Creating a Property Development Contract with your Builder

Many private property developers aim to save money by carrying out some of the construction work themselves.   This can often be very successful, and usually depends upon the competency and persistence of the developer.  However, it also depends a lot on the developer having the time to do the work.  It’s fine if the novice developer does not have to do a ‘normal’ job every weekday and can just concentrate on the construction/alteration works.  Most developers, when beginning their ventures though have to juggle a day-to-day job and run their property ventures in their spare time.  I can assure you from experience that having a full-time job and having to squeeze in work on another property in the evenings, weekends and holidays will test your motivation and persistence.  In short, it gets quite stressful.

Apart from the obviously increased expense, it usually makes a lot of sense to get builders in to do the work for you (or at least the majority of it).  The larger the project, the more benefit there is.

Where to start though?  All developers will at some point come to this stage.  Knowing that substantial outside help must be secured, but not quite knowing what to do first.

 

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The first step is to decide exactly what needs to be done to the property.  On smaller projects where the work will only amount to a few thousand pounds (such as very minor alterations) the route will be different to larger projects of hundreds of thousands or even millions.  On small projects it’s more likely the developer will have a good idea of what work they require the builder to carry out.  It’s very important to write this down, placing it in logical steps.  An example of this might be:

  1. Lift Patio area to rear of property (state the extent of this if possible).
  2. Re-route/prepare drains for foundations to comply with Building Regulations.
  3. Dig and lay suitable foundations in preparation for extension.
  4. Construct double-skin brick/block extension to full property height in accordance with planning conditions, tying bricks and blocks in with existing structure.

This list in its entirety should be concluded with important points, for example ‘all associated excess material and refuse to be removed from site upon completion’ and ‘all appropriate Building Regulations to be complied with’.

This list is often referred to as the ‘Scope of Work’ and becomes more important as the size of the project increases.  The scope of work can help you out at this point by enabling you to obtain several different quotes for the work if you feel you would like to look around for the most competitive price (known as ‘going to Tender’).   If the idea of compiling this list is daunting because you are not experienced enough to place the required work into steps, contact either a professional (such as a Building Surveyor, Architect or Structural Engineer) or ask a reputable builder who will not be actually doing the work (so that the scope of work is impartial) to help out.

The process of finding a suitable contractor with the use of a scope of work is called ‘Tendering’.  The larger the project the more important it is to find a contractor that will provide the right work at the right price.   Once the builder has been chosen to carry out the required works (it might be the one who produced the most reasonable quote, or the firm who you feel might be the best suited to the work you need carried out) the next step is to establish the terms of the builders contract.

In almost all cases (around 70% – 80%), a Joint Contracts Tribunal (JCT) contract is used to establish the terms of the agreement between client and contractor.

The contract type depends on the type and scope of work to be done.  For the smallest work, such as a house extension a ‘Homeowner’ contract would be used.  There is further choice within this, for cases where the homeowner is overseeing the work, and where a consultant oversees it.  At the other end of the scale is a ‘Design & Build’ contract where the contractor actually designs much of the work to be done.

It must also be mentioned, that when a project is being designed by a contractor, the company MUST have the appropriate level of competence and Professional Indemnity insurance to carry out the design work.  This can be achieved by outsourcing to a Structural Engineer or Architect.  However it is asking for trouble if a small building contracting firm designs a structure, dwelling or substantial alteration themselves without the appropriate level of design competence.  The worst case scenario is if the structure fails or becomes unsafe.  As developer, it is possible you could find yourself in court under a charge of negligence for failing to ensure the project was properly designed.   Always approach the planning of your project in a professional manner.

For a guide to choosing the most suitable JCT contract, visit their site at:

http://www.jctcontracts.com/contracts/choosing.jsp

Please note, this article has been considerably condensed.  Buy for the full version for only £2.


Feb 15th, 2012

The Property Speculator’s Second Podcast!

