FINANCIAL APPRAISAL - community-led housing london

Page created by Robin Mccormick
 
CONTINUE READING
FINANCIAL APPRAISAL - community-led housing london
FINANCIAL
APPRAISAL

            MARCH 2020
FINANCIAL APPRAISAL - community-led housing london
CONTENTS
WHAT IS A FINANCIAL APPRAISAL? ................................................... 4
GROSS DEVELOPMENT VALUE ........................................................... 6
schedule of accommodation ................................................................................................................ 6
Rents and Sales Values ......................................................................................................................... 6
Affordable Housing ................................................................................................................................ 6
Transaction costs .................................................................................................................................. 7

COSTS ........................................................................................... 8
Site investigation costs.......................................................................................................................... 8
Construction costs ................................................................................................................................. 8
Contingency ............................................................................................................................................ 9
Professional fees ................................................................................................................................... 9
Planning fees, Building regulation fees ................................................................................................ 9
Planning obligations ............................................................................................................................ 10
Finance costs ....................................................................................................................................... 10
Agent’s fees and Marketing ................................................................................................................. 11
Return .................................................................................................................................................... 11
Land cost .............................................................................................................................................. 12
Site Acquisition .................................................................................................................................... 12
Tax......................................................................................................................................................... 12

CASH FLOW AND DISCOUNTED CASH FLOW ........................................ 13
LONG TERM FINANCIAL APPRAISAL .................................................. 14
UNCERTAINTY AND RISK ................................................................. 16
Planning Risk and Land Cost............................................................................................................... 16
Finance Risk and Interest .................................................................................................................... 16
Construction Risk and Cost ................................................................................................................. 17
Market Cycle Risk and Values ............................................................................................................. 17

COMPARABLE VALUATION ............................................................... 18

                                                                              2
GUIDE SUMMARY
In this guide, we cover development
appraisals, introduce cash flow concepts,
and cover long term financial modelling.
We talk about where the money comes from
in the guide ‘Development Finance’

HOW TO READ THIS GUIDE
Throughout the guide, there are links to
useful documents and websites for further
reading. These are highlighted in blue
We have also suggested group activities and
outputs to help you and your group work
through each stage.
If at any point you would like advice and
guidance, you can contact us at
info@communityledhousing.london

DISCLAIMER
Our team and associate Advisers encourage
groups to think openly and clearly about their
objectives and how to achieve them. The
information in this guide is for general
guidance and is not legal, financial, or
professional advice.
Community Led Housing London assumes no
responsibility for the contents of linked
websites. The inclusion of any link should not
be taken as endorsement of any kind or any
association with its operators.
You can read our full disclaimer here

                                                 3
WHAT IS A FINANCIAL APPRAISAL?
A financial appraisal helps check that the                 different sites. The work will become more
project is viable in terms of development and              resolved as more detail is added.
in the long term. For private developments,
the appraisal establishes the potential for                Development appraisals look at the
profit in relation to the risks incurred. For              development phase of a scheme. This may
non-profit organisations, appraisals attempt               be sufficient if the intention is to sell all of the
to ensure that the costs are recoverable, and              homes.
the scheme achieves what you want.
                                                           Long term financial appraisals or ‘investment
Assessing and evaluating a development is                  appraisals’ should be included if the
not just a one-off task, but a continuous                  organisation intends to hold rented units. We
process which needs constant monitoring                    will cover these later.
and revisions, typically on a spreadsheet.
                                                           ‘Residual’ valuations use the known variables,
Different scenarios should be tested and the
                                                           or those easier to estimate, to asses an
implications of changes to assumptions
                                                           ‘unknown’ value. The residual equation can
understood. It is very important to use
                                                           be rearranged depending on what you want
realistic assumptions rather than trying to
                                                           to find out. To work out a residual valuation,
make the numbers say what you want.
                                                           you will need to isolate components of the
Because the assumptions are so important,                  proposed development such as land price,
appraisals should be carried out by                        construction cost, finance cost and housing
experienced RICS valuation surveyors1 and                  rents/prices.
informed by the advice of your wider
                                                           In a residual land value appraisal, you assess
professional team, and the market.
                                                           whether your likely eventual income can
You need to understand what they are doing                 cover the costs of your development.
and how they arrived at different costs as the             Whatever remains is the Residual Land Value,
decision to proceed and carry the risk,                    i.e. what you can pay for the land.
ultimately rests with your organisation.
                                                           If you know or assume the cost of land, it can
An indicative site is often useful in order to             also tell you the likely return or profit.
work up a model. This can be translated for

