Chapter 10: Financing Planned City Extension

Liz Paterson Gauntner
Liz Paterson Gauntner is a consultant in urban development, including economic development, public finance, and transportation modelling, with experience providing technical assistance to projects in over 10 countries.
Miquel Morell
Miquel Morell is an economist with more than 10 years of experience in urban planning consulting.

Introduction

In the world’s rapidly urbanizing countries, the question is not if cities will grow, but how. Planned city extension (PCE) is an alternative to unplanned urban expansion. In many countries, the pace of urban expansion is surpassing what is planned and served by public infrastructure. The result is informal, unplanned, segregated, and sprawling developments on the urban periphery. Wealthier communities create disconnect-ed private infrastructure surrounded by walls, and poorer communities form neighborhoods without access to basic services. Planned extension strategies are explicitly called for in the New Urban Agenda as a means to improve connectivity, enhance productivity, and support resource efficiency.

It is critical that cities begin to plan in advance of urban expansion. Such planning must specify the urban spatial patterns that reinforce economic efficiency, social integration, and environmental protection. These patterns are compact, connected, and mixed. They include the provision of a quality and connected street network, sufficient public space, a mixture of land uses, socially mixed neighborhoods, and adequate density.

In many countries, the pace of urban expansion is surpassing what is planned and served by public infrastructure.

PCE is a methodology to address sustainable urban growth at a required scale, creating an adequate supply of serviced buildable plots to accommodate population growth without the loss of affordability or the creation of informal settlements. In short, PCE sets the stage for sustainable urban growth.1

Implementation of PCE should follow an integrated “three-pronged approach,” incorporating urban planning and design, rules and regulations, and public financial management. If these three elements are not well-integrated, implementation will be disjointed or piecemeal, and the vision of the PCE will be divorced from reality.

Local governments in particular sometimes struggle to pay for what they plan, and should integrate a financial strategy into the planning process in order to support improved prioritization and leveraging of available resources. As such, creating a realistic financial implementation strategy for PCE is the subject of this chapter.

The chapter begins by explaining the self-financing PCE approach, wherein PCE pays for itself. The chapter then discusses how to tailor financial planning to a city’s financial and economic capacity. Next it explains how to conduct a rapid financial feasibility assessment to help ensure the plan is realistic. This is followed by a discussion of various ways to calculate private sector potential, as in many instances the implementation of a PCE falls to private actors. The chapter concludes with a list of key considerations for making an initial analysis of financial feasibility.

  • 1. Complementary to planned extension, planned infill and redevelopment of the existing urban core can and should also contribute to the absorption of expanding urban populations. This is particularly important for cities with insufficient density or large amounts of underutilized land in the existing urban area. Regulatory and land issues are often at the heart of whether redevelopment and infill are attractive to the private real estate sector. Infill can be a legally and politically complex process in cities with land titling issues, speculation, or political control of land. The existence of ground pollution or unusable structures on potential brownfield redevelopment sites can add cost and complexity to infill. Due to differences in financial and legal issues related to planned city infill, this chapter only focuses on PCE.

In many countries, the pace of urban expansion is surpassing what is planned and served by public infrastructure.

Linking development with revenues: The self-financing PCE approach

In an ideal situation, planned city extension will pay for itself. As development occurs, it should generate tax revenues to pay the municipality for services, including sufficient revenue to cover debt service on investments in infrastructure. For this situation to materialize there are two core requirements:

  • Financial capacity: There must be a source of sufficient upfront capital funds for initial investments in public infrastructure and services through borrowing, grants, a revolving fund, or other sources, as well as a functioning mechanism to generate revenue from land or activities in the PCE as it develops.
  • Economic capacity: There must be enough income-generating economic potential to support the required revenue streams.

Unfortunately, these two conditions do not hold true in many of the world’s fastest-growing cities. Many local governments lack sufficient capital budgets and do not have the ability to borrow or manage debt. This can be due to legal barriers, insufficient revenue, or poor financial management capacity. Local government also may lack the capacity or legal authority to generate public revenues from urban development.

Economic capacity is another common issue among growing cities that may lack a broad productive base and have high levels of poverty. Those expected to live in the city extension, particularly if they are rural-to-urban migrants, may struggle to find income-generating activities that can support their basic needs, much less make payments towards taxes or other PCE funding streams.

Despite the commonality of financial and economic challenges, PCE can still be a financially viable strategy; however, it may require support from the national level or donors, and may not be self-financing in the near term. Even urban improvement projects in high-income countries often get grants from national or philanthropic sources, so this should not be seen as an indication of financial failure. As the economy and municipal management capacity grow, PCE should begin to generate revenues.