The second of the Property Speculator’s Podcasts is an interview with Andrew Montlake and Julian Ingall of Coreco Group.

Andrew and Julian are real characters are were a delight to interview.  As you would expect of the Directors of a firmly established Financial Broker partnership based within a stones-throw of the Gherkin in the City of London, they really know their stuff.

We speak about how the Candy Brothers started their multi-million pound property development company, why it’s often better to begin developing property as a private individual rather than a limited company and a few opinions on the attitude of finance providers prior to the recession.

Andrew and Julian can be contacted through the Coreco Webite ‘Contact Us’ page

Listen to The Property Speculator’s Coreco podcast here.

Subscribe to the podcasts here

Feb 6th, 2012

The Property Speculator’s First Podcast!

After a steep learning curve of ‘XML Files’, audio editing software and getting over the hatred of my own voice, I’m proud to announce the first of hopefully many podcasts.

In this edition, I interview Ryan Fuller of The Fuller Long Partnership.  They are an established firm of Town Planning Consultants headed by 2 former colleagues of mine (James Long and Ryan).   Ryan has been a Professional Town Planner for many years and has worked in a variety of settings.

Ryan speaks about how the novice developer should approach the process of planning applications, explains the truth about some widely-held myths and suggests a slightly different way of making development plans than the usual one.

Ryan can be contacted through the Fuller Long website which is at www.Fullerlong.com.

Please note this podcast will be placed on iTunes very soon!

Access the Fuller Long Podcast Here

Jan 29th, 2012

Property and VAT

Having at least an understanding of tax and how it relates to a property development is valuable knowledge.  Obviously the larger the project(s) the more likely tax will feature strongly in your plans.

Contrary to what many protestors in London feel, I think there’s nothing noble in paying more tax than you absolutely have to.  Therefore, it’s good to learn.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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At the moment, VAT is not fully recoverable on a conversion from a commercial property to a residential one.  This means that costs in the form of labour and materials will be subject to VAT at the rate of 5% on this particular type of conversion.  If you are buying the materials yourself, you will be charged the normal rate of VAT at the point of sale and will only be able to claim it back once the build is complete and it qualifies with the criteria set by HMRC.  If the project is a new build, some aspects might be zero-rated for VAT.  If you are the person purchasing materials or procuring labour, you will again be charged the full rate of VAT at the point of purchase or invoice.  This however can be claimed back from HMRC under the ‘DIY House Builders & Converters VAT Refund Scheme’ or if you are VAT registered, all incurred costs would offset your annual VAT liability.

Quoting information available on the HMRC website, the following table briefly shows the rate of VAT that should be paid on particular construction work:

Construction Work Rate of VAT
Construction of new qualifying dwellings & communal residential buildings

0%
Conversion of a non-residential dwelling into a qualifying dwelling for a housing association

0%
Conversion of a non-residential building into a qualifying dwelling (other than for a housing association)

5%
Renovation or alteration of empty residential dwelling

5%
Approved alterations to a listed dwelling

0%
Alterations to suit the condition of people with disabilities

0%
Installation of energy saving materials and grant funded heating system measures.

5%
Development of a residential caravan park

0%
Home improvements on domestic properties on the Isle of Man

5%

To qualify as a ‘qualifying dwelling’, the following conditions have to be met:

  1. If it is built from scratch, any pre-existing building is demolished to ground level.
  2. No more than a single facade (or double in the case of corner sites) of an original building is used if that is a condition or requirement of planning or listed building consent.
  3. If a new building is constructed that shares an existing wall of a neighbouring property, no internal access must exist between them.
  4. If an existing building is extended and this creates an additional dwelling/dwellings.  This does not include dwellings that are attached to business premises and cannot be disposed of separately.  The additional dwelling must also be wholly within the enlargement or extension to be zero-rated.
  5. An Annexe to an existing building is constructed.  This does not include ‘granny annexes’ or enclosed separate swimming pools.
  6. The building is one of several constructed at the same time on the same site.  This must be used together with the other buildings for a ‘relevant residential purpose’.

