Valuation is a critical skill that all property developers need to learn. Basic principles of valuation are used when putting together a project feasibility, which is the starting point for many developers when assessing the viability of a 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 that developers face. New entrants and seasoned developers who are looking to scale and capitalise on the nascent demand for housing are driving land prices higher—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 are so frequently caught and publicised by the media who are quick to highlight how much a property is sold for compared to its government’s valuation (or CV). For developers, however, a property’s CV plays little to no role in their assessment of value. Instead, what one is willing to pay is driven by a property’s residual value.
The Basic Formula of Residual Valuation Method
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.
The Process of Calculating Gross Realisable Value (GRV)
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: The number of units the developer is able to build on the property (in accordance with council planning rules.
Typology: The design of the product being built. This includes things like the Gross Floor Area (GFA) of each unit, the number of bedrooms, bathrooms and other design considerations.
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.
Factors to Consider in Calculating Total Development Cost
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)
- Quantity Surveyor
- Legal + other
- Construction monitoring (engineer, quality surveyor)
- Council fees and levies (development contributions, utility connection charges)
- Titling (surveyor & legal)
- Sales and marketing
- Sale commission
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.
Setting Ideal Project Margins
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%.
Applying Residual Method – Example
Consider a proposed development project for an integrated townhouse development.
A developer is proposing to build:
- 10 residential units, 2-bedroom, 1 bathroom, floor area 80 sqm.
- Asking price of $850,000 (expected end value)
- Build cost is $2,600 per sqm
- Subdivision costs (earthworks, drainage, etc)
- Council Contributions, Connection Charges, Infrastructure Growth Charges
- Project margin of 20%
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, and pay all costs required to complete the development with an expected return of $0.8m (being 20%).