Residual Method of Valuation

Objectives of Unit 9
• To learn another method of valuation which
could be used in-case there is no comparable
evidence nor rentals being paid to enable the
direct comparison method or the investment
method to be used.
• To appreciate circumstances in which the
residual method is the more appropriate
method to adopt in carrying-out a valuation.
 RESIDUAL METHOD OF VALUATION
• The residual method /the developer’s method is adopted in the
valuation of development property.
• The residual method of valuation works on the premise that the
price which a purchaser can pay for land is the residue after he has
taken from the proceeds of sale of the finished development, the
cost of construction, cost of purchase or sale, the cost of finance as
well as an allowance for profit required to carry out the project.
• In short, the above paragraph can be expressed as follows:
➢ Net proceeds of sale less cost of development plus developer’s
profit = surplus for land.
➢ A developer’s profit can either be expressed as a percentage of
gross proceeds of sale of the completed development or as
proportion of building costs for the development.
• Withstanding the above seemly simple equation there may be
difficulty in accurately estimating the components of the equation.
 The components of residual valuation
method equation
• Anticipated sales proceeds/gross development value – this
arises from the sale of the completed development and is
determined by the market conditions as well as the yield
which developer expects from the project.
• Development costs comprise the following:
➢ Demolition or site preparation costs
➢ Building /construction costs
➢ Professional fees – the project team has to paid
➢ Finance charges- interest has to paid on borrowed funds
➢ Landscaping charges
➢ Risk and profit allowance (developer’s profit).
All the above items may vary during the construction period hence
they have to be accurately estimated at all times
• The amount available to purchase the land is therefore a
residue arrived at by deducting the development costs from
the anticipated sales proceeds of the development.
 When to use of the residual method
• To calculate the maximum value of a development site
which is on sale in the open market. The maximum value
would then be compared with the asking price to see
whether a developer can afford the site.
• To calculate the expected profit from undertaking the
development where the site is owned by the developer. In
this case the site value would be a known cost of
development. The residual amount in this case would be
the profit which can then be compared with the profit
margin which the developer expects from the development
• To calculate a cost ceiling for construction where land has
been acquired and is therefore a known cost and a
minimum acceptable profit margin can be decided on.
 Example 1
• To fully appreciate how the residual method of
valuation works, lets consider the example below:
➢You are required to appraise the freehold interest in Lot
4964 Gaborone and to determine the price for the land
taking into account the information provided below:
✓ The property comprises of an old house which is presently
vacant. The owner has secured planning permission to
demolish the house and build a shop with offices above on
the site.
✓The shop will have a frontage of 10 metres and a depth of
25 metres. Two floors of offices will be built over the shop,
with separate access from the main road. Each floor will
provide 120 m2 of lettable space. The offices are expected
to be let at P75 per m2 and the shop at P25 000 per annum.
✓The completed development is expected to sell on the basis
of a 5 % return on capital.
 Further information for Example 1
• The following information is further provided in relation to
the above development:
✓ Legal costs for selling the development = 2% of sale value
✓ Building costs per m2 = P900 for shop space and P1200 for office
space
✓ The development will take one year to complete
✓ Interest charged on money borrowed for the project will be
charged at 12% per annum
✓ The developer expects a 25% profit on the total developmental
costs
✓ Fees on land purchase will be charged at 4% of the price of land
✓ Professional services will be charged at 12% of total building
costs
✓ Demolition costs amount to P10 000.00.
 SOLUTION

• Determination of proceeds of sale/GDV

✓Shop rent P25 000
✓Office rent; 240m2 @ P75 P18 000
✓ P43 000
✓YP in perpetuity @ 5% *20
✓Capital Value P 860 000
 Solution cont.
• Cost of sale at 2% of sale proceeds
✓ P860 000 * 0.02 = P17 200.00

