Valuation Methods. Residual

This article should be read in conjunction with the Property Speculator’s Residual Valuation calculator.

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

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

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

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

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

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

Clearly, the higher the required profit level, the less will be available to purchase the land.  So a balance must be struck.  Profits could be around 33% of GDV (a very crude assessment of a property development was’ 1/3rd for land costs, 1/3rd for build costs and 1/3rd for profit’).  This might still be attainable now, but in practice, it certainly helps to be conservative and cautious when appraising a development.

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

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

Don’t Overlook Unfashionable, Post-war Properties

 

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

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

Consider the following photos:

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

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

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

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

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

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

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

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

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

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

 

 

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

Calculation of Build Costs

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

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

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

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

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

It should be mentioned however that the values provided in the sources referred to are based upon an average across regions and nationwide.  Clearly substantial economies can be achieved through shrewd research and good contacts.  It is certainly possible to reduce build costs if you know where to look and who to speak to.  This perhaps is one of the secrets and ‘art’ of making a healthy profit in property development.

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

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

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

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

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

For the more specific prices:

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

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

 

 

 

Capital Gains Tax

The present UK system of Capital Gains Tax (CGT) was introduced in 1965 by the Finance Act.  The intention back then was simply to tax individuals on the realisation (liquidation) of assets.  However, the secondary effect was a tax on the inflationary appreciation in value of these assets.

A definition of Capital Gains Tax could be:

‘A tax on chargeable gains when an individual disposes of assets’

Each UK resident has an allowance that enables him/her a certain amount of tax relief on CGT.  Any amount over and above the allowance will be charged at the appropriate rate.  The current rates can be found on the website of the HMRC on this link.

To be regarded as a UK resident:

  • A person must spend at least 6 months of a tax year in the UK or have a residence in the UK (whether it is used or not, or owned or not).
  • The person must have spent at least 3 years continually in the UK.
  • For a company to be considered resident in the UK, it must be incorporated in the UK or have its registered office and main correspondence address in the UK.

People and companies exempt from CGT are:

  • Local Authorities
  • Trade Unions
  • Non-residents, not having a business in the UK.
  • Registered Charities
  • Pension funds

The definition of ‘Disposal’ is (in the words of HMRC):

‘An asset is disposed of whenever its ownership changes or whenever the owner divests himself of his rights in or interests over that asset, for example by sale, exchange or gift’.

This includes the sale of a leasehold property interest, receiving substantial insurance money or gifts.  However, it does not include death.

To calculate the amount of Capital Gains a taxpayer will be taxed upon, the following should be subtracted from the eventual amount received:

  • The cost of original acquisition.
  • Any expenditure made to improve the quality of the asset that has been disposed of.  This has to be an ‘identifiable change’ in the asset value.
  • Any costs incurred by the owner in defending or establishing his right to ownership of the asset.  For example, if someone has to incur legal costs to prove inherited ownership of a deceased relative’s property.

So to use an example, a person sells their second property that was bought 5 years ago.  From the eventual sum the property sells for, the value at purchase, the amount spent on it to increase value and any legal costs incurred when the owner had to establish a boundary are subtracted.  The remaining sum is the amount that will be taxed.  Subsequently, it is the amount of gain that is taxed, not the value that is received.

Calculating the amount of CGT payable on the net gain, can be quite complicated.  This is because there are 2 different rates of CGT, an individual allowance and Entrepreneurs relief to consider.   However, I’ll do my best to explain using another example:

Amount subject to CGT – £50,000

Individual CGT exemption allowance – £10,100 (for tax year 2010-2011)

Subtotal liable for CGT – £39,900

Entrepreneurs Relief allows all gains that qualify* to be taxed at 10% (for June 2010 onwards).  Therefore from the initial sum of £50,000, a CGT tax bill of £3,990.00 would be likely†.

Note * to qualify for Entrepreneurs relief, the capital must have come from the disposal of a business asset, not a personal one.   There is also now (from April 2011) a lifetime limit of £10m.

Note † this figure is merely a guide.  It should not be relied upon and professional advice should be sought.

An alternative relief to Entrepreneurs Relief is Business Asset Roll-Over Relief.  This applies to capital income from the sale of a business asset such as a property, provided the capital is used to purchase another business property or certain type of asset.  If it ‘leaves’ the company, it will be subject to CGT.

 

13 Steps to Getting a Property Sold

If you are planning on developing a property, the very final stage is the sale at the end.  No developer wants a long wait to sell the property, no capital or rent is coming in and meanwhile mortgage repayments have to be covered.  The longer it stays on the market, the more the developer will financially lose out.

So, to ensure that you have the very best chance of getting the completed property sold, here is a checklist to run through so that you know you are less likely to miss out.

