Buying a development site can be difficult and stressful, especially when it comes to deciding what price is right for the site… For me its one of the most challenging parts of property development.
To help you with buying sites and to breakdown the financial assessment related to buying sites, this article will take you through the concept of a development appraisal and how to complete one in order to assess the profitability of a project and the site value.
The development appraisal is an essential tool for all developers to assess the land value of any piece of land, site or building which has development potential. This is something we have incredible focus on within the PLP Academy, where members have access to our industry standard spreadsheets and a range of courses tackling the appraisal.
Before buying or bidding on any site, you as the developer should always complete and analysis a development appraisal for the opportunity.
Careful management of the financial side of your development is the key to being profitable and this starts with the development appraisal. It is the essential tool for working out how profitable an opportunity is and how much you can afford to pay for a site.
Within this article, I will take you through what a development appraisal is, the inputs required and how to use the information it provides.
The development appraisal can then be used to assess the profitability of a project once the land is purchased.
Finding sites can be difficult… buying them well is critical…
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What is a Development Appraisal?
The technical term for the development appraisal which I will be discussing in this article is the residual method of valuation.
In simple terms, it’s a calculation or formula which gives you the land value or property value as the final output, based on a set of assumptions for revenue and costs.
The formula looks something like this:
Land Value = Gross Development Value – (Fees + Costs + Profit + Finance)
Very much so…
A simple example to show you the calculation.
You are looking to buy a site which you can build a single house on.
That house when finished can be sold for £2.5m.
The cost of your construction is £450k and you expect to spend circa £75k on professional fees (architects, project manager, planning permissions etc). Your sales costs assumption is around 2% of the sales price which covers the sales agency, furniture staging and a small contingency.
You have around £20k of other costs (council tax, utilities etc) and you will buy the site with no mortgage or bank financing. You include a contingency of £25k and finally, you are happy with a profit of £500k (circa 20% of the GDV).
Your total costs, therefore, are £1,120,000.
Let’s add this to the formula:
Using the example above, we now know that we can afford to spend £1.38m on the property or site to make our expected return.
Armed with this information, you can now open up negotiations and know where your limits are.
This is soo important..!!
Accuracy is King:
But the skill of a property developer is to make sure the development appraisal is as accurate as possible, and with that in mind, the accuracy and usefulness of a development appraisal is solely based on the quality of inputs used.
You are buying a plot to build a single house and you know that the house next door sold for £1m this year. This is a great comparable for your house, and assuming its of similar size, then you could expect to sell your completed project for a similar amount (yes I know, this is a very simplistic view, but bear with me…).
If you then put £2m into your development appraisal, you will have a poor quality input and the assumption used will mean you have an unreliable development appraisal.
Your assessment of the project will not be accurate and you may up losing all your profit from a poor financial assessment of the site.
With the concept understood, lets now take a detailed look at all the inputs and assumptions you need to include in your development appraisal…
Development Appraisal Inputs:
I will now run through, in thorough detail, all of the main and fundamental inputs you need to think about for in your development appraisal.
Gross Development Value (GDV):
The GDV of your development site is the expected end value or revenue you think you will get from the completed development project. It’s the ‘residue’ of your project.
It is arguably the most important input and assumption you make for the development appraisal.
Simply because it is the biggest number you will be making an assumption on. Small changes in the GDV will have the largest impact on your development appraisal.
Lets assume your GDV is £4.25m and your build cost (usually the second largest number in the appraisal) is £1.5m. A 5% change in the GDV is equal to £212,500 whereas the same percentage change in the build cost is only equal to £75,000.
So you see how critical the GDV is.
I will discuss profit in some more detail below, but many developers like to base their profit return as a percentage of the GDV. So again, you see how important the correct GDV is, as it may have a direct impact on the profitability of the development.
What is included as GDV?
The GDV is the end revenue of the project and will be specific to your own project, however, some of the common sources of the GDV are:
• Property sale revenue
• Property rental income
• Ground rent income
• Car parking sale
• Furniture packs
• Any other revenue generated from the development
I will talk about accuracy of inputs a lot in this article, and you’ll probably be sick and tired of reading it…
The GDV is only as accurate as the inputs you are using.
Therefore, you should take the time and effort to research and complete a full sales and marketing report to establish your site’s potential GDV.
This should include sourcing comparable data, reviewing land registry, speaking to local sales agents for advice and completing a thorough review of what is currently on the market. If you end product is more specialist, then you need to speak to the professionals who would sell your product so you have an accurate view on the GDV.
Let’s use an example:
The site you are looking at has planning permission to build 20 apartments, of which 5 are affordable housing.
Your GDV will (or may) be generated from the following:
• Sales revenue for the private apartments.
• Sales revenue from a housing association for the affordable apartments
• Revenue from car parking spaces (common in London).
• Revenue from the sale of ground rents for the 15 private apartments.
So for your development opportunity, make sure you know where your GDV will be coming from and make sure you take the time to assess the accuracy of your assumptions.
