1. Session 3: The Mechanics of viability testing

2. Residential vs. commercial ResidentialCommercial Purchaser usually buying a home they intend to occupy themselves Purchaser usually buying a rental stream as well as the property itself One customer: Usually a purchaser looking for a new home. Two customers: Tenant looking for suitable premises and investor looking for a rental stream. Usually valued using GIAUsually valued using NIA

3. What is the ‘yield’? The rent as a proportion of the purchase price There is an inverse relationship between yields & values, i.e. a higher yield means a lower value & a lower yield means a higher value. Yields are often used in development appraisals to estimate the value of the completed development when it is expected to be rented to a tenant (or tenants). This consequently usually applies to commercial property, although it can apply to residential property where it is also rented.

4. Yield example Offices are often not bought by companies who wish to occupy them, but investors such as pension funds. Let us assume a pension fund wants to buy an office when it is fully occupied by a tenant (or tenants). The developer should have a firm idea of what rent the building is likely to achieve e.g. £100,000pa. In basic development appraisals, the initial rent is therefore used to help estimate the development value. The key question is therefore how much should this rent should be multiplied by to calculate what price a purchaser will pay.

5. Yield example (continued…) The “multiplier” is calculated as 1 / yield. Therefore: Development Value = Initial Rent x (1 / Yield) x 100 Let’s assume the pension fund requires a return of 6% pa. Therefore the value of the rented office building as an investment is calculated as follows: £100,000 x (1 / 6) x 100 = £1.6m

6. Yield example (continued…) The previous scenario did not include assumptions on future rent or prospects for capital growth of the asset i.e. it assumed the pension fund would receive a flat £100,000 pa in perpetuity. Let us now assume the office is in a good location with a good tenant and good prospects for rental growth e.g. up and coming area, office market looking healthy locally etc. With this information the pension fund is likely to accept a lower initial yield e.g. 5%: £100,000 x (1 / 5) x 100 = £2m

7. Yield example (continued…) Let us now assume the pension fund are less convinced that the rent will rise in the future and they are worried that the tenant found by the developer are unlikely to stay solvent or remain in the area long term. With this information the pension fund is likely to want a much higher yield e.g. 10%: £100,000 x (1 / 10) x 100 = £1m These examples demonstrate the inverse relationship between yields & values. Clearly it would make no sense for the pension fund to pay over the odds for a riskier investment.

8. What affects yields? Risk & future growth prospects (rental stream & capital value of property). High risk = high yield. But, the higher the future growth prospects = lower yield Low risk = lower return e.g. savings in an ISA. In a casino you would be aiming for a higher 'yield' to compensate for the probability of failure For the main investment classes Government Bonds (gilts) are low risk whereas stocks & shares are more high risk. Returns on property investment tend to be in the middle, offering more income & capital growth potential than gilts and less risk than shares

9. What affects property yields? The tenant - Is it a strong tenant in terms of security of income (or rent)? Security is something you would normally expect to pay for, perhaps by accepting a lower initial return on your investment. The area - Is the location suitable for a building of this quality? Is it declining or improving? Is the access good? The building itself - What is it like? If the tenant goes bust, how easy will it be to find a new tenant? Do these and other lease clauses protect your investment e.g. upward only rent reviews etc.?

10. Rent to Value Table 5.1 Capitalised typical rents £/m 2 Rent£/m2YieldCapitalised Rent £/m2 Large industrial417.0%586 Small industrial487.0%686 Distribution506.0%833 Large office936.5%1,431 Small office1007.0%1,429 Large retail - Convenience1305.0%2,600 Large retail - Other1207.0%1,714 Small Retail1057.0%1,500 Leicester Shops2367.0%3,371 Other Shops15011.0%1,364 Hotels 6.5%2,150 Student Halls 6.5%2,225 Leisure758.0%938

11. Rents, Yield and Capital Value Development Value = Rent x (1 / Yield) x 100 Yield = (Rent / Value) x 100 Years Purchase (YP) = 1/Yield

12. Yield Exercise

13. A simple development viability appraisal Data Collection Calculation (Residual Value, Cashflow) Reality Check Interpretation Use of data Note: Will discuss consultation later – it is vital and required!

14. Internal Rate of Return – IRR The rate of interest (expressed as a percentage) at which all future cash flows (positive and negative) must be discounted in order that the net present value of those cash flows, including the initial investment, should be equal to zero. It is found by trial and error by applying present values at different rates of interest in turn to the net cash flow. It is sometimes called the discounted cash flow rate of return. In development financial viability appraisals the IRR is commonly, although not always, calculated on a without-finance basis as a total project IRR. (RICS Guidance)

15. Data Collection Rubbish in = Rubbish out All inputs MUST be sourced!

16. Income Data

17. Basic Prices by £/m 2 Residential Prices – House v flats Commercial / non-residential Affordable Prices New v existing Incentives and discounts Variance by location or situation? Grants, subsidies

18. Gross internal area? BCIS (the costs) as ‘Rate per m 2 gross internal floor area for the building’ Direct from developers Calculate – it will be an estimate

19. Income Data - Residential Land Registry Hometrack Rightmove / Zoopla / Mouseprice Halifax / Nationwide CORE Developers and RPs

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23. Income Data – Non-Residential EGi Data / EGI Property Link Agents Valuation Office Agency Developers