  1.  Establish your position.  You have to realistic about selling the property; if the market is currently flat in the area you are selling in you might well have to reduce the price at some point in the marketing process.  If you are not in a particular hurry to sell, you might feel that reducing the asking price is not an option you want to consider.  Don’t rule it out though.
  2. Consider the purchaser’s aspect when pricing the property.  Clearly it will depend on what the property is valued at but remember that houses are usually priced strategically just below the Stamp Duty Land Tax thresholds.  This is not coincidence.  If a property is priced just below the threshold and a competing one is just above it, the difference between them might only be a few thousand pounds but the cheaper one is likely to be on the market for a shorter length of time.
  3. Consider your market.  Much is made on TV property programmes of selling to ‘young professionals’; however there are occasionally people outside this category who buy properties.  Of course, I recommend buying a development property with a particular customer in mind but you should certainly be selling it knowing who should be buying it.  Students for example (or rather their parents), will be considering different things than a young family or a retired couple.  Far better to cater for an existing local need than trying in vain to sell a property  that’s being marketed to the wrong people.  Speak to Estate Agents (several), they should be able to tell you where the local needs lie.
  4. Ensure that the work that needs to be done, is actually done.  If you’ve just had work done on the property then there shouldn’t be any excuse for leaking gutters, damp or mildew on walls or dodgy hinges on doors (for example).  Not every developer will be carrying out a complete ‘gutting’ of the property, so if the turn-round is a rapid one to get it back on the market, make sure nothing is overlooked.  If someone is having a viewing and looking round the property, if they find one obvious fault they might start to look for others.
  5. Always have an idea of what the property is worth.  Property valuation is not rocket science; it’s easy to get to know a particular area’s property market.  After a few weeks you will probably be able to gauge neighbouring property prices to within around 5% of what a professional valuer would put it at.  This will definitely help when it does finally get to the stage of accepting an offer, you will be able to distinguish between a silly offer and a realistic one.  Having a look on a couple of property websites will help to get an idea of what neighbouring properties sold for (www.nethouseprices.com or www.rightmove.co.uk).
  6. Choose the right estate agent.  Some are good, some are bad but it’s highly likely you will be stuck with them for at least 6 months if the property does not sell.  Word of mouth is a good way to get an idea of true reputation, and don’t be taken in by their sales pitch, remain sceptical!  If you choose to put the property on the market with a single agent, there’s no reason why you should have to pay more than 1% (plus VAT) of the sale price.  If you go with dual agents, it’s very likely you will be charged 2% (plus VAT).
  7. Once the property is on the market, make sure it’s kept tidy inside and out whenever possible.  Potential purchasers will do ‘drive-byes’, where they drive past a property to have a quick, discreet look and get a feel for the area without committing to a viewing.  If there’s rubbish or builders waste left outside the property, it can be really off-putting for them.
  8. If the estate agent has promised you that the property is displayed in their window and being aggressively marketed, periodically check that they’re telling the truth.  Speaking from experience, an agent had stressed that the particulars of a house was in their window for all passers-by to see; but upon arriving at the shop, my wife and I found that not only was it not in the window it wasn’t displayed inside the shop either.  They were poor agents and this was the final straw in making the decision to sack them.
  9. Be picky about the property details produced by the agent.  Their job is to get your property sold as quickly and efficiently as possible.  If you feel that the details are not satisfactory, don’t be afraid of telling them.  You will ultimately be paying for this service so they should always be acting in your best interests.
  10. Pester the agent for feedback on viewings.  Agents are not always the most communicative of people so they might need prompting occasionally.  You might be fobbed off with a vague comment the agent picked up from the viewee, but after a few weeks of pestering them for accurate feedback, they’ll make sure they have proper answers for you.  Some aspects of the property might be unavoidable, such as parking.  However some things might be easily solved such as borrowing some furniture to ‘pad-out’ an empty property.
  11. Consider exactly what you might be prepared to put in the property for the purchasers.  For example you could throw in all the fitted carpets if the purchasers pay full asking price; they don’t know that you managed to get a load of inexpensive carpet from a friend.  Same for curtains, you (as developer and vendor) might feel that putting up some (decent quality) curtains is of such little consideration as to be next-to worthless to the purchaser.  This is not the case, buying and fitting good quality curtains and rails can run into thousands of pounds in some cases.  If you can source them cheaply, you might well swing the deal in your favour.
  12. When an offer does come along, you should have a figure in your mind that marks the border between what would be acceptable and what wouldn’t.  This value has to be realistic though.  In the current climate, buyers are looking for bargains and if you won’t consider dropping the price at all then it might be a while before the property sells.  It’s a difficult market and sellers have to do what they can to keep their businesses running.  Obviously a reduction in selling price over what you might have expected will reduce your profit margin, therefore consider this very carefully.
  13. Do anything possible to increase the exposure of the property.  Sarah Beeny’s website Tepilo is very good, and free.  You won’t lose anything by making use of it!  If you look around, websites and blogs can be free too these days (for example www.wordpress.com), give the property its own site!  You have nothing to lose and it should not affect the arrangement you have with your estate agent.