Using Financial Leverage

Financial leverage is basically the practice of using borrowed money to supplement equity (non-borrowed money). In the field of private property development and investment, this is often done at a ratio of between around 20%-50% equity, the remainder being borrowed in the form of a mortgage.

The term ‘gearing’ is closely related to this subject. Gearing is the particular ratio of debt to equity. The proportion of debt is expressed as a percentage of the equity. So if a property is geared at a ratio of 65%, this means that the amount of capital borrowed to purchase the property is 65% of the total investment. In the world of finance, if a particular company is geared at 65%, then it would be regarded as high risk. However, private property investors might have to borrow up to 3 times the equity level. This would not be regarded as risky in the same way as corporations, but you should always acknowledge the risk factor in any investment. The return on your investment is the payback for accepting this risk.

A certain amount of financial leverage is not only (for the majority of people) inevitable, but it is also desirable. This is because of 2 reasons:

1. It enables a speculator to increase his holding several times over. It makes more financial sense to place 25% of your total investment into each of 4 properties, rather than placing 100% of it into a single one. This enables investment diversification (which helps minimise risk) and maximises potential future returns.

2. Purchasing a property using 100% equity is the most expensive way to run a development or investment company. This is because tax is payable on a company’s NET profits. If the vast majority of your return is regarded on paper as profit then you must pay tax on it. Mortgage repayments are regarded as liabilities and will subsequently reduce tax liabilities.
Property is quite unique as an investment as it enables speculators to borrow higher levels against the property value. This is because it offers a tangible investment. Even if the property remains unoccupied or unsold for an extended period of time, the lender will always have (at the very least) the land value to guard against the loss of their capital. Even if the building upon the land is destroyed somehow, the land will always have some value. Most other investments do not offer this.

An example of why financial gearing increases returns is as follows:

An investor purchases a property at a price of £100,000. Equity is £35,000, and £65,000 is borrowed.
Investment capital £100,000
Less loan £65,000
Property owners equity £35,000

Rent for initial 5 years £8,000 per annum
Less loan interest £5,200 per annum
Net income to property owner £2,800 per annum

Return on Property Investor’s equity £2,800 ÷£35,000 = 8%

So the property investor achieves a return of 8% per year for the first 5 years. However it is in the subsequent years where the advantages of leverage become clearer.

Reviewed rent for next 5 year term £10,000 per annum
Less loan interest £5,200 per annum
Net income to property owner £4,800 per annum

Return on Property Investor’s equity £4,800÷£35,000 = 13.71%

Subsequent terms will reflect even greater returns in comparison to the level of equity placed into the investment. This investment would be a 65% gearing.

It is highly unlikely that an investment of only £35,000 could produce a return of 13.71% and more if invested in stocks. Prior to the recession, Hedge Fund Managers spoke of producing returns of up to 40% per annum. However, a minimum investment is required (far in excess of our example value of £35,000) and the investment risk would be regarded as far higher than that of property. Many hedge funds have gone out of business post recession, taking their invested capital with them. Remember though, property is a tangible investment and it is difficult to foresee a situation where it would ever be worthless.

Building or Developing on Contaminated Land

There is a (reasonably) well known quote by Mark Twain that goes:

“Buy land! They’re not making it anymore”

Personally, I quite like this, as it is a very succinct way of reminding people of the relative scarcity and finite nature of land.

What this means to the novice property developer and investor is that theoretically, at some point all land could be bought and developed upon. Of course, this is never likely to happen but what is foreseeable is a point where all available land has become so sought after that the asking price has been driven up to a level where it renders a project financially unviable.

In this situation, brownfield sites (sites that have developed previously and are currently available for a new use; possibly subject to a grant of planning permission) might have to be considered. Sometimes, these plots will have been used for activities that would render them contaminated (for example, a filling station). When novice developers think about a contaminated site, they might visualise being ankle-deep in oil or waste fuel while the building work is carried out. The reality is that this could never be the case.

The control of contaminated areas of land is governed by either the planning process as a whole, or Part IIA of The Environmental Protection Act 1990 (EPA 1990). Under Planning Policy Statement 23, a property developer is responsible for making sure the development is safe for its intended use. So if the site is suspected or there is proof of it being contaminated, the planning authority will require assessments to be carried out before any planning consent is granted.

Under EPA 1990 Pt IIA, if the site is not dealt with through the planning process, then a local authority has an obligation to investigate any potentially contaminated land within its boundaries. If any contamination is found, then the developer must carry out a clean-up if the contamination is considered a risk to people, property or the environment. Clean up of an area will include some or all of the following:

1. ‘Desktop study’, site visit and initial risk assessment. This will entail an appreciation of the site history; original, current and future/proposed use; information on expected contaminants and their sources; information on potential ‘receptors’ such as people and flora/fauna. When Phase 1 has been completed, a report containing a preliminary risk assessment and recommendations for further investigative work will be submitted to the local authority and the Environmental Agency prior to moving on to Phase 2.

