Sunday 27 February 2011

Development Appraisals with Chris Lloyd

Introduction

Development appraisals are a cost and benefit assessment tool for developers and investors. They can be extremely comprehensive and complicated, but will predict almost every cost to the developer and investor. From all of this, they identify the expected profit margin.

However, development appraisals can never be completely accurate. They are likely to increase in accuracy throughout the project process - once some real costs have been pinned down. Therefore, an appraisal should be seen as a development aid that indicates, rather than guarantees outcomes. They help developers and investors decide whether to take a calculated risk.

Appraisals are calculated in Excel spreadsheets that gives instant results and demonstrates that very small changes in certain inputs effect the outputs dramatically. Finely-tuned data sets will make the final predictions more robust. A great deal of pressure therefore rests on the surveyors calculating the correct figures to input in the first place, and on the project management to keep construction costs to a minimum, if profit is to be maximised.

Practical Example

Chris used the appraisal for Neo Bankside, a recent development beside the Tate Modern in North Southwark to guide us through the process. Colours below relate to the appraisal's inputs on the spreadsheet.

The appraisal was basic, but had two main sections: a schedule of areas (red border) and a schedule of variables (green border), including costs and outcomes.

The first task is to work out the aggregate area of development for each use, such as private and affordable housing (orange), and how many units will be for sale. This information will come from the design team, who will pass it onto the QS to estimate the construction costs (yellow). These figures will become more accurate if the design team work with the Local Authority, who will be able to advise on a realistic scheme and the expected volume of permitted development.

We then estimated all the costs: site prep £0.5m-£1.5m, External Works £0.5m etc. It is likely however that the developer used similar figures to ours at the start of the project, way back in 2004 or thereabouts when he was purchasing the site.

Filling in the Regulatory Fees (pink) and general Fees (green) are standard costs that are required by the planning process, design and legal professionals. The Section 106 costs however, are dependent on the number of built units, and for Neo Bankside, amounted in almost £10m (= 774units x £12000).

The S106 rate is negotiated at £/unit. So if the cost/unit is reduced from £12000 to £10000, the aggregate outcome is a reduction of £1.5m less S106. This illustrates the importance of S106 negotiations.

The private residential Values (light blue) are were taken from the Neo Bankside brochure and are £12000/sqm. The affordable residential Values are estimates of what RSLs pay for the affordable units, and are priced at £1500/sqm. I was surprised that this figure was so low, but it explains why the developers often try to negotiate the percentage of affordable housing units - because they are sold at such deflated rates.

Specific Inputs are the developer's specific costs, which in this instance include the purchase of the land and the residual profit. These are calculated on the other sheets which include much of the same data and are linked in. They use the Net Development Value calculation to work out the change in cost over time, the reduction of capital costs and therefore the risk. The land was purchased for £27m, so with this method, they have worked out the increase in land value is £55m and the residual profit stretching as far as £279m.

Finance and Time are also variables that require estimates and these will affect the outcomes significantly over time because payment of interest will result in millions lost if the flats remains empty and unsold.

Obviously, any change in the inputs will cause fluctuations to the outputs. But changes to the sale price/square metre is the most important factor – as tiny changes here will massively effect the rate of return. For instance, just dropping the private residential price from £13000/sqm to £11000/sqm, causes a £43m loss (£279m to £236m). This indicates how susceptible market confidence is to tiny fluctuations in property prices.

One final comparison with this appraisal, is the public-private gains. The units are being sold at £12000/sqm, and the S106 is calculated at £12000/unit. This results in a public sector gain, approximately 1/30th of that made by the developer, who's total profit is nearing £300m.

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