8.2.1 Replacement cost

The replacement building and site improvements should be functionally equivalent to the subject property. This means that the modern equivalent replacement may not be the same size, layout, design and specification as the actual property. When estimating replacement building costs, the valuer needs to decide what constitutes the building and what constitutes plant and machinery. Sometimes, relatively standard properties have specialised features and adaptations and a valuer may decide that comparable evidence is available for the property and the specialised features can be valued separately using the replacement cost method. Some specialised features may have no market value and could have a negative value if they are regarded as an encumbrance.

The replacement cost will cover all the usual costs associated with the construction of a building, including setup costs (planning fees, site preparation), building costs, professional fees, a contingency allowance, and finance (unless there is an assumption of ‘instant build’) but not developer's profit. If replacement is likely to take a long time, then it may be justifiable to forecast variations in costs.

Professional fees are usually estimated as a percentage of the building cost. Complex schemes or highly specialised buildings may require specialist cost professionals such as quantity surveyors, civil engineers, and structural engineers.

The cost of finance for the construction can be calculated in one of two ways, both of which average the drawdown finance requirement over the estimated length of the construction period. Either calculate compound interest on half of the construction costs at the finance rate for the whole construction period or calculate compound interest on all the construction at the finance rate for the half of the construction period.

If the premises are historic, the extra cost associated with their direct replacement is usually ignored if the service or output could be provided from modern equivalent premises. However, if the historic nature of the premises is intrinsic to the use (a museum for example), then the cost of reproduction would be appropriate. If reproduction is not feasible, the construction of a building with a similarly distinctive design and specification might be appropriate. Of course, some buildings may simply be irreplaceable.

Estimates of construction costs can be obtained from professional cost estimators (quantity surveyors), cost manuals, builders and contractors. The actual cost of constructing the original property may be useful evidence once it has been adjusted for inflation, but with due consideration for any variation that might be due to the existence of a prepared site, the need to reconstruct as quickly as possible, possible changes to planning policy, building regulations and so on.

8.2.2 Depreciation

Because the subject property already exists, and may have done so for some time, the cost of an equivalent new one should be written down or depreciated to reflect any diminution in value. This might be due to age (and estimated remaining economic life²), comparative efficiency, functionality and running costs. The building is valued as it is, taking account of any lack of repair and maintenance, but, looking ahead, an assumption of routine repair and maintenance is acceptable.

Throughout a building's life, its value will tend to depreciate for two principal reasons: deterioration and obsolescence. Deterioration results from wear and tear and is hastened by a lack of maintenance. It is usually measured by reference to the estimated economic life of the asset. It is not easy to generalise about the life of various building types, but prime shop units are much less prone to deterioration than industrial units due to the nature of the use of the building and the proportion of total value attributable to land. Usually, occupiers and owners will want to delay the onset of deterioration as much as possible and this is achieved through good design and construction and active property management. Sound maintenance and management policies help to identify, plan and budget for the onset of deterioration. But inevitably, as the building gets older, maintenance costs increase and the rental value falls because the building is no longer modern and attractive. Consequently, the value of the building declines relative to site value until it becomes economically viable to redevelop the site.

Obsolescence refers to a decline in value resulting from changes that are extraneous to the property. It is a decline in utility not directly related to physical usage or the passage of time. A good‐quality, flexible design can combat obsolescence but, to a certain extent, matters are beyond the control of the property owner or occupier and management and maintenance will have little impact. A building may become obsolete for any number of reasons that rarely work in isolation. Common forms of obsolescence are:

• Functional. The property can no longer be used for its intended purpose, perhaps due to technological changes rendering layout, configuration or internal specification of the property obsolete, and adaptation is not economically viable. Similarly, a property may be adequate in terms of its physical characteristics but is in the wrong location.
• Socio‐economic changes in the optimum use for a site due to market movements may render the existing use obsolete, the building may not depreciate but the development potential of the site appreciates due to changes in the social fabric of the locality or changes in consumer demand, working environment and so on.
• Aesthetic. Image and design requirements are constantly changing and a property that no longer projects the right image may become obsolete.
• Regulatory. This includes changes in planning policy, environmental regulations, health and safety legislation, and lease terms for example.

Whereas physical deterioration may be a continual but gradual process, obsolescence may strike at irregular intervals regardless of age. The responsibility for maintaining the physical condition of a property is usually passed on to the tenant when a commercial property is let on full repairing and insuring (FRI) lease terms, but the risk of obsolescence cannot be managed in this way and is ultimately borne by the owner. The onset of deterioration and obsolescence can be measured by looking at the depreciation in value of the building in relation to modern replacements and by looking at the development value of the land in comparison to its value in its existing state. A sudden switch in the relative magnitudes of development land value and existing use value may occur because of a ‘trigger event’ that presents an opportunity for a more valuable use such as the granting of planning permission. For example, suppose a small industrial estate located on the edge of a town is around 15 years old and the units are looking a little tired. The owner can fill the units with small businesses paying low rents. A by‐pass has recently been constructed around the town and accessibility to the industrial estate is greatly improved. At the same time ‘factory outlet shopping’ has become popular and planning permission to allow an element of retail trade from the industrial units is forthcoming. The owner of the industrial estate anticipates being able to charge higher rents to the factory outlet traders and therefore decides to redevelop the site.

