The Property Speculator » gross development value

An Introduction to ‘Pricing’ Development Land

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

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:

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

The undeveloped property might be:

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

© Copyright Robin Webster and licensed for reuse under thisCreative Commons Licence

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:

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

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

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

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

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

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

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

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

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

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Apr 29th, 2012

The Property Speculator’s Second Podcast!

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

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

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

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

Listen to The Property Speculator’s Coreco podcast here.

Subscribe to the podcasts here

Feb 6th, 2012

Applying Discounted Cash Flow (DCF) to a Property Valuation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Nov 9th, 2011

Using Discounted Cash Flow (DCF) to establish Property Value

This article builds upon the use of Valuation and Investment Tables

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

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

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

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

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

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

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

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

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

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

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

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

Nov 6th, 2011

Risk Management in Property Investment & Development

Let’s be clear on this, investing in or developing property represents an element of risk to a greater or lesser degree.

Most prospective property developers and investors realise this but some subsequently procrastinate over taking positive steps to progress their venture. Perceived risk can include:

Getting a property project only partially complete before running out of cash.
Experiencing a problem during build of such scale that the contingency fund does not cover it.
Finishing the build and not being able to sell or let the property in order to recoup costs.
The property build/conversion will cost so much that the developer with experience substantial financial hardship in order to get it finished.

All these concerns can be effectively managed and guarded against prior to the start of the project. This is where a particular approach is vital; these risks should not put anyone off engaging in a property development or investment project.

© Copyright Jeremy Bolwell and licensed for reuse under this Creative Commons Licence

Risk is the ‘price’ of the return from a venture. It’s been said that ‘the higher the risk, the greater the reward’; however this seems (to me anyway) to be a contradiction in terms. If risk is high, then there is no guarantee of reward at all. People generally have very differing views on the amount of risk they are comfortable to adopt. However, if a developer is looking to borrow in order to fund the purchase and renovation/conversion of a property, then the mortgage provider will be very keen to see the project organised as low a risk as possible. This includes the developer putting around 50% (for first-time developers) of their own money into it.

So in conclusion, it’s important to minimise risk wherever possible. And to be honest, property is one of the lower-risk methods of investment and capital building. It’s not THE lowest, but there are far riskier investments available to those with the appetite.

To address the points above in turn:

1. Running out of cash mid-project.

This element of risk is managed by careful planning of the project. Many novice developers run low on cash, but it’s almost always because the budget has not been organised properly. The principles of running a financially viable project are:

Purchasing the property at a good price. It takes time to select the right property; it must fulfil many criteria – purchase price being one of the most important. If you are purchasing at an auction and the bid goes above your maximum level, you MUST resist the temptation to continue bidding. In my experience, if one opportunity has come along, then the chances are that another is not far behind. Once in a lifetime chances are just not that common. It’s far better to purchase a property at a good price and sell at an average one, rather than buying at an average price and hoping to sell at an exceptional one.

Agreeing a fixed-price contract with the builder. This is insisted on in many cases when obtaining development finance. It should be possible to agree stages of build with the contractor, where you pay a proportion at the end of a stage before moving on to the next. The agreement is likely to specify what is not covered in a fixed-price agreement. This might be substantial ground work or structural alterations. This is all in the negotiation.

Sourcing materials shrewdly. This might fall into the principle above, but if you intend to do it yourself, approach it as a business and not a personal ‘statement’. Buying the property and approaching the building work with your head, not your heart helps so much in this. Keep in your mind that the aim is to get the property let or sold and move on to the next.

2. Blowing the contingency fund on an unforeseen problem.

A contingency fund is an excellent idea. This is usually around 10% of the whole project budget. A fund of this amount will actually be a condition of borrowing with many companies (you’ll have to produce proof of the amount in a bank account).

So if a whole project budget is £240,000 for example, a contingency of £24,000 should be available in addition.

If the principles above are followed, there really should not be any reason for unforeseen problems to require more than 10% of the budget to rectify. Ground, structural and roof problems are usually the most expensive to sort out, but almost all of these can be taken into consideration if a good survey is carried out prior to purchase. Excessive build/conversion costs are another one of the criteria that should be considered before purchasing the property.

In some cases, problems do arise that there really was no way of knowing about before the project is bought. In this case, a degree of imagination is sometimes called for to resolve it without blowing that contingency fund. The most expensive and challenging problems are things like disused wells or buried objects. However these are rare.

3. Not being able to sell or let the property at the end of the building phase.

This is a problem that has affected many aspiring property developers over the past 4 years. As mortgage companies suddenly tightened their criteria for lending, the amount of buyers across the market as a whole reduced to such an extent that demand came to an abrupt halt.

