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Risk Management on a Major Property Development Project in New Zealand
Qu, J.
Unitec New Zealand
(email: [email protected])
Boon, J.
Unitec New Zealand, New Zealand
(email: [email protected])
Abstract
The development of a commercial investment property such as a large office block often involves a
lengthy process which may extend for 5 – 8 years from inception to completion. Over that time the
risk profile of the development may change due to changes in the economy or with technology. It is
therefore useful to ask how the risks that arise from the long term nature of such developments can
be managed. This paper presents a case study of an office block in Auckland, New Zealand with a
focus on these risk management issues. It was found that the case project was managed by breaking
into phases much as the literature suggests. A major component of the developers risk management
strategy was to negotiate with the principal tenant and landowner (a bank) for a period of over four
years. At the end of this period the developer had either eliminated or reduced to an acceptable level
all major risks. Only at that point did the developer finally commit to the project. The project also
demonstrated a clear use of review points and decision gates as a means of exercising project
governance and risk control. The arrival in the market of a green star rating system and technology
resulted in a late decision to change the building design to achieve a five star rating
Keywords: property development, risk management, project governance.
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1. Introduction
The development of a commercial investment property such as a large office block often involves a
lengthy process which may extend for 5 – 8 years from inception to completion. Over that time the
risk profile of the development may change due to changes in the economy or with technology.
Developments of this nature completed in 2009 were initiated in a period of economic boom but
delivered into the market post the global economic collapse in 2007. In addition over the period of
their development significant advances have been made in the design and assessment of green
buildings and with that market perceptions of the desirability of green buildings as investments. It is
therefore useful to ask how the risks that arise from the long term nature of such developments can be
managed. This paper presents a case study of an office block in Auckland New Zealand with a focus
on these risk management issues.
2. Literature Review
The literature review conducted prior to the collection of the case study data looked firstly the
property development process, then the risks involved in property development and finally at the
process of managing risks.
2.1 Property development process
The literature generally describes the property development process as a phased process with authors
varying in the number of phases and sub-phases. Byrne and Cadman (1984) take a simplistic
approach breaking the process into three parts, acquisition, production and disposal. Cadman and
Austin (1978) have a slightly more complex approach which acknowledges better the strategising and
investigation that is undertaken at the outset of the process. They have four phases, evaluation,
preparation, implementation and disposal. Ashworth (2002) develops thinking further with a five
phase approach which acknowledges the full life cycle of the building by including occupation and
demolition phases. Ashworth also breaks the phases into parts so that within the inception phase he
includes appraisal, strategic briefing and feasibility & viability. Similarly the design phase
breakdown acknowledges that the design is taken through a number of proposal iterations before
developed design and production information is produced. Many authors including Ashworth make
reference to the RIBA Plan of Work which in its 2007 version has five main work stages, preparation,
design, preconstruction, construction and use. These work stages are then broken down into eleven
sub-stages. Particularly useful for the purposes of this paper are the division of the preparation stage
into appraisal and design brief and the design stage into concept, design development and technical
design. However whilst the RIB Plan of Work (2007) provides an authoritative outline of the process
to design and construct a building it does not concern itself with other aspects of commercial property
development such finding tenants for the building, finding an investor to purchase the completed
development nor the issues in obtaining funding for the development. The UK Office of Government
Commerce (OGC) (2007) follows the RIBA Plan of Work but goes further in defining the control
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mechanisms within the process by establishing a series of “decision gateways”. At each of these
gateways the project must be reviewed and receive formal approval before proceeding further. Miles,
Berens and Weiss (2000) offer an eight stage model with more emphasis on the development and
testing of the basic proposal (3 stages) as well as recognition of the ongoing asset management
activity on completion of the development. Whiteside (1993) goes into the most detail with a fourteen
stage model which extends beyond the RIBA Plan of Work in recognising the extent of pre-design
investigation (five stages) as well as the financing, leasing and sale activities of entrepreneurial
property development.
