RE3DAF Development Appraisal and Finance: London Metropolitan Projects

Question:

What is the purpose of this assessment?

The following table shows which of the module learning outcomes are being assessed in this assignment. Use this table to help you see the connection between this assessment and your learning on the module.

Module Learning Outcomes Being Assessed

At the end of the project, students are expected to be able to:

  • investigate and understand the range of inputs into a development appraisal;
  • apply discounted cash flow techniques to the financial analysis of development opportunities;
  • understand the outputs of development appraisal models;
  • incorporate different financing arrangements in development financial feasibility models; and evaluate risk and uncertainty in development projects.

Task

You are employed by a real estate development company who typically focus residential development projects in the London metropolitan area.  There are a team of five in total in the company.  Typically, the company complete one scheme per annum.  At any one time, they can have 2-3 schemes under construction/being marketed, another 2-3 schemes being acquired or at the mobilisation stage and 10-15 potential projects where detailed feasibility analysis is underway before potential bidding/negotiation.   

Target rate of return

Depending on the riskiness of the project, they have a target IRR of 10%-20% per annum before gearing. The bottom of the IRR range reflects the required return for accepting the broad systematic risks associated with undertaking real estate development in the current and expected macro-economic environment.  Estimation of an appropriate target rate of return should reflect the level of specific risk associated with the project e.g., planning risk, complexity of construction, geotechnical risks, flexibility (to phase, pause, amend etc. the scheme), quality of location, potential oversupply in the locality etc. that will not affect similar developments in London.  Given that the scheme has a planning consent, is not a complex build and there a no major developments expected within the submarket, this is expected to be a low-medium risk development.  There are concerns about geo-technical risks associated with the plasticity of the clay, potential asbestos and other contamination from historic uses. A target rate of return of 13% per annum has been recommended for the project.  

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 residential sales: 2% of sale price. 

Contingency: 5% of construction costs

Land acquisition: 

If the bid is accepted, it is expected that the land will be acquired on 1 April 2022. 

Planning obligations:

Note that details of s106 costs are provided in the agent’s brochure. details of CIL (Mayoral and borough) need some calculation.  There is a CIL form and CIL is discussed in the Planning Statement.

Affordable housing:

It is estimated that social rented and intermediate tenures will sell at discounts of 25% of Market Value and 60% of Market Value respectively.  To be clear, if a one-bedroom social rented flat has an estimated Market Value of £6,000 psm, it is expected that it will be sold to a registered provider for £1,500 psm.  

Disposal costs for affordable housing are expected to be £1,000 per unit.   

Under a ‘Golden Brick’ agreement, it is expected that 25% of the revenues from affordable housing will be received at commencement of construction, 25% will be received six months after commencement of construction and the remaining 50% will be received at Practical Completion.

Office values

The firm have recently bid for a site with planning consent for offices in the same submarket.  The research carried out suggests that a yield for new space let to a reasonable covenant would be 5%.  It was estimated that a rent of £300 psm would be achievable with a rent-free period of 18 months.  Leasing costs are estimated at 10% of the Market Rent.

Having obtained a new planning consent for the site at 6 Lansdowne Hill, 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 Lambeth’s planning portal. The reference number is 19/02840/FUL. You’ll get some sense here of the work and cost involved in submitting a planning application.  You have also been provided with the sales brochure for the site.  

The sales brochure contains the clearest information that I’ve seen on the sellable area of the proposed scheme. It can be frustrating that there are usually inconsistencies between various documents. Whilst it is common for a valuation to be done for each individual unit reflecting differences in view, perspective, location within the building etc., it is also common to apply a blended rate or blended rates per square metre. It is not required that each individual unit is valued in this assignment.  You should estimate a blended rate. There may be different estimates of blended rates for one-bedroom, two-bedroom etc. units.

A blended rate represents an estimate of the (weighted) average price that the units would be expected to sell at. Given the difficulties of identifying all the differences between comparables and the subject property and how to work out how all these differences (in location, quality, view, ground rent, unexpired lease term, specification, condition, facilities etc.) affect prices, valuers tend to rely on a mix of qualitative judgement and quantitative analysis to make an estimate of a blended rate.      

You have been asked by the MD to produce a report providing a preliminary financial appraisal of the development opportunity and evaluating the risks of the proposed development.  They would like to see

  • A justification of the key inputsused in the development appraisal. There is generally no need to justify or repeat any information provided in this brief. An exception here is the introduction to the report where the purpose of the report needs to be outlined.
  • A project-level unlevered discounted cash flow appraisal of the development opportunity to estimate an appropriate bid for the site. Estimates of the key performance metrics (IRR, cash profit, profit on cost %, profit on GDV% and equity multiple) are required.

Assuming that the estimated land bid is paid, estimate of IRR, cash profit (but not profit margin %), equity multiple, LTV and LTC ratios (with associated cash flows) for the development opportunity based on the gearing scenario below.

Levered Scenario – Approximately 50% of the developer’s equity required in the project-level cash flow is financed by a senior loan. It is expected that the developer’s equity will finance land acquisition with any remaining funds being used to finance non-land development costs before drawdown of the senior loan commences.  When the project begins to generate a cash surplus after completion, the senior lender will have first priority on funds returned. This is an equity first loan.  It is expected that the interest rate for the senior loan will be 6% per annum.  An arrangement fee of 1% of the loan principal is payable upon first drawdown.  An exit fee of 1% of loan principal is payable upon final repayment. There is a monitoring fee of £20,000 fee per quarter with payments beginning at first drawdown and stopping at repayment.  Legal fees for arranging the loan are expected to be 1% of the loan principal payable at first drawdown. The loan fees will be paid for by the developer as part of the equity investment.

