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(Conor) RICS APC Commercial Real Estate S1 2024 > Development Appraisals > Flashcards

Development Appraisals Flashcards

1
Q

Describe a Typical Development Appraisal of an office property from Start to Finish: (Assume you are paying X for a piece of land and the Y is the target (Profit/Return).

A

(1) Acceptance of the instruction, COI check, terms of engagement, understanding of the key requirements of the client, crucially for the appraisal: Profit desired (or profit on cost, or ROCE) I.e. what they are trying to achieve, build costs based on contractors quotes received, timing, cost of finance – the inputs that may be more specific to them and qualified with quotes / previous experience of the developer.

AND what you are targeting – are you trying to establish how much they should pay for a site, or how much profit you would be able to make.

(2) Calculation of Gross Development Value (MR * Cap Rate)

  • your MR would come from comparable evidence
  • your cap rate would also come from comparables – cap rate would be described as a NIY or All-risk yield (implicit in the yield are all factors).

(3) Establish full costs of the development:

  • Cost of the Land inc acquisition costs
  • Cost of construction.
  • Contingencies
  • Professional Fees
  • Cost of Finance (Straight line compound for the development land, but S-Curve construction costs because of the timing of the drawdown)
  • Cost of sales agent
  • Letting fees (10% of Y1 rent)
  • Void/Holding Cost

(4) Calculate profit on cost of the development, and then make and report an assessment of viability on the site.

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2
Q

What basis of measurement are BCIS Cost Estimations provided against?

A

For commercial property they are provided in £/m² on a Gross Internal Area (GIA) basis. And for residential property they are provided on a GEA basis.

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3
Q

Have you Actually been onto the BCIS? How Does it Work?

A

No I use Spons and cost modelling data - GIA

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4
Q

How is CIL Calculated?

A

It varies from council to council, and is based on floor area and uplift in value.

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5
Q

What are exemptions from CIL?

A
  • Minor development exemption - with a GIA of less than 100 square metres
  • Self build exemption - If you build a house and occupy it yourself for 3 years
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6
Q

What is S106?

A

Section 106 of the 1990 Town and Country Planning Act. It requires developers to provide a certain amount of affordable housing as part of their development or make a financial contribution to provide infrastructure.

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7
Q

What is the difference between a development appraisal and a residual valuation?

A

A development appraisal is a series of calculations to establish the viability/profitability of a proposed development based upon client inputs

Development Appraisal: GDV – Total Development Costs - Residual Site Value = Profit

A residual is a valuation of a property to find the market value of the site based on market inputs.

Residual: GDV – Total Development Costs - Profit = Site Value

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8
Q

What assumptions does a residual appraisal use?

A

Market

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9
Q

What assumptions does a development appraisal use?

A

Client specific and market.

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10
Q

How do you choose a finance rate?

A

Based on current market assumptions. If known, should be based on specific rate at which client can lend.

If not, usually reflects LIBOR plus a premium or BoE plus premium. LIBOR to be replaced by SONIA (Sterling Overnight Index Average) in 2021.

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11
Q

Is 100% finance rate realistic?

A

No, but it’s the market normal/standardised practice and used in an appraisal to reflect the opportunity cost of capital.

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12
Q

What is GDV and how is it calculated?

A

This is a market value of the proposed completed development scheme, assuming present values and current market conditions.

The comparable method is used to establish market rent, which is capitalised at an All Risks Yield. Also incentives such as a rent free, letting void should be assumed if appropriate.

Purchaser’s costs should be deducted.

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13
Q

What is included in your Total Development Costs?

A
  1. Site preparation (demolition, landfill tax, remediation works)
  2. Build costs
  3. Planning costs (including s.106 and CIL if applicable)
  4. Professional Fees
  5. Finance Costs
  6. Contingency
  7. Marketing Costs
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14
Q

What is included in professional fees?

A

Usually 10% - 15% of construction costs. Includes architects, structural engineers, project managers, QS, CDM etc.

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15
Q

What is CIL?

A

CIL is adopted by LPA’s for offsite payments to raise funds for infrastructure and to support development in the local area. CIL charges are based on a formulae (tariff) and relate to the size or change of size on a developments gross floor space.

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16
Q

What is included in marketing costs?