Depreciation can vary according to type of structure and obsolescence may affect different parts of building at different rates. To counter depreciation, there may be a trade‐off between spending more money on the initial design and specification of the building, thus achieving relatively low future costs‐in‐use, or spending less at the start and instead spending relatively more to maintain the premises over its life. The time value of money affects this trade‐off significantly. In quantifying the diminution in value that results from depreciation, the objective is to reflect the way the market would view the asset. When there is a group of buildings to be valued, it is important to consider alternative uses for the premises and their associated lifespans. It is reasonable to assume that routine servicing and repairs are undertaken when estimating lifespan but not significant refurbishments or replacement of components. If refurbishment takes place, then the economic life of the building might be extended. Sometimes, obsolescence can be absolute, other times, partial, perhaps rendering less‐efficient service potential.

8.2.3 Land value

When estimating land value, a modern equivalent site is assumed to have the appropriate characteristics to deliver the required service potential at least cost. It may not be the same size or location as the actual site. Indeed, the actual site may not be appropriate if the surroundings have changed. For example, it may be an old prison or a hospital in a city centre location, which is now surrounded by housing. It is also important to note that certain public buildings, such as a school or a health centre, need to be in certain localities, and this constrains site selection.

The land value is based on the size of the plot that is required for the use so, if a school is on a 2.5‐ha site when 1.5 ha is sufficient, it would be valued based on 1.5 ha. The land value is estimated by referring to evidence of transactions of comparable size, tenure and location. If the actual site uses space inefficiently or even inappropriately given changes in technology or production, then modern equivalent sites should be considered. The fundamental principle is an economic one; a hypothetical buyer would purchase the least cost site that is suitable and appropriate for the use. The valuer should also consider whether the actual site location is now one that a modern equivalent would use and whether any vacant land at the actual site is still required for a modern replacement. These considerations can be somewhat subjective as vacant land may be held for expansion, for security or simply may be surplus to requirements.

Because of the specialised nature of the businesses and operations, finding comparable land values is difficult and the valuer may need to broaden the search to include a wider range of alternative site uses. For example, if the use is specialised industrial, then reference to general industrial land prices is usually acceptable. The aim is to select the lowest cost site for an equivalent operation in a relevant location. If the actual site is held on a lease, then the lease terms should be considered when estimating the land value.

The finance cost for the land is estimated by calculating compound interest on the land value over the whole construction period. In other words, the land is assumed to be purchased first and therefore finance is payable for the whole construction period. This finance cost is hypothetical in the replacement cost method because the land is already owned.

Bringing these three components of the replacement cost method together, an example valuation can be presented. A secondary school comprising 3500 square metres (gross) has 12 years of its estimated 50‐year life remaining. Construction costs for a modern equivalent school are £1700 per square metre and the construction period is estimated at 1.5 years. Professional fees are assumed to be 12.5% of building costs. The total site area including playing fields is 11 000 square metres and the land is estimated to be £18 000 per hectare. The local authority, which owns the school, can secure finance for construction and land purchase at a finance rate of 2% per annum.

The final stage of the valuation is to stand back and look – a final reconciliation to ensure that depreciation has not been double‐counted or ignored and to check whether the characteristics of the property being valued might lead a buyer to bid more than a modern equivalent. When reporting a valuation that is based on the replacement cost method, this must be stated in the report, along with the assumption that the value is subject to the adequate profitability of the company if the property is held in the private sector or subject to the prospect and viability of continued occupation and use if it is a public sector property.

At some point, the property value will fall below the development land value and development becomes viable. This would occur at different times depending on the ratio of land to building components of property value. Figure 8.1 provides an example where there are two sites: a city centre site with a land value of £6m and an out‐of‐town site with a land value of £2m. Building costs and estimated lifespans of the buildings are the same at £5m and 50 years respectively, and the property depreciation rate is 2% in both cases. Because the city centre site has a higher ratio, it has a shorter economic life. Accountants often simplify the process by assuming buildings have standard lifespans, typically 50 years, after which their value is written off, leaving just the land value. In economic terms this would be the point at which land value exceeds building value, signifying redevelopment. Figure 8.1 illustrates this arrangement and shows that now the two properties have the same economic life. This treatment of depreciation is forced by the 50‐years' life‐span assumption.

8.2.4 Application of the replacement cost method

The valuer may need to agree certain matters with the client as part of the valuation: the potential location of a replacement property, factors that may affect the estimated remaining economic life and details of capital expenditure on maintenance, repairs, improvements, refurbishments, and reconstruction. The valuer is reliant on information provided by the client to a greater extent than for non‐specialised properties, particularly in relation to costs, design features and the performance of the property in relation to its use.

8.2.5 Issues arising from the application of the replacement cost method

It is important to remember that cost is a production‐related concept whereas value is an exchange or use‐related concept. Using cost as a proxy for value assumes that a property is worth its replacement cost rather than what someone is prepared to pay for it. For this reason, the method is often regarded as a last resort approach to estimating market value. The strong cost element and the necessity for extensive subjective input by the valuer throughout the valuation has led the courts to express ‘considerable reservations about a basis which gives full rein to a valuer's judgement without offering any market evidence to support the opinion of value against which the results may be judged’ (Scarrett 1991).

Although the resulting valuation from the method is a replacement cost, estimation of the inputs (land prices, build costs, depreciation allowances for example) can be based on market information when it is available. Adjustments may be made to these inputs to reflect differences in size, quality, utility, and so on in the same way as undertaken for the comparison approach. Comparable information is often available for build costs but less so for land prices, and particular difficulties may be encountered when trying to derive a depreciation rate. Valuers should observe economic lives of existing buildings and other improvements in comparison with new or recent replacements as a way of calculating depreciation rates. However, given the specialised nature of the properties concerned, it may be challenging to reconcile such diverse evidence.

