an equity injection over and above the value of the land valued at 303 million, amounting to Kshs 241 million will be required to finance some of the project costs which include financing costs amounting to Kshs 175 million, professional fees, surveys and approvals. 3 Develop and sale approach Based on a sales approach the project shall be able to attain a total sales income of Kshs 1.25 Bn. This is as shown below; Unit type 4 Bed townhouse Sales amount Kshs (000) No. of units Gross income Kshs (000) 22 1,650,000 75,000 Net income 1,650,000 Project returns The below tables illustrate the expected profitability from the project. Income statement Kshs (000) 1,650,000 (785,286) 864,714 864,-% (33,000) (175,537) 656,177 Sale proceeds Cost of sales Gross profit Other income GP margin Sales and administrative expenses Interest expense Profit before tax Developer return Developer cash flows Developer cash out flows Developer cash in flows Net developer cash in flows Developer IRR Unit Kshs Kshs Kshs percentage Total (544,315) 950,891 406,-% The developer’s internal rate of return amounts to 25.97% from an investment of Kshs 303 million in land and cash of up to Kshs 241 million. In monetary terms the developer will attain a 1.75 times money back. The times money back indicates how many times one can turn his money initially invested. 4 Develop and Lease Approach If the project is held for rental purposes, under the scenario the developer will hold the asset for income generating purposes. The expected rental rates are shown below. Rental Rate 250,000 4 Bed town house Project returns Units 22 Annually 66,000,000 A cash flow model based on the above rental rates has been prepared to depict the project net cash flows. Year Occupancy rate Timeline 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 70% 75% 80% 85% 90% 90% 100% 100% 100% 100% Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Lease income Annual Gross Rentals Vacancy costs Credit Losses 66,000,000 69,300,000 72,765,000 76,403,250 80,223,413 84,234,583 88,446,312 92,868,628 97,512,059 102,387,662 (19,800,000) (17,325,000) (14,553,000) (11,460,488) (8,022,341) (8,423,458) - - - - (660,000) (693,000) (727,650) (764,033) (802,234) (842,346) (884,463) (928,686) (975,121) (1,023,877) 45,540,000 51,282,000 57,484,350 64,178,730 71,398,837 74,968,779 87,561,849 91,939,942 96,536,939 101,363,786 Administration (700,000) (721,000) (742,630) (764,909) (787,856) (811,492) (835,837) (860,912) (886,739) (913,341) Rent and rates (250,000) (250,000) (250,000) (250,000) (250,000) (250,000) (250,000) (250,000) (250,000) (250,000) Salaries and wages for management staff (700,000) (721,000) (757,050) (794,903) (834,648) (876,380) (920,199) (966,209) (1,014,519) (1,065,245) Total Expenses (1,650,000) (1,692,000) (1,749,680) (1,809,811) (1,872,504) (1,937,872) (2,006,036) (2,077,121) (2,151,258) (2,228,587) Net Operating Income 43,890,000 49,590,000 55,734,670 62,368,919 69,526,333 73,030,907 85,555,814 89,862,821 94,385,680 99,135,199 (20,856,509) (24,610,680) (29,040,603) (34,267,911) (40,436,135) (47,714,639) (56,303,274) (66,437,864) (78,396,679) (75,856,627) Effective gross income Operational expenses Financing expenses Principal Interest (88,303,028) (84,548,856) (80,118,934) (74,891,625) (68,723,401) (61,444,897) (52,856,262) (42,721,672) (30,762,857) (16,651,455) Net cashflow (65,269,536) (59,569,536) (53,424,866) (46,790,617) (39,633,203) (36,128,629) (23,603,723) (19,296,715) (14,773,856) 6,627,118 5 The table above illustrates the project net cash flows and expected rental return. From the analysis it is evident that the project is unable to meet expected financial obligations from rental incomes based on very conservative occupancy levels. The cash flows are negative over the first nine years. The internal rate of return is at 6.5% and 1.6% on a ten and five year period respectively. Rental Internal rate of return IRR Developer leveraged IRR(BT) 10 years 6.5% Developer leveraged IRR(BT) 5 