RICS draft guidance note - Valuation of development land, 1st edition

Valuation of development land, 1st edition

Appendix B: Treatment of inputs into the residual method

B.1 The form of any inputs into a residual valuation can vary depending on the type and application of the method. The discounted cash flow or cash flow technique allows for a more detailed set of assumptions to be applied to many of the inputs into a residual valuation. Appendix B1 addresses the various inputs into a residual by reference to the more detailed cash flow approach. In Appendix B2, the different approach to some of the inputs within a basic residual method is examined.

B1 Discounted cash flow technique

B1.1 Value of completed property development and phasing of inflows

B1.1.1 The value to be adopted is normally the market value, subject to any special assumption concerning the basis of valuation and the purpose. The market value normally reflects an optimum proposed development. The market value is assessed on the special assumption, in accordance with a defined plan and specification - see VPS 4, paragraph 9.5 - that the development is complete at the date of valuation in the market conditions prevailing at that date. This is referred to as the completed property value (see IVS 410) or gross development value (GDV).

B1.1.2 There are several RICS guidance notes in addition to those mentioned in section 3, as well as plenty of other advice, on the valuation of specific property types and these should be referred to when assessing the market value of these properties. The GDV is likely to be influenced by assumptions made concerning whether the completed property is to be sold at the end of the development period, sold in phases during the development period, let and then sold or held as an investment. Where the income approach is used, assumptions concerning leasing can be made as in any other valuation of an investment property. These assumptions must be fully set out under special assumptions as mentioned in the preceding paragraph.

B1.1.3 For some developments, particularly residential, the approach may be to adopt the total of the values of the individual properties. This may also be the case in mixed-use or any other multi-asset development.

B1.1.4 Where an income capitalisation approach is used for the GDV, normal assumptions should be made within the particular market sector concerning the treatment of purchaser's costs. The GDV should represent the expected contract price - the net proceeds of disposal (or net development value (NDV)) is the expected contract price minus seller's costs. Fees are dealt with in more detail in section B2 of this appendix.

B1.1.5 Additional assumptions include phasing of rental income and sales that can be explicitly included in the cash flow.

B1.1.6 Where individual buildings or units may be sold within the development period, particularly where the development includes residential properties, the sales need to be phased over a certain period. In these circumstances, the inflow is to be recognised in the cash flow at the appropriate time and the incidence of the relevant costs needs to reflect the actual timing of such payments.

B1.1.7 Larger schemes developing a number of discrete assets within the scheme over longer timeframes are more likely to be phased.

B1.1.8 Phasing can include properties that can be let during the development period while other properties are completed and the timing and extent of this additional income within the development period can be incorporated into the cash flow. Where income producing assets are included in the development scheme, the timing of lettings, rent free periods, capital contributions and so on can also be incorporated into the cash flow; the development period can also be extended and contracted appropriately.

B1.1.9 Change in values can be specifically incorporated into the cash flow and it is important to identify whether the cash flow incorporates expected changes. The adoption of either current or forecasted values raises questions of consistent treatment of other inputs, costs, for example; it also raises questions of whether real or nominal rates of interest are used in the valuation - i.e. target rates of return and the use of real or nominal finance rates.

B1.2 Development costs

B1.2.1 The following paragraphs regarding development costs should be read in the context of the comments in B1 concerning the optimum and the actual development. The actual scheme may not be the optimum scheme and reduced costs for the actual scheme - on account of, for example, development consent being granted before the date of valuation - would not apply for the optimum development if it were different to the actual planned development.

B1.2.1 Planning permission and associated matters

B1.2.1.1 Where there is no existing development consent for the project, it is necessary to allow for the costs of obtaining this permission. Where the development may be contentious, allowances may be made for the potential additional costs, including delays caused by appeals and/or inquiries - these include fees and additional holding costs and may extend to creating models, lobbying and so on.

B1.2.1.2 The impact of legally binding agreements linked with the grant of development consent should be considered, since these may involve liabilities that need to be offset against the value of the asset without them. Where developer contributions are made, some will be delivered on-site and may be part of the appraisal, but others could be outside of the site; for example, the provision of off-site highways provision. The requirements might be for a cash payment, the provision of community facilities, affordable housing or providing enhanced public transport. Furthermore, the timing of the payments, or the fulfilling of the obligations, may be relevant in these cases.

