Valuation by Residual Method
For me, comparable sales can be a good reference, but they are not the only method people in the property development industry use to evaluate property with development potential. On many occasions, the residual method is used, where a financial feasibility is built up with inputs including development costs and post developed values that are based on the sites development potential.
There are many variables that need to be considered including tax, which sometimes gets forgotten. The analysis also considers cash-flow and funding requirements, escalation and required minimum returns, and therefore pre-developed values can be more accurately understood.
On many occasions however, the residual value ends up being quite different to what the vendor is expecting, many times less but sometimes more! So the buyer either gets a bargain, or no deal is done. Most of the time it’s the latter.
The lack of developable property transactions in growth areas is particularly evident in recent years, and I don’t believe that’s just a coincidence. I think the answer lies in the methodology used and the impact of (and consideration to) short term market movements. Vendors generally aren’t equipped with the right tools to use the residual method, so the natural process of any vendor is to compare sold prices in the area. If their neighbours sold for a certain price per square metre, and because property value generally increases over time, should they anticipate at least the same or more?
Not quite. Are we comparing apples & apples? Each property is unique, and some properties may be more developable than others (or less ‘encumbered’) due to variable planning zone provisions, building constraints and other authority servicing requirements. There are also cases that previous buyers may have in fact paid too much as their growth assumptions may not have reflected recent market adjustments (i.e. post 2010).
These factors can have a significant impact on anticipated development costs and revenues, and therefore the residual land value has to adjust accordingly.
The key point here is that whether you are a seller or a buyer of property with development potential, you could be doing yourself a major disservice by relying only on the comparable sales method. A proper due diligence and feasibility study using a combination of comparable and residual land value analysis is proven to be a more accurate measure of your developable property’s worth.
So if you own or are looking for a property with development potential, please contact us to help you accurately assess the value of that property and get the right deal.
Stay tuned for part 3…. We will go a little more into the ‘time value of money’ risks and the ‘time’ importance of getting the deal done.