Development appraisals

Question 1

What is the difference between a development appraisal and a residual valuation?

Answer 1

• Development appraisal: establish the viability/profitability of a proposed development using a client’s inputs
• Residual valuation: establish the market value of a site using market inputs

Question 2

What is the methodology for calculating residual site value?

Answer 2

Gross development value (GDV) - Total development costs (TDC) = Gross site value

Gross site value - purchasers’ costs = Residual site vale

Question 3

What costs would you allow for as part of total development costs?

Answer 3

• Site preparation
• Planning costs
• Building costs
• Professional fees + VAT
• Contingency
• Marketing costs & fees
• Finance costs
• Developers profit

Question 4

What would be included in your estimate for site preparation costs and how would you estimate them?

Answer 4

• Demolition, remediation works, landfill tax, site clearance, levelling and fencing
• Obtain a contractor’s estimate for these works

Question 5

What would be included in your estimate for planning costs?

Answer 5

• Section 106 payments under the Town and Country Planning Act 1990
• Community Infrastructure Levy (CIL) charged by most Local Planning Authorities
• Required percentage of affordable housing for a new residential development in the form of social, intermediate and key worker housing
• Section 278 payments for highway works
• Planning application and building regulation fees
• Costs of planning consultants
• Cost of any specialist reports required by the LPA (e.g. Environmental Assessment)

Question 6

How would you estimate the building costs?

Answer 6

• Client information
• Spons Building Costs book
• Quantity Surveyor estimate / bill of quantities / cost estimate
• Building Surveyor estimate
• RICS Building Cost Information Service (BCIS)

Question 7

What basis are the cost on BCIS usually expressed? Where does RICS obtain the information from?

Answer 7

• Usually based on a GIA basis

* Obtain monthly updates from Quantity Surveyors / Building Surveyors and recent contract prices / tenders agreed

Question 8

What would be included in your estimate for professional fees and how would you estimate them?

Answer 8

• Architects, M&E consultants, project managers, structural engineers, quantity surveyors
• Typically 10-15% (plus VAT) of total construction costs
• Can vary them depending on the complexity of the project e.g. lower architects fees required for an industrial warehouse than a high-rise residential building

Question 9

What would you typically estimate for contingency costs?

Answer 9

5-10% of total construction costs (depending on the level of risk and likely movements in building costs)

Question 10

What would be included in your estimate for marketing costs and fees and how would you estimate them?

Answer 10

Marketing budget (use evidence/quotes):
• Cost of an EPC
• Sales fee: 1-2% GDV
• Letting fee: 10-15% of initial annual rent
• National House Building Council (NHBC) warranty for residential schemes

Question 11

How would you estimate the interest rate?

Answer 11

• SONIA (Sterling Overnight Index Average)
• Bank of England Base rate + premium
• Rate at which the client can borrow money

Question 12

What THREE elements does the developer need to borrow money to finance? What basis would they be represented?

Answer 12

1. Site purchase + purchaser’s costs: compound interest (straight-line basis)
2. Total construction costs + fees: based on an s-curve taking hold of the costs over the length of the build programme
3. Holding over costs to cover voids until the disposal of the scheme: compound interest (straight-line basis)

Question 13

What holding over costs need to be accounted for after the development is completed, until the disposal of the scheme?

Answer 13

Empty rates, service charges and interest charges

Question 14

What capital stack does the development appraisal process assume?

Answer 14

100% debt finance

Question 15

Explain the concept of the s-curve and why it is applicable.

Answer 15

• Assumes that total constructions costs + fees are paid over half the time period
• Reflects when monies tend to be drawn down - lower levels of expenditure at the beginning and end of projects

Question 16

What would you typically estimate for developers profit?

Answer 16

15-20% of total construction costs or GDV (GDV more frequently used as a base for residential use)

Consented sites will typically have a profit on cost of 15-20%. Non-consented sites will have 20-25%, depending on how it complies to local policies and whether they’d had a positive pre-application

Question 17

What will influence the level of profit required by a developer?

Answer 17

• Depends on the level of risk
• If scheme is low-risk (or pre-let / sold) a lower return may be required
• Current riskier market conditions means the percentage of profit required has risen

Question 18

How should you verify the output of a development appraisal?

Answer 18

Cross check site value with comparable site sales if possible

Question 19

When conducting a residual site valuation, what date should the inputs be taken from?

Answer 19

Taken at the date of valuation

Question 20

What are the two main methods of development finance?

Answer 20

1. Debt finance: lending money from a bank or other funding institution
2. Equity finance: selling shares in a company, JV partnership, own money used, forward purchase from an investor or occupier

Question 21

What is a typical loan to value (LTV) ratio?

