Profits or returns from development can be an emotive issue, made more contentious by a perceived lack of transparency, accusations of gaming in the planning viability system planning and – some would say – obscene bonus payments to housebuilders. Research carried out by the Department of Real Estate and Planning at the University of Reading for RICS has therefore examined the available information on developer returns.
Previous research has made significant criticisms of development appraisal methods and their application, and has highlighted issues with the metrics used for development profits and with the level or rate of profit adopted in appraisal models.
The two most common approaches to appraisal are the traditional residual model and the discounted cash-flow model, which adopt different measures for the developer's return. The former requires the cash margins relative to cost or value that are commonly quoted in the development sector, while periodic rates of return are necessary for the latter. Finance should be incorporated into a residual valuation as a crude representation of the time frame for the development; but it should never be combined with project revenues and costs in a cash flow model because the cost of capital is reflected in decisions about the discount rate.
Unfortunately, previous research has shown that some of these modelling intricacies are not always understood in professional practice; the RICS guidance note Valuation of development property published last autumn deals with some of these issues.
The research therefore explored several questions raised by variation in practice among market participants when handling developer returns. For example, is there a relationship between expected cash margins such as profit on cost and rates of return? Are practitioners applying the right metric to the right model? What is an appropriate developer return? How do returns vary depending on scheme, timing and the way that return is measured?
All project evaluations assessing land value require an estimate of profit or return. But little is known about the performance of development schemes; each scheme represents the creation of a new asset with no prior cash flow and with specific features concerning the site, process and product. Nevertheless, each appraisal requires an individual estimate of expected return.
"Previous research has shown that some modelling intricacies are not always understood in professional practice"
The research used a mixture of methods to investigate these issues, including a review of existing literature and a questionnaire survey of UK commercial and residential property developers, backed up with interviews and analysis of property company and housebuilder accounts. The research was carried out early in 2019 and most responses were from smaller organisations, relatively evenly split between residential and commercial developers. Most of the interviews were with representatives of larger organisations.
The research found that the traditional residual method of valuation, together with profit margins on either cost or value, still dominates project appraisal practice for small- and medium-sized developers. Just less than two-thirds of respondents use the residual method, while around a third use cash flows.
Larger developers and those that develop commercial or mixed-use schemes tend to use cash-flow techniques and performance measures based on rates of return, albeit in combination with cash-margin measures. Such organisations were more likely to carry out cash-flow modelling of feasibility alongside any residual-based assessment of profit or land bid.
Reports from practice and published viability appraisals also revealed widespread use of simple cash margins as measures of return. These were most commonly expressed as a percentage of development cost, but also as a percentage of development value; on rare occasions, the return was expressed as a rate of return, usually an internal rate of return (IRR). The required profit margin was between 15 and 20 per cent in most cases, with the IRR also selected from this range despite being a very different measure.
"Are practitioners applying the right metric to the right model? What is an appropriate developer return?"
The questionnaire responses supported the findings of the previous reports and confirmed that residential developers favour the cash-based target. A figure of 20 per cent profit on costs was mentioned regularly for sites without significant risks – for example those relating to planning permission – and 25 per cent for sites that have higher levels of perceived risk. These levels of profit on cost imply a margin on gross development value of around 1520 per cent.
The residential developers in our sample were less likely to use target rates of return, corresponding to their preference for the basic residual method over a cash-flow technique. Using cash-flow techniques, the larger developers quoted target rates of return of around ten to 12 per cent per annum, and this corresponds to the higher cash returns that are sometimes required for longer projects.
It is common to include finance in development appraisals, yet, given that debt is often used to help finance development, it was surprising that measures of return on developer equity were found to be less well used. This may reflect the fact that the details of any financial structure are likely to be unknown at the initial feasibility stage, and the emphasis on returns to equity may therefore increase for appraisals carried out later. Commercial, residential and mixed-use developers are all just as likely to use profit on cost as a benchmark as they would a project IRR.
Other benchmarks were specified, such as development yield. Net present value was an important output, as was using profit as a cash sum only without scaling it to costs or values, and – for commercial redevelopment opportunities in particular – cash-on-cash return.
The interviews also shed further light on the relationship between the model and the profit or return metric used. The surprise was that, although the differences were well known, profit on gross development value or profit on cost tended to be the default measure of profitability in most cases, even when more sophisticated modelling was used that required or could generate internal rates of return.
Back-testing of completed schemes to identify how achieved project returns deviated from original estimates was found to be far from standard practice among developers. Around 65 per cent of the respondents usually or always carried out a post-development review of their appraisal, while slightly more than 20 per cent only did so occasionally, and ten per cent of respondents never back-tested the outcomes of a project against the feasibility appraisal at all.
Finally, there was a mixed response to questions about which factors would cause developers to vary the target return for a development scheme. Some would adjust this upwards for longer developments, but several respondents noted that it would depend on the precise nature of the scheme and hence the level of perceived risk.
What are the implications of this research for practice? Profit that is expressed as a simple cash margin does not reflect the timing of receipts and is hard to compare with expected returns from alternative investment opportunities, which are often quoted as rates of return. Nevertheless, residual techniques may approximate the outcomes from more sophisticated models if the target profit margin is adjusted to mirror the way target rates in a cash flow setting might be altered for projects with different attributes and hence different risks.
The research revealed that, although the use of the conventional residual method remains widespread, many – particularly larger – developers now use cash-flow methods routinely too. Simple cash margins are often supplemented with return rate metrics, showing anticipated returns both before and after finance. Valuers working in this area can find useful information in the Valuation of development property guidance note.
Neil Crosby FRICS is professor of real estate and planning at the University of Reading firstname.lastname@example.org
Dr Steven Devaney is associate professor of real estate and planning at the University of Reading email@example.com
Peter Wyatt MRICS is professor of real estate and planning at the University of Reading firstname.lastname@example.org
Related competencies: Development appraisals, Planning and development management, Valuation
Prof. Sara Wilkinson FRICS, Dr Gill Armstrong, Dr Kusal Nanayakkara, Mark Willers FRICS, Prof. Jua Cilliers and Dr Robert Fleck 08 December 2023