Limited academic literature only provides a partial answer

Real estate developments are known to be risky and consequently, institutional investors limit their exposure. The problem is however, that hardly anybody really knows the risk return profile of development. It is known that development projects are typically requiring a 20-30% development return. It is also known that developments are especially risky in downturns when development companies are struggling to stay solvent. Translating these return requirements and risks into a measurable risk return profile hasn’t been done yet; at least not by academic
research. I believe, however, that this should be basic information to make an appropriate strategic allocation and investment decisions.

The real estate development process can be split in four stages: pre-construction, construction, lease-up and stabilisation phase. The first phase is about getting the right permits, securing land and designs. This is a risky stage with a high probability of failure, but the investment is only limited.

Figure 1: Typical real estate development process with visualisation
of cumulative investment (blue) and risk level (orange)

The construction phase is the most challenging one. This phase requires the majority of the investment, which is locked in at the start and will be drawn over the construction period. In this period, profitability can decline by, changing market fundamental, costs overruns and delays, while it can increase by market movements. So, relative to standing investments, there are more downside risks. The last 2 phases are covering the risk of leasing up and stabilisation of the asset.

When reviewing academic literature, there are not many papers covering the risk and return profile of developments. I highlight the 3 most relevant papers:

1) One of the first papers focused on the return of developments was based on REITs, by Brounen andEichholtz (2004) ¹ . They demonstrated that there was a positive link between the amount of developments and returns for REITs. But as expected, also the volatility was strongly correlated.
2) The first study on direct real estate was done by IPD (now MSCI) in 2010 ². This paper actually showed lower average returns and higher risks for developments compared to standing investments. The paper led to a lot of discussion, as some of the assumptions were questioned (like the exact timing of the end of development and sectoral differences).
3) The third paper is written by Geltner et al. (2021) ³ and focuses on REITs, as these data are widely available. It is similar to the first paper, but now with much more data and detailed analysis. It concludes that there is a positive relationship between development pipeline and company value, but it also highlights a stronger impact of busts relative to the boom periods. As with financial leverage, it hurts a lot on the downside, while it adds value on the upside. It also discovers a negative impact of development land on company value.

The academic research on developments is rather limited, focuses on return and is skewed to listed realestate. Unfortunately, there is still a lack of research on risk levels, sectoral differences, impact development length and an understanding whether the relationship
is linear or not. Based on experience, I believe the relationship is similar to financial leverage: a bit of leverage is nice, but too much is negative for overall.

¹ Brounen, D. & Eichholtz, P. (2004), Development involvement and
property share performance: international evidence. The Journal of
Real Estate Finance and Economics, 29, 79-97
² IPD, The Performance of UK Commercial Property Developments,
2010
³ Geltner, D., Kumar A. & Van de Minne, A.M. (2022): Is There Super-
Normal Profit in Real Estate Development? Journal of Real Estate
Research