A

Brochure/advertising.

EPC.

Usually around 1-2% of GDV.

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17
Q

What is a usual Developer’s Profit assumption?

A

Usually 15-20% of profit on cost.

Profit on GDV is generally for used for residential, however Profit on Cost is also used.

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18
Q

Can you explain the concept of development finance.

A
  1. Finance for borrowing money to purchase the land is calculated on a straight line basis over the length of the development period.
  2. Calculation of finance required for the construction period is to assume the total cost of construction (including fees) over half of time period using the S curve which means that that the assumption of halve the interest that would be borrowed for all of the construction period.
  3. The S Curve reflects the incidence of costs being drawn down
  4. Assumes 100% debt finance
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19
Q

What is VAT payable on?

A

All professional fees.

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20
Q

What is profit erosion period?

A

The length of time it will take for the development profit to be eroded by holding charges following the completion of the scheme until the profit from the scheme has been completely drawn down.

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21
Q

What are the limitations of development appraisals?

A
  1. Importance of accurate information and inputs.
  2. It does not consider the timing of cashflows.
  3. Very sensitive to minor adjustments.
  4. Implicit assumptions hidden and not explicit (unlike in a DCF).
  5. Always cross check with comparable land values if possible.
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22
Q

What are the forms of sensitivity analysis?

A

Simple sensitivity – analysis of key variables (eg. Ield, GDV, build costs).

Scenario analysis – timing and costs

Monte Carlo simulation – using probability theory.

23
Q

What does a cashflow look like?

A

Timeline of income and costs over a set period of time.

Shows the timings of assumptions made.

Cost of finance.

24
Q

What does a planning permission contain? What are typical conditions included?

A

When planning permission was granted.

Conditions of approval.

Reference.

Description of development.

Location of development.

Date of application.

25
Q

What is the difference between debt, mezzanine and equity finance? What is the capital stack?

A
  • Debt finance – lending money from a bank or other funding institution
  • Equity finance – selling shares in a company or JV partnership or own money used.
  • Mezz funding – additional funding from another source for the additional monies required.
  • Senior funding – first loan.

The capital stack refers to the layers of capital that go into purchasing and operating a commercial real estate investment.

26
Q

What do you need planning permission for?

A

Anything that constitutes development under the 1990 Town and Country Planning Act

  1. Demolition
  2. Rebuilding
  3. Structural alterations
  4. Amalgamations
27
Q

What don’t you need planning permission for?

A

Maintenance/interior alterations – although mezzanines over a certain size now require planning permission.

Permitted development.

28
Q

In a development appraisal, give some examples where risk might be reflected?

A
  1. Contingency
  2. Yield (all risks) on ERV
  3. Profit on cost (if exceptionally large development)
29
Q

How long does planning permission last for?

A

Usually 3 years.

Outline applications normally last 3 years with development taking place within 2 years of the approval being granted.

You can apply for an extension

30
Q

What does a cashflow look like?

A

Timeline of income and costs over a set period of time. Shows the timings of assumptions made and the cost of finance.

Time cost of money.

31
Q

Explain the concept of finance costs.

A

Most development projects are funded from interest-paying borrowings which are highly sensitive to timescales.

Interest arises on land acquisition and development costs.

The rate of interest reflects levels in the market for the type of scheme involved. It is either paid when due or deferred (rolled up) throughout the projected programme.

Conventionally, the interest is compounded either quarterly or annually (market practice).

Delay, added complications, or shifts in the money markets can all have an important impact on finance costs.

Viability appraisals generally assume that projects are fully funded by borrowing money.

This is often referred to as 100% gearing. Even where the funder has provided only part of the finance debt and the developer has used his own funds for the balance (equity), the appraisal should reflect the total cost of the funding.

32
Q

What is IRR?

A

Internal rate of return.

A measure of profitability.

The discount rate required to make the net present value of all future cash flows equal to zero.

The % interest earned on each £1 invested.

33
Q

What guidance did the RICS release on valuing development property?

A

RICS GN Valuation of development property, 2019

34
Q

How is development property defined in RICS Valuation of development property, 2019?

A

Development Property is where redevelopment is required to achieve the highest and best use or where improvements are either being contemplated or are in progress at the valuation date

35
Q

According to RICS Valuation of development property, 2019, what should Market Value for a development property assume?