B1.2.1.3 There are various matters relating to statutory and regulatory obligations that may have to be considered. Such matters, which could incur significant costs, will depend on the individual jurisdiction but could typically include:

  • heritage building special consents and any associated negotiations
  • the accommodation of archaeological surveys or digs
  • environmental protection during demolition and construction and
  • obtaining necessary approvals under any regulations relating to building construction.

B1.2.2 Site acquisition costs

B1.2.2.1 These include:

  • agents' fees
  • legal costs and
  • any taxes payable on the acquisition of land prior to the commencement of the development.

B1.2.3 Site-related costs

B1.2.3.1 It is necessary to consider the costs to be incurred before the main construction activity can proceed. These include:

  • the cost of meeting any environmental issues - while this can relate to any remedial works, it can also reflect important conservation or flood protection requirements
  • there may be an obligation to remove contamination, and the consequential waste management obligations, and special environmental provisions to abate noise or control emissions
  • there may be ground improvement works needed before the main construction period begins to make the site safe for development. Indeed, liaison with a civil and/or structural engineer may be appropriate
  • any archaeological investigation costs may be borne before the main contract is let - the time to undertake such work and associated cost needs to be understood
  • diversion of essential services and highway works and other off-site infrastructure costs
  • creating the site establishment and the erection of hoardings
  • the costs of conforming to appropriate health and safety regulations during the course of the development; there may also be issues surrounding sustainability that may have a direct bearing on the site
  • if appropriate, it may be necessary to estimate the costs incurred in securing vacant possession, acquiring necessary interests in the subject site, extinguishing easements or removing restrictive covenants, rights of light compensation, party wall agreements and so on. Realistic allowances have to be made, reflecting that the other parties expect to share in the development value generated and
  • the letting out of advertising space on hoardings or the securing of short-term tenancies - for example, surface car parking - can help to offset other costs before and during the development phase.

B1.2.4 Construction costs

B1.2.4.1 An estimation of the construction costs at the valuation date is a major component in a residual valuation. In other than the most straightforward schemes it is recommended that the costs be estimated with the assistance of an appropriately qualified expert. Buildings should be measured in accordance with the following:

  • Code of measuring practice (6th edition), RICS guidance note
  • RICS property measurement (2nd edition), RICS professional statement and
  • International Property Measurement Standards (IPMS) and International Construction Measurement Standards (ICMS) documentation.

Care is to be taken to check that calculations provided by other professionals are on the same measurement basis.

B1.2.4.2 The choice of procurement route imposes differing responsibilities on the parties and is a key consideration in determining the construction cost. Reference is often made to a fixed price contract. While this does allow for inflation it is only fixed to the extent of the works outlined in the contract. A contractor can amend the pricing if any variations to the specification are made or unforeseen events occur.

B1.2.4.3 It is essential that the valuer understands which route has been, or is likely to be, chosen. The suitability for the particular development and the implications of that choice on the relevant elements of the residual calculation may require recourse to other surveying disciplines.

B1.2.4.4 If the cash flow has been constructed using forecasts of changes in costs, those forecasts need to be similarly incorporated into the model. The cash flow approach allows for the phasing of costs and requires more specific assumptions regarding the timing and shape of the phasing. Two common shapes for the distribution of costs within cash flow models are:

  • Straight line: This assumes that the preliminary costs are incurred near to/at the beginning of the development period and the principal development costs are incurred in equal tranches at regular and equal intervals throughout the development period.
  • S-curve: The weighting of the construction costs may be incurred irregularly within a scheme and different property types may require a different pattern of delivery of construction costs. Rather than distribute these costs equally over the development period, generally the costs are quite small at the beginning of a construction project, relatively accelerate in the middle and reduce towards the end of the construction period. The purpose of an s-curve is to reflect more accurately the incidence of the costs in a particular scheme and may require expert advice from other construction professionals involved with the development.

B1.2.4.5 As procurement practices change, the shape and weighting of costs through a typical development scheme will also develop and change. The cash flow allows these changes to be incorporated period-by-period.

