Development appraisal Residual Method

Residual Method Assumes an element of residual value is released after development has taken place Used to determine a snapshot of either Land value Developer’s 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

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

Residual land valuation: simple 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?

Simple residual land valuation (don’t 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 @ 8% x 12.5 8,125,000 Less Development costs (DC): Construction costs (5,000m2 @ £800/m2) -4,000,000 Profit on construction costs @ 20% DV -1,625,000 -5,625,000 Residual land value (RLV) 2,500,000

Residual land valuation: detailed 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 @ 8% x 12.5 Gross development value (£) 7,031,250 less purchaser’s costs @ 5.75% of NDV (£) - 382,314 Net development value (NDV) (£)   6,648,936

Residual land valuation (2/4) Less Construction Costs: Building costs 5,000m2 @ £800/m2 (£) -4,000,000 External works (£) -80,000 Professional fees @ 14% of bldg & ext costs (£) -571,200 Ancillary costs (£) -150,000 Contingency @ 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 @ 0.5% NDV (£) -34,467 (e) Bank's arrangement fee @ 1% NDV (£) -68,934 (f) Developer's legal fees @ 0.5% NDV (£) Total construction costs (£) -5,070,092

Residual land valuation (3/4) Less Interest: on half total construction costs for whole building period @ 7% pa -270,785 on total construction costs & finance for void period @ 7% pa -278,011 Total Interest Payable   -548,796 Less Letting & Sale Costs: Letting agent's fee @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 @ 15% -£856,239 TOTAL COSTS -£6,564,503

Residual land valuation (4/4) Future residual balance (exc. profit on land) (NDV less Total Costs) £84,433 less Developer's profit on land costs @ 15% -£11,013 Future balance (inc. interest on land & acquisition costs) £73,420 less interest on land and acquisition costs for total development and void period (PV£1 for 2.75yrs @ 7%) x 0.8302 Present residual balance for land and acquisition costs £60,953 less Acquisition Costs @ 5.75% site acquisition price -£3,314 Residual land value £57,639

Case Study See hand-out…

Revenue Inputs NIA GIA = 2,000 m2 Estimated (net) annual rent 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 In May 2009 the 7,761 ft2 4th floor in Aviva’s 42,000 ft2 Pinnacle building at 20 Tudor Road, Reading, Axa was let for £23.50/ft2 on a 10 year lease with a break in year 5. In October 2008 Bucks Consultants took the 7,800 ft2 top floor of the 5 story building at £23.50/ft2. Building stood empty for 4 years

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

Cost Inputs Disposal costs NDV = GDV / (1 + 0.0575) (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 Property agents fees: introductory agent 1% acquisition price site survey flat fee, say £5k environmental survey £1,200 per estate Property legal fees: solicitors 0.050% acquisition price Adding acquisition price and acquisition costs equals gross entry price and this, plus rent apportionment and working capital equals total acquisition cash-flow required. Buildings costs are usually estimated by a quantity surveyor, but an approximation can be gained by reference to recent contracts for similar developments. For example, reference may be made to the standard listing in building price books such as Spons Architects and Builders Price Book (Davis Langdon Everest, 2004) or to online indexes such as BCIS. These sources contain overall figures for construction costs (but excluding external works and professional fees) based on GIA but adjusted depending on the geographical region in which the development is located. It is usual to use current cost estimates and assume that cost inflation will match rental growth over the development period. Having said this, it is worth noting that construction contracts vary; they may be agreed on a ‘rise and fall’ or ‘fixed price’ basis. A building contractor who agrees to a fixed price contract is likely to charge a higher price because risk the exposure is greater. For info, bldg costs: £1,400-1,750/m2 for city offices med rise

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…

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

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 Professional fees are usually agreed as a percentage of the construction costs, but may be a fixed sum. Marshall and Kennedy (1993) found that a typical total for fees averaged 14.5%. The appropriate fee level depends on the type (e.g. less for resi) and location of the development. A representative breakdown of fees might be:   Professional Fee as a % of building costs Architect 5 - 7.5% Quantity Surveyor 2 – 3% Structural engineer 2.5 - 3% Civil engineer 1 – 3% Project manager 2+ % Mechanical & Electrical 0.5 - 3% Agents fees Land acquisition Residential sales Leasing Commercial sales

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... The contingency allowance is a reserve fund to allow for any increase in costs. As construction costs are the single largest sum after land, any inflationary effect is likely to have a significant impact on costs. If the economy is particularly volatile, a cautionary approach is to apply the contingency allowance to all costs, including finance costs, but this will depend on the perceived risk of the project. Marshall and Kennedy (1993) found that the contingency fund is generally set at 3-5% of building costs, professional fees (and sometimes interest payments) but the figure varied depending on the nature of site (restrictive site, subsoil, etc.) and the development project itself. Generally, the longer the development period and the more complex the construction of the building, the higher the risk of unforeseen changes, therefore, the higher the contingency allowance.