Residual Land Value Appraisal
Gross Development                  Development                   Return                   Residual Land
      Value2
                           –          Cost3
                                                       –       Requirement
                                                                                 =            Value

Development Return Appraisal
Gross Development                  Development                                              Return
      Value3
                           –          Cost
                                                       –   Cost of the Land      =     (on Capital or IRR)

1 The                                                      2
      professional body in the UK is the Royal               Gross Development Value is the estimated value of
Institution of Chartered Surveyors (RICS), not to be       the completed development.
                                                           3 Development Costs are all of the likely costs
confused with Quantity Surveyors.
                                                           involved in building the project.

                                                       4
5
GROSS DEVELOPMENT VALUE
The Gross Development Value (GDV) is the                      specification. It’s important that you base the
final capital value of the completed                          estimate on firm reliable evidence and careful
development. It is calculated by assessing                    analysis and not to rely heavily on a forecast
what the properties would be sold or rented                   or overestimations. The property market is
for, based on current comparable evidence4.                   impossible to forecast accurately so the
                                                              emphasis should be on the current market.
                                                              Annual rents and sales values are usually
SCHEDULE OF ACCOMMODATION
                                                              best analysed by reference to a rate per
To work out the GDV, you will need a
                                                              square foot (or per square meter) and are
schedule of accommodation which outlines:
                                                              based on net internal area (NIA).
•   how many homes you are proposing
•   their net internal area (NIA)5.                           Investment yield of rental property
•   their tenure.                                             The investment yield is a quick way to
It does not need to be the definitive design                  estimate the capital value of rental property.
but should be realistic. This is usually                      A snapshot of the annual rental income is
prepared by an architect, following an initial                multiplied by the inverse of the yield which
capacity study of the site. For example:                      represents the growth in the rental income
                                                              and the risks associated with it.
→ RUSS Schedule of Accommodation
                                                              Annual Rental                1            Capital
→ OWCH Unit Mix Schedule                                                           ×               =
                                                                Income                  % Yield         Value

RENTS AND SALES VALUES                                        The yield can be obtained by comparing
Market rents and sales values are best                        similar recent sales of rental properties for
established with an agent or a valuer. The                    investment purposes. In general, the faster
estimates must be as realistic as possible                    the rent is expected to grow, the lower the
and based on a thorough analysis of the                       yield, and the higher the level of perceived
market, refering to comparable evidence,                      risk the higher the yield.
based on recent sales or lettings of similar
schemes in the surrounding area.
                                                              AFFORDABLE HOUSING
Information from property sites such as
Zoopla and Rightmove, collate all their                       The GLA set out a series of affordable
information from Land Registry and can                        housing products :
provide a rough starting point.                               •   London Affordable Rent
As no two properties are identical, it is                     •   London Living Rent
important to make adjustments to reflect                      •   London Shared Ownership
differences in size, age, quality and

4The emphasis should be put on current and not projected values.
5The net area of the housing unit (the internal usable space excluding lifts and corridors in a block etc) needs to
be established and is known as the net internal area (NIA).

                                                         6
The GLA defines and publishes rents for                      funding from the GLA or other funders. The
differently sized units in different parts of                affordable housing grant rates are fairly low
London. These can be used for your                           and unlikely to fully cover the gap between
appraisal, however there is still a need to                  market values and affordable housing.
establish market values, as this will be                     Established housing associations typically
needed by lenders to act as their security,                  use the income from unencumbered existing
and will help you work out how others would                  stock or build market value units to cross-
approach a residual valuation (to compare                    subsidise additional social units. This GLA
your valuation against).                                     report finds that this may not continue to
Community led housing organisations can                      work, and greater levels of affordable
innovate in affordable housing products and                  housing grant are needed.
tenures, working out what affordability
means to their community, and how it can be
                                                             TRANSACTION COSTS
set. The London Community Housing Fund
                                                             Regardless of whether the you intend to hold
Prospectus has further information about the
                                                             the property to let or sell units to residents,
fixed and negotiated grant rates available.
                                                             the gross development value needs to be
                                                             expressed as a net development value to
Income from grants                                           allow for purchaser’s costs such as stamp
Grants are usually included as another form                  duty, agent’s fees and legal fees (incl VAT).
of income for the scheme. This may include

