The Residual Valuaton of a Propery Developmen Inroducton
It’s a fairly common sight to see land for sale which appears to have the potenal for development. The asking price of land varies by a huge amount depending on many many factors. So how does a developer know if the asking price is a good one or not? He will need to establish what what the land is worth to him. In this circumstance it’s it’s probably inially worthwhile to forget forget the asking price. There’s a chance it’s it ’s completely overpriced overpr iced anyway. The developer has to establish what he should pay for it. It is vital when developing property property that you have a reasonably accurate idea of what the property will ulmately be worth !"apital and#or $ental value% when work is completed. The Residual method !or Hypothecal &evelopment 'ethod% is a way of valuing a property !this includes parcels of undeveloped land% land% that has development potenal. potenal. Incidentally this can also be known as (latent value’. )hether a parcular property has potenal to be developed will depend upon the e*pected development development when work is complete. +or e*ample if a developer developer wishes to build a solitary house on a large plot of land the eventual sale price will be dramacally di,erent di,erent to if a commercial property is built on it. The residual valuaon method method is designed to compare the eventual eventual sale price against the total cost of purchase and building work. work. The pro-ect can be fairly uickly assessed to to establish the overall /nancial viability of it before commi0ng to a detailed /nancial analysis of costs and e*pected bene/ts. The amount available for land purchase is the absolute ma*imum that the developer should pay for the undeveloped pro-ect. In pracce however however the developer must also take into account professional fees involved involved with the land#property purchase and S&1T#pr S&1T#property operty ta*es too within this purchase price. The undeveloped property might be2 3. 4rown/el 4rown/eld d or 5reen/eld 5reen/eld land where where buildings buildings have have never never stood stood and may or may may not have been registered as (contaminated’. 6. 7 cleared cleared site site where where the proper property ty has been demolished demolished.. 8. 7 property property that reuir reuires es renovao renovaon n or conversio conversion n to a lesser or greate greaterr degree. degree. The Equaton
The /rst value to establish is the ( Gross Developmen Value’ (GDV. It can be de/ned as2 ‘The expected property value, all circumstances being ‘normal ’ and using recent transacons as guidance, when sold to a willing purchaser on the open market’
The GDV forms the very basis of any /nancial appraisal appraisal carried out on the pro-ect. It is the /gure that permits all the other consideraons such as reuired pro/t building costs legal costs and site purchase cost to be weighed against enabling analysis of the /nancial viability of the pro-ect.
To establish the 5&9 the compara!le method of valuaon will be used to obtain reasonably accurate sale values for recent transacons of similar properes. These can be analysed and the selling price compared to the property in ueson. 7lthough the comparable method is not :awless it is actually about the most accurate method available and forms the basis of most methods of property valuaons. It is not only the e*pected capital value that would form the 5&9. If the property is to be developed for investment then the purchaser might use recent le0ngs to /nd comparable rental values. He can then a;empt to establish a likely annual rent< the rent /gure is then mulplied by a suitable yield /gure !which is established through general property=type market analysis and e*perience% to produce an appro*imate capital value. 7n e*ample of this might be if a property is e*pected to produce an annual rent of >@@@@ !or A% to the 1andlord the market may signal that properes of this parcular type are currently producing a B yield. )hat this means is >@@@@ represents B of the capital value of it. This produces a capital value of >3 million !again this works with A too%. This is a very appro*imate /gure and this way of valuing a property is known as the Invesmen method. The property market is very cyclical. This means that demand for property goes up and down in reacon to what is happening in the economy as a whole. This has uite an e,ect on yield rates because as demand for investment property drops !for e*ample% capital values drop too. If rents stay the same !as they form part of the tenancy agreement% then the yield /gure will rise and vice= versa.
Cote the e*pected price is di,erent to a ( forecas price’ where the developer would a;empt to predict a future value of the property. This would obviously become inaccurate should any aspect of the property market change and it’s a common mis-udgement among novice developers. The 5&9 should always be based upon values available at the me the valuaon is carried out and upon the most eDcient use of the property#plot. If !for e*ample% a site is available that can accommodate E houses and only 6 are built it could be argued the completed value of the development is not the true 5&9. +or e*ample a residenal development of !for e*ample% 38 properes is to be built. +airly accurate and recent comparable sale values should be established. The combined sales value of all 38 properes would produce the 5&9. Fbviously all properes are di,erent to some degree !such as locaon siGe outlook or facilies% and this should be re:ected in the e*pected values of each property. This 5&9 represents the total value obtained if all properes were sold on the open market. This could be considered a hypothecal situaon because it’s unlikely that all 38 properes would be sold in uick succession and without reducon of the value of at least one individual unit. There is 6 ways of using the residual valuaon method.
The basic formula to calculate land value !when the reuired level of pro/t is known% is2
The formula shows how the $esidual method allows the appropriate land purchase value to be established using the GDV /gure minus all e*pected costs including pro/t. It is however an e*cellent consideraon for the novice developer as it places the emphasis on e*pected property value using current and recent comparisons. This is in contrast to hoping for an e*ceponal property sale price that e*ceeds most or any that are typical at the parcular me of appraisal.