years 1.6% 6 SCENARIO 2: OF PROJECT COST USING DEBT The total unit costs for the project are as shown below. Average costs per unit Land cost per unit Construction cost (incl. 5% contingency) per unit Professional fees per unit Other costs per unit Total development cost ("TDC") per unit Unit Kshs/unit Kshs/unit Kshs/unit Kshs/unit Kshs/unit Value 13,772,727 19,029,600 2,511,907 13,212,306 48,526,540 If the project is financed by a 100% of the project cost as debt, the resulting project cost and finance budget will be as shown below; Project cost Uses of funds Land (incl. transaction costs) Construction cost (incl. 5% contingency) Professional fees Other costs Senior debt cost Construction VAT Total uses of funds ("TDC") % 29.28% 40.45% 5.34% 0.81% 16.96% 7.16% 100.00% Kshs (000) 303,000 418,651 55,262 8,373 175,537 74,065 1,034,888 Project finance Sources of funds Developer land Developer cash Senior debt Total sources of funds % 29.29% 17.75% 52.97% 100.00% KSH ('000) 303,000 183,606 547,978 1,034,584 The total cost for the project based on a high leverage ratio totals to Kshs 1.034 billion and the project shall be financed using cash investment of Kshs 183 million as well as debt amounting to Kshs 547 million up from Kshs 490 million in the previous scenario. 7 Develop and sale approach Based on this level of financing the project cash flows after sales as exhibited by the revenue schedule and income statement will be as shown below; Project revenue schedule Unit type 4 bed town houses Net income Sales amount Kshs (000) 75,000 No. of units Gross income KSH ('000) 22 1,650,000 1,650,000 Projected Income statement (FY2018) Sale proceeds Cost of sales Gross profit Other income Gross Profit GP margin Sales and administrative expenses Interest expense Profit Before Tax PBT margin Kshs ‘000 1,650,000 (785,286) 864,714 864,-% (33,000) (175,233) 656,-% From the table above the project is able to attain a profit before tax of Kshs 656 million representing a PBT margin of 39%. 8 Developer returns The potential returns to the developer through a high leverage are as shown below. Developer cash flows Developer cash out flows Developer cash in flows Net developer cash in flows Developer IRR Developer times money back Unit KSHS KSHS KSHS percentage Total (486,606) 893,789 407,-% 1.84x The developer’s internal rate of return amounts to 27.7% from an investment of Kshs 303 million in land and cash of up to Kshs 183 million. In monetary terms the developer will attain a 1.84 times money back. Develop and Lease Approach If the project is held for rental purposes, under the scenario the developer will hold the asset for income generating purposes. The expected rental rates are shown below. 4 Bed townhouses Rental Rate 250,000 Units 22 Monthly Annually 5,500,000 66,000,000 Rental Returns Equity leveraged IRR(BT) 10years Equity leveraged IRR(BT) 5 years 4.6% 0.7% Over the forecast period the project is able to achieve a very low return of 4.6% and 0.7% internal rate of return over a ten and five year period. This low returns illustrates the negative cash flows as seen in the below table. 9 Operational cash flow model A projected 10 year cash flow schedule based on the expected incomes is shown below. Year 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Occupancy rate 70% 75% 85% 90% 90% 90% 90% 90% 90% 90% Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 66,000,000 69,300,000 72,765,000 76,403,250 80,223,413 84,234,583 88,446,312 92,868,628 97,512,059 102,387,662 (19,800,000) (17,325,000) (10,914,750) (7,640,325) (8,022,341) (8,423,458) (8,844,631) (9,286,863) (9,751,206) (10,238,766) (330,000) (346,500) (363,825) (382,016) (401,117) (421,173) (442,232) (464,343) (487,560) (511,938) 45,870,000 51,628,500 61,486,425 68,380,909 71,799,954 75,389,952 79,159,449 83,117,422 87,273,293 91,636,958 Administration (700,000) (721,000) (742,630) (764,909) (787,856) (811,492) (835,837) (860,912) (886,739) (913,341) Rent and rates (250,000) (250,000) (250,000) (250,000) (250,000) (250,000) (250,000) (250,000) (250,000) (250,000) Salaries and wages (700,000) (721,000) (757,050) (794,903) (834,648) (876,380) (920,199) (966,209) (1,014,519) (1,065,245) Total Expenses (1,650,000) (1,692,000) (1,749,680) (1,809,811) (1,872,504) (1,937,872) (2,006,036) (2,077,121) (2,151,258) (2,228,587) Net Operating Income 44,220,000 49,936,500 59,736,745 66,571,097 69,927,450 73,452,080 77,153,414 81,040,301 85,122,035 89,408,371 Principal 23,297,081 27,490,555 32,438,855 38,277,849 45,167,862 53,298,077 62,891,731 74,212,243 87,570,447 84,733,164 Interest 98,636,009 94,442,534 89,494,234 83,655,241 83,655,241 76,765,228 59,041,359 47,720,847 34,362,643 18,599,963 (77,713,090) (71,996,590) (62,196,345) (55,361,992) (58,895,652) (56,611,225) (44,779,676) (40,892,788) (36,811,055) (13,924,756) Timeline Lease income Annual Gross Rentals Vacancy costs Credit Losses Effective gross income Operational expenses Financing expenses Net cash flow From the cash flow model it is evident the project cash inflows are not capable of meeting the financing expenditures of the project over a long-term horizon. The cash flows are struggling over the initial 10 year period. 10 OPTION 2: DEVELOPMENT OF 5 BED VILLAS The second option analyses viability of developing 10 no. 5 bedroom villas on the subject site. Each of the units will have a total area of 450 sqm. The option has also been analyzed from a financing spectrum to evaluate which method of financing to adopt. Project scale Land size in square meters Land size in acres Land size in hectares Land density Number of units Unit Value 2 M Acres Hectares Units/acre Units 20,- SCENARIO 1: PROJECT DEBT AT 65% OF PROJECT COST The average unit costs for the units are as shown below. Average costs per unit Land cost per unit Construction cost (incl. 5% contingency) per unit Professional fees per unit Other costs per unit Total development cost ("TDC") per unit Unit KSHS/unit KSHS/unit KSHS/unit KSHS/unit KSHS/unit Value 30,300,000 21,408,300 2,825,896 11,733,063 66,267,259 In the first scenario we have assumed the project will be partially be financed through debt and equity. A conservative gearing ratio of 65% will be used to fund the project development cost. The expected project cost and project finance schedules are shown below; Project cost Uses of funds Land (incl. transaction costs) Construction cost (incl. 5% contingency) Professional fees Senior debt cost Construction VAT Total uses of funds ("TDC") % 45.18% 31.92% 4.21% 12.40% 5.65% 100.00% Kshs $/m2 67,333 47,574 6,280 18,483 8,416 149,038 KSHS (000) 303,000 214,083 28,259 83,172 37,874 670,669 11 Project finance Sources of funds % Developer land 45.18% Developer cash 18.30% Senior debt 36.52% Total sources of funds 100.00% KSH ('000) 303,000 122,755 244,914 670,669 KSH ('000) 303,000 122,755 244,914 670,669 The project shall have a projected cost of Kshs 670 million. This cost will be financed using debt and equity with the former amounting to Kshs 244 million. The debt shall be secured through a 18% interest cost to be repaid over a two year period. The total finance costs amounts to Kshs 83 million. Equity in the form of land has been valued at Kshs 60 million per acre. In addition a Kshs 122 million cash infusion shall be required from the developer to meet interest expenses and other costs including professional fees and approval costs. 