Map showing the price per sq. ft by postcode. Interactive version available here

                                                        7
COSTS
SITE INVESTIGATION COSTS                                   materials used in the building and the cost of
                                                           labour, as well as the following extra sums:
Investigations and surveys should give a
better idea of what can be built and reduce                Abnormals are additional costs that may be
the risk of unexpected costs further down the              required on a particular site, such as dealing
line. To begin with, you may rely on desktop               with contamination, asbestos, flood risk, or
research and surveys which can be cheaper                  infrastructure.
to carry out. When you need more intrusive                 Demolition of existing property either in full
surveys, you will probably need the                        or partially, including.
landowner’s permission.
                                                           External works including landscaping and
A list of surveys you may want to                          access, such as car parking, outdoor amenity
commission are listed in our guide on                      space, highways, footpaths, cycle and refuse
‘Finding a Site’.                                          storage.
While it is good practice to systematically
investigate everything about a site, it is more
                                                           Self-build is where prospective residents and
economical and efficient to focus on
                                                           volunteers contribute their labour into the
particular aspects that are likely to pose
                                                           construction. It can make some savings on
issues, so you can understand their
                                                           construction cost, although it is usually
implications better.
                                                           relatively small compared to overall
                                                           development costs (including the cost of
CONSTRUCTION COSTS                                         land). The labour and materials cost in
                                                           construction are usually evenly split. You may
For simple appraisals, construction costs are
                                                           still require professionals to carry out more
usually estimated as a rate per square metre.
                                                           specialist and complicated work, and there
This is then multiplied by the gross external
                                                           will still be supervision and insurance costs.
area (GEA) of the proposed building6. The
                                                           It is also important to bear in mind labour
building costs are estimated at the time of
                                                           with limited training and experience may take
the proposed implementation of the
                                                           longer on site, and time spent working on
development project. Usually no allowance is
                                                           site, may mean you are not able to earn as
made for construction cost inflation, but a
                                                           much in other work. However there may be
contingency of 10% is included.
                                                           non-monetary benefits in self-build, when
Spons’ and BCIS provide average                            considered holistically.
construction cost data, for different building
types and construction methods.
                                                           Pre-fabrication and off-site manufacture is
As designs develop a Quantity Surveyor will
                                                           not necessarily much cheaper for smaller
come on board and work alongside other
                                                           schemes where economies of scale may not
consultants to provide further resolution.
                                                           be possible, and where tight sites require
They will look at a detailed breakdown of the
                                                           creative design responses to optimise

6 Gross area of the building can be measured in a          perimeter walls, or the centre line of the party wall. It
number of ways. For construction cost, you measure         does not include open balconies, external fire
the Gross External Area (GEA) includes the whole are       escapes, parking areas, terraces, gardens or covered
of the building up to the external face of the             walkways.

                                                       8
housing density, rather than units with                This includes the architect, the quantity
standard dimensions. It is important to                surveyor, the structural engineer, the
establish what is included in quotes from off-         mechanical and electrical engineers and the
site manufacturers, as foundations and                 project manager. It may also include
groundworks are not often included and are             environmental and planning consultants,
significant proportion of construction costs.          landscape architects, traffic engineers,
Although it may actually be more expensive             acoustic consultants, party wall surveyors
on a per square meter rate, off-site                   and other specialists. Community led housing
manufacture can make the overall                       projects may also want to make special
construction time period shorter and may               allowances for a deeper co-design processes
provide cost certainty compared to traditional         than conventional schemes.
construction methods. It is usually better to          The total cost of professional fees is
ask your professional team to explore the              normally estimated around 12–18% of the
role of pre-fabrication in your project, without       ‘hard’ construction cost. The actual rates can
being fixed on something that may not be the           vary with the size of the project and
best suited for your particular site or project.       complexity of the task.
External works, such as landscaping and                They are either calculated on a ‘flat fee’ basis
highways, are often treated separately with            or a negotiated percentage. The agreed fee
different square meter rates or fixed sums.            may depend your relationship with each
                                                       professional. Small refurbishment schemes
                                                       normally attract higher percentages than
CONTINGENCY                                            larger development projects. If professionals
Developments never stick entirely to the               perceive your scheme to be high profile or
initial budget forecast. It is important to            innovative in some way, they may compete to
include a development or construction                  be a part of the project and reduce their
contingency to cover unexpected costs.                 rates.
Contingency typically ranges up to 10%
depending on the complexity of the
development and usually covers the potential           PLANNING FEES, BUILDING
increases costs such as labour, construction           REGULATION FEES
or unanticipated delays.                               These fees are paid to the local authority in
The actual contingency itself depends on               making a planning application and are based
your ability to plan and execute:                      on the scale and nature of the scheme. A list
                                                       of fees can be found on local authority
•   an accurate development plan
                                                       websites.
•   the associated time period
•   the level of risk and return built into the        If obtaining planning permission proves
    proposal                                           difficult, or in the event of an appeal, you may
                                                       have to allow for planning consultant fees,
                                                       solicitors, counsel and expert witnesses. The
PROFESSIONAL FEES                                      extra time period involved will need to be
These fees are normally calculated as a                reflected in the finance costs too.
percentage of the ‘hard’ construction costs            Building regulation fees are on a sliding scale
and include all fees for professional services         based on the final building cost. Details are
employed in the development.

