Could you please explain in greater detail how a DCF appraisal would be undertaken to establish the value of a site for a new residential estate?
As with any appraisal exercise a number of important preliminary investigations need to be completed before one can begin to consider financial implications. These considerations include the assessment by the appraiser of the highest and best use for the underdeveloped site. Frequently this will involve discussions with the local planning authority to ascertain the most probable density and mix of development for which planning consent might be granted. But it also involves the entrepreneurial skills of the developer and/or appraisal team, as obviously market forces as well as planning hopes will dictate the best and most sensible (profitable) scheme for development.
Linked with these investigations are those that help to establish development costs. The site must be inspected to discover all physical and legal impediments to development. Questions need to be asked and answers found to a variety of issues ranging from the nature of the subsoil to rights of way; from highway access to the position of existing underground and overhead cables, pipes, etc; from the availability and capacity of existing mains services to the protection of trees and rare plant species. The list is almost endless but the investigations need to be as thorough as possible to avoid unscheduled delays in the construction process once the site has been acquired. Although such delays will be post the acquisition, the possibility of there being delays must be built into the appraisal if the developer is to acquire the site at a price that will provide profit at a level commensurate with the risks involved.
At this initial stage of the appraisal exercise the appraiser should be able to determine a “best estimate” of all the costs and benefits of the scheme at current price levels. It should also be possible to judge the phasing of the development in terms of the likely market take-up for new homes in that locality and the related best phasing of construction to meet that demand, having regard to any (and all) site, servicing, labour and construction issues.
Subsequently a view may be taken and figures amended if, over the projected development period, it is felt that either costs or benefits are likely to change owing to real or inflationary price movements. The extent to which a particular developer is prepared to do this is debatable. In fact, at the present time, in the London area it would seem that site owners can ask almost any price for residential land and that perhaps in the short run the whole concept of residual values has been reversed — the equation now reading:
Site acquisition + construction costs + profit = gross development value
and
Gross development value number of units = price to be charged per unit
With house prices in some parts of London reported to be rising by about £50 per day, one can appreciate why some developers are willing to take a gamble — surely not a calculated risk — on the house price spiral continuing.
Fortunately, for the student taking professional examinations, most of the main decisions relating to development appraisal have already been taken. All the examiner looks for is evidence that, on the basis of stated assumptions, the candidate is capable of handling a DCF calculation.
Diane Butler in Applied Valuation(*) includes a typical problem which has been amended here in order to demonstrate how a site value can be assessed using a DCF approach. However, as with any development appraisal, the technique can be used to derive any one of the major variables, provided a best estimate can be made of the others. Thus the method can be used to assess site value or, given site value, to assess developer’s profit or the minimum sale price needed to achieve profit, or the maximum sum available for construction given all the other variables.
Example
A site with outline consent for 110 bungalows is to be offered for sale by tender. It is estimated that it will take one year to complete the whole scheme and that 30 units would be sold after six months, 50 more after nine months and the last 30 after 12 months.
The following assumptions have been made:
Acquisition costs of the land to be taken at 4% on purchase price;
Gross area of each bungalow to be 82m2; QS and architect’s fees to be taken at 10% of building cost with 60% payable on commencement and 40% upon completion;
Estate agency and legal fees etc to be taken as 4% of sale price;
Financing costs to be at 1% per month;
Sale price per bungalow to be £35,000;
Developer’s profit of £500,000 to be taken out by the developer.
Calculate, using a month-by-month DCF the maximum price Rapidbuild plc can offer.
Certain initial calculations are necessary to provide the data for the DCF solution:
The DCF monthly calculation on these assumptions are set out in table 1 (p 640).
From this it is possible to calculate the maximum tender price that Rapidbuild can afford to submit with the tender document.
Totalling the monthly figures, having due regard to the plus and minus signs, produces a figure of £1,049,506. This represents profit of £500,000, purchase price and acquisition costs thus:
Thus offering in the region of £525,000 would produce the desired level of profit on the assumptions made. But not necessarily success in the tender as, clearly, a more optimistic developer would be able to offer a higher price. These figures are illustrative and must be assumed to include every cost item including contingencies that every respectable developer would normally allow for on an item-by-item basis. Additionally, the assumptions of timing are gross simplifications of the house-building process in the real world.
Many trainee surveyors find it difficult to appreciate that in a DCF exercise such as this there is no need to add on the interest charges before discounting. For example, why, if £135,000 is to be paid out immediately, is there no apparent provision for interest at 1% per month for 12 months? The more astute will, however, see immediately that if interest were to be added the expenditure in period 0 would be moved forward to period 12 compounded at 1% per month, only to be brought back to period 0 by discounting at 1% per month. It is simple to demonstrate that the DCF exercise as set out fully reflects the nature and incidence of interest charges at 1% per month by testing the residual result by accounting forward from period 0 to period 12 — see Table 2.
Acquiring at a figure of £528,371 produces after-interest charges (note sign changes in Table 2) both for interest payable and interest receivable is £564,154. The profit allowed for was for a present sum of £500,000 and therefore a future sum of £564,154 represents the result after allowing for interest at 1% per month.
£500,000 X (1 + 0.01)12 = say £564,000
As with any set of calculations, the results are totally dependent on the inputs. Therefore clear thinking is needed if a DCF calculation is to produce meaningful results. Thus it would have been possible to have expressed profit as a return on cost or as a percentage of sale price or to have taken or allowed for £500,000 in period 12. The timing and the amounts will influence the final conclusion.
Consider for a moment the change in profit to the developer if, having purchased at £525,000, he succeeded in selling 20 units in months 2, 4, 6, 8 and 10 and the last 10 in month 12. Naturally, altering the variables this way and testing to see the effect on the results is very much simpler if the basic tabulation is set up in the form of a spreadsheet calculation. If in fact the figure for profit of £500,000 had been taken out in period 12 then the developer’s bid could have gone up to £582,505.
It is argued that DCF is a better technique for the appraisal of development sites than the traditional residual. In particular for large residential schemes where (as here) cash inflows can at times exceed accumulative cash outflows. This allows the developer effectively to deposit money. A residual cannot allow for this factor, a DCF can in fact allow for differences in interest between that payable and that receivable.
The ever-improving standards of project management which have led to ever-faster construction schedules must mean that if valuers are to retain their position in the development team they will have to bring their appraisal techniques into line with the tight schedules and cash-flow controls exercised by the project managers. It seems increasingly naive of the valuer to set his textbook residual next to the “fast track” network produced by the quantity surveyor or project manager. Naturally, there remains a place for the quick initial residual calculation to support the developer’s “hunch” or “feel” for a good prospect. But after that the valuer needs to demonstrate a far higher appreciation of the construction process and his or her own ability to handle far more complex cash flows than illustrated here if he is to provide a service other than that of estimating rentals and resale values.
(*) Applied Valuations by Diane Butler, 1987 (Macmillan Education)
