An Introduction to ‘Pricing’ Development Land

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 (Agents and Legal) and SDLT/property taxes.
  2. Consider discounting the land value to account for general economic inflation that will occur during the development period.
  3. Any interest payable on capital used to fund the land purchase (not already included in the main finance total).

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’ 1/3rdfor land costs, 1/3rdfor 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).

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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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.

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.


An Introduction to Property Use Classes

Within the very large field of property, there are several categories and sub-categories of building.  The reason for this is that council planning departments use these classes when planning residential, commercial and retail developments in an urban or rural environment.  It is far easier to refer to the use classes as they are, rather than a description such as ‘Industrial’ or ‘retail’ as ambiguity and ‘grey areas’ are common.

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The classes are issued by The Secretary of State as he/she is ultimately responsible for all UK planning matters (a method of appeal against planning decisions is to address the Secretary of State).  In most cases, converting a property so that it moves from one use class to another, needs the grant of planning permission before work is allowed to go ahead.  There are some exceptions however, such as a flat can be added to a retail property provided it is used in association with the retail property.

The table of Use Classes is as follows:

Use Class Use Description Is Change Permitted?
A1 

Shops

 

Sale of goods and cold food, retail warehouses, hairdressers, travel and ticket agencies, post offices, domestic hire shops, funeral directors, dry cleaners, internet cafes No change of use without permission, except to A1 plus single flat 

 

A2 

Financial and professional services

 

Professional (excluding health and medical services) and financial services (banks and building societies); other services appropriate in a shopping area where the services are provided principally to visiting members of the public Change to A1 permitted only if there is a ground floor display window 

 

A3 

Restaurants and cafes

Sale of food and drink for consumption on premises, e.g. in restaurants, cafes Change to A1 or A2 permitted
 

A4

Drinking establishments

Public house, wine bar or other drinking establishment Change to A1 or A2 or A3 permitted
A5 

Hot food takeaways

 

Sale of hot food for consumption off the premises Change to A1 or A2 or A3 permitted 

 

Sui Generis 

 

Launderettes, taxi businesses, car hire businesses, filling stations, scrapyards, shops selling or displaying motor vehicles for sale, retail warehouse clubs No change of use permitted 

 

 

 

B1

Business

 

a Offices other than financial and professional services providing for the visiting members of the public 

b Research and development

c Other industrial processes appropriate in a residential area

 

 

Change to B8 (only up to 235 m2 of floor space) permitted

 

 

 

B2 

General industrial

 

General industry, not within B1 Change to B1 or B8 (only up to 235 m2 of floor space) 

 

B8 

Storage or distribution

Storage or distribution centres Change to B1 (only up to 235 m2 of floor space) permitted
Sui Generis 

 

Work registerable under Alkali etc, Works Regulation Act No change of use permitted 

 

C1 

Hotels

 

Hotels, boarding and guest houses, provided that care is not provided No change of use permitted 

 

C2 

Residential institutions

 

Residential accommodation for provision of care (e.g. old age homes); residential schools and colleges and training centres; hospitals and nursing homes No change of use permitted 

 

C2A 

Secure residential accommodation

 

Prison; young offenders institutions; detention centres; secure training centres; custody centres; short-term holding centres; secure hospitals; secure local authority accommodation; military barracks No change of use permitted 

 

C3 

Dwellinghouses

 

Dwellinghouses for individuals, families and up to six individuals living as a single household Subdivision of dwellinghouses into two or more dwellinghouses not permitted
C4 

Houses in multiple occupation

Use of a dwellinghouse by not more than six residents as a house in multiple occupation Change to C3 permitted 

 

Sui Generis Hostels No change of use permitted
D1 

Non-residential institutions

 

Clinics, health centres, crèches, day nurseries, day centres, consulting rooms (not attached to doctor’s house); museums, libraries, art galleries, public and exhibition halls; non-residential schools, colleges and other educational centres; public worship or religious instruction; law courts No change of use permitted 

 

D2 

Assembly and leisure

 

Cinemas, dance and concert halls; swimming pools, skating rinks, gymnasiums; other indoor and outdoor sports and leisure uses, bingo halls No change of use permitted 

 

Sui Generis 

 

Theatres, amusement arcades and centres, fun fairs, nightclubs, casinos (as from 6 April 2006) No change of use permitted 

 

Developing a Mixed-Use Property

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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.

