The Residual method is a way of valuing a property that has development potential.

Whether a particular property has good potential to be developed will depend upon the

increase in property value exceeding the cost of building work. The project can be studied to

establish the overall financial viability of it before committing to a detailed financial analysis

of costs and expected benefits.

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 available. However if no comparable values

are available, the residual method is used.

The primary use for a residual appraisal is to produce a figure for land purchase, in addition it

can also be used to:

1. Establish a required profit from a project and place that figure into the calculation.

2. Consideration of the maximum value available for build costs, above which the

project will become less financially attractive.

The basic formula for a residual appraisal is:

Gross Development Value or Value completed

Less

Costs and Profit

Equals

Amount available for Land Purchase

The amount available for land purchase is the absolute maximum that the developer would

pay for the undeveloped project. In practice however, the developer is likely to pay less than

this because he has to:

1. Allow for professional fees and SDLT or property taxes.

2. Pay interest charges on any money borrowed to fund the development.

The undeveloped property might be:

1. Brownfield or Greenfield land where buildings have never stood.

2. A cleared site where the property has been demolished.

3. A property that requires renovation or conversion to a lesser or greater degree.

Gross Development Value (GDV) can be defined as

“The value of the completed proposed development if the property is sold to a willing

purchaser on the open market”.

If the proposed use is residential, then comparable values from similar sold properties can be

used to calculate an overall scheme value. If the development is planned to be Office,

Industrial or retail then comparable similar rental rates (per sq ft/M) and yields can be used to

establish an appropriate value.

Build costs could include:

1. 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.

2. 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

it’s being built in and whether the contractor is a main one or not. As a very

approximate guide, high-end office property will cost upwards of £100(around $150)

per sq ft or £1,000($1,500) per sq M.

3. Contingency sum. This is often around 5% of total build costs.

Professional fees for Architect, Legal, Quantity Surveyor and Structural Engineer often

come to around 12% of total building costs, without VAT.

Finance costs cover the expense of borrowing money for the project. This will not be for a

very long term, but is likely to be from 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.

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Most medium sized projects will be constructed within around 12 months. If the building

period is 12 months, the cost of borrowing would not be 12 months worth of interest though.

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, plus 6 months occupancy void =

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 around 2%-5% above current base

rate. However in the case of large projects where an investment company is contracted to

purchase the property when it’s completed, the developer might be able to borrow funds at a

more favourable rate than from a bank.

Large residential development projects can often offset the amount borrowed from a bank, by

selling properties that are completed early on in the programme.

Letting fees for commercial properties are often 10% of the annual rent figure.

The profit gained through a development project is often around approximately 20% of total

build costs or 15% of GDV. 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 developers

look when they are pushed to pay more for land or costs. The profit can easily be squeezed

out in order to be competitive.

If the land price is already agreed, an alternative to the residual appraisal formula stated

above is:

Gross Development Value

less

All costs (including land, taxes and fees)

equals

Profit

The residual method can be used to get an idea of all the particular aspects that go into the

development appraisal. It uses an equation that can be simplified to such a degree as to allow

very approximate appraisals to be carried out mentally.