Development Appraisal: A Guide to Assess Real Estate Viability

Development appraisal is the process of evaluating the viability and profitability of potential real estate development projects. It involves analysing the costs and revenues associated with a proposed development to determine whether it will likely provide an adequate return on investment.

Purpose of Development Appraisals

Development appraisals serve several key purposes:

• To assess the financial feasibility of potential development projects
• To inform investment and development decisions
• To establish a budget and set measurable objectives
• To identify risks and make provisions to mitigate them
• To attract financing and investment
• To meet statutory requirements such as planning permission

Performing thorough appraisals ensures that only viable and profitable developments proceed. It prevents wasted time, effort and capital on unfeasible projects.

Stages in the Development Appraisal Process

The development appraisal process typically involves the following key stages:

Market Analysis

• Research market conditions, demand and competition
• Identify target market and ideal property uses
• Establish achievable values or rents

Site Analysis

• Assess site characteristics, constraints and opportunities
• Check planning policies and the likelihood of obtaining permission
• Consider access, infrastructure and ground conditions

Scheme Design

• Formulate a development concept and design
• Calculate areas and specify building attributes
• Estimate construction costs

Financial Appraisal

• Forecast all development costs
• Project revenues from sales or lettings
• Calculate performance measures such as profit, ROI, IRR

Risk Assessment

• Identify development risks
• Quantify the impact of risks
• Develop risk mitigation strategies

The appraisal may need to be revised and refined at each stage as more information comes to light. The process is iterative, with constant feedback between each step.

Sources of Information for Appraisals

Development appraisals require extensive amounts of data from diverse sources:

• Market research – rental values, sales prices, yields, demand
• Planning policies – local plans, emerging policies, constraints
• Site investigations – surveys, tests, environmental reports
• Cost consultants – cost plans, life cycle costs
• Valuers – land values, property values
• Engineers – servicing, infrastructure
• Architects – drawings, areas, specifications
• Authorities – taxes, charges, contributions
• Finance – interest rates, lending criteria

Reliable, up-to-date information is essential to produce realistic appraisals. Engaging suitable professional consultants ensures access to expert knowledge.

Key Appraisal Calculations

Several key figures need to be forecasted and calculated during development appraisals:

Development Value

• Also called gross development value (GDV)
• Total capital value of the completed development
• Based on projected rents or sales prices

Development Costs

• Land acquisition, with taxes and fees
• Construction costs
• Professional fees for services
• Financing costs
• Marketing and sales costs
• Developer’s profit margin

Development Profit  

• Development value minus development costs
• Profit amount before tax

Performance Measures

• Profit on cost ratio
• Return on capital/equity  
• Internal rate of return (IRR)
• Net present value (NPV)

These indicate commercial viability and guide investment decisions. Target thresholds need to be achieved.

Accounting for Risk and Uncertainty

Development appraisals involve forecasting many factors well into the future. There are inherent risks stemming from market fluctuations, cost escalations, programme delays, changing policies and other uncertainties.

Prudent appraisals build in safety margins and contingencies to cater for downside risks. Common approaches include:

• Sensitivity analysis – assess the impact of changing key variables
• Scenario analysis – model best and worst-case outcomes
• Monte Carlo simulation – use probability distributions for variables
• Apply contingency allowances – on costs and revenues
• Increase return requirements – higher target IRRs and profits
• Phase developments – reduce scale and exposure  

Adopting combinations of these strategies helps to evaluate risk impacts and maintain viable proposals.

Uses of Development Appraisals

Development appraisals have many important applications throughout the property development process:

Land Acquisition

• Calculate the maximum price that can be afforded for site purchase.

Planning Applications

• Demonstrate financial viability to gain permission
• Provide evidence for density, massing, heights  

Construction Funding

• Raise development finance based on appraisal figures
• Agree stage payments and drawdowns

Sales and Lettings

• Set appropriate asking prices or rents
• Phase sales or lettings schedule

Decision Making

• Decide whether to proceed at each stage
• Evaluate alternative schemes and mixes
• Assess impact of design changes  

Updated appraisals enable informed decisions at every step. They are vital strategic tools for developers and investors.

