My love story with development appraisals started during an unpaid internship with Inspired asset management in 2012. Since then, I have carried out appraisals to purchase land, manage complex regeneration schemes, and carry out sensitivity/ scenario analysis. In the space of eight years, I went from seeing development appraisals as a mystic art to something as familiar as using a calculator.
As daunting as a perfectly modeled excel spreadsheet can look, do not be dismayed. I will explain the basics of a development appraisal from both the private and public sectors.
What is a development appraisal
In simple terms and from my understanding, a development appraisal is a series of calculations used to determine the profitability or viability of a particular property development opportunity. In most private sector organisations, they will be looking to determine the profit after all expenses. Meanwhile, in the public sector, they will use investment metrics like positive Net Present Value ("NPV"), Internal Rate of Return ("IRR") or yield.
As complex as these calculations sound, especially in the public sector, they are relatively straightforward when breaking them down into small chunks.
The key calculations
In whatever guise people try to make development appraisals seem complicated, the calculation is as surprisingly as simple as adding and subtracting.
To calculate profit- Gross Development value ("GDV") – Gross development costs ("GDC") – Land – interest = profit
To calculate land value- GDV – GDC – profit – interest = land value
The GDV is established by researching comparable sales within a particular area. Developers either use Right move, zoopla or land registry. There are more bespoke software such a Molier london, Realyse or right move plus which provide help find information of sold or selling prices.
A discounted cash flow which is typically used in the public/ PRS sector, is a lot more complicated, but in simplistic terms, the calculation is as follows:
A= Cashflow(Capital spend + Interest rate + rent + maintenance on a year by year basis)
B= Discount rate
n = Time in years before the future cashflow
In very simplistic terms, these are the main calculations used to assess the viability of property development projects, how much to purchase land and how to review a discounted cash flow.
Many of us approach various situations differently. Some people are optimistic, others
pessimistic whilst a few a neutral. When doing development appraisals, I have found that it is much more prudent to swim in pessimistic or natural waters. Why? Because pessimism allows you to see what others may not, it allows you to save the best part of the meal (selling, renting or refinancing) until last, which may also come with a pleasant surprise (increase in values).
An example of being pessimistic is knowing that the comparable property values for a 1
bedroom flat in an area are £250k, but you input £240k into your appraisal. Like most industries, property development is one where things can change at any moment. A pessimistic approach to your inputs could be your intentional buffer, whereas optimism is good in some circumstances but could end in disappointment.
My favorite saying is, "When you expect nothing and get everything, that's Destiny.
To me, this quote means be prepared for the worst but expect the best.
Being neutral is also an excellent place to be as you are not hedging on significant inflation in prices, not undercooking your build costs and not reducing your contingency to a value that is too low.
I am a natural optimist, but when doing development appraisals, I am more pessimistic/ neutral. I guess this is what experience does to you after some time.
There is a place for optimism which is should be at the end of a project as many things can go wrong throughout.
Have enough oil in all of your buckets
Development appraisals are used by developers (using their inputs) to purchase land and assess the viability of a scheme. Investors and lenders also use development appraisals to determine whether they will invest with you or lend to you.
It is important that everyone knows the essential buckets in development appraisals and ensure you have enough oil to see your project to a successful conclusion.
The main buckets in any development appraisal are:
GDV - value of all the homes once sold.
GDC- build costs, professional fees, insurance, legal fees etc.
Land costs- cost of purchasing land
Contingency- typically 5-10% of build costs
Cost of finance- 7-10% per year
Discount rate- normally the same as your cost of finance
Understating GDC or over-inflating sales values GDV will most likely lead to disaster. A good development manager and land buyer will ensure that a sufficient budget is attached to each essential item within a development appraisal, adding an extra layer of contingency in unforeseen circumstances. My view is that if your key assumptions are wrong from the onset, it will be difficult to make a profit on a scheme.
Typically, professional fees are 12% of the build cost, and this covers architects fees, civil/ structural, a quantity surveyor. The contingency amount is normally between 5-15% of build costs which is dependent on the experience of the developer and the risks involved in a particular project.
The difference between the public and private appraisal
The house building sector tries to establish the underlining profit in a scheme. The calculation of profit is straightforward but knowing what makes up each of these figures isn't so straightforward. The private sector also seeks to establish Return of Capital Employed and peak funds which shows the maximum amount of money you will need until you start selling homes or bringing in income. Private rented sector investors take a similar approach to how the public sector apprise development schemes.
The public sector tends to use a discounted cash flow appraisal to determine a scheme's long-term profitability. Discounted cashflow appraisals have many more inputs than your standard residual appraisal as it considers short/ long term interest rates, management costs, life cycle costings, void costs, discount rates and much more.
Tools used in different sectors
The private sector organisations that I have worked for have used bespoke excel based models, Anaplan (cashflow appraisal) and Argus Developer. Some developers are now using a new online appraisal system call Aprao, which seems to be receiving excellent reviews as you can pay monthly at affordable rates. The main appraisal systems I have used are:
Excel- This is the father of all appraisals and is free as long as you know how to put together financial models.
Aparo ( subscription/ online based appraisal system).
Proval (discounted cashflow appraisal generally used in the public sector).
Argus Developer (used in both private and public sectors).
Anaplan which is a cashflow based appraisal system.
Having worked in both the private and public sector, I have been fortunate to have used various appraisal systems. I like system-based appraisals because it removes the likelihood of human error in calculations. The drawback of using software for appraisals is that it is not 100% clear how essential calculations are carried out. With Excel, on the other hand, you can work all the calculations back to the key components, which helps break down the numbers. Although Excel is prone to human error, you type the wrong cell or formula, then you could find yourself in a tricky position.
When carrying out development appraisals, the main thing to consider is to ensure that you take a measured approach to your inputs. If you overstate your costs, this could be the difference between winning a bid for a site or missing out on an opportunity. On the flip side, if you understate your costs, you'll effectively fail before you begin by overpaying for a site and not having enough money to complete your project.
Check your numbers constantly to ensure that your inputs and calculations are correct. It is better to be meticulous when carrying out appraisals to not enter into crisis during your project.
A prudent Development Manager refreshes their development appraisal either every month or when anything happens that impacts costs or values.
Finally, be the person that can stand behind every number that you input into your appraisal. My old Development Director required us to have a backup sheet for every number in our appraisal. This meant build cost, professional fees, interest rates, sales values, selling fees etc., needed a backup sheet to justify the primary appraisal. This is an approach I hated due to the time involved, but I now appreciate the practice as it allows you to have a clear rationale behind your numbers. So if your board or investors ask for the basis of your assumptions, you can send up your backup sheets, which removes all doubt.
Rest in peace to Martin Skinner.