2.2 Risk factors in property development
The literature recognises that property development is an inherently risky business. Flanagan and
Norman (2000) distinguish between pure risk where there is no potential for gain (such as an accident
or technical failure) and speculative risk where there is potential for both loss and gain (such as
movement in price levels in the property market).
Extensive lists of risks can be derived from many authors such as Harvard (2008), Cadman and
Austin (1978) Millington and Anderson (2007) and Newell and Steglick (2007). However Byrne
1996 usefully puts property development risk into three categories, Acquisition (the risks associated
with acquiring the right piece of land and planning approvals) Production (the design and
construction of the development) and Disposal (leasing and selling the completed development).
2.3 Risk management process
There are well established standards for risk management processes, the Australia/ New Zealand
standard AS/NZS 4360: 2004 is similar to most international standards and advocates a stepped
process of: establish the context, identify risks, analyse risks (including determining consequences
and likelihood) evaluate risks, treat risks and monitor and review. The Project Management
Institute’s PMBOK Guide (2004) has a similar approach with the following steps: risk management
planning, risk identification, qualitative risk analysis, quantitative risk analysis, risk monitoring and
control. Flanagan and Norman (2002) and Sadgrove (2005) both advocate similar processes.
Various techniques are advocated for identifying risks, AS/NZS 4360: 2004 lists, “checklists,
judgements based on experience and records, flow charts, brainstorming, systems analysis, scenario
analysis and systems engineering techniques” (p16). PMBOK (2004) has a similar list.
Risk quantification is dealt with extensively in the literature with recognition that both qualitative and
quantitative techniques are needed. The need to quantify both sensitivity (consequences) and
probability (likelihood) is generally accepted and recommended by both AS/NZ 4360:2004 and
PMBOK (2004). Some authors advocate advanced mathematical modelling techniques such as Monte
Carlo simulation (e.g. Flanagan and Norman 2000). Suggestions regarding the presentation of risk
analysis most typically propose a matrix showing the risk event together with its probability and
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sensitivity. (e.g. OGC 2004) Sometimes probability and sensitivity are shown as a score out of 5
(or10) and then multiplied to produce a total score, this is advocated by Harrison & Lock 2004. Other
authors such as Flanagan and Norman advocate the use of spider diagrams.
Within the literature risk treatment options are typically grouped under a limited number of headings
such as, avoid, transfer and mitigate (PMBOK 2004) or avoidance, reduction, transfer and retention
(OGC 2007).
Most authors such as Sadgrove (2005) and PMBOK (2004) recommend that risk management
decisions be recorded in a “risk register” and be subject to ongoing monitoring and review without
being specific about how such monitoring and review is to be conducted. However OGC (2007) does
provide useful guidance that risks should be formally reviewed at the decision gate events described
above and the project not being allowed to proceed to its next phase until all risks are satisfactorily
under control. OGC (2004) also make clear recommendations regarding the need for a “risk
allowance” in the budget to cover the potential financial impact of risks that the client has retained.
More recent literature such as Haimes (2009) and McIndoe (2009) argue that risks are
multidimensional and nuanced and as such a systems based approach looking at the resilience of the
whole organisation is needed. Such an approach needs to prepare the organisation to be resilient to a
wide spectrum of major risks including IT failure, pandemics and global economic crises.
3. Research methodology
The data for this case study was assembled firstly by collecting publicly available information from
press reports, websites etc on both the project and the environment within which it was carried out, as
well as direct observation of the projects progress. Then members of the project team and the
managing director of the development company were interviewed. Interviews were of a semi
structured nature that focussed firstly on the progression of the development and how that was
managed, then specifically on risks as perceived by the property development team and how those
risks were managed.
4. The case study
4.1 The context
The office development that is the subject of this case study was initiated in 2002 and completed for
occupancy in late 2009. It is located in the central business district of Auckland New Zealand.
The Auckland region has a population of approximately 1.3m (2006 census) which is about one third
of the total population of New Zealand. It is the largest city in New Zealand and the principal
commercial centre. Its significance as the principal commercial centre has grown progressively over
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the last three decades. Auckland currently has a population growth rate of approximately 2.5% (ARC
2007) arising from, natural growth and internal and external migration.
