Appraisal and Risk Property Development 6 th Edition Publisher Routledge wwwroutledgecom Authors Professor RG Reed and Dr S Sims 31 INTRODUCTION ID: 657155
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Slide1
Chapter
3
Development
Appraisal and Risk
Property Development
(
6
th
Edition)
Publisher
:
Routledge
www.routledge.com
Authors
: Professor R.G
.
Reed and Dr
S
. SimsSlide2
3.1 INTRODUCTION
Assessing and evaluating the financial viability of a development constantly occurs throughout all stages of the development process.
Many dynamic factors influence development and their status must be updated and re-evaluated in light of the overall risk attached to the development.
Risk is an inherent and unavoidable part of the property development process and
should be assessed
as part of the overall evaluation process.
T
he
influence of uncertainly
can
be contained in order to reduce the effect on risk. Slide3
3.2
FINANCIAL EVALUATION
3.2.1
Conventional Techniques
Conventional techniques of identifying the various components of value in a proposed development are relatively straightforward based on using a form of ‘residual’ valuation.
This type of model is designed to isolate an individual component of a development such as the level of risk/return or the land value, and assess their individual ‘unknown’ value when information about all of the other variables are known.
T
wo
primary types of residual valuation undertaken
depend
on the final outcome
sought where
the
first focuses on calculating the investment risk/return, the second on calculating the remaining (residual)
cash.
The model considers the following: affordable land purchase price, net development value, purchaser’s costs, development costs, planning fees, building regulation fees, funding fees, finance costs/interest, letting agent’s fees, promotion costs, sale costs, other development costs, contingency allowance, developer’s profit/risk allowance.
Slide4
3.2
FINANCIAL EVALUATION
1.
Investment
risk/return
This model commences with (a) the final estimated value of the completed property development based on estimated final market prices
. Then
(b) the total development costs (e.g. land, construction cost) can be deducted from (a) to establish whether the project produces (c) an adequate rate of return for the developer or financier, either in terms of a trading profit, an investment yield or return on capital
.
2. Affordable land purchase
price
An alternative approach for using a residual valuation is to assess (a) the likely costs of producing a development scheme and by deducting these costs from (b) an estimate of the value of the completed development scheme to arrive at (c) a land purchase price.
3
. Purchaser’s
costs
T
he
final completed development value needs to be expressed as a net development value to allow for purchaser’s costs such as stamp duty, agent’s fees and legal fees. Slide5
3.2
FINANCIAL EVALUATION
4. Development costs
(a) Land costs (b) building costs (c) professional fees (d) site investigation fees.
5. Planning
fees
These costs relate to government fees required to make a planning application and securing consent for the property development project.
6. Building regulation
fees
Usually
these costs are on a sliding scale based on the final building cost.
7. Funding
fees
Most
financial institutions and lenders charge fees when arranging development finance.
8. Finance
costs/interest
Interest
costs for borrowed funds are a critical element of the appraisal and can have an adverse effect on the overall viability of any development proposal
. These
costs reflect either (a) the actual cost to the developer of borrowing money over time or (b) the implied or notional opportunity
cost. A sample timeline is shown in
Figure
3.1. Slide6Slide7
3.2
FINANCIAL EVALUATION
9. Letting agent’s
fees
These
fees relate to the cost of the agent letting the building to new tenants
.
10. Promotion
costs
The
developer has to make an assessment of the likely sum of money that needs to be spent on promoting the project in order to let the
property.
11. Sale
costs
Costs
associated with selling the completed development will need to be included if the developer intends to sell the building once it is fully let.
12. Other development
costs
The
inclusion of other costs within the evaluation will depend on the nature of the development and will be specific to the
project. Slide8
Discussion points:
What are the various components of value when undertaking a property development
?
Explain the relevance between the level of profit/risk and the overall development.Slide9
3.2
FINANCIAL EVALUATION
3.2.2 Cash-Flow Method
This
model
presents
a more realistic and accurate assessment of development costs and income against the variable of time
.
It
is the nature of property development that the timing of cash-flows is irregular and
uneven.
C
ash
-flow is critical due to the cost of repaying borrowing funds and the effect of compound interest over an extended period of
time, therefore
the potential to develop a property in phases can be a major advantage for the overall viability of the project
.
S
ome
offices in high-rise buildings can be let or even
sold off
and allow the new owners to occupy the lower floors, even though the upper floors or other sections of the building are still under construction.
T
he
model enables the developer to adjust for changes in interest rates easily over the development period or for different sources of
finance.
Slide10
3.2
FINANCIAL EVALUATION
3.2.3
Discounted Cash-Flow Method
A discounted
cash-flow (DCF) can examine different cash-flow
models;
they are all discounted back (i.e. using a present value formula) to a common point in time to facilitate an even comparison or
analysis.
The time periods can be modified to any time period, such as days or years depending on the intended complexity of the
DCF.
The main advantage of this approach to the developer is that it allows a subsequent calculation of the ‘internal rate of return’ (IRR), which is the measure used by some developers to assess the profitability of a scheme since IRR considers both the timing of the cash-flows and the magnitude of each cash-flow.
IRR is also ideal for comparing different potential property developments with their own variations in the timing and size of the cash-
flows.
A
DCF
method is more likely to be used by investors who wish to retain the development in their portfolio and also seek to analyse the return on their investment. Slide11
3.3
THE ROLE OF UNCERTAINTY AND RISK
Basic model
is based on a considerable number of variable
factors
including
: land
costs
,
r
ental
value, square
footage (or metres) of
building, investment yield,
b
uilding
cost, professional fees, time
including pre-building contract, building and letting/sale
periods, short
-term rates of
interest, real
estate agents’
fees, promotion costs and other
development
costs
(Figure
3.1).
It
is important that the financial information input into the cash-flow model is as reliable as possible.
The level of reliability depends on the developer’s experience and assumptions behind sources of information the developer uses.
It is important that the developer uses current and up-to-date rental values and accurate building costs to reflect income and expenses in every development appraisal.
An understanding of the complexities of risk is essential for a successful developer
. Risk
is embedded throughout the property market and is the starting point for every analysis involving property. Slide12
Discussion
point: Why are uncertainly and risk major considerations when using the cash flow method?Slide13
3.3
THE ROLE OF UNCERTAINTY AND RISK
Land
cost
T
he
purchase price of the land (either vacant or partially improved with an existing old structure) is usually the first major financial commitment.
Building cost
The building construction cost is the second major financial
commitment,
in
combination with a number of other
costs
relating directly to the final sum.
Short-term interest rates
In
obtaining the essential finance to acquire the land and build the scheme, the developer will be exposed to any fluctuations in short-term interest rates.
Investment yield
Investment yields are dictated by decisions of stakeholders in the property investment market, being the relationship between the total value of the completed property
developments and
the total annual rent received.
Sensitivity analysis
M
easures
the level of uncertainty involved in a particular property development scheme and therefore how much profit is required to balance the resultant risk. Slide14
Chapter
3 Development Appraisal and Risk
Property Development
(
6
th
Edition)
Publisher
:
Routledge
www.routledge.com
Authors
: Professor R.G
.
Reed and
Dr
S
. Sims