                                                   9
available from the council’s building control            rate that a developer would be offered for
department or other approved inspectors.                 senior debt. However, the actual cost of the
                                                         finance is affected by many factors which
                                                         can include:
PLANNING OBLIGATIONS
                                                         •   varying underlying interest rates
These are payments made to the Local
                                                         •   refinancing of loans on differing terms
Authority and GLA to account for the impact
                                                         •   amortisation (reducing or paying off a
of development on the surrounding area.
                                                             debt with regular payments)
Community Infrastructure Levy (CIL) is a set             •   the risk in the development
rate per meter square of development                     •   the relationship between the borrower
collected by Local Authorities to fund                       and the financier
transport, schools, open spaces and other                •   the risk that the borrowed funds will be
infrastructure across the borough. It is set                 paid in full by the due date
differently in different places and for different
kinds of development, and you need to check
                                                         Different lenders will lend on different criteria
planning policy documents.
                                                         but they will all look closely at security value
Affordable housing doesn’t usually require               and asset cover:
CIL payments to be made, although planners
will have to accept your proposals meet their
affordable housing definitions and policies.             Security Value is the value that a lender can
                                                         expect to recover should the borrower default
Self-build and custom-build is also exempt
                                                         on a loan and the lender must repossess the
from CIL, and most community-led housing
                                                         property. This tends to be below the price of
should fall within this definition even if there
                                                         a new home, to reflect that if it were
is no physical construction work by residents.
                                                         repossessed, it would by that time be second
Section 106 agreements are negotiated on a               hand, and the lender would wish to sell it
scheme by scheme basis, and place                        quickly and would also incur costs in selling it
obligations on the development including                 again.
payments for individual site-specific items.
These could include contributions towards
affordable housing if it is not being provided           Asset Cover is a test to determine an
on site.                                                 organisation’s ability to cover its debt
                                                         obligations with its assets, after all liabilities
                                                         have been met. In effect it determines if, in a
FINANCE COSTS                                            worst-case scenario, an organisation has
Very rarely will a developer cover the                   enough assets that can be sold to repay its
development costs entirely with their own                loans. Funders cover this issue by lending up
money. Normally finance is arranged through              to a set percentage of overall value of the
a funder who will lend a proportion of the               development. This is called the Loan to Value
costs for a return on the loan. This is the              ratio. Thus, if the value of the site was £1m
interest rate charged on the loan for the                and the Loan to Value (LTV) percentage was
‘term’, or duration of the loan, which is a              70%, the maximum debt that could be raised
further cost for the development.                        would be £700k.
In the residual calculation, the interest rate on
costs traditionally takes the market interest

