Development appraisal

1
Development appraisal

• Residual Method

2
Residual Method

• Assumes an element of residual value is released
  after development has taken place
• Used to determine a snapshot of either
• Land value
• Developers profit
• Involves estimation of lots of inputs, which can
  lead to wide variations in valuations
• Usually refer to comparable evidence to estimate
  inputs
• Pre-cursor to more rigorous (cash-flow)
  techniques
• Useful for testing alternative development schemes

3
Residual Method

• Value of completed development
• - Development (construction, fees, finance, etc.)
  costs
• - Developers profit (e.g. costs or value)
• Residual land value
• Equation can be rearranged to estimate profit
  once land cost is known (i.e. from valuation to
  appraisal)
• Land prices per hectare of similar sites that
  have recently been sold provide a useful check
• The residual valuation of a development site
  usually begins broadly at the evaluation stage
  and is gradually fine-tuned before the site
  acquisition and construction phases

4
Residual land valuationsimple example

• Development opportunity for 5,000m2 offices that
  it is estimated will let for 130/m2 and sell at
  an initial yield of 8
• Construction costs are estimated to be 800/m2
  and the development will take, after a lead-in
  period of 0.5 years, 1.5 years to complete, plus
  a void of 0.75 years
• The developer is seeking a minimum return on
  development value of 20
• What is the value of the site?

5
Simple residual land valuation
(dont worry about timing of completion yet)
Development value (DV)
Total constructed area (m2) 5,000
Estimated market rent (/m2) x 130
Estimated annual market rent () 650,000
Capitalised _at_ 8 x 12.5
8,125,000
Less Development costs (DC)
Construction costs (5,000m2 _at_ 800/m2) Construction costs (5,000m2 _at_ 800/m2) -4,000,000
Profit on construction costs _at_ 20 DV -1,625,000
-5,625,000
Residual land value (RLV) 2,500,000
6
Residual land valuationdetailed example (1/4)
Development value
Net internal area (NIA) (m2) 3,750
Estimated rent (/m2) x 150
Estimated rental value () 562,500
Capitalised in perpetuity _at_ 8 x 12.5
Gross development value () 7,031,250
less purchasers costs _at_ 5.75 of NDV () - 382,314
Net development value (NDV) ()   6,648,936

7
Residual land valuation (2/4)
Less Construction Costs
Building costs 5,000m2 _at_ 800/m2 () Building costs 5,000m2 _at_ 800/m2 () -4,000,000
External works () -80,000
Professional fees _at_ 14 of bldg ext costs () Professional fees _at_ 14 of bldg ext costs () Professional fees _at_ 14 of bldg ext costs () Professional fees _at_ 14 of bldg ext costs () -571,200
Ancillary costs () -150,000
Contingency _at_ 2 bldg, ext, ancillary costs fees () Contingency _at_ 2 bldg, ext, ancillary costs fees () Contingency _at_ 2 bldg, ext, ancillary costs fees () Contingency _at_ 2 bldg, ext, ancillary costs fees () -96,024
Other costs and fees
(a) Site Investigations, say () -10,000
(b) Planning fees, say () -5,000
(c) Building Regs, say () -20,000
(d) Bank's legal fees _at_ 0.5 NDV () (d) Bank's legal fees _at_ 0.5 NDV () (d) Bank's legal fees _at_ 0.5 NDV () (d) Bank's legal fees _at_ 0.5 NDV () -34,467
(e) Bank's arrangement fee _at_ 1 NDV () -68,934
(f) Developer's legal fees _at_ 0.5 NDV () -34,467
Total construction costs () -5,070,092
8
Residual land valuation (3/4)
Less Interest
on half total construction costs for whole building period _at_ 7 pa on half total construction costs for whole building period _at_ 7 pa on half total construction costs for whole building period _at_ 7 pa -270,785
on total construction costs finance for void period _at_ 7 pa on total construction costs finance for void period _at_ 7 pa on total construction costs finance for void period _at_ 7 pa -278,011
Total Interest Payable   -548,796
Less Letting Sale Costs
Letting agent's fee _at_15 of estimated rental value () Letting agent's fee _at_15 of estimated rental value () Letting agent's fee _at_15 of estimated rental value () -84,375
Marketing -5,000
Total Letting Sales Fees     -89,375
Total Development Costs -5,708,263
Less Developer's profit on total development costs _at_ 15 Less Developer's profit on total development costs _at_ 15 Less Developer's profit on total development costs _at_ 15 -856,239
TOTAL COSTS -6,564,503
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Residual land valuation (4/4)
Future residual balance (exc. profit on land) (NDV less Total Costs) Future residual balance (exc. profit on land) (NDV less Total Costs) 84,433
less Developer's profit on land costs _at_ 15 less Developer's profit on land costs _at_ 15 less Developer's profit on land costs _at_ 15 less Developer's profit on land costs _at_ 15 less Developer's profit on land costs _at_ 15 -11,013
Future balance (inc. interest on land acquisition costs) Future balance (inc. interest on land acquisition costs) Future balance (inc. interest on land acquisition costs) Future balance (inc. interest on land acquisition costs) Future balance (inc. interest on land acquisition costs) 73,420
less interest on land and acquisition costs for total development and void period (PV1 for 2.75yrs _at_ 7) less interest on land and acquisition costs for total development and void period (PV1 for 2.75yrs _at_ 7) less interest on land and acquisition costs for total development and void period (PV1 for 2.75yrs _at_ 7) less interest on land and acquisition costs for total development and void period (PV1 for 2.75yrs _at_ 7) less interest on land and acquisition costs for total development and void period (PV1 for 2.75yrs _at_ 7) less interest on land and acquisition costs for total development and void period (PV1 for 2.75yrs _at_ 7) x 0.8302
Present residual balance for land and acquisition costs Present residual balance for land and acquisition costs Present residual balance for land and acquisition costs Present residual balance for land and acquisition costs 60,953
less Acquisition Costs _at_ 5.75 site acquisition price less Acquisition Costs _at_ 5.75 site acquisition price less Acquisition Costs _at_ 5.75 site acquisition price less Acquisition Costs _at_ 5.75 site acquisition price -3,314
Residual land value 57,639
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Case Study
See hand-out
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Revenue Inputs

