The Residual Valuation of a Property Development

Introduction

Its a fairly common sight to see land for sale which appears to have the potential for development.
The asking price of land varies by a huge amount depending on many factors. So how does a
developer know if the asking price is a good one or not? He will need to establish what the land is
worth to him. In this circumstance, its probably initially worthwhile to forget the asking price.
Theres a chance its completely overpriced anyway. The developer has to establish what he should
pay for it. It is vital when developing property, that you have a reasonably accurate idea of what the
property will ultimately be worth (Capital and/or Rental value) when work is completed.

The Residual method (or Hypothetical Development Method) is a way of valuing a property (this
includes parcels of undeveloped land) that has development potential. Incidentally this can also be
known as latent value.

Whether a particular property has potential to be developed will depend upon the expected
development when work is complete. For example, if a developer wishes to build a solitary house on
a large plot of land, the eventual sale price will be dramatically different to if a commercial property
is built on it. The residual valuation method is designed to compare the eventual sale price against
the total cost of purchase and building work. The project can be fairly quickly assessed to establish
the overall financial viability of it before committing to a detailed financial analysis of costs and
expected benefits.

The amount available for land purchase is the absolute maximum that the developer should pay for
the undeveloped project. In practice however, the developer must also take into account
professional fees involved with the land/property purchase and SDLT/property taxes too within this
purchase price.

The undeveloped property might be:

1. Brownfield or Greenfield land where buildings have never stood and may or may not have
been registered as contaminated.
2. A cleared site where the property has been demolished.
3. A property that requires renovation or conversion to a lesser or greater degree.

The Equation

The first value to establish is the Gross Development Value (GDV). It can be defined as:

The expected property value, all circumstances being normal and using recent
transactions as guidance, when sold to a willing purchaser on the open market

The GDV forms the very basis of any financial appraisal carried out on the project. It is the figure
that permits all the other considerations such as required profit, building costs, legal costs and site
purchase cost to be weighed against, enabling analysis of the financial viability of the project.
To establish the GDV, the comparable method of valuation will be used to obtain reasonably accurate
sale values for recent transactions of similar properties. These can be analysed and the selling price
compared to the property in question. Although the comparable method is not flawless, it is actually
about the most accurate method available and forms the basis of most methods of property
valuations.

It is not only the expected capital value that would form the GDV. If the property is to be developed
for investment, then the purchaser might use recent lettings to find comparable rental values. He
can then attempt to establish a likely annual rent; the rent figure is then multiplied by a suitable yield
figure (which is established through general property-type market analysis and experience) to
produce an approximate capital value. An example of this might be if a property is expected to
produce an annual rent of 50,000 (or $) to the Landlord, the market may signal that properties of
this particular type are currently producing a 5% yield. What this means is 50,000 represents 5% of
the capital value of it. This produces a capital value of 1 million (again, this works with $ too). This
is a very approximate figure and this way of valuing a property is known as the Investment method.
The property market is very cyclical. This means that demand for property goes up and down in
reaction to what is happening in the economy as a whole. This has quite an effect on yield rates
because as demand for investment property drops (for example), capital values drop too. If rents
stay the same (as they form part of the tenancy agreement) then the yield figure will rise and vice-
versa.

Note the expected price is different to a forecast price where the developer would attempt to
predict a future value of the property. This would obviously become inaccurate should any aspect of
the property market change and its a common misjudgement among novice developers. The GDV
should always be based upon values available at the time the valuation is carried out and upon the
most efficient use of the property/plot. If (for example) a site is available that can accommodate 4
houses and only 2 are built, it could be argued the completed value of the development is not the
true GDV.

For example a residential development of (for example) 13 properties is to be built. Fairly accurate
and recent comparable sale values should be established. The combined sales value of all 13
properties would produce the GDV. Obviously all properties are different to some degree (such as
location, size, outlook or facilities) and this should be reflected in the expected values of each
property. This GDV represents the total value obtained if all properties were sold on the open
market. This could be considered a hypothetical situation because its unlikely that all 13 properties
would be sold in quick succession and without reduction of the value of at least one individual unit.

There is 2 ways of using the residual valuation method.

The basic formula to calculate land value (when the required level of profit is known) is:
The formula shows how the Residual method allows the appropriate land purchase value to be
established using the GDV figure minus all expected costs, including profit.