This might be regarded as the greatest of all the risks involved in a property venture. It is theoretically possible to have a property advertised for sale for an indefinite period of time; and this scares the life out of many prospective developers.

Property is widely regarded as being highly ‘illiquid’. This means that the value cannot easily be released. The opposite end of the scale is cash; this is obviously a ready source of capital that can be used easily. Because of the nature of property’s lack of liquidity, it has certain characteristics such as a degree of stability of value (due to the fact that it is a tangible item, unlike for example – company shares). Unfortunately because of this shortcoming, capital can be ‘wrapped up’ in a property with little way of extracting it.

The way this problem is managed, is again by proper financial management. To reuse my quotation from above…. far better to purchase a property at a good price and sell at an average one, rather than buying at an average price and hoping to sell at an exceptional one. You must remember this! In many cases, the reason why properties stay on the market for so long is because they are overpriced for resale. Sticking to a rigid budget dramatically reduces this risk because there is less chance of financial overstretch. You should certainly make sure that you have planned for the property to be complete yet vacant for around 6 months after the build.

4. Experiencing financial hardship in order to complete the build.

Clearly, this is a variation on the perceived risks already mentioned. Most successful private developers have sufficient ‘surplus’ income to cope with the increased monthly outlay to cover another mortgage.

Some amount of flexibility will be needed to cover unforeseen problems, but the contingency fund will be in place to cover them.

There are not really many valid reasons why novice developers should find themselves enduring financial hardship to get their project completed.

To conclude, sensible and realistic budgeting should go a very long way to managing the anticipated risks involved. However as I’ve mentioned already, property development and investment is risky; if it wasn’t, there would be no money to be made in it.

May 13th, 2011

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:

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.
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’.
The owner of an area of land where contamination is found to have originated from is often liable for the clean-up costs.
Successive UK governments have encouraged development on brownfield sites in preference to greenfield. This makes developers consider purchasing contaminated sites more readily.
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.

© Copyright Evelyn Simak and licensed for reuse under this Creative Commons Licence

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

The original cause of the contamination. I.e. what the substance was/is that resulted in the contamination.
The general response to the scope of the contamination, both by the potential purchaser and the Local Authority.
The amount of work required to establish the level of contamination and what has to be done to remedy it.
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:

Scepticism over the effectiveness of land remediation.
The risk of inadequacy of the remediation process.
The risk of changes in legislation or remediation standards leading to further work.
The difficulty in obtaining finance.
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.

May 11th, 2011

Developing a Georgian Property

As I wrote in the earlier article in connection with developing a listed building, the majority of people tend to fall in love with period houses. It’s no surprise really. They tend to be beautiful, but to develop one for sale or rent on the open market is not for the fainthearted.

If however, you are not discouraged from taking this path, it’s important to have at least a basic understanding of architectural styles. This is because it is always important to retain original property features. Not many purchasers look at period properties expecting to find a combination of styles. It is important to know the particular characteristics of each type so that the property can be tastefully and sympathetically restored.

One of the very prettiest (my opinion) architectural styles is Georgian. It is the name given to the fashion that most houses were built in during the reign of George I, the II, the III and the IV. This was primarily between 1714 and 1830, so it covers a considerable period. This is longer than most of the other architectural periods.

Some Georgian architecture can be further divided into particular sub-categories; this is due to the individual creativity of well-known period architects:

Palladian Architecture. This was heavily influenced by the Italian architecture of the 16^th century. It is characterised by the exceptionally grand-looking features such as high porticos with roman style pillars. Buckingham Palace was refaced in this style in 1913. Palladian style was however, quite a superficial concept. The buildings built in this style were often incredibly wide and tall but only amounted to a single room’s depth.

Palladian style is clearly recognisable in Woburn Abbey in Bedfordshire.

Gothic Revival Architecture. This was obviously influenced by the original gothic architectural movement which was evident as early as the 16^th century. Gothic style was used primarily on cathedrals, as the ‘Gothic’ era was the period in Europe before the renaissance, which was considered ‘backward’ because the church ruled all aspects of citizen’s lives. The style is recognised by ornate arches, vaulted roofs and tall spires.

Gothic Style can be seen at Tom Tower in Christ Church College in Oxford.

Regency Architecture. This is probably the most well known of all the Georgian styles. The Regency period was between 1795 and 1837 and characterised by fine and extravagant architectural features. Brighton Pavilion and much of the City of Bath are excellent examples of Georgian Regency architecture.