The alternave residual appraisal formula is where the land value is known but the &eveloper’s reuired pro/t is not2
This is a more convenonal way of appraising a property development as many novice developers might feel that pro/t is more of a bonus than an e*pectaon !especially in the current /nancial climate%. "learly if the land value is known and the pro/t is a parcular amount another aspect must be changed. +or the $esidual valuaon method to work one variable amount !i.e. not (/*ed’% must be present in the formula. "uild coss could include2
a. Site clearance. If the site has an e*isng property it will need to be demolished and taken away. If this property is occupied then tenants will need to be compensated for the premature ending of the lease. b.
"onstrucon costs. These can vary by a massive amount. It will depend on end uality of the property !i.e 5rade 7 oDces or lower=end Industrial% the region#area it’s being built in and whether the contractor is a main one or not. 7s a very appro*imate guide most residenal property builds would be around >36@=3@ per +t or >36@@=>3@@ per ' !A3@ per +t% high=end oDce property will cost upwards of >6@@!around A8@@ % per s J or >6@@@!A8@@@% per s '.
c.
"onngency sum. This is oJen around B of total build costs.
#inance coss cover the e*pense of borrowing money for the pro-ect. This is unlikely to be for a very
long term but is likely to be from appro*imately the commencement of construcon to the eventual sale or let of the property. The cost of borrowing will depend on the amount of capital put into the pro-ect the construcon period and the rate of interest applied to the loan. 7s the vast ma-ority of property development building contractors are paid in stages the /nance costs are very roughly esmated by halving the total interest payable on the full borrowed amount over the full term of the development see below for a fuller e*planaon. 'ost small to medium siGed pro-ects will be constructed within around 36 months. If this is the case the cost of borrowing will not actually be 36 months worth of interest. This is because the contractor
would be paid as the work progresses not in a single lump=sum at the beginning. 7lso there is likely to be a void between the compleon of the property and the point of sale or let. So to calculate the /nancial liability of the pro-ect2 36 month construcon period K6 !say% L N M months occupancy void
M months interest M 36 months worth of interest
Therefore for a combined construcon and void period of around 3 months 36 months worth of repayments might be a /gure to adopt. The rate of interest adopted for the appraisal could be several percent above base rate. However in the case of large pro-ects where an investment company is contracted to purchase the property when it’s completed or a Tenant has already signed an agreement to occupy the premises at an agreed rent !known as a pre=let% the developer will be able to borrow funds at a more favourable rate than if the development is speculave !i.e. an occupier is not secured prior to build commencement%. "uild phase professional fees for 7rchitect 1egal Ouanty Surveyor and Structural Pngineer oJen
come to around 36B of total building costs without 97T !in the QR some ualifying developments will be 97T e*empt for materials and some other costs however rofessional fees will always be sub-ect to 97T%. The level of pro$ a developer will seek is usually dependent on the amount of risk he feels he is taking. ro/t is the reward for the risk involved in developing a property. If the property is pre=let or even=pre=sold the risk would be regarded as low and a pro/t of 3B of the 5&9 !for e*ample% or 6@B of build costs might suDce. However a higher risk development might reuire a pro/t of up to around 8@B. This should hopefully be enough to cover 6=8 years rent. ro/t is vital to the ongoing business of property development but it is the /rst place a developer looks when he#she is pushed to pay more for land or costs. The pro/t can easily be sueeGed out in order to be compeve. It is down to the individual and the circumstances which approach to pro/t is to be adopted !i.e. a slightly lower percentage of 5&9 compared to a higher percentage of build costs% an assessment should be carried out to calculate which one suits the situaon more. Goin% ino more Deail
4uild costs
In relaon to $nancial coss the method of simply halving the total interest payments over the term of the construcon suits the idea of the residual appraisal because it’s a very easy mental calculaon to make. However in reality the rate at which cash is used during a property construcon pro-ect tends to run in what is known as an S curve. The S curve is well known not only in the /eld of roperty &evelopment but also "ivil Pngineering and ro-ect 'anagement.
S "urve
This graph illustrates the typical pa;ern of e*penditure for a property development through the construcon phase. Parly in the pro-ect the work is mainly desktop based in the form of legal environmental and topographical work and is only related to the site itself. This stage does not tend to use up cash at the same rate as the mid=point of the build. This stage tends to involve the use of large plant machinery many trades=people and pro-ect management is in full swing. Towards the end of the pro-ect the work rate and resulng cash=use rate slows dramacally. 7t this point the developer might be preparing for markeng or sale to an investment company. The S "urve can provide uite an accurate predicon of the monthly interest payments throughout the pro-ect. This is done by applying the agreed monthly interest rate !annual rate divided by 36% to the accumulated borrowed e*penditure< this produces the e*pected subseuent monthly interest payment. Fbviously the longer the pro-ect the more interest is accumulated. Qsing the S "urve illustraon it’s possible to see that the /nances can be uite accurately monitored. 4ecause of the S="urve pa;ern of e*pected monthly /nance payments a schedule can be produced that is accurate provided the pro-ect progresses at the e*pected rate. The end value of the /nance costs !at pro-ect compleon% is very likely to be di,erent to the simpli/ed method menoned above. 1arge modular development pro-ects !such as mulple residenal properes or a series of small industrial units% can oJen o,set the amount borrowed from a bank by selling properes that are completed early on in the programme. 7ny rent=free periods or other /nancial incenves for the Tenant can be included in the S="urve type schedule of /nancial costs.