In considering the ability of the PCE to generate public revenues, it is useful to pay special attention to land value sharing instruments. Land value sharing refers to the idea that land values frequently rise in response to public actions to improve a city or neighborhood, and that the windfall gains to private landholders can be shared in the form of public revenues to pay for public services and investments. These instruments can serve as the link between public investments and public revenues, enabling financial sustainability.

There are many instruments that can be used for land value sharing. These include value-based annual land taxes, local capital gains taxes, sale of development rights (for example, height exemption fees), special levies where property owners pay directly towards the cost of specific improvements impacting them, and many others. Land value sharing is covered more in depth in Chapter 9.2

Cities with varying levels of financial and economic capacity should consider a financial strategy for the PCE that suits their situation. This is discussed in detail in the following two sections.

  • 2. Additional resources on this topic include UN-Habitat & GLTN, Land and Property Tax: A Policy Guide (Nairobi, UN-Habitat, 2011), available from http://unhabitat.org/books/land-and-property-tax/; and UN-Habitat & GLTN, Leveraging Land; Land-Based Finance for Local Governments (Nairobi, UN-Habitat, 2016).
Herat town, Kabul

Private–public division of responsibilities

The idea of planned city extension is that the municipal government should provide an adequate supply of serviced developable plots for socially, economically, and environmentally sustainable urban growth. Embedded in this description is the idea that the private sector (developers or individual households) is responsible for what is developed within private plots, and the public sector is responsible for what is developed outside private plots, including roads, parks, schools, etc. However, in cities with higher rates of poverty, the government may choose to support private housing and businesses through subsidies or assistance programs. Conversely, in cities with a strong economic base, private sector developers may be sophisticated enough to play the lead role in implementing infrastructure and services in the PCE.

Classic PPP concession agreement models where users pay a fee for services received are one way the private sector can pay for infrastructure, particularly infrastructure used for delivery of services such as water, sanitation, and electricity. PPP models are further addressed in Chapter 7.

Broader private infrastructure provision, including roads, drainage, parks, and amenities, can be financially lucrative if combined with income-generating real estate development. In this case, a developer may play the role typically envisioned for the municipality, seeking the capital for improvements and collecting revenues from development (in the form of sales and rent instead of taxes). If it is determined that such an arrangement has significant advantages over publicly led infrastructure development, perhaps due to differences in access to financing or management capacity, the public sector may even contribute to privately led implementation through instruments such as tax abatement, assistance in land pooling, direct subsidies, or a risk-sharing arrangement.

When negotiating joint development agreements, it is critical that the public sector independently assess the level of profitability of planned real estate developments in order to give the government the information needed to seek a fair share of costs and risks.

Whether the private sector plays a large or small role in implementation, it is essential that municipal leaders ensure that private developers and households will comply with the plan and its core components, such as a connected street grid, adequate public space, density, mixed use, and social mix.

Tailoring financial planning to the city’s financial capacity

In cities with existing capacity to generate revenue through property taxes or similar means, the financial planning for the PCE will rely on ensuring the PCE’s economic success and the creation of a solid tax base. Financial planning can focus on structuring efficient and clear agreements with implement-ing partners, including national agencies, utility companies, and private developers, about the contributions to the PCE, as well as selecting the best financial instruments for low-cost financing and revenue generation. The PCE may present an opportunity for testing new financial instruments such as betterment levies, sale of development rights, tax increment financing, etc. Selection of existing or new financial instruments should carefully weigh their potential impacts, both intended and unintended. For example, some financial instruments may risk displacing lower-income households through increased taxes or land values. Such impacts should be carefully examined and mitigated if necessary.

In cities with low financial capacity, city leaders will undertake two complementary lines of work towards financial planning for the PCE. The first is to create an immediate-term plan to garner enough contributions to launch critical early investments. The second line of work is to create a strategy to improve local financial capacity so that in 5–10 years, the local government will be able to assume more financial management of PCE implementation, including both capital and operating expenditures. These two lines of work are discussed below.

Lilyfield - Midrand, South Africa

Immediate-term financial coordination plan

The major hurdle in the minds of many local leaders is the first task, involving financial planning for PCE investments in the immediate term. These contributions must be secured without any promise that they will be repaid through PCE-generated revenues. This may sound like an impossible undertaking, but can often be seen as a matter of coordination of existing grants from donors and national agencies.

