Know in advance if your project is viable with a development appraisal

Know in advance if your project is viable with a development appraisal Residential Developments

Development appraisals are used to assess the viability of a proposed construction project. They are, in essence, an objective financial viability test used to evaluate how profitable, if at all, a small and medium-sized building project could be.

RICS define the key outcomes in a positive development appraisal as the project covers its development costs, meets required planning obligations, pays the landowner an appropriate site value and delivers the developer a market-risk adjusted return.

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Who uses development appraisals and why?

Development appraisals are important to stakeholders for a variety of reasons including:

  • Property developers: to assess how viable a proposed project is and whether it’s worth pursuing.
  • Investors and lenders: to calculate potential levels of return and balance those returns against project risk.
  • Local authorities: to judge where a proposed development is consistent with local planning policies and whether the completed scheme will be a positive contribution to the local community and local businesses.
  • Landowners: to assess the potential of their site. 

Why some landowners use development appraisals

Some property investors (landowners) only ever trade land. They have no intention of building on the land they buy and own at any point.

Instead, these investors use appraisals to evaluate a site’s commercial viability and calculate potential returns (by subtracting expected costs from anticipated income) across a number of different development scenarios and options. 

Appraisal results allow landowners to negotiate the best price when buying or selling a particular area of land. For example, an investor may decide to buy land if there is a significant enough uplift in the price of the land if planning approval is granted. Once they receive approval, they sell the land at a higher price.

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What do architects contribute to development appraisals?

There are many different stages during an appraisal at which an architect gets involved, specifically:

  • Design feasibility study: This is the initial design addressing both the client brief and the constraints of a proposed site for a development property. At this point, the architect helps the client explore different options in areas like massing (like a 3D overview of a project), layout and materials used. This helps in determining initial potential costs and value.
  • Planning survey: This is an overview of the project from the perspective of obtaining planning permission and meeting Building Regulations. By factoring in known local authority preferences, for example, this can reduce uncertainty surrounding the project.
  • Scheme feasibility: This involves comparing alternative design and spec options for a project to help estimate the costs of construction and likely timescale needed for project completion.
  • Value engineering: In value engineering, architects work with clients to review and optimise project design and specs to reduce construction costs and increase value without affecting building functionality or quality.

Key inputs for a development appraisal

There are several key inputs a developer needs to consider when appraising a new site and determining its financial viability. They are financial metrics like gross development value (GDV), profit on cost (POC), internal rate of return (IRR) and net present value (NPV).

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Land costs

In addition to acquiring the site, you should factor in costs related to site conditions, zoning regulations and location. You need to base these cost estimates on recent sales data, market research and gathering contractor estimates.

Build costs

Make sure you go through the value engineering phase of your appraisal with your architect to bring down overall build costs as much as possible. Then obtain quotes from construction companies based on local market conditions and your project’s unique specifications. You also need to factor in costs like equipment rental, materials, project management costs, and so on. Few projects meet budget or time targets so you should add in spare for unexpected expenses and project overruns.

Sales prices

Whether you’re selling individual units or lots, the sale prices you aim to achieve should be based on recent sales data, market research and aligned with local buyers’ expectations of market value.

Rental income

As with sales prices, your rental expectations should be close to what local individuals (or businesses if your project is commercial) feel is reasonable. In your appraisal, try to account for vacant periods and, for commercial projects, rent concessions.

Finance costs

Important to the viability of many projects are financing costs like professional fees, broker fees, interest rates and closing charges. There is healthy competition among lenders and brokers for development projects however inexperienced developers should expect to pay more.

Know in advance if your project is viable with a development appraisal

Development project sensitivity analysis techniques

As mentioned early, projects rarely run to budget or time, even the best-planned projects. If you are successful in time and budget targets, building in sensitivity to your appraisals will mean you achieve a better return.

Four common sensitivity analysis techniques to factor in uncertainty related to a development project are:

  • One-way sensitivity analysis: examining the effect on viability with a significant change to one variable (for example, a 10% undershoot or overshoot in construction costs from the plan).
  • Two-way sensitivity analysis: as one-way but with two impacts. This would allow you to see what would happen if, compared to what’s in your plan, construction costs overshot by 10% but sale/rental prices were 10% less.
  • Scenario analysis: this involves running multiple tests designed to reflect a spread of optimistic and pessimistic market conditions by adjusting different factors in your plan.
  • Monte Carlo simulation: a scenario analysis in extremis where hundreds of different outcomes are played out based on probability distributions for financing costs, rental income, sales prices, build costs, land costs and so on.

Best practices when conducting development appraisals

In addition to conducting a sensitivity analysis, developers should undertake the following four steps to ensure they manage risk effectively and make the right decisions are:

Use market research-based inputs

The inputs you use in your development appraisal should reflect current pricing signals on finance, land, construction and sales/rental levels. This gives you a much greater understanding of the financial viability of a project and whether this is a wise allocation of your resources.

Surround yourself with professionals

You should consult regularly with architects, solicitors, estate agents, surveyors and engineers from the outset of your development appraisal. Having a holistic view allows you to see issues or risks much earlier in the process and account for them.

Be transparent with stakeholders on risks

With lenders, clients who pay you pre-completion deposits and local authority officials, you should be transparent about all the risks associated with your project. Expect to receive tough questioning on the variables and assumptions you’re basing your forecasts on. By being available to speak to and clear in your responses, you build up trust with all stakeholders who will show you greater patience and understanding on time and budget overruns.

Consider social and environmental factors

Sustainability and community impacts greatly influence local planning officials on development projects. You may have to revise your plans a number of times during the development appraisal stage to meet their expectations. But, by preparing for this, you mitigate the risk that any future changes imposed on your plans severely impact the profitability of your project.

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