Residual method
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The residual method values land by estimating the total value of a completed development project and subtracting all development costs (construction costs, fees, finance costs, and developer's profit) to arrive at the residual land value. A simple example estimates the development value of an office building at £8,125,000, subtracts estimated construction costs of £4,000,000 and developer profit of £1,625,000 to get a residual land value of £2,500,000. The method is sensitive to inputs and assumes costs, but can estimate land value at the evaluation stage of a potential development.
![How interest is calculated
Over construction period:
= (£2,622,944 / 2) x [(1 + 0.1)1.25
-1]
= £165,934
25
Interest on half
construction
costs over
construction
period
For void period,
interest is on all
construction
costs and
interest rolled
up so far
6 months 15 months 3 months
£1,311,473
£2,622,945
Over void period:
= (£2,622,944 + £165,934) x [(1 + 0.1)0.25
-1]
= £67,250](https://image.slidesharecdn.com/residualmethod-170427030639/85/Residual-method-15-320.jpg)
![Cost Inputs
Developer’s Profit
• Reward for initiating and facilitating the development; the entrepreneurial
return for taking the risks
• Dependent upon state of the market, the size, length and type of
development, the degree of competition for the site and whether it is pre-
let or forward sold
• More risky than standing investment activity
• Commercial developers seek a return on cost (10-25%)
• Residential developers seek a return on GDV (12.5-15% net of
overheads) aka sales margin
• Other criteria: Initial yield on cost, IRR
Profit on development costs = £2,917,128 x 20%
= £583,426
On land costs = future residual balance – [future residual balance / (1 + 20%)]
= £1,092,489 – (1,092,489 / 1.20)
= £182,081](https://image.slidesharecdn.com/residualmethod-170427030639/85/Residual-method-17-320.jpg)
![Land Value output
Interest on site costs* = £910,407 x [1/(1 + 0.1)2
]
= £752,403
Acquisition costs**
Site value = residual balance / (1 + 0.0575)
= £752,403 / 1.0575
= £711,492
Maximum amount that should be paid for the site
if the proposed development was to proceed and
all of the valuation assumptions held true
*If site was purchased at the start of the development, interest on site costs must be paid over the total
development period. To do this the figure calculated thus far must be discounted to determine its present
value at the short-term finance rate of 7% over the total development period. Even if money is not
borrowed to fund site purchase or construction the opportunity cost of funds used should be reflected in
the valuation and the lending rate is a good proxy for the opportunity cost of capital.
**Usually include legal costs, tax (Stamp Duty and VAT), valuation and agents’ fees plus any pre-contract
investigations such as soil surveys, environmental impact assessments and contamination reports](https://image.slidesharecdn.com/residualmethod-170427030639/85/Residual-method-18-320.jpg)
![Profit appraisal
Profit erosion: rent cover
• Number of years it takes before profit is eroded by rent payments
• Relevant in pre-funded arrangements where developer may guarantee
rent
Profit erosion: interest cover
• Number of years before profit is eroded by interest payments to bank*
• Relevant for spec developments financed using bank loan which is
then converted to mortgage on completion
Rent : debt ratio
• Rent divided by annual payments on an interest-only loan**
33
*Formula for calculating interest payments to bank assuming a mortgage term of n years
and rate of i%:
Costs x (((1+i)n
)*i)/((1+i)n
-1) [i.e. costs compounded over term x r which is then PV’d -1]](https://image.slidesharecdn.com/residualmethod-170427030639/85/Residual-method-23-320.jpg)
![DCF procedure (source: GMCE)
1. Forecast expected cash-flow
2. Determine TRR
3. Discount (1) at (2) to PV
[ ]
[ ]
[ ]
[ ]
[ ]
[ ]
[ ]
[ ]t
t
t
t
rE
CFE
rE
CFE
rE
CFE
rE
CFE
V
0
0
1
0
10
2
0
20
0
10
0
11
...
