Residual Method of Valuation and Development Appraisals

Question 1

What is the purpose of Development Appraisals?

Answer 1

A development appraisal is a tool to financially assess the viability of a development scheme

One can be used to established a residual site value

Can be used to assess the profitability of a proposed scheme and its sensitivity to changing inputs, or assessing the viability of different uses, rents, yields or financial contributions such a S.106 / CIL payment

Question 2

What is a development appraisal?

Answer 2

A calculation or series of calculations to establish the value / viability / profitability / suitability of a proposed development based upon the clients inputs

It can assume a site value or calculate a site value

Provides guidance as to the viability of the proposed development

Question 3

What is a Residual Site Valuation?

Answer 3

Most common purpose is for a specific valuation of a property holding to find the Market Value of the site based on market inputs

At one moment in time, at the valuation date, for a particular purpose

This is a form of development appraisal

It can be based upon a simple residual valuation or the DCF method

All inputs are always taken at the valuation date

Question 4

What is the Gross Development Value? (GDV)

Answer 4

Capital value of completed scheme

Question 5

What is the methodology for a Residual Site Valuation?

Answer 5

GDV
- MV of completed proposed development at today’s date / date of valuation
- Use plans if needed and measure on CAD (take check measurements if you can)
- Valued at current date assuming present values and market conditions
- Comparable method of valuation used to establish rents and yield
- All Risks Yield used
- An allowance of a rent-free period or tenants incentives and marketing void can be assumed
- Purchaser’s costs are usually deducted for commercial property valuations

Question 6

What are some examples of Total Development Costs (TDC)

Answer 6

Site preparation

Planning costs

Building costs

Professional fees

Contingency

Marketing Costs & Fees

Calculation of Finance

Question 7

Can you explain Site Preparation costs?

Answer 7

Demolition, remediation works, landfill tax, provision of services, site clearance, levelling and fencing

Obtain a contractors cost plan for these works

Question 8

Can you explain Planning costs?

Answer 8

Section 106 Payment

Community Infrastructure Levy (CIL) - Charged by post LPA’s

Local planning policy - will outline required percentage of affordable housing required for new residential development in the form of social, intermediate and key worker housing

Other planning obligations could relate to the provisions of open spaces/playgrounds, public art, financial contributions towards local services

Section 278 Payment for highway works

Planning application and building regulation fees

Cost of planning consultant

Cost of any specialist reports required by the LPA (Environmental Assessment)

Question 9

What is a Section 106?

Answer 9

Under the Town and Country Planning Act 1990 Section 106 Payments are a legal agreement for planning obligations (eg. affordable housing, infrastructure costs, new school etc) to gain a planning consent

Question 10

Can you explain Building Costs?

Answer 10

Estimated total cost of building works

Sources of building costs:
- Client information (for development appraisal)
- Spons Architects and Builders Price book
- Quantity Surveyor estimate/bill of quantities / cost plan
- Building Surveyor estimate
- RICS Building Cost Information Service (BCIS) usually based on a GIA basis. BCIS obtains updates from QS/BS sources and recent contract prices/tenders agreed

Question 11

Can you explain Professional fees?

Answer 11

10%-15% plus VAT of total construction costs for the professional fees for architects, M&E, consultants, project managers, structural engineers etc

Architects are usually the largest proportion of total fees

Remember CDM Principal Designer costs

Question 12

Can you explain Contingency?

Answer 12

5%-10% of construction costs depending upon level of risk and likely movements in building costs

Question 13

Can you explain Marketing costs and fees?

Answer 13

Assumes a realistic marketing budget (uses evidence/quotes)

Cost of an EPC

NHBC warranty (for residential schemes)

Normal sale fee around 1%-2% GDV & normal letting fee around 10% of initial annual rent

Question 14

What are the choices of interest when calculated finance?

Answer 14

LIBOR (London Inter Bank Offer Rate which is the variable lending rate between banks for a 3 month borrowing term) plus the premium to reflect interest rate which is available. Note the eplacement of this by SONIA (Sterling Overnight Index Average) occurred at the end of 2021

Bank of England Base rate plus premium

Rate at which the client can borrow the money

Question 15

What are the three elements for finance:

Answer 15

The developer needs to borrow money for:

1. Site purchase (include purchaser’s costs) - compound interest (straight line basis)
2. Total construction and associated costs - calculation based on an S-curve taking half the costs over the length of the build programme
3. Holding costs to cover voids until the disposal of the scheme (empty rates, SC & interest charges) - compound interest on a straight line basis

Question 16

Method of calculating finance?

