Residual valuation

Order Instructions/Description

There is the example to calculate:

A prospective developer is attempting to evaluate whether a proposed development should be undertaken on a site which has planning permission for an 800 square metre office block.
On completion the development will provide 750 square metres of lettable space.  Comparable developments in close proximity yield £350 per square metre.
The development period is expected to be 24 months with a building period of 12 months: building costs are estimated to be £1500 per square metre.  Six months have been allocated prior to building work to account for design, estimation and tendering.  Six months have been allowed following the completion of building work for any potential letting voids.
Building costs fall due over the last 18 months of the development so interest on building costs should be calculated for this period.  As is conventional we can include an entry in the budget for half of this total liability.
Similarly interest on fees should be calculated for an 18 month period. As is conventional we can include an entry in the budget for two thirds of this total liability.
A contingency allowance of 5% on building costs is to be made.  Professional fees are estimated at 12.5 % of building costs, letting’s agents fees at 10% of initial rental value, selling agents’ fees at 3% of gross development value.  A £50,000 budget is available for sales and marketing.
Finance can be arranged at 1.2% per month.  A developer’s profit of 15% is required.
The residual method (1)
Let’s take things in stages.

You are advising a developer on what would be a fair price to pay for a piece of land upon which the developer wishes to build an office block.
Beginning with the first element – anticipated development value:
Capital value post development
Gross development value on completion of scheme 750 square         A
metres @ £350 psm
Year’s purchase in perpetuity @ 6%                           B
Gross development value                        C
Begin by calculating the gross development value – what the developer anticipates it will be worth on completion…Then subtract the costs associated with the sale of the development (sales and marketing)…
Gross development value on completion of scheme 750 square     262,500
metres @ £350 psm
Year’s purchase in perpetuity @ 6%                       16.667
Gross development value                    4,375,000
The residual method 2
Gross development value                    4,375,000
Gross development costs
i.    Building costs: 800 sq. metres @ £1500 psm            1,200,000
ii.    Building finance                         143,704
(interest on building costs 1.2% for 18 months x ½)
iii.    Professional fees 12.5% on building costs            150,000
Interest on fees                        23,951
1.2% for 18 months x 2/3)
v.    Promotion and marketing
(estimated budget)                         50,000
Contingency                        78,383
5% on cumulative costs
vii.    Agents’ fees:
Letting at 10% on initial rent                    26,250
Sale at 4% on gross development value                      175,000
viii.    Developer’s profit
15% on gross development value                656,250
ix.    Total development costs                    2,503,538
The residual method 3
Capital value after development            4,375,000
Development costs                     2,503,538
Residual valuation
Sum available for land, acquisition and interest      1,871,462
Asking price for site                    1,400,000
Acquisition costs @ 4.5%                63,000
Interest on land acquisition @ 1.2% for 24 months    482,790
Sub total                        1,945,790
RESIDUAL VALUATION                 -74,328
What do you think?
Should the development go ahead?
Could the seller be bid down to a lower asking price?
Alternatively – look at the costs again – the developer requires a 15% profit.  If they would accept a 13% profit margin (£581,922) this would bring the development back to parity (residual value of nil).
Bear in mind that if any of the costs are inaccurate on the low side it is the profit margin that is eroded.
What would you advise?
Do we always get things right?