What is a Residual Method of Valuation? | A Guide for Developers
A residual method of valuation is a way of valuing land. Here is what a residual method of valuation is, when it might be used and how it works.
What Exactly is a Residual Method of Valuation?
A residual method of valuation is a method of valuing land based on its developed value.
There are a number of different approaches to valuing development land including the market comparison method and the residual method.
Land and property can be valued on the basis of its market value, ie. its value as a piece of land or property which may be based on the value of comparable property. However, the residual method of valuation works by assessing a value based on its developed value less the cost of developing it.
In simple terms, residual refers to the amount ‘left over’ after all the relevant costs of development and profit have been deducted.
Valuers may use both a market comparison valuation and a residual valuation alongside other methods when valuing land.
There are also two kinds of residual valuation. These are the basic residual valuation and the discounted cash flow method, which is a more complex form of residual valuation.
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What a Residual Method of Valuation is Used For
Property developers are likely to use a residual method of land valuation. It is a way of estimating the likely costs, likely returns and possible profits on a development project that they are considering and so helping them decide whether it is viable.
A residual method of valuation is a way of planning a budget and of managing the risk on a project.
A residual method of valuation may also be of use in obtaining finance for a project. It will indicate to the lender what the completed property and the land to be purchased is worth.
A residual method may be used as a way of ascertaining what the undeveloped land is worth and how much should be paid for it. This may be of use when negotiating the purchase of it with the seller.
How to Calculate a Residual Method of Valuation
The residual method of valuation works on the basis that the value of a property with
development potential equals the value of the property after development less the cost of carrying out the development and a profit for the developer.
A basic residual valuation is calculated like this:
Residual value = Gross development value (GDV) – total development costs including profit
What is Involved in a Residual Method of Valuation
Although the residual valuation calculation is essentially a simple calculation there are a number of different issues to consider and different values to estimate when using the residual method.
Gross development value (GDV): This is the market value of the completed project. It may be based on the likely rent and yield of the completed project.
Profit: This is the amount of profit that the developer of the project requires or is willing to accept. It is likely to dictate the maximum price the developer is willing to pay for the land.
Now to consider total development costs:
Land costs: The comprises the purchase price or likely purchase price of the land at the point of buying it. It includes any purchase taxes payable. These are also known as acquisition costs.
Build or construction costs: This comprises the cost of building on the land. It is likely to be based on an estimate, allowing for an estimate of the likely cost when the work is carried out. It may include fees which arise directly from the building work including legal fees, project management, planning costs and section 106 costs.
Fees: This includes most professional fees payable on the project which are not included in building costs. For example, other legal fees, planning consultant’s fees, environmental impact assessments etc.
Sales or letting costs: These comprise an estate agent’s fees and commission for selling a completed development or a letting agent’s fees for finding a tenant or tenants. They also include the marketing costs of the completed project.
Finance costs: This comprises the cost of financing the project, including the interest rate and arrangement fees on borrowed capital. When considering finance a valuation should also take into account cash flow.
Contingency costs: A residual method of valuation may include a contingency for cost overruns and other increased costs.
Other costs: The above list of costs to be considered in a residual valuation is not exclusive and may include other costs depending on the particular project. For example, land surveys, demolition costs and land remediation costs (eg. the removal of contaminated material). It may incorporate an allowance for expenses between when a project is completed and when it is sold or let, eg. utility and security costs and void periods.
It is necessary to consider these costs not only at the point the residual valuation is carried out but at that future point at which the proposed development is completed. This can be addressed by way of the discounted cash flow method. Also, it is important to bear in mind that some forecasts and estimates may change. For example, building costs change once a detailed design has been worked up.
Is it Possible to Have a Negative Residual Land Valuation?
Yes, it is possible to have a residual land valuation that is a negative amount. A negative valuation would be obtained where the costs of developing land according to a particular scheme are greater than its gross development value.
How to Obtain a Residual Valuation
In theory it is possible to use the residual method of valuation yourself in order to value development land.
There are also some online calculators which say they can provide a quick appraisal of the residual valuation.
Obtaining an accurate residual valuation requires a detailed knowledge of the appropriate methods to use, good local knowledge and in depth research however. So it is advisable to consult a qualified surveyor in order to obtain an accurate residual valuation.