                                                    10
It is usual for lenders to stipulate their                 The finance cost is therefore divided in half
desired level of Asset Cover and Interest                  and the interest is calculated on that sum
Cover in the loan documentation and                        over the whole construction period.
agreements. These are known as Loan                        In order to calculate compound interest on a
Covenants and will be clearly outlined in any              quarterly basis the annual interest rate is
term sheets.                                               divided by 4 to obtain the quarterly rate (say
Finance is needed over a period of time.                   2%).
Interest is only paid on funds drawn down.                 This produces a compound interest formula
The drawdown of funds, and therefore                       of (1.02)n, where ‘n’ represents the number of
distribution of finance costs are not incurred             quarters over which the interest is calculated.
at once, or even in a linear manner. In order to
calculate the interest costs, it is common to
                                                           Finance fees
estimate the total length of the development,
                                                           These fees are related to the costs
when expenditure will stop and cash inflows
                                                           associated with arranging development
will occur (when the homes are sold, or let
                                                           finance. For example, you will need to pay the
and refinanced).
                                                           bank’s arrangement fees, solicitor’s fee and
                                                           surveyor’s fee. Fees can be negotiated, but
Pre-development                                            usually reflect the size of the required loan
Typically, you might assume a 12-18 month                  and may be anything between 3-10% of the
pre-development period where you obtain                    value of the loan.
planning permission and prepare for start on
site8. Costs prior to site acquisition, such as
searching for potential sites, are usually not             AGENT’S FEES AND MARKETING
considered to be substantial enough that you
                                                           Agent fees are what a developer would pay
will need to borrow.
                                                           an estate agent to sell or let individual units.
                                                           Most developers will also make an allowance
Development                                                to spend on promoting and marketing the
The site acquisition is usually the first                  project. This may not be needed to the same
commitment that requires a major outlay and,               extent for community led housing projects,
therefore, interest is calculated on all site              which may have a ready pool of people
acquisition costs over the entire development              looking to move in. However, it may be a
period.                                                    good idea to make an allowance for running
You would assume 18-24 months of                           allocation and selection processes and
construction time, plus any time after                     checking eligibility for sub-market housing.
construction completes before income
comes in7. Many developers try to defer the
                                                           RETURN
payment for the land until later to reduce the
interest payments.                                         The return requirement8 in your model
                                                           depends on the risks involved with the
A ‘rule of thumb’ assumes that costs are
                                                           scheme, a higher level of risk will need a
incurred evenly over the construction period.

7These are assumptions and do not take into                on site, can add a significant amount of time into the
account the scale or complexity of the project.            pre-development and construction time.
                                                           8 Also known as Developer’s Profit
Delays in the project such as planning or abnormals

                                                      11
higher level of return. So this can also be           the landowner in order to achieve a target
interpreted as a ‘risk allowance’.                    rate of return through the Residual Land
Return is usually expressed as a percentage           Valuation (see page 4).
of the total development costs in
straightforward or simple projects.
                                                      SITE ACQUISITION
It is difficult to generalise but often
                                                      Site acquisition costs and fees usually
developers will seek between a 15% and 25%
                                                      include: legal fees between 0.25–0.5% of the
of the total cost as return, the percentage
                                                      land price, depending on the complexity of
rising with perceived risk. You may also
                                                      the deal, and agent’s introduction fee
include contingencies within your return,
                                                      normally agreed at 1–2% of the land price.
rather than a separate allowance for
                                                      These have to be set aside from what can be
contingencies as discussed below.
                                                      offered to the landowner.
For projects with greater complexity, for
example larger developments that will take a
long and make be built in phases, return may          TAX
also be expressed as the profit on GDV. More          Stamp duty is paid as a percentage of the
sophisticated developers will consider the            land price. You can look up stamp duty rates,
Internal Rate of Return (IRR) calculated using        as well as reliefs and exemptions, and other
a Discounted Cash Flow (DCF) model (see               information. Stamp duty will also have to be
page 16). This allows a better comparison             set aside from what can be offered to the
between different projects of different               landowner.
lengths.
                                                      There are usually VAT implications to be
It is important not to confuse the not-for-           factored into the development appraisal.
profit nature of community led housing                Different types of developers and different
projects, and assume a profit margin does             types of schemes all have different VAT
not need to be included in the appraisal. Not-        implications including standard, reduced and
for-profit housing associations typically seek        zero-rated VAT scenarios. Even if VAT is
an Internal Rate of Return (IRR) of 7%. This          recovered, there may be a cash flow
ensures there is some money to keep the               implication between the payment of VAT and
organisation going to the next scheme.                its recovery.
                                                      Stamp duty and particularly VAT are complex,
LAND COST                                             and you should get a relevant accountant or
                                                      tax adviser on board, to structure the
The price to be paid for the land may already
                                                      development in the best way.
be agreed or sought by the landowner
(vendor). In most cases the developer has to
establish a land price that can be offered to