12 Develop and sales approach. If the project is sold upon completion, the projected sales income and profitability will be as shown below. Unit type 5 bed villas Selling price per unit Kshs (000) No of units Total sales income Kshs (000) 90,000 10 900,000 Income statement Kshs (000) 900,000 (549,624) 350,376 350,-% (18,000) (83,172) 249,-% Sale proceeds Cost of sales Gross profit Other income Gross profit GP margin Sales and administrative expenses Interest expense Profit before tax PBT margin Developer returns Developer cash flows Developer cash out flows Developer cash in flows Net developer cash in flows Developer IRR Developer times money back Unit KSHS KSHS KSHS percentage Multiple Total (425,755) 553,914 128,-% 1.30x The developer’s internal rate of return amounts to 10.65% from an investment of Kshs 303 million in land and cash of up to Kshs 122 million. In monetary terms the developer will attain a 1.3 times money back. 13 Develop and lease approach Alternatively, the project can be held for income producing purposes. The developer will earn a rental yield from the asset and a capital yield from appreciation of the asset value. A depiction of the revenue schedule and cash flow projection is shown below. Units 5 Bed Villa Operation Cash Flow Model Rental Rate 324,000 No. Of Units 10 Monthly 3,240,000 Annually 38,880,000 The cash flow model illustrates the total net cash flow expected from lease of the villas. Year 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 Occupancy rate 70% 75% 80% 85% 90% 90% 90% 90% 90% 90% Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 38,880,000 40,824,000 42,865,200 45,008,460 47,258,883 49,621,827 52,102,919 54,708,064 57,443,468 60,315,641 (11,664,000) (10,206,000) (8,573,040) (6,751,269) (4,725,888) (4,962,183) (5,210,292) (5,470,806) (5,744,347) (6,031,564) (194,400) (204,120) (214,326) (225,042) (236,294) (248,109) (260,515) (273,540) (287,217) (301,578) 27,021,600 30,413,880 34,077,834 38,032,149 42,296,700 44,411,535 46,632,112 48,963,718 51,411,904 53,982,499 Administration (700,000) (721,000) (742,630) (764,909) (787,856) (811,492) (835,837) (860,912) (886,739) (913,341) Rent and rates (250,000) (2,427) (2,427) (2,427) (2,427) (2,427) (2,427) (2,427) (2,427) (2,427) Salaries and wages (700,000) (721,000) (757,050) (794,903) (834,648) (876,380) (920,199) (966,209) (1,014,519) (1,065,245) Total Expenses (1,650,000) (1,444,427) (1,502,107) (1,562,239) (1,624,931) (1,690,299) (1,758,463) (1,829,548) (1,903,686) (1,981,014) Net Operating Income 25,371,600 28,969,453 32,575,727 36,469,910 40,671,769 42,721,236 44,873,649 47,134,170 49,508,218 52,001,485 Principal 12,062,526 13,871,905 15,952,690 18,345,594 21,097,433 24,262,048 27,901,355 32,086,558 36,899,542 36,069,302 Interest 36,737,119 34,927,740 32,846,954 30,454,050 27,702,211 24,537,596 20,898,289 16,713,086 11,900,102 6,365,171 (23,428,044) (19,830,191) (16,223,917) (12,329,734) (8,127,875) (6,078,408) (3,925,995) (1,665,474) 708,574 9,567,012 Timeline Lease income Annual Gross Rentals Vacancy costs Credit Losses Effective gross income Operational expenses Financing expenses Net Cash Flow 14 From the table above, the project has a negative cash net flow over the operational period. This signifies the inability to meet financing costs over the loan amortization period. Internal rate of return Equity leveraged IRR(BT) 10 years Equity leveraged IRR(BT) 5 years % 5.2% 1.5% The project has low internal rate of return amounting to 5.2% and 6.3% over a ten year period respectively. This compounds the unattractiveness of the funding and development concept from a hold strategy. SCENARIO 2: DEBT FINANCE AT 100% OF PROJECT COST The second scenario under this option studies the feasibility of the project if 100% debt is used to fund the construction cost and professional fees. The respective project cost and project finance summaries are as shown below; Unit cost Average costs per unit Land cost per unit Construction cost (incl. 5% contingency) per unit Professional fees per unit Other costs per unit Total development cost ("TDC") per unit Unit KSHS/unit KSHS/unit KSHS/unit KSHS/unit KSHS/unit Value 30,300,000 23,328,000 3,079,296 13,317,423 70,024,719 % 41.88% 32.24% 4.26% 15.27% 5.70% 100.00% KSHS (000) 303,000 233,280 30,793 110,509 41,270 723,517 Project cost Uses of funds Land (incl. transaction costs) Construction cost (incl. 5% contingency) Professional fees Senior debt cost Construction VAT Total uses of funds ("TDC") 15 Project finance Sources of funds % Developer land 41.88% Developer cash 15.92% Senior debt 42.20% Total