B1.2.5 Contingency allowance

B1.2.5.1 It is normal to include a contingency allowance to cater for any unexpected increases in costs due to unforeseen circumstances. The quantum, which is usually reflected as a percentage of the building contract sum, is dependent upon the nature of the development, the procurement method and the perceived accuracy of the information obtained.

B1.2.5.2 However, whether a contingency allowance is appropriate is linked to the analysis of risk within development schemes. A contingency allowance can count the input uncertainty risk twice as uncertainty is also allowed in the risk adjusted discount rates applied within development valuations.

B1.2.5.3 Unforeseen increases in costs are an inherent risk in development and higher development target returns are required to compensate for risks such as these. A higher contingency allowance should be compensated by a relatively lower target rate of return.

B1.2.6 Fees and expenses

B1.2.6.1 The incidence of fees and expenses can vary significantly according to the size and complexity of the development. In the context of the sale, letting, design, construction and financing of the development, consider the following:

  • professional consultants to design, cost and project manage the development, including an environmental and/or planning consultant, an architect, a quantity surveyor and a civil and/or structural engineer. Additional specialist services may be supplied as appropriate by mechanical and electrical engineers, landscape architects, traffic engineers, acoustic consultants and project managers
  • fees incurred in negotiating or conforming to statutory requirements or any planning agreements
  • the costs of conforming to the relevant health and safety regulations during the development
  • costs related to the raising of development finance (these can include the lender's monitoring surveyor's fees and legal fees) and
  • in some cases, the prospective tenant/purchaser may incur fees on monitoring the development (these may have to be reflected as an expense where they would normally be incurred by the developer).

B1.2.6.2 And in the context of the letting and sale of the completed development, consider the following:

  • lettings and sales expenses - where the development is not pre-sold, or fully pre-let, as a single unit this item includes incentives, promotion costs and agents' commissions. The costs of creating a show unit in a residential development may also be appropriate and
  • incentives on letting, such as rent-free periods, capital payments to prospective tenants, whether as an incentive or recognising the tenants' fitting out liabilities and time periods. These may be reflected by either continuing interest charges on the land and development costs until rent commencement or taking account of the costs in the valuation of the completed development.

B1.2.6.3 Finally, consider the following in the context of financing the development:

  • fees regarding the arrangement of development funding and
  • legal advice and representation at any stage of the project.

B1.2.7 Tax relief and grants

B1.2.7.1 For some specific properties, special tax allowances may be available to the developer. These may relate to the cost of remediation of contaminated land, promotion of job creation or assistance to ensure that a scheme proceeds. The availability of such funds needs to be established with the relevant government office and the possibility of their availability being changed, or withdrawn at short notice, is to be recognised.

B1.2.8 Finance and interest payments

B1.2.8.1 Contrary to much custom and practice, appraisal theory is clear that interest and finance on borrowings should not appear in a formal discounted cash flow individual project appraisal. Where cash flows are discounted at a target rate of return, this incorporates a risk premium based on the project risk and should be at a higher rate than the cost of finance. This is true where the lender does not share in the risk of the project. Where the lender does take an equal share of the risk and potential profit, their target rate of return should be equal to the development as a whole.

B1.2.8.2 In many applications in practice, finance does appear in discounted cash flows and it is often a major input into the valuation. Valuers should become aware of the issues introduced by this poor practice.

B1.2.8.3 Almost invariably, in such an application, the implicit assumption is made of 100 per cent financing of both costs and land value. The finance is rolled up through the development and deducted from the development proceeds at the end of the development (or before if the development is deemed to go into profit before the development appraisal period is complete). This application of a cash flow approach also allows profit to be identified at the end of the development as a single lump sum that is then often tied to the gross development value or the overall costs of the development as a simple percentage of GDV or costs.

B1.2.8.4 The discounted cash flow approach should simply identify the actual cash flow from the development and discount at a project risk adjusted target rate of return to represent profit as an internal rate of return.

B1.2.8.5 A discounted cash flow model could be amended to take into account a variety of finance arrangements and loan to cost ratios. In that case the cash flow is constructed on the equity provided by the developer and the target rate of return is based on the risk of that equity. Depending upon the financial arrangements, that risk would normally be higher than the overall project risk (this assumes lower risk exposure by the lender) and the equity target rate of return would normally be in excess of the project target rate of return.

