House Valuations - How Property Developers Appraisals Work

One, if not, the most vital way to reduce significant risk on a project is to conduct a well thought out and detailed valuation. Essentially, is this property development endeavour worth it financially? This is the question we developers ask ourselves all the time, and the appraisal is the tool to make that assessment. Because a site could look amazing at first glance, but once you crunch the numbers, things might not add up!

In this article we will go through the most common types of appraisals and valuations that property developers produce when valuing a site, and how this directly informs our deal structures when pitching an offer to you, the landowner; whether that be an options agreement or a promotions agreement. We will also outline the theories and techniques involved within an appraisal, but crucially, explain the shortcomings of each, so you can have a better understanding whether you are in good sound hands when dealing with a property developer, like us!

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What are Development Appraisals?

Basically they are a reality check. Whether you are intending to do an extension, refurbishment, change of use or alterations to an existing property and/or build something entirely new, a development appraisal plays an important role in checking whether a project makes sense. It forces us to re-think the project where there might be significant financial risk.

In most situations it will be a bank that lends money to a developer to fund any particular project. Typically they will require a RICS registered valuer to undertake a development appraisal as a formal market valuation of the project, and even a second valuer if the project is significant in value to cross check the work.

The Residual Valuation Method

Typically development appraisals are done using a residual valuation method, which is a fancy way of saying - tally up the development costs, fees, financing and profit in order subtract this value from the projected sale value of the project.

Today, the calculation is commonly modelled on excel spreadsheets, however some developers use specialist software. Nevertheless, the level of skill and expertise a developer has usually determines the outcome, as it’s the level of detail and understanding within their breakdown that will determine the quality of the valuation.

Unfortunately, only when a project crystallises will the hidden risk come out and cause havoc, for example, inflation will affect the project's costs as the project develops. Additionally, borrowing debt rates either as a consequence of inflation or for alternative reasons, presents another layer of hidden risk. It’s quite clear that there are inherent drawbacks when using this method, as it’s not so easy to factor in inflation and changing debt rates using this model.

So why use this method?

It is simple, quick and effective for its intended purpose. It offers a pragmatic and adaptable method for modelling a project's risk and reward balance. However we need to understand the ‘input uncertainty’ inherent within this model, because the value of money changes over time. This is where the discounted cash flow method can be used to help iron out these weaknesses.

The Discounted Cash Flow Method

Combining the discounted cash flow (DCF) method with the residual method allows the developer to fill the conceptual inconsistencies mentioned previously.

This method calculates the land value by factoring in the future cash flows over a set period, then discounting them to the present value, and then subtracting the total development cost from the residual terminal value.

Basically, what are the future profits worth today when adjusting for time and risk. Using this method inside the residual model helps map out a timeline of when the money actually comes in and out instead of assuming it all happens today, all at once.

However, even with this added to our residual model, there is still a level of speculation involved without looking at what is actually out there in the open market. This is where the comparable method becomes useful.

Market Comparable Method

Evidence of market value of similar projects within the local area can offer developers important data indicating current prices for project types. This builds an average of the market property prices that best matches the project in spec and build quality. That is to say, there is no good comparing high end marketed properties when your project is an affordable housing scheme!

Also, this method allows for built in transparency, and therefore less likely to be manipulated by optimism or wishful thinking. It seems Tribunal prefers this method over the residual method as it provides evidence of how the market is behaving, however for the developer the residual method is preferred. Why? Because our objectives are completely different.

Developers price for project viability, whereas Tribunal settles legal disputes by looking at historical evidence and existing data. Using a combination of both provides developers with a reality check against the traditional residual method. However, where there is limited market evidence and poor comparable data, this method falls short of accuracy, as you can only be as good as the data inputted.

Important elements of an Appraisal

Gross Development Value (GDV)

The development value, also known as GDV, is the total projected market value of a project after construction and development is completed.

This comprises of development costs including interest, land costs including stamp duty and developers profit.

Yield

The percentage of interest paid from rental income of a property compared to the capital value.

Capital Value

What the property is valued right now on the open market.

Years’ Purchase in perpetuity

A property valuation multiplier used to convert the predicted yearly rental income into a single capital sum. Basically:

YP in perp = 1 / yield

How Developers Appraisals Work

In conclusion, although the residual appraisal is the industry standard and preferred method of valuing that provides a pragmatic and simplified heuristic for illustrating the risks and uplifts of any given property project, we have touched its weaknesses and why it is not a stand alone model.

Nevertheless, the residual model needs buttressing and detail added to the model, by incorporating the market comparable to bring the project to some sense of reality. This removes some of the speculation, by focusing on data driven comparables and understanding the market.

Moreover, realising that a building's lifecycle is susceptible to such things as inflation, and using the discounted cash flow method to stress test the model, allows to remedy the residual model’s inconsistencies.

Appraisals are a dense and detailed area of a property developer's responsibility, however it is one of the most vital skills to master. Which is why instead of making this article unbearably long, we will continue this topic in future articles to break down this topic in more detail.

If you are a landowner or investor looking for a design-led property developer with expertise to help unlock hidden development potential, then make sure to fill out the contact form below and get in touch today!