Notwithstanding this challenge, depreciation rates may be all‐encompassing or separated into physical deterioration, functional and economic obsolescence elements. Separation into component parts is only likely to be feasible when the body of comparable evidence allows. UK valuation guidance suggests that, for physical deterioration, costs of specific elements of rectification may be considered or direct unit value comparisons between properties in a similar condition may be undertaken. A further challenge is to identify changes in depreciation rates and remaining economic life estimates caused by market fluctuations.

Usually, it is not possible to obtain market data on which to base a measure of depreciation. Instead, valuers make assumptions about how improvements depreciate over time. This is typically a straight‐line rate of depreciation based on the ratio of the estimated life of the building to its actual age at the valuation date. Because of the difficulty in putting a precise lifespan on a building, bands of say less than 20, 20–50 and over 50 years are often used.

The replacement cost method assumes that value is derived from an additive relationship between land value and depreciated building cost. This simple relationship is open to question: as Whipple (1995) argues, land and improvements ‘merge to provide an undifferentiated stream of utility’ so not only is it virtually impossible to determine the contribution to value made by each individual capital item, but their aggregate contribution is also highly unlikely to be a simple additive one.

The cost approach relies on the assumption of continuing existing use and so alternative uses of the land need to be considered separately. Unless instructed otherwise, a valuation of any alternative use, including redevelopment land value, is likely to take the form of a simple indication that the value of the site for a potential alternative use may be significantly higher than the replacement cost valuation.

In summary, because of a lack of comparable market transaction information, the method estimates replacement cost rather than exchange price. It does not produce a market valuation (an estimate of value‐in‐exchange) because cost relates to production rather than exchange and it is regarded as the method of last resort for this reason. It is a means of estimating the replacement cost or deprival value of company and public sector properties for which there is no market.

8.3.1 Basic residual technique

The basic residual technique can be summarised as follows:

(8.1)

whereLV ₀ = Present residual land value

• i = Cost of finance (annual interest rate)
• t = Development period (years)
• DV ₀ = Current estimate of development value
• p = Profit, calculated as a percentage of DV
• DC ₀ = Current estimate of development costs
• I = Finance costs (usually calculated over the construction phase of the development period only)

The model produces a simplified representation of the financial flows in development based on the following assumptions:

• The development value, expressed in current values, is received at the end of the development period.
• All development costs (land and construction) are debt financed with repayment in full at the end of the development period.
• Building costs are incurred evenly throughout the construction period and interest is calculated by halving the time over which interest accrues. The use of the finance rate effectively delays payment for the costs of development to the end of the development, placing them at the same date at which development value is received.
• Profit is deducted as a cash lump sum, taken as a proportion of total development costs or development value. As profit is also a cost to the development at the end of the development, all the income and outgoings are now placed at the end.
• Finally, the gross residual amount is the amount that can be paid for the site at the end of the development. But site value is a present value and therefore the residual surplus at completion of the development is discounted back from the end of the development to the beginning at the finance rate. Consequently, it is assumed that the land value is paid to the landowner at the commencement of the development and is funded entirely by debt.

An example of a basic residual valuation is shown below. This is an office scheme, and the relevant steps of the valuation are explained below the valuation.

8.3.1.3 Cost of finance

Short‐term finance is usually included in valuations of development land because development typically requires debt finance. The cost of finance depends on two factors, the interest rate and the duration of the loan. A lender will charge interest at the bank base rate for lending plus a return for risk. The magnitude of the risk premium will depend on the nature of the scheme, the status of developer, the size and length of loan and the amount of collateral the developer intends to contribute.

The duration of the loan depends on the estimated length of the development period. In simple terms, the development period comprises a lead‐in period, the construction period, and a void period. The lead‐in period allows time for obtaining planning consent, preparing drawings and so on. The void period sits between the end of the construction period and occupation by a tenant, including a possible rent‐free period. During a void period, interest is payable on all costs so any extensions to this period will significantly increase the amount of loan finance incurred. In this example, a lead‐in period of 3 months, a construction period of 18 months and a void period of 3 months has been assumed.

Interest payments on money borrowed to fund construction usually accrue monthly but are rolled up over the development period and paid back when the development is let or sold. In a basic residual valuation, finance is assumed at 100% of all construction and land‐related costs. This is achieved by compounding interest on the construction costs over the construction period and by discounting the residual land value at the interest rate over the development period. Whereas finance is calculated on the land‐related costs over the development period, because finance is not drawn on all construction costs at the start of the construction period, one of three techniques is usually employed to calculate the finance on the construction‐related costs. The first is to set out the costs as a cash flow and determine the total interest payment. This technique requires a quarterly or monthly breakdown of construction costs and, for a basic residual valuation, this might seem too detailed. Therefore, an averaging technique is often employed by assuming that either interest accumulates on half the construction‐related costs over the whole construction period, or that all construction costs are borrowed over half the construction period (the approach used in this example). This averaging of either cost or time reflects the fact that interest is not paid on the full amount over the entire building period. Usually costs start off low, peak in the middle and then tail off towards the end as illustrated in Figure 8.2. By averaging, a straight line rather than an s‐shaped build‐up of costs is assumed. Sometimes, interest on professional fees is calculated separately by compounding the amount over two thirds of the building period. This reflects the presumption that such fees tend to be incurred early in the development, during the planning and design phase and hence interest will be incurred for a longer period.

