The primary use for a residual appraisal is to produce a figure for land or undeveloped property purchase, in addition it can also be used to:

1. Establish a required profit from a project and place that figure into the calculation.
2. Consideration of the maximum value available for build costs, above which the project will become less financially attractive.

The undeveloped property might be:

1. Brownfield or Greenfield land where buildings have never stood.
2. A cleared site where the property has been demolished.
3. A property that requires renovation or conversion to a lesser or greater degree.

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The very basic formula for a Residual Valuation is:

Gross Development Value or Value completed

Less

Costs and Profit

Equals

Amount available for Land Purchase/Pre-Development Property

The first value that has to be established is the Gross Development Value.  This is essentially the total value of the completely finished project.  In most cases, the comparable method of valuation will be used to obtain reasonably accurate values for Sq Ft or Sq M.  Recent transactions can be analysed and the selling price or annual rent compared to the property in question.  Although the comparable method is not flawless, it is about the most accurate method to establish (completed) property value available.

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 amount available for land purchase is the absolute maximum that the developer would pay for the undeveloped project.  In practice however, this figure is likely to become the Gross Land Value because he has to:

1. Allow for professional fees and SDLT or property taxes.
2. Pay interest charges on any money borrowed to fund the development.

When the above have been subtracted, the Developer is left with the Net Land Value.

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) or Community Infrastructure Levy (CIL).  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 consultant’s 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’ 1/3^rd for land costs, 1/3^rdfor build costs and 1/3^rd 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).

To download the very finest guide to Assessing Land Value, the Residual Valuation method and Gross Development Value currently available on the internet for only £5, please have a look at my ‘How to Price Development Land‘ page.

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Whether or not you receive funding will probably be the biggest factor in determining the success of your project and/or venture.  If you don’t have the available capital to begin, and no one will lend to you, you are unlikely to get very far.

Therefore, finance is very important to the novice and experienced developer alike.

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I’ve written on the subject of Property Development Risk before, and to present the subject of obtaining finance it’s necessary to bring it up again.  However it’s probably not in the way you expect.

Managing risk is very important in any business venture.  If a company exposes themselves to too much risk on a regular basis, sooner or later something will go wrong and the consequences could be substantial.  Likewise if risk is avoided at all costs, the venture is unlikely to grow.  Risk is to be embraced but in a controlled way.  Profit or losses are the wages of risk.  There are ways for a property developer to manage risk; however it should be done with a view to your partner.

When I mention a partner, I mean the bank.  If you obtain funding, you will literally be going into partnership with the bank.  It’s most definitely not like an unsecured loan or even an owner/occupier mortgage.  If you are using a substantial chunk of the bank’s money, they will want to know absolutely everything about your venture.  This is when it’s important to consider the flip-side of risk management.  Your bank is also extremely interested in risk management; therefore everything you do to limit risk, might have the effect of moving the risk in their direction.  The bank is in the driving seat, there is a good chance they have put more money into the venture than you have, so they will be working hard to limit their own level of risk.  In this situation, if you really need to borrow to realise your plans, you must take on a significant amount of risk.

Visualise the banks as being like a wild animal, they need gentle and convincing coaxing to entertain your plans.  If you offer them a deal where they end up shouldering too high a proportion of the risk, they’ll be off before you know it.

So what should you be doing to get the banks to take you seriously?

Don’t use a Limited Company.  The whole purpose of a limited company is to control and limit liability on the owner/s.  Therefore if you set up your development/investment business as a Ltd company, the bank faces substantial risk because they will be severely hampered in recouping any potential losses if the venture goes wrong.  The bank will be much more comfortable if they are lending to an individual rather than a company.

The CV of the Borrower.   The person borrowing the money should really have a good idea of what they’re doing.  And if it’s your first property development venture and you are considered a novice, it’s an excellent idea to work with someone else who does know what they’re doing.  Obviously this is a bit ‘catch-22’, you can’t borrow the cash until you’re experienced, and you can’t gain experience because you can’t get the cash.  No one said it was easy; do your homework, plan the project (especially the finances) well, take advice from a building contractor/Building Surveyor/Architect so that it’s less likely you will go far wrong.  This is what the banks are looking for.

Don’t take on too big a project before you’ve gained experience.  Most successful property developers start their new careers by carrying out very light renovations to properties that just require a bit of updating and tidying.  This way the developer gains experience, and begins to accumulate more capital (hopefully).  It’s important to learn what works well, and what doesn’t.  It makes a big difference to your decisions when it’s your money going into a project.

Don’t expect to borrow heavily against your first project.  This point is probably quite an obvious one in the current financial climate; however it’s an important point.  There are financial advantages to borrowing against a property development, but fine-tuning the gearing is something to concentrate on when you are experienced and running a larger project/portfolio.  Banks are beginning to be slightly more flexible in their lending criteria, however you really should be able to invest at least 25% into a project and also have enough in reserve to cover a part of the early construction phase and contingencies.

It’s important to see the banks point of view when approaching them for finance.  They are in a powerful position, and it is vital that the developer/investor convinces the bank they represent a low risk.

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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.

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

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

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:

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 1^st 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:

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.