Financial Appraisal Report Content
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THE FINANCIAL APPRAISAL OF REAL ESTATE DEVELOPMENTS The basic method used to assess the financial viability of a proposed development is the residual valuation. This is based on the simple assumption that if the value of a finished scheme exceeds the cost of its development by a margin sufficient to leave the developer with an appropriate level of profit, then development will occur. That is
Gross Development Value - Developments Costs = Residual
OR
Gross Development Value - (Building Costs + Land Costs) = Developer’s Profit Clearly, this equation can be reformulated so that, providing any three elements are known, any fourth element can be calculated (see Figure 4). Thus, the residual can be used to estimate the minimum value needed to cover costs and profit; a building cost ceiling; or a maximum price to pay for land. Following the formulation above, the two crucial stages in assessing the financial viability of a scheme are the calculations of value and of cost.
Figure 4: Residual Valuation
A Worked Example of a Residual Valuation In order to undertake a residual valuation, the value of a range of inputs must first be ascertained relating to the subject scheme. The extended example pursued below illustrates the application of the method and is based on a fictional scheme. A spreadsheet has been used to undertake the calculations and to analyse the results. The various figures and tables have been extracted from or
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are based upon the spreadsheet ‘Worked Example Spreadsheet’, a copy of which should be downloaded from the relevant module folder in MOLE. The example. A property development company is considering whether to acquire the freehold of a 1.45 ha. site on the fringe of the central area of a major provincial city. The site has the benefit of planning permission for a scheme shown in the below table. The site has two existing buildings, of which a proportion of both are currently let to tenants – a car body shop in Building 1 and an accountants in Building 2. BUILDINGS AND SITE COVERAGE Site Area: 14,537 sq m Area (sq m) by Level
Land Use 0 1 2 3 All
Levels Hardstanding 3830 3,830 Footpaths 532 532 Roads 605 605 Grassed Areas 1915 1,915 Planted Areas 57 57 Multi Story Carpark 457 457 914 Apartments 1 Undercroft parking 957 957 Apartments 1 957 957 957 2,871 Offices 1 957 957 487 487 2,888 Offices 2 1915 1915 1436 718 5,984 Hotel 1265 1265 1265 3,795 Retail (shops, convenience & high street) 957 957 1,914 Refurbished Workshops 1090 1090 2,180
0 0
Totals 14,537 7,598 4,145 2,162 28,442 The company intends to develop a scheme speculatively. The residential element consists of apartments built for sale. The commercial element - offices, hotel, retail and refurbished workshops - will be let on completion and then sold as standing investments to investors. Further details of the physical character of the site and of the proposed development are given in the SCHEME NOTES page of the spreadsheet. Before committing itself to the land purchase, the developer must undertake an initial appraisal of the development to assess its financial viability. The first stage involves the calculation of the LAND COSTS. These may range between two values: (i) development value; and (ii) existing use value. • Development value incorporates an assumption that the site will be
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(re)developed for a new/higher use – hence the name. It is estimated either by reference to prices bid for other development sites in similar locations (that is, using the comparative method) or by applying the land value residual to the subject site (as above). In this example, the former approach is used. The site area is multiplied by the unit cost (a range of unit costs - development value per square metre - is given on the COST & VALUE DATA page of the spreadsheet). • Existing use value is more complicated to estimate. If any land or buildings on the site are vacant/derelict, they will have no value. If, however, they are productively occupied, they will have to be purchased for an appropriate price. In the example, there are two tenanted buildings whose value has been estimated using the method described in the VALUATION section below. The net/gross floorspace ratio, the rents and the yields that have been used reflect the age and condition of the buildings (compared with new accommodation, the ratio is lower, rents are lower and yields are higher). The developer will try to acquire the site for the lowest price possible. However, the spreadsheet makes the conservative assumption that the land costs will equal the higher of the two values (see cell I29).
Figure 5: The Calculation of Land Costs
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The next stage involves the estimation of the CONSTRUCTION COSTS of the scheme (see Figure 6). These consist of the costs of site works and building works. They are calculated by measuring off from the drawings the relevant areas (for buildings this is gross floor space; that space within the external walls) and applying appropriate unit costs to them (see the COST & VALUE DATA page of the spreadsheet) to derive total costs. The data on unit costs relate both to the construction of new buildings of each type and to the refurbishment of existing buildings for office use.
Figure 6: The Calculation of Construction Costs
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The third stage is to undertake a VALUATION of the development (see that page of the spreadsheet). Upon physical completion, the developer may (sooner or later) dispose of the scheme. Disposal can take two basic forms.
i) Sale to an owner-occupier An organisation purchases (one of) the building(s) for its own occupation and use, paying a price equal to the development costs or to the value of the premises to the occupier (not the same).
