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