 

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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.

The Contractors Method of Commercial Property Valuation

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.

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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 Institute of Chartered Surveyors) ‘an art, not a science’.  This means that although the methodology is reasonably straight forward, the application of it not particularly simple.

Using the Comparable Method of Valuation for Commercial Properties

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.

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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.
  7. The frequency of rent reviews.  These are often timed to occur every 3 or 5 years.  A new rent can either be negotiated between the parties or be determined by an external influence such as the Retail Price Index.  ‘Upwards only’ rent reviews are common, this doesn’t necessarily mean (as the expression suggests) that the rent is guaranteed to increase.  It does mean however that it won’t decrease, even in the event of an economic downturn.  These various ways of structuring a lease can benefit either party, subsequently it will have some effect on the rent that the tenant is prepared to pay and what the landlord is prepared to accept.

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.

Valuing a Commercial Property based on 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.

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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.

 

Using the Investment Method of Valuation on a Commercial Property

The purchaser of a commercial investment property will be concerned with:

  1. Security of Capital (i.e. the value of the investment will not be lost overnight like company shares could do).
  2. Security of Income (meaning that income from the investment is guaranteed).
  3. Ease of Sale (this is a weaker point of property; it’s one of the most illiquid of all investments, especially in an economic downturn).
  4. Management of the Property (Again, this is a shortcoming of property as an investment, company shares and bonds do require ‘management’ to the extent that property does).

There is a basic assumption (which means it’s not necessarily true) that the higher a property’s capital value, the greater the rental value.  This ‘view’ forms the basis of the investment method of valuation.  The healthier the rental income, the greater the sum an investor will pay for it.

To establish the income figure, the annual sum is used.  In the case of new developments, this will be the expected annual rental income (based on comparable similar lettings).

It’s not only the amount of rent that will be received though; it’s the regularity of the payments that matter too.  An investor always looks for a high-quality tenant (meaning a tenant that is unlikely to breach the covenant of regular rent payments).  A tenant that has a good credit history, shows healthy company accounts and has been established for some time will be regarded as a ‘good covenant’.  This relates back to the security of income aspect of the investment.  The majority of commercial property investors would probably be regarded as risk-averse.

If the investor is purchasing a property with a tenant already in place, the terms of the lease and the quality of the tenant will represent some value.  For example, a lease with 15 years left to run, to a blue-chip company would be worth more in investment value than a lease at a similar rent but only 3 years left until expiry and to a company that is facing financial difficulty.  An obvious example I know, but this is just to show the contrast.

To analyse the relationship between rental income and capital value, two aspects can be used:

1)      Yield.  This figure is expressed as a percentage and is calculated by dividing the capital value by the annual rent figure.  So if a property had a capital value of £1,000,000 ($1,500,000), if the annual rental income was £50,000 (around $75,000) then the yield would be 5%.

2)      Years Purchase (YP).  This is a slightly different way of analysing things.  As above, it is calculated by dividing the capital value by the rent figure but it’s not expressed as a percentage.  So using the example above, if a property brought in £50,000 per annum in rent and was valued at £1,000,000 then the YP figure would be 20 (think of it as taking 20 years at £50k per year, to purchase the property at £1m.  It’s a hypothetical situation but simply another way of comparing investments).

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Property value’s relationship with interest rates

If a commercial property is offered for sale for £400,000 ($600,000), and the current annual rent is set at £32,000 ($48,000), then the yield on this investment can be calculated as:

 

£32,000 ÷ ($400,000 ÷ 100) = 8%

Or

$48,000 ÷ ($600,000 ÷ 100) = 8%

The investor will usually have a particular yield figure in mind and 8% might or might not be suitable.  The rate is comparable to other investments, allowing an initial direct comparison to be made.   For the purpose of illustration, examples of alternative average returns might be:

Government bonds – 5%

Company Shares – 6.5%

Bank Deposits – 2%

In comparison, if the investor can receive a return of 8% on the property above then he/she is likely to go for that.  However, a direct comparison between these investments is tricky for the following reasons:

1)      The investment property is the most illiquid of all of these investments.