Services provided by professionals such as Architects, Surveyors, Project Managers and Supervisors are always standard-rated for VAT.  Plant equipment, scaffolding hire, security fencing and mobile offices cannot be zero-rated and will attract the full rate of VAT (although the service of erecting and dismantling scaffolding will be zero-rated if associated with zero-rated work).

Sometimes only part of a building might qualify for zero-rating, such as a mixed-use development.  In this case, the work that is carried out on the qualifying portion of the development can be zero-rated.  This is called apportionment.

When selling or granting a leasehold interest in a zero-rated building, it is usually only the first transfer that does not attract VAT.  On mixed-qualifying developments this can be apportioned appropriately.  All subsequent transfers will be subject to VAT but this can offset the VAT bill of the party purchasing the interest.

Usually, a property that has previously been lived in cannot be zero-rated and will attract a VAT rate of 5%.  However if you can prove that the property has not been lived in for at least 10 years, then it will be zero-rated for VAT incurred in renovation/alteration work to make it habitable as a residential dwelling.  In order to prove the building has not been lived in for a minimum of 10 years, records from the local authority in reference to council tax or electoral roll can be used, alternatively a letter from a local authority Empty Property Officer can provide sufficient evidence to render the other forms of proof unnecessary.

In the renovation or alteration of empty residential property, most VAT will be charged at a reduced rate (currently 5%).   To qualify as ‘empty’, the property must have been unlived in for at least 2 years prior to commencing the renovation work (this ignores ant occupancy by squatters or a property guardian).   If the property is inhabited during the renovation works, it still qualifies at the reduced rate provided there is a clear period of 2 years immediately prior to commencement of work.  The occupants can move in on the day after work begins.

Be aware that if you take advantage of a zero-rating on VAT, the building must stay in the specific residential use it was designed and built for.  If not, a taxable charge will apply.  This charge decreases the longer the building stays in its original use; after 10 complete years no taxable charge will apply.

Unfortunately as from the 1st March 2011, if the building is sold or it is leased to a party who does not intend to use it for its intended residential purpose a taxable charge will apply:

Number of complete years before sale or change in use:

 VAT Charge (as a percentage of the total VAT that would have been payable).
0

100%
1

90%

2

80%

3

70%

4

60%

5

50%

6

40%

7

30%

8

20%

9

10%

10

0%

Subsequently, the zero-rating facility is only really suitable for constructor/investors to take advantage of.  However professional developers are likely to be in a position to avail themselves of the reduced rate of 5%.

For further information on VAT on property, follow this link to the HMRC guidance notes.

Dec 29th, 2011

Calculating Build Costs for a Property Development Project

When establishing a budget for a property development, the issue of build costs is hugely important.  An accurate build cost value is a vital component of the residual valuation.

Build costs are not just for the construction of new build properties.  If an existing property (for example) is to be renovated and the usage changed, or a residential property needs a lot of work to bring it back to a habitable state, the costs of work will be very similar to building from new. So to use new build costs is appropriate in the majority of cases.

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Build costs are calculated using the gross internal floor area.  This is essentially the area of the internal space measured between the inside of the outside walls.  This includes all common areas such as hallways and toilets etc.

Build costs are generally available from 2 sources.  The first source is the subscription website BCIS (Building Cost Information Service), the second is SPONS (available in book format and updated every year).  Both sources are well-regarded in the construction industry as being accurate enough to use in detailed development appraisals but are expensive when you are beginning your venture (both sources are a fairly similar annual price).  When using the resources, you will find that a particular rate per M² or M³ is provided.  For example, when demolishing a building up to 50M³, a rate of £49.92 would be appropriate per M³.  The larger the building, the less expensive the work per M³ is to have carried out (economies of scale).