Valuation Methods in Appraisals

Various valuation methods can be used to produce property and land valuations for inclusion in development appraisals:

Comparative Method

• Analyse sales prices achieved for similar properties
• Make adjustments for differences in factors like location and condition
• Suitable for residential valuations with plenty of market evidence

Investment Method

• Value based on capitalising net rental income at a suitable yield
• Used for income-producing commercial property
• Yield reflects rates of return on alternative investments

Residual Method

• Estimate completed development value
• Deduct all development costs
• Residual value equates to underlying site value

Contractor’s Method

• Calculate cost to rebuild in current prices
• Used for specialised properties lacking market evidence
• Must deduct depreciation due to age and obsolescence

Profits Method

• Value-based on capitalised maintainable profits
• Applies to trading properties like hotels and leisure  
• Deduct operating expenses to establish maintainable profit

The most suitable methodology depends on the property type, data availability and appraisal purpose.

Appraising Alternative Schemes

Appraising different development schemes for a site can help to determine the optimal option:

• Vary mixes of uses – office, retail, residential
• Change densities and site coverage
• Adjust building heights and massing
• Consider phased developments  

Testing alternative proposals may identify a scheme that maximises value and returns, within planning constraints.

Appraising options also facilitates sensitivity testing – assessing viability impact of changes in key appraisal variables.

Factors to appraise for alternate schemes include:

• Construction costs
• Programme and phasing
• Revenue potential
• Finance costs
• Risk profile
• Planning policy compliance

Comparing appraisals provides evidence to select the best approach, balancing returns, risk, timescales and compliance.

Presenting Appraisals

Development appraisals require comprehensive presentation formats to enable thorough evaluation by various stakeholders. Typical documents include:

Appraisal Summary

A concise summary of critical inputs, calculations and outcomes

Detailed Appraisal

A full working model with explanations and reasoning

Cash Flow Forecast

Year-by-year cash flow projection for the duration of development

Risk Analysis

Assessment of risk factors, impacts, probabilities and sensitivities

Design Statement

Explanation of design approach and compliance with planning policy

Marketing Report

Evidence supporting sales prices and rental values used

Well-presented, logically structured reports ensure transparency. They facilitate approval by investors, lenders and authorities.

Automation Tools

Specialist software tools and spreadsheets facilitate efficient appraisal preparation, sensitivity testing and data sharing:

• Integrated development appraisal systems
• Cashflow forecasting and risk analysis programs
• Advanced simulation and optimisation systems
• Custom appraisal templates
• Cloud-based collaboration platforms

Automation enables rapid preparation of multiple appraisals for different schemes, sites or scenarios. It also improves consistency and reliability.

Appraisal Updates

While initial appraisals are prepared during feasibility studies, they should be continually refined as projects progress to reflect the latest information:

Post-Planning Stage

– Update with planning authority requirements

– Recalculate with approved plans

Pre-Construction Stage

– Input contractor prices

– Confirm final agreements and detail

Change Monitoring

– Assess impact of variations and delays

– Track cash flow and expenditure

Pre-Sale / Pre-Letting

– Validate marketing valuations

– Set sale prices and rental levels

Project Close

– Record actual final outturn costs and revenues

– Identify lessons for future appraisals

Regularly updating appraisals enables effective budget management, decision making and accountability throughout the development lifecycle.

Conclusion

Comprehensive development appraisals are vital to establish viability, maximise returns and secure funding for real estate projects. They inform intelligent investment and planning decisions when undertaken rigorously. Adopting best practices for appraising alternative schemes, addressing uncertainties, presenting information and utilising automation can further enhance the value of development appraisals. Expert input from relevant consultants ensures appraisals reflect precise project parameters and up-to-date information. As critical decision-making tools, development appraisals need to be at the core of every successful property development.