Development
appraisal
Residual Method
Residual Method
Value of completed development
- Development (construction, fees, finance,
etc.) costs
- Developers 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
3
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
(dont worry about timing of completion yet)
Development value (DV):
Total constructed area (m2)
Estimated market rent (/m2)
5,000
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
5
Case Study
See hand-out
10
Revenue Inputs
NIA
GIA
Efficiency ratio
So NIA
=
=
=
=
2,000 m2
85%
2,000 x 0.85
1,700 m2
Estimated (net) annual rent
GDV
=
=
=
NIA x estimated rent / m2
1,700 m2 x 200 / m2
340,000
=
=
=
Estimated annual rent / yield
340,000 / 0.07
4,857,143
Cost Inputs
Disposal costs
(agent and legal fees if sold or refinancing and
valuation fees if retained as an investment)
NDV
Building costs
GDV / (1 + 0.0575)
4,857,143 / 1.0575
4,593,043
building cost / m2 x GIA
969/ m2 x 2,000 m2
1,938,000
Cost Inputs
Professional fees
Architect
QS
Engineers (structural, M&E)
Legal
Consultants (planning, highways, ecology, archaeology)
Developer / project management
Landscape architect
Professional fees
2,083,000 x 0.13
267,540
(building costs + other works) x 13%
16
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...
Development time-line & cost build-up
Lead-in period
(6 months)
Site
acquisition
Construction period
(15 months)
Void period
(3 months)
Construction
completed
Construction
begins
Total development period
Total
Costs
()
Fitting out
Main
construction
activity
Cost of site
Site
acquisition
Site
clearance,
foundations,
etc.
Construction
begins
Construction
completed
Development
let and/or
sold 20
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
We know we will need
to finance land
purchase but dont
know what the price is
so need to come back
to this later
?
6 months
18 months
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
22
Building costs
TOTAL = -2,622,945
-1,209,920
-479,341
-454,341
-227,171
-227,171
-25,000
Q0
Q1
Q2
Q3
Q4
Q5
Q6
23
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
-603 -617 -6,110 -17,816 -47,421 -59,521 -66,434 -68,036
TOTAL = -265,956
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How interest is calculated
2,622,945
1,311,473
Interest on half
construction
costs over
construction
period
6 months
Over construction period:
= (2,622,944 / 2) x [(1 + 0.1)1.25-1]
= 165,934
15 months
For void period,
interest is on all
construction
costs and
interest rolled
up so far
3 months
Over void period:
= (2,622,944 + 165,934) x [(1 + 0.1)0.25 -1]
= 67,250
25
Cost Inputs
Letting fee
estimated annual rent x
15%
=
=
340,000 x 0.15
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.
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Cost Inputs
Developers 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
Developers profit
Interest / finance costs
Acquisition costs
Development period
29
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
Acquisition costs @ 5.75% site price
-711,492
-40,911
-752,403
*This is the general model as it can be used to back out
land value
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Construction Costs:
2,622,945
Total Construction Costs ('s):
Interest:
Over building period
Over void period
On site costs over total devt
period
165,93
4
-67,250
158,00
5
Total Interest Payable :
391,189
Letting & Sale Fees:
-61,000
Total
costs
*equaldevelopment
to profit on land
and development
costs in residual site valuation
Developer's
profit on
completion*
3,827,536
31
765,507
Profit appraisal: snapshot methods of
expressing developers profit
Profit as % of development costs (return on costs)
All of these
Useful for trader developers
measures are at
Profit as a % of net development value
time of scheme
Remember profit as % costs or value are related
completion, i.e.
they have not
Income yield
been PVd
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
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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 PVd -1]
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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.
cost
Defer (PV)
Defer (PV)
void
construction
site
time
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
35
Development
appraisal
Cash-Flows
What for?
Why
Larger, more complex schemes
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 cashflow can be used to monitor actual
costs compared to the estimates and
thus how the developers profit might
be affected
Examine viability in more detail and
using more conventional financial
concepts (NPV, IRR)
Valuation method becomes an
appraisal tool...
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
For whom?
Developers
Lenders (who may be financing the
development)
Investors (who may be acquiring
the scheme on completion)
DCF procedure
(source: GMCE)
1. Forecast expected cash-flow
2. Determine TRR
3. Discount (1) at (2) to PV
V0
E0 CF1 E0 CF2
E0 CFt 1
E0 CFt
...
t 1
t
1 E0 r 1 E0 r 2
1 E0 r
1 E0 r
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...
39
Appraisal questions
Pre-finance:
Discounting the cash-flow (which includes land price) at
the developers target rate, what is NPV/IRR?
Discounting the cash-flow (which doesnt include land
price) at the developers 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)
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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
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
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