2. Site investigation and risk assessment. This phase involves the investigation into the scale of the contamination. This could be heavy metals, oil and fuels or gas. A ‘Sampling Strategy’ will be drawn up to specify the depth, scope, pattern and frequency of sampling. An assessment of risk to human health, waterways and other receptors will also be carried out at this stage. Upon completion, a report will have to be submitted to the local authority and The Environmental Agency detailing the recommendation as to whether remedial action is required to make the ground fit for use.

3. Remediation approach and works. The approach to be adopted for remediation will include the intended standard to be achieved. The works is when the physical work is actually carried out to make the site fit for development. It might include the removal of contaminated soil from the site and/or the introduction of a layer of impermeable material to prevent contamination seeping through. Any potential source of contamination will also be remedied to prevent further contamination.

4. Validation of remedial works. This is when the ground will be re-sampled to establish how effective the works have been. A Remedial Works and Supporting Validation Report must be submitted to the local authority and the Environment Agency. If it has been successful, then a written decision will be issued and the usual application for planning consent can be submitted.
Clearly, this is not a particularly speedy process. And it is also unlikely to be particularly cheap. However, there are specialist companies who will look after the process for you. Assessing the cost involved is a difficult thing to do because it depends entirely upon the scope and nature of the contamination, the size and location of the site and the intended eventual use of the site.
A very approximate indication of prices however is:
Removal of contaminated material – £50-£170 per cubic metre.
On-site encapsulation – £40-£100 per cubic metre.
Soil washing £60-£120 per tonne.

Items that might have to be included in the above are:

Haulage costs.
Landfill tax
Accommodation of personnel (if required)
Traffic management

The best recommendation I can provide if you are considering developing on a site you suspect to be contaminated, is to speak to one of the specialist companies (links provided below). They are fairly unlikely to be able to give you a very accurate quote for clean-up, but should be able to give you some idea of approximate costs. An appraisal could then be carried out to see if the project is financially viable.

Building on a contaminated site might financially benefit you, as many other developers might be unwilling to use the land, even post clear-up. Subsequently, if you considered this a worthwhile idea, the land cost might prove to be substantially cheaper than the alternatives even after inclusion of the cost of clean-up.

Links:
Environmental Agency page on Contaminated Land
http://www.environment-agency.gov.uk/research/planning/33710.aspx

Land Remediation Specialists:
http://www.trm-ltd.com/

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Developing a Victorian Property

As I’ve mentioned before, it’s never an easy ride developing a property for profit. Developing a listed property is more difficult still and not to be recommended for the novice developer. That said, it’s almost always period properties that manage to keep their romantic appeal over the more modern ones.

The vast majority of period property purchasers are pleasantly surprised to find that period features have been retained and enhanced. It can be quite disappointing for viewers to a period property to discover that the interior has been cleared of features and looks like a new-build. Therefore, it’s important to remember that if a property is a period one, you must keep the internal and external features.

Victorian properties are probably the most common of all listed properties. This is because the Victorian era covered many years. It took over from the Georgian period and began in approximately 1840 and lasted until around 1900. It’s fairly easy to notice the crossover period between Georgian and Victorian, unsurprisingly Georgian architectural features blended gradually into Victorian. A specific feature of typical Georgian architecture is symmetrical and proportional windows of many small panes, where the height of the windows is exactly double that of the width. Victorian properties however have very tall and narrow windows of only one or two panes. Technology had moved on to facilitate larger panes of glass which allowed more natural light to enter the property.

At the small end of Victorian properties, there are the long rows of terraced houses. These are situated in almost every town and provide the novice developer with an ideal property to learn the ropes on. They tend not to vary too much in layout; the only differences are the orientation of the stairwell and which floor the bathroom is on. Victorian properties tend to be robustly designed and built but occasionally turn out to have no foundations. This means that a survey is highly recommended as it’s not unheard of to find subsidence to some degree in these properties. On a more optimistic note though, most of these houses that were built without foundations have now had the necessary work carried out to prevent catastrophic movement. Always make sure though…remember – caveat emptor.
Larger Victorian properties are often built in a ‘villa’ style. This means that they were built in a certain architectural style that the smaller terraced houses weren’t. This style can be shown in the ornate features that these properties have, such as intricate window mullions and projected porches. Much of this was influenced by the gothic revival period (1850-1880). These houses often had cellars and attic space for servant’s accommodation. Victorian houses tended to be either terraced or detached in towns and cities. Semi-detached Victorian properties are more likely to be found in rural areas as they were built for the workers on the large estates.