A

Optimum development i.e. the development which yields the highest value, taking into account the perspective economic and planning conditions

36
Q

What does RICS Valuation of development property, 2019 state about the use of multiple valuation approaches?

A

Best practice avoids reliance on a single approach or method of assessing the value of development property

Output should always be cross-checked using another method (market comparison approach, residual method)

37
Q

What method does the RICS Valuation of development property state should be used for complex and/or lengthy development schemes?

A

Discounted cash flow (DCF) technique. Simple residual method can be used in other cases

38
Q

What does RICS Valuation of development property, 2019 recommend should be done to account for risk in the valuation process?

A
  • Risk analysis should be used to show changes to the inputs which might affect the valuation
  • Risk and return levels and assumptions should be explicitly stated in the valuation report
39
Q

How should you value land that is in the course of development according to RICS Valuation of development property, 2019?

A

• Value of the land + costs expended at the valuation date

and/or

• Completed development value - costs remaining to be expended at the valuation date

40
Q

How should the output of the valuation be reported according to RICS Valuation of development property, 2019?

A

Reported as a single figure, except where there is potential for significant variation (e.g. if there is uncertainty around the valuation the different options identified should be report)

41
Q

Why is profit on cost a more reliable method of measuring developers profit than profit on GDV?

A

GDV is subject to more variation

42
Q

What do developers consider the greatest risk when undertaking a development?

A

Planning permission

43
Q

What would you typically estimate for contingency costs?

A

5-10% of total construction costs (depending on the level of risk and likely movements in building costs)

44
Q

What THREE elements does the developer need to borrow money to finance? What basis would they be represented?

A
  1. Site purchase + purchaser’s costs: compound interest (straight-line basis)
  2. Total construction costs + fees: based on an s-curve taking hold of the costs over the length of the build programme
  3. Holding over costs to cover voids until the disposal of the scheme: compound interest (straight-line basis)
45
Q

What holding over costs need to be accounted for after the development is completed, until the disposal of the scheme?

A

Empty rates, service charges and interest charges

46
Q

Explain the concept of the s-curve and why it is applicable.

A
  • Assumes that total constructions costs + fees are paid over half the time period
  • Reflects when monies tend to be drawn down - lower levels of expenditure at the beginning and end of projects
47
Q

What are the typical components of a capital stack for development financing?

A
  • Senior debt: takes precedence over other sources of funding. If the borrower defaults, the lender can take ownership of the property
  • Mezzanine finance: will sit below the senior debt in terms of priority. Typically has a higher rate of return than senior debt but lower than equity
  • Equity: riskiest and most profitable portion of the capital stack. Riskiest as the other tranches of capital will be repaid before the equity holders
48
Q

What are the limitations of the residual valuation methodology?

A
  • Dependent on accurate information and inputs
  • Does not consider timing of cash inflows
  • Very sensitive to minor adjustments
  • Implicit assumptions hidden and not explicit
  • Assumes 100% debt finance
49
Q

What are the inputs required to derive the residual or land value of a development site?

A

Start with GDV using the comparable method.

Then deduct development costs including:

Professional fees (architect, legal, surveyors, contractors)
Construction costs
Finance costs
Contingency
Developers profit
Site acquisition costs (Stamp duty, agency fees)

Results in residual value

50
Q

What factors could affect the timeline/costs of development and therefore residual value?

A

Increase construction costs

Contract delays caused by adverse weather or other matters outside of developer’s control

Delays in obtaining statutory consents

Supplier failures

Delays in finding a buyer or lessee for the completed project

51
Q

What is a sensitivity analysis?

A

A series of calculations resulting from the residual appraisal involving one or more variables (sales values, build costs, finance costs etc.) that are varied to show the differing results.

52
Q

For the residual valuation you used on the Kensington hotel, what interest rate did you use for development finance?

A

The bank of England base rate at the time was around 3% and so i added a risk premium of 6% to reflect the risks associated with development

53
Q

For the residual valuation you used on the Kensington hotel, what was the timeline?

A

I adopted 12 months

(Conor) RICS APC Commercial Real Estate S1 2024 (16 decks)

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