Note, this article should be read in conjunction with the Property Speculator’s Excel-based Residual Valuation Calculator.
The primary use for a residual appraisal is to produce a figure for land or undeveloped property purchase, in addition it can also be used to:
- Establish a required profit from a project and place that figure into the calculation.
- Consideration of the maximum value available for build costs, above which the project will become less financially attractive.
The undeveloped property might be:
- Brownfield or Greenfield land where buildings have never stood.
- A cleared site where the property has been demolished.
- A property that requires renovation or conversion to a lesser or greater degree.
The very basic formula for a Residual Valuation is:
Gross Development Value or Value completed
Costs and Profit
Amount available for Land Purchase/Pre-Development Property
The first value that has to be established is the Gross Development Value. This is essentially the total value of the completely finished project. In most cases, the comparable method of valuation will be used to obtain reasonably accurate values for Sq Ft or Sq M. Recent transactions can be analysed and the selling price or annual rent compared to the property in question. Although the comparable method is not flawless, it is about the most accurate method to establish (completed) property value available.
Some important considerations are:
- If a project containing multiple dwellings is to be analysed, the GDV will be based upon the total value obtained from the sale of all the units. The value that can be obtained on the market can be expressed as a rate per M² and can be established through the study of comparable, similar properties recent sold prices (NOT the values they are offered at).
- When establishing the total value of the finished project, remember that common areas such as stairways, hallways and foyers are not included within this value, but they will be included in build costs.
- The amount available for land purchase is the absolute maximum that the developer would pay for the undeveloped project. In practice however, this figure is likely to become the Gross Land Value because he has to:
- Allow for professional fees (Agents and Legal) and SDLT/property taxes.
- Consider discounting the land value to account for general economic inflation that will occur during the development period.
- Any interest payable on capital used to fund the land purchase (not already included in the main finance total).
When the above have been subtracted, the Developer is left with the Net Land Value.
The second value to be looked at is the total costs of the project. This will include build costs, consultant’s fees, finance costs, infrastructure/landscaping costs and any obligation for S.106 agreement (a contribution to the Local Council in connection with the project) or Community Infrastructure Levy (CIL). Considerations are:
- As mentioned above, build costs will include the total value of the units to be sold and any common built areas (based upon Gross Internal Area). Build costs can range from £600 per M² to £1600 per M² depending on the area of your project (obviously London/South east will be more expensive than Northern England and Wales) the required quality of finish and who you intend to do the work (Main Contractors is the most expensive route). Click on the link for information on build costs. VAT can often be reclaimed on many costs involved with new-builds.
- The amount spent on consultants will vary according to the size of the project. However for the purpose of appraising the project, using percentages is the most appropriate way for the majority of projects to be looked at. Examples are: Architect 5-7.5% of build costs and a Project Manager around 2% of build costs) VAT will almost always be payable on consultant’s fees.
- Site infrastructure will include drainage, water, gas and electricity supplies. For small projects, the cost will be negligible and the same goes for landscaping costs. This is why a percentage calculation is appropriate.
- Finance costs will depend heavily upon the amount borrowed and the rate it’s borrowed at. If the project is intended to be solely a development (rather than a development with the aim of letting at the end of the construction phase) then the costs should be recouped as soon as possible. Obviously the longer it takes to recoup all construction costs; the more must be paid in finance costs. For the purposes of calculation, a construction period of 1-12 months and a post-construction marketing period of 2-8 months should cover the vast majority of situations.
- S.106 costs will be related to how the project as a whole ‘fits in’ to the local environment. A contribution is often requested by the local authority to pay for changed infrastructure to serve the project. This might be a widened road leading to the development to serve the occupants. Follow the link to read more about s.106 obligations for developers.
- Estate agents fees are quite negotiable depending on the size of the development. It would not be unreasonable to attempt to negotiate a slight discount of half a percent or so for sole agents that will be acting for a large development.
The next figure is the required profit level. This is often calculated as a percentage of the GDV value. It’s important that the profit is considered in the equation, because it’s surprising how many novice developers regard a profit as a bonus. To continue developing property must be regarded as a business. If no profit is made, then the business will not survive for long.
Clearly, the higher the required profit level, the less will be available to purchase the land. So a balance must be struck. Pre-recession profits could be around 33% of GDV (a very crude assessment of a property development was’ 1/3rdfor land costs, 1/3rdfor build costs and 1/3rd for profit’). It’s very doubtful whether this would still be attainable now, in practice a rate of around 15% of GDV is realistic. It certainly helps to be conservative and cautious when appraising a development.
The final and eventual figure to be generated is the sum available for land purchase. This can be changed considerably if the input figures are changed. In fact one of the criticisms of the residual valuation method is that for relatively small changes in the input figures, large changes in the eventual values can be seen. This is why it helps to be cautious with input figures, overestimation of costs is better than underestimation.
The land purchase figure is the figure that forms the basis of your negotiation. If the property is being bid on at an auction, obviously no opportunity to negotiate will exist. It will however provide you with a good idea of how your project finances will work and if you bid above your ideal value, the other figures will be reduced accordingly (profit is usually first to suffer).
To download the very finest guide to Assessing Land Value, the Residual Valuation method and Gross Development Value currently available on the internet for only £5, please have a look at my ‘How to Price Development Land‘ page.
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