The Victorians were the first to introduce the beginning of what we know now to be Building Regulations.  From the middle of the 19th century, there was an increased importance placed on sanitation in properties. Of course this wasn’t always particularly comfortable in the small properties (i.e. outside toilets) but larger houses were more likely to have a (downstairs) cloakroom built. Proper drainage (meaning the sewers were enclosed) was also introduced. Towards the end of the Georgian period, it was only a very few properties that had running water. By the end of the Victorian era, hot and cold running water was available in the majority of homes. The cellars of Victorian houses were used for the storage of coal. The pavement outside and immediately in front of the property would have a small flap or cover that allowed the coalman to pour the coal directly into the cellar without having to carry the coalbags through the house.
The Victorians strongly believed that a ‘bare’-looking interior was a sign of very bad taste. Subsequently, they tended to fill their homes with as many knick-knacks as possible. It is extremely unlikely that anyone would follow such a trend in modern times. However, it’s also not a good idea to attempt to incorporate a modern, almost minimalistic look into a period home unless you absolutely know what you are doing and it can be done sympathetically. Most people can’t.   A compromise between the two would be to look for comfortable and classic looking fixtures and furniture to acknowledge the history of the property without overfilling it. The general intentional feeling of Victorian homes is of comfort. The Victorians prized their home-comforts more than the Georgians.

In common with the Georgian era, Victorian house interiors in towns and cities were generally not painted in particularly bright colours. This was because of a combination of the pollution and the fact that paint technology was not very advanced. As the era progressed though, more interesting colours became popular such a rich greens and reds. The general idea was to use a single colour as a main one and add several ‘secondary’ colours to compliment it. These secondary colours were intended to compliment the main one by giving a contrast but without clashing. Varying textures between mouldings, ceilings and woodworks was also popular towards the end of the 19th century.

The most obvious features of Victorian interiors is coving, cornicing and ceiling roses. Originally, Dado rails were fitted in dining rooms at chair-back height. This was to protect the walls from dining chairs hitting them whenever a diner stood up. Picture rails were fitted in drawing rooms and parlours, where they did actually support pictures hanging beneath. Coving and ornamental woodwork should be painted in gloss white paint. This gives a ‘clean’ look that contrasts with the colour of the wall (just make sure the lines are straight…).

Wallpaper also became popular in the Victorian era. Although it was not quite as you might imagine. The patterns were extremely bold and were full of florals and swirls. In common with the idea of filling the property with lots of ornaments, it’s unlikely a developer would seek out Victorian style wallpaper unless it was intending to be a very accurate ‘museum’-type property. A good compromise would be to look at the Laura Ashley type of wallpaper. This would be regarded as sympathetic to a Victorian property, without being too accurate (i.e. dark). There’s no reason for a Victorian property to ever be dark. If the interior furnishings and decoration are light, then in combination with the tall windows, a Victorian property can be a very pleasant place to be.

Developing a Mixed Use Property

A very common way of getting started in property development and investment is converting or renovating a mixed use development.

‘Mixed-Use’ can mean a combination of Residential, Office or Retail within a single development (it’s highly unlikely Industrial type properties would be included in this, for example I can’t imagine a residential flat being situated above an industrial unit). So an example of this could be a shop with a flat/flats above it, or offices with residential above. Incidentally the residential portion is situated towards the top of the property because it’s not likely to require a street-level frontage, like a shop or an office might. The residential area of the property also tends to be quieter and the commercial occupants are less likely to have cause to go upstairs into this area of the property.

It is certainly possible to convert only part of a property to a use that’s different to the original one. Be aware though that (currently) Planning Consent is required to change the use of a property (or part of a property) from Commercial to Residential and between sub-groups within Commercial. Building Regulations also need to be fully complied with.

The different ways of occupying a property are:

1. Freehold. This is the closest to owning the property outright (It’s only a Government body which can carry out compulsory purchase though). The Freeholder theoretically owns the plot, the land beneath the plot and the area above it (although this isn’t really enforceable in reality). Being a Freeholder offers the luxury of selling a leasehold interest in the property if he/she wishes.

2. Leasehold. This is usually for a period of time (term) of 99 years or more (sometimes 999 years). The freeholder effectively sells the right to use the property for the term stated in the contract. Along with this, the Leaseholder sometimes receives the right to allow Tenants to occupy the property and collect the rent. In order to reduce the chances of confusion, this is often called the Long-Leasehold interest. It is bought in a similar way to the Freehold Interest (i.e. a large amount of capital is paid for it, rather than a monthly or quarterly rent).