Final Advice on GDV:
To finish this section on GDV, I have two final pieces of essential information:
1. The GDV is the Gross revenue figures, i.e. any costs are not yet deducted. Such as the sales agent fee or marketing costs.
2. Only a fool puts inflation into their GDV assumptions. I know a lot of people do… but I definitely do not. I use today’s achievable values and today’s costs, which I suggest you do the same. Building in house price growth is not sensible and will increase the risk on your project significantly.
That’s the revenue section finished… lets discuss the costs:
Development Appraisal Costs:
Below I will go into detail of the key costs which should be included in your development appraisal.
In some cases I will also provide industry standard budget assumptions and some more advice on where to best find the costs to use.
Pretty good right..!
Sales, Marketing & Legals:
This should include all the costs which are used to sell your completed development. Your budget here will depend on site specific conditions, however, as an industry standard rule of thumb, you should use between 1.5%-5% of the GDV as an assumption.
This budget will cover the following:
• Solicitor conveyancing costs
• Sales agent
• Furniture staging
• Marketing events
• Sales suite and/or show rooms
There may, of course, be some other additional items which is included, but the list above are some of the common costs which I have used before.
Any survey which you need to complete for the property or site should included here. This may include:
• Building survey
• Japanese knotweed
Again, the number of surveys required and the budget allocated will largely depend on the site which you are looking at buying.
All costs associated with securing planning permissions, CIL, affordable housing, building control and party wall agreements.
The professional fee budget is an important one as it will get you thinking from an early stage about who you need in your project team and how to structure the development.
Your development appraisal should either included a % of build cost budget, or a detailed itemised budget allocation per design team consultant.
The industry standard (at the early pre-acquisition stage) is to include a budget percentage, which is typically between 10% and 20% of the build cost.
Once you have purchased the site and approached all the designers and project team for quotes, this real live data can then be replaced with the percentage budget allocation.
Any costs associated with preparing a site ready for construction must be included. This can be demolition costs, site clearance or anything which prepared the site.
Often the second biggest cost within the development appraisal and one which some care and thought is needed.
There are many ways to budget your build costs and this will depend on the type of development which you are looking at. I recommend finding a builder to discuss costs and find other methods of budgeting your costs. It doesn’t matter if you are doing a house extension or new build, you need to know your costs.
Property Holding Costs:
The regular monthly or yearly costs of holding the property should be factored in. This will included costs such as Council tax, business rate, utility bills, insurance and any other holding costs.
This may also include income and the actual figure used here should be net of costs and income.
Its sensible to include a small budget to account for any costs whilst you are holding the final completed product. These will be similar to the property holding costs above, but will be directly related to the completed product which you are now trying to sell or rent.
Every development appraisal must include a contingency.
Property development is risky and there are so many things which can go wrong and many unexpected items along the way.
This is fine… we know to expect the unexpected and its impossible for us to know all this upfront.
Therefore, a contingency budget is setup to cover any unexpected items.
I typically use 10% of all costs as a budget.
Cost of Finance:
If you are using bank finance or funding the project through lending, then the cost of the finance must be included.
The most important cost..!!
The one that we do everything for..!!
If we can’t make a project profitable then there is no point and our development appraisal is the tool that gives us the ability to assess the profitability of a potential development site.
If you have already written your business plan and you have set your profit targets then this section is fairly straight forward. Simply include your profit target as a cost.
However, if you do not know what profit to achieve, then you should set some targets. These targets will be specific to you, your investors and how you have structured your development sites.
The three common metrics for assessing profitability within the industry and these are:
• Profit as a percentage of GDV
• Profit as a percentage of Total Costs
• Internal Rate of Return (IRR)
I’m not going to go into to much detail about these, however, it is worth knowing how to calculate them.
The industry standard for housebuilders is to target between 20%-25% profit on GDV, however, a lot of investors may be looking at an IRR return which is the profit over time.
To finish discussing profit, my advice is to think about what targets or hurdles you want to achieve and include these into your development appraisal. You should understand how your profit figure returns as a metric shown above so you can compare projects.
Property development is all about making profit and we take huge risks in development, so make sure you are happy with the profit you are targeting and don’t be scared of turning a site away because it is not profitable enough.
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Development Appraisal: Final Thoughts…
The development appraisal is the fundamental tool to help us developers assess the potential of a development site and find sites we want to buy.
It is critical that we understand and use the development appraisal correctly and make sure the inputs are as accurate as possible.
You should be stress testing your development appraisal, include some sensitivity analysis to see the impact of rising costs and decreasing sales prices.
Use all the sources around you to fully appraise a site. Speak to professionals, agents and other developers to help form your development appraisal.
Hopefully, you now know what a development appraisal is, what is included and the simple calculation which is needed.
Its now worth getting onto excel and building some simple development appraisal models yourself. By building it yourself you will have full control over the numbers and really understand how each cost affects the land value.
All the best,