FINANCIAL APPRAISAL - community-led housing london
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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
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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
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