One example of such a situation is a planned city extension in Rubavu, Rwanda, where the district government is only generating 17 per cent of the local budget through own-source revenues, amounting to less than US$7 per district resident. The district’s capital budget, the main source of funds available for the PCE, is 100 per cent funded through national transfers. In order to create a feasible PCE financial strategy, the PCE plan was adjusted to reduce costs by making changes to the highest-cost planned investments (for example, one change was the recommendation to pave only some roads). Contributions from private developers and potential for a water concession agreement were explored. Under the proposed scenario, the bulk of initial investments in the PCE will be paid for by central transfers to the district’s capital budget, in coordination with some developer contributions to infrastructure, and a pilot water concession agreement. Water tariff levels were determined by a prior UN-Habitat study at levels that could both cover costs (including investments costs) and be afford-able for lower-income households. Simultaneously, the national government is pursuing major reforms to tax administration to make decentralized revenue generation more effective.3

A PCE with even fewer resources is that in Naca-la-al-Velha District, in northern Mozambique, where the district has a capital budget that is only able to cover 4 per cent of the Phase 1 cost and has no authority to collect taxes due to its administrative classification. Key stakeholders met to discuss PCE implementation, and the district was able to identify funding to pay for an additional 29 per cent of the investment costs for Phase I from national agencies working in the area. Even these funds will rely on the ability of stakeholders to agree to direct their investments in ways that comply with the PCE rather than previously planned uncoordinated investments. The remaining funding gap (67 per cent) can potentially be met by two large private-sector funding sources. One is the Nacala Logistics Corridor Consortium led by Vale, which has expressed interest in the PCE and willingness to fund investments that will contribute to the sustainable development of the area through their Social Investment Plan. Another is infrastructure planned and implemented through GAZEDA, Mozambique’s agency in charge of industrial development, which has significant activities in the region and has not yet coordinated funding or planned investments with the District’s PCE. After a recent stakeholders meeting, an action plan was agreed upon that includes formation of an Implementation Working Group composed of key stake-holder agencies, a fundraising conference, and a legal examination of the district’s possibilities for own-source revenue generation.4

Takeaways from the experiences of Rubavu and Nacala-al-Velha are that the most critical capital investments for success of the PCE can be funded through coordination of existing funding streams from (a) local capital budgets, (b) national funding agencies and infrastructure funds, and (c) the private sector, which has an economic interest in the orderly development of the city. However, coordination of these funding sources is critical, and the capacity of the lead coordinating agency must therefore be an immediate focus of financial planning actions.

Financial capacity and revenue enhancement

Finding sources of funding for Phase I of PCE implementation should be paired with efforts to improve own-source revenue generating capacity. If successful implementation of PCE is not paired with good financial management, particularly the ability to generate public revenue from land, there will be a huge missed opportunity for the city: As the value of the land within the PCE increases due to good planning and public investments, there will be large unearned windfalls to private landholders at the city’s expense. Furthermore, failure to appropriately generate public revenues from the PCE is a threat to the sustained health of the area. Without public revenue, maintenance of investments will not keep pace with deterioration, and the quality of services will degrade. Disinvestment in the PCE after initial implementation will cause enormous losses for both the city and its residents.

Revenue enhancement should begin with an assessment of current weaknesses and opportunities for improvement. This assessment can examine both policy and administration. Successful administration of land value sharing instruments will include up-to-date records, a fair and efficient valuation system, and functioning systems for billing, collection, and enforcement.

Beyond basic tax administration, taxpayer compliance is likely to be better where there is a strong social contract between taxpayers and the local government. Taxpayers should be able to see that payment of taxes benefits them through the services the local government provides. All else equal, the more visible the benefits of taxes are, the more willing taxpayers will be to comply with timely payments.

  • 3. For more information, see Paterson, Morell, Kamiya, and Möhlmann, Rubavu District Planned City Extension Phase I (2015-2025) Financial Plan (Nairobi, UN-Habitat, 2015).
  • 4. 1 For more information, see UN-Habitat, “Rapid Financial Feasibility Assessment for Planned City Extensions (PCE)” (Nairobi, UN-Habitat, 2016).

Tailoring financial planning to the city’s economic capacity

Cities with a solid economic base should focus on economic linkages and planning to support the needs of businesses in order to generate a productive PCE. The PCE should also attract a mixture of income types in order to prevent a socially isolated poverty trap.

