RICS draft guidance note - Valuation of development land, 1st edition

Valuation of development land, 1st edition

6 Valuation: the residual method

6.1 Residual valuation method

6.1.1 The residual method is based on the simple concept that the value of a property with development potential is the value of the property after development minus the cost of undertaking that development, including a profit for the developer. Put simply:

  • gross development value - total development costs (including profit) = residual land value

 

The residual method is based on the simple concept that the value of a property with development potential is the value of the property after development less the cost of undertaking that development, including a profit for the developer.

6.1.2 The residual amount is the available surplus attributable to the existing land or redevelopment property. The residual method can be used to determine other outcomes, such as the surplus available for the developer's profit if the price of the land has already been fixed. This guidance note focuses on the valuation of development land and will initially develop valuation methods on the assumption that the site value is the required residual amount.

6.1.3 The simple residual valuation concept is complicated by the fact that development takes time and the timing of events in the development process is dynamic while the valuation is at a single time point. Because of this, two different techniques have been developed regarding the application of the residual valuation method: the discounted cash flow method and the more basic residual method.

6.1.4 This guidance note sets out the underlying principles behind these two methods. There are several issues surrounding the residual method and the techniques of application; the valuer should evaluate these issues when using the method and adjust where appropriate. These basic issues and a discussion of the input choices within the two different techniques are explored in detail in Appendix B in order to aid that evaluation and to help identify the appropriate technique and inputs for each individual valuation.

6.1.5 The sophistication of the method used will depend on the role of the valuation, the timing within the development process and the type of asset. The basic residual method might be used for less complex assets or indeed early in the development process to consider optimum development; a discounted cash flow method may be used for more complex assets with phased construction or disposal where the timing of events needs to be fully accounted for in the valuation.

6.1.6 Many of the inflows and outflows of the development are not affected by the method itself but each requires careful consideration of how the inputs and outputs are generated. This guidance note identifies these and suggests some solutions. The market comparison approach will play an important part in the determination of many of the inputs into the residual method. No one solution may be relevant for all circumstances, so it is for the valuer to determine how they deal with the detailed inputs into the residual valuation model. Variations in potential development scenarios may involve different assumptions and forecasts for the various inputs.

6.1.7 Typical inflows and costs to be considered in residual valuations include:

  • the value of the completed property: this is the appropriate basis of value of the completed development without adjustment for any sale costs. IVS 410 employs this term, but it also uses gross development value. Both terms represent the estimated contract price of the developed property. It assumes, therefore, that any prospective acquisition costs of the purchaser that may have reduced the price have been accounted for
  • net development value: this is the appropriate basis of value of the completed development net of any sale costs
  • site clearance, remediation or preparation costs
  • costs of construction, including any contingencies
  • professional fees linked to construction
  • costs and professional fees relating to planning
  • any planning obligations or levies linked to the development
  • finance for the development, including the site
  • developer's profit
  • any other costs or inflows related to the development and
  • site costs where land value is not the residual.

6.1.8 Note that this guidance note does not prescribe the particular application of the residual method - this should always be a decision for the valuer in the particular circumstances, not least considering the asset class involved and the way that the market in that asset class actually operates.

 

Two different techniques have been developed regarding the application of the residual valuation method: the discounted cash flow method and a more basic residual valuation method. A basic residual valuation might be used for less complex assets or early in the development process to consider optimum development. A discounted cash flow may be used for more complex assets with phased construction or disposal where the timing of events needs to be fully accounted for in the valuation.

6.2 Residual discounted cash flow method

6.2.1 Cash flow models reflect assumptions about the timing of revenue and expenditure over the development period on a period-by-period basis. The approach of a discounted cash flow is to calculate the net present value (NPV) of the estimated costs and revenues over the duration of the development scheme. With all other costs and revenues accounted for, the NPV will be a current estimate of the residual land value. The discounted cash flow model can be summarised as follows:

6.2.1 formula (002)

Where:

  • R = estimated periodic net revenue received, or net expenditure incurred at the end of each period
  • LV0 = land value at time, t = 0
  • DV = estimate of development value
  • n = number of periods over which the development takes place and
  • d = target rate of return.

6.2.2The NPV model is set out in numerous corporate finance and investment appraisal texts. In a standard cash flow, profit is represented as a return on capital and the NPV, assuming that it is positive, is then the residual land value.

6.2.3 Some applications of the discounted cash flow technique within the context of development appraisal have been criticised for departing from this basic NPV model and for incorporating inappropriate inputs (or inappropriate application of certain inputs). The main issues surround value and cost changes during the development period, including phasing and value/cost forecasting, the treatment of finance and the specification of development profit.

6.2.4As indicated from the equation, the discounted cash flow method requires period-by-period assumptions concerning the breakdown of costs and values during the development period and the time frame, monthly or quarterly, for example. It also requires an assumption for the target rate of return. It allows market dynamics through time to be easily incorporated, such as changes in costs and values where appropriate. If value and cost forecasting is being adopted, this needs to be explicitly stated together with an explanation of the assumptions underpinning those forecasts.

6.2.5Other assumptions, including required target rate of return, should also explicitly stated. Evidence of rates of return, forecasts and other inputs should be tested against transaction evidence wherever possible.

The basic application of a discounted cash flow is to calculate the net present value (NPV) of the estimated costs and revenues over the duration of the development scheme. With all other costs and revenues accounted for, the NPV will be a current estimate of the residual land value.

 

If value/cost forecasting is being used, this needs to be explicitly stated together with an explanation of the assumptions underpinning those forecasts. Other assumptions, including required target rate of return, should also explicitly stated.

6.3 The basic residual method

6.3.1 The basic residual valuation method is a more simplified representation of the expected revenue and expenditure from a development. The residual land value is the value of the completed development (net) minus the development costs, including developer's profit. It can be summarised as:

6.3.1 formula

Where:

LV0 = residual development property/land value at time, t = 0

  • i = cost of finance (annual interest rate)
  • t = development period
  • DV0 = current estimate of development value
  • p = profit as a percentage of DV
  • DC0 = current estimate of development costs and
  • I = total finance costs.

6.3.2 This application has been subject to major scrutiny - several issues arise as to the simplicity of the application and in relation to the accuracy of the inputs and outputs. For example, changes in value and cost through the development period are more difficult to incorporate within a basic residual valuation.

6.3.3 These issues are discussed in Appendix B for both applications of the residual method.

The basic residual valuation method is a more simplified representation of the expected revenue and expenditure from a development. The residual land value is the value of the completed development (net) minus the development costs including developer's profit.