The valuation of residential development sites is possibly one of the most logical valuation exercises that we can contemplate. However, for those active in this market, initial analysis and valuation will often be based on direct comparison rather than on the theoretically sound cash-flow analysis. But at later stages in negotiations initial approximations will be checked against results obtained from cash-flow models. Once a scheme is under way the discounting process of valuation is replaced by cash-flow accounting so that targets can be monitored and maintained — without this development control, profit margins would be eroded. This accounting process perfectly illustrates the valuation exercise needed at the preliminary appraisal stage. For example, let us assume that a local builder has purchased a small in fill site for one house in an established residential location at a cost of £25,000. The final account for this development might appear as set out in Table 1.
The figures in Table 1 are illustrative and represent an approximate summary of a builder’s accounts: in the real world the labour charges, material invoices, VAT statements etc would be far more complex. Indeed the payment of many amounts would be deferred several months and the whole picture complicated by the builder’s other contracting activities which might take his labour offsite for days or weeks. Nevertheless the figures help to emphasise several points.
First is the importance of allowing for interest charges. Whether a builder uses his own money or borrows all the money, an allowance must be made for interest payable or notional interest lost if an accurate picture is to be found of the cost of building a house. The interest column illustrates how these costs rise over the construction period to be a significant element, and again assist in understanding the need for “creative accounting”. Thus a shrewd builder should be weighing the discounts for prompt cash payments against the increased interest payable on money used for such payments for, say, four to eight weeks ahead of final demands.
Here the total charge to interest is approaching £5,000, and represents some 7.5% of the costs. It also illustrates the need to defer site purchase until all the preliminaries are completed. If site purchase can be deferred until detailed consent is obtained then the date of purchase can become the date of commencement of construction. The amounts here are small, but they can be very significant on a major central area scheme. Thus as far as possible developers will transfer this burden on to the existing landowner.
Second, delays during the construction period are costly. Most can now be avoided through sound project management: some, however, can not, such as the discovery of mass burials or other archaeological matters.
Third, it illustrates a golden rule which is “sell to build” not “build to sell”. Speculative development is risky but some risk elements can be reduced to acceptable levels: one such is associated with finding a buyer (or in commercial developments the tenant). A careful balance has to be struck between achieving a sale too soon at current prices against the cost of a delay beyond completion but achieving a future inflated price. At this scale builders still tend to put the property on the market too close to practical completion — they build to sell — it can take several months for the buyer to complete and such delays after the bargain has been made will be costly for the builder.
Finally one can see why the Lands Tribunal and others are so keen to criticise development appraisals and how keen the media is to criticise the level of development profits. Here the builder has taken a calculated risk and has achieved a profit of 9.71% over and above his allowances for overheads etc. If, however, he had based his bid on an expected sale of £75,000 and found that over the 10-month construction period prices had risen by 10% his profit would have risen to say £16,500 to show a return on costs of 25%. This is completely outside the builder’s control as it is a function of the housing market. If, on the other hand, he failed to achieve a sale at £75,000 and after a three-month delay had to accept a sale at £72,500 his margins for profit would be similarly eroded. The latter can and has happened but in periods of inflationary house prices the media soon forget.
The market in the south of England is now so competitive that a part of the inflation in house prices has to be reflected in the site bids. In addition, owners of the larger residential sites now expect to participate in the equity of the large schemes by gearing the price of the sites to the sale price of the houses — for example a site might be sold on the basis that the landowner will receive a nominal initial sum plus 35% of the final sale price of each unit sold. In this way part of the developer’s unexpected super profit will be shared with the landowner.
Residential site valuation is the contractor’s account in reverse as the object of the exercise is to assess a sensible bid price for the site — see Table 2.
In Table 1 interest at 1% per month was added. Alternatively, each month’s total could have been multiplied by 1 + i, here by 1 + 0.01, that is by 1.01. So in Table 2 to allow for this element the cash flow needs to be discounted back month by month by dividing by 1.01.
These two tables demonstrate the simple difference between accounting over time and discounting over time. At this level of the residential land market most competent builders can go direct to plot value by comparison or by the simple process of deducting an estimate of construction from the expected sale price, such as £75,000 less £50,000 equals £25,000 for the site. In the case of larger sites it becomes more complicated as one must allow for the phasing of the scheme and for the complex flows of moneys in and out. A full cash flow analysis is in effect Table 2 accumulated on a timescale 10, 20 or 100 times according to the size of the development. In some cases it will be useful to repeat the exercise (a) to check for the sensitivity of any of the variables and (b) to incorporate estimated inflation in house prices and building costs.
The two tables help to illustrate the nature of the market for single plots and some of the strange prices paid in the market by potential owner-occupiers. Single plots tend to attract the small local builder and the owner-occupier keen to build a home to an architect’s interpretation of their own design. The larger builder may not be able to compete because of larger overheads. However, at an increased density it is the small builder who cannot compete because of their inability to reap the economics of scale enjoyed by the national housebuilders. The apparently high prices paid by the future owner-occupier can be explained in part by a lack of understanding and an element of DIY. The owner-occupier will rarely reflect interest charges in his or her calculations and will forget to allow for a profit-margin.
Fortunately for many, inflation in house prices provides a sufficient margin at the end for the mortgage valuation to support the decision to build and to provide the necessary long-term funds to repay short-term borrowings plus interest. In addition the owner-occupier has a tendency to account differently to a builder and ignores the cost of his or her own labour when undertaking the non-contracted works. Finally, as the owner-occupier tends to sub-contract most of the construction work, he or she will avoid some of the overheads that a builder has to include. The result is that at auctions individuals may carry on bidding after the local builder has withdrawn. The local builder relies more on his knowledge of the area and site finding skills to maintain a flow of small sites outside the auction room.
Crucial to all residential site valuation work is the skill of the appraiser in assessing demand, the level of demand, the highest and best use for a site and the price people will pay for completed units. Without this skill there would be insufficient accurate information to complete the appraisal; thus, as always, experience and the valuer’s art has to blend with the science of valuation to produce supportable opinions of worth.