24. EGI – Propertydata

25. EGI Property Link

26. Costs

27. Construction BCIS Site Costs Abnormals Contingency

28. BCIS

29. Construction BCIS Site Costs – 10% to 20% Abnormals – site by site Highways, flooding demolition, design, decontamination etc. Contingency – 2.5% Greenfield 5% Brownfield +7% on horrible sites

30. Phasing and Build Rate Size of site Size of developer Availability of mortgages Pre 200745 to 50 per year Now?30 to 35 per year Multiple developers

31. Variables Small Changes of cost or income can have a huge difference in result – the bigger the numbers the more sensitive. –101-100=1 but 102-100=2 –1% change in price results in a 100% change in outcome Scenarios – cost and price change policy requirements

32. Building the model up and scenario testing Discounted Cash Flow –NPV –IRR Return On Capital Employed (ROCE)

33. Assumptions and testing “make some very cautious and transparent assumptions with sensitivity testing of the robustness of those assumptions it is important that variations against baseline costs, as well as values, are tested.” (page 27 – Harman)

34. Viability over time 5 year supply should not be prejudiced by unrealistic forecasting assumptions Sensitivity testing should inform policy context for years 5-15, forecasts for latter part of the period are unlikely to be accurate and will need review LPAs may wish to incorporate target-based policies for years 6-15

35. Carveth Read: “It is better to be vaguely right than exactly wrong” Logic, deductive and inductive (1898), p. 351

36. Monitoring Viability By reference to indices: CostsBCIS GDVLand Reg Halifax / Nationwide CompositeAcademetrics Hometrack Rightmove / Zoopla / BUT – have new build followed wider market?

37. Consultation Why Who with When So what and what do you do with the results?

38. Consultations Engagement A fundamental part of plan making and a requirement of NPPF, CIL Regs, Harman Guidance Don’t be afraid to ask the developers –For some evidence to support figures –To explain / for detail Record process and comments METICULOUSLY What have you actually asked and is it in the context of delivering the development plan

39. Engagement Phases Delay at your peril Two or three stages

40. Stage 1 Engagement Background and why –Methodology –Viability test –Appraisal assumptions Not results Certainly not policy Stage 1 includes establishing agreement on methodology and assumptions (build costs, sale prices etc.) Does not include workings.

41. Stage 2 Engagement Changes made from first consultation (or not) –Methodology –Viability test –Appraisal assumptions Draft Results Emerging conclusions Still not policy

42. Stage 3 Engagement Results Factors other than viability to consider Emerging and developing policy Changes to existing policy Approve now or hang on?

43. Case study: South Worcestershire

44. Case Study – South Worcestershire Local Plan

45. No additional requirements No affordable housing Built to Building Regulations (Part L) Density informed by consultation with officers and developers – lower than policy to reflect current delivery (targets assume high content of flats etc) Greenfield sites over 1 hectare have 40% open space No CIL or s106 All other requirements over high quality and locally distinctive design and safe design remain

46. No additional requirements

47. Build Standards Code for Sustainable Homes Level 4 from April 2013 –Add 6% to cost of house SWLP 26 Renewable and Low Carbon Energy (a)All new developments will be required to incorporate the generation of energy…by at least 10%. (b)All new development (as part of the major developments) will be required to incorporate the generation of energy…by at least 20%. –Add 2.5% to cost of house (+/- £2,500 /dwelling) NOT JUST REDUCING USE – ACTUALLY ABOUT GENERATION NO EVIDENCE OF ANY PRICE BENEFIT FROM REDUCED ENERGY BILLS

48. CfSH Level 4 + Onsite Generation

49. Affordable Housing 15 or more40% 10 – 14 30% 5 – 920% As social rented, affordable rented and intermediate tenure and provided on site NOT TESTEDLess than 5, a financial contribution will be required.

50. Affordable Housing

51. Density Density informed by consultation – lower than policy Greenfield sites over 1 hectare have 40% open space Brownfield sites NO Public Open Space Greenfield sites less than 1ha but more than 5 units 20% open space

52. Affordable Housing, Density, CfSH4, Onsite Generation, ‘No’ CIL

53. Uncertain Market Average Prices

54. Uncertain Market Indexed turn over (from January 2006)

55. 5% fall in prices

56. Cumulative Impact of Policies Affordable Housing, Density, CfSH4, Onsite Generation

57. TEA BREAK

58. Exercise: Acronym bingo

59. Acronym Bingo! a)The estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s-length transaction b)A measure of the level of profit relative to level of capital employed/required to deliver a project. The average level of developer overhead and profit. c)Where an alternative use can be readily identified as generating a higher value for a site, the value for this alternative use would be the market value with an assumption. d)All income from the scheme. e)The value at which a typical willing landowner is likely to release land for development. f)An excess of abbreviations formed from the initial components in a phrase/word. GDV TLV TMA EUV AUV ROCE

60. Contact us Emailgilian.macinnes@local.gov.uk pas@local.gov.uk Web www.pas.gov.uk Phone 020 7664 3187 Simon Drummond-Hay Emailsimon@drummond-hay.co.uk Phone015242 76205 / 07989 975 977 David Carlisle Emaildavid.a.carlisle@urs.com Phone020 7821 4194 / 07827353558