B1.2.8.6 The issue of cash flows expressed in expected nominal or current values is relevant to the treatment of finance. Interest rates will vary depending upon how the cash flow is expressed with nominal rates of return on nominal cash flows and real rates of return on cash flows that have not been projected forwards.

B1.2.9 Development profit

B1.2.9.1 Understanding the nature of the risk of the development is crucial to the identification of the appropriate return to the developer for undertaking the development. Many of these risks relate to the volatility of the profit relative to input uncertainty regarding the major inflows and outflows over the development period.

B1.2.9.2 In a discounted cash flow, the nominal cash flows are discounted at the project target rate of return. This target rate is based on the required rate of return for a risk-free investment or project plus a premium for the risk undertaken. Development profit is therefore represented as a rate of return, not a single lump sum at some point in the development.

B1.2.9.3 The target rate of return (internal rate of return) can vary significantly between projects and is extremely hard to determine. Development, depending upon any of the contractual arrangements with contractors, prospective tenants and purchasers, planning and other uncertainties within the development process, is a high-risk activity attracting a high-risk premium. Development profits may fluctuate significantly and small changes in the value or costs can cause major shifts in the level of profit. These effects can cause land value estimates to be very volatile but, once the land has been purchased, it is the level of profit that becomes highly susceptible to this volatility.

B1.2.9.4 Where practical, the rate of return should be identified from an analysis of individual land transactions based on assumptions of GDV and construction and other costs.

B1.2.9.5 There are other ways in which profit can be specified within a discounted cash flow approach, but these profits usually introduce other complications over and above the choice of rate of return. For example, it is possible to incorporate profit as a single lump sum element based either on return on GDV or return on development costs. Incorporating a lump sum profit into the cash flow raises issues of what rate to discount the remaining cash flows.

B1.2.9.6 Another common approach to profit is to accumulate the cash flow with interest based on 100 per cent borrowings on both land and construction costs. It is in effect a net terminal value over and above a borrowing rate. If required it can be discounted back at the borrowing rate to identify net present value, which can in turn be used to identify a land valuation residual if no land value element is included.

B1.2.9.7 This approach is designed to be the closest to the application of a more basic residual valuation set out in section B2.

B1.2.9.8 These alternatives do not conform to standard approaches of appraisal modelling in other asset classes; they use profit measures that do not account for time. They often include finance when they should not, and the financing provisions used are often unrealistic. They can lead to a confusing mixture of returns based on periodic rates of return and single lump sums.

B1.2.9.9 All techniques have their limitations. In this case an approach based on the target rate of return on the direct costs and values has fewer limitations than the alternative applications set out above. Valuers should be aware of the limitations of the various alternative approaches.

B2 Treatment of inputs: basic residual model

B2.1 Value of completed development

B2.1.1 In the basic residual, the GDV is normally the current value assuming this value is realised at the end of the development period. In this approach to residual valuations, it is not normal to adjust the GDV for any increase or decrease in values over the development period or to discount the GDV back to the valuation date. However, it is possible and assumptions of value change over the development period may be made in the pricing process and could therefore be reflected in the valuation.

B2.1.2 The GDV can be phased through the development where part of the development is sold or let during the development period, but this is difficult to incorporate into the traditional layout to a residual calculation. It is one reason why cash flows are often applied to the valuation of development properties in more complex cases.

B2.2 Development costs

B2.1.3 It is not normal in basic residual valuations to incorporate expected construction cost changes (in line with the approach to GDV). Current values and costs at the date of valuation are normally utilised. However, it is possible to incorporate cost change where it forms part of the pricing process although it is more difficult and less accurate than in the cash flow format.

B2.2.1 Interest or financing costs

B2.2.1.1 In a basic residual valuation, finance is assumed at 100 per cent of both land and building costs.

B2.2.1.2 The development property/land value finance costs are included by reference to the residual value being discounted by the borrowing costs over the development period.