Auckland’s growth in the post war period has occurred firstly within a national economic regime that
until 1984 provided protection to local industry through import controls and encouragement to export
through tax incentives. However since 1984 a liberal economic management regime has existed with
few controls or restrictions. In the 2009 Heritage Foundation / Wall Street Journal survey New
Zealand was rated fifth out of 179 countries surveyed for economic freedom. It is also substantially
free from corruption with a score of 94% in the same survey which notes that Transparency
International ranked New Zealand first in its Corruption Perception Index for 2007.
At the time of inception of the project New Zealand was experiencing positive economic growth, this
continued through to 2007 when the economy went into decline as part of the global economic
collapse.
Source National Bank Quarterly Economic Forecast October 2009
In line with the overall economy returns on property investment (both income return and capital
growth) were also positive through to the end of 2008 when capital growth turned negative.
Source IDP/PCNZ June 2009
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Office face rents grew through the period to peak in 2007. By late 2009 they had fallen about 8% on
new leases. In addition the practice of offering new tenants incentives such as rent holiday and fit out
allowances had also increased (Colliers 2009). However rents on existing leases had not fallen as
they are generally prevented from doing so by ratchet clauses.
A number of other office buildings in the CBD were also developed during the period all of which
were substantially leased by the time of completion with one exception. The exception is a fully
refurbished office building of approximately 14,500m2 which was redeveloped in the period 2006 –
2009 and is currently unleased.
Overall vacancy rates declined from about 14% at the start of the period to a low of 5% in 2007 and
then rose to about 8% in late 2009 (Colliers 2009).
4.2 Green buildings
Significant interest in green Buildings emerged later in New Zealand than in Europe. The New
Zealand Green Building Council was not formed until 2005 and published its Green Star office rating
system in 2007. However most CBD office buildings reaching the market in 2008 / 2009 were Green
Star rated.
4.3 The project
The case study project is a 25 storey office building with retail at ground level and basement parking.
Net lettable area is approximately 22,000m2 of offices, 1,000m
2 retail and 180 car parks. It is located
in Queen St the main street of the Auckland CBD.
Prior to development the site was occupied by an early 80’s office building used as bank offices with
a 1930’s art-deco building at the rear of the site which had been used as a post office. The site was
owned and occupied by a major trading bank (the bank).
4.3.1 The parties
In 2002 the bank decided it wished to consolidate its Auckland operations onto one site and that in
order to achieve this it should redevelop the case study site. After scoping options the bank entered
into negotiations with an Australian headquartered developer (the developer) with a view to
developing the site as a joint venture. The developer had established operations in New Zealand over
the previous five years which included, development, construction, investment and management
activities. A memo of understanding was signed between the two parties towards the end of 2003.
This memo served as the basis for the parties working together to evolve the development. A final
development agreement was not signed until August 2006 a month before construction commenced.
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4.3.2 Project phasing
From the developers perspective the project was phased in a manner similar to that found in the
literature as shown below.
4.3.3 Project management
The project was managed by the developer through a project control group (PCG) chaired by a
development manager. Membership of the PCG changed over time as the project evolved. Initially it
comprised representatives of the developer and the bank and then grew to include representatives of
the construction division, the design team and the major non-bank tenant.
4.3.4 Leasing and selling
The initial concept for the project was a regional headquarters for the Bank. However the
development potential for the site within the District Plan (zoning regulations) allowed for a building
that was almost twice the size of the banks requirements. By the time the Development Agreement
was signed in August 2006 negotiations had progresses to the point where the basis of the agreement
was that the developer would purchase the site from the bank and develop the building. The bank
agreed to lease 60% of the floor area and take the naming rights.
Negotiations to lease the remainder of the building took place in 2007 (during the first year of
construction). As a result of those negotiations, the bank reduced its commitment to 55% and gave
up naming rights. A major accounting firm committed to leasing the upper 45% of the building and
to take the naming rights. Ground floor retail not required by the bank was leased to a third party.