11 +
+
+
++
+
+
+
= −
−
Where CFt = net cash-flow in period t
V0 = value at t = 0, i.e. present value
E0 [r] = expected average multi-period return (per
period) at t = 0 (i.e. now)
t = exit period (i.e. end of holding period) such
that CFt includes capitalised exit value in
addition to income cash-flow in that period](https://image.slidesharecdn.com/residualmethod-170427030639/85/Residual-method-28-320.jpg)
Residual method
- 2. Residual Method Value of completed development - Development (construction, fees, finance, etc.) costs - Developer’s profit (e.g. % costs or % value) = Residual land value • Equation can be rearranged to estimate profit once land cost is known (i.e. from valuation to appraisal) • Land prices per hectare of similar sites that have recently been sold provide a useful check • The residual valuation of a development site usually begins broadly at the evaluation stage and is gradually fine-tuned before the site acquisition and construction phases 3
- 3. Residual land valuation: simple example • Development opportunity for 5,000m2 offices that it is estimated will let for £130/m2 and sell at an initial yield of 8% • Construction costs are estimated to be £800/m2 and the development will take, after a lead-in period of 0.5 years, 1.5 years to complete, plus a void of 0.75 years • The developer is seeking a minimum return on development value of 20% • What is the value of the site? 4
- 4. Simple residual land valuation Development value (DV): Total constructed area (m2 ) 5,000 Estimated market rent (£/m2 ) x 130 Estimated annual market rent (£) 650,000 Capitalised @ 8% x 12.5 8,125,000 Less Development costs (DC): Construction costs (5,000m2 @ £800/m2 ) -4,000,000 Profit on construction costs @ 20% DV -1,625,000 -5,625,000 Residual land value (RLV) 2,500,000 5 (don’t worry about timing of completion yet…)
- 6. Revenue Inputs NIA GIA = 2,000 m2 Efficiency ratio = 85% So NIA = 2,000 x 0.85 = 1,700 m2 Estimated (net) annual rent = NIA x estimated rent / m2 = 1,700 m2 x £200 / m2 = £340,000 GDV = Estimated annual rent / yield = £340,000 / 0.07 = £4,857,143
- 7. Cost Inputs Disposal costs (agent and legal fees if sold or refinancing and valuation fees if retained as an investment) NDV = GDV / (1 + 0.0575) = £4,857,143 / 1.0575 = £4,593,043 Building costs = building cost / m2 x GIA = £969/ m2 x 2,000 m2 = £1,938,000
- 8. Cost Inputs Professional fees • Architect • QS • Engineers (structural, M&E) • Legal • Consultants (planning, highways, ecology, archaeology) • Developer / project management • Landscape architect Professional fees = (building costs + other works) x 13% = £2,083,000 x 0.13 = £267,540 16
- 9. Cost Inputs Ancillary costs Might include planning fees, building regulation fees, insurance and other incidental costs Contingency = (bldg costs + other costs + ancillaries + fees) x 3% = (£1,938,000 + £120,000 + £267,540 + £80,000) x 0.03 = £72,166 Other costs and fees Estimates for various additional costs and fees can be included...
- 10. Development time-line & cost build-up 20 Lead-in period (6 months) Construction period (15 months) Void period (3 months) Total development period Construction begins Construction completed Site acquisition Site clearance, foundations, etc. Main construction activity Fitting out Total Costs (£) Site acquisition Construction begins Construction completed Development let and/or sold Cost of site
- 11. Interest • Interest is rolled up and paid back, along with all other costs, at end of development period from proceeds (balloon payment) • During a void period interest is payable on all costs so any extensions to this time period will significantly increase the amount of loan finance incurred • A lender will charge interest at the bank base rate for lending plus a return for risk – Magnitude of risk premium will depend on the status of developer, the size and length of loan and the amount of collateral the developer intends to contribute. • Detailed cash flow projections are essential once the project is under way in order to incorporate changes in revenue and costs, and particularly so for phased developments • Interest accrued on money borrowed to purchase the site, construct the property and hold over any void period is calculated separately
- 12. Interest on land costs 22 6 months 18 months £? We know we will need to finance land purchase but don’t know what the price is so need to come back to this later… The calculation of the amount of interest incurred on money borrowed to purchase the site is incorporated in the final stages of the residual valuation because it is based on the figure we are trying to estimate, namely site value
- 13. Building costs 23 Q3 TOTAL = -£2,622,945 -£227,171 -£479,341 -£1,209,920 -£454,341 -£227,171 -£25,000 Q5Q4Q2Q1Q0 Q6
- 14. Interest on building costs is cumulative 24 -603 -617 -6,110 -17,816 -47,421 -59,521 -66,434 -68,036 TOTAL = -£265,956 Interest is not paid on the full amount over the entire building period. The s- shaped build-up of costs is simplified to a straight line and an approximation is obtained by calculating the annual interest on half of the costs over the construction period
- 15. How interest is calculated Over construction period: = (£2,622,944 / 2) x [(1 + 0.1)1.25 -1] = £165,934 25 Interest on half construction costs over construction period For void period, interest is on all construction costs and interest rolled up so far 6 months 15 months 3 months £1,311,473 £2,622,945 Over void period: = (£2,622,944 + £165,934) x [(1 + 0.1)0.25 -1] = £67,250
- 16. Cost Inputs 26 Letting fee = estimated annual rent x 15% = £340,000 x 0.15 = £51,000 Marketing cost Would cover items such as advertising, opening ceremony, brochure design and production. The scale would obviously depend on the nature of the development.