                                                 12
CASH FLOW AND DISCOUNTED CASH FLOW
Cash Flow appraisals allow the timing of                Discounted Cash Flow (DCF) models
costs and income to be spread over the                  examine the different cash flows, but they are
development period, or the long term, to give           all discounted back (using a present value
a better assessment of finance costs. While             formula) to a common point in time to allow
Residual Valuations are relatively simple, they         an even comparison.
are not very flexible in handling the timing of         The DCF approach is a method of valuing an
costs and income.                                       asset using the concepts of the time value of
In practice, some of the development costs              money. It is an explicit approach where all
are incurred before the start of the building           future cash flows are estimated and
contract, e.g. finance fees and much of the             discounted to their present value. The
professional fees. The construction costs               discount rate reflects the time value of
usually follow an S-curve of cumulative                 money and a risk premium, representing
expenditure. The final 3% of construction               compensation for the risk inherent in future
costs is usually held back as a ‘retention’             cash flows that are uncertain.
under the building contract. There may also             In simple terms, the time value of money can
be a gap between completion of the                      be considered to represent interest foregone.
construction until the full letting, sale or re-
                                                        The discounting acknowledges the
finance. Quantity surveyors and project
                                                        relationship between time and money. The
managers can estimate the timing of costs.
                                                        “time value of money” can be explained by
In the cash flow model, interest is calculated          thinking about if you’d prefer £100 now or
on the outstanding balance (including                   £100 in a years’ time. Clearly you’d prefer it
interest) at the end of each month at a                 now. If you’re offered £100 now and £200 in
monthly rate equivalent to the effective                a years’ time you’d choose £200 in a years’
annual rate (EAR). Adjusting the pattern of             time, as it is unlikely you will more than
expenditure, may lower the total interest               double the money in that time. Somewhere
figure. The cash flow method is particularly            between those figures is a figure that will
useful where receipts come in before the                make you equally happy either way. Say £120
completion of the full scheme, e.g. a phased            in a years’ time is equivalent for you to £100
development. The model also allows you to               now. So £120 in a years’ time is worth 83% of
adjust for changes in interest rates over the           its value in today’s money. ( 100 / 120 = .83)
development period or for different sources
                                                        This allows a calculation of the ‘internal rate
of finance within the appraisal.
                                                        of return’ (IRR), which considers both the
A cash flow appraisal will be required to               timing and the size of each cash flow. This
satisfy potential lenders with a detailed               can be used instead of a percentage return
business case. You may use both techniques              on cost and is ideal for comparing different
together, using the cash flow method to                 potential projects. However, the DCF method
calculate the interest cost and put this into a         does not show the outstanding debt at a
conventional residual appraisal for clear               particular time. It shows the profit in today’s
presentation. The cash flow method will be              value rather than the actual sum that will be
used throughout the development to evaluate             received at the end of the development.
the project as costs are incurred and
influencing variables change.

                                                   13
LONG TERM FINANCIAL APPRAISAL
Long term modelling considers the life of the           annual income. Simply being a community
scheme after the development period. A 30-              led organisation is unlikely to reduce voids.
40-year cash flow analysis will be required             Similarly, an assumption must be made for
where you intend to hold property to let. This          rent and service charges which are not paid
may integrate with your development                     by tenants who fall into arears. This is usually
appraisal, or if you are buying homes built by          around 2% of annual income but may be
another developer it can establish what price           greater if specialist groups with multiple
you can afford to pay for the homes.                    needs are to be housed.
A long-term financial model will establish
whether a single development will be                    Management costs
financially viable after it is built and can be         Management costs will be influenced by the
managed and maintained at agreed                        model of management chosen, for example;
standards.                                              volunteer, employee, agency, or a
If this is the only scheme of a new                     combination of these. Typically, these are
organisation, it must also ensure that it can           assumed at around £500 per property per
sustain itself over the long term. Existing             year. Management costs may include office
organisations will adapt their financial plans          costs and other associated overheads,
to include the new scheme and ensure that it            employee or managing agency costs,
does not place an unreasonable burden or                recruitment or procurement costs and
drain on existing residents or other activities,        contract management costs.
and that the organisation is viable over the
long term.
                                                        Maintenance and servicing
Whilst a yield can be used as a quick way to            There will be an expected annual cost of
establish the capital value of rented homes,            maintaining the landlord’s fixtures and
long term modelling should consider the                 fittings in each property. Whilst day to day
following in more detail:                               repairs should be low in the early years after
                                                        construction or refurbishment, the costs are
Rent inflation or growth rate                           likely to rise over the medium and long term.
As well as knowing the rent, long term                  The maintenance of common parts and the
appraisals must make assumptions on how                 landlord’s structural elements should also be
much the rent will be increased each year               considered. The cost of servicing the scheme
over the long term. If the community led                will be present throughout.
housing organisation is a Registered Provider
(RP), or the homes are being managed by                 Asset management
one, the Rent Standard will place restrictions          A costed asset management plan should
on rental increases.                                    inform the financial plan regarding the long-
                                                        term costs of major works programmes and
Void and bad debt levels                                cyclical maintenance (such as lifts every 15
Rent and service charge income will be lost             years for example). Enough funds should be
due to periods when homes are ‘void’ or                 set aside over several years.
untenanted. Usually assumed around 2% of

                                                   14
Governance costs
Running the organisation brings on going
costs including meetings, member expenses,
consultation and involvement, comms and
marketing, insurance, annual return fees,
accountancy and audit costs and legal fees.