• NIA
• GIA 2,000 m2
• Efficiency ratio 85
• So NIA 2,000 x 0.85
• 1,700 m2
• Estimated (net) annual rent
• NIA x estimated rent / m2
• 1,700 m2 x 200 / m2
• 340,000
• GDV Estimated annual rent / yield
• 340,000 / 0.07
• 4,857,143

12
Commercial revenue

• Non-domestic land uses
• Rental value(s) (/m2 p.a.)
• Yield(s)

13
Cost Inputs

• Disposal costs
• (agent and legal fees if sold or refinancing and
  valuation fees if retained as an investment)
• NDV GDV / (1 0.0575)
• 4,857,143 / 1.0575
• 4,593,043
• Building costs building cost / m2 x GIA
• 969/ m2 x 2,000 m2
• 1,938,000

14
Fees marketing/sales

• Core development team additional consultants
• 10 20 of build costs
• Marketing
• 2-3 of value
• Letting agent legal fees
• 10 5 of annual rental value
• Sales agent legal fees
• 1.50-1.75 of NDV
• Other professionals

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Cost Inputs

• Site prep and other works
• Might include
• demolition,
• site clearance
• roads, car parking, landscaping
• engineering works and ground investigations
• contamination remediation
• Utilities (water, gas, electricity)
• compulsory purchase and compensation
• other costs associated with the development that
  are in addition to the unit price building cost
  estimated above

16
Cost Inputs

• Professional fees
• Architect
• QS
• Engineers (structural, ME)
• Legal
• Consultants (planning, highways, ecology,
  archaeology)
• Developer / project management
• Landscape architect
• Professional fees (building costs other
  works) x 13
• 2,083,000 x 0.13
• 267,540

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Cost Inputs

• Ancillary costs
• Might include planning fees, building
  regulation fees, insurance and other incidental
  costs
• Contingency (bldg costs other costs
  ancillaries fees) x 3
• (1,938,000 120,000 267,540 80,000)
  x 0.03
• 72,166
• Other costs and fees
• Estimates for various additional costs and fees
  can be included...

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Other costs and fees

• Planning application (full and outline) fees,
  building regulation fees
• S106 costs / planning obligations
• (/unit, /m2, differentiated for green and
  brownfield, off-site / commuted what difference
  does this make to profit?)
• Environmental Impact Assessment (EIA)
• Miscellaneous surveys
• NHBC costs (for residential developments)
• VAT
• Financing fees (banks, lawyers)
• Overage agreements (sales overage, disposal
  overage if site sold on)
• CPC
• Buying leasehold interests, overriding interests

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Development period stages

• US style
• Planning/pre-construction
• Construction
• Lease-up
• Stabilised operation

• UK style
• Lead-in or pre-build period
• Construction
• Void
• Disposal

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Development time-line cost build-up
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Interest

• Interest is rolled up and paid back, along with
  all other costs, at end of development period
  from proceeds (balloon payment)
• During a void period interest is payable on all
  costs so any extensions to this time period will
  significantly increase the amount of loan finance
  incurred
• A lender will charge interest at the bank base
  rate for lending plus a return for risk
• Magnitude of risk premium will depend on the
  status of developer, the size and length of loan
  and the amount of collateral the developer
  intends to contribute.
• Detailed cash flow projections are essential once
  the project is under way in order to incorporate
  changes in revenue and costs, and particularly so
  for phased developments
• Interest accrued on money borrowed to purchase
  the site, construct the property and hold over
  any void period is calculated separately