3. Tenancy. This is really just a different way of occupying the property under a leasehold interest, however for the purpose of avoiding confusion over these occupancies, I refer to it as a Tenancy (even though the occupational contract is still called a Lease…). This is paid for in the form of rent, usually paid monthly or quarterly (depending on it being Residential or Commercial). A tenancy is always shorter than the long-leasehold interest (even if it’s only 1 day shorter) but is usually much shorter, between 3 and 25 years is usual. A tenancy does not really have much value in itself other than to the landlord. This is because it’s not really possible to sell a tenancy by itself; you can however purchase the leasehold interest with a tenant already in place.

Commercial and Residential tenancies are usually quite different. The main issue is that all Commercial tenancies are awarded Security of Tenure unless specifically contracted out of it. This means that a Commercial landlord can only make the tenant leave the premise at the end of the term in certain circumstances (for example if the landlord wants to redevelop the property and has plans in place to prove this). To contract out of this, the lease agreement must specifically state that both parties wish to contract out of the Security of Tenure provisions of Part 2 of The Landlord and Tenant Act 1954, s 24-28 (or words to the same effect). Contracting out of the act should benefit both parties (such as when a lower rent is agreed upon to reflect a lower ‘risk’ to the landlord).

In contrast, Residential tenancies tend to be more heavily weighted in favour of the Landlord. A tenant does not really have any Security of Tenure at the end of the term. Many Residential tenancies are only for an initial period of 6 months. If the tenant stays in the property with the permission of the landlord at the end of the term, a Periodic Tenancy is formed. If the tenant pays rent on a monthly or weekly basis, this period becomes the notice period for either party to bring the tenancy to an end. A periodic tenancy continues until the landlord or the tenant brings it to an end.

It’s important to have an understanding of how the different types of occupation work. When developers of mixed use properties consider their projects, they intend it to work in a slightly different way to the usual private residential developer. Where a private developer buys a property at a reduced price, spends the bare minimum but produces a good finish then sells on to a new owner, a mixed use development often requires a different approach. Of course it is possible to buy and sell a mixed use development in the same way as a small residential (i.e. the freehold), but because of the combination of property types within the development it usually makes more sense to keep the freehold of the property and sell the long-leasehold interest as and when an occupier or investor is found.

If the freehold is retained, tenants can be found to occupy the office or retail portion. The residential areas of the building can be let the same way as the commercial but this involves a lot of management of tenants taking 6 or 12 month tenancies and of course, the developer will not receive capital in return in a lump sum. It’s far better to sell the long-leasehold interest in the residential units to either investors or leasehold-occupiers. This way, a profit can be made (the value of a long-leasehold interest is more-or-less the same as the freehold price) on individual units of the property. Investors or leasehold-occupiers can buy individual long-leaseholds interests one-by-one if necessary. If the residential units are above the ground floor, it is not possible to sell any of the freehold interests in these. A freehold must always be on the ground floor or associated with a property on a ground floor. If an investor purchases any of the long-leasehold interests, they will be obliged to honour any tenancies that might have been agreed prior to their completion.

It’s also important to understand how service charges apply to a property of mixed uses. A service charge is essentially a further charge to the tenant(s) to contribute to the upkeep of common areas such as grounds maintenance or cleaning and decorating of hallways and stairwells. Service charges should be ‘fair and reasonable’ and not produce a profit or a loss for the landlord. For Commercial tenants, The Royal Institute of Chartered Surveyors publish a Code of Practice guide on service charges. The method of dealing with dispute resolution will be stated in the lease. Residential tenancy service charges however, are very strictly regulated. A landlord who doesn’t follow the statutory procedures might find himself limited under law as to how much can be recovered from the tenant at the end of the occupancy.
Tenants should be supplied with a schedule of the previous year’s service costs and justification of the current level of charge. In a mixed use property however, tenants will occupy different sized areas and even use different facilities in the property. For example a Commercial tenant on the ground floor would not be expected to pay for the upkeep of a lift to service the residential units on the floors above. The principle way of deciding who should pay for what, is to consider which property a particular service will benefit. A Commercial tenant should have the opportunity of negotiating the service charge. It is sometimes possible to opt out of the charge for services that are available but will not be used.

Explaining Property Yields

When investing in property, it is important to have a good understanding of the term ‘yield’.  Contrary to popular belief, it does not mean the actual sum of money received on a particular investment.

The term Yield can be defined as:

The annual return on an investment, expressed as a percentage of the capital value.

 So for example, the annual return on a property investment is currently £12,000 a year gross.  If the property has been valued at £220,000 then the yield can be calculated by:

  • Dividing the capital value (220,000) by 100, to get the value of 1%.  It works out to 2,200 in this case.
  • Divide the annual rent figure by 1% of the capital value.  This produces a figure of 5.45.
  • Therefore, the yield on this investment can be said to be 5.45%.