sources of funds 100.00% Kshs (000) 303,000 115,174 305,343 723,517 The project shall have a projected cost of Kshs 723 million. This cost will be financed using debt and equity with the former amounting to Kshs 305 million. The debt shall be secured through 18% interest cost to be repaid over a two year period. The total finance costs amounts to kshs 110 million. Equity in the form of land has been valued at Kshs 60 million per acre totaling to Kshs 303 million. In addition a Kshs 115 million cash infusion shall be required from the developer to meet interest expenses and other costs including approval costs. Returns Develop and sale From a sales perspective the units can be sold at Kshs 90 million to generate a total gross inflow of Kshs 900 million. The income statement below illustrates the project profitability. Income Statement Sale proceeds Cost of sales Gross profit Other income Total Gross Profit GP margin Sales and administrative expenses Interest expense Profit before tax Profit before tax margin Kshs (000) 900,000 (571,739) 328,261 328,-% (18,000) (110,509) 199,-% 16 Through this model, the project is able to realize an income of Kshs 199 million before taxes. From a yield perspective the developer will earn the below return; Developer cash flows Unit Developer cash out flows KSHS (418,174) Developer cash in flows KSHS 466,148 Net developer cash in flows KSHS 47,974 percentage 4.33% Multiple 1.11x Developer IRR Developer times money Total The developer’s internal rate of return amounts to 4.33% from an investment of Kshs 303 million in land and cash of up to Kshs 115 million. In monetary terms the developer will attain a 1.11 times money back. 17 Develop and lease approach The second alternative examines the profitability to the developer if the asset is held for income generating purposes. The below table illustrates the rental revenue schedule and operational 10 year forecast. Year 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Occupancy rate 60% 70% 80% 90% 90% 90% 90% 90% 90% 90% Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 38,880,000 40,824,000 42,865,200 45,008,460 47,258,883 49,621,827 52,102,919 54,708,064 57,443,468 60,315,641 (15,552,000) (12,247,200) (8,573,040) (4,500,846) (4,725,888) (4,962,183) (5,210,292) (5,470,806) (5,744,347) (6,031,564) (194,400) (204,120) (214,326) (225,042) (236,294) (248,109) (260,515) (273,540) (287,217) (301,578) 23,133,600 28,372,680 34,077,834 40,282,572 42,296,700 44,411,535 46,632,112 48,963,718 51,411,904 53,982,499 Administration (700,000) (721,000) (742,630) (764,909) (787,856) (811,492) (835,837) (860,912) (886,739) (913,341) Rent and rates (250,000) (2,427) (2,427) (2,427) (2,427) (2,427) (2,427) (2,427) (2,427) (2,427) Salaries and wages (700,000) (721,000) (757,050) (794,903) (834,648) (876,380) (920,199) (966,209) (1,014,519) (1,065,245) Total Expenses (1,650,000) (1,444,427) (1,502,107) (1,562,239) (1,624,931) (1,690,299) (1,758,463) (1,829,548) (1,903,686) (1,981,014) Net Operating Income 21,483,600 26,928,253 32,575,727 38,720,333 40,671,769 42,721,236 44,873,649 47,134,170 49,508,218 52,001,485 Principal 12,981,554 15,318,233 18,075,515 21,329,108 25,168,347 29,698,650 35,044,407 41,352,400 48,795,832 47,214,847 Interest 54,961,763 52,625,084 49,867,802 46,614,209 42,774,969 38,244,667 32,898,910 26,590,917 19,147,485 10,364,235 (46,459,717) (41,015,064) (35,367,590) (29,222,984) (27,271,548) (25,222,081) (23,069,668) (20,809,147) (18,435,099) (5,577,597) Timeline Lease income Annual Gross Rentals Vacancy costs Credit Losses Effective gross income Operational expenses Financing expenses 18 The project operational forecast illustrates the low revenue earning potential of the asset in light of financial obligations the asset is required to meet. The cash flows are not able to meet the interest and principal payments over the holding period. This is exhibited below by the low yields achieved at 2.5% and -3.4% over a ten and five year periods respectively. IRR