It is usual for interest to be treated as a development cost up to the assumed letting date of the last unit unless a forward sale agreement dictates otherwise. If an assumption is made that the completed development is held beyond the date of completion, the costs of holding that building during this void period must be added. These may include insurance, security, cleaning and energy costs. A proportion of the service charge on partially let properties may have to be included together with any potential liability for empty property taxes. Interest can then be accumulated in two parts; in the construction period as indicated above and then in the post construction void period, where the full costs of development can be included in the interest calculations. Interest accrued during the void period is calculated by compounding the total construction costs and interest rolled up during the construction period at the annual interest rate. A significant amount of interest can accrue during a void period. That is why it is very important to keep the length of any void period to a minimum. Detailed cash‐flow projections are essential once the project is under way to incorporate changes in revenue and costs and particularly so for phased developments.

8.3.1.5 Developer's profit

Developer's profit is the reward for initiating and facilitating the development and is dependent upon the size, length and type of development, the degree of competition for the site and whether it is pre‐let or sold before construction is complete (a forward sale). Property development is perceived as riskier than investment in completed and let properties. Consequently, the required return will be higher than these ‘standing’ property investments. It is usual to express developer's profit in the basic residual valuation as a cash sum, expressed as a percentage of the development cost (including finance and land costs) or of development value.³ A typical range of profit as a percentage of costs is 15–25%. Here, 20% has been assumed.

The developer also takes a profit margin on the residual land costs. The equation below shows how this is calculated.

8.3.1.6 Residual land costs

Once developer's profit has been deducted from the residual land costs, the remaining sum must cover the land price, purchase costs and finance on these costs. These are handled in reverse order. Regarding finance, assuming the site was purchased by the developer at the start of the development, interest on land costs will accrue over the total development period. To reflect this, the residual land costs are discounted at the short‐term finance rate of 10% over the total development period to determine their present value.⁴

Acquisition costs are deducted to leave the net amount remaining for purchase of the land. These acquisition costs usually include legal costs, transfer tax or Stamp Duty agents' fees:

The final figure is the residual land value and represents the maximum amount that should be paid for the site if the proposed development was to proceed and all the valuation assumptions held true.

8.3.2 Basic residual profit appraisal

Given all the value and cost inputs, including a developer's profit margin, the output from the residual method is usually a land valuation. However, if a land price is one of the cost inputs, then the method can be used to estimate the amount of developer's profit.

In a basic residual, if the land price or value is known, it becomes a cost to the development. It occurs at the beginning of the development and interest accrues on it over the development period. This cost is added to the other development costs and then deducted from development value to leave an estimate of residual profit at the end of the development period.

The basic equation for the residual land valuation can be transposed to determine the level of profit achieved given construction and site costs. The equation would look like this:

Using the example above, the estimation of developer's profit would proceed as follows.

The site price is assumed or is known and can therefore be inserted. Costs associated with site acquisition (typically agent and legal fees) must be added to the costs. Assuming the site was acquired at the very start, interest will accrue on this cost over the whole development period. Here the site costs will incur interest for two years at an annual interest rate of 10%.

The estimated developer's profit can be expressed in several ways to assess the viability of the development and to compare it to other development opportunities. Profit as a percentage of development costs is useful for merchant developers, who need to sell the completed development to raise capital for future projects. Some developers, particularly housebuilders, prefer to express profit as a percentage of value. Development yield is rent expressed as a percentage of development costs and is useful for investor developers who, in contrast to trader developers, retain the development as an investment. Just as the difference between total costs and total capital value represents capital profit, so the difference between the investment yield and development yield represents the developer's annual profit margin over standing investments.

8.3.3 Discounted cash‐flow technique

The discounted cash‐flow technique requires period‐by‐period assumptions concerning the breakdown of costs and values during the development period such as the time frame (monthly, quarterly, etc). It thus allows market dynamics through time to be incorporated, such as changes in costs and values, where appropriate. The basic application of a discounted cash flow is to calculate the present residual land value of the estimated costs and revenues over the duration of the development scheme. With all other costs and revenues accounted for, profit is incorporated as a cash sum, usually estimated as a percentage of total costs or revenue.

Whereas a basic residual valuation is often used at an early stage to provide a snapshot of development feasibility, a cash flow provides a more detailed assessment, usually reserved for larger, more‐complex proposals. Projecting a cash flow is particularly useful for developments where the initial land acquisition or disposal of the completed development is phased, such as residential or industrial estates, where some units may be sold before others are constructed, or complex central area shopping schemes where parts may be let or sold before the remainder is complete. In short, the advantage of the cash‐flow technique is its dynamic capability.

The essential difference between a basic residual valuation and a cash‐flow valuation is the way that the timing of expenditure and revenue is handled. The basic residual assumes that revenue from the development is received at the end of the development and interest on expenditure is calculated on 50% of all costs over the building period (alternatively, interest is calculated on the total costs over half of the building period). In contrast, a cash flow divides the development project into time periods (usually months or quarters) to allow more refined judgements to be made regarding the flow of income and expenditure. Payments and receipts that were stated as aggregate figures in the residual valuation may now be estimated as to when they are likely to occur. This permits a more accurate calculation of interest payments to be incorporated and allows the valuer to examine how changes in the timing of costs and revenue might affect value or profitability of the development. Throughout the construction phase, adjustments can be made to the cash flow as and when costs and income are realised. This will determine how the project stands at any point in time in terms of potential profit and what began as a valuation becomes an appraisal tool. In a basic residual, it is usually assumed that income is received (and costs incurred) annually in arrears. A cash flow typically assumes that costs and revenue are incurred and received quarterly in arrears. There may be a mixture of timings for incurring expenditure and receiving revenue: construction costs are usually paid in arrears whereas income from property in the form of rent is usually receivable quarterly in advance.

