Real Estate Development: Appraisal and Analysis
Title: Investment Committee Memorandum
Word Limit:
Assignment Brief:
Scenario
You are employed by a real estate development/investment company. Their investment portfolio contains a mix of office, retail and residential assets with a current value of c£150 million. For development, they have been focusing on residential development projects in the inner London area. The development team consists of seven in total. Typically, the company completes one scheme per annum. At any one time, they can have 1-3 schemes under construction/being marketed, another 1-3 schemes being acquired or at the mobilisation stage and 10-15 potential projects where detailed feasibility analysis is underway before potential bidding/negotiation.
Having obtained a new planning consent for the site at Islay Wharf, Lochnagar Street, London, E14 0LA in the London Borough of Tower Hamlets, rather than execute the project themselves, the current site owner is now seeking to sell this development opportunity. Details of the scheme can be obtained on the London Borough of Tower Hamlet’s planning portal. The reference number is PA/19/01760/A1. You’ll get some sense here of the work and cost involved in submitting a planning application.
However, we have made the agent’s brochure available to you via Blackboard – this contains lots of useful information about the proposed development that will assist you.
Task
You have been asked by the Director of Development to produce a memorandum for the Investment Committee providing a preliminary financial appraisal of the development opportunity.
They would like to see:
A justification of the key appraisal inputs used in the development appraisal (mainly revenues from residential and commercial units, construction costs and development programme – see below for details) and outputs.
The memorandum should include three appraisals:
Appraisal 1 should estimate land value using a simple residual approach.
Appraisal 2 should estimate land value using a discounted cash flow approach incorporating interest and a developer’s profit margin.
Appraisal 3 should estimate land value using a discounted cash flow approach incorporating a target rate of return. For Appraisal 3, the expected equity multiple, cash profit, profit as a % of total costs and profit as a % of GDV should also be estimated.
You will see from the planning application documents that various viability appraisals have been carried out for the project on behalf of the developer and the council. These have been carried out for a specific purpose in the planning system and are subject to specific requirements. Whilst the estimates in the viability appraisals about construction costs, values etc. provide a useful sense check, they are likely to be biased to some extent. In addition, they are out-of-date. You need to provide your own evidence base for your estimates of costs and revenues. You may comment on whether your estimates are in line with the estimates in the various viability appraisals.
Additional Resources
We have made the following documents available to you via Blackboard:
Sales brochure – this is the marketing document and provides useful background information including the net and gross floorspace by tenure type, as well as the CIL and s.106 costs.
Key Assumptions
The firm has a number of standard assumptions that it tends to use.
Purchasers’ fees for land and commercial space: 6.8% of land price.
Sales and marketing fees for private residential sales: 2% of sale price. Note that you must value the private residential units for sale – they are not going to be for private rent.
Developer’s contingency: 5% of construction costs.
In addition, a number of other inputs for this specific project have been estimated in advance.
External works: Given the high density of this site, it has been estimated that external works will be 1.5% of construction costs. 20% of the costs of external works will be incurred in the site preparation/demolition phase with the remaining 80% incurred in the two quarters prior to Practical Completion.
Professional fees: It is estimated that professional fees will be 8% of construction costs. It is estimated that 40% of the professional fees will be incurred in the mobilisation phase with the remaining 60% spread equally over the remaining site preparation/demolition and construction periods.
Target rate of return: Following discussions with colleagues it has been agreed that an unlevered target rate of return for the project should be 20%. (Use for Appraisal 3 only).
Required profit margin: The developer requires 20% of Gross Development Value as a profit margin. This is receivable at the end of the development period. (Use for Appraisals 1 and 2 only).
Finance costs: Finance costs are 6% per annum. (Use for Appraisals 1 and 2 only).
Affordable housing: You may use the following simplifying assumptions:
London Shared Ownership (intermediate tenure) housing can be valued at 70% of the corresponding private tenure housing values.
London Living Rent (intermediate tenure) housing can be valued at 60% of the corresponding private tenure housing values.
London Affordable Rent (rented tenure) housing can be valued at 40% of the corresponding private tenure housing values.
Read this snappy guide for more detail about the difference between these tenures.
Note that in ‘real life’ you would have to conduct your own robust valuations of affordable housing and use these in your calculations, rather than rely on assumptions such as those above.
Disposal costs for affordable housing are expected to be £1,000 per unit.
Timing of affordable housing revenue: Under a ‘Golden Brick’ agreement, it is expected that 25% of the revenues from affordable housing will be received at commencement of construction, 50% will be received six months after commencement of construction and the remaining 25% will be received at Practical Completion.
Commercial space: It is estimated that all commercial space will be let at a rent of £220 psm and sell at a yield of 6%. This should incorporate transaction costs of 6.8%.
Land acquisition: If the bid is accepted, it is expected that the land will be acquired on 1 December 2021.
CIL and s.106 costs: You should use the figures on CIL and s106 costs in the agent’s brochure.
Advice
Evidence
A common problem is inadequate discussion and weighing up of evidence, particularly relating to sales values. It is generally not sufficient to simply list the comparable evidence you have used to arrive at your adopted values. You need to demonstrate how you have used the comparable evidence to arrive at your estimated values. It is not always possible to get all the information that you would like but you should try to evaluate the comparable evidence in terms of its similarity to the proposed development in terms of timing, location, quality etc. It needs to be clear to the reader what evidence you have used, as well as how you have used it. Averaging can be simplistic. If using adjustments or weightings, think about whether there is evidence to support them. Bear in mind that prices (asking and achieved) will vary according to micro-location in the locality and even within an individual building (height, view, condition etc.).
Audience
You should provide a memorandum that is ‘pitched’ at the appropriate level given the reader’s existing knowledge. In this case, you should assume that the reader knows more than you do! The reader may be specified in the brief. It is normally not appropriate to include materials from textbooks and/or academic papers in this type of document.
Formatting Guidelines
The memorandum should NOT include:
A description of the proposed project.
A description of the local market conditions unless it is required as part of the justification for a specific appraisal input e.g. changes in price levels over the development period.
A description of the techniques or methods used to appraise the project.
A description of the developer’ position and objectives.
Definitions of the inputs.
Details of the assumptions provided in the brief.
A recommendation of whether to acquire the site.
Here is some guidance on how you could allocate the 1,000 word limit. The following structure is suggested.
Purpose of the memorandum: (approximately 100 words)
Justification of revenue estimates for private residential units (including growth if appropriate) (approximately 500 words).
Whilst you may collect lots of comparables, you need to be selective here and focus on the key evidence. In addition, you should focus on evaluating and analysing this evidence rather than discussing the process by which the evidence was collected. It is important that the key evidence is discussed in the main body of the memorandum.
Justification of construction costs (including growth if appropriate): (approximately 200 words).
Details of development programme (including a GANTT chart): (approximately 100 words).
Discussion of land value estimates and expected financial performance: (approximately 100 words).