Equity leveraged IRR(BT) 10years 2.5% Equity leveraged IRR(BT) 5 years -3.4% OPTION 3: JOINT VENTURE STRUCTURE The option investigates the economic feasibility of developing the project through a joint venture structure. The joint venture partner shall inject an equal amount of capital in to the project equivalent to the value of land. The financing structure adopted in this analysis is based on the development of 22 four bed high end townhouses. Project cost Uses of funds Land (incl. transaction costs) Construction cost (incl. 5% contingency) Professional fees Other costs Developer fees Senior debt cost Construction VAT Total uses of funds ("TDC") % 31.87% 44.04% 5.81% 0.88% 9.61% 7.79% 100.00% KSHS (000) 303,000 418,651 55,262 8,373 91,332 74,065 950,683 Finance structure Sources of funds Developer land External equity Senior debt Total sources of funds % 31.87% 31.87% 36.26% 100.00% KSH ('000) 303,000 303,000 344,683 950,683 The project cost from the above table reduces considerably owing to the reduction in amount of debt secured. The injection of cash equity for development purposes improves the project prospects. The parties to the joint venture will each have a 50/50 shareholding in the project. 19 Developer SPV shareholding structure 50% Investor 1 50% Returns Owing to the limited time horizon for most joint venture partnerships the returns have been calculated using a sales approach. Develop and sale Sales income Unit type 4 Bed townhouse Net income Sales amount Kshs (000) 75,000 No. of units 22 Gross income Kshs (000) 1,650,000 1,650,000 Income statement Sale proceeds Cost of sales Gross profit Other income Gross profit margin GP margin Sales and administrative expenses Interest expense Profit Before Tax PBT margin Kshs (000) 1,650,000 (785,286) 864,714 864,-% (33,000) (91,332) 740,-% The project using the methodology of financing produces a profitability of Kshs 740 million before taxes. 20 Developer and investor return DEVELOPER RETURN METRICS Developer cash flows Unit Developer cash out flows KSHS (303,000) Developer cash in flows KSHS 583,480 Net developer cash in flows KSHS 280,481 percentage 29.52% Developer IRR Total Developer TMB EXTERNAL EQUITY External equity cash flows External equity cash outflows External equity cash inflows Net investor cash in flows Investor IRR Investor TMB 1.93X Unit KSHS KSHS KSHS percentage Total (303,000) 583,480 280,-% 1.93X From the tables above it is evident a shared risk in the project leads to greater returns to the investor and the developer. The reduced debt investment leads to higher returns as shown above. The investor earns a return of 29.52% similar to the developer. This amount to a times money back of 1.93 times or a net cash outflow of Kshs 280 million. Please note the cash flows are before tax. Alternatively, the developer may hold units for rental. The units held will be in proportion to the invested capital and the return on sums invested. The external equity investor shall be liquidated to exit the development after completion of sales. From the assumptions laid out above the outcome of the repayments of the capital i.e. debt and equity is as shown below in addition to an allocation of units prorate; 21 Amount Kshs (000) UNIT No. Debt Capital 344,683 6 Equity Capital 606,000 8 Total 950,683 14 Profits 560,961 8 Developer 280,481 4 Investor 280,481 4 Total Profits 560,961 8 Capital repayment Allocation; 22 After allocations, the annual expected cash flows to the developer from the 8 units held shall be as shown below. Cash flow statement 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 Occupancy rate 70% 80% 90% 90% 90% 90% 100% 100% 100% 100% Units occupied 15 18 20 20 20 20 22 22 22 22 Units not occupied 7 4 2 2 2 2 - - - - Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Annual Gross Rentals 26,400,000 27,720,000 29,106,000 30,561,300 32,089,365 33,693,833 35,378,525 37,147,451 39,004,824 40,955,065 Vacancy costs (7,920,000) (5,544,000) (2,910,600) (3,056,130) (3,208,937) (3,369,383) - - - - (132,000) (138,600) (145,530) (152,807) (160,447) (168,469) (176,893) (185,737) (195,024) (204,775) 18,348,000 22,037,400 26,049,870 27,352,364 28,719,982 30,155,981 35,201,632 36,961,714 38,809,800 40,750,290 Administration (350,000) (360,500) (371,315) (382,454) (393,928) (405,746) (417,918) (430,456) (443,370) (456,671) Rent and rates (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) (100,000) Timeline Lease income Credit Losses Effective gross income Operational expenses Salaries and wages (250,000) (257,500) (270,375) (283,894) (298,088) (312,993) (328,643) (345,075) (362,328) (380,445) Total Expenses (700,000) (718,000) (741,690) (766,348) (792,017) (818,739) (846,561) (875,530) (905,698) (937,115) 17,648,000 21,319,400 25,308,180 26,586,015 27,927,965 29,337,242 34,355,071 36,086,183 37,904,102 39,813,174 Net Operating Income Returns Measure Gross Rental Yield Internal rate of return Payback Period Return 7.88% 13.37% 10.8 Years 23 From the above cash flow statement, we see that the developer shall be able to earn a gross rental yield of 7.9%. This return is slightly above gross rental yields for residential properties in Kenya which are at 6.9%. The project internal rate of return stands at 13.4% slightly above market expectations for residential properties which peak at between 12.5%. The projects payback period is at 10.8 years which is slightly above the maximum 10 year recommended time horizon for a project to be considered feasible. FINDINGS OPTION 1: DEVELOP 4 BED TOWN HOUSES Sales Scenario 1 65% DEBT FUNDING Kshs 241 million 25.97% 1.75x Kshs 406 million Scenario 2 100% DEBT FUNDING Kshs 183 million 27.7% 1.84x Kshs 407 million Scenario 1 65% DEBT FUNDING Kshs 241 million 6.5% Scenario 2 100% DEBT FUNDING Kshs 183 million 4.6% Cash equity requirement IRR TMB Cash return Scenario 1 65% DEBT FUNDING Kshs 122 million 10.65% 1.3x Kshs 128 million Scenario 2 100% DEBT FUNDING Kshs 110 million 4.33% 1.11x Kshs 47 million Rental Cash equity requirement IRR( 10 yr) Scenario 1 Kshs 122 million 5.2% Scenario 2 Kshs 110 million 2.5% Cash equity requirement IRR TMB Cash return Rental Cash equity requirement 10 year Internal Rate of Return OPTION 2: DEVELOP 5 BED VILLAS Sales 24 OPTION 3: JOINT VENTURE Complete sale of units Return Investor IRR Developer times money Developer IRR External investor times money Cash return Proportion % 29.52% 1.93X 29.52% 1.93X Kshs 280 million Developers hold strategy in lieu of capital redemption and profits Measure Gross Rental Yield Internal Rate of Return Payback Period Net Present Value Return 7.88% 13.37% 10.8 Years Kshs 94,553,336 Conclusion From the analysis performed above, we see that if we develop the site using 4 bed town houses we achieve decent returns of above 26% regardless of the financing structure. A more leveraged structure results in a higher yield to the developer as exhibited in the second scenario where debt is at 100% of total project cost. The project under this scenario achieves a return of 27.7%. A less leveraged model at 65% debt, results in a lower return as measured by the IRR at 25.97% which also requires a higher level of cash equity investment. Using the first scenario, the developer is able to achieve a cash net flow of Kshs 406 million almost similar to Kshs 407 million in the second scenario. This is after repayment of all liabilities including debt and equity invested. Further looking at Option 2, the developer is developing 5 bed villas and is able to achieve a poor return. This is a result of a slightly higher development cost and lower revenue generation from sales thus lower returns consequently. This renders the five bed villas unprofitable. This can further be evidenced from market survey reports as new stock of 5 bed villas in the area is minimal compared to four bed villas. If the project from both development concepts i.e. 4 bed or 5 bed villas is considered for rental all the options yield very poor returns as shown by the 25 