A key advantage of a cash‐flow valuation is that it can deal with non‐standard patterns of revenue and expenditure. Whereas a basic residual valuation assumes sales must come at the end of the development (albeit after a possible void period), the cash‐flow method easily deals with phased schemes, allowing rental income to be accounted for when rent commences before the investment is sold. For example, the leasing of advertising space on hoardings or securing short‐term tenancies (for example surface car parking) can help to offset costs before and during the development phase. This is simple to include by incorporating two income lines: one for rent and one for sales. Where phased sales occur, the associated costs, such as agent and legal fees, should also appear in the calculation at the appropriate time. Also, when the opening balance becomes positive, no interest should be charged.

The basic approach of the discounted cash‐flow approach can be formalised as follows:

(8.2)

where R = Recurring periodic net revenue received at the end of each period, f = cost of finance, n = number of periods and other variables are as defined above.

In this simple cash‐flow valuation, revenue and expenditure are discounted at the finance rate and developer's profit is included as a cash sum at the end. This is the same as the approach adopted in the basic residual, but a cash flow means that where revenue is expected to be received in phases, receipts can be recognised in the cash flow at the appropriate time. Phasing may be appropriate for residential development where homes are built and sold incrementally or for commercial developments where some existing properties are let on a short‐term basis while new properties are built. The timing and extent of phased costs and revenue within the development period can be incorporated into the cash flow. Where income‐producing properties are included in the development, the timing of lettings, rent‐free periods, capital contributions, etc., can also be incorporated into the cash flow and the development period can be extended as necessary.

Using the example from above, the cash flow below replicates the input costs but allocates them across the development period in a more realistic way. The land price is input at the start, construction costs and fees are spread over the eight quarters and developer's profit is paid out at the end. Discounting the cash flow at the finance rate leaves a small negative net present value (NPV). Whereas the basic residual assumed all costs were incurred at the halfway point, in the cash flow, the spread of costs is weighted a little before the halfway point. This leads to slightly higher finance costs and thus a small negative closing balance of ‐£46 408. This would eat into the developer's profit. To see how much the developer should reduce the land bid price to preserve the profit margin, the higher finance cost can be fed back into a revised land valuation using iteration (‘goal seek’ in Excel) to set the closing balance to zero and altering the land price input. The revised land price is £757 077.

Iteration can also be used to determine how the developer's profit might change if the land price had to remain at £793 090. In this case, the profit sum drops to £747 242.

In practice, developers rarely if ever use 100% debt to finance land acquisition and construction. A cash flow can be used to consider various finance arrangements and loan to cost ratios. In doing so, the cash flow is constructed on the equity provided by the developer and the target rate of return is based on the risk of that equity. Depending upon the financial arrangements, that risk would normally be higher than the overall project risk (this assumes lower risk exposure by the lender) and the equity target rate of return would normally be in excess of the project target rate of return.

To summarise, there is a great deal of uncertainty in the residual method. Although there may be a predictable set of costs associated with parts of a development project, there will inevitably be unforeseen costs and delays. Typically, these are handled by a contingency allowance and a suitable risk‐adjusted profit margin for the developer. Nevertheless, given very high yet relatively predictable costs (building, fees, finance, etc.) and more volatile revenue (sale prices, rents, yields, letting voids, etc.), developers face high operational gearing. Most projects are lengthy, and costs, values and market activity will change during the development time frame. Little forecasting is undertaken in residual land valuations so this presents additional risk to the developer. Because of inherent uncertainty in the model and the highly geared nature of the residual land value, the method comes with two major health warnings: it is highly site specific and has a very limited shelf‐life.

Replacement cost method

1. A local authority owns a recycling centre that must be valued for their register of assets. The property is expected to have a further 25 years of useful life remaining from its original life expectancy of 40 years. The building comprises 5000 square metres gross internal area and construction costs are estimated at £1098 per square metre. A replacement building and compound would take 9 months to construct, fees are estimated at 12% and the local authority could be expected to secure finance at 4.5%. The building is located on a site comprising 18 000 square metres and the price of land per hectare (per 10 000 square metres) for refuse and recycling centre use is estimated at £18 500. Value the freehold of the building.
2. A purpose‐built glass works comprises specialised industrial buildings, a warehouse, canteen and office accommodation, details of which are shown in the schedule below. The property has been developed over several years on a site comprising 2.5 ha. Market evidence shows that current land values are approximately £52 000 per hectare for heavy industrial use.

   Building description	Life expectancy	Remaining useful life	Gross replacement cost (including fees and finance per building)
   Main glass works	60	20	£6 000 000
   Laboratory	60	20	£1 000 000
   Canteen and offices	30	5	£800 000
   Warehouse	60	40	£9 000 000

   1. Assuming a replacement building would take 21 months to reinstate, and that the owner could secure a finance rate of 7% per annum, value the freehold interest.
   2. If you were aware that the main glass works building had an inefficient layout for modern manufacturing methods, how might you adjust your valuation?
   3. If you were aware that modern manufacturing plants to replace this building would now be located on a site comprising 1.75 ha, how might you adjust your valuation?