Answer 21

c. 60%

Question 22

What are the typical components of a capital stack for development financing?

Answer 22

• Senior debt: takes precedence over other sources of funding. If the borrower defaults, the lender can take ownership of the property
• Mezzanine finance: will sit below the senior debt in terms of priority. Typically has a higher rate of return than senior debt but lower than equity
• Equity: riskiest and most profitable portion of the capital stack. Riskiest as the other tranches of capital will be repaid before the equity holders

Question 23

When would you use mezzanine financing?

Answer 23

Funding for additional monies required over the normal LTV lending

Question 24

What are swaps and how are they used?

Answer 24

Form of derivative hedging for interest rates. Swap rate will be the market rate for a fixed rate, fixed term loan

Question 25

What is overage?

Answer 25

Arrangement for the sharing of any extra receipts received over and above the profits originally expected, as dictated by a pre-agreed formula Usually shared between vendor/landowner and developer in a pre-arrangement apportionment

Question 26

What is the profit erosion period?

Answer 26

Length of time it takes for the development profit to be completely eroded, due to empty rates, service charges and interest costs, following the completion of the scheme

Question 27

What are the limitations of the residual valuation methodology?

Answer 27

* Dependent on **accurate information** and inputs * Does not consider **timing** of cash inflows * Very **sensitive** to minor adjustments * **Implicit assumptions** hidden and not explicit * Assumes **100% debt** finance

Question 28

What variables would you typically conduct a sensitivity analysis on?

Answer 28

* GDV * Build costs * Finance rate

Question 29

What are the THREE forms of sensitivity analysis?

Answer 29

1. Simple sensitivity analysis - of key variables e.g. yield, GDV, build costs and finance rate 2. Scenario analysis - changing scenarios for the development content/timing/costs such as phasing the scheme or modifying the design 3. Monte carlo simulation - using probability theory with software such as Crystal ball

Question 30

What guidance did the RICS release on valuing development property?

Answer 30

RICS Valuation of development property, 2019

Question 31

How is development property defined in RICS Valuation of development property, 2019?

Answer 31

Interests where redevelopment is required to achieve the highest and best use or where improvements are either being contemplated or are in progress at the valuation date

Question 32

According to RICS Valuation of development property, 2019, what should Market Value for a development property assume?

Answer 32

Optimum development i.e. the development which yields the highest value, taking into account the perspective economic and planning conditions

Question 33

What does RICS Valuation of development property, 2019 state about the use of multiple valuation approaches?

Answer 33

Best practice avoids reliance on a single approach or method of assessing the value of development property Output should always be cross-checked using another method (market comparison approach, residual method)

Question 34

What method does the RICS Valuation of development property state should be used for complex and/or lengthy development schemes?

Answer 34

Discounted cash flow (DCF) technique. Simple residual method can be used in other cases

Question 35

What does RICS Valuation of development property, 2019 recommend should be done to account for risk in the valuation process?

Answer 35

* Risk analysis should be used to show changes to the inputs which might affect the valuation * Risk and return levels and assumptions should be explicitly stated in the valuation report

Question 36

How should you value land that is in the course of development according to RICS Valuation of development property, 2019?

Answer 36

• Value of the land + costs expended at the valuation date and/or • Completed development value - costs remaining to be expended at the valuation date

Question 37

How should the output of the valuation be reported according to RICS Valuation of development property, 2019?

Answer 37

Reported as a single figure, except where there is potential for significant variation (e.g. if there is uncertainty around the valuation the different options identified should be report)

Question 38

Why is profit on cost a more reliable method of measuring developers profit than profit on GDV?

Answer 38

GDV is subject to more variation

Question 39

What financing rate would you typically assume when running a residual valuation?

Answer 39

Depends on the risks associated with the site. Typically this would be around 5.5% but are likely to increase to 6% or more given the current uncertainties in the debt market

Question 40

If you were to conduct a residual valuation now, how would you approach it differently in light of the current circumstances?

Answer 40

* Increase your contingency to reflect uncertainties in material costs * Increase the timescales to reflect that it would take longer for you to get on site. * Increase finance costs as cost of debt has increased

Question 41

What is GDV?

Answer 41

Gross development value (GDV) is the estimated contract price or Market Value of the completed development. States gross as it is prior to any marketing fees being deducted

Question 42

What do developers consider the greatest risk when undertaking a development?

Answer 42

Planning permission

Question 43

How did you use special assumptions in your residual valuation approach?

Answer 43

GDV was the aggregate market value of the proposed development, assessed on the special assumption that the development is complete on the date of valuation in the market prevailing conditions