• Determining the development costs

✓ Building costs: 250m2 @ P900/m2 (shop) P225 000
✓ 240m2 @P1200/m2 (office) P288 000
✓ P513 000
✓ Demolition costs @ P10 000
✓ Costs of finance:
➢ Demolition costs: P10 000 for 1 year at 12% * P1 200
➢ Building costs: P513 000 for half year @ 12%** P30 780
Total Development Costs P554 980.00
* Money that borrowed to purchase land is required at the beginning of the project
hence interest on same charged for the whole development period.
**Money for building is normally obtained in stages and not at a go hence the interest
chargeable on same is for half the period of construction.
It should also be noted that in some instances, for example where a housing
development is being undertaken the developer can sell some units whilst the project
is still on-going hence receiving money to fund the project going forward.
 Solution cont.
• Determining the developers profit
➢ Building costs P513 000.00
➢ Demolition costs P10 000.00
P523 000.00
➢ Anticipated Developers Profit @ 25% P130 750.00
• Determining the surplus for land
➢ Proceeds of sale P860 000
➢ Less – costs of sale P 17 200
➢ Net proceeds of sale P842 800
➢ Costs of development P554 980.00
➢ Developers profit P130750 P685 730.00
• Surplus for land P157 070.00
• As a norm the developer’s profit is calculated based on the
development costs of the project at say 25% or on the Gross
development value of the project a say 20%.
 Solution cont.
• As will be noted, P157 070.00 is the surplus for
land and not necessarily the price for land. The
above surplus is made up of the following items:
➢The price to be paid for land
➢Professional fees to be paid, e.g. legal fees for
conveyancing. These we are advised will be charged at
4% of the price of land.
➢Developers profit on the value of the land. The
developer expects a profit of 25% on the price of land
➢Interest charged on money borrowed to purchase the
land plus interest on professional fees for a period of
one year during which the property will be developed.
 Solution cont.
• To find the actual price to be paid for the land lets
assume:
➢ The land price is 1x
➢ Fees on land purchase at 4% of the purchase price = 1x
*0.04 = 0.04x
➢ Developers profit at 25% of the gross price =1.04x * 25% =
0.26x
➢ Interest charged on money borrowed on purchasing the
land as well as professional fees = 1.04x for 1 year at 12%,
which is = 0.1248x
➢ The total surplus for land = 1x + 0.04x + 0.26x + 0.1248x
(1+0.04+0.26 + 0.1248)X
➢ = 1.4248x
➢ This means that 1.4248x = P 157 070.00
• Hence x = P157 070 / 1.4248 which = P110 240.00
• Hence the price for land is P110 240.00.
 CONCLUSION
• The residual method is adopted in the valuation of
development or re-development property.
• The method works on the premise that net proceeds
of sale less cost of development plus developer’s
profit equals the surplus for land.
• A project is viable if the surplus for land is positive as it
means that the development costs are less than the
sale proceeds.
• The surplus for land is not necessarily equal to the
price of land as costs relating to the purchase of the
land have to be deducted from the surplus prior to
arriving at the actual price of the land.
 Accuracy of the Residual method
• As will be noted the method relies on a number of
estimates being made by the valuer. The accuracy
of the resultant value is therefore very much
dependent on how accurate the estimates made by
the valuer have been.
• Whilst the method is very much used to appraise
development projects, opinions on value
determined by different valuers are known vary
widely at times. Variance in opinions is largely due
to many variables that have to estimated when
using the method. A small variation in one variable
can make a large difference in the answer arrived at
using this method.
 Lessons learnt
• A developer wishes to know the present residual value of a freehold
industrial site where the total net income from the completed buildings is
expected to be P100 000.00 per annum.
• The total development costs, that is including all fees incurred are
expected to be P700 000.00. The building period is expected to be 2 years
whilst the total development period is 2.5 years.
• A yield of 8% is expected from the completed development. The developer
expects a return to cover for his risk & profit of 20% of the capital value of
the development.
• Short term finance over the development period shall be charged at an
interest rate of 15%.
• Determine the present residual value of the industrial site.
 Solution
• Expected value
➢ Net income P100 000
➢ YP in perp.@8% 12.5
➢ Capital value P1 250 000
• Expected costs
➢ Building costs, fees included P700 000
➢ Cost of short term finance @15% for 2yrs/2 P105 000
➢ P805 000
➢ Developer’s risk & profit @ 20% of P1 250 000 P250 000 P1 055 000
Residual site value in 2.5 years (on completion of dev.) P195 000
PV for 2.5 years @ 15% 0.7051
Therefore present value of residual value P137 496.00