Residual method

1. You have been asked to value an office development site based on the following assumptions:
   • Gross internal area of 5000 square metres and an efficiency ratio of 85%.
   • The market rent is estimated to be £200 per square metre and the investment yield 6%.
   • Building costs are £1200 per square metre, external works £250 000 and ancillary costs £200 000.
   • Lead in period: 0.50 years, building period: 1.50 years, void period: 0.75 years
   • Professional fees are estimated to be 10% of building costs and external works.
   • There is a contingency allowance of 3% of building costs, external works, ancillary costs and professional fees.
   • Other costs and fees include site investigations of £10 000, planning application fees of £5000, building regulations of £20 000.
   • Finance can be arranged at a rate of 7% per annum.
   • The letting agent fee is 10% of the ERV and the letting legal fee is 5% of the ERV. The marketing budget is £150 000.
   • Developer's profit is 15% of all development and land costs.
2. A property development company is proposing to develop an office building on a recently acquired town‐centre site. The purchase price was £1.6m and the previous owner had obtained outline planning consent for a four‐storey building on the site some two years previously but had not pursued this proposal. A local commercial letting agent has indicated that demand for office space in the town is high and leases have recently been negotiated at rental levels of £220 per square metre per annum. The agent is not aware of any other new office development proposals in the town. Recent investment transactions show capitalization rates around 8%. The developer has appointed local architects and surveyors and, on the basis of their knowledge, the architect has drawn up a design that provides a building with a gross internal area of 4667 square metres. Analysis of the design shows that the efficiency ratio will be 90%. The developer's agent reports that, among other expressions of interest, they have received firm enquiries from several tenants about leasing space in the development. The quantity surveyor has indicated that building costs for good‐quality speculative offices are expected to be £1075 per square metre. External works are expected to cost approximately £250 000 and a separate contract has already been let for site clearance and the demolition of some small buildings on the site at a price of £100 000. The project manager has drawn up an outline procurement programme that allows six months for design, 15 months for construction and a six‐month letting void. The developer intends to borrow the cost of the development from a bank. Current interest rates on project loans of this nature are around 8% per annum. Calculate the developer's profit and report it as a cash sum, as a percentage of costs and as a percentage of value.
3. Estimate the residual land value from the following net cash flow, assuming a finance rate of 10% per annum.

   Quarter	0	1	2	3	4	5	6
   Net cash flow	(138 284)	(500 000)	(500 000)	(500 000)	(500 000)	(500 000)	4 000 000

4. Estimate the residual land value from the following development revenue and expenditure items over a one‐year development period, assuming a finance rate of 10% per annum.

   Quarter	1	2	3	4
   Sales	0	0	300 000	300 000
   Construction	(25 000)	(25 000)	(25 000)	(25 000)
   Demolition	(20 000)	0	0	0
   Prof. fees	(2250)	(1250)	(1250)	(1250)
   Sale fees	0	0	(4500)	(4500)
   Contingency	(2363)	(1313)	(1538)	(1538)
   Profit				(120 000)

5. Estimate the residual land value of the following development cash flow. The development has a gross internal area of 900 square metres and an efficiency ratio of 80%. Site clearance costs of £100 000 are anticipated in Q1. Building costs are £900 per square metre, with 25% due in Q2, 50% in Q3 and 25% in Q4. Professional fees are 10% of building costs and contingencies are 5% of building costs and professional fees. A simultaneous letting and sale is anticipated in Q7. The MR is estimated to be £220 per square metre, the yield 6%, letting fee 10% of MR and sale fee 2% of NDV. Developer's profit is 17% of GDV and finance can be arranged at a cost of 8% per annum.
6. Estimate the developer's profit from the following inputs. Assume that the build costs are spread evenly between Q2 and Q5.

   INPUTS
   Land price (£)	850 000
   Yield	7.00%
   Gross internal area (m2)	2000
   Efficiency ratio	90%
   Build cost (£/m2)	1000
   Estimated MR (£/m2)	175
   Land purchase costs (% land price)	5.75%
   Investment sale fee (% NDV)	5.75%
   Letting fee (% MR)	10%
   Lead‐in period (quarters)	1
   Building period (quarters)	4
   Void period (quarters)	2
   Contingencies (% build costs and fees)	5%
   Professional fees (% build costs)	10%
   Finance rate (per quarter)	2.00%

Replacement cost method

1. 
   

   Building area (m2)	5000
   Building cost (£/m2)	1098
   Cost of modern equivalent building (£)		5 490 000
   Fees (% build cost)	12%	658 800
   Finance on build cost and fees over half build period @	4.50%	102 336
   Gross replacement cost of building (£)		6 251 136
   Depreciation allowance (age/estimated economic life)		38%
   Net replacement cost of building (£)			3 906 960
   Site area (ha)	1.80
   Land value (£/ha)	18 500
   Value of land (£)		33 300
   Finance on land over build period @	4.50%	1118
   Cost of land (£)			34 418
   Valuation before PCs (£)			3 941 378

2. 
   