It is however, an excellent consideration for the novice developer as it places the emphasis on
expected property value using current and recent comparisons. This is in contrast to hoping for an
exceptional property sale price that exceeds most or any that are typical at the particular time of
appraisal.

The alternative residual appraisal formula is where the land value is known but the Developers
required profit is not:

This is a more conventional way of appraising a property development, as many novice developers
might feel that profit is more of a bonus than an expectation (especially in the current financial
climate).

Clearly if the land value is known and the profit is a particular amount, another aspect must be
changed. For the Residual valuation method to work, one variable amount (i.e. not fixed) must be
present in the formula.

Build costs could include:

a. Site clearance. If the site has an existing 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. Construction costs. These can vary by a massive amount. It will depend on end quality of
the property (i.e Grade A offices or lower-end Industrial), the region/area its being built in
and whether the contractor is a main one or not. As a very approximate guide, most
residential property builds would be around 120-150 per Ft or 1200-1500 per M ($180
per Ft) high-end office property will cost upwards of 200(around $300) per sq ft or
2,000($3,000) per sq M.
c. Contingency sum. This is often around 5% of total build costs.

Finance costs cover the expense of borrowing money for the project. This is unlikely to be for a very
long term, but is likely to be from approximately the commencement of construction to the eventual
sale or let of the property. The cost of borrowing will depend on the amount of capital put into the
project, the construction period, and the rate of interest applied to the loan. As the vast majority of
property development building contractors are paid in stages, the finance costs are very roughly
estimated by halving the total interest payable on the full borrowed amount over the full term of the
development, see below for a fuller explanation.

Most small to medium sized projects will be constructed within around 12 months. If this is the case,
the cost of borrowing will not actually be 12 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. Also, there is likely
to be a void between the completion of the property and the point of sale or let. So to calculate the
financial liability of the project:

12 month construction period 2 (say) = 6 months interest

+ 6 months occupancy void 6
12 months worth of interest

Therefore for a combined construction and void period of around 18 months, 12 months worth of
repayments might be a figure to adopt.

The rate of interest adopted for the appraisal could be several percent above base rate. However in
the case of large projects where an investment company is contracted to purchase the property
when its 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 speculative (i.e. an occupier is not secured prior to build
commencement).

Build phase professional fees for Architect, Legal, Quantity Surveyor and Structural Engineer often
come to around 12% of total building costs, without VAT (in the UK some qualifying developments
will be VAT exempt for materials and some other costs, however Professional fees will always be
subject to VAT).

The level of profit a developer will seek is usually dependent on the amount of risk he feels he is
taking. Profit 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 profit of 15% of the GDV (for example) or
20% of build costs might suffice. However, a higher risk development might require a profit of up to
around 30%. This should hopefully be enough to cover 2-3 years rent. Profit is vital to the ongoing
business of property development, but it is the first place a developer looks when he/she is pushed
to pay more for land or costs. The profit can easily be squeezed out in order to be competitive. It is
down to the individual and the circumstances which approach to profit is to be adopted (i.e. a
slightly lower percentage of GDV compared to a higher percentage of build costs), an assessment
should be carried out to calculate which one suits the situation more.

Going into more Detail

Build costs

In relation to financial costs, the method of simply halving the total interest payments over the term
of the construction suits the idea of the residual appraisal because its a very easy mental calculation
to make. However in reality, the rate at which cash is used during a property construction project
tends to run in what is known as an S curve. The S curve is well known not only in the field of
Property Development, but also Civil Engineering and Project Management.
S Curve

This graph illustrates the typical pattern of expenditure for a property development through the
construction phase.

Early in the project, 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 project management is in full swing. Towards the end of the
project, the work rate and resulting cash-use rate slows dramatically. At this point, the developer
might be preparing for marketing or sale to an investment company.

The S Curve can provide quite an accurate prediction of the monthly interest payments throughout
the project. This is done by applying the agreed monthly interest rate (annual rate divided by 12) to
the accumulated borrowed expenditure; this produces the expected subsequent monthly interest
payment. Obviously the longer the project, the more interest is accumulated. Using the S Curve
illustration, its possible to see that the finances can be quite accurately monitored. Because of the
S-Curve pattern of expected monthly finance payments, a schedule can be produced that is accurate
provided the project progresses at the expected rate. The end value of the finance costs (at project
completion) is very likely to be different to the simplified method mentioned above.