This is a very straight-forward calculation that is only really carried out to enable people to compare investments across types and sub-types.  This is known as the Initial Yield figure.  The annual rent figure used in the calculation is the ‘passing rent’, meaning it is not discounted in any way by rent-free periods (a common incentive).

The next type of ‘yield’ is called an ‘All-Risks Yield’ (ARY).  This is also expressed as a percentage but even if used in connection with the very same investment calculation used above, the figure is likely to be different. It is used mainly by Commercial Property valuers to be manipulated accordingly to provide an indication of the risks involved in a particular property investment.

This is done by using it in a slightly different way to the above Initial Yield figure, which is a result of the calculation.  When establishing an ARY figure, a basic principle must be followed:

  • In a falling (Bear) market, yields rise because they represent a higher proportion of the property’s capital value (rents stay fairly static, capital values fluctuate).
  • In a rising market (Bull), yields fall because the capital value increases and the annual rent figure accounts for a lower percentage of the capital value.

Therefore, the analysis of yield figures provides an insight to the property market as a whole.  It is often far easier to consider yield values of more interest than the capital values used to calculate them.  Capital values can only really be established by looking at recent transactions of similar properties, whereas yields can be comparable across all properties.  Because of this, it is common practice to apply a yield figure as a multiplier for the annual rent, resulting in an estimate of the capital value.  An example is as follows:

A commercial office building is currently let at £50,000 per year.  If an appropriate yield figure across similar properties is 6%, then the capital value will be in the region of £833,333 ((50,000 ÷ 6) x 100).

The yield figure can be manipulated to produce a different capital value.  This is done to reflect the various risks involved in letting a property to a tenant because:

  • If the tenant is likely to default on rent payments or vacate the building leaving damage, then the value of the investment as a whole will be worth less than average.  This would produce a higher yield figure.
  • Alternatively, if the tenant is a highly regarded national company and almost guaranteed to be a ‘perfect’ occupant, the value is higher to an investor because it represents a lower risk.  This would produce a lower yield figure. Incidentally, the yield figure of a very high quality building with an exceptional tenant represents a benchmark situation, this results in a ‘Prime Yield’.

The term ‘All-Risks Yield’ is therefore used to describe a yield figure that hopes to reflect all associated risks and benefits to the investor.

Net Yield is a further expression used to describe the yield after expenses have been subtracted.  An example of this is:

A residential development of flats returns £60,000 per year for the investment company.  The capital value of the development as a whole is estimated to be £1m.  This produces an initial yield of 6%.

However, if the investment company regularly spend £15,000 per year on management costs and associated fees, this changes the yield figure.  The net return is reduced to £45,000.  Therefore the net yield is 4.5% (45,000 ÷(£1m ÷100)).

Careful analysis of yield figures to this degree is unlikely to be the practice of the novice property investor.  However, when projects get bigger and budgets increase in proportion, it is important to have an understanding of how property capital values and yields work together.

 

Valuation Methods. Profits

In the case of most types of commercial property such as retail, office and industrial, it will be a reasonably straight forward job to establish a rent or a capital value (for when being sold on the open market).  The rent or capital values will likely be set by close comparison with similar property transactions in the immediate area.

Sometimes however, it’s just not possible to compare similar properties, because the information might simply not be available.  This might be because the property is very unique or because similar transactions have not occurred recently enough to be of any use.  This is often the case for leisure properties such as pubs, restaurants and hotels.  These are often sold on the open market but because they’re a specialised investment field, you probably haven’t seen them unless you’ve been looking out for them.  In fact, it’s not just professional investors  who would have an interest in how these properties are valued, prospective tenants planning on running the business themselves should also know how the valuation process works.   If you understand how the property is valued, you will have far more leverage when it comes to negotiation on the eventual rent figure.

If no comparable information is available, the only alternative is profits.  Obviously this means that the property has to have an operational business currently running from within.

I personally feel that the profits method is a far better way to place a rental value on this type of property, even if accurate and relevant information on comparables is available.  This is because these types of properties can be a similar size and closely situated but make extremely different levels of profit.  The business that’s been more shrewdly run might appear to be worth more.  It should be mentioned however that the business itself is not being valued, rather the ‘facility’ to run a business from the property.

To begin to establish the profits, the past 3 years accounts must be looked at.  It’s very important that these are accurate enough to be relied upon; a good indication is if a reputable accountancy firm have prepared them.  A very basic way of estimating the net profit figure is by the following summation:

Gross Earnings

Less Purchases

Equals Gross Profit

Less Working Expenses

Equals Net Profit

Gross Earnings is the total annual revenue that the business earns, before anything is subtracted.

Purchases are the ‘raw material’ that must be purchased in order that the business can operate.  In the case of a restaurant for example, this would be food, beverages and equipment.

Gross Profit is the resulting figure that is produced from subtracting the business purchases from the gross earnings.