   a)Main glass works
   Gross replacement cost inc. fees and finance (£)			6 000 000
   Depreciation allowance (% remaining life)	20	60	33%
   Net replacement cost (£)				2 000 000
   Laboratory
   Gross replacement cost inc. fees and finance (£)			1 000 000
   Depreciation allowance (% remaining life)	20	60	33%
   Net replacement cost (£)				333 333
   Canteen and offices
   Gross replacement cost (inc. fees and finance)			800 000
   Depreciation allowance (% remaining life)	5	30	17%
   Net replacement cost (£)				133 333
   Warehouse
   Gross replacement cost (inc. fees and finance)			9 000 000
   Depreciation allowance (% remaining life)	40	60	67%
   Net replacement cost (£)				6 000 000
   Land
   Site area (ha)		2.5
   Estimate value (£/ha)		52 000
   			130 000
   Finance on land cost (FV £1 for 1.75 years at 7% p.a.)	1.75	7.00%	1.1257
   				146 341
   Replacement cost valuation (£)				8 613 007

   b) A further percentage deduction might be made in addition to the straight‐line depreciation charge made on the main chemical works due to its size.

   c) Recalculate the land costs based on 1.75 ha. Also consider if the remaining hectare has an alternative use value and could be valued separately to reflect any development land value.

Residual method

1. 
   

   INPUTS
   Areas
   Gross internal area (GIA) (m2)		5000
   Efficiency ratio (net/gross area)		85%
   Net internal area (NIA) (m2)		4250
   Time
   Lead‐in period (years)		0.5
   Building period (years)		1.5
   Void period (years)		0.75
   Values
   Estimated rental value (ERV) (£/m2 NIA)		200
   Net initial yield		6.00%
   Costs
   Site preparation (£)		10 000
   Building costs (£/m2 GIA)		1200
   External works (£)		250 000
   Professional fees (% construction costs and external works)		10%
   Miscellaneous costs (£)		200 000
   Contingency allowance (% of all construction costs)		5.00%
   Planning fees (£)		5000
   Building regulation fees (£)		20 000
   Planning obligations (£)		0
   Other fees, e.g. legal, loan, valuation (£)		0
   Short‐term finance rate (annual)		7.00%
   Letting agent's fee (% ERV)		10%
   Letting legal fee (% ERV)		5%
   Marketing (£)		150 000
   Sale costs (% NDV)		2.00%
   Land purchase costs (% land price)		6.50%
   Developer's profit (% development costs)		15.00%

   RESIDUAL LAND VALUATION
   Development value
   Net internal area (NIA) (m2)	4250
   Estimated rental value (ERV) (£/m2 NIA)	200	___________
   		850 000
   Net initial yield	6.00%	16.6667
   Gross development value (GDV) before sale costs (£)			14 166 667
   Net development value (NDV) after sale costs (£)			13 888 889
   Development costs
   Site preparation (£)		(10 000)
   Building costs (£/m2 GIA)	1200	(6 000 000)
   External works (£)		(250 000)
   Professional fees (% construction costs and external works)	10.00%	(625 000)
   Miscellaneous costs (£)		(200 000)
   Contingency allowance (% of all construction costs)	5.00%	(353 750)
   Planning fees (£)		(5000)
   Building regulation fees (£)		(20 000)
   Planning obligations (£)		0
   Other fees (£)		0
   Finance on above costs for half building period @	7.00%	(388 514)
   Finance on above costs for void period @	7.00%	(408 738)
   Letting agent's fee (% ERV)	10.00%	(85 000)
   Letting legal fee (% ERV)	5.00%	(42 500)
   Marketing (£)		(150 000)
   Developer's profit on above costs @	15.00%	(1 280 775)
   Total development costs (TDC) (£)			(9 819 278)
   NDV − TDC (£)			4 069 611
   Land costs
   Developer's profit on land costs @	15.00%	(530 819)	3 538 792
   Finance on land costs over total development period @	7.00%	2.75	0.8302	_________
   Residual land value before purchase costs (£)				2 937 986
   Residual land value after purchase costs (£)	6.50%			2 758 672

2. 
   

   INPUTS
   Areas
   Gross internal area (GIA) (m2)	4667
   Efficiency ratio (net/gross area)	90%
   Net internal area (NIA) (m2)	4200
   Time
   Lead‐in period (years)	0.50
   Building period (years)	1.25
   Void period (years)	0.50
   Values
   Estimated rental value (ERV) (£/m2 NIA)	£220.00
   Net initial yield	8.00%
   Costs
   Land price (£)	1 600 000
   Site preparation (£)	100 000
   Building costs (£/m2 GIA)	1075
   External works (£)	250 000
   Professional fees (% construction costs and external works)	13.00%
   Miscellaneous costs (£)	0
   Contingency allowance (% of all construction costs)	3.00%
   Planning fees (£)	0
   Building regulation fees (£)	0
   Planning obligations (£)	0
   Other fees, e.g. legal, loan, valuation (£)	0
   Short‐term finance rate (annual)	8.00%
   Letting agent's fee (% ERV)	10.00%
   Letting legal fee (% ERV)	5.00%
   Marketing (£)	0
   Sale costs (% NDV)	2.00%
   Land purchase costs (% land price)	6.50%