The majority of Georgian style properties however, are easily recognised. Georgian architecture in the majority of fairly modest sized house was intended to be symmetrical and always in proportion. This meant that windows (for example) were planned for the height to be exactly double the width measurement. In the early part of the Georgian period, the buildings were constructed with chimneys on either side. Another, very obvious feature of this style is the small individual panes of glass in the windows. This was because at that time, the technology to produce large glass panes (such as in the Victorian era) did not exist.

Annes Grove House by Mike Searle

Internal features of Georgian houses are unsurprisingly, similarly ornate. The decoration tended to be centred round forming a contrast between woodwork and mouldings, and the walls. This means that coving and ceiling roses were painted in white, and the walls were painted in a dark-toned colour (these were browns and dark reds originally, because paint dye was based on oxides). Exposed wood in the home was very rare, and this was the most expensive woods such as Walnut or Oak. Wood was mainly painted white to fit in with the rest of the mouldings. A modern spin on the Georgian theme would be to introduce more pastel colours on the walls; this can still contrast with woodword and mouldings to give a very neat, manicured look.

If you are planning to renovate a Georgian property, you must keep as many original features as possible. Window frames, staircases, mouldings, doors and door furniture must be retained (and properly repaired if necessary) if the property is to look ‘right’. It’s very easy nowadays to drift towards modern double-glazed windows; they’re cheap to install and very thermally efficient, but this temptation must be avoided. Reproduction double-glazed sash windows are also easily available now but it is unlikely they will suit a genuine Georgian property. Georgian window frames tended to be quite delicate and the modern frames are a little too substantial to the ‘keen’ eye. There are several companies who specialise in restoring period window frames but be warned that this approach is not cheap. The SPAB (Society for the Protection of Ancient Buildings) recommends fitting secondary double glazing in preference to anything else.

For further information on looking after a period property, I recommend you pay a visit to SPAB.

Apr 18th, 2011

Using Gross Development Value to carry out a Property Residual Development Appraisal

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The Residual method of property appraisal (or Hypothetical Development Method) is used to help in assessing whether a property development project is financially viable or not. If a property has development value (it can also be known as ‘latent value’), it means that its expected future value after works exceeds the expenditure.

The first value that must be established is the Gross Development Value (GDV). This is the capital value that the completed property is expected to be worth on the open market when sold to a willing purchaser. The GDV is different to the forecast price, where the developer attempts to predict the value of the property in line with a falling or rising market. This is unsurprisingly quite inaccurate, but it’s a common misjudgement among novice developers. The GDV should always be based upon values available at the time the appraisal is carried out. The GDV should be based upon the most efficient use of the property/plot. If a site is available that can accommodate 4 houses (for example) and only 2 are built, the completed value of the development is not the true GDV.

To establish the GDV, the most accurate method is the comparative method of valuation.

The residual appraisal is a very easy concept to understand, the equation is based upon a very logical approach. It is as follows:

The amount available for land purchase is the absolute maximum that the developer should consider paying. This is because there will be other considerations, such as repayments on the development mortgage, legal fees and Stamp Duty Land Tax (SDLT). Therefore, if the developer can purchase the property for less than his budgeted amount, he will certainly benefit.

Through transposition of the individual components within it, the residual method can be used for 3 main purposes:

1. Calculating the potential profit margin where the GDV, build costs and land/property cost is already known.

2. Finding a maximum value for build costs, where profit, GDV and land value is known.

3. Establishing a maximum price to be paid for the land/property when other values are known.

Build costs are probably one of the trickiest aspects to consider when carrying out a residual appraisal. The easiest way to do this is to apply a rate per sq ft or sq M and multiply it by the expected area of the completed property. So if a property of around 2,000 sq ft is to be developed or built, a rate of £100 per sq ft could be applied. This would produce a build cost of around £200,000. However, a more realistic rate is more likely to be closer to £80 per sq ft (by current standards). This will include fees and a contingency amount. If development work is substantial, then a ‘build cost rate’ can be applied as it will be so similar to a ‘renovation cost rate’.

Finance costs can vary quite considerably, depending on amount borrowed, construction time and rate of interest. As discussed in many other posts, to provide all project funds in the form of equity (money that has not been borrowed) is not a particularly shrewd idea. Likewise, to borrow too much in the form of a loan is not a good idea either.

If the project takes 12 months from initial completion to sale of the property, then that’s 12 months worth of loan repayments that must be included into the associated costs. For a mortgage of £200,000 that can be around £12,000 in total, depending upon the variable mentioned above.

