The Residual method of property appraisal (or Hypothetical Development Method) is used to help in assessing whether a property development project is financially viable or not. If a property has development value (it can also be known as ‘latent value’), it means that its expected future value after works exceeds the expenditure.
The first value that must be established is the Gross Development Value (GDV). This is the capital value that the completed property is expected to be worth on the open market when sold to a willing purchaser. The GDV is different to the forecast price, where the developer attempts to predict the value of the property in line with a falling or rising market. This is unsurprisingly quite inaccurate, but it’s a common misjudgement among novice developers. The GDV should always be based upon values available at the time the appraisal is carried out. The GDV should be based upon the most efficient use of the property/plot. If a site is available that can accommodate 4 houses (for example) and only 2 are built, the completed value of the development is not the true GDV.
To establish the GDV, the most accurate method is the comparative method of valuation.
The residual appraisal is a very easy concept to understand, the equation is based upon a very logical approach. It is as follows:
The amount available for land purchase is the absolute maximum that the developer should consider paying. This is because there will be other considerations, such as repayments on the development mortgage, legal fees and Stamp Duty Land Tax (SDLT). Therefore, if the developer can purchase the property for less than his budgeted amount, he will certainly benefit.
Through transposition of the individual components within it, the residual method can be used for 3 main purposes:
1. Calculating the potential profit margin where the GDV, build costs and land/property cost is already known.
2. Finding a maximum value for build costs, where profit, GDV and land value is known.
3. Establishing a maximum price to be paid for the land/property when other values are known.
Build costs are probably one of the trickiest aspects to consider when carrying out a residual appraisal. The easiest way to do this is to apply a rate per sq ft or sq M and multiply it by the expected area of the completed property. So if a property of around 2,000 sq ft is to be developed or built, a rate of £100 per sq ft could be applied. This would produce a build cost of around £200,000. However, a more realistic rate is more likely to be closer to £80 per sq ft (by current standards). This will include fees and a contingency amount. If development work is substantial, then a ‘build cost rate’ can be applied as it will be so similar to a ‘renovation cost rate’.
Finance costs can vary quite considerably, depending on amount borrowed, construction time and rate of interest. As discussed in many other posts, to provide all project funds in the form of equity (money that has not been borrowed) is not a particularly shrewd idea. Likewise, to borrow too much in the form of a loan is not a good idea either.
If the project takes 12 months from initial completion to sale of the property, then that’s 12 months worth of loan repayments that must be included into the associated costs. For a mortgage of £200,000 that can be around £12,000 in total, depending upon the variable mentioned above.
Profit is also a vital aspect of development. Many novice developers calculate their projects the wrong way, they consider the property cost; add the expected build/renovation costs and the remainder once it has sold is profit. This is not the best way to approach your venture, a business needs profit to survive and you need it to invest in your next property project.
An example of a residual appraisal is as follows:
This calculation shows that around £130,000 (to round the figure up) would be around the price you should be buying the undeveloped house at. This does NOT mean that you should start negotiation at this figure, it would be prudent be place in an initial offer comfortably below this price.
To download the very finest guide available on the internet to Assessing Land Value, the Residual Valuation method and Gross Development Value for only £5, follow this link to my ‘Assessing Land Value‘ page.