- 17. Cost Inputs Developer’s Profit • Reward for initiating and facilitating the development; the entrepreneurial return for taking the risks • Dependent upon state of the market, the size, length and type of development, the degree of competition for the site and whether it is pre- let or forward sold • More risky than standing investment activity • Commercial developers seek a return on cost (10-25%) • Residential developers seek a return on GDV (12.5-15% net of overheads) aka sales margin • Other criteria: Initial yield on cost, IRR Profit on development costs = £2,917,128 x 20% = £583,426 On land costs = future residual balance – [future residual balance / (1 + 20%)] = £1,092,489 – (1,092,489 / 1.20) = £182,081
- 18. Land Value output Interest on site costs* = £910,407 x [1/(1 + 0.1)2 ] = £752,403 Acquisition costs** Site value = residual balance / (1 + 0.0575) = £752,403 / 1.0575 = £711,492 Maximum amount that should be paid for the site if the proposed development was to proceed and all of the valuation assumptions held true *If site was purchased at the start of the development, interest on site costs must be paid over the total development period. To do this the figure calculated thus far must be discounted to determine its present value at the short-term finance rate of 7% over the total development period. Even if money is not borrowed to fund site purchase or construction the opportunity cost of funds used should be reflected in the valuation and the lending rate is a good proxy for the opportunity cost of capital. **Usually include legal costs, tax (Stamp Duty and VAT), valuation and agents’ fees plus any pre-contract investigations such as soil surveys, environmental impact assessments and contamination reports
- 19. Key Inputs • Gross and net internal area and efficiency ratio • Rent and yield • Gross and net development value and disposal costs • Building costs, external and ancillary costs • Professional fees • Contingency • Marketing costs and letting fee • Developer’s profit • Interest / finance costs • Acquisition costs • Development period 29
- 20. Residual profit valuation* • Also known as profit appraisal or viability statement • Assume – Development retained as an investment so no sale fees Development value: Net Development Value £4,593,043 30 Site Costs: Site price -£711,492 Acquisition costs @ 5.75% site price -£40,911 -£752,403 *This is the general model as it can be used to ‘back out’ land value
- 21. 31 Construction Costs: Total Construction Costs (£'s): -£2,622,945 Interest: Over building period -£165,934 Over void period -£67,250 On site costs over total dev’t period -£158,005 Total Interest Payable : -£391,189 Letting & Sale Fees: -£61,000 Total development costs -£3,827,536 Developer's profit on completion* £765,507 *equal to profit on land and development costs in residual site valuation
- 22. Profit appraisal: snapshot methods of expressing developer’s profit Profit as % of development costs (return on costs) • Useful for trader developers 32 Profit as a % of net development value • Remember profit as % costs or value are related Income yield • Rent as % of development costs • Useful for investor developers as it reports the annual profit • must be higher than interest payments in the long run • £340,000 / £3,993,950 = 8.51% per annum Payback (years) • indicates number of years to pay back costs to break even point • Inverse of income yield (cf YP) • cost/rent = years to payback • £3,993,950 / £340,000 = 11.75 years All of these measures are at time of scheme completion, i.e. they have not been PV’d
- 23. Profit appraisal Profit erosion: rent cover • Number of years it takes before profit is eroded by rent payments • Relevant in pre-funded arrangements where developer may guarantee rent Profit erosion: interest cover • Number of years before profit is eroded by interest payments to bank* • Relevant for spec developments financed using bank loan which is then converted to mortgage on completion Rent : debt ratio • Rent divided by annual payments on an interest-only loan** 33 *Formula for calculating interest payments to bank assuming a mortgage term of n years and rate of i%: Costs x (((1+i)n )*i)/((1+i)n -1) [i.e. costs compounded over term x r which is then PV’d -1]
- 24. Problems with residual method • Simple cost assumptions • Uses finance rate as discount rate • Not able to handle phased costs and revenue very well • Sensitive to cumulative errors in inputs, esp. if site cost is small relative to other costs – Therefore, risk analysis... • Handling of finance... time cost site construction void Defer (PV) Defer (PV) Calculating interest on half of the building costs over the construction period assumes these costs are incurred evenly throughout this period. But often they are not. In general, the initial build up of costs tends to be gradual, peaks at 60% and then tails off. Typically only 40% building costs are incurred half way through the construction period whereas the residual method assumes 50%. Consequently accrued interest is actually less than the amount calculated using the residual method. In addition, interest on money borrowed usually accumulates monthly rather than annually as assumed in the residual method.