Profit is also a vital aspect of development. Many novice developers calculate their projects the wrong way, they consider the property cost; add the expected build/renovation costs and the remainder once it has sold is profit. This is not the best way to approach your venture, a business needs profit to survive and you need it to invest in your next property project.

An example of a residual appraisal is as follows:

This calculation shows that around £130,000 (to round the figure up) would be around the price you should be buying the undeveloped house at. This does NOT mean that you should start negotiation at this figure, it would be prudent be place in an initial offer comfortably below this price.

To download the very finest guide available on the internet to Assessing Land Value, the Residual Valuation method and Gross Development Value for only £5, follow this link to my ‘Assessing Land Value‘ page.

Mar 8th, 2011

Increasing the Value of a Property

To be a successful property developer and/or investor, you must learn to see your business or property through other people’s eyes. That is to say that if you intend to have a tenant occupy the property for example, you must think about how a prospective tenant will see your property when they view it. It is far too easy to make the assumption that your property (the ‘product’ of your business) is the perfect one for them because they have identical taste to you. Likewise, if a prospective purchaser arrives to view the property they are unlikely to be particularly impressed by a hot-tub installation or a state of the art media system as in almost all cases, a new property owner enjoys the process of changing the property to suit his or her own taste.

Have you ever noticed how builders change properties when they purchase them? This is yet another ‘pair of eyes’ that you should learn to view a property through. Builders know better than almost anyone how to add value to a property and fully maximise all features and benefits. This is one of the very reasons why they are probably about the most successful group of people at developing property. The other reason they are so successful is because they know how to carry out the development in the most cost-effective way possible. All materials and labour will be sourced shrewdly. Extensions, loft conversions and conservatories will be added to the property wherever possible. Rooms will be knocked through to make open-plan areas, en-suites and downstairs loos will be added and cellars (where present) will be used, all for the purpose of fully increasing the value of the property. They are very successful at it too. Be aware though, that in the majority of cases, planning permission must be sought to ensure legal compliance.

The way in which the extensions and loft conversions etc increase the property value is simply by increasing the internal property area. That’s it; the most certain way of increasing the value of a property is to increase the internal dimensions. There are some other ways to increase the value but they are not as reliable as ‘square footage’. They will be discussed later.

Property valuation is described by property professionals as ‘an art, not a science’. This means that there are no difficult calculations to carry out and no secret information that only estate agents are privy to. The majority of property valuations are based upon ‘comparables’. Comparables (in the context of property valuation) are similar transactions completed recently, that provide a guide to the likely sale price of a particular property. So to use a very basic example, if a 2 bedroom flat sold 3 months ago for £220,000; and another 2 bedroom flat sold 4 months before that for £215,000, then it would be fair to say that any similar 2 bedroom flat is likely to sell for a similar amount now. This is the technique that estate agents and valuers use, and it’s also the technique that anyone who knows the property market in a particular area uses. It really does not take long to get the feel for an area and whether properties are over or underpriced.

Property features such as garages, swimming pools, a quality kitchen and bathroom will also add value. However, there is a danger that you might not recover the initial cost of these things in the eventual sale price of the house. A double garage can cost around £10,000 to have built, but it is not guaranteed that it will make £10,000 worth of difference in the value.

So what happens if you have a property that cannot be extended or substantially altered such as a terraced house or a flat? There are still many ways that the value can be increased, it’s just a little trickier. This is because it depends so much on the property itself and the prospective owner or tenant you are hoping to ‘sell’ to. If the property is Grade II listed for example, period features must be kept and probably even emphasised. A high quality finish to the kitchen and bathroom is probably the most reliable way of adding value in this case. Materials such as slate and oak are instantly noticeable and will give that impression of quality.

In more modern and unlisted properties, the alteration of various internal walls to allow more natural light into the property will help a great deal as this will give the impression of extra space. This can also be done by adding velux type windows where possible or a ‘Sky Tunnel’. In these types of properties, it’s easier to alter things to maximise the feeling of space because you aren’t limited by the traditional layout and features of listed properties.

The modern practice of adding en-suite bathrooms wherever possible should be discussed here. A master bedroom (in a property with multiple bedrooms) with an en-suite is a clever move. If the property has more than 3 bedrooms, an en-suite to the 1^st and 2^nd bedrooms is a good move too. However, an en-suite to every single bedroom is too much. Once the bedrooms begin to get smaller, en-suites simply rob the room of valuable space. If you are hoping to sell or let the property to a family with young children, an en-suite will be useless in a baby or infant’s room. A single bedroomed property is not really suitable for an en-suite either. One bathroom/toilet is plenty.