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Interest on land costs
We know we will need to finance land purchase but
dont know what the price is so need to come back
to this later
?
The calculation of the amount of interest
incurred on money borrowed to purchase the site
is incorporated in the final stages of the
residual valuation because it is based on the
figure we are trying to estimate, namely site
value
23
Building costs
-1,209,920
-479,341
-454,341
-227,171
-227,171
-25,000
Q5
Q4
Q2
Q1
Q0
Q6
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Interest on building costs iscumulative
Interest is not paid on the full amount over the
entire building period. The s-shaped build-up of
costs is simplified to a straight line and an
approximation is obtained by calculating the
annual interest on half of the costs over the
construction period
-603 -617 -6,110 -17,816 -47,421 -59,521 -66,434 -68,036
TOTAL -265,956
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How interest is calculated

• Over construction period
• (2,622,944 / 2) x (1 0.1)1.25-1
• 165,934

Over void period (2,622,944 165,934) x (1
0.1)0.25 -1 67,250
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Cost Inputs
Letting fee estimated annual rent x
15 340,000 x 0.15 51,000 Marketing
cost Would cover items such as advertising,
opening ceremony, brochure design and production.
The scale would obviously depend on the nature
of the development.
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Cost Inputs

• Developers Profit
• Reward for initiating and facilitating the
  development the entrepreneurial return for
  taking the risks
• Dependent upon state of the market, the size,
  length and type of development, the degree of
  competition for the site and whether it is
  pre-let or forward sold
• More risky than standing investment activity
• Commercial developers seek a return on cost
  (10-25)
• Residential developers seek a return on GDV
  (12.5-15 net of overheads) aka sales margin
• Other criteria Initial yield on cost, IRR
• Profit on development costs 2,917,128 x
  20
• 583,426
• On land costs future residual balance
  future residual balance / (1 20)
• 1,092,489 (1,092,489 / 1.20)
• 182,081

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Land Value output

• Interest on site costs 910,407 x 1/(1
  0.1)2
• 752,403
• Acquisition costs
• Site value residual balance / (1 0.0575)
• 752,403 / 1.0575
• 711,492

Maximum amount that should be paid for the site
if the proposed development was to proceed and
all of the valuation assumptions held true
If site was purchased at the start of the
development, interest on site costs must be paid
over the total development period. To do this
the figure calculated thus far must be discounted
to determine its present value at the short-term
finance rate of 7 over the total development
period. Even if money is not borrowed to fund
site purchase or construction the opportunity
cost of funds used should be reflected in the
valuation and the lending rate is a good proxy
for the opportunity cost of capital. Usually
include legal costs, tax (Stamp Duty and VAT),
valuation and agents fees plus any pre-contract
investigations such as soil surveys,
environmental impact assessments and
contamination reports
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Key Inputs

• Gross and net internal area and efficiency ratio
• Rent and yield
• Gross and net development value and disposal
  costs
• Building costs, external and ancillary costs
• Professional fees
• Contingency
• Marketing costs and letting fee
• Developers profit
• Interest / finance costs
• Acquisition costs
• Development period

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Residual profit valuation

• Also known as profit appraisal or viability
  statement
• Assume
• Development retained as an investment so no sale
  fees

Development value
Net Development Value 4,593,043
Site Costs
Site price -711,492
Acquisition costs _at_ 5.75 site price -40,911
-752,403
This is the general model as it can be used to
back out land value
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Construction Costs
Total Construction Costs ('s) -2,622,945
Interest
Over building period -165,934
Over void period -67,250
On site costs over total devt period -158,005
Total Interest Payable -391,189
Letting Sale Fees -61,000
Total development costs -3,827,536
Developer's profit on completion 765,507
equal to profit on land and development costs in
residual site valuation
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Profit appraisal snapshot methods ofexpressing
developers profit

• Profit as of development costs (return on
  costs)
• Useful for trader developers

All of these measures are at time of scheme
completion, i.e. they have not been PVd

• Profit as a of net development value
• Remember profit as costs or value are related
• Income yield
• Rent as of development costs
• Useful for investor developers as it reports the
  annual profit
• must be higher than interest payments in the long
  run
• 340,000 / 3,993,950 8.51 per annum
• Payback (years)
• indicates number of years to pay back costs to
  break even point
• Inverse of income yield (cf YP)
• cost/rent years to payback
• 3,993,950 / 340,000 11.75 years