One example of good planning for social mix and a variety of uses is a PCE in Cagayan de Oro, Philippines. An elevated part of the city has been envisioned as the location of a new commercial hub with the relocation of municipal government offices away from a high-risk flood zone. The surrounding area will include a network of parks and green spaces and adequate space for natural drainage. The site already has a high-income development planned and existing social housing, as well as lower-middle-income housing nearby. Additional housing mix as well as neighborhood services will contribute to a vibrant and attractive area. The area is also adjacent to a potential ecotourism site and includes the road linkage to agricultural areas that may support an agro-processing centre at one edge of the PCE, with the potential to create a range of jobs for PCE residents.5

Whether the city has high or low economic capacity, one of the goals of the PCE will be to support the economic functionality of the city. Good design (density, mixed use, connectivity, etc.) is the foundation of the economically successful PCE. The PCE should also draw upon national and subnational economic strategies to ensure that the needs of target industries are well-supported by land use and public services. This may include facilities for these industries, well-serviced space for other industries in the same value chains or clusters, or housing that meets the needs of the specific labour force in terms of location, amenities, and transport options. Working with business leaders, entrepreneurs, and investors from the private sector can help ensure that the PCE will be designed and implemented to foster firm competitiveness.

In lower-income cities, economic planning related to the PCE is even more critical and will determine the financial sustainability of the PCE in the long term. Coordination with economic policy implementation at national and subnational levels can help to foster linkages to national, regional, and global value chains.

If the economic role of the PCE is not clear after review of relevant economic policies, it is import-ant to conduct an economic assessment specific to the PCE and form a task force with both public and private participation to leverage the development of the PCE for job creation and prosperity.

In Silay, Philippines, planning for a PCE was done in conjunction with a new local economic development strategy for the city. Historically, Silay’s economy has been largely based on sugarcane farming, but a reduction in trade protections will reduce the competitiveness of Philippine sugarcane and could put many out of work in Silay. After a business survey and an analysis of strengths, weaknesses, opportunities, and threats (SWOT analysis), the city has identified three sectors for job creation: tourism, diversified agriculture, and IT, as well as the strategies to improve the business environment and support these sectors. These strategies have been incorporated into the PCE planning process. Additionally, a group of land owners is working with the city to attract new industries to an enterprise zone being planned in conjunction with the PCE.

  • 5. For more information, see UN-Habitat, Cagayan de Oro Planned City Extension (PCE) Final Report (Manila, UN-Habitat, 2015); and UN-Habitat, Planning City Extensions for Sustainable Urban Development: A Quick Guide for Philippine Local Governments (Manila, UN-Habitat, 2016).
Pedestrian crossing in Silay, Philippines

Rapid financial feasibility assessment: Key steps and considerations

During the PCE process financial planning should go hand-in-hand with urban design and physical planning. It is useful to do a rapid financial planning exercise as the urban design is developed in order to ensure the plan’s financial feasibility and help planners create a realistic plan. At an early stage, a back-of-the-envelope rough calculation of costs and available funds is enough to get a sense of financial feasibility. Rapid assessment has the added benefit of facilitating initial conversations among funding agencies about implementing the PCE.

The idea of rapid financial feasibility assessment is to identify who will pay for what and when. This exercise will result in a sources and uses statement identifying the major costs of PCE implementation (uses) and the sources of funding for each (sources), including both initial investments and recurring costs.

Rapid financial feasibility assessment: Basic steps

1. Assess the financial situation.

  • List general financial roles and responsibilities. (Who typically pays for what?)
  • Examine the municipal budget and available budget from other agencies.
  • Check available financing options, including borrowing, PPP, and land-based instruments (even if not currently used).
  • Assess opportunities for improved financial performance of the municipality.

2. Calculate the cost of the plan.

  • Determine which investments and operating costs will be the public sector’s responsibility.
  • Estimate quantities of infrastructure and services based on the conceptual plan.
  • Multiply quantities by generalized unit costs for each type of investment (e.g., per m2 or per household).
  • Assess ongoing costs based on population and expected infrastructure maintenance.

3. Assign funding responsibility.

  • Draw upon available agency budgets.
  • Use municipal borrowing if available and if projected revenues cover debt service.
  • Consider private sector potential to contribute.

4. Balance sources and uses.

  • Adjust the plan if needed.
  • Explore alternative financing options and options for revenue enhancement.
  • Modify implementation phasing if needed.

The costs of initial implementation can be estimated from the conceptual plan, multiplying the quantities of public infrastructure and services by basic unit costs for each. This can be done for multiple planning scenarios, including business as usual, and can be useful in demonstrating the higher costs of sprawling, disconnected development. This initial rough estimate of costs will have a high margin of error; however, the figures will be updated later, as the detailed plan is created and implementing agencies conduct their own studies.

Recurring annual costs should be estimated based on the current operating budget, expected population growth, and infrastructure lifecycle costs.

Note that rapid financial feasibility assessment will focus on costs and funding for areas of public responsibility. However, an assessment of private sector financial feasibility can be useful as a separate exercise, particularly when assessing whether planned land uses and densities are realistic under market conditions and whether private developers have high enough profitability to support exactions or other negotiated contributions to infrastructure, services, or social housing (see the next section).