One of the recognised shortcomings of the residual method of development appraisal, is that the output (the land value) differs a great deal through only small changes in one of the inputs (in this case, build costs).  The larger the project, the more likely it is to happen.  For example, if 30 houses of 100 M² each are being constructed at a rate of £1,000 per M², the total build costs will be £3m.  If the build cost rate were to increase to £1010 per M², total build costs would increase to £3.03m.  So for just an increase of £10 per M², the total build costs would dramatically increase by £30,000.  Therefore it is important to get as accurate a figure as possible.  Fortunately the sources mentioned above are regarded as very accurate.

It can be a time consuming process reading through the construction cost guides if you are unfamiliar with them (I don’t profess to be an expert myself).  They are extremely thorough and specific, however if you simply want to know how much it will be to build a 3 bedroomed house (at a rate per M²) then a far cheaper (free) option exists.  A regularly updated source of inclusive build costs is at:  www.homebuilding.co.uk/buildcosts.  It obviously depends on how deeply you want to go into the analysis of costs, but this alternative provides accurate information if it’s an inclusive rate you’re looking for.  It’s compiled for self-builders, not really private property developers but it offers a good indication and shows the degree of variance across regions.  If you do need to go into the deeper intricacies of building costs then I suggest purchasing either the SPONS book or taking out a BCIS subscription (incidentally, SPONS books are available ‘used’ at a discount at places such as Amazon Marketplace but obviously the accuracy suffers as they age).

At the last update on the ‘homebuilding-buildcosts’ site (Dec 2011) a large 2-storey house being built in the South-East to an excellent standard by main contractors would be in the region of £1291 per M² to build.  At the opposite end of the spectrum, a small single storey house built to a reasonable standard through a combination of DIY and sub-contractors in the North-East or Wales would be in the region of £793 per M².  These values have been put together by experts using the more detailed costs guides.

The more detailed guides (BCIS & SPONS) allow the reader to obtain far greater information.  For example, according to the 2011 version of SPONS:

  • High quality Inner London apartments would be in the region of £2350 – £2850 per M² to build.
  • Large budget student schemes with en-suite bathroom would be £1025 – £1275 per M² to build.
  • Warehouse conversion to apartments would be £1025 – £1275 per M².
  • Minor office refurbishment in Central London would be £435 – £530 per M².

Clearly some interpretation has to be applied to this information, as regional variations on prices can move beyond the ranges listed.  It should also be remembered that these prices are inclusive of builder’s profits and overheads, but not of professional fees associated with the work.

For the more specific prices:

  • For machine-excavated trench fill foundations at 600mm wide x 1 metre deep, a rate of £79.00 – £100.00 per metre.
  • For facing-brick walls, single skin and pointed both sides would be £81.00 – £105.00 per M².
  • For a cement and sand screed floor of 50mm thick would be £12.40 – £16.80 per M².

The SPONS books and the BCIS provide a huge amount of information (the SPONS book is over 1,000 pages).  You must remember though, that looking into the specific works and simply adding the costs together is risky because without experience, it’s easy to overlook some vital work component.  This can have a significant effect on the overall build costs.

Dec 15th, 2011

Understanding Property Auctions

Property auctions are one of the most popular places for prospective investors and developers to look for projects.  There are many alternatives, but auctions remain very popular despite the current difficulties in obtaining finance.

The auction hall is often looked upon as the first step on the path to running a property business.  However, auction day is really the very end of the first stage.

There are some terms that are used when describing auction lots that many potential bidders are not familiar with.  It is so important to understand what you are getting into; auctions can be unforgiving to the unprepared:

“The vendor is a Mortgagee not in possession“.

  • Obviously the Vendor is the party who is selling the property at auction.
  • The ‘Mortgagee‘ is the bank or building society who originally provided the loan for the purchase of the property (the Lender).  This is the opposite of the ‘Mortgagor’ who is the person(s) buying the property (borrower).
  • The term ‘Not in Possession‘ means that the party selling the property do not actually own the legal interest (whether this is Freehold or Leasehold).  When a lender provides a loan (mortgage) for a person to buy a property, the lender has a ‘first charge’ on the property.  This means that they retain the legal right to sell the property to recoup financial loss in the event of the borrower breaching the terms of the mortgage by defaulting on the repayments.