Cost inflation assumptions
All costs increase over time as inflation
impacts on the initial cost base. However,
cost inflation is not uniform and realistic
assumptions must be made for different
costs such as materials, wages, insurance,
utilities and professional fees. Unrealistic
assumptions about cost inflation when
compounded over the long term can be
catastrophic to financial viability.

Tax liabilities
The taxation implications for long term
models should also be considered, including
VAT, Corporation Tax, Annual Taxation on
Enveloped Dwellings and employer tax
liabilities, where relevant.

Financing or net borrowing costs
The remaining rental income after
management and maintenance etc must be
able to pay down any debt outstanding when
a development is completed (ie development
finance that is not paid back though the sales
of homes). This may require assumptions
over long term financing and interest rates.
Typically, the first 5-10 years are most
challenging as rents will not grow
significantly. A healthy margin of error for
‘interest cover’ during this time will be key.
Interest rates will also apply to reserves
accumulated over the long term, although
this will likely be lower.

                                                 15
UNCERTAINTY AND RISK
Risk is an inherent part of the property              PLANNING RISK AND LAND COST
development process and needs to be
                                                      Planning risk refers to the risk in a change of
assessed as part of this process. You can
                                                      use, or detailed design consent for the
reduce elements of risk at a cost. The degree
                                                      development, or other relevant government
of risk is usually related to the complexity
                                                      consents required to progress to the
and scale of the proposed development.
                                                      construction phase of the development.
It is important that the inputs as reliable as
                                                      The purchase price of the land is usually the
possible and based on the experience of
                                                      first major financial commitment (page 11).
professional advice and/or robust sources of
                                                      In order to reduce risk, it is common to try to
information.
                                                      agree an ‘option’ or negotiate a purchase that
You should avoid getting caught up with               is subject to obtaining a satisfactory planning
making an appraisal “work”, if it means you           consent, when the detailed construction cost
are being unrealistic or over optimistic about        is also clearer.
assumptions. It is also good to test scenarios
                                                      The greater the possibility that planning and
to understand what things are more sensitive,
                                                      related permissions will be denied, or
and to make sure your project can cope with
                                                      complicated and time consuming to achieve,
a margin of error. Sensitivity analysis can be
                                                      the greater the assessed planning risk. This
built in the appraisal to clearly identify
                                                      translates into a higher developer’s risk
changes in inputs.
                                                      required, and likely lower land value.
The two major types of risk are systematic
                                                      Once planning consent has been obtained,
(wider market context) risk or unsystematic
                                                      the value of the scheme is clearer. Before a
(property specific) risk.
                                                      planning consent it is unclear what exactly
Rental and sales values and construction              you will be able to get permission for, and
costs are usually the most sensitive variables        how long that will take. Further applications
and are subject to fluctuations outside your          may be made after a site is purchased.
control.                                              However, planning applications take time and
Over the development process, your                    any potential increase in value needs to be
commitment to the scheme increases and it             balanced against the cost of holding the site.
becomes more difficult to change course,
even if things around you are changing. At
                                                      FINANCE RISK AND INTEREST
the same time risks reduce over the
development period, as they either emerge, or         Funding arrangements need to be in place
as pass away. For example, a project very             before any major commitment is made. In
close to completion will not have any                 obtaining the necessary finance to acquire
planning risk, minimal construction risk and          the land and build the scheme, you will be
very little market cycle risk, hence the              exposed to any fluctuations in interest rates
developer’s profit required in taking such a          during the development period. However, at a
scheme on at the valuation date will be a             cost, you can either fix or cap the interest
much lower percentage of profit on cost than          rate. The terms of long-term finance
a scheme without planning permission.                 negotiated before the development are likely
                                                      to be less favourable than those that can be

