A development appraisal is a critical component of any development project. It entails a financial feasibility test in which the ability of a project to pay its financial responsibilities while assuring appropriate site value for the landowner and an appealing return for the developer is assessed. A development evaluation can be used to determine the amount of affordable housing, analyze land use, and assess the amount and form of planning obligation contributions (Isaac et al. 311). The residual approach is the most widely utilized method in development appraisal. It is assumed that some residual value is always released once a project is completed. The residual method determines the land value as well as the developer’s profit. Besides, the method is useful in testing alternative development schemes. It involves estimation of many inputs which are likely to lead to wide variations in different valuations. Comparable evidence is used in estimating the inputs. The residual valuation of a site that is reserved for development starts broadly at the stage of evaluation and it is progressively adjusted before the acquisition as well as construction phases of a site.
The following development appraisal seeks to establish whether the development project that Valleyridge wishes to undertake is financially viable. Valleyridge specializes in mixed-use schemes and is interested in the Waterside site. The development appraisal will help the company in making decisions in relation to placing a sealed bid for the site. Besides, it will determine whether the development project will meet its costs while ensuring the appropriate site for the landowner as well as a market risk adjusted return for Valleyridge in delivering the project. The valuation method used is the residual method. The residual method recognizes that the value of the scheme is a function of various elements. It involves subtracting the cost of the development from the estimated value of the project. Besides, the development appraisal seeks to evaluate the level of return that the proposed project is likely to generate as well as to establish the residual value of a site by entering an already determined level of return (Isaac et al. 312). On the other hand, the development appraisal will involve a research on the constraints as well as the opportunities that evolve from the location, legal, and planning aspects of the site.
The function for a residual method of valuation is:
Gross Development Value – Development Costs = Profit.
Gross development value consists of the estimated value of the scheme, rental estimates or the sales, floor space, and the number of units that are its components. The development cost includes the cost of acquiring the site or the value of the land as well as the value of the existing building (Isaac et al. 314). The build cost is expressed as an overall cost or cost per square meters and it is also a development cost. Professional fees, finance costs, contingencies, planning obligations, and sales costs also constitute the development costs. The profit is the financial return to the Valleyridge and it is either shown in pounds or as a percentage of the gross development value.
Maximum Price for Valleyridge
Valleyridge required a rate of return is 18%. In other words, the company will undertake the project if it will get a return of 18% or above. Since the bankers have allowed Valleyridge to borrow up to 85% of the development cost at a preferential rate of 9%, then the company will have to use 15% equity to fund the project.
According to the RICS Building Cost Information Service (BCIS) in August 2015, the build cost expressed in pounds per square meter for residential of 10 units and below is 6% higher than for larger development. The percentage is -5% for schemes that deal with flats only and +14% for schemes that deal with housing only. The extra base construction cost for 1-10-unit development of houses is above £100,000. Since Valleyridge is a mixed development, the percentage difference compared to the development of more than ten units is 6% while the difference in £/m2 is 64. The average unit size is 80 m2 and the average difference per development is £51,200.
The scheme is considered viable based on the variable of residual land. If a project delivers a land value that is unacceptable, then there is a likelihood that the land will not be released for the scheme to proceed. A value of 25% of the gross margin on sales should be assumed. The general building principle determines to a large extent the acceptable land value. For instance, in case the land is greenfield but has some form of development allocation, the residual value is judged against a comparable value in the same geographic and market area. The estimated land value in Waterside lies in the order of £683,184 per hectare. Conclusively, the maximum price Valleyridge should pay under the sealed bid will be:
Gross area of commercial space 1000 m2
Residential unit £4000 per unit
Gross/net ratio for spaces 90%
Rent for the spaces £500 per m2
Cost of finance 9%
Construction cost per m2 £2,865 per m2
Land Value £2,200,000
Construction period 21 months
Void period 9 months
Rental Income
500,000
Residential 4000 per Unit
4,000,000
All Risk Yield
6.5%
Total Gross Development Value
9,678,600
Total Construction Costs
-2,865,000
Engineer fee 2% of the Cost
-57,300
Architect fee 6% of the Cost
-171,900
Quantity Surveyor 3% of the Cost
-85,950
Agents Cost 3% of the GDP
-290,358
Funding of Construction
-560,317
-4,030,825
Land Costs
Cost of the Site
-2,200,000
Cost of Land Purchase 6.8%
-149,600
Interest on Land Purchase 2%
-513,675
-2,863,275
Gross Residual Profit
2,784,500
Task 2
Sensitivity Analysis
The development process is subject to uncertainty because of two aspects. Firstly, the expected cash flows are uncertain to varying degrees and, therefore, the resulting figure of gross development profit is prone to uncertainty (Diaz 35). Sensitivity analysis is a technique used while assessing the impact of different variables within the development appraisal. It involves modelling different scenarios to determine the viability of a project. Any small change to any of the input variables is likely to have a disproportionate effect on the output. Sensitivity to change occurs regardless of the residual method applied in coming up with the gross development profit. The following is what happens to the gross development profit in two scenarios.