2)      The property will entail risks such as non payment of rent, vandalism and rent voids.

3)      It will be subject to management costs to ensure it remains in optimum condition.

4)      Property value can be increased through building work.

If interest rates were to go up, the increased return on bank deposits might influence an investor to simply place the capital in a bank rather than face the risk and work involved in property investment.

If interest rates were to go down, it would have the effect of investors looking for alternatives to bank deposits, shares and bonds.  If investors felt that property was a shrewd buy, then values would tend to go up because of the increase in demand.  If the capital value goes up and the rent stays the same, then the yield figure will fall.  This is because the annual rent figure will account for a lower percentage of the property capital value.

Using the example above, if all comparable properties yield can be calculated at around 7%, we can calculate the increased capital value:

(£32,000 ÷7) x 100 = £457,000 (originally £400,000 at 8%)

Or

($48,000 ÷7) x 100 = $686,000 (originally $600,000 at 8%)

This illustrates the change in property capital value when interest rates and demand change the yield figure.  It also shows perfectly the Investment method of valuation.  Essentially the 2 variables involved are:

  1. Annual rent
  2. Yield

With these 2 components, the capital value can be calculated extremely quickly using the equation:

(Annual Rent ÷Yield) x 100 = Capital Value

This is a very simplistic but unrefined way of establishing the capital value, the larger the property, the less accurate this is.  What the equation is good at however is providing a very quick way of gaining an idea of what the capital value will be in the region of.  Remember, no two properties are the same.

Property Investment and Risk

Investment in property is risky.  It is the element of risk however that effectively provides the return.  If a particular property reflects a high risk, for example if it’s looking tired and the tenant has only 3 years left in occupation and is unlikely to renew, then the capital value of the property will not be particularly high.  If the rent is set at a level that compares with similar properties, the yield figure will be high.  This means the rent will be high in comparison to the purchase value.  This way, the investor will stand to recoup as much of the capital outlay as possible, as quickly as possible.

So the risk that a particular property presents can be assessed by the rate of yield.  High yield can mean high risk, and vice-versa.  This enables valuers, Surveyors and investors to compare risk levels between investment properties.  A yield figure can be applied with the intention reflecting all the risks involved in an investment.  This is simply called the ‘all risks yield’ and works by using a particular rate (as a percentage) that goes up when the risk is high, and drops when the risk falls. It is intended to ‘reflect all future benefits and risk’. This method is open to debate though, as many property professionals feel that it is a crude way of valuation and furthermore, investment risk cannot be solely expressed simply as a rate of yield.

A property that represents an extremely low risk would be well located, with modern design and in good condition.  Let on a long lease to a good, reliable tenant who is responsible for repairs.  This property would be regarded as ‘Prime’ or Grade A (in the case of offices).

A high risk property would be the opposite of the above, poorly located and with an older design that is becoming more expensive to maintain.  It would be let on a short lease to an unreliable Tenant who is not responsible for repairs.  This property would be regarded as either ‘Secondary’ or ‘Tertiary’.

The Effect of Contamination on Development Land Value

Developing a property on contaminated land is not as ridiculous as it first seems.  Contaminated land is a massive problem for developers because:

  1. The sheer amount of contaminated sites across the UK.  There are an estimated 50,000 – 100,000 potentially contaminated sites in the UK which in total, which cover around 1% of the UK landmass.
  2. Very large companies and government agencies such as Shell, Esso, British Gas and the MoD regularly dispose of large amounts of land which will be regarded as contaminated.  In some circumstances, the very fact that certain activities have been carried out on a plot, automatically labels the area ‘contaminated’.
  3. The owner of an area of land where contamination is found to have originated from is often liable for the clean-up costs.
  4. Successive UK governments have encouraged development on brownfield sites in preference to greenfield.   This makes developers consider purchasing contaminated sites more readily.
  5. Contamination has a very large effect on property/land value.

But, to completely disregard contaminated land as ‘undevelopable’ would be to intentionally miss out on many opportunities.