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At the time of signing the Development Agreement the developer decided to hold open the option of
selling the building or retaining it in their own investment portfolio. In 2008 they put the
development on the market for sale but were unable to achieve a sale at a satisfactory price level.
4.3.5 Risk management
During the inception phase of the project the developer perceived their major risks to be:
Leasing the building beyond the banks commitment
Project takeout – either sale or transfer to one of their own investment portfolios, of the
building at a level that would produce a satisfactory development profit.
Project funding – obtaining the required funds to carry out the development at a satisfactory
price.
Design and construction risks – getting the building built to a design that met leasing and
sales obligations on time and to budget.
During the inception stage detailed financial feasibility studies were produced which enabled
sensitivity studies to be conducted. Within the feasibility studies contingency sums were
incorporated for risk items such as tenant incentives and design risk. These sums were arrived at by
judgements based on experience.
Risk management was exercised at two levels. At the higher level it was controlled by the developers
“Development Investment Risk Committee” (DIRC). This comprised the group chief executive
officer, divisional managing director, group general counsel and chief financial officer. DIRC held
responsibility for reviewing and approving the project proceeding (or not proceeding) at each major
milestone. Those milestones included, the original memo of understanding, major design milestones,
the development agreement, major construction contracts, major lease agreements and major
variations to contracts. At the second level month by month risk management was exercised by the
PCG who maintained and reviewed a risk register as part of their monthly meeting process.
4.4 Management of specific risks
4.4.1 Leasing
After negotiations had progressed to the point where it was understood that the development would
be done entirely by the developer (rather than as a joint venture) the developer formed the view that
they would be unwilling to proceed unless they had a lease commitment for a minimum of 60% of the
space. This threshold met their own internal risk management requirements and those of potential
funders, as it would provide the cashflow needed at completion of the project to service development
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loans if the project was not sold on completion. It also would make the project more attractive to
potential purchasers.
In order to ensure the project proceeded the bank undertook to lease that level of space despite it
exceeding their requirements. Their intention was to then sub-lease the surplus space before
completion of the project. However the bank was able to reduce some of its commitment when
negotiations were completed with the accounting firm to take 45% of the space together with naming
rights some fifteen months after the development agreement was signed.
4.4.2 Project takeout
As indicated above the developer retained this risk at the time of signing the development agreement.
In 2008 they attempted to sell the development but were unsuccessful and have consequentially
retained the building. Whilst information on this specific building is not available, Property Council
of New Zealand (2009) data shows that capital values have declined by 6.9% since the peak of the
market in 2007.
4.4.3 Project Funding
Because the minimum leasing threshold as described above was achieved as part of the development
agreement the developer was able to provide potential funders with certainty of cashflow to service
development loans on completion of the project. In addition the project financial feasibility studies
demonstrated that the project met funders other criteria such a profit margins. Obtaining project funds
was therefore not a problem.
4.4.4 Design and construction risks
Design and construction risks were substantially passed to the developer’s construction division by
negotiation during the inception phase and by formal contract at the time of signing the development
agreement. However not all risks were passed.
Immediately prior to the signing of the development agreement the developer took the decision in
principle that the building should have a five star green building rating. This was largely driven by a
desire to ensure the building would be competitive in the market place in the long term and to meet
the needs of the accounting firm tenant. Changes to the design and final commitment to the additional
costs were not confirmed and signed off by DIRC until a year later in October 2007. However some
work to achieve the green star rating was implemented before final sign off. For instance the
recovery and recycling of demolition material and adjustments to the structure to incorporate double
skin cladding on the west face. The costs of the changes to meet the green star requirements were
covered by contingency sums built into the financial feasibility before the development agreement
was approved by DIRC.
The developer also retained the risks associated with unforeseen ground conditions and inclement
weather. Delays for these reasons did eventuate and amounted to about one hundred days. The
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contractor mitigated some of this delay through accelerating the tower construction by using a second
crane, nevertheless some delay and expense was experienced.
