1. Development appraisal
Residual Method

2. 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

3. 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

4. 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?

5. 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 8% x
8,125,000
Less Development costs (DC):
Construction costs £800/m2)
-4,000,000
Profit on construction 20% DV
-1,625,000
-5,625,000
Residual land value (RLV)
2,500,000

6. 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 8%
x 12.5
Gross development value (£)
7,031,250
less purchaser’s 5.75% of NDV (£)
- 382,314
Net development value (NDV) (£)
6,648,936

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

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

9. Residual land valuation (4/4)
Future residual balance (exc. profit on land) (NDV less Total Costs)
£84,433
less Developer's profit on land 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 7%) x
Present residual balance for land and acquisition costs
£60,953
less Acquisition 5.75% site acquisition price
-£3,314
Residual land value
£57,639

10. Case Study
See hand-out…

11. 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

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

13. 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 / ( )
= £4,857,143 /
= £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 % 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

14. 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
% of NDV
Other professionals…

15. 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

16. 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 %
Quantity Surveyor 2 – 3%
Structural engineer %
Civil engineer 1 – 3%
Project manager 2+ %
Mechanical & Electrical %
Agents fees
Land acquisition
Residential sales
Leasing
Commercial sales

17. 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.

18. 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 £
Inspection charge £
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 %

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

20. 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).

21. 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

22. 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

23. 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

24. 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 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

25. 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 [( )1.25-1] = £165,934
Over void period:
= (£2,622,944 + £165,934) x [( ) ]
= £67,250

26. 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.

27. 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 ( % 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 .

28. Land Value output Interest on site costs* = £910,407 x [1/(1 + 0.1)2]
= £752,403
Acquisition costs**
Site value = residual balance / ( )
= £752,403 /
= £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

29. 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?

30. 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 5.75% site price
-£40,911
-£752,403
*This is the general model as it can be used to ‘back out’ land value

31. 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

32. 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 = years

33. 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]

34. 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)

35. 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

36. Development appraisal
Cash-Flows

37. 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)

38. 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

39. 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...

40. 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)

41. 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

42. 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