Jan 25th, 2011

The Comparative Method of Property Valuation

It is essential when planning a property venture that you have an appreciation of what the property will be worth when you have finished it and it is ready to be placed on the market or let to a Tenant. This anticipated future value forms the very foundation of your property project financial planning. The final capital value (the price it would be expected to fetch on the open market to a willing purchaser) is known as the GDV (Gross Development value).

It is an excellent idea to carry out an appraisal of the project prior to committing to purchase. The GDV is the figure that underpins your profit, the amount available for fees and building work and ultimately, the price you should be paying for the undeveloped property.

So how do you produce an accurate GDV figure for your development property? This is where you have to attempt to do a valuers job; you have to place a reasonably accurate figure on your completed property.

All forms of property valuation are based in some way upon the comparative method of valuation. It requires an appreciation of the 2 major factors that property value is dependent upon, Supply and Demand. Unfortunately these are never constant but the valuation has to be based on an identical situation to recent, surrounding property sales. Subsequently the valuation figure has to be manipulated to reflect anticipated market conditions. So if a property is sold for £250,000 one week, then an identical house should sell for the same amount the following week. However, it won’t. This is because market conditions can change quite suddenly, purchasers have differing requirements and considerations, and no two properties are ever absolutely identical.

The comparable method of valuation is only accurate when the following conditions can be met:

The properties are physically similar
The properties are in the same area
The legal interest is the same (freehold or leasehold)
There are many accurate records of similar transactions
The transactions are recent
The market is stable

If these become less ‘perfect’, then the valuation becomes less accurate. An example of comparative valuation is shown below:

Property 1 is a 1920s –built, detached house. It has brick cavity walls with solid ground floor.

The interior dimensions are:-

Lounge 27′ x 10′; Dining 12′ x 13′; Study 12 x 13′; Kitchen 10′ x 9′; Bathroom 6′ x 7′.

Bedroom 1 is 12′ x 11′; Bedroom 2 10′ x 9′; Bedroom 3 10′ x 9′.

The interior and exterior have been very well maintained, it has a brick garage and around 1/8 acre of land.

Property 2 is a detached, Victorian house built around 1880. It has rendered walls, a shingle roof and hollow floors. Internal dimensions are:

Lounge is 12′x10′; Dining 8′ x 10′; Study 12′ x 7′; Kitchen 10′ x 14′.

Bedroom 1 18′ x 14′; Bedroom 2 14′ x 14′; Bedroom 3 12′ x 10′; Bathroom 9’ x 7′

The first floor requires updating, but it has a new kitchen fitted. The exterior requires some maintenance and it has a wooden garage and around 1/3 acre of land.

Sold 1 year ago for £250,000

Property 3 is a newly-built estate type house. It has a brick outer skin and concrete suspended floor. Internal dimensions are:

Lounge 12′ x 14′; Dining 12′ x 10′; Family Rm 14′ x 10′; Cloakroom 10′ x 11′

Bedroom 1 12’ x 10′; Bedroom 2 12’ x 10′; Bedroom 3 12′ x 10′; Bathroom 8’ x 8′

The interior and exterior are finished and maintained to a high standard. It has a brick built garage and around 1/3 acre of land.

Sold 18 months ago for £230,000

To establish a market value for Property A, a consideration of the sale prices of Properties B & C is necessary.

Property A must first be ‘adjusted’ to allow a proper comparison between properties. This is done by adding particular values to the sale price of property C ( estate-type houses are typically less sought-after than modern, estate type properties) and subtracting from property B; this is because Property B would be expected to fetch a higher price on the open market due to the desirability of its period Victorian features.

The exact values to be added or subtracted would be judged by the valuer himself, but a general guide might be:

Subtract £20,000 from the sale price of Property B because Victorian era houses are in higher demand than 1920s ones.
Subtract a further £15,000 from the value of Property B because Property A has a fairly small garden.
Adding £10,000 because Property A has been maintained to an excellent standard and can be considered to not require updating by the new purchaser.

Using the guideline of Property B, this brings the value of Property A out at £225,000 if it had been sold around 18 months ago. If it can be established that house prices have increased in the approximate area by 6% per year, then the value of £225,000 can be increased by 9% to bring it into line with current values. This produces a figure of £245,250 or £245,000.

So property A might be expected to be placed on the market at around £245,000. However, bear in mind that this might a ‘strategic’ price. It is comfortably below the (current) SDLT threshold of £250,000, and also priced under the vast majority of properties in this price bracket that always seem to be placed on the market at £249,950. The vendor would be sensible to understand that this is merely a starting price and might end up bearing little relation to the eventual selling price. The established final value of the post-work project is the GDV.

Dec 3rd, 2010

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