Working Expenses are the everyday costs involved in running a business such as electricity, staff wages and insurance.

Net Profit is the final figure left after all expenses and purchases have been deducted from the Gross Earnings.

The valuer who establishes the rental value based on profits is obliged to use his judgement in deciding if the net profit figure is accurate enough.  Company accounts can only show what has been recorded.  However if the business has been underperforming for some time, the valuer might consider the net profit figure too low compared to what might be achievable.  Likewise if the business has been run exceptionally well, the net profit figure might be reduced for the purposes of the calculation to give a more realistic figure.  In practice, the Property Professional who values a property based on profits will be a specialist in this particular field of commercial property.

It is common practice to divide the net profit figure in half (or thereabouts) to produce an annual rental value.  One half is known as the ‘Tenant’s Share’ and is intended to account for the Tenant’s work and enterprise in running the business.  The other half would be regarded as the annual rental value.

So for example:

Gross earnings – £100,000

Less Purchases – £35,000

Equals Gross Profit – £65,000

Less Expenses – £25,000

Equals net profit – £40,000

Tenant’s share of 50% – £20,000

Annual rental value – £20,000

When calculating the net profit figure, the Tenant’s wages should not be included as an expense.  This is because the Tenant’s share is included at the later stage and must not be considered twice.

Valuation Methods. Residual

This article should be read in conjunction with the Property Speculator’s 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 undeveloped state.

The first value that has to be established is the Gross Development Value (GDV).  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. 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).  An article on build costs is planned for the very near future.  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.  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.
  • 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 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.  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’).  This might still be attainable now, but in practice, 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).

Valuation Methods. Contractor’s.

In some cases, the 4 other methods of valuation (Comparison, Residual, Profits and Investment) are just not suitable for a particular property.  Some buildings are designed to be used by Town Councils or public sector/healthcare/military workers and are therefore quite unique and it’s simply not appropriate or possible to value it for a commercial use.  These properties very rarely change hands and because of this, almost no comparable evidence is available.

In this case, the Contractors method of valuation can be used (also known as Summation). It is not without it’s limitations it has to be said and is sometimes referred to as a ‘last resort’ method.  This is because it works on the basis of a building or property’s value being the same as cost (which in most cases is a flawed concept, as ‘cost’ is a fairly definite sum, whereas ‘value’ is not).

The Contractors method works on the idea of the cost of the land plus the cost of the buildings upon it equals the value of the property as a whole.  This sounds about as simple as it’s possible to get in Real Estate valuation, however it’s in the detail that the skill lies.  The users of these non-commercial buildings could hypothetically move to a different site and have a similar building constructed.  As no aspect of competition exists, the value is quite likely to be similar whichever site is used (assuming it’s a similar size).  The value of the land should only be based upon the intended use, not best use.  This is because land where (for example) offices are permitted to be built would be worth considerably more than land upon which only a fire-station could be built.

Another consideration is that the value of a new building would be worth more (theoretically) than the value of one that which already stood on the site.  There must be some amount of depreciation for general wear-and-tear and obsolescence.  The basic equation for the Contractor’s Valuation is:

        Cost of Building

plus Cost of Site

     = Total Cost of Similar Property

   less Amount for depreciation and obsolescence

           = Value of Existing Property

In practice, the process of establishing the value would be:

  1. Apply build costs (at a rate per Sq Ft/M) at the time of valuation, and discount this by a percentage to allow for depreciation and obsolescence (this could be 25% for obsolescence and a further 15% for depreciation).
  2. Add the revised total build costs to the land value, including costs of plot works and fees.
  3. The result is the value of the property.

Clearly this method has its limitations; Not only can build costs be difficult to establish with accuracy (due to the envisaged specialist nature of the building), but the level of discount to be applied to allow for obsolescence and depreciation must be quite specific.

Valuation is (quoted from the Royal Institution of Chartered Surveyors) ‘an art, not a science’.  This means that although the methodology is reasonably straight forward, the application of it not simple.

Valuation Methods. Comparison

Of all the 5 methods of Real Estate valuation, the Comparable method (also known as the Comparison Method) is king.  It underpins all other forms of valuation to some degree.

I like to be able to work with a definition of a term so that I can truly understand it.  So I will attempt to define the term ‘Comparable Valuation’:

‘The establishment of a Property’s Capital or Rental value using recent, similar transactions as a guide’.