negative net cash flows from year one all the way to year ten. Thus the option of development and lease is unattractive. The third option presents better option to the developer and the investor. It will involve less burden for cash equity raise through own developer funding. Supplementary capital from an external source will bridge development cost gap. The high land value ensures that additional capital contributed in order to have a 50-50 scenario will automatically reduce our debt reliance. This strategy leads to very attractive returns as it yields an IRR of 29% and a cash return of Kshs 280 million with less financial risk. This is after repayment of invested capital in land and cash for the developer and investor respectively. Alternatively, if the developer was to hold the asset, they would earn an annual return of 7.9%. The asset would take 10.8 years to repay the cost of developing the 8 units and have a total yield of 13.4%. A net present value of Kshs 94 million will be obtained after discounting the future cash flows to the present period (Year 2019). Recommendations From the analysis we recommend the adoption of Option 1 whereby the developer would develop four bedroom town houses all for sale and use 100% debt funding of the project cost. This will translate to better fortunes as the developer shall make Kshs 407 million in cash returns after repayment of all liabilities including debt and capital but before taxes. However, this will require a cash equity injection of Kshs 183 million to cater for interest costs and other project soft costs such as survey as well as approval costs. Alternatively, the developer may partner with an external equity investor to assist in funding the development. The 50/50 joint venture will provide good returns to both investor and developer after complete sale at 29% translating to Kshs 280 million in net cash returns. The reduced equity investment enhances the return and spreads the risk across the capital structure. A hold strategy has good returns however comparatively based on the net present value; it would be beneficial to sell the units as opposed to holding since the net present value of the hold strategy is far lower than the present value of the cash to be obtained from a sale option at end of Year 2019. The net present value of the hold strategy amounts to Kshs 94 million compared to Kshs 280 million from a complete sale strategy. Therefore a sale strategy would economically be more appropriate to a joint venture structure. 26 ANNEXURES Market comparables Sales prices 5 bed units No. Location/Development Price Size 1 Windsor park 65,000,000 0.25 acre 2 Ridge ways 85,000,000 0.25 acre 3 Garden estate 70,000,000 5 Garden estate 65,000,000 6 Garden estate 80,000,000 Image 0.5 acre 0.5 acre 0.5 acre 27 7 Ridge ways 75,000,000 8 Ridge ways 85,000,000 9 Ridge ways Road 57,000,000 0.4 acre 0.5 acre 3/4 acre. 28 4 bed units Development Location Price 1 Almasi Villas Ridgeways 60,000,000 2 Sabari villas Ridgeways 47,000,000 0.25 acre 3 Ridgeways Ridgeways Rd 60,000,000 0.25 acre 4 Ridgeways Ridgeways 70,000,000 5 Ridge ways Ridgeways 55,000,000 6 55 FOURWAYS Ridgeways 30,950,000 Land Acreage Image 0.4 acre 0.2 acre 0.5 acre 1/7 acre 29 7 Windsor Dream Mansion Ridge ways Rd 250,000,00 0 0.25 acre 8 Ridge ways Lane Ridge ways 37,000,000 1/8 acre Ridge ways 62,000,000 0.25 Acres 9 WINDSOR PARK Rental prices 4 BED 1 2 3 4 5 1 2 3 4 5 LOCATION RIDGEWAYS RIDGEWAYS BROOK GARDEN ESTATE RIDGEWAYS GARDEN ESTATE Average 5 BED LOCATION GARDEN ESTATE GARDEN ESTATE GARDEN ESTATE RIDGEWAYS RIDGEWAYS Average DEVELOPEMENT ALMASI VILLAS RIDGEWAYS GARDEN ESTATE FOURWAYS JUNCTION TOWNHOUSE MONTHLY RENT 250,000 300,000 150,000 120,000 230,000 210,000 Unfurnished Furnished Unfurnished Unfurnished Unfurnished DEVELOPEMENT WINDSOR PARK OWNER SELF BUILD TOWN HOUSE RIDGEWAYS SPRINGS OWNER SELF BUILD MONTHLY RENT 750,000 190,000 110,000 250,000 320,000 324,000 Furnished Unfurnished Unfurnished Unfurnished Unfurnished 30