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) CP&C Buying leasehold interests, overriding interests Affordable housing: 35%, 70:30 in favour of social rented Service charges on AH? Bldg regs: (not dwellings and not fit out) all +VAT Cost of work; 0 – 1,000,000 Plan charge £1758.80 Inspection charge £2638.20 For each 1,000 Plan charge £1.12 Inspection charge £1.68 Planning obligations: £18-22k / resi unit on greenfield, £10k in central areas, £10/ft2 for commercial S106: Kettering - £12,600 per dwelling and £62.50 per m2 commercial, Broxborne - £3,000 per bed Financing fees: bank fees = 0.30% acquisition price bank lawyers = 0.25% acquisition price bank valuation = (min £2,250) Prop value Fee 0-1.5m 0.175% 1.5-2m 0.150% 2-2.5m 0.137% 2.5-5m 0.100% 5m+ 0.090%

Development period stages US style Planning/pre-construction Construction Lease-up Stabilised operation UK style Lead-in or pre-build period Construction Void Disposal

Development time-line & cost build-up Lead-in period (6 months) Construction period (15 months) Void period (3 months) Total development period Construction begins Construction completed Site acquisition Site clearance, foundations, etc. Main construction activity Fitting out Total Costs (£) Site acquisition Construction begins Construction completed Development let and/or sold Cost of site The total development period needs to allow for obtaining planning consent, preparing drawings and so on. This is sometimes referred to as a lead-in period. There may also be a period of time between completion of the development and occupation by a tenant, including a possible rent-free period and this is referred to as a void period. Development costs tend to accrue slowly at first, then accelerate, then tail off (S-curve).

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 6 months 18 months 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… £? 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

Building costs Q3 TOTAL = -£2,622,945 -£1,209,920 -£479,341 -£454,341 -£227,171 -£227,171 -£25,000 Q0 Q1 Q2 Q4 Q5 Q6

Interest on building costs is cumulative 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 An enhanced version of this simplification for costs that are not spread evenly is to alter the period over which interest is calculated. E.g. items not paid until the very end (agents and legal fees) will incur no interest so a period of 0 is appropriate. Items paid at the start (land) will incur interest over the whole period. Items towards the start (professional fees) may be weighted at 0.75. Marketing (toward the end) may be weighted at 0.25, etc. -603 -617 -6,110 -17,816 -47,421 -59,521 -66,434 -68,036 TOTAL = -£265,956

How interest is calculated Interest on half construction costs over construction period For void period, interest is on all construction costs and interest rolled up so far 6 months 15 months 3 months £1,311,473 £2,622,945 Interest accrued during the void period is calculated by compounding the total construction costs and interest rolled up during the construction period over the void period at the finance rate. 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

Cost Inputs Letting fee = estimated annual rent x 15% Marketing cost = £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.

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 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 .

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 DEVELOPER’S PROFIT Entrepreneurial return for taking the risks. Is development low, medium or high risk activity? Does the figure look and feel right?

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 @ 5.75% site price -£40,911 -£752,403 *This is the general model as it can be used to ‘back out’ land value

Total Construction Costs (£'s): -£2,622,945 Interest: Over building period -£165,934 Over void period -£67,250 On site costs over total dev’t 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

Profit appraisal: snapshot methods of expressing developer’s 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 PV’d 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

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]

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. time cost site construction void Defer (PV)

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

Development appraisal Cash-Flows

What for? Why For whom? 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 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... For whom? Developers Lenders (who may be financing the development) Investors (who may be acquiring the scheme on completion)

DCF procedure (source: GMCE) Forecast expected cash-flow Determine TRR 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

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...

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)

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

Choice of method... Residual method Cash Flows: 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