The Key to Successful Property Development
An important insight that can significantly impact property development success is determining the highest and best use of a site. Determining the highest and best use of a site plays a crucial role in its success. Over the past 14 years, our team at Development Finance Partners (DFP) has assessed thousands of project feasibilities and financed numerous projects across various asset classes and sizes, spanning all phases of debt and property cycles. This extensive experience has given us a unique perspective on what sets successful property developers apart—chief among them is their ability to identify the optimal use of a site.
What Is the Definition of Highest and Best Use?
The term "highest and best use" is widely recognised in real estate and property appraisal. It refers to the most profitable legal use of a property, determined by evaluating four key criteria:
- Legally Permissible: The use must comply with zoning laws, regulations, and other legal restrictions.
- Physically Possible: The property’s size, shape, topography, and accessibility must support the intended use.
- Financially Feasible: The proposed use should generate sufficient revenue to justify the investment.
- Maximally Productive: Among all feasible uses, this identifies the one that yields the highest return on investment.
From a financing perspective, incorporating the concept of Risk-Adjusted Return on Capital (RAROC) further enhances this definition. By applying RAROC, property developers can evaluate how to:
- De-risk the project
- Save time
- Reduce cash equity requirements
In simple terms, the highest and best use is determined by answering this question: What generates the most profit, with the least risk, in the shortest possible time, and with the lowest cash equity investment?
Where to Start in Determining the Highest and Best Use
The best approach to identifying the highest and best use of a site is by conducting a base case project feasibility analysis. This should be supported by a cash flow model, funding tables, and a structured development program that outlines key project and risk milestones.
The Development Program
A development program integrates four essential components:
- Project Feasibility: Establishes the project’s profitability.
- Contractual Milestones of Risk: Defines key project deadlines and associated risks.
- Cash Flow Forecasting: Determines when and how various development costs (design, approvals, construction) will be funded and by whom.
- Funding Tables: Identify the required loans and cash equity at different project stages.
A well-structured development program is crucial for mitigating risks such as:
- Finance approval risk
- Development approval (DA) risk
- Market risk
- Project feasibility risk
- Land settlement risk
Key Financial Metrics to Measure Highest and Best Use
At a minimum, a well-developed financial strategy should produce the following key metrics:
- Development Margin on Total Development Costs (TDC): Measures profitability relative to total costs.
- Internal Rate of Return (IRR) on Cash Equity: The most critical metric for developers looking to scale their portfolio.
- Total Project Profit: The absolute profit figure derived from the project feasibility.
These financial metrics should be compared against alternative development programs to determine the best option.
Why IRR on Cash Equity Is Critical
For most emerging property developers, cash equity is the most limited resource. Efficiently leveraging cash equity while managing risk is crucial to scaling up a development portfolio.
To maximise returns, developers should consider:
- How much cash equity is required throughout the project lifecycle
- The timeline for equity deployment and repayment
- Strategies to minimise equity outlay while maximising returns
Final Thoughts
Determining the highest and best use of a development site requires careful analysis of project feasibility, cash flow forecasting, and risk management. By structuring a comprehensive development program and integrating a funding table, developers can optimise capital efficiency, mitigate risks, and achieve strong financial outcomes.
The ultimate goal is to:
- Maximise profit
- Minimise risk
- Achieve results in the shortest possible timeframe
By taking a strategic approach to financing and risk management, developers can ensure their projects stay on track and deliver the best possible returns.
Let’s Discuss Your Development Finance Strategy
Want to make sure your project is financially structured for success? Let’s chat about how we can help you navigate the challenges of development finance and maximise your returns.