Matching sources with uses is the next step, and will likely involve conversations with multiple implementing agencies about their available budgets and financing options. This may include utility companies, donors, and national ministries in charge of roads, education, health, and/or social housing. After initial conversation with these agencies and organizations, it may become clear that their plans or the plan for the PCE may need to change. For example, in the case of the PCE in Nacala-al-Velha, Mozambique, a large housing investment was planned by the national Housing Fund (Fundo de Fomento de Habitacão) outside of the boundaries of the PCE, and without corresponding roads or utilities. The PCE planning process has opened communication about this planned development, and the Housing Fund will hopefully adjust its plans to fit into the district’s vision of a compact, connected, and serviced urban core.

In addition to vertical coordination, horizontal coordination may also be important, particularly in urban areas where development extends beyond the municipal administrative limits. City extension planned for an area that falls partially or totally outside the municipal boundaries of the primary city presents an administrative challenge that is reflect-ed in financial planning for implementation. In such a case the municipality must coordinate carefully with the other jurisdictions involved to develop a fair and equitable distribution of financial responsibilities and revenues. There are various models available for metropolitan coordination, and various types of metropolitan governance structures. Some approaches are summarized below.

Approaches to metropolitan governance

6The main models and approaches to metropoli- tan governance are the following:

  • Cooperation among local governments partnerships, consultative platforms, etc.
    • Case-by-case joint initiatives
    • Contracting among local governments
    • Committees, commissions, working groups, partnerships, consultative platforms, etc.
  • Regional authorities (sometimes called “special purpose districts”)
    • A metropolitan council of governments (COG)
    • A regional planning authority
    • A regional service delivery authority
    • A regional planning and service delivery authority
  • Metropolitan-level government
    • Metropolitan-level local government
    • A regional government established by a higher tier of government (federal, state, or provincial)
  • Annexation of territory or amalgamation of local governments.
  • 6. For a more in-depth look at models of metropolitan government, including international examples, see E. Slack, “Innovative Governance Approaches in Metropolitan Areas of Developing Countries,” in The Challenge of Local Government Financing in Developing Countries (Nairobi, UN-Habitat, 2015). Available from http://unhabitat.org/books/the-challenge-of-local-government-financing-….
Source:
Excerpt from M. Andersson, “Metropolitan Governance and Finance,” in C. Farvacque-Vitkovic and M. Kopanyi, eds., Municipal Finances: A Handbook for Local Governments (Washington, World Bank, 2014), p. 51.
Women walking in Nacal Porto, Mozambique

After an initial attempt to match costs and funding, adjustments may need to be made to achieve financial feasibility.

If debt financing is an option, the municipality will need to assess whether the PCE will generate sufficient revenues to cover debt service. Risk assessment, as well as sensitivity testing under scenarios where revenue projections fail to materialize, is prudent to ensure that the municipality will be able to meet its financial obligations. In cities where debt financing is an option, legal regulations and internal procedures governing borrowing will play a role in assessing whether debt financing is a viable alternative for the PCE. For example, planners who designed a city extension in Iloilo, Philippines, could count on good compliance with property taxes from residential and commercial developments in the PCE. This opened the option of borrowing to finance a portion of public investments with plans to pay debt service through property tax revenues. This borrowing will comply with debt service limits established by the legal code.

After an initial attempt to match costs and funding, adjustments may need to be made to achieve financial feasibility. These adjustments can fall into three categories: changes to planned expenditures, development of alternative financing strategies, or changes to implementation phasing.

Changes to planned expenditures

It may be necessary to alter the plan or forgo some planned improvements due to their cost. This prioritization process must consider economic, social, and environmental goals. The views and priorities of key stakeholder groups, including vulnerable populations such as women, youth, and low-income households, should be considered.

One example of adjusting planned expenditures is the PCE in Rubavu District, Rwanda. The initial plan far exceeded the district’s capital budget. To improve feasibility, UN-Habitat recommended that the three largest capital costs be reduced. The first was the piped sewerage system originally planned, which would require huge investments, including a costly wastewater treatment facility. Instead, subsidies for high-quality on-site sanitation would reduce capital costs while still providing adequate sanitation for the city. As the city grows economically and in population, both the need and the revenue for a piped sanitation system will increase.

The second major planned expense was for social housing. UN-Habitat recommended that instead of providing fully built houses for low-income house-holds, the district could instead facilitate access to low-cost serviced land, allowing households to build incrementally on well-planned plots that will transform over time. Under such an arrangement, the dramatic reduction of costs would allow the district to reach more households while ensuring that funding for basic infrastructure and services remains. While housing quality will likely be low at first, access to services and security of tenure provide stability for gradual self-upgrading. At the same time, the lowest-income families may still need support to obtain a basic dwelling.