                                                 16
negotiated upon completion, although you              local or global economy, the higher the risk
can secure both together.                             that the market could change to the
                                                      developer’s detriment before the delivery of
                                                      the scheme.
CONSTRUCTION RISK AND COST
                                                      Rental values for affordable housing tend to
The construction cost is the second major
                                                      be well defined and increase in line with set
financial commitment.
                                                      formulas or local incomes etc, rather than the
Construction risk refers to the risk that             speculative property market. However values
construction will be delayed potentially due          may be more closely linked to the property
to variations or late information, labour             market (for example as a percentage of
becoming unavailable, labour and materials            market values)
costs rising during the course of works
                                                      It is essential to obtain the most reliable, up-
(partly due to inflation) or that unexpected
                                                      to-date value estimates. Due to the
events cause sudden escalations in the cost.
                                                      complexity of the property market, valuers
The more technically demanding, large,                are unable to predict future changes in
complex and long the build programme is,              property values with a high degree of
the higher the risk.                                  certainty. You therefore shouldn’t try to
There are some ways of making the                     predict future values, even when construction
construction cost more certain by passing all         costs in the appraisal grow at current
or some of the risk and design responsibility         inflation rates, as this would expose you to
onto the contractor, although greater                 more risk. It cannot always be assumed that
certainty of cost usually means a higher cost         rises in construction costs during a
overall. Good project management is vital to          development, will be saved by rises in values.
preventing increases in cost and time delays.         However, the level of uncertainty associated
You should question every aspect of the               with achieving an estimated sales value can
building contract in order to manage any              be removed if a pre-sales or off-plan sales
problems as they arise.                               can be achieved.
                                                      The benefit of a pre-sale reducing risk has to
MARKET CYCLE RISK AND VALUES                          be weighed against the opportunity costs of
                                                      achieving a potentially higher value in a rising
Market cycle risk is the risk that during the
                                                      market. Although there may be an advantage
course of the development market demand
                                                      in reducing void periods before income is
for the development changes. The longer the
                                                      received, as the building will be handed over
development programme, the more
                                                      on completion without further interest
uncertainty there is in the prevailing market,
                                                      payments.

                                                 17
COMPARABLE VALUATION
Although the residual method is usually                   took place 2 years ago may not be
preferred for development projects, the                   relevant to a valuation where the market
comparable method of valuation is                         has changed significantly over that
commonly used by valuers for other property               period).
valuations.                                            The above list is not exhaustive. It gives an
The comparable method is typically adopted             indication of the thinking adopted by valuers.
in markets with enough recent evidence of              Other factors may need to be considered
similar transactions. It involves searching for        depending on the value drivers for the type of
recent transactions that give an indication of         development. For example when assessing
the price the market would pay.                        land value for a retail development or an
Land transactions that can act as                      office development.
comparable guides to the price that can be             After establishing relevant comparables, the
achieved on a site, should be similar to the           valuer usually adjusts the sale prices
site in the following ways:                            evidenced by these transactions to reflect
• situated nearby or in a similar type of              differences between the comparable land’s
  location to the subject site                         value driving factors/characteristics and
                                                       those of the subject land. This is often
• of the same planning category or
                                                       practically achieved either:
  permissions as the subject land (e.g. both
  sites have planning permission for                   • through an implicit adjustment to the
  industrial use);                                       prices achieved on the comparable sales
                                                         by an experienced valuer; or
• identical or similar in respect of the
  utilities present or near the site (e.g. both        • through a more explicit process of listing
  sites have water, electricity and gas                  each value factor and applying a premium
  present and capped on site or access at                or discount to the comparable price
  the edge of the site);                                 achieved to reflect an adjustment due to
                                                         differences between the comparable and
• topographically like the subject site (e.g.
                                                         the land/site being valued.
  both sites are flat and have vegetation);
• with similar access to transport links (e.g.
                                                       Valuing land with the comparable method
  both sites have direct highway access);
                                                       can be tricky as it is difficult to find suitable
• surrounded by similar infrastructure (e.g.           comparables and any attempt to 'equalise'
  both sites are situated in the town centre           the differences can become a fruitless and
  with good access to the surrounding retail,          unverifiable exercise. Land transactions also
  leisure and town centre amenities);                  lack the transparency of other property
• situated in a position with access to a              transactions. It is not easy to find out how the
  similar socio-demographic profile as the             deal was structured and influencing factors.
  subject site (e.g. both sites are situated           The residual method usually offers a more
  close to small towns with affluent                   rational alternative as to what a potential
  catchments);                                         purchaser ought to pay, although the
• not too historic to be irrelevant to the             comparable method may be used to
  current valuation (e.g. a transaction that           determine GDV.

                                                  18
Contact us
7-14 Great Dover Street
London
SE1 4YR

020 3096 7769
info@communityledhousing.london

Follow us on social media
@CLHLondon

                            19
You can also read