Large modular development projects (such as multiple residential properties or a series of small
industrial units) can often offset the amount borrowed from a bank, by selling properties that are
completed early on in the programme. Any rent-free periods or other financial incentives for the
Tenant can be included in the S-Curve type schedule of financial costs.
VAT is another important aspect to consider. Specialist VAT advice is beyond the scope of this
publication; however certain principles can be confirmed. Initially, VAT 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 initially paying the VAT charges and actually receiving the money back. Therefore it
will usually only have effects on the cashflow during the construction. If the property is commercial,
it is likely the sale or letting of the eventual finished property will be subject to VAT too; this will
offset the developers outlay.

Fees can be predicted much more accurately than using the percentage rates mentioned above. Its
always a good idea to establish a fixed cost agreement with as many contractors as possible. This will
clearly be based upon the work only involved specific elements; any work over and above that in the
agreement will no doubt be charged extra. However, in this way its possible to obtain accurate
quotes of the work to be carried out. This will contribute to a far more accurate residual valuation.
The above example can be used as a template within this Word document in the later versions of MS
Office. If you are running a version which doesnt allow this, the useable template/example can be
downloaded from:
http://www.thepropertyspeculator.co.uk/Downloads/Example%20Detailed%20Residual.xls

To edit the above Excel file in later versions of MS Office, double click on the table.

Template Instructions (numbers relate to the individual fields):

1. The Gross Development Value calculation. This can be based upon a development of
several properties or just one. The calculations of rates per M are there mainly to aid
calculation of build costs.

The expected sale price of the properties can be altered as this is never guaranteed in
practice. This value can also be changed to carry out a sensitivity analysis.

2. Construction Phase. The demolition costs can be omitted if appropriate to the calculation.
The build costs are one of the most influential aspects of the residual calculation. The
eventual land value will tend to change substantially with only a small change in build costs.

The landscaping costs can be omitted too if appropriate.

3. Fees and Costs. These costs amount to only a small proportion of the build costs. Therefore
they tend to have less of an influence over the eventual land value produced by the
calculation. Its important to have a contingency built in. Property Development involves
many unknown factors and they tend to require money to overcome.

4. Finance Costs. In the example, the expected monthly repayments are placed in an S-Curve
pattern. The annual percentage rate of the borrowed amount can be divided by 12 to
produce the monthly interest payable on outstanding borrowed funds. Over the period of
construction, this is totalled to produce an overall financial cost of the project.

It is assumed that the financial arrangement will be based upon paying regular interest-only
payments. The capital amount borrowed will then be repaid at the end of the project when
the development is sold.

5. S.106 Agreement costs. In the UK, the planning authorities usually place a particular
condition within the planning consent that states the developer must make a financial
contribution to the surrounding area. This is (sort-of) the price for receiving the required
permission to construct the development. It does NOT amount to a bribe, as the local
authority is legally obliged to use it in association with the planned project. This might be
(for example) the widening of an access road, or to construct a childrens playground. Clearly
this costs the developer money, and must be considered in the calculation.

Sometimes, a S.106 agreement has to be paid at the very beginning of the project,
sometimes at the end. If the contribution must be paid at the end, it is common practice to
discount this money back to a present value over the expected construction period of the
project. Obviously if this type of arrangement does not apply in certain countries, place a
zero in these particular cells.
 6. Developers Required Profit. If using the above as a template, it is possible to select how
the profit is to be calculated. This is by using the radio buttons within the field.

7. Marketing and Sales fees. These are associated with the eventual sale of the development
and if any aspect is not applicable, just place a zero in the cells.

8. Land Value. The Gross Land Value is the result of applying the Residual Valuation formula.
However, this is likely to be subject to legal fees and tax (SDLT in the UK). A land option fee
might also be payable to the existing owner of the land.

The result is the Net Land Value. This represents the maximum that should be paid for the
land or property at the very beginning of the project.

The Residual method of valuation is really intended to be a very quick way of getting a fairly accurate
idea of how much to pay for a development project. It is designed to be basic enough to perform
mentally without any need to write it out. This is why its such a good idea to have a rate of build
costs, finance costs and required profit in mind when looking at a prospective project.