The third major cost reduction was based on the idea that the district doesn’t need to pave all Phase I roads immediately, but can leave local connections unpaved as well as some of the width of major roads. Importantly, adequate space for street paving and widening for the long-term transformation of the district will still be reserved and protected from private development. In cases like Rubavu, less-than-ideal services should be planned in a way to allow for upgrading at a later stage of development.

Another example of alterations to an extension plan based on financial analysis is the City of Galt, California, U.S.A. Galt is a small agricultural town, but in 2011 decided to update its land use plan due to projected population growth that will likely more than double the city’s size by 2030. The city analyzed the public expenditures and revenues associated with a residential expansion plan and found that its initial plan was not financially feasible. From there, the City considered alternative scenarios involving higher densities and a mixture of uses, and deter-mined that mixed-use development was the best option from the standpoint of public finances, providing enough revenues to complete payback of public loans within the required 30-year time limit. The financial model showed a fiscal gap of approximately US$600 per unit for the original fully residential plan, showing that the city could implement it only with additional fees totaling $600 per new unit.7

Development of alternative financing strategies

A planned city extension provides an opportunity to pilot new financing strategies. Because the government will be creating value through good planning and public services, this value can be leveraged to generate public revenues or in-kind private sector contributions. The municipality should consider the possibility of developer exactions and public–private partnerships, in addition to land-based financing instruments such as betterment levies and sale of development rights. In most cases, some of the PCE’s residents will be less able to bear the burden of taxes and fees than others. This should be incorporated into financial planning for the sake of both financial feasibility and social equity. A community serving only middle- to high-income households does not serve the core purpose of a PCE, which is to serve as an alternative to informal, unplanned, and unserviced development. If the PCE excludes poor households, they will settle elsewhere.

Piloting of new financial instruments may require creation of a new agency or coalition with capacity to manage implementation, such as a municipal development corporation or a special purpose vehicle. If the municipality lacks authority or capacity to use new financial instruments, the new agency may need to exist at a higher level of government, with municipal representation.

Changes to implementation phasing

The buildout of infrastructure and services can be spread over time to reduce the financial burden and make revenues from the initial phases available for reinvestment in later phases. This can be particularly useful where investments in Phase I will provide a substantial increase in local revenue. Some PCE-wide investments will be necessary early on (for example, connector roads or a solid waste facility), while others may be built out at a pace to match population growth and avoid unplanned development spillover.

Typically, delineating road and public space reserves for the entire extension during the first phase of implementation is a shrewd tactic to ensure that if unplanned development does occur, public spaces will be protected. It can be legally, financially, and socially difficult to reclaim this space later if it becomes occupied.

  • 7. Sacramento Council of Governments (SACOG) & AECOM, Utilizing the Integrated Model for Planning and Cost Scenarios Tool to Understand the Fiscal Impacts of Development: A Spotlight on the City of Galt (Sacramento, SACOG, 2011).

Calculating private sector potential

As previously noted, the implementation of the PCE may fall to either public or private actors, or some combination of the two. Many times, the private sector focuses on the development of built real estate products within publicly serviced plots. Government leaders may still wish to conduct a financial assessment of planned private development in order to (a) ensure that planned land uses can be supported by the private real estate market and (b) check the level of profitability for the sake of negotiating developer exactions. This type of private sector feasibility assessment should be based on traditional methods of analysing real estate investment. These will be influenced by the basic concepts examined briefly below.

Risk and time as the basic financial principles

Every planned city extension project is implemented over a period of time that, in many cases, spans several decades.

Bearing this in mind, the time factor takes on crucial importance in these kinds of projects, and must be taken into account and incorporated as another cost to be considered in the feasibility of the PCE.

There are two fundamental financial principles that illustrate the importance of time and risk as indispensable variables to be taken into consideration: 1) A dollar today is worth more than a dollar tomorrow, because a dollar today can be invested to start earning interest immediately, and 2) A safe dollar is worth more than a risky one, for which reason most investors avoid risk if they can do so without sacrificing profitability.8

  • 8. B.A. Brealey and S.C. Myers, Principles of Corporate Finance, 5th Edition (n.p. McGraw-Hill/Interamericana de España, SAU, 2001).

Time as a cost in an investment project

Imagine an investment project that requires an initial investment of $150,000 and in the following two years will generate a positive cash flow of $100,000 and $300,000, respectively. A first look at the economic results of the project involves calculating the total cash flow balance generated by the project ($250,000).

