Preliminary Financial Appraisal for Real Estate Development Opportunity

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.

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.

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.   

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

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

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.

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.  

Task

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.

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.