B2.2.1.3 There are three ways to determine the amount of interest paid on the cost of borrowing the building related costs:

  1. The first is to set out the costs as a cash flow and determine the total interest payments. These are then included as a cost to be deducted from the development proceeds. Some of the residual valuation proprietary software adopt that particular approach. In that form, it represents a cash flow model assuming 100 per cent borrowings on land and building/ancillary costs and a fixed profit based on a per cent of GDV or costs.
  2. Second, interest on construction-based borrowings can be more crudely approximated by assuming that interest accumulates on half the development costs excluding land and profit at the cost of borrowing over the whole construction period.
  3. Third, they can be approximated by assuming that the whole of those costs is borrowed over half the construction period.

B2.2.1.4 Where the residual does not adopt a cash flow format, interest does play a role in giving the development appraisal some time frame to it with the interest payments crudely representing discounting of all values within the development time frame back to the present-day to form a current value for the land.

B2.2.1.5 It is usual for interest to be treated as a development cost up to the assumed letting date of the last unit, unless a forward sale agreement dictates otherwise.

B2.2.1.6 In the case of residential developments, the sales of individual units may occur at various stages during the development and the drawdown assumptions can be amended to compensate. As with any phasing of sales and lettings, this requires the cash flow format to replace the basic residual approach to identify the total interest payments that can then be deducted within the basic residual model.

B2.2.1.7 If an assumption is made that the completed development is held beyond the date of completion, first the attendant costs of holding that building should be added. These may include such items as insurance, security, cleaning and fuel. A proportion of the service charge on partially let properties may have to be included together with any potential liability for empty property taxes. Interest can then be accumulated in two parts; in the construction period as indicated above and then in the post construction period where the full costs of development can be included in the interest calculations.

B2.2.2 Developer's profit

B2.2.2.1 The nature of the development, and the prevailing practice in the market for the sector, helps to determine the selection of the profit margin, or rate of return, and the percentage to be adopted varies for each case.

B2.2.2.2 As indicated above, although the IRR is a truer measure of the required return of a development scheme taking the timing into account, it is usual to express profit within a basic residual valuation as a capital profit expressed as a percentage of the total development cost (including finance) or of GDV.

B2.2.2.3 It is also common practice for development companies who retain completed schemes in their investment portfolios to judge the success of a scheme in terms of the enhancement of the balance sheet (net asset value) rather than the profit and loss account (income).

B2.2.2.4 There are, however, other criteria that are sometimes adopted. These include:

  • Initial yield on cost: the net rental return calculated as the initial full annual rental on completion of letting expressed as a percentage of the total development cost. This criterion may be significant in establishing whether the developer could service a long-term mortgage loan, or for evaluating the effect of the development scheme on the profit and loss account of the company.
  • Cash-on-cash (or equity yield): the capital uplift or (more usually) net income (after interest charges on any long-term mortgage loan) expressed as a percentage of the long-term equity finance provided by the developer.
  • Interest on capital employed: a technique that has regard to the rate of return on actual costs expended calculated net of interest and any relevant taxes.
  • Amount of cover: the extent to which the rent or sale price can be reduced, or the letting or sale period extended (often expressed as a number of months of rolled-up interest or loss of rent) without suffering an overall loss on the development.

B2.2.2.5 The appropriate profit to be expected from a particular development will be influenced by a number of factors that in turn either increase or decrease the risk and uncertainty within the particular development. These issues include the certainty of inputs, such as pre-sales or pre-lettings, fixed construction costs or variable costs, long or short-term projects and fixed or variable finance rates.

B3 Assessing the land value

B3.1 The land value in a discounted cash flow is the net present value of the project cash flows.

B3.2 In a basic residual, the land value is expressed as a gross residual at the end of the development period after deduction of costs including finance and profit from the development proceeds to determine the amount available to pay for the land.

B3.3 As the land value is placed at the end of the calculation the same device of 100 per cent finance is used to move the residual value from the end back to the beginning of the development period, discounting the residual at the finance rate rather than accumulating it. This has the effect of bringing both GDV and all costs including profit back from the end of the period to the beginning and producing a residual amount for the land that is at the date of valuation.

B3.4 To complete the basic residual valuation, the land value is reduced for purchase costs as the residual amount is the total amount available to fund the site purchase, which is the contract price plus the legal and agency costs and any relevant taxes.