Session 2: The role of viability in plan-making and development management

2. Session 2: The role of viability in plan-making and development management

3. A Development Viability Appraisal Costs Income Cash flow

4. Key Inputs - GDV Gross development value (GDV) • The income from the development • Sale of product • Subsidy and grant. • Expressed as £/m2 • Set by the market and largely beyond the control of LPA or developer

5. Residential vs. commercial

6. What is the ‘yield’? • The rent as a proportion of the purchase price • There is an inverse relationship between yields & values, i.e. a higher yield means a lower value & a lower yield means a higher value. • Yields are often used in development appraisals to estimate the value of the completed development when it is expected to be rented to a tenant (or tenants). This consequently usually applies to commercial property, although it can apply to residential property where it is also rented.

7. Yield example • Offices are normally bought by investors such as pension funds. Let us assume a pension fund wants to buy an office when it is fully occupied by a tenant(s)… • The developer should have a firm idea of what rent the building is likely to achieve e.g. £100,000pa. • In basic development appraisals, the initial rent is therefore used to help estimate the development value. The key question is therefore how much should this rent should be multiplied by to calculate what price a purchaser will pay.

8. Yield example (continued…) • The “multiplier” is calculated as 1 / yield. Therefore: Development Value = Initial Rent x (1 / Yield) x 100 • Let’s assume the pension fund requires a return of 6% pa. Therefore the value of the rented office building as an investment is calculated as follows: £100,000 x (1 / 6) x 100 = £1.6m

9. Yield example (continued…) • The previous scenario did not include assumptions on future rent or prospects for capital growth of the asset i.e. it assumed the pension fund would receive a flat £100,000 pa in perpetuity. • Let us now assume the office is in a good location with a good tenant and good prospects for rental growth e.g. up and coming area, office market looking healthy locally etc. With this information the pension fund is likely to accept a lower initial yield e.g. 5%: £100,000 x (1 / 5) x 100 = £2m

10. Yield example (continued…) • Let us now assume the pension fund are less convinced that the rent will rise in the future and they are worried that the tenant found by the developer are unlikely to stay solvent or remain in the area long term. With this information the pension fund is likely to want a much higher yield e.g. 10%: £100,000 x (1 / 10) x 100 = £1m • These examples demonstrate the inverse relationship between yields & values. Clearly it would make no sense for the pension fund to pay over the odds for a riskier investment.

11. What affects yields? • Risk & future growth prospects (rental stream & capital value of property). High risk = high yield. But, the higher the future growth prospects = lower yield • Low risk = lower return e.g. savings in an ISA. In a casino you would be aiming for a higher 'yield' to compensate for the probability of failure • For the main investment classes Government Bonds (gilts) are low risk whereas stocks & shares are more high risk. Returns on property investment tend to be in the middle, offering more income & capital growth potential than gilts and less risk than shares

12. What affects property yields? • The tenant - Is it a strong tenant in terms of security of income (or rent)? Security is something you would normally expect to pay for, perhaps by accepting a lower initial return on your investment. • The area - Is the location suitable for a building of this quality? Is it declining or improving? Is the access good? • The building itself - What is it like? If the tenant goes bust, how easy will it be to find a new tenant? Do these and other lease clauses protect your investment e.g. upward only rent reviews etc.?

13. Rent to Value

14. Rents, Yield and Capital Value Development Value = Rent x (1 / Yield) x 100 Yield = (Rent / Value) x 100 Years Purchase (YP) = 1/Yield

15. Yield Exercise

16. Key Inputs - Cost of development • Construction Costs (BCIS) • Site Costs • LPA ‘discretionary’ costs e.g. CfSH, Affordable Housing, CIL, s106 etc. • Abnormal Costs e.g. Flood defences, Grouting, Demolition, Contamination etc. • Fees i.e. Architects, Planning, Engineers • Finance i.e. Interest, Fees, Legal and valuation • Sales i.e. Agents, Advertising • Contingency and Profit

17. Key Inputs - Profit • To reflect risk • Reward • Cost of Capital On GDV or on Cost?

18. Profit On GDV or on Cost? Two schemes, A and B, each with a GDV £1,000,000 A has a development cost of £750,000 B a lesser cost of say £500,000 All being equal in the schemes the developer stands to lose £750,000 in scheme A, but only £500,000 in B. A is therefore more risky, it follows that the developer will wish (and need) a higher return. By calculating profit (at 20%) on costs, the developer’s return in scheme A would be £150,000 and in scheme B would be £100,000 and so reflect the risk – whereas if calculated on GDV the profits would be £200,000 in both.

