Residual valuation of land
Residual valuation is the process of valuing land with development potential.
The sum of money available for the purchase of land can be calculated from the value of the completed development minus the costs of development (including profit). The complexity lies in the calculation of inflation, finance terms, interest and cash flow against a programme timeframe.
Development costs may include things such as:
- Building costs.
- Professional fees.
- Marketing and sales costs.
- Other ancillary costs.
- Land acquisition costs.
In the UK, building cost information is published by organisations such as the Building Cost Information Service (BCIS) every quarter (this is a subscriber only service), giving details of historical cost information for a wide range of building types. This information is based on a national average of tender prices and is exclusive of external works, fees and VAT. There are regional adjustments to be made dependent on location. It is important to check whether cost information is based on the gross external area, including common parts, or based on net lettable areas. The difference can be as much as 20%.
- Feature lighting.
- Health and safety consultancy.
- Acoustic consultancy.
- Planning consultancy.
- Traffic modelling.
- Interior design.
- Site inspection.
- Building Information Modelling (BIM).
- Environmental impact assessment.
It is customary to apply a 5% to 7.5% contingency allowance based on estimated building costs to allow for unforeseen circumstances and cost risks. Until construction contracts are let, unforeseen risks can be mitigated by redesign, but that flexibility is no longer easily available once construction contracts have been placed.
Developers often use their own seed capital to fund the appraisal stage of development, which might include any design work necessary to obtain a planning consent. However, with the appraisal and planning risks out of the way, terms for funding loans are more advantageous and so they are likely to turn to banks or other institutions to fund construction and perhaps the latter stages of design.
The agreed interest rate and draw down facilities will be encapsulated in the funding or loan contract. Interest rates might be fixed, variable and/or capped. S curves are used to predict expenditure in respect of cash flow against an assumed programme.
Drawdown facilities (often on a quarterly basis) need to be more than sufficient, and timed to meet contractor's monthly valuations. Often developers will base residual value calculations on drawing down all construction and professional payments by the two thirds stage of the building period to avoid any risk of defaulting on payments.
Promotional marketing campaigns can cost as much as 1% of the development value. Letting agents traditionally look for 10% of the first year’s rental income or 2% of sales revenue. On the major schemes there is an opportunity using competition to negotiate these figures down.
Ancillary costs might include:
- Void costs between building completion and achieving total rental income. This might include: interest, insurance, rates, cleaning, maintenance, fuel, and security.
- Planning fees.
- Demolition and enabling works such as service diversions or site clearance.
- Public consultations and exhibitions.
- Planning conditions, planning obligations and the community infrastructure levy.
- Third party fees, such as party wall surveyors or lawyers.
- Topographical surveys.
- Geotechnical investigation such as boreholes and trial pits.
- Public utility charges.
- Archaeology costs.
- Site decontamination.
- Legal costs on sales or leases.
Gross development value is calculated by multiplying annual rent by the ‘year purchase’ at a yield appropriate to the type of property proposed in a given location. So a rent of £500,000 and a yield at 7.5% provides a year purchase of 13.33 and so a capital value of £6,665,000.
 Other considerations
 Development timescale
In calculating residual value a view has to be taken on how long the project is going to take from the point of incurring costs to the time when the full projected rental stream has been achieved, or sale is completed. The programme will have an effect on all aspects of cost, including finance charges.
Large-scale speculative commercial and retail developments may suffer a substantial void period before attracting tenants, and landlords sometimes offer rent free periods to entice tenants into the building. In property market downturns building development might only proceed with pre-letting agreements in place to avoid the risk of void costs and also reducing marketing costs.
Many larger projects can take far longer in the planning stages than in construction. Terminal 5 at Heathrow Airport, which was subject to a public enquiry, took thirteen years to get to the construction stage, but just four years to build.
Where costs and revenue are being incurred over a very long period it is usual to prepare a cash flow business plan, mapping out income, expenditure and cash flow position on a quarterly basis over the given period.
The cash flows are discounted back to the present rather than having interest added. The income is projected alongside projections of rental growth and discounted back to net present value (NPV) using an appropriate discount rate.
 Parry’s valuation and investment tables
- Net income received.
- The period over which net income will be received.
- The required yield.
A good knowledge of the letting and investment market is required to provide these inputs.
A sensitivity analysis should be carried out to highlight those variables with the highest impact on the development appraisal. The revenue income is normally a higher risk than the costs, the latter being slightly easier to predict than future national and local property market movements.
A £2 per sq ft difference in projected rent on a 100,000 sq. ft office block has a significantly greater effect on calculations than the cost of unforeseen ground obstructions or an increase in steel prices. From such analysis and an assessment of the likelihood that the risk will occur, a mitigation strategy can be developed.
Risks can be retained, shared, transferred or insured. As a general rule risk is best placed with the party that has greatest ability to control it. For example, ground risks might be placed with a contractor (albeit at a price). Incentives can also be used, for example, target cost contracts can be used with both consultants and contractors to share risk.
 Toolkits for residual valuation
Most developers have their own software for development appraisal with built in formula that allow them to choose variables and undertake sensitivity analysis. Assumption about interest rates, investment yields, and timescales can significantly alter the outcome, as can the projected rent per sq. ft.
Furthermore the criteria can shift during the course of the project, for example, net to gross calculations can only be fully determined when the design is complete.
 Related articles on Designing Buildings Wiki
- Appointing consultants.
- Base year.
- Compound Annual Growth Rate (CAGR).
- Consultant team.
- Development appraisal.
- Discounted cash flow.
- Funding options.
- Funding prospectus.
- Property valuation.
- Residual value insurance.
- Site selection and acquisition.
- Site appraisal.
- Site information.
- Site surveys.
- Speculative construction.
- Technical due diligence.
 External references
- Property Development appraisal and finance - second edition by David Isaac, John O’Leary and Mark Daley - published by Palgrave Macmillan.
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