Contaminated Land @ The Property Speculator

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The contamination will have the effect of reducing the value of the land or property because of:

  1. The original cause of the contamination.  I.e. what the substance was/is that resulted in the contamination.
  2. The general response to the scope of the contamination, both by the potential purchaser and the Local Authority.
  3. The amount of work required to establish the level of contamination and what has to be done to remedy it.
  4. The resulting effect on the eventual sale or letting value of the property.

Roughly, costs involved in a contaminated site can be categorised into Direct and Indirect.  Direct costs include the funding of remedial work, and penalties for not following exactly what the local council require and in the case of a commercial investment property, a void period – where the occupants must be moved out in order to carry out the work.  The indirect cost is tricky to quantify; it is associated with the effects and public perception of contamination.  A desirable area can quickly become not-so-desirable when the public discover that contamination has occurred.   This perception can be a very individual view among prospective purchasers or tenants.  This is known as Stigma.

The actual calculation involved in establishing a basic development value on a contaminated site is really not too different from a standard Residual Appraisal.  The formula for which is:

Value of land = GDV – (Build Costs + Required Profit)

To add the contamination component into the equation produces:

Value of Land = GDV – (Cost of Land Remediation + Build Costs + Required Profit)

However, this might serve to over simplify things a bit too much.  This does not take the element of Stigma into consideration.

Stigma, when used in the context of contaminated land can be defined as:

“the blighting effect on property value caused by perceived risk and uncertainty in the effectiveness of contamination remediation”.

To put it another way, it is the difference in value between a remediated contaminated site and a comparable “clean” site with no history of contamination.

These uncertainties are based on intangible factors such as:

  1. Scepticism over the effectiveness of land remediation.
  2. The risk of inadequacy of the remediation process.
  3. The risk of changes in legislation or remediation standards leading to further work.
  4. The difficulty in obtaining finance.
  5. A general fear of the unknown.

It might be argued that this general reluctance to use previously contaminated land is justified.  Many people believe the term ‘remediation’ is simply another term for clean-up.  It isn’t.  The term ‘remediation’ simply means that the level of contamination on the site has been reduced to a level below that specified by the Environmental Agency.  The term ‘Caveat Emptor’ (‘let the buyer beware) springs to mind here.

Clearly, because the influence of Stigma is difficult to quantify, it’s also difficult to measure.  What can be done, is analyse the behaviour of experts in this field:

During the summer of 1998, a four-page mail questionnaire was sent to a targeted, preselected group of 208 Property appraisers in the United States and Canada. The target group consisted of 192 appraisers in the United States and 16 in Canada.

Of the participants, nearly 60% (49) reduced rental income to account for on-site contamination. However, some comments indicated that a noticeable number of respondents found no impact on the rental income of contaminated properties that were used for commercial, retail, or industrial purposes. Several additional comments indicated that some respondents also used increased operating expenses when valuing a contaminated property.

While 73% of respondents reported that they occasionally made a separate deduction for stigma, only 26% indicate that they did so as often as 75% of the time. The uncertainties and risks associated with cash flows from a contaminated property are most frequently reflected in decreased estimates of value via sales comparison analysis (73%), followed by an increased capitalization rate (66%) or an increased yield, or discount, rate (61%).

All but one of the respondents said they would not ignore anticipated or forecast remediation costs in valuing contaminated properties. Some 60% indicated that they would deduct the present worth of total remediation costs estimated by environmental experts.

Although it seems to stand to reason that properties built on previously contaminated land are negatively affected, the degree of this effect is not necessarily substantial.  In the last decade or two, technology and methods have improved a great deal to make remediation techniques much more effective. I have personally dealt with previously contaminated land where a client intended to build a new, high-profile office block.  The value of the site was scarcely different to a comparable site with no history of contamination.

To quote a case study, results from a study of the market sales data of post-remediated vacant residential land along the Swan River, in Perth, Western Australia, from 1992-1998 can be looked at. The intention of the study was to establish the amount of “stigma” arising from a site’s contamination history.  The effects of this were measured on residential property values of remediated property. The results showed that while a site’s contamination history impacts negatively on property prices, the price decreases were offset by the positive influence on price from additional amenities provided in the area where the case study was carried out.

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