19. Profit On GDV or on Cost? Not trying to recreate a particular model. In fact risk and profit are more complicated. Profit Return on Capital Loan to value (LtV) of funding Contingency fund Development risk Bankers security / risk / confidence A pragmatic approach

20. Phasing and Developer’s Return • Why are developers obsessed with build rates and phasing? • Return on Capital employed…

21. Effect of phasing

22. Dead Romans found in foundations….

23. English Heritage get involved…

25. How much equity at risk and what is the return on that?

26. Internal Rate of Return – IRR The rate of interest (expressed as a percentage) at which all future cash flows (positive and negative) must be discounted in order that the net present value of those cash flows, including the initial investment, should be equal to zero. It is found by trial and error by applying present values at different rates of interest in turn to the net cash flow. It is sometimes called the discounted cash flow rate of return. In development financial viability appraisals the IRR is commonly, although not always, calculated on a without-finance basis as a total project IRR. (RICS Guidance)

27. Key Inputs – Land Value • The worth of the site • Alternative use value • When assessed – before planning starts • Hope value • Competitive Return (Relates back to the ‘big question’) A life changing event? – Not what they paid!

28. Harman v RICS Harman: We recommend that the Threshold Land Value is based on a premium over current use values and credible alternative use values. RICS: Threshold land value. A term developed by the Homes and Communities Agency (HCA) being essentially a land value at or above that which it is assumed a landowner would be prepared to sell. It is not a recognised valuation definition or approach.

29. Harman v RICS “It is somewhat misleading to describe this approach (EUV plus a margin) as totally arbitrary. The market value approach on the other hand, while offering certainty on the price paid for a development site, suffers from being based on prices agreed in an historic policy context…I don’t believe that the EUV approach can be accurately described as fundamentally flawed or that this examination should be adjourned to allow work based on the market approach to be done.” Report to The Mayor of London” Keith Holland BA (Hons) DipTP MRTPI ARICS (Jan 2012)

30. A Pragmatic Viability Test EUV Plus a premium – reality checked against market value. Will EUV Plus provide competitive returns? Land owner’s have expectations (life changing?) Will land come forward? PAS SUPPORT THIS APPROACH

31. Gross Development Value All income from a Scheme Construction Site Remediation Abnormals Etc. Fees Design Engineer Sales Etc. Profit Developers Builders Land Existing / Alternative Use Value + premium (TLV/EUV+) Policies/CIL CIL, affordable housing, CfSH, open space etc.

32. Overview of the HDH simple viability model

33. Using the model in practice The model used on this course is a basic residual method based on a residential scheme. In practice you will be faced with more complex scenarios such as: • Mixed use schemes incorporating commercial - therefore you’ll need to grasp what a ‘yield’ is. • Alternative or more complex viability models e.g. Internal Rate of Return (IRR) based models Valuation is a 3 year degree on its own, but you need to be able to interrogate the evidence provided to you.

34. Residual appraisal exercise 1

35. Context: Savills research • Looked at appeals data for major schemes in the past 2 years for 190 authorities across southern England • Proportion of major appeals relating to schemes of 10+ homes going against councils has risen. 72% cent of schemes allowed following inquiry (October - December 2012) • Average of 5.7 years land supply • 34% of LPAs in 20% buffer category

36. Bishops Cleeve, Tewkesbury, Gloucestershire 1,000 homes – SoS decision letter said that the most significant material consideration was the requirement for a five-year housing land supply, which he said could not be demonstrated against the plan. Compliance with objectively assessed housing needs is key. DCS Number 100-078-098

37. Burgess Farm, Salford 350 homes on a greenfield site was allowed by the SoS against the inspector's advice. Despite the permanent loss of an area of open countryside and the fact that the development would seriously degrade the character and appearance of the area. SoS considered that this was outweighed by the scheme's contribution to reducing the significant shortfall of some 4,000 homes (2.5 years supply) against the five year housing land requirement. DCS Number 100-078-099

38. Clay Farm, Cambridge - 07/0621/OUT The SoS agrees with the Inspector that the appellants’ approach to assessing viability has the effect of protecting historic land values as well as insulating the developer against a risk for which he is already indemnified by profit margins and that this would be at the expense of affordable housing levels. He therefore also agrees with the Inspector that the residual land value (RLV) approach used by the Council is the appropriate methodology for evaluating the economics of these developments…he is concerned that there is nowhere else to accommodate the affordable housing at the levels intended for these sites in the development plan. The SoS attaches very substantial weight to this matter and considers that it outweighs the shortfall in the Council's five year supply of developable sites.