- 25. Key points • Residual method is based on a simple economic concept – land value is a surplus after estimated development costs (including expected profit) have been deducted from the estimated value of the completed development • Difficulties arise when estimating input values because small errors in each can lead to large variation in output • In practice the method is first employed in its simplest form and then the complexity level increases as development plans crystallise 35
- 27. What for? • Larger, more complex schemes • Valuation of land • Estimation of profit – return on equity (or yield-to-equity) put up by developer, as distinct from debt (loan) provided by lender • Show financial position (cash flow) at any point in time – an essential ingredient of any negotiations with possible lenders Why • Flexibility: handle spread of construction costs, fees and revenue (short-term lets, phasing) • Include forecasts: inflation in construction costs and fees, growth in rents and values • Detailed projection of costs and revenue over the development period • Once land price is known the cash- flow can be used to monitor actual costs compared to the estimates and thus how the developer’s profit might be affected • Examine viability in more detail and using more conventional financial concepts (NPV, IRR) • Valuation method becomes an appraisal tool... • Developers • Lenders (who may be financing the development) • Investors (who may be acquiring the scheme on completion) For whom?
- 28. DCF procedure (source: GMCE) 1. Forecast expected cash-flow 2. Determine TRR 3. Discount (1) at (2) to PV [ ] [ ] [ ] [ ] [ ] [ ] [ ] [ ]t t t t rE CFE rE CFE rE CFE rE CFE V 0 0 1 0 10 2 0 20 0 10 0 11 ... 11 + + + ++ + + + = − − Where CFt = net cash-flow in period t V0 = value at t = 0, i.e. present value E0 [r] = expected average multi-period return (per period) at t = 0 (i.e. now) t = exit period (i.e. end of holding period) such that CFt includes capitalised exit value in addition to income cash-flow in that period
- 29. Diff between standing investment and development cash-flows • Cash-flow expenditure occurs over time • Debt financing of construction almost universal • Phased risk profile; high during construction and maybe letting period and reduced once let Valuation ------ appraisal... 39
- 30. Appraisal questions Pre-finance: • Discounting the cash-flow (which includes land price) at the developer’s target rate, what is NPV/IRR? • Discounting the cash-flow (which doesn’t include land price) at the developer’s target rate, what is the NPV (i.e. the land price but without finance costs)? Post-finance: • Having discounted the cash-flow (which includes land price) at the finance rate, what profit is left? • With profit included as a lump sum in the cash-flow and discounting at the finance rate, what is the land price (with finance costs)? (cf. residual) 40
- 31. Cash Flow Example • 100% debt • Nominal quarterly interest rate • All building costs assumed to occur half-way through building period – Slightly different from assuming half costs over whole building period • When finance rate and target rate are the same and scheme is 100% debt financed... – Comparable to residual • Now spread costs more realistically… • Additional assumptions, e.g. forecasts – Cost inflation forecasts, broken down by land use – Value inflation forecasts, broken down by land use NB. NPV assumes 1st cash flow is period 1 - be careful to block period ONE to end and then add on period Zero outside NPV calculation
- 32. Choice of method... • Residual method – valid and useful but has drawbacks • Cash Flows: – can deal greater complexity, different cost and income patterns and fluctuations: they are more flexible – can be used for land valuations and development appraisals – Enable valuers to be explicit about the breakdown of costs and revenue, providing a reasonably accurate assessment of monetary flow over a specified time period 42
Editor's Notes
- #12: In May 2009 the 7,761 ft2 4th floor in Aviva’s 42,000 ft2 Pinnacle building at 20 Tudor Road, Reading, Axa was let for £23.50/ft2 on a 10 year lease with a break in year 5. In October 2008 Bucks Consultants took the 7,800 ft2 top floor of the 5 story building at £23.50/ft2. Building stood empty for 4 years