So, what the term above means in laymans terms, is

“that the party selling the property is a bank/building society who do not actually hold the legal title on the property, but who are exercising their legal right to get their money back by selling the property.”   Essentially, it’s a repossession.

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“Therefore the accommodation and any basis of occupancy cannot be confirmed”

  • This means that the parties offering the property up for sale at auction (the legal firm and the auction agents providing the details) will not offer any indication of the state of current occupancy.  There could be (for example) 20-odd families living in it, or there could be a terminally ill old lady…..  It’s absolutely the responsibility of the person intending to buy the property to reassure themselves and investigate the situation before they bid.
  • If you were to bid on a particular property and actually get the winning bid, you do not have much in the way of recourse if it turns out you’ve bought something not quite right.  It’s only if a property has been falsely advertised and you believe something you are told in good faith that you can take action to legally rectify this (by suing someone for example).  This is why the auction agents will not give any information in respect of anything they don’t know for certain, it’s because they know they can be sued for it if it turns out to be incorrect.
  • If you were to successfully bid on a property and it turns out someone is already living in it (legally or otherwise), that party often has some legal rights to stay there until you obtain a court-order to evict them.

Essentially, it’s up to the bidding party to investigate the current circumstances of the property.  If you want to purchase an investment property with a tenant already in place, then it’s up to you to make sure that the tenancy and lease are all in order and no-one is living there who shouldn’t be.  If you intend to buy a vacant property, then it’s up to you to make sure it is indeed empty before you bid.  There is often hidden legal issues in property, especially at auction.  However, there is usually every opportunity to make sure that nothing comes back to bite you on the a***.  If you are offered a property without actually seeing and investigating it, then (to be realistic) you shouldn’t pay much for it because you’re exposing yourself to massive financial risk.

In respect of purchasing the property at auction, it is 80%-90% a legal process.  You are purchasing the legal title to a property which means you will have ‘exclusive possession’ (unless someone else is living in it and also has a legal right to be there).  You should be 100% certain that you know what you’re buying into before you bid.

When buying a property at auction, it pays to be suspicious about everything; so do your homework!

Nov 30th, 2011

Using the Residual Valuation Method

Note, this article should be read in conjunction with the Property Speculator’s Excel-based Residual Valuation Calculator.

The Residual method of valuation is used to establish how much should be paid for development land or a project in an un-developed state.

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The first value that has to be established is the Gross Development value.  This is essentially the total value of the completely finished project.  Some important considerations are:

  • If a project containing multiple dwellings is to be analysed, the GDV will be based upon the total value obtained from the sale of all the units.  The value that can be obtained on the market can be expressed as a rate per M² and can be established through the study of comparable, similar properties recent sold prices (NOT the values they are offered at).
  • When establishing the total value of the finished project, remember that common areas such as stairways, hallways and foyers are not included within this value, but they will be included in build costs.

The second value to be looked at is the total costs of the project.  This will include build costs, consultant’s fees, finance costs, infrastructure/landscaping costs and any obligation for S.106 agreement (a contribution to the Local Council in connection with the project).  Considerations are:

  • As mentioned above, build costs will include the total value of the units to be sold and any common built areas (based upon Gross Internal Area).  Build costs can range from £600 per M² to £1600 per M² depending on the area of your project (obviously London/South east will be more expensive than Northern England and Wales) the required quality of finish and who you intend to do the work (Main Contractors is the most expensive route).  Click on the link for information on build costs.  VAT can often be reclaimed on many costs involved with new-builds.
  • The amount spent on consultants will vary according to the size of the project.  However for the purpose of appraising the project, using percentages is the most appropriate way for the majority of projects to be looked at.  Examples are:  Architect 5-7.5% of build costs and a Project Manager around 2% of build costs) VAT will almost always be payable on consultants fees.
  • Site infrastructure will include drainage, water, gas and electricity supplies.  For small projects, the cost will be negligible and the same goes for landscaping costs.  This is why a percentage calculation is appropriate.
  • Finance costs will depend heavily upon the amount borrowed and the rate it’s borrowed at.  If the project is intended to be solely a development (rather than a development with the aim of letting at the end of the construction phase) then the costs should be recouped as soon as possible.  Obviously the longer it takes to recoup all construction costs; the more must be paid in finance costs.  For the purposes of calculation, a construction period of 1-12 months and a post-construction marketing period of 2-8 months should cover the vast majority of situations.
  • S.106 costs will be related to how the project as a whole ‘fits in’ to the local environment.  A contribution is often requested by the local authority to pay for changed infrastructure to serve the project.  This might be a widened road leading to the development to serve the occupants.  Follow the link to read more about s.106 obligations for developers.
  • Estate agents fees are quite negotiable depending on the size of the development.  It would not be unreasonable to attempt to negotiate a slight discount of half a percent or so for sole agents that will be acting for a large development.

The next figure is the required profit level.  This is often calculated as a percentage of the GDV value.   It’s important that the profit is considered in the equation, because it’s surprising how many novice developers regard a profit as a bonus.  To continue developing property must be regarded as a business.  If no profit is made, then the business will not survive for long.

Clearly, the higher the required profit level, the less will be available to purchase the land.  So a balance must be struck.  Pre-recession profits could be around 33% of GDV (a very crude assessment of a property development was’ 1/3rd for land costs, 1/3rd for build costs and 1/3rd for profit’).  It’s very doubtful whether this would still be attainable now, in practice a rate of around 15% of GDV is realistic.  It certainly helps to be conservative and cautious when appraising a development.

The final and eventual figure to be generated is the sum available for land purchase.  This can be changed considerably if the input figures are changed.  In fact one of the criticisms of the residual valuation method is that for relatively small changes in the input figures, large changes in the eventual values can be seen.  This is why it helps to be cautious with input figures, overestimation of costs is better than underestimation.

The land purchase figure is the figure that forms the basis of your negotiation.  If the property is being bid on at an auction, obviously no opportunity to negotiate will exist.  It will however provide you with a good idea of how your project finances will work and if you bid above your ideal value, the other figures will be reduced accordingly (profit is usually first to suffer).

Nov 20th, 2011

Applying Discounted Cash Flow (DCF) to a Property Valuation

Building upon the previous articles explaining the use of Valuation and Investment tables and how Discounted Cash Flow and Net Present Values work, we are now looking at how we can establish the true return on a property according to an assumed rate of growth and expected rents over a particular term.

This technique is known in financial circles as Internal Rate of Return (IRR), whereas property professionals refer to it as Equated Yield.

A Net Present Value appraisal allows an analysis of expected rents over the term of a lease and can produce an end figure that shows a profit or loss according to an expected rate of return.  To use the example in the article on DCF (see below), an investor pays £100,000 for the expected return of £30,000 at the end of years 1 and 2, and £40,000 at the end of years 3 and 4.  However he is borrowing the entire initial capital sum at an interest rate of 12% per annum.  Is the investment worth pursuing?  :

The table shows that the investor will end up with a profit of £4,585.00 after the costs of borrowing are taken into consideration.   Whether this is worth his effort or not is not relevant to us at this point, it does show however that as long as the return exceeds 12%, the remainder is profit.

So what if we have to find the actual return on an investment?   It’s all very well just ensuring that the return exceeds a certain level, but what if we need the precise figure that the investment will return?  We use the equated yield method.

It can be stated that as the NPV value gets closer to zero, the adopted yield figure (for the calculation) will be closer to the true return.  For example if the required return was placed higher at 14%, the profit would be absolutely minimal:

The NPV at this rate is clearly much closer to zero.  This signifies that after the negative and positive cashflows have been accounted for, the actual return on the investment is very close to 14%.