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This static approach does not include time as an additional cost of the project. In order to include the time costs, it is necessary to determine what rate of return a typical investor interested in carrying out the project would demand to accept this deferred income. This is called the opportunity cost of capital, discount factor, or hurdle rate. If we assume the opportunity cost of the invested capital is 7 per cent, we can see that the project’s economic and financial results change, and that the surplus economic resources are now $205,400. Part of the previously shown economic returns has had to be reduced to offset the time factor, evaluated as the opportunity cost of the capital invested by the typical investor ($44,600 in this example).

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Risk as a cost in an investment project

There are a number of risk factors involved in investments related to the development of a particular area (e.g., management risk, liquidity risk, legislative risk, inflation risk, interest rate risk, environmental risk, archaeological risk, etc.), and not all investments entail the same level and type of risk. Real estate development is, generally speaking, more risky than government bonds (i.e., gilt-edged securities), and the development of rural land into serviced urban parcels is likely even more risky than the construction of the final real estate product.

Therefore, depending on the risk inherent in each investment project, we need to add a risk premium to the opportunity cost of the capital, as appropriate for that particular project.

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Net present value and internal rate of return as metrics of financial feasibility

Net present value (NPV) is the indicator par excellence, and its purpose is to update, at any given moment, all cash flows generated by the investment project under analysis:

equation

CF = Estimated cash flow for each time unit (year, six-month period, etc.)

i = Discount factor applied to each time unit

n = Number of time units estimated for the investment project (years, six-month periods, etc.)

 

A project with a positive NPV means that:

  1. It has returned all capital invested.
  2. It has paid back the cost of all resources used to fund it.
  3. It has generated an additional surplus equivalent to the volume indicated by the NPV in question.

NPV is the best indicator for the economic and financial assessment of any urban transformation project since it is the indicator, along with the internal rate of return (discussed below), that takes into account the time value of money and that is based solely on the inflow and outflow of economic resources provided for in the project and on their opportunity cost.

The internal rate of return (IRR)

IRR is defined as the interest rate at which the NPV would be zero.

equation

CF = Estimated cash flow for each time unit (year, six-month period, etc.)

i = Discount factor applied to each time unit

n = Number of time units estimated for the investment project (years, six-month periods, etc.)

Thus, the IRR tells us the maximum discount rate that the investment project can incur to achieve a NPV equal to zero. Above this rate, the NPV will be negative. This implies that the higher the IRR, the higher the chances of the project having a positive net present value with regard to the discount rate used. The IRR provides the criteria for us to choose the investment projects that offer return rates higher than the opportunity cost of capital.

Many operators, both public and private, prefer the criteria of the IRR to the NPV. Although both criteria, when properly laid out, are formally equivalent, we must point out that the IRR has some weaknesses that we must consider when using it as a benchmark (multiple rates of return, mutually exclusive projects, etc.).9

Types of private developers involved in PCE implementation

Investors in the real estate market can be individuals, partnerships, corporations, or corporate entities specifically designed for real estate investments, such as real estate investment trusts (REITs). The common theme is that all are seeking to utilize available market knowledge and financial tools in order to acquire profitable real estate investments. One of the differentiating factors among these entities is the cost of capital and the financial structure available to execute urban development.

It is obvious that, depending on the type of investor implementing the plan, the economic and financial results of the project will be different. For example, short-term investors will likely be more interested in standard and market-tested real estate products where serviced plots are already available. Similarly, some real estate development firms have the capacity to construct buildings but lack experience and interest in infrastructure provision. On the other hand, some developers also specialize in land development, including infrastructure provision, which can be useful for projects where the government lacks management capacity or ability to borrow. Additionally, if the plan seeks to promote new real estate products that are not yet prevalent in the market (e.g., mixed-use buildings in a city where all land uses are separate), the government may need to actively seek a developer with a longer-term social vision and willingness to experiment.

The sources of real estate capital are diverse, ranging from individuals to large organizations and institutions and, depending on the financial cost of these sources of capital, the economic and financial results of the transformation project may be larger or smaller. For example, a real estate project that is executed by an asset-based operator that makes its pro t in the long term by renting its assets along with equity-based financing will not produce the same result if it is implemented by a real estate operator whose profits are based on the sale of housing off-plan and a liability structure based on bank debt.

The financing structure of an urban transformation project is usually based on one of the two main sources of nance, debt and equity, and there are numerous financial actors involved in each of these two sources. In the case of debt financing, for example, the actors include banks, commercial mortgage-backed securities, insurance companies, mortgage REITs, government credit agencies, pension funds, and private, nonbank, untraded funds. In the case of equity financing, there are other actors, such as private investors (develop- er assets and equity, local investors, landowners, opportunity funds, hedge funds, sovereign funds, private financial institutions, family offices, etc.), equity REITs, and pension funds. To ensure the success of a project, it would be advisable for it to be undertaken by a specific operator that can guarantee the capital cost of the operation.