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Profit appraisal

• Profit erosion rent cover
• Number of years it takes before profit is eroded
  by rent payments
• Relevant in pre-funded arrangements where
  developer may guarantee rent
• Profit erosion interest cover
• Number of years before profit is eroded by
  interest payments to bank
• Relevant for spec developments financed using
  bank loan which is then converted to mortgage on
  completion
• Rent debt ratio
• Rent divided by annual payments on an
  interest-only loan

Formula for calculating interest payments to
bank assuming a mortgage term of n years and rate
of i Costs x (((1i)n)i)/((1i)n-1)
i.e. costs compounded over term x r which is
then PVd -1
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Problems with residual method

• Simple cost assumptions
• Uses finance rate as discount rate
• Not able to handle phased costs and revenue very
  well
• Sensitive to cumulative errors in inputs, esp. if
  site cost is small relative to other costs
• Therefore, risk analysis...
• Handling of finance...

Calculating interest on half of the building
costs over the construction period assumes these
costs are incurred evenly throughout this period.
But often they are not. In general, the initial
build up of costs tends to be gradual, peaks at
60 and then tails off. Typically only 40
building costs are incurred half way through the
construction period whereas the residual method
assumes 50. Consequently accrued interest is
actually less than the amount calculated using
the residual method. In addition, interest on
money borrowed usually accumulates monthly rather
than annually as assumed in the residual method.
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Key points

• Residual method is based on a simple economic
  concept land value is a surplus after estimated
  development costs (including expected profit)
  have been deducted from the estimated value of
  the completed development
• Difficulties arise when estimating input values
  because small errors in each can lead to large
  variation in output
• In practice the method is first employed in its
  simplest form and then the complexity level
  increases as development plans crystallise

36
Development appraisal

• Cash-Flows

37

• What for?

• Why

• Larger, more complex schemes
• Valuation of land
• Estimation of profit
• return on equity (or yield-to-equity) put up by
  developer, as distinct from debt (loan) provided
  by lender
• Show financial position (cash flow) at any point
  in time
• an essential ingredient of any negotiations with
  possible lenders

• Flexibility handle spread of construction costs,
  fees and revenue (short-term lets, phasing)
• Include forecasts inflation in construction
  costs and fees, growth in rents and values
• Detailed projection of costs and revenue over the
  development period
• Once land price is known the cash-flow can be
  used to monitor actual costs compared to the
  estimates and thus how the developers profit
  might be affected
• Examine viability in more detail and using more
  conventional financial concepts (NPV, IRR)
• Valuation method becomes an appraisal tool...

For whom?

• Developers
• Lenders (who may be financing the development)
• Investors (who may be acquiring the scheme on
  completion)

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DCF procedure (source GMCE)

1. Forecast expected cash-flow
2. Determine TRR
3. Discount (1) at (2) to PV

Where CFt net cash-flow in period t V0 value
at t 0, i.e. present value E0 r expected
average multi-period return (per period)
at t 0 (i.e. now) t exit period (i.e. end
of holding period) such that CFt includes
capitalised exit value in addition to
income cash-flow in that period
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Diff between standing investmentand development
cash-flows

• Cash-flow expenditure occurs over time
• Debt financing of construction almost universal
• Phased risk profile high during construction and
  maybe letting period and reduced once let
• Valuation ------ appraisal...

40
Appraisal questions

• Pre-finance
• Discounting the cash-flow (which includes land
  price) at the developers target rate, what is
  NPV/IRR?
• Discounting the cash-flow (which doesnt include
  land price) at the developers target rate, what
  is the NPV (i.e. the land price but without
  finance costs)?
• Post-finance
• Having discounted the cash-flow (which includes
  land price) at the finance rate, what profit is
  left?
• With profit included as a lump sum in the
  cash-flow and discounting at the finance rate,
  what is the land price (with finance costs)? (cf.
  residual)

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Cash Flow Example

• 100 debt
• Nominal quarterly interest rate
• All building costs assumed to occur half-way
  through building period
• Slightly different from assuming half costs over
  whole building period
• When finance rate and target rate are the same
  and scheme is 100 debt financed...
• Comparable to residual
• Now spread costs more realistically
• Additional assumptions, e.g. forecasts
• Cost inflation forecasts, broken down by land use
• Value inflation forecasts, broken down by land
  use

NB. NPV assumes 1st cash flow is period 1 - be
careful to block period ONE to end and then add
on period Zero outside NPV calculation
42
Choice of method...

• Residual method
• valid and useful but has drawbacks
• Cash Flows
• can deal greater complexity, different cost and
  income patterns and fluctuations they are more
  flexible
• can be used for land valuations and development
  appraisals
• Enable valuers to be explicit about the breakdown
  of costs and revenue, providing a reasonably
  accurate assessment of monetary flow over a
  specified time period