   RESIDUAL PROFIT VALUATION
   Development value
   Net internal area (NIA) (m2)	4200
   Estimated rental value (ERV) (£/m2 NIA)	220	__________
   		924 066
   Net initial yield	8.00%	12.5000
   Gross development value (GDV) before sale costs (£)			11 550 825
   Net development value (NDV) after sale costs (£)			11 324 338
   Development costs
   Land price (£)		(1 600 000)
   Land purchase costs (% land price)	6.50%	(104 000)
   Finance on land costs for total development period @	8.00%	(322 157)
   Site preparation (£)		(100 000)
   Building costs (£/m2 GIA)	£1075	(5 017 025)
   External works (£)		(250 000)
   Professional fees (% construction costs and external works)	13.00%	(684 713)
   Miscellaneous costs (£)		0
   Contingency allowance (% of all construction costs)	3.00%	(178 552)
   Planning fees (£)		0
   Building regulation fees (£)		0
   Planning obligations (£)		0
   Other fees, e.g. legal, loan, valuation (£)		0
   Finance on above costs for half building period @	8.00%	(307 005)
   Finance on above costs for void period @	8.00%	(256 461)
   Letting agent's fee (% ERV)	10.00%	(92 407)
   Letting legal fee (% ERV)	5.00%	(46 203)
   Marketing (£)		0
   Total development costs (TDC) (£)			(8 958 524)
   Developer's profit on completion (NDV − TDC) (£)			2 365 814
   Profit as a percentage of costs			26.41%
   Profit as a percentage of value (NDV)			20.89%
   Income yield (ERV as a percentage of costs)			10.31%

3. Convert 10% per annum to quarterly equivalent rate: (1.10)^0.25 − 1 = 2.41% p.q.

   Quarter	0	1	2	3	4	5	6
   Net cash flow (£)	(138 284)	(500 000)	(500 000)	(500 000)	(500 000)	(500 000)	4 000 000
   PV @ 2.41%	1	0.9765	0.9535	0.9310	0.9091	0.8877	0.8668
   PV of cash flow (£)	(138 284)	(488 227)	(476 731)	(465 506)	(454 545)	(443 843)	3 467 137
   NPV (residual land value before PCs) (£)	1 000 000
   Residual land value after PCs @ 6.5% (£)	938 967

4. Convert 10% per annum to quarterly equivalent rate: (1.10)^0.25 − 1 = 2.41% p.q.

   Quarter	1	2				3						4
   Net cash flow (£)	(49 613)	(27 563)				267 712						147 712
   PV @ 2.41%	(48 445)	(26 280)				249 243						134 284

   NPV (residual land value before PCs) (£)

   308 802

5. 
   

   Inputs
   Gross internal area (m2)	900
   Efficiency ratio	80%
   Build cost (£/m2)	900
   Professional fees (% build cost)	10%
   Contingencies (% build cost and fees)	5%
   Rent (£/m2)	220
   Yield	6.00%
   Investment sale fee	2.00%
   Letting fee (% MR)	10%
   Land purchase costs (% land value)	6.50%
   Developer's profit (% GDV)	17%
   Finance rate (% p.a.)	8%
   Calculations
   Estimated MR (£/m2)	158 400
   Gross development value (£)	2 640 000
   Net development value (£)	2 478 873
   Quarterly finance rate (% p.q.)	1.94%

   Cash flow
   Quarter	1	2	3	4	5	6	7
   NDV (£)							2 478 873
   Site clearance (£)	(100 000)
   Building (£)		(202 500)	(405 000)	(202 500)
   Professional fees (£)		(20 250)	(40 500)	(20 250)
   Contingencies (£)		(11 138)	(22 275)	(11 138)
   Letting fee (£)							(15 840)
   Developer's profit (£)							(448 800)
   Net cash flow (£)	(100 000)	(233 888)	(467 775)	(233 888)	0	0	2 014 233
   PV £1 @ finance rate	0.9809	0.9623	0.9439	0.9259	0.9083	0.8910	0.8740
   PV of cash flow (£)	(98 094)	(225 058)	(441 539)	(216 563)	0	0	1 760 428
   (residual land value before PCs) (£)							779 173
   Residual land value after PCs @ 6.5%							731 618

6. 
   

   Calculations
   Build costs (£)	2 000 000
   Market rent (£ p.a.)	315 000
   Gross development value (GDV) (£)	4 500 000
   Net development value (NDV) (£)	4 255 319

   Cash flow
   Quarter	0	1	2	3	4	5	6	7	TOTALS
   Land price (£)	(850 000)
   Land purchase costs (% land price)	(48 875)
   Building costs (£)			(500 000)	(500 000)	(500 000)	(500 000)
   Professional fees (% build costs)			(50 000)	(50 000)	(50 000)	(50 000)
   Contingencies (% build costs and fees)			(27 500)	(27 500)	(27 500)	(27 500)
   Letting fee (% MR)								(31 500)	(3 240 375)
   Net development value (NDV)								4 255 319
   Net cash flow (£)	(898 875)		(577 500)	(577 500)	(577 500)	(577 500)		4 223 819

   Finance
   Opening balance (£)		(898 875)	(916 853)	(1 512 690)	(2 120 443)	(2 740 352)	(3 372 659)	(3 440 112)
   Interest (arrears) (£)		(17 978)	(18 337)	(30 254)	(42 409)	(54 807)	(67 453)	(68 802)	(300 040)
   Closing balance (£)	(898 875)	(916 853)	(1 512 690)	(2 120 443)	(2 740 352)	(3 372 659)	(3 440 112)	714 904

   Profit sum (£)	714 904
   Profit on cost	20.19%	Final closing balance divided by all costs including interest
   Profit on GDV	15.89%	Final closing balance divided by GDV
   Development yield	8.90%	Market rent divided by costs
   Profit erosion by rent (years)	2.27	Closing balance divided by market rent