4.4.5 Heritage issues
Although not seen as a significant issue at the outset of the project the art – deco building at the rear
of the site did provide difficulties during the planning consent stage. The City Council deemed that
the façade of the building together with some interior elements were of historical significance.
Through a process of negotiation which took over a year it was agreed that the façade would be
retained and that some interior elements adjacent to the facade (particularly ceiling details) would be
replicated in the new building. This added cost to the development and compromised the floor to
ceiling height of the podium floors. It also caused a significant delay in the design phase of the
project. However this issue was fully resolved and all impacts understood at the time of signing the
development agreement.
5. Conclusions
The case study in many ways reinforces the findings of the literature review but also provides
additional insights into risk management on this type of project.
The project was managed through a series of well defined phases much as described in the literature.
In the case study risk management is an integrated part of the management of the project rather than a
separate stream of management as the literature tends to imply.
In this case there was less emphasis on risk quantification than suggested in much of the literature.
Those interviewed were of the view that they understood the risks and did not need further
quantification. For instance the risk of not having secured the cash flow that comes from leasing the
property is so large that had to be brought under control before the developer was willing to proceed.
Having detailed quantification of probability and sensitivity would not have altered the required
management action.
The use of contingency sums as allowances for retained risks appears to follow the recommendations
in the literature and to have worked in a satisfactory manner. However the theoretical underpinning
of the risk allowances appears weak, relying solely on judgement based on experience.
With regard to the risks on this type of development of changes in technology the case does provide
an illustration of the nature of the risk with the decision to implement design changes to incorporate
green building technology at the start of the construction phase some three years into the project but
also three years before building completion. It also illustrates the practical difficulty of managing
such changes with work being implemented before final sign off by DIRC.
The observed practice in the case is clearer than most of the literature in the use of decision gates at
critical points. At these points the project and its risks were reviewed and decisions made to either
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allow the project to proceed further, require further work before proceeding further or potentially to
halt the project. The two tier structure used for risk management makes this practice clearer with the
DIRC exercising a governance role at these decision gate points and the PCG a continuous project
management role between decision gates.
The other insight into the practice of risk management that the case provides is in the lengthy period
of negotiation and the amount of work that was done before the developer finally committed to
proceeding with the project. Negotiations between the developer and bank started in early 2003 and
the memorandum of understanding was signed at the end of that year. However the developer did not
finally commit to the project until they signed the development agreement in August 2006 more than
three years later. In the intervening period the design had been substantially completed and risks
regarding planning approval, construction costs, funding and tenant commitment had been either
eliminated or substantially reduced. Although by that time the developer had committed significant
expenditure in design and legal fees, given the size of their organisation they could have absorbed
those costs if the DIRC had decided not to proceed and sign the development agreement. The process
of negotiating over a period of three years until risks were reduced to an acceptable level was the
major component of the developers risk management strategy.
The one risk that was not under control at the time of signing the development agreement was the end
value (sale or transfer price) of the project. The developer potentially could have eliminated this risk
by negotiating a sale to a third party before finalising the development agreement but chose not to do
so. This risk is in Flanagan & Norman’s (2000) terms a speculative risk, the developer had the
potential to gain if property prices continued to increase during the construction period or loose if
they fell. DIRC was prepared to take that risk (with a view to the potential gain) because the lease
commitment from the bank provided certainty that a cashflow was available to service the loans
needed to execute the project once the project was completed. As things currently stand at the
beginning of 2010 the value of the project is less than that anticipated and the potential benefits of
taking the speculative risks have not been realised.
This situation of the exposure to the risk of the value and timing of the sale of the project, to some
extent illustrates the issue of organisational resilience found in the literature. The global economic
collapse in 2007 not only caused problems to this project but would also have caused problems to all
projects to which the developer had similar risk exposure. In fact this project was the only major
property development that the developer was involved with in NZ. The developer appears to have
appropriate mechanisms to assess issues of organisational resilience to this type of risk by dealing
with all major risks through a single board level committee the DIRC.
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