- #14: Property agents fees: introductory agent1% acquisition price site surveyflat fee, say £5k environmental survey£1,200 per estate Property legal fees: solicitors0.050% acquisition price Adding acquisition price and acquisition costs equals gross entry price and this, plus rent apportionment and working capital equals total acquisition cash-flow required. Buildings costs are usually estimated by a quantity surveyor, but an approximation can be gained by reference to recent contracts for similar developments. For example, reference may be made to the standard listing in building price books such as Spons Architects and Builders Price Book (Davis Langdon Everest, 2004) or to online indexes such as BCIS. These sources contain overall figures for construction costs (but excluding external works and professional fees) based on GIA but adjusted depending on the geographical region in which the development is located. It is usual to use current cost estimates and assume that cost inflation will match rental growth over the development period. Having said this, it is worth noting that construction contracts vary; they may be agreed on a ‘rise and fall’ or ‘fixed price’ basis. A building contractor who agrees to a fixed price contract is likely to charge a higher price because risk the exposure is greater. For info, bldg costs: £1,400-1,750/m2 for city offices med rise
- #17: Professional fees are usually agreed as a percentage of the construction costs, but may be a fixed sum. Marshall and Kennedy (1993) found that a typical total for fees averaged 14.5%. The appropriate fee level depends on the type (e.g. less for resi) and location of the development. A representative breakdown of fees might be: ProfessionalFee as a % of building costs Architect5 - 7.5% Quantity Surveyor2 – 3% Structural engineer2.5 - 3% Civil engineer 1 – 3% Project manager2+ % Mechanical & Electrical0.5 - 3% Agents fees Land acquisition Residential sales Leasing Commercial sales
- #18: The contingency allowance is a reserve fund to allow for any increase in costs. As construction costs are the single largest sum after land, any inflationary effect is likely to have a significant impact on costs. If the economy is particularly volatile, a cautionary approach is to apply the contingency allowance to all costs, including finance costs, but this will depend on the perceived risk of the project. Marshall and Kennedy (1993) found that the contingency fund is generally set at 3-5% of building costs, professional fees (and sometimes interest payments) but the figure varied depending on the nature of site (restrictive site, subsoil, etc.) and the development project itself. Generally, the longer the development period and the more complex the construction of the building, the higher the risk of unforeseen changes, therefore, the higher the contingency allowance.
- #19: Affordable housing: 35%, 70:30 in favour of social rented Service charges on AH? Bldg regs: (not dwellings and not fit out) all +VAT Cost of work;0 – 1,000,000 Plan charge£1758.80 Inspection charge£2638.20 For each 1,000 Plan charge£1.12 Inspection charge£1.68 Planning obligations: £18-22k / resi unit on greenfield, £10k in central areas, £10/ft2 for commercial S106: Kettering - £12,600 per dwelling and £62.50 per m2 commercial, Broxborne - £3,000 per bed Financing fees: bank fees = 0.30% acquisition price bank lawyers = 0.25% acquisition price bank valuation = (min £2,250) Prop valueFee 0-1.5m0.175% 1.5-2m0.150% 2-2.5m0.137% 2.5-5m0.100% 5m+0.090%
- #21: The total development period needs to allow for obtaining planning consent, preparing drawings and so on. This is sometimes referred to as a lead-in period. There may also be a period of time between completion of the development and occupation by a tenant, including a possible rent-free period and this is referred to as a void period. Development costs tend to accrue slowly at first, then accelerate, then tail off (S-curve).
- #25: An enhanced version of this simplification for costs that are not spread evenly is to alter the period over which interest is calculated. E.g. items not paid until the very end (agents and legal fees) will incur no interest so a period of 0 is appropriate. Items paid at the start (land) will incur interest over the whole period. Items towards the start (professional fees) may be weighted at 0.75. Marketing (toward the end) may be weighted at 0.25, etc.
- #26: Interest accrued during the void period is calculated by compounding the total construction costs and interest rolled up during the construction period over the void period at the finance rate.
- #28: .
- #30: DEVELOPER’S PROFIT Entrepreneurial return for taking the risks. Is development low, medium or high risk activity? Does the figure look and feel right?