The first thing to mention about this valuation method is that it is not rocket science.  It is essentially the method that not only residential Estate Agents (Realtors) use to establish an initial property asking price, but also potential buyers.  That means that if you have ever got a particular ‘feel’ for the market in an area and felt that a house or flat is over or undervalued, you have used this method too.  This is because all it is is comparing one property value to another.  This might be oversimplifying slightly, because there are certain considerations to look into:

  1. The difference between the asking price and the eventual sale price (or asking rent compared to eventual agreed rent) is quite likely to be significant. This is down to the negotiation between vendor and purchaser (or landlord and potential tenant).  An example of this is when residential Estate Agents are very optimistic when placing an initial asking price on a property.  It’s very important when researching recent transactions that actual sale or ‘let at’ values are used.  Asking prices and rents can be ignored.
  2. The recent transactions should be as recent as possible. It’s far easier to use the comparable method when the commercial property market is active and stable.  This is because information is far easier to gather.  Sometimes it’s just not possible to find sale or let figures that have been produced in the preceding weeks or even months; however you must understand that the older the information on other transactions, the less accurate it is.  Property is hugely influenced by changes in demand and supply; this means that if (for example) an office building was sold 3 years ago for £1.35m (Approximately $2.025m) it does not necessarily follow that it would sell for more than that now.
  3. Transactional information should ideally be based upon properties that are located very closely together. In Central London and (presumably) other similar large cities, buildings should be on the same side of a particular street and preferably within a few hundred yards of each other before they can be considered closely comparable.  However, that leads us on to the final consideration:
  4. All properties are different in some way. This could be different Use (offices, industrial or retail plus sub-uses such as financial and professional services, general business or light industrial etc), Grade (the high profile, well-equipped and modern offices are known as Grade ‘A’, grades then go to B & C depending upon condition, level of amenities and pleasantness of the building in general), Size (the difference in sizes of buildings is addressed by dividing the rent or sale price of a property achieved by the area.  This produces a value per square foot or square metre) and Location (this might be the difference between (for example) a building in Central London and a building in Warrington; or even different areas in the same city, such as a building in Streatham, London and a building in St James’ Square, London).   These will all have an influence on value to some degree.  If rent is being negotiated, 2 apparently identical buildings side-by-side could have different rates negotiated.  This could simply be because a particular business tenant presents a lower risk to the landlord and was therefore able to negotiate a slightly lower rent than the neighbouring tenant.
  5. Economic conditions can affect the demand for property, and subsequently the agreed rent or price. The cost of borrowing is a big factor in property sales; likewise the general level of confidence in the macro-economy will affect investor’s appetite to acquire what amounts to a highly illiquid asset.  In economic downturns, businesses are much less likely to expand or move premises and this increases an investor’s exposure to risk.

It’s often said that Real Estate valuation is an art, not a science.  In relation to the considerations above, establishing a property value is not difficult.  However, establishing an accurate figure is where the skill comes in.  Determining an approximate rate per square foot or metre is not difficult; however it’s knowing where to adjust a figure and how to account for differences between apparently similar property transactions that sometimes produces unexpected results.

In the case of commercial tenancies, lease terms will have a substantial affect on the agreed rent:

  1. The lease Term (length of tenancy). A long term is normally of benefit to the landlord, except (for example) if he plans to redevelop the site in the mid to long-term.
  2. Break Clause. This allows one or either party to bring the lease agreement to a premature end.  In the UK, it is often placed into the lease terms in 3 or 5 year intervals.  It will be subject to around 6 months notice usually and might involve some reward if it isn’t exercised (such as a rent-free period).
  3. If the tenant has some Security of Tenure. In the UK this means that the landlord can only insist the tenant leaves the premises under certain circumstances.  All commercial leases in the UK are automatically subject to this unless both parties agree to exclude it at the beginning of the Term and this is specifically mentioned in the lease contract.
  4. The financial standing of the tenant. 3 years of company accounts are normally required for the landlord to consider.  This is because if the company has an excellent credit rating and has been established for quite some time, it will present far less of a risk to the landlord than a company that is in its infancy or has defaulted on some payments to creditors.
  5. Ease of use of the premises. If for example, a tenant is unable to access premises outside normal working hours, this can have an effect on agreed rent as it might be a significant inconvenience.  Likewise if an out-of-town office building does not have sufficient car-parking spaces for the staff, this is also likely to reflect in the agreed rent.
  6. Obligations regarding repairing and maintaining the building. If a tenant is obliged to take on responsibility for all building maintenance and repair, the rent is likely to be lower as the terms of the agreement are simply less favourable for him.  The same can be applied to insurance.  If the tenant is obliged to pay for insurance, it represents a burden for him.  Insurance payments are collected from the tenant by the landlord.  The landlord usually takes responsibility for arrangement and ensuring that insurance payments are made, as this way he knows that cover is in place.  The payments are recharged to the tenant under a separate arrangement.

An example of the Commercial use of the comparable valuation method is as follows:

To establish the rental value of Building A, three further buildings (B, C and D) can be considered for comparable evidence.

Building A is 3,000 Sq M office building.  It is established that rents in the area have increased by 7% in the last 12 months.

