Defining the project value in CRE

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: 1) Comparison value (comparison with similar rental prices in the area), 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. These values are the key unknowns, which need to be determined for the project success.

1. Asset value (Sachwererfahren)

The basic calculation goes (for the german readers, WertV98):

+ Building

+ Exterior

+ 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

+Land value

= Property value

Very straightforward, right? The cost of the building can be approximated with the following two methods:

1. 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.
2. 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 property is seen as an asset, as it produces cashflow, and has capital value. The calculation goes:

+ Annual gross income (from rents)

– 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

x multiplicators

+/- 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. Can be very imprecise, if not done right.

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. Here is a lecture from columbia university on this topic.

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.