Chapter 3 Development Appraisal and Risk

Property Development (6th Edition)

Publisher: Routledge www.routledge.com

Authors: Professor R.G. Reed and Dr S. Sims

3.1 INTRODUCTION

• Assessing and evaluating the financial viability of a development constantly occurs throughout all stages of the development process.

• Many dynamic factors influence development and their status must be updated and re-evaluated in light of the overall risk attached to the development.

• Risk is an inherent and unavoidable part of the property development process and should be assessed as part of the overall evaluation process.

• The influence of uncertainly can be contained in order to reduce the effect on risk.

3.2 FINANCIAL EVALUATION

3.2.1 Conventional Techniques • Conventional techniques of identifying the various components of value in a

proposed development are relatively straightforward based on using a form of ‘residual’ valuation.

• This type of model is designed to isolate an individual component of a development such as the level of risk/return or the land value, and assess their individual ‘unknown’ value when information about all of the other variables are known.

• Two primary types of residual valuation undertaken depend on the final outcome sought where the first focuses on calculating the investment risk/return, the second on calculating the remaining (residual) cash.

• The model considers the following: affordable land purchase price, net development value, purchaser’s costs, development costs, planning fees, building regulation fees, funding fees, finance costs/interest, letting agent’s fees, promotion costs, sale costs, other development costs, contingency allowance, developer’s profit/risk allowance.

3.2 FINANCIAL EVALUATION

1. Investment risk/return• This model commences with (a) the final estimated value of the completed

property development based on estimated final market prices. Then (b) the total development costs (e.g. land, construction cost) can be deducted from (a) to establish whether the project produces (c) an adequate rate of return for the developer or financier, either in terms of a trading profit, an investment yield or return on capital.

2. Affordable land purchase price• An alternative approach for using a residual valuation is to assess (a) the likely

costs of producing a development scheme and by deducting these costs from (b) an estimate of the value of the completed development scheme to arrive at (c) a land purchase price.

3. Purchaser’s costs• The final completed development value needs to be expressed as a net

development value to allow for purchaser’s costs such as stamp duty, agent’s fees and legal fees.

3.2 FINANCIAL EVALUATION

4. Development costs • (a) Land costs (b) building costs (c) professional fees (d) site investigation fees.5. Planning fees • These costs relate to government fees required to make a planning

application and securing consent for the property development project. 6. Building regulation fees• Usually these costs are on a sliding scale based on the final building cost. 7. Funding fees• Most financial institutions and lenders charge fees when arranging

development finance. 8. Finance costs/interest• Interest costs for borrowed funds are a critical element of the appraisal and

can have an adverse effect on the overall viability of any development proposal. These costs reflect either (a) the actual cost to the developer of borrowing money over time or (b) the implied or notional opportunity cost. A sample timeline is shown in Figure 3.1.

3.2 FINANCIAL EVALUATION

9. Letting agent’s fees • These fees relate to the cost of the agent letting the building to new tenants.10. Promotion costs • The developer has to make an assessment of the likely sum of money that

needs to be spent on promoting the project in order to let the property. 11. Sale costs • Costs associated with selling the completed development will need to be

included if the developer intends to sell the building once it is fully let. 12. Other development costs • The inclusion of other costs within the evaluation will depend on the nature

of the development and will be specific to the project.

Discussion points: What are the various components of value when undertaking a property development?

Explain the relevance between the level of profit/risk and the overall development.

3.2 FINANCIAL EVALUATION

3.2.2 Cash-Flow Method• This model presents a more realistic and accurate assessment of development

costs and income against the variable of time.• It is the nature of property development that the timing of cash-flows is

irregular and uneven.• Cash-flow is critical due to the cost of repaying borrowing funds and the effect

of compound interest over an extended period of time, therefore the potential to develop a property in phases can be a major advantage for the overall viability of the project.

• Some offices in high-rise buildings can be let or even sold off and allow the new owners to occupy the lower floors, even though the upper floors or other sections of the building are still under construction.

• The model enables the developer to adjust for changes in interest rates easily over the development period or for different sources of finance.

3.2 FINANCIAL EVALUATION

3.2.3 Discounted Cash-Flow Method • A discounted cash-flow (DCF) can examine different cash-flow models; they

are all discounted back (i.e. using a present value formula) to a common point in time to facilitate an even comparison or analysis.

• The time periods can be modified to any time period, such as days or years depending on the intended complexity of the DCF.

• The main advantage of this approach to the developer is that it allows a subsequent calculation of the ‘internal rate of return’ (IRR), which is the measure used by some developers to assess the profitability of a scheme since IRR considers both the timing of the cash-flows and the magnitude of each cash-flow.

• IRR is also ideal for comparing different potential property developments with their own variations in the timing and size of the cash-flows.

• A DCF method is more likely to be used by investors who wish to retain the development in their portfolio and also seek to analyse the return on their investment.

3.3 THE ROLE OF UNCERTAINTY AND RISK

• Basic model is based on a considerable number of variable factors including: land costs, rental value, square footage (or metres) of building, investment yield, building cost, professional fees, time including pre-building contract, building and letting/sale periods, short-term rates of interest, real estate agents’ fees, promotion costs and other development costs (Figure 3.1).

• It is important that the financial information input into the cash-flow model is as reliable as possible.

• The level of reliability depends on the developer’s experience and assumptions behind sources of information the developer uses.

• It is important that the developer uses current and up-to-date rental values and accurate building costs to reflect income and expenses in every development appraisal.

• An understanding of the complexities of risk is essential for a successful developer. Risk is embedded throughout the property market and is the starting point for every analysis involving property.

Discussion point: Why are uncertainly and risk major considerations when using the cash flow method?

3.3 THE ROLE OF UNCERTAINTY AND RISK

Land cost • The purchase price of the land (either vacant or partially improved with an

existing old structure) is usually the first major financial commitment. Building cost • The building construction cost is the second major financial commitment, in

combination with a number of other costs relating directly to the final sum. Short-term interest rates • In obtaining the essential finance to acquire the land and build the scheme,

the developer will be exposed to any fluctuations in short-term interest rates. Investment yield • Investment yields are dictated by decisions of stakeholders in the property

investment market, being the relationship between the total value of the completed property developments and the total annual rent received.

Sensitivity analysis • Measures the level of uncertainty involved in a particular property

development scheme and therefore how much profit is required to balance the resultant risk.

Chapter 3 Development Appraisal and Risk

Property Development (6th Edition)

Publisher: Routledge www.routledge.com

Authors: Professor R.G. Reed and Dr S. Sims