97T is another important aspect to consider. Specialist 97T advice is beyond the scope of this publicaon< however certain principles can be con/rmed. Inially 97T will be charged on most aspects of the build. In some cases this can be claimed back but there will be a gap of several months between inially paying the 97T charges and actually receiving the money back. Therefore it will usually only have e,ects on the cash:ow during the construcon. If the property is commercial it is likely the sale or le0ng of the eventual /nished property will be sub-ect to 97T too< this will o,set the developer’s outlay. +ees can be predicted much more accurately than using the percentage rates menoned above. It’s always a good idea to establish a /*ed cost agreement with as many contractors as possible. This will clearly be based upon the work only involved speci/c elements< any work over and above that in the agreement will no doubt be charged e*tra. However in this way it’s possible to obtain accurate uotes of the work to be carried out. This will contribute to a far more accurate residual valuaon.
The above e*ample can be used as a template within this )ord document in the later versions of 'S FDce. If you are running a version which doesn’t allow this the useable template#e*ample can be downloaded from2
h;p2##www.thepropertyspeculator.co.uk#&ownloads#P*ampleB6@&etailedB6@$esidual.*ls To edit the above P*cel /le in later versions of 'S FDce double click on the table. Template Instrucons !numbers relate to the individual /elds%2 3.
The Gross Developmen Value calculaton . This can be based upon a development of
several properes or -ust one. The calculaons of rates per ' are there mainly to aid calculaon of build costs. The e*pected sale price of the properes can be altered as this is never guaranteed in pracce. This value can also be changed to carry out a sensivity analysis. 6. &onsructon Phase. The demolion costs can be omi;ed if appropriate to the calculaon. The build costs are one of the most in:uenal aspects of the residual calculaon. The eventual land value will tend to change substanally with only a small change in build costs. The landscaping costs can be omi;ed too if appropriate. 8. #ees and &oss. These costs amount to only a small proporon of the build costs. Therefore they tend to have less of an in:uence over the eventual land value produced by the calculaon. It’s important to have a conngency built in. roperty &evelopment involves many unknown factors and they tend to reuire money to overcome. E. #inance &oss. In the e*ample the e*pected monthly repayments are placed in an S="urve pa;ern. The annual percentage rate of the borrowed amount can be divided by 36 to produce the monthly interest payable on outstanding borrowed funds. Fver the period of construcon this is totalled to produce an overall /nancial cost of the pro-ect. It is assumed that the /nancial arrangement will be based upon paying regular interest=only payments. The capital amount borrowed will then be repaid at the end of the pro-ect when the development is sold. . ')*+ ,%reemen coss. In the QR the planning authories usually place a parcular condion within the planning consent that states the developer must make a /nancial contribuon to the surrounding area. This is !sort=of% the price for receiving the reuired permission to construct the development. It does CFT amount to a bribe as the local authority is legally obliged to use it in associaon with the planned pro-ect. This might be !for e*ample% the widening of an access road or to construct a children’s playground. "learly this costs the developer money and must be considered in the calculaon. Somemes a S.3@M agreement has to be paid at the very beginning of the pro-ect somemes at the end. If the contribuon must be paid at the end it is common pracce to discount this money back to a present value over the e*pected construcon period of the pro-ect. Fbviously if this type of arrangement does not apply in certain countries place a (Gero’ in these parcular cells.
M. Developer’s Required Pro$ . If using the above as a template it is possible to select how the pro/t is to be calculated. This is by using the (radio’ bu;ons within the /eld. . -ar.etn% and 'ales fees. These are associated with the eventual sale of the development and if any aspect is not applicable -ust place a Gero in the cells.
. /and Value. The 5ross 1and 9alue is the result of applying the $esidual 9aluaon formula. However this is likely to be sub-ect to legal fees and ta* !S&1T in the QR%. 7 land opon fee might also be payable to the e*isng owner of the land. The result is the Cet 1and 9alue. This represents the ma*imum that should be paid for the land or property at the very beginning of the pro-ect.
The $esidual method of valuaon is really intended to be a very uick way of ge0ng a fairly accurate idea of how much to pay for a development pro-ect. It is designed to be basic enough to perform mentally without any need to write it out. This is why it’s such a good idea to have a rate of build costs /nance costs and reuired pro/t in mind when looking at a prospecve pro-ect.
