Investment Appraisal – Lesson 2

Development Economics – BE4405

Development Economics I – BE 4418

Dr. Thanuja Ramachandra

 Syllabus Outline

• Structure of the property industry: Types of property,

Property Developers, Characteristics of property
development
• Factors influencing property market and development
• Property development process
• Developers Budget: Development Appraisal
techniques, Sensitivity analysis
 Investment
• Used in all sorts of business context.

• Making a cash outlay with the intention of receiving, in

return, future cash inflows (Lumby, 1988).

• Involves making an outlay of something of economic

value, usually cash, at one point in time that is expected
to yield economic benefits to the investor at some other
point in time ( Atrill and McLaney, 2002).
 Investment Appraisal

• Decision making process which businesses adapt to

decide which investment to take.

• Choose between mutually exclusive investments, or

decide whether to pursue or reject a particular
investment.
❑ Absolute profitability
❑ Relative profitability
 Appraisal Techniques

• Static methods: Assess the profitability of an

investment for a time span of one period (average),
ignore the passage of time.

• Discounted methods: Takes time into account,

discounting cash flows to one point in time.

• Alternatives are comparable in regard to their project

type, amount of capital-tie up, economic lives.
 Methods

Static Methods Dynamic methods

Payback period Net Present Value
Average Rate of Return Internal Rate of Return
Profit comparison Annuity Method
Cost comparison
Dynamic/ Discounted Cash flow
Methods
 Time value of money

• Considers more than one time period, acknowledges the

time value of money
• Described in terms of streams of (expected) cash inflows
and outflows over the whole course of economic life,
different periods
• Discounting - all cash flows are converted to their
equivalent value as at beginning of the investment
project
• Compounding – all cash flows are converted to their
equivalent value as at end of the investment project
 Example - Compounding

• When a sum of money is invested at a fixed rate of

interest such that the interest earned is added to the
principal and no withdrawals are made then the
amount invested will grow at an increasing rate

• Formula: FV = X (1+r)n where FV –amount; X-principal;

r-rate of interest ; n-period
Rs.1000 invested today at the rate of 10% p.a for three
years. Calculate the amount in 3 years time

Principal Compounded Future value

Amount @10% p.a
Rs.1000 100 1100
Rs.1100 110 1210
Rs.1210 121 1331

Using the formula FV = PV (1+r)n where n=3; PV= 1000/-

; r=10%.
 Discounting

• Reverse of compounding. In compounding if we invest

Rs.X now at r% per annum for n years we get Rs.FV in
n years where FV = X (1+r)n

• In Discounting if we want to have Rs.FV in n years

how much (PV) you need to invest at r% p.a now in
order to obtain the required sum of money in future

• Discounting - Obtain the present value of a future

sum
 Contd’

Formula:
FV = PV (1+r)n
PV = FV.1/(1+r)n
PV = FV (DCF)

Example: Calculate the present value of

Rs.30,000 to be paid in 8 years at
the discount rate of 10% p.a
 Annuity
• Monetary value of an investment results from a stream
of identical cash flows over several years
• PV of stream of identical cash flows are calculated using
annuity factor (capital recovery factor)
• PV = Annuity. (1+i)n -1
i.(1+i)n
Eg: PV of an annuity of Rs.10,000 incurred for 3 years
and with an interest rate of 10%
 Continued

• A single cash flow received in time period 0 can be

transformed into an annuity using the inverse of annuity
factor

• Annuity = PV. (1+i)n.i

(1+i)n -1

• Eg: Annuity of Rs.10,000 received at time 0 with i=10%

and t =3 years
 Net Present Value (NPV)
• Popular, academically preferred method with no serious
flaws.

• Equals the sum of present values of all net cash inflows

minus the present value of the investment cash
outflows.

• Calculated by discounting net cash flows at a specified

rate.

• Discount rate – cost of capital, a risk-adjusted rate, an

arbitrary profitability target rate, or any other rate.
 Cont’d

Decision rule:
• Investment project with highest NPV value is
selected among competing opportunities.

• A single project – NPV greater than zero is

accepted.
 Example
Data Project A Project B
Initial investment outlay 100,000 60,000
Economic Life (years) 5 4
Liquidation value 5000 0
Net cash flows
N=1 28,000 22,000
N=2 30,000 26,000
N=3 35,000 28,000
N=4 32,000 28,000
N=5 30,000 -
Discount rate (%) 8 8
 Advantages and disadvantages

• Includes relevant cash flows and their respective

timing.

• Size disparities and cash flow timing pattern

disparities are considered in comparing
competing alternatives.

• Single target measure, NPV

 Cont’d

• Uses inherent conceptual assumptions and

forecasts – Initial investment outlay, project’s
economic life, liquidation value, discount rate, all
future cash flows

• Difficulties in selecting the suitable discount rate

• Difficulties in comparing mutually exclusive

investments with different project life time
 Internal Rate of Return (IRR)

• Similar to the NPV method to certain extent but

appraisal start from different point.

• Target measure, IRR is the discount rate which

sets the NPV of an investment to zero.