  • 9. For detailed information see UN-Habitat, Draft Technical Guidebook for Financing Planned City Extension: The Economic and Financial Feasibility of Urban Planning (Nairobi, UN-Habitat, 2016).

The ability to forecast future market behaviour

When assessing the financial feasibility of real estate projects, it is important to forecast the sales price of the final constructed units. To do this requires forecasting future supply and demand scenarios of real estate products; however, even a meticulous analysis will never be able to reduce the risk of future uncertainty to zero. This component of uncertainty is an integral part of an investment project, equivalent to risk—a cost that, as explained earlier, must be included if the intention is to attract private resources to execute the urban planning project.

Forecasting future real estate prices can begin by examining market trends, population growth, and whether the supply of real estate has generally kept up with housing demand. Population projections paired with economic projections can help determine the demand forecast, and previous supply-side behaviour can be projected forward. Information about other real estate units entering the market, the land management and planning regulations in force, future planning strategies, the market absorption rate for current real estate products, the phase of the real estate cycle, the ability of households to purchase a property or to acquire one by alternative means such as renting, etc., can also influence projections.

The financing structure of an urban transformation project is usually based on one of the two main sources of finance, debt and equity, and there are numerous financial actors involved in each of these two sources.

One of the most serious problems city leaders face when considering future market behaviour is obtaining transparent and accurate data with which to make a reasonable estimate of supply and demand. Independent private firms with experience in real estate can be contracted to assist with market analysis; however, this can be costly and should not be done if the potential benefits to forecasting do not outweigh the costs or if there is a conflict of interest.

There is an added layer of complexity when considering price forecasts for a planned city extension, since one of the goals of the PCE is to provide a large enough supply of buildable land to preserve urban affordability. If the PCE will achieve its goals, one could assume that property values will be similar to current prices or that they will be affordable to the majority of the expanding population. A cautionary note is that flooding the real estate market to alleviate price increases is against the developer’s profit interest. Therefore, planners who intend to have an impact on real estate affordability should work with other city leaders to prevent build-out by a small number of large developers who can restrict supply.

Depending on the market conditions and income status of the urban population, it may not be financially feasible for PCE beneficiaries to pay the prices required by the real estate sector. In such cases, private market-based development should be paired with subsidized housing options and/or models where lower-income households can obtain land and build incrementally, using designs that enable future densification.

Summing up, the ability to forecast the future market behaviour is not easy. However, forecasting and planning is not a theoretical exercise but rather a road map for the person or agency taking on the risk by leading the process, whether in the public or private sector. This lead actor will need to take into account both macroeconomic and microeconomic variables such as the land management and planning regulations in force in the region in question, future planning strategies, the market absorption rate for the real estate products included in the plan, the phase of the real estate cycle, the ability of households to purchase a property or to acquire one by alternative means such as renting, etc.

Housing in the outskirts of Lima, Peru

Concluding recommendations

PCE implementation can be expressed as a succession of expenditure flows corresponding to the cost of land development and subsequent real estate development, in addition to the revenue flows corresponding to the income obtained from the real estate products once placed on the market. The temporary balances between negative and positive flows demand a financing proposal that determines the profitability of the urban development.

There are a variety of methodologies available, some more complex than others, for evaluating the financial feasibility of implementation, but which-ever is used must be adapted to the specific circumstances of the particular plan. If common sense is not used, a rigid analysis could lead to a misleading or even nonsensical outcome.

The following is a list of key considerations for making an initial analysis of financial feasibility:

  1. The public and private sector actors responsible for each planned element
  2. Phasing of implementation allocating the investments in each phase
  3. The total costs attributable to each element of plan implementation
  4. The potential revenue to both the public sector (taxes and fees) and private sector (rents and sales)
  5. The options available for financing investments, and the financial cost/cost of capital
  6. Metrics of financial feasibility, such as NPV, IRR, or other metrics of private developer profitability
  7. The ability of implementing actors to finance and manage planned implementation
  8. The ability of intended beneficiaries to utilize the PCE based on their needs and income status
  9. The tax balance sheet for the plan measured in terms that guarantee future sustainable economic management
  10. The balance between the investments assigned by the proposal to the different public administrations involved and their economic and financial capacity to assume them throughout the planned timescale

With these considerations in mind, local governments can test whether their plans are financially feasible for those who will implement the plan. If PCE adjustments are required, it is better to discover this while still in the planning process and to make necessary adjustments.