The Importance of Development Appraisal

Financial appraisal is a key part of assessing the viability of a development project. It is used throughout the development process to fulfil different requirements at different stages.

Firstly, an appraisal is used to determine the maximum price that should be bid for a parcel of land. Land for development has no intrinsic value: its value is derived from the use to which it can be put. Each scheme proposed for a plot of land will generate a different land value. A land owner will generally sell to the developer who submits the highest viable bid. The appraisal process, when used to determine land value, determines the highest bid a potential developer can make and still meet a target return.

Secondly it is used to determine the level of profit (or loss) that a scheme is likely to make. This is vitally important, not only to show the developer whether the scheme is viable but also as a tool to obtain finance. Potential financial backers, be they commercial lenders or potential purchasers of the final development, are not primarily interested in the aesthetics of the scheme or the cleverness of its technical solution. They are concerned with its financial viability.

Commercial lenders will scrutinise the financial appraisal very carefully before agreeing to advance any funds. They will essentially be looking at two things:

1.    Whether the assumptions underlying the development proposal are sound and whether the programming is realistic. They will ask a number of questions: for example, are the assumptions about the value fair, are the selling or leasing arrangements realistic, are construction costs appropriate, etc. The developer will have to demonstrate that all aspects of the appraisal are soundly based.

2.    Assuming that the scheme proposals are sound, then the finance provider will look closely at the profit margin predicted by the appraisal and will want to be satisfied that the developer is set to make a sufficient profit margin. This is not out of concern for the developer’s wealth as such but rather because the profit margin reflects a risk to the development. Effectively, the larger the profit margin is the lower the risk that the borrower will default because there is less chance that the scheme will go into deficit if things go wrong. There is no set scale as to the margin that lenders require but the table below gives an approximation of what they will be looking for:

Type of Scheme                       Normal Return on Cost Expected by lenders
Speculative commercial            20%
Commercial with pre-letting    10-20%
Residential                              10-15%