Development appraisal Residual Method Residual Method Value

Development appraisal Residual Method

Residual Method Value of completed development - Development (construction, fees, finance, etc. ) costs - Developer’s 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 3

Residual land valuation: simple example • Development opportunity for 5, 000 m 2 offices that it is estimated will let for £ 130/m 2 and sell at an initial yield of 8% • Construction costs are estimated to be £ 800/m 2 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? 4

Simple residual land valuation (don’t worry about timing of completion yet…) Development value (DV): Total constructed area (m 2) Estimated market rent (£/m 2) 5, 000 x 130 Estimated annual market rent (£) Capitalised @ 8% 650, 000 x 12. 5 8, 125, 000 Less Development costs (DC): Construction costs (5, 000 m 2 @ £ 800/m 2) -4, 000 Profit on construction costs @ 20% DV -1, 625, 000 -5, 625, 000 Residual land value (RLV) 2, 500, 000 5

Case Study See hand-out… 10

Revenue Inputs NIA GIA Efficiency ratio So NIA = = 2, 000 m 2 85% 2, 000 x 0. 85 1, 700 m 2 Estimated (net) annual rent = = = GDV NIA x estimated rent / m 2 1, 700 m 2 x £ 200 / m 2 £ 340, 000 = = = Estimated annual rent / yield £ 340, 000 / 0. 07 £ 4, 857, 143

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 = Building costs = £ 4, 593, 043 = building cost / m 2 x GIA = £ 969/ m 2 x 2, 000 m 2 = £ 1, 938, 000

Cost Inputs Professional fees • Architect • QS • Engineers (structural, M&E) • 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 16

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. . .

Development time-line & cost build-up Lead-in period (6 months) Site acquisitio n Construction period (15 months) Void period (3 months) Construction completed Construction begins Total development period Total Costs (£) Fitting out Main construction activity Cost of site Site acquisitio n Site clearance, foundation s, etc. Constructi on begins Constructi on completed Developm ent let 20 and/or sold

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

Interest on land costs We know we will need to finance land purchase but don’t know what the price is so need to come back to this later… £? 6 months 18 months 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 22

Building costs TOTAL = -£ 2, 622, 945 -£ 1, 209, 920 -£ 479, 341 -£ 454, 341 -£ 227, 171 -£ 25, 000 Q 1 Q 2 Q 3 Q 4 Q 5 Q 6 23

Interest on building costs is cumulative Interest is not paid on the full amount over the entire building period. The sshaped 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 24

How interest is calculated £ 2, 622, 945 £ 1, 311, 473 Interest on half construction costs over construction period 6 months Over construction period: = (£ 2, 622, 944 / 2) x [(1 + 0. 1)1. 25 -1] = £ 165, 934 15 months For void period, interest is on all construction costs and interest rolled up so far 3 months Over void period: = (£ 2, 622, 944 + £ 165, 934) x [(1 + 0. 1)0. 25 -1] = £ 67, 250 25

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. 26

Cost Inputs Developer’s 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 prelet 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

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

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 • Developer’s profit • Interest / finance costs • Acquisition costs • Development period 29

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 Acquisition costs @ 5. 75% site price -£ 711, 492 -£ 40, 911 -£ 752, 403 *This is the general model as it can be used to ‘back out’ land value 30

Construction Costs: -£ 2, 622, 945 Total Construction Costs (£'s): Interest: Over building period Over void period On site costs over total dev’t period -£ 165, 934 -£ 67, 250 -£ 158, 005 Total Interest Payable : -£ 391, 189 Letting & Sale Fees: -£ 61, 000 Total development costs Developer's profit on completion* *equal to profit on land development costs in residual site valuation -£ 3, 827, 536 £ 765, 507 31

Profit appraisal: snapshot methods of expressing developer’s profit Profit as % of development costs (return on costs) • Useful for trader developers Profit as a % of net development value • Remember profit as % costs or value are related All of these measures are at time of scheme completion, i. e. they have not been PV’d 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 32

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 (((1+i)n)*i)/((1+i)n-1) [i. e. costs compounded over term x r which is then PV’d -1] 33

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. cost Defer (PV) void construction site time

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 35

Development appraisal Cash-Flows

What for? Why • Larger, more complex schemes • • Valuation of land • Estimation of profit 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 developer’s profit might be affected • Examine viability in more detail and using more conventional financial concepts (NPV, IRR) • Valuation method becomes an appraisal tool. . . – 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 For whom? • Developers • Lenders (who may be financing the development) • Investors (who may be acquiring the scheme on completion)

DCF procedure (source: GMCE) 1. Forecast expected cash-flow 2. Determine TRR 3. Discount (1) at (2) to PV Where CFt V 0 E 0 [r] t = net cash-flow in period t = value at t = 0, i. e. present value = expected average multi-period return (per period) at t = 0 (i. e. now) = exit period (i. e. end of holding period) such that CFt includes capitalised exit value in addition to income cash-flow in that period

Diff between standing investment and 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. . . 39

Appraisal questions Pre-finance: • Discounting the cash-flow (which includes land price) at the developer’s target rate, what is NPV/IRR? • Discounting the cash-flow (which doesn’t include land price) at the developer’s 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) 40

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 1 st cash flow is period 1 - be careful to block period ONE to end and then add on period Zero outside NPV calculation

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 42