Calculating the actual equated yield figure is initially a process of trial and error.  This is because 2 trial rates should be used (these can actually be quite far apart) so that the true rate ends up somewhere in between them.

Again, using the example above, we know that the true rate will be very close to 14%, but for the purposes of demonstration a higher rate of 16% will be adopted and the lower rate of 12% will be re-used.

Clearly the resulting NPV figure is a negative one.  The effect of this is that the investment will make a significant loss if a return of 16% is required.  It does however, provide us with an upper rate with which to calculate the true investment return (or equated yield figure).

In order to calculate the equated yield, an equation is used:

Note:  LTR – Lower Trial Rate; HTR – Higher Trial Rate.

Therefore we can establish that the actual return on the original investment is 14.1%

When applying this technique to the context of a lease, the expected returns are incorporated and if the lease is expected to include a particular pattern of rent reviews (for example 5 yearly) the expected rate of rent increase should also be incorporated.

Nov 9th, 2011

Using Discounted Cash Flow (DCF) to establish Property Value

This article builds upon the use of Valuation and Investment Tables

DCF works on the concept of money available now is worth more than an identical sum in the future.  To use an example, if someone were to offer you £10 today or £10 next year, you’re likely to opt for the cash today.  This is for a number of reasons:

  1. Risk.  To receive money today involves no risk; the chance of money being received next year is lower.
  2. Inflation.  £10 today will provide more ‘spending power’ than £10 in a year’s time.  This is because of the effect of inflation.
  3. Alternative investment opportunities.   Why opt to receive the same amount next year as you could receive today?  You could take the money today and invest it and receive a greater sum next year.

DCF is used to establish a value on an investment (not only property) depending on future incomes in the form of rent or dividends, and the length of time the investor has to wait for the returns.

So, how would you establish the present-day value of a future stream of income?  Firstly, a rate of discount is adopted; in practice it is common to look at several analyses each using different rates.  If we use our example of £10 available now, we could assume that the economy in general will suffer inflation of (say) 6% per year.  So £10 now will have the same purchasing power of around £9.43 will next year (this is calculated using valuation and investment tables).  Likewise if we apply a discount rate of 10%, the sum of £10 available now will only be worth £9.09 next year.

In the context of a property investment, if a property provides a return (in the form of rent) of say, £10,000 per annum, after 5 years or so the rent will not be worth as much in actual value as it was at the outset.  Clearly this is why we have rent reviews.

To calculate the present day value of a stream of income over a period of time, we compile a table of future rent payments:

This example shows that an income of £10,000 per year has a present value of £42,124 if inflation rises at 6%.

We can use a similar table to analyse investments that must fulfil particular criteria.  For example, an investor pays £100,000 for an investment that returns £30,000 after years 1 and 2, and £40,000 after years 3 and 4.   However, the rate of interest charged on the initial loan of £100,000 is 12%.  At the end of the 4 year period, will the investor have made a profit or a loss?

This example shows that the investor will make a small profit if the cost of borrowing is 12%.  If the cost of borrowing were 10% (for example) the individual present value multiplier figures would be higher.  This would produce a higher present value figure and subsequently a higher NPV value.

The advantages of using the DCF method of investment valuation are:

  1. An element of risk can be incorporated into the calculation.
  2. Any period of time within an investment period can be examined.
  3. The effects of tax and inflation can be considered.
  4. The particular timings of expenditure and returns can be looked at.
  5. The effect of depreciation is fully considered.

It must be remembered however, to take the DCF valuation model at face value.  As with all other asset valuations, if any input figure changes, the output figure will change accordingly.