39. Bristol: APP/P0119/A/08/2069226 • McCarthy & Stone – 29 sheltered apartments for the elderly including associated communal facilities and car parking. • A main issue at appeal was whether the proposal would make suitable provision for affordable housing. Policy seeks 33.3% affordable housing. On-site not suitable therefore parties agreed that an off-site contribution was acceptable subject to viability. • At the Inquiry appellant stated viability of the proposal would only allow a contribution of £115,000 which would fund only 1 or 2 affordable units, and is well below the target of 33.3%. The LPA were seeking circa £414k based on previous successful appeal decisions.

40. Bristol: APP/P0119/A/08/2069226 • Both parties conducted appraisals using the old Housing Corporation model. There were differences between the parties on BCIS construction costs, finance costs, contingency, developers profit, build rates and CfSH. Resulting in different residual values from LPA and appellant. • LPA argued that the appellant had inflated costs of the scheme. LPA used a comparable site from another appeal. Inspector placed little weight on this approach as that comparable scheme had not yet come forward. Further he felt the appellants assumptions were reasonable and evidenced. • “Any reservations that I may have about the balance of viability arguments are outweighed by what I consider are clear benefits of the proposal.” (due to lack of sheltered housing locally).

41. Beckenham: APP/G5180/A/08/2084559 • change of use of office building to residential and enlargement to comprise 55 dwellings including key worker and affordable housing. • Main issues – whether the proposed development meets development plan policies concerning the provision of affordable housing or a payment inlieu thereof and, whether there are any other material planning considerations relevant to the determination of the case.

42. Beckenham: APP/G5180/A/08/2084559 • At the Inquiry a SoCG was submitted agreeing a) the residual site value with no affordable housing (£2.773 million) b) the residual value with affordable housing (£1.9223 million) and c) the existing use value of the site (£2.482 million). These agreed values determine that without an affordable housing contribution, the scheme will only yield less than 12% above the existing use value, 8% below the generally accepted margin necessary to induce such development to proceed. Self-evidently, with a 35% AH target, such a scheme must also be, in the view of the appellant, considered non-viable.

43. Beckenham: APP/G5180/A/08/2084559 • The appellant maintains that the CUV is an ‘abnormal cost’ insofar as it is an intrinsic and unique component of the market value of the site, which they are bound to take into account when assessing the relative residual values of the site. • The Council maintain CUV cannot be deemed ‘abnormal’, and should not be accounted (notwithstanding their acceptance of the figure in the SoCG) in relation to viability.

44. Beckenham: APP/G5180/A/08/2084559 • It seems to me therefore that the CUV of the appeal site, as agreed in the SoCG, is a legitimate component of market value, and so an intrinsic and necessary component of the viability analysis. I conclude the CUV constitutes an abnormal cost in this specific case. Such a conclusion determines that when the agreed residual value of the site, incorporating 35% affordable housing is set against CUV, the development becomes unviable. Having carefully weighed the matter, I conclude the viability report convincingly demonstrates that the proposals cannot support any affordable housing; accordingly they are not in contravention of LBB and LP affordable housing policy.

45. Shinfield • APP/X0360/A/12/2179141 • Reading University • Wokingham Council • 8th January 2013

46. Site and scheme • 8.5 ha, 5 km south of Reading • Was National Institute for Research into Dairying (closed in 1980s) • 4.5 ha within development limits – with buildings etc • 4 ha beyond development limits – pasture • To clear site and build 126 new dwellings within development limits – remainder to be open space etc

47. History • Long history • 18,766m2 of B1 in 1992 • 2001 identified as being suitable for 80 dwellings by Local Plan inspector • 2003 part of site developed • The principle of development was not contested.

48. Main Issues ‘The main issues are: (i) whether the proposals make adequate provision for mitigating any adverse impact they would have upon local services and infrastructure; and (ii) whether the proposed amount of affordable housing would be appropriate in the context of the viability of the development, the National Planning Policy Framework, development plan policy and all other material planning considerations.’

49. The problem The Council wanted… The Developer offered… £2,312,569 in developer contributions 2% affordable housing • £2,028,920 in developer contributions • 40% affordable housing (policy says subject to viability) • Higher sales prices • Lower developers profit • Different Benchmark land value / site value

50. Developers Profit The appellants supported their calculations by providing letters and emails from six national housebuilders who set out their net profit margin targets for residential developments. The figures ranged from a minimum of 17% to 28%, with the usual target being in the range 20-25%. Those that differentiated between market and affordable housing in their correspondence did not set different profit margins. Due to the level and nature of the supporting evidence, I give great weight it. I conclude that the national housebuilders’ figures are to be preferred and that a figure of 20% of GDV, which is at the lower end of the range, is reasonable.