RICS draft guidance note - Valuation of development land, 1st edition

Valuation of development land, 1st edition

7 Risk analysis and residual profit

7.1 Risk analysis

7.1.1 The valuation of development property by either the market approach or the residual method has some characteristics that make the assessment of the value especially difficult, regardless of whether it is market value or some other appropriate basis. In the case of the market approach it is the individuality of each site and the impact that this has on the quality and quantity of comparisons.

7.1.2 In the case of the residual method, whichever technique is adopted, it is the fact that the residual amount is a function of a number of relatively high value inputs (this can also the case with other valuations for complex standing investments). This means that variation in the development cost and value inputs can have a disproportionate impact on the residual land value. This is one of reasons why this guidance note emphasises that reliance should not be placed on a single approach or method of assessing the value of development property.

7.1.3 The presence of various options to develop within different time scales and scenarios inherent in the development process adds to the possible valuation variation inherent in the development process. This suggests some additional analysis would help contextualise the valuation outcome. Risk analysis techniques address some of these issues and can help indicate likely variation around the valuation.

7.1.4 The simplest form of risk analysis is sensitivity analysis, which should be used to evaluate how changes to individual inputs, such as construction cost or sales values, might affect the valuation of development property. It should be undertaken in order to inform the valuation, which may lead the valuer arriving at a different market value to the residual output single valuation outcome (while also considering any analysis of comparables).

7.1.5 Scenario modelling can also be used to evaluate how different combinations of inputs, perhaps optimistic and pessimistic views of the economy, can affect the valuation. Using these risk analysis techniques in combination with the discounted cash flow technique permits the testing of the impact of different timings of events on the valuation more easily than within the basic residual framework.

7.1.6 Taking the analysis of risk further, it is possible to assign probabilities to the various scenarios and use simulation models to combine these probabilities over multiple runs. It is important to note that all these risk analysis techniques rely on valuer assumptions concerning the distribution around the best estimate of each input and any relationships (correlations) between the inputs. These should be set out explicitly when reporting valuations of development property.

Risk analysis should be used to evaluate how changes to individual inputs, such as construction cost or sales values, might affect the valuation of development property.

7.1.7 Individual development schemes will have different levels of risk. Valuation uncertainty will often, but not always, be closely related to the level of risk; normally both the risk of the development and the level of valuation variation will be higher than for many other types of property and valuation. However, valuation uncertainty could be very low where a number of very good direct comparable transactions are available as comparables even where the actual risk and uncertainty attached to the development is very high. These two types of uncertainty should not be confused with each other.

7.1.8 Risk analysis will enable the inputs that have the most impact on the outcome to be evaluated and also give some relative measure of volatility between different types of investment and development to inform the decision on the appropriate level of development profit. In any event an explanation of, and assumptions relied upon in identifying, the level of risk and return used should be explicitly stated by the valuer as this is a key input into residual approach irrespective of which technique is used.

7.1.9 In addition to any quantitative risk analysis undertaken, the outputs of any valuation require some additional non-quantitative reflection on the valuation outcome. For development property, particular issues to reflect on include the potentially large valuation variation caused by the impact of small changes to important inputs into the residual valuation. Development property also includes options that are not always picked up within a valuation method even though these options impact on the value of the development property.

7.1.10 Valuers should compare residual valuation outcomes with market transactions wherever possible and fully explore alternative scenarios and other potential outcomes.

An explanation of, and assumptions relied upon in identifying, the level of risk and return used should be explicitly stated by the valuer as this is a key input into residual approach irrespective of which technique is used.

7.2 Residual profit

7.2.1 Because this guidance note concerns the valuation of land and property with development potential, it has focused on the process underpinning the valuation of development land using both market comparison and residual methods. The residual method, both the basic and the discounted cash flow techniques, can also be used to determine the profitability and viability of proposed development schemes for the subject property where land price or value has already been determined.

7.2.2 In a basic residual, if land price or value is known, the land price becomes a cost to the development. Usually, the land sale takes place at the beginning of the development. All other costs and values are assumed at the end of the development period - costs are assumed to accrue at the borrowing rate and both development costs and interest are paid off at the end of the development.

7.2.3 In order to estimate the profit at the end of the development, the land value (which is a present-day NPV figure) also has to be taken to the end of the development period and this is accomplished by adding interest over the whole of the development period to the land value. The costs including land are then deducted from the net development value (NDV) to leave the residual profit timed at the end of the development period.

7.2.4 In a discounted cash flow, all inflows and outflows are discounted back to the start of the cash flow. If land cost is a known input, it can be inserted at the beginning of the cash flow (or wherever it occurs) and the internal rate of return (IRR) of the cash flow becomes an estimate of the developer's return. It is important to note that the IRR is a project return, i.e. before finance.

7.2.5 If the valuer wants to determine a profit as a single lump sum at the end of the development, the land value is again inserted at the beginning of the cash flow (or wherever it occurs). Interest on this land price together with interest on all other development costs is compounded to the end of the development period (assuming 100 per cent borrowing). After deducting accrued income within the cash flow, any surplus at the end of the cash flow is the expected profit at the end of the development.

7.2.6 It is possible within the cash flow format to develop applications that take account of the level of borrowing and different costs of borrowing on different forms of debt. When developing these models, the role and purpose of the valuation should be fully recognised. Market valuations require market-based inputs and assumptions as to highest and best use. Specific funding arrangements and rates of return required by individual developers are not necessarily based on market indicators.

 

The residual method, both basic and discounted cash flow, can also be used to determine the profitability and viability of proposed development schemes for the subject property where land price or value has already been determined.