Tuesday, August 15, 2006

Wait and See: Development on Orchard Road

It might be puzzling to some that the site above the Orchard Road MRT station (the Orchard Turn site) as well as the carpark above the Somerset MRT station (the Somerset Central site) have stood idly by as the rest of Orchard developed, grew and aged. Why did these sites remain vacant, their vacant status being way below their “highest and best use” for many years? Some of you might have guessed that the value of these plots is not captured by the net present value of rents, which would surely indicate that development should be undertaken immediately. There is something more. This something more is what economists commonly refer to as a timing option. In this case the option is the owner’s right to defer development of the site. This flexibility, which is ignored by NPV calculations, is particularly valuable when there is significant uncertainty because it allows the owner to wait for just the right moment to act. The timing options of these two sites were held exclusively by the Singapore government through the Urban Redevelopment Authority of Singapore (URA) (the Somerset site is currently up for tender).

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Many would agree that retail/office sites like those of Orchard Road depend a lot on what’s going on around the area. The government knows this, the developers know this and in all likelihood, the government knows what the developers are thinking. A location that is primarily retail is not exactly like a residential site. You especially need vibrancy, you need foot traffic, and you need something that attracts people. You like that shoppers window shop and comparison shop. (The benefit of “co-location” to generate a critical mass of customers is part of what is known as agglomeration economies.) To illustrate, on a micro-level, small retail establishments rely on anchor tenants to draw crowds, this explains why tenant-mix is often deemed as being important to a shopping centre. The same goes for a street like Orchard Road, but on a larger scale. I bet that the success of any future development goes hand in hand with any revitalization planned. This is also why a great deal of interest in these sites is generated when the URA holds exhibitions about what it has in store for Orchard Road via its Development Guide Plan (DGP). Developers like to be convinced of the likely success of these plans. The URA knows that developers also care a lot of what’s going on and what is expected in the years to come regarding office and retail rents, consumer spending and confidence and generally what’s going on in the international and domestic economy. So URA has to time its sales right. It does this via the Reserve List System. Under this system, a developer who is interested in purchasing a site submits a bid to the URA. If the bid is high enough, it effectively provides a signal that the market may be ripe for the picking. The URA then puts the land up for tender. When the URA sells the sites, they have already exercised the timing option. All things considered, a sale will go through when the price is right, when it exceeds the URA’s reserve price – in a sense, the government is immunised from any downside financial loss.

When a developer wins the tender to a site, there is a new timing option. The value of this option is limited, however. URA requires the Somerset site to be developed within 9 years after its sale. The value of the developer’s option decreases with time. To that extent, it seems all probable therefore, the sites will be sold when confidence is pretty high, almost all interested developers will see that such optimism continue into the foreseeable future and construction is likely to be swift. For there is no turning back once the leasehold-clock starts ticking.*

What does a developer pay? Basically, the price of a plot of land reflects how a winning developer quantifies his expectation. Essentially, the price is derived from two things: (a) future rents and (b) price appreciation of the future development. It also reflects how these expectations are evaluated via the probability of success of the DGP programmes and the capitalised value of future rents that follow.

*There can be recourse but not without an exorbitant cost.

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