Development appraisalResidual Method

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

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?

4

Simple residual land valuation

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

5

(don’t worry about timing of completion yet…)

Case Study

10

See hand-out…

Revenue Inputs NIA

GIA = 2,000 m2

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

Cost Inputs

Disposal costs(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

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

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 feesEstimates for various additional costs and fees can be included...

Development time-line & cost build-up

20

Lead-in period(6 months)

Construction period(15 months)

Void period(3 months)

Total development period

Construction begins

Construction completed

Siteacquisition

Site clearance,

foundations, etc.

Main construction

activity

Fitting out

TotalCosts

(£)

Siteacquisition

Construction begins

Construction completed

Development let and/or

sold

Cost of site

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

22

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

23

Q3

TOTAL = -£2,622,945

-£227,171

-£479,341

-£1,209,920

-£454,341

-£227,171-£25,000

Q5Q4Q2Q1Q0 Q6

Interest on building costs iscumulative

24

-603 -617 -6,110 -17,816 -47,421 -59,521 -66,434 -68,036

TOTAL = -£265,956

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

How interest is calculated

Over construction period:= (£2,622,944 / 2) x [(1 + 0.1)1.25-1]= £165,934

25

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

Over void period:

= (£2,622,944 + £165,934) x [(1 + 0.1)0.25 -1]

= £67,250

Cost Inputs

26

Letting fee = estimated annual rent x 15%

= £340,000 x 0.15= £51,000

Marketing costWould cover items such as advertising, opening ceremony, brochure design and production. The scale would obviously depend on the nature of the development.

Cost InputsDeveloper’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

= £711,492Maximum 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

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

30

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

31

Construction Costs:

Total Construction Costs (£'s):-

£2,622,945

Interest:

Over building period

-£165,93

4

Over void period -£67,250

On site costs over total dev’t period

-£158,00

5

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 ofexpressing developer’s profit

Profit as % of development costs (return on costs)• Useful for trader developers

32

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

All of these measures are at time of scheme completion, i.e. they have not been PV’d

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**

33

*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...

time

cost

site

construction

void

Defer (PV)

Defer (PV)

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.

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 appraisalCash-Flows

What for?• 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

Why• 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...

• Developers

• Lenders (who may be financing the development)

• Investors (who may be acquiring the scheme on completion)

For whom?

DCF procedure (source: GMCE)

1. Forecast expected cash-flow

2. Determine TRR

3. Discount (1) at (2) to PV

tt

tt

rE

CFE

rE

CFE

rE

CFE

rE

CFEV

0

01

0

102

0

20

0

100

11...

11

Where CFt = net cash-flow in period tV0 = value at t = 0, i.e. present valueE0 [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 investmentand 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 questionsPre-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)

40

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

42