Scenario One
If the commercial rental levels increase by 7%, commercial yields fall by 0.5%, building cost increases by 3%, and residential unit cost 9000, then the gross development profit will be:
Rental Income
535,000
Residential 9000 per Unit
9,000,000
All Risk Yield
6.0%
Total Gross Development Value
10,673,450
Total Construction Costs
-3,724,500
Engineer Fee 2% of the Cost
-74,490
Architect Fee 6% of the Cost
-223,470
Quantity Surveyor 3% of the Cost
-1,117,350
Agents Cost 3% of the GDP
-320,204
Funding of Construction
-560,317
-6,020,331
Land Costs
Cost of the Site
-2,200,000
Cost of Land Purchase 6.8%
-149,600
Interest on Land Purchase 2%
-513,675
-2,863,275
Gross Residual Profit
2,453,119
It is evident that the gross development profit will decrease with increase in the build cost, commercial rent per square meters, and a fall in all risk yield.
Scenario Two
If the commercial rent falls by 5%, the commercial yield increases by 0.8%, an increase of demand for residential increases by 1.5% per month, and the building inflation increased to 8%; then the gross development profit would be:
Rental Income
475,000
Residential 4,000 per Unit
4,000,000
All Risk Yield
7.3%
Total Gross Development Value
9,315,200
Total Construction Costs
-3,094,200
Engineer Fee 2% of the Cost
-61,884
Architect Fee 6% of the Cost
-185,652
Quantity Surveyor 3% of the Cost
-928,260
Agents Cost 3% of the GDP
-279,456
Funding of Construction
-560,317
-5,109,769
Land Costs
Cost of the Site
-2,200,000
Cost of Land Purchase 6.8%
-149,600
Interest on Land Purchase 2%
-513,675
-2,863,275
Gross Residual Profit
1,342,156
The gross development decreases significantly with increase in building costs and commercial rent. There is a problem with the sensitivity analysis (Diaz 35). Despite the fact that it shows the downside and upside risk of the project, the sensitivity analysis does not provide a probability of the different results in global development profit and fails to establish the correlation between the input variables being tested. Besides, it only allows testing for selected input variables while the other variables in the model are ignored. In other words, the sensitivity analysis looks at the best or the worst scenario above or below the original estimates which are considered to be the best and focuses on the variations from the resulting value of gross development profit. In the case of Valleyridge, scenario one is the best while scenario two is for the worst case.
Task 3
In the event that the local authority refuses to grant planning permission to Valleyridge or accepts under conditions that are unacceptable, the law requires that it gives written reasons. If Valleyridge finds the reasons for refusal to be unclear or needs clarification on the conditions set by the local authority, it can talk to a staff member of the local authority planning development. Valleyridge can ask them if it would make a difference if the plans were changed, since they are allowed to submit another modified application free of charge within 12 months after the rejection of the first application. However, if Valleyridge feels that the local authority was unreasonable in their decision to deny planning permission, they can appeal to the Secretary of State. Besides, if the local authority fails to make a decision in eight weeks, Valleyridge has a right to make an appeal as well unless it has been agreed in wringing to extend the duration of issuing a decision. Upon appealing, the company’s application will no longer be in the hands of the local authority, but in the hands of the Secretary of State (Sayce et al. 630). Appeals are considered to be the last report, since they can take months to issue a decision. It takes less time when Valleyridge opts to discuss what could be changed in the plan to make it acceptable rather than appealing. In the case of non-determination or when the local authority takes more than eight weeks without issuing a decision, the company should ask the local authority when their application will be decided rather than appealing. On the other hand, if Valleyridge decides to make an appeal, it should be done within six weeks after the day of decision.
Works Cited
Diaz, Julian. “How Appraisers Do Their Work: A Test of the Appraisal Process and the Development of a Descriptive Model.” Journal of Real Estate Research, vol. 5, no. 1, 1990, pp. 1-15.
Isaac, David, et al. Property Development: Appraisal and Finance. Palgrave Macmillan, 2010.
Sayce, Sarah, et al. “Understanding Investment Drivers for UK Sustainable Property.” Building Research & Information, vol. 35, no. 6, 2007, pp. 629-643.
