This is part of a Series in eight parts. Here are the other posts.
- On commercial Real estate
- Defining project Value in CRE
- Identifying Risks in RE
- Sample table Project development
- On Construction contracts
- Essential types of project development
- Capital funding
- Components of project development
To further my research into the world of CRE investment I bought a book from W. Alda, J. Hirschner: Projektentwicklung in der Immobilienwirtschaft (3rd edition, 2009). The rough translation should be Project development in Real estate. It is a coursebook at my Local university here in Stuttgart. In this article I will take a look at how to define project budgets. The second chapter of the book talks about how to define the value of an investment. Underneath is a brief translation of the chapter. Last time we were talking about the frontdoor and backdoor approach to defining the project costs. We will add some other possible ways to define project budgets.
Defining the property value is the biggest risk factor in project development. In the buying phase we can expect that costs can fluctuate in between 10-20% (+ and -), which is a lot. With the Development calculation you can calculate the feasibility of a project. There are many methods and I will present some of of the most used ones.
Gross Development Value (GDV)
To many property developers, GDV is one of the most important performance metrics and they will monitor it throughout the course of a project. This method helps to highlight the capital and rental value of their property or development project, even when all the redevelopment works have been completed.
The most common and most basic formula to estimate the general value is as follows:
Land = GDV – (Construction + Fees + Profit)
Land = Purchase price of land/property/site acquisition
GDV = Gross development value
Construction = Building and construction costs
Fees = Fees and transaction costs
Profit = Required profit for Developers
Alternative form is:
Profit = GDV – (Construction + Fees + Land)
If you want to play with some numbers, here is a simple calculator. There are three key components, which define the value of a project: Comparison value (with similar rental prices), Income value (Value of rents, sales, interests) and Asset value (Substance, value of the building). In the future chapters we will take a detailed look on these categories.
1. Asset value (Sachwererfahren)
The basic calculation goes (for the german readers, WertV98):
+ Special equipment (for specific business uses)
-Reduction for the age of the building
-Reduction for the damages and defects
+- Consideration of other circumstances
= Value of building
+Value of other areas/installations
= construction value
= Property value
Ver straight forward, right? The cost of the building can be approximated with the following two methods:
- Markdown (Abschlagsverfahren). Expenditure billing method. Multiply the brutto area content (BRI) with a current market value (€/m2). Full factors, such as construction costs (15%), should be taken into account.
- Price indexing (Indexverfahren). Multiply the gross area with the construction costs indices. Those indices are developed on the basis of similar projects, and give you a good estimate of the costs for your project. Look at BKI, great tool do define the construction costs.
2. Asset value method (Ertragswertverfahren)
This method is the sum of construction value and future nett profits of this property. The calculation goes:
+ Annual gross income
– Running costs (administration 3-5%, operating costs, maintenance, loss of rental income 4%)
= yearly pure profit
-Property value interest payment (Property value x property-interest rate
= property nett earnings
+/- other value influencing factors
= Building earnings value
+ Property value
= Capitalised Earnings power
Rents (or property prices) are the single biggest influencer in this equation. It is important to pay special attention to them.
3. Comparison value method (Vergleichswertverfahren)
This one is very straightforward. Compare your project with similar projects in size or scope, but also with nearby locations. Key factors are: size, land use, similar location and timeframe.
4. Other methods
4.1 Discounted cash flow method (barwertverfahren)
This method comes from finance and it simulates future incomes from a property. The usual timeframe is 10 – 15 years. You basically calculate the internal rate of returns (IRR), which is a useful tool to compare different alternative investments. It is not a real value identification method, but it is very helpful in decision making.
4.2 residual method
This method is based on the principle that the price to be paid for a property that is suitable for development is equal to the difference between the completed value of the highest and best form of permitted development and the total cost of carrying out that development. It is a highly subjective method of valuation and should be used with caution.