Promote Scenario – The developer is also considering acting as a promoter and partnering with an investor. The key terms of a promotion agreement are expected to be: 

  • The Promoter (Developer) will invest 10% of required equity assuming that the senior loan has been secured. For example, if required equity after senior loan is £15 million, the promoter will invest £1.5 million and receive 10% of the shares in a Special Purpose Vehicle created to execute the project. 
  • The Investor will invest 90% of equity required and receive 90% of shares in the Special Purpose Vehicle created to execute the project.   
  • Unless all equity investment is required to purchase the site, the Promoter and Investor will not contribute all their funds at the beginning of the development. The Promoter and Investor will inject their equity contributions side-by-side with their funds being contributed as needed during the project.  
  • Shareholders will receive a preferred return of 10% IRR per annum generated by the levered project. 
  • Promoter will receive a promote payment of 25% of any* cash surplus above 10% preferred return generated by the levered project.   
  • All remaining funds to be distributed to shareholders in accordance with shareholdings.  
  • A development management fee is payable to the promoter.  However, you should assume that this fee covers the promoter’s costs of managing the development. Since the fee and costs are expected to broadly cancel each other out, they do not need to be included in the cash flow.

* It is possible that your model may not generate a financial surplus above the preferred return. If this occurs, you should still estimate the IRR, cash profit and the equity multiple generated for both the Promoter and the Investor. Please do not discuss the details of the terms of the senior loan or the promotion agreement in the report.   

To be clear, the report should include five cash flow models

  1. DCF model to estimate land value
  2. Unlevered project cash flow
  3. Levered cash flow
  4. Investor’s cash flow
  5. Promoter’s cash flow.

However, there is no need to replicate individual elements of the costs and revenues (construction costs, professional fees etc) cash flows five times. This is only required for the DCF model to estimate land value.  

Finally, (sorry if this sounds repetitive), you should provide financial performance metrics (IRR, cash profit and equity multiple) for the cash flow models 2, 3, 4 and 5.  Model 2 also needs to provide profit on cost% and profit on GDV%. Model 3 needs to provide LTV and LTC ratios.

What is required of me in this assessment?

Guidelines/Details of How to Prepare Your Submission

Please comply with the guidance provided here on how to structure your report.  

 

The assessment criteria to be used for marking this piece of work

See ‘Marking Rubric’ below.

Self-Regulation: Make sure That You…

See Appendix A. Please include this checklist at the beginning of your report after the contents page.

Three Key Pieces of Advice Based on the Feedback Given to the Previous Cohort who Completed This Assignment

Brief

It is surprisingly common how often students do not comply with the brief.  It’s unusual – but it happens – for them to fail to do things that they were asked to do.  It’s more usual for them to include materials in the assignment that they were asked NOT to include.

 

Evidence

A common problem is inadequate discussion and weighing up of evidence, particularly relating to rental and sales values. It is generally not sufficient to simply list the comparable evidence you have used to arrive at your adopted values.  It is not always possible to get all the information that you would like (view, condition, design, specification, remaining lease term, service charge, ground rent etc.) 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. You can get my take on it here –  Incomparable valuation – GetRealPat (wordpress.com).  This has a link to RICS guidance on analysing comparables.

 

Audience

You should provide a professional report 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.  Often, there is a tendency to focus on the process – comparables were gather from…Focus on the evidence not the process.

 

It is normally not appropriate to include materials from textbooks and/or academic papers in this type of report.

 

Formatting Guidelines

The report should NOT include:

o A description of the proposed project

o 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.

o A description of the techniques or methods used to appraise the project.

o A description of the developer’ position and objectives.

o Definitions of the inputs

o A description of the terms of the loan or the promotion agreement.

o A recommendation of whether to acquire the site.  

 

Some guidance on structure

There’s quite a lot of tasks, information required etc.in this assignment.   Here is some guidance on how we think you could allocate the 1500 words limit.  

After a title page, contents page, QA sheet and executive summary, the following structure is suggested.

1. Introduction: Approximately 100-150 words

2. Justification of residential revenue estimates (including forecasted price inflation if appropriate): Approximately 500 words

3. Justification of construction costs (including growth if appropriate): Approximately 150-200 words

4. Justification of other development cost assumptions: Approximately 200-300 words

(I’ve tried to cover most of the costs above.  However, I may have missed some.)  

5. Justification of development programme: Approximately 250 words

6. Conclusion/findings/recommendations: Approximately 150 words.  The conclusion should summarise the key findings of the cash flow models and risk analysis.

· Appendix 1 should contain the five discounted cash flow models

Other appendices (if appropriate) should follow.

 

Word Limit/Guidance and Penalty Applied

1,500 words in length (excluding title and contents page, executive summary, cash flows, appendices and bibliography).  This is a word limit and should not be exceeded. There is no margin (e.g. 10%) by which you can exceed this limit.

 

The University policy on word limits states:

 

“In the case of a mandatory word limit, a student should not benefit from submitting a piece of work which exceeds the specified length: a marker should not be obliged to read beyond the word limit and a

mark based on the work up to the word limit should normally be awarded.”

 

Referencing Style

Not specified.  Since we are simulating a professional report, compliance with academic norms is not required in terms of the format of referencing.  You should of course indicate the provenance of figures and information.  It just does not have to be in a particular format.  See guidance on academic misconduct below.

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