Nov 6th, 2011

Using Valuation Tables to Produce an Investment Appraisal

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When an appraisal is being put together for a particular property, the Investment or Valuation Professional will refer to ‘Parry’s Valuation & Investment Tables’.  This is simply a reference book full of tables (funnily enough) that assist the practitioner in carrying out mathematical analysis of investments.  Admittedly this doesn’t sound a particularly interesting read; however it’s a very handy thing to know how to use because it allows a way of comparing several investments to each other and looking at them in different ways.

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One of the principles of investment is that a particular sum of money available now is worth more than the same amount at some future date.  This is for 2 reasons:

  1. The effects of inflation over time.  For example £1 now is worth more than £1 in ten years.
  2. The fact that the money could be invested in various forms.  So £1, invested at a rate of 10% per annum will be worth £1.10 next year.  This is the ‘compensation’ for having to wait for the money.  Why would you wait a year and only receive the same amount you could have now?

Without tables, detailed analysis of financial information would be very tedious.  The tables within the book give the reader a simple multiplier figure to apply to a relevant sum of money.  An example of this is:

A Commercial property lease is agreed to at a rent of £10,000 per annum for 20 years.  On the face of it, this would produce £200,000 for the Landlord (£10,000 x 20).

However because of the effects of inflation, the rent of £10,000 per annum would be worth considerably less in 20 years time than its present value.  Using the relevant table from the book and an assumed rate of inflation, it’s possible to produce a present value of 20 years worth of rent.  To calculate the present value of £10,000 at an assumed rate of say, 5% the ‘Present Value of £1 per Annum (Quarterly in Advance)’ set of tables can be used.  This produces a multiplier figure of 12.85 (this particular figure is simply a multiplier, and until it’s used in conjunction with the annual rent figure means very little).

If the annual rent figure of £10,000 is multiplied by 12.85, it produces £128,500.00. Therefore if inflation is expected to rise at around 5% per year, it would be reasonable to give the 20 year lease a present value of £128,500.00.

The equation used for this is:

n = Number of years

i = the interest receivable on each £1.  Therefore if the rate percentage is R, then i = R/100

In the above example, it’s only the lease of 20 years which is being valued.  The Landlord actually has the ‘facility’ of receiving a similar sum into perpetuity (or until he sells the property to another investor) because the building will theoretically always have the potential of producing an income in the form of rent paid to the Landlord.  If the investment potential of the property itself is valued, it produces a different figure:

Again, using a rate of 5%, we can reference a multiplier figure of 20.62 (using the ‘Years Purchase in Perpetuity’ tables).  If this is applied to the annual rent figure of £10,000, a total of £206,200.00 is produced.

The equation used for this is:

r = effective yield

On reflection, the figure of £206,200.00 does not seem particularly high considering we are examining earnings into perpetuity.  However it should be noted that this is not a reflection of accumulated future earnings.  It simply provides a way of placing a present value of the ongoing income potential of the property.

These 2 examples demonstrate the simpler aspects of what is possible with Valuation tables.  The tables can and do go much deeper. It’s possible to appraise various investments (not only property) with allowances for a large range of interest and growth rates and taxes too.  For example, it’s possible to obtain the multipliers for calculation of:

  1. The rate of Internal Rate of Return (IRR).  This is the actual rate of return received when all expected rent increases are considered.
  2. Annual Sinking Fund.  This is the amount that must be put aside each year to provide capital to replace an asset (remember a leasehold interest is a wasting asset, the closer to the end of the term the less the legal interest is worth).
  3. The Years Purchase with Dual Rate (‘Dual’ because it includes the aspect of a sinking fund). The additional tables allow consideration of tax rates of between 10% and 50%.

I have found that until an investment or valuation professional gets into the very complicated aspects of appraisal, it is not really vital to understand the actual equations.  The very practice of knowing where to look to obtain the correct multiplier is far more important.  The use of valuation and investment tables is like almost everything, the more frequently they are used, the easier the process becomes.

Through the use of Valuation and Investment tables, quite complex calculations can be made such as Discounted Cash Flow.

Oct 16th, 2011
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