• Calculation of discount rate for NPV is zero

requires arithmetic interpolation.
 Cont’d

Decision rule :
• Investment with highest calculated IRR is
chosen with several alternatives.

• If IRR exceeds a pre-defined minimum

rate of return is accepted.
 Continued

• IRR method – calculated result is intuitively easy

to understand, percentage return.

• Takes into account – amount and timing of all

relevant cash flows.

• IRR methods suffer from the same deficiencies

of NPV approach

• Use example above – interest rate 18%.

 Annuity Method

• Series of cash flows of equal amounts in each

period of the total planning period.
• An amount an investor can withdraw in every
period when undertaking the investment project.
– Absolute profitability: Annuity is greater than zero
– Relative profitability: Project with highest annuity
than alternatives.
• Example: Previous example.
 Development Appraisal
• It is a cash flow summation of all the elements of
income and costs in the development process.
• Ascertains the capital value of an estimated future
income (sale price of the completed development) and
then to deduct from that the cost of all works needed to
complete the development to a standard able to
command such a future income.
• Development appraisal/residual valuation is used by
developer to decide whether a proposed development
will be viable.
 Cont’d…

• Developers to asses the likely performance of the many

differing development options which may be available to
them + land value
• Funders (and their valuers) to asses the viability/risk of
differing funding propositions that may be put before
them
• Land owners (and their valuers) to asses the underlying
value of their assets which may have development
potential
 Residual Approach
• The residual approach has been traditionally used for the
valuation of land or buildings with redevelopment
potential.
• Fairly simple appraisal technique helps developers to
determine a realistic value for the land or property
purchase
• Identifying a realistic land or property value helps a
property developer to determine other expenditure and
the maximum that they can afford to spend on site
preparation, land remediation, building costs,
professional fees etc. to achieve a profitable outcome
 Cont’d…

• Residual figure can represent:

• Residual to land value
GDV (value of the completed development) – Total costs (All
construction costs, interest on construction, professional fees and developer’s
profit) = Gross Residual (Maximum bid for site includes acquisition costs,
professional fees and finance of land purchase)

• Residual to profit

GDV (value of the completed development) – Total costs (All

construction costs, interest on construction, professional fees and land value)
= Developer’s profit
 Cont’d…

• One of the main concerns is the amount available for

land/site purchase – how much initially you should pay for the
development of site or building

• Other important element – GDV, investors are keen to

establish at the outset

• GDV – the final capital value of the finished development is

projected to be when it is eventually sold to an interested
party

• GDV in the residual approach is based on current values not

on projected values
 Cont’d

• GDV – depends on the estimated total annual rent

accruing from the completed building after deduction for
costs of outgoings (such as maintenance, repairs and
management, etc.)

• GDV = The net annual income x YP

• YP - Years Purchase Factor – commonly used in property

valuation, refers to the number of years income it takes
to recover the capital outlay
 Cont’d…

▪ Building costs and fees -

✓ Site preparation and construction costs of the property
✓ Payments to professionals involved in the process –
solicitors, planning consultants, architects, engineers,
property agents etc

▪ Developer’s profit – needs to consider the developer’s

expected return on investment
 Cont’d….
• Cost of land includes:
Land value
Legal fees – Transformation of deed to developer
Stamp duty – Land sale
Surveyor fees – Surveyor plan
 Construction cost of building
• Per square meter of floor area (often usable floor area) Or
elemental cost analysis is the basis
• Cost are adjusted for
– Quantity – cost data for GFA for each element
– Quality – for number of stories/major elements – finishes,
fittings etc
– Price – Construction Cost Index
• Adjustments to following
– Preliminaries as % of total cost excluding provisional sum
– No head office overhead as developers are on direct
labour contract
– Site overheads are added – A % to basic cost
• Professional fees form as part of construction cost.
• Contingencies - % of construction cost
 Cont’d…
• Architect’s and Surveyor’s fees –
– normally a 10-15% of the cost of building
– covers the preparation of all contract documents and supervision of
and financial arrangements for the contract, including employment of
project manger etc.

• Legal and agency fees –

– An average allowance to cover legal costs on purchase of site, including
stamp duty, and preparation of lease agreement,
– agent’s fees on letting the property and advertising costs – 2-3% of
GDV

• Developer’s profit –
– An allowance of 10-20% of GDV is made as return to the developer for
devoting his skill, time, and risks he undertakes
– Risks include – rising costs, falling rentals and inability to lease the
property on completion
 Cont’d…
Cost of finance include:

To purchase the building site – borrowed capital and interest on it or

use own capital and forgo the return on it.
For the period from the date of purchase to the time when the
completed building is let or sold

Financings will proceed throughout the contract period as payments are

made to the contractor periodically.
Building cost finance is calculated at an agreed rate of interest on
half the building cost for the full contract period OR
the full building cost for half the contract period assuming a constant
cash flow throughout the work
Suitable annual interest rate, usually a compound interest rare for the
lengthy contract periods is considered
 Cont’d

• Gross Profit = Sale price – Total cost

• Net Profit = Gross profit X 1/(1+r)^n where n is disposal
period
• Developers don’t get the expected profit on the
completion. They gain part from pre sale and have to
wait for sometime to dispose the balance. Thus the Net
Profit is calculated at the end of the disposal period.
• Rate of return = Present value of profit as a % of sale
price and total cost
– ROR = Net profit / Sales Price X 100
– ROR = Net profit /Total cost X 100
 Cont’d…

Outputs
• Development Profit
• Profit on cost %
• Profit on cost IRR (inc/exc finance)
• Yield on cost
• Profit /rent cover
 Example 1
Development Value:

• Residual valuation is one of the methods that is used in assessing the

profitability of development proposals

Two main approaches:

• Land Value = GDV – (Development Costs + Profit Margin)
• Profit Margin = GDV – (Development Costs + Land Value)

• What would the Land Value be?