Building B is 2,000 sq M and is of poorer grade than Building A.  It was let around 2 months ago at £400,000 per annum (around $600,000).  This works out to £200 per sq M but this value would be below that expected for Building A as the grade is poorer.

Building C is also 2,000 sq M and is similar grade to building A.  It was let 12 months ago at £600,000 per annum (around $900,000).  This works out to be £300 per sq M for a similar quality of office but rents have increased since this was completed.

Building D is 1,000 sq M and is also a similar grade to building A.  It was let 1 month ago for £350,000 per annum (around $525,000).  This works out to be £350 per sq M and the information is quite recent.

It could be determined that Building A could be worth around £300 per sq M.  The justification for this is that it is a larger unit than C & D and although rents have increased since Building C was let, Building C would command a higher rent because smaller units are in higher demand.  If Building C was being valued now, it could be justified to value it at a slightly higher rate than Building A.

Clearly this example is very simplified.  However it demonstrates the technique, additional factors such as location and lease terms would have to be considered.

 

 

Don’t Overlook Unfashionable, Post-war Properties

 

Much of being a successful property speculator is establishing a target market and tailoring the investment or development property to appeal to it.  Unlike other walks of life, fashion in property tends to come and go quite slowly.  Period properties remain very popular and no doubt will remain so for the foreseeable future.  Meanwhile, many properties built in the post-war years were not particularly attractively styled (although generally they were actually built to a fairly high standard).  This lack of popularity often means that in comparison to period properties, these houses are undervalued.

These unfashionable houses tend to be overlooked by many potential developers and investors, as they believe they are uninspiring and will not be occupied or sold easily.  This need not be the case.   The appearance of many post-war properties has been changed substantially to incredible effect.

Consider the following photos:

Pictures kindly supplied courtesy of Erincastle Exterior Design; www.erincastle.co.uk

“The owners of this house wanted to add more space and improve its exterior. After an Erincastle Design Consultation, the front garden was improved, the front door and windows were restored to their original design and an extra floor was added to accommodate a new luxury Master en suite. The overall effect is obviously a breathtaking improvement, increasing the desirability and market value of the house.”

This amazing transformation was created by exterior design consultants Erincastle.  It’s not difficult to see that this programme of transformation would certainly add value to any investment or development project and therefore an opportunity to increase profit.   Many residential developers believe that the only way to change the appearance of a property is to repaint the exterior and tidy up the garden.   It is possible to achieve so much more.

The idea that a house considered by many to be ugly, can be transformed into one with character means that for now, there are more opportunities available than many people thought.  The more work that is carried out on a development property, the greater the opportunity to make a profit.  Taking the time to make substantial, tasteful changes to the exterior is certainly an area that is likely to pay dividends upon valuation for resale or letting.  However, the alterations carried out should not be too expensive.  The cost of the works should still be substantially less than the expected increase in the property value.

Obviously if the property is within a row of semi-detached or terraced houses, a dramatic change to the exterior is likely to look rather odd and create too much of a contrast.  Therefore when choosing a development property, your intended work should be taken into consideration.  The building’s original layout, profile and shape will influence the finished item.  A great deal of the property’s appearance can be changed; such as adding extensions, demolishing parts and altering roof lines.

Popular ways of changing the appearance of a modern property is by adding additional external finishes to the walls, such as replica wooden cladding to create the ‘New England’ look.   If windows are to be changed, this also provides an opportunity to change the property theme, such as sash windows to give a Victorian or Georgian look.  One of the most substantial changes that can be made is a roof alteration.  This is probably the most expensive of all cosmetic works but can achieve the most substantial change of look.  If much of these things need changing as part of the intended development work, then the additional cost involved in changing the property ‘look’ might not amount to a great deal more.

It should be pointed out that under the Town & Country Planning Act 1990, changing the external appearance of a property does correspond to the legal definition of development. Depending upon the amount of work you intend to carry out, planning consent will almost certainly be required.

For new-build projects, you might feel that options are limited in finding designs that don’t look too artificial.  Erincastle also have experience in creating designs that genuinely look like listed buildings:

“TOWER HOUSE ” A NEW BUILD BESPOKE HOUSE DESIGNED BY STEVEN JAMES TYLER, COPYRIGHT ERINCASTLE 2006.

“HILL HOUSE ” – A NEW BUILD BESPOKE HOUSE DESIGNED FOR AN UNUSUAL HILLSIDE PLOT BY STEVEN JAMES TYLER, COPYRIGHT

 

 

Note: If the property you intend to carry out these works to is listed however, or in a conservation area; it is highly unlikely that you will be granted permission to change the look of the property.  Houses that fall into these categories might not necessarily be full of charm, but unfortunately they cannot be changed without the express permission of the local planning authority.