Answer 16

Assumes 100% debt finance

Finance for borrowing the money to purchase the land is calculated on a straight-line basis using compound interest over the length of the development period

Rolled up method of calculation is used (compound interest)

To calculate the finance required for the construction period, assume total construction costs (inc fees) over half of time period using an ‘S’ curve calculation

The principle of the ‘S’ curve is that as the payment of construction costs adopts the profile of an ‘S’ shaped curve over the length of the development projects, the usual assumption is to halve the interest that would be borrowed for all of the construction period

The purpose of the ‘S’ curve is to reflect when monies tend to be drawn down

Calculate any fiance required for on-going holding costs from completion of construction until disposal on a straight-line basis using compound interest

Question 17

Developer’s Profit

Answer 17

Percentage of GDV or total construction cost - say around 15%-20% depending upon risk

GDV more frequently used as a base for residential use

If scheme low risk (or pre-let/sold) a lower return may be required

The percentage of profit required has recently risen given the current riskier market conditions

Other methods to calculate the profit required is to base it on the return upon capital employed

Deduct the TDC from the GDV to establish the site value having allowed for normal purchasers costs

Cross check the site value with a valuation of comparable site values if possible

Question 18

What are the two main methods of funding for Development Finance?

Answer 18

Debt Finance - Lending money from a bank or other funding institution

Equity Finance - Selling shares in a company or joint venture partnership or own money used

Others can include:

Joint Ventures - 2 or more parties join to develop

Forward sales - where completed scheme pre-sold to either an investor or occupier

Question 19

Key information on Development Finance?

Answer 19

Loan to value (LTV) - typically in the region of 60% but in difficult markets, lenders may adopt a Loan to Cost (LTC) ration (eg. of 60%)

Interest is calculated on a rolled up basis - added to the loan as the project proceeds

Senior debt is the first level of borrowing which takes precedence over secondary/mezzanine funding

Mezzanine funding is additional funding for the additional monies required over the normal LTV lending

Swaps are a form of derivative hedging rate for interest rates

A swap rate is the market interest rate for fixed rate, fixed term loans

Question 20

What is Overage?

Answer 20

The arrangement made for the sharing of any extra receipts received over and above the profits originally expected or agreed in a pre-agreed formula

It can be shared between the vendor/landowner and developer in a pre-arranged apportionment

Known as a claw back

Question 21

VAT?

Answer 21

Remember VAT is payable on all professional fees

Question 22

Profit erosion period

Answer 22

This term relates to 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 bee completely drawn down, due to interest charges, and the scheme is loss making

Question 23

What are the limitations of residual valuation methodology and financial modelling?

Answer 23

Importance of accurate information and inputs

A residual valuation does not consider timing of cash flows

Very sensitive to minor adjustments

Implicit assumptions hidden and not explicit (unliked a DCF)

Always cross-check with a comparable site valuation if possible

Question 24

Why is Sensitivity Analysis required and what are the different forms?

Answer 24

Required for key variables such as GDV, build costs and the finance rate to show range of values

1. Simple sensitivity analysis of key variables - such as yield, GDV, build costs and finance rate
2. Scenario analysis - change scenarios for the development content / timing / costs such as phasing the scheme or modifying its design
3. Monte Carlo simulation - using probability theory using software such as Crystal Ball

Question 25

What is the RICS guidance on development property?

Answer 25

RICS Guidance Note ‘Valuation of Development Property’ 2019

Effective 1st Feb 2020

Question 26

What is the purpose of the GD?

Answer 26

To supplement the International Valuation Standard (IVS) 410 ‘Development Property’

Question 27

What does the International Valuation Standard (IVS) 410 ‘Development Property ‘ provide?

Answer 27

Detailed overview of the valuation of development property and defines development property as:

‘interests 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’ this may include:

• Construction of buildings
• Previously undeveloped land which is being provided with infrastructure
• The redevelopment of a previously developed land
• The improvement or alteration of existing buildings or structures
• Land allocated for development in a statutory plan
• Land allocated for a higher value use / higher density in a statutory plan

Question 28

Other key areas of the Guidance Note?

Answer 28

• When valuing development property assumptions / special assumptions (marriage value / hope value) must be clearly identified in the valuation approach (GN provides illustrative examples)
• A common basis of value is Market Value (potentially subject to assumptions/special assumptions) - in which case there is an assumption of optimum development which should take into account current and prospective economic and planning conditions
• Best practice avoids reliance on a single approach in the valuation of development property. Cross check with the market approach
• For complex/lengthy development schemes - DCF technique might be best employes whereas a basic residual model can be used in other cases
• Best practice requires risk analysis. So that changes to inputs which might affect the valuation of development property can be assessed and various scenarios modelled .
• Risk, return levels and assumptions should be explicitly stated in the valuation report
• Valuer can determine the land value as either: 1. land plus costs expended at val date and or 2. completed development value minus costs expended at the val date. Both can be used to check against each other
• Valuation should be reported as a single figure - except where there is the potential for significant variation

Question 29

What is required for a Financial Viability Assessment?

Answer 29

When undertaken for a planning application practitioners must comply with:

RICS Professional Statement ‘Financial Viability in Planning: Conduct and Reporting’ 2019