• Gross Development Value (GDV): estimated to be at £30 million at the
beginning of a development
• Developer’s profit @ 20% of GDV = £6,000,000
• All development costs including professional fees, construction costs,
ancillaries, contingencies, finance charges, marketing, letting and disposal
fees = £16,000,000
• Land value inclusive of costs, interest payments and land tax = ?
 Example 2
• Residual Value of Land =
Gross Development Value –Total Development Cost

GROSS DEVELOPMENT VALUE (GDV) example £4,000,000

LESS
all costs of development say £3,000,000
balance £1,000,000
ADJUST for interest (cost of finance) say 2.25 years @ 6%
1/(1.06)^2.25= 0.877 126 877,126
LESS fees on land purchase say 7% 61,398
(Residual site value -i.e. maximum bid value for the land £815,728
 Example 1:
• Planning consent has been given for the erection of an office block of 10 000 m2 on a
vacant building site. It is estimated that the building will produce a net income of Rs1400
000 pa and will cost Rs.680/m2 to build. Assuming it will take eighteen months to build,
determine the present market value of the site.

Feasible Assumptions

• The building cost finance is usually calculated at an agreed rate of interest on

half the building cost for the full contract period or the full building cost for half the
contract period assuming a constant cash flow throughout the work. A suitable annual
rate of interest was around 8 %, using compound interest for lengthy contract periods.
• Architect’s, surveyor's and consultants' fees - 16 %
• Legal and agency fees and advertising costs – 3% of GDV
• Developer's profit - 10% of GDV
• The residue represents three items: value of the land; acquisition costs (4% of value); and
cost of borrowing for 2 years @ 11 % pa on land value and costs.
• The anticipated return of the developer is usually assessed at about seven to nine per cent
of development costs, and it would be useful to check the figures in this example by the
anticipated return method. The net income of 1400 000 gives a 8.89 % return on the
development costs of 15750000, and so it is at the higher end of the scale. The rate of
return varies considerably with fluctuations in the relationships between income,
building costs and interest rates.
 Example 2:

• A site is available at a purchase price of 750000 and it is anticipated

that planning permission could be obtained for a factory of 7500m2 or
an office block of 17500m2. The estimated cost of the factory including
site works is 1875000 and the comparable cost of the office block is
9450000. The contract periods are assessed at one year for the factory
and two years for the office block. On completion the office block is
likely to have an annual rental value of 1400000 with the landlord's
annual outgoings of 300000. The normal return on office blocks in this
area is 7%. The factory is likely to sell for 3 800 000 on completion.
Legal, agency and advertising costs are likely to be 90000 for the
factory and 420000 for the office block. Architect's and surveyor's fees
are 12 % of construction costs and finance is at a specially
advantageous interest rate of 9 per cent. Determine the form of
development likely to profit the developer most.
 Example 3
• A developer is proposing to erect a block of six lock-up shops with
two floors of offices above them. The shops are likely to let at an
average annual rent of 300/m2 and the offices at 150/m2. The net
floor areas will be 500 m2 for the shops and 900 m2 for the offices.
Circulation areas will amount to about ten per cent of total floor area
and will remain under the control of the landlord, whose annual
outgoings are estimated at twenty-five per cent of income. The
developer requires a twelve per cent profit on the development. The
freehold site is available at a purchase price of 130000 and site works
are estimated to cost 15000. The rate of return in this area for similar
developments is around seven per cent. The contract period is likely
to be one year and finance is available at 11 per cent rate of interest.
Legal, agency and advertising costs are likely to be about three per
cent of gross development value. Determine the allowable building
cost per m2 of gross floor area and its feasibility.

• An analysis of recently completed similar buildings in the district

show this to be a suitable rate for the provision of shops and offices
with good quality finishes and including allowance for increased
costs, as it is within 1.5 per cent of the mean updated price.
 Example 4
Residual Approach

Inputs - offices
Gross area of offices (square metres) 1,000
Gross/net ratio for offices (%) 90
Rent for offices (per square metre) 475
All risk yield - offices (%) 6.5
Cost of finance (%) 12
Interest rate (per qtr) 3
Costruction cost (per square metre) 1,750
Construction period (months) 18
Void period (months) 6
Land value 2,500,000
Costs of land purchase (%) 7.5%
Professional Fees (11%)
Architect (of costs) 6.00%
Engineers (of costs) 2.00%
Quantity Surveyors (of costs) 3.00%

Agents (Sales/Letting; of GDV) 3.00%

Thank You.