Valuation is a critical skill all property developers need to learn. Basic principles of property valuation are used when putting together a project feasibility, which is the starting point for many developers when assessing the viability of new project. The resulting feasibility will dictate the price one can pay for the land, based on a pre-determined margin.
Today’s market is highly competitive and securing land is perhaps one of the greatest challenges developers are faced with – new entrants and seasoned developers looking to scale and capitalize on the nascent demand for housing has resulted in escalating land prices, especially for properties that are well located, have services on-site and have zoning favourable for medium to high density developments.
It is these transactions that so frequently catch the attention of the media who are quick to highlight how much the property sold for compared to its government’s valuation (or CV). For developers, however, a properties CV plays little to no role in their assessment of value. Instead, what one is willing to pay is driven the properties residual value.
The residual valuation method is reductive. First, the developer estimates the total value of each proposed unit in the development. The sum of which is known as the Gross Realisable Value or GRV.
From this figure, expected costs associated with the development, an allowance for profit (and risk), and miscellaneous fees are deducted.
The amount left is the properties residual value, which implies the price a developer can pay to acquire the site. The basic formula for the calculation of residual value is:
Residual Value = Gross Realisable Value – (Total Development Cost + Project Margin + Fees)
Note: All figures should be stated on a GST exclusive basis.
GRV is the total value of all units within a development on an as-if complete basis, or simply; the total sales revenue (less GST) that the developer expects to generate once all the units within the development are sold.
The ‘as-if-complete’ value is driven by evaluation of comparable units that have recently sold in the immediate area and analysis of current property listings. Input from local real estate agents and other property professionals can also be invaluable.
Property developers spend a significant amount time and effort in assessing how they can maximise a site’s GRV while keeping costs low – this is what will drive a project profitability.
GRV estimations are heavily influenced by the following factors:
Yield and typology go hand in hand – a developer will typically run a few scenarios for a given site to see the variable return profiles of each typology. For example, what will the GRV look like if you build 8 two-bedroom townhouses vs. 4 generously sized four-bedroom townhouses.
In all instances, the proposed scenarios will need to fit within local council planning rules – a detailed knowledge of planning rules can help uncover a sites true development potential and enable you to move quickly on opportunities as and when they arise. Project consultants including architects and planners are also an invaluable resource.
GRV should not be assessed in isolation – one needs to consider how the final typology mix will impact the total project costs.
There is a myriad of costs that need to be carefully considered when using the residual valuation method. Below we have detailed just some of the costs items likely to be incurred by a developer for a typical residential townhouses project.
Pre-development (planning and consenting)
Sales and marketing
Ensuring that cost assumptions are realistic and include an appropriate contingency is a must for the accurate assessment of the residual value. Projects are always susceptible to delays, cost escalations, and other unforeseen expenditures. Allocating extra funds for contingencies in the budget can help reduce the impact of cost escalation.
Changes to a projects’ costs can result in significant changes to the residual value of the property, which is one of the reasons the residual valuation methodology is considered to be a highly sensitive method of property valuation.
Project margin refers to the profit the developer expects to earn from the project. For residual valuation method, the developer decides on the return they require in accordance with risk inherent to a given development.
Larger, more complex projects come with additional risks and typically require a great return. While for simple projects, a developer may be willing to accept a lesser return.
In the residual valuation method, if a developer increases the margin they require to move forward with a project, it decreases what the developer can afford to pay for the land – or in other words reduces the residual value of the property. In contrast, if a developer decides they are willing accept a lower profit margin for the project, it will increase the amount they are willing to pay for land.
Today, 20% is widely considered and acceptable profit and risk allowance for a typical residential townhouse development. If you are developing a single residential plot, the margins can be scaled down below 20%.
Consider a proposed development project for an integrated townhouse development:
A developer is proposing to build:
GRV (excluding GST) = $850,000 x 10 = 8.5 million
The total project cost (excluding GST) = 4.0 million
20% Profit and risk allowance = 0.8 million
Land Residual Value = GRV – (Build Cost + Project margin)
$8.5m – ($4.0m + $0.8m)
Residual land value = $3.7 million + GST
Based on the residual valuation method, the above implies that a developer can pay $3.7 million + GST for the land, pay all costs required to complete the development with an expected return of $0.8m (being 20%).
ASAP Finance is a leading development and construction finance provider in Auckland. Our team can help you in all aspects of property financing – use this link to get in touch today.