ii) Sale to an investor An individual or an organisation purchases the building as an investment. The occupier(s) of the building pay a rent to the owner that is (part of) the latter’s return on his/her/its investment. The price paid by the investor equates to his/her/its valuation of the property as an investment. If the developer retains the development then the transaction is notional but the value of the scheme will still need to be assessed for financial/accounting purposes. The value of a proposed development can be assessed using the comparative method. That is, by gathering sufficient data relating to open market sales of similar properties, one can estimate the likely price that could be achieved for the sale of the proposed development. Frequently, units of comparison are used: for acquisitions by owner- occupiers these will simply be capital value expressed as £’s per square foot/metre; for investment sales information relating to capital value, rent and yield will be needed. A range of unit values is given on the COST & VALUE DATA page of the spreadsheet. As with costs, these data relate to new, purpose-built accommodation and to refurbished buildings. The proposed scheme contains one element for sale to owner-occupiers: the apartments (although there is no reason why small, personal investors may not acquire an apartment on a ‘buy-to-rent’ basis). There are seven elements for sale to investors: the two new-build offices, the refurbished workshops, the hotel, the retail (high street and convenience), the multi story carpark and the undercroft carpark. For the apartments, the application of the unit price to the area gives the total value (see Figure 7). For the latter commercial properties, the value is based on the following relationship between rent (R), yield (Y) and capital value (CV). CV = R/Y Both calculations require the Gross Floor Area of the buildings to be converted by the application of a Net/Gross Floorspace Ratio (the proportion of total floorspace that is useable by the occupier, expressed as a percentage) to a Net Lettable/Saleable Area. ‘Netting’ practice varies with property type and market usage. Older, refurbished buildings generally have lower floorspace ratios than their modern equivalents (note the ratio used for the listed building).
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Figure 7: The Valuation of the Development
The final stage is to undertake the financial APPRAISAL 1 of the scheme. This incorporates costs additional to land and construction costs in the calculation and estimates the difference between the value and the total cost of the scheme. The workings are described in Figure 8. The various elements of the appraisal (relating to each specified row of the spreadsheet) are described below. ROW 5 Gross Development Value is brought forward from the VALUATION pages of the spreadsheet. ROW 7 Land costs include the land value brought forward from the LAND COSTS page and land acquisition fees (see ROW28). ROW 9 Construction Costs are brought forward from the CONSTRUCTION COSTS page of the spreadsheet. ROW 11 Finance costs incorporate finance on construction costs (ROW 39), finance on professional fees (ROW 41), land cost finance to completion (ROW 46) and holding costs (ROW 50) ROW 13 Professional fees include professional fees (ROW 40), letting fee (ROW 51), investment sales fee (ROW 52) and occupier sales fee (ROW 53)
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Figure 8: The Financial Appraisal of the Development Proposal
ROW 15 Residual profit is taken from CELL D57 which is the result of gross development value (CELL D35) minus Total Costs (CELL D55) ROWS 18-23 Different parts of the development period are described in Figure 9 (overleaf). The specific values entered here are related to information in the COST & VALUE DATA page of the spreadsheet. ROW 26 Finance rate: interest rate (short term) on money borrowed to cover costs arising during the development period, expressed as a % per annum. ROW 27 Professional fees: fees paid for architects, surveyors etc., as % of building costs. ROW 28 Land acquisition fees: fees charged for arranging site purchase, expressed as % of land costs.
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Figure 9: The Development Programme
ROW 29 Letting fee: fee paid to agents for letting the tenanted buildings in the scheme, expressed as % of (estimated) achieved rent. ROW 30 Investment sales fee: fee charged by agents for arranging sale of the rented element of completed scheme to investors, expressed as % of Gross Development Value. ROW 31 Occupier sales fee: fee charged by agents for arranging sale of the owner- occupied element of the completed scheme, expressed as % of price achieved (estimated capital value). ROWS 35-57 The various elements of the residual valuation are brought together and the residual valuation calculation generates the residual profit. ROW 39 The half rule of thumb is used to calculate the finance on construction costs, that is, the cost of short-term finance to fund physical construction of the scheme. The whole cost is not incurred on the first day of the building contract period, so assumptions concerning the cost profile must be made. The standard assumption made is that costs are evenly spread over the building contract period; that is that half the costs are incurred halfway through the period (see Figure 10). Consequently, to calculate finance on building costs, the ‘half rule of thumb’ is used in the following way: the standard formula is x*(1+i)n - x = finance cost (minus x to avoid double counting) where x is the principal, in this case the building costs, i is the finance rate (expressed as a decimal) and n is the period of the loan in years, in this case, the building contract period; This formula can be amended by halving x or i or n. Each gives a different answer and all are inaccurate to the extent that actual cost
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profiles differ from the assumed profile (see Figures 11-13). ROW 41 The finance on professional fees. Because professional fees are ‘front loaded’ a ‘three-quarter rule of thumb’ is used. Click on the cell to see which other cells the calculation brings in. ROW 46 The finance on land costs, which is the cost of short-term finance for the purchase and holding of the land over the period to completion. In this case all costs are incurred on the first day of the period. Consequently the standard compound interest formula is used. Click on the cell to see which other cells the calculation brings in. ROW 50 Holding costs: cost of short-term finance to fund the holding of the scheme over the disposal period (CELL D22). Interest is calculated on all capital expenditure and rolled-up finance costs as at physical completion, using the standard compound interest formula.
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ROW 51 Letting fee: CELL D29 x ERV (Estimated Rental Value: see cell G27 on the VALUATION page) ROW 52 Investment sales fee: CELL D30 x GDV of rented accommodation (see cell I27 on the VALUATION page). ROW 53 Occupier sales fee: CELL D31 x CV (capital value of owner-occupied accommodation; see CELL I15 on the VALUATION page). ROWS 50-53 These fees are incurred at disposal, so do not generate any finance costs. ROW 55 Total costs: sum of CELLS D48-D53. ROW 57 Residual: sum of CELL D35 – D55 ROW 59 Developer’s profit on costs: (D57 / D55) x 100. In this case the profit rate is 15.39%. The target profit rate for property development is about 15- 20%, so the scheme is viable.
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