THE RESIDUAL METHOD OF VALUATION
1. Introduction:
This method is used to value property with development potential.
Development potential (or latent value) is present when a property
can be improved or developed so that the value will be increased by
more than the expenditure.
The residual method may be set out in outline as follows:
a. Estimate the value of the property when developed to the best
advantage. This is the Gross Development Value (GDV).
b. Deduct the estimated expenses of development including an
allowance for risks and developer’s profit. The allowance for
‘risk’ is made because the prospect of getting the expected income
from the development of land is a speculative one and hence, the
prospective purchaser is unlikely to purchase a site except at a
price which allows some margin for this risk.
c. This will leave a residual figure which is the estimated value of
the site in its unimproved state, i.e. the amount which a developer
could afford to pay.
Therefore, the basic formula for the residual method is:
Gross Development Value V
Less
Costs and Profit C+P
Equals
Sum Available for Land Purchase L
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2. Outline residual valuation:
A. Gross Development Value (GDV) V
Net (lettable) space: ….. sq.m. @ $... p.s.m. $.......
YP perp @ ..% …... $......
or Net (saleable) space: ….. sq.m. @ $...p.s.m. $.....
$V
B. Cost of development C
1. Building costs:
a. Gross area: ….. sq.m. @ $...p.s.m. $.....
b. Professional fees $.....
2. Finance costs:
1. a & b @ ..% p.a. for half building period $.....
3. Contingencies: @ 5% building costs $.....
Total costs $...C...
C. Developer’s profit & risk P $...P...
Total costs and profit $C + P
D. Residual amount for land L $V - (C+P)
PV in ….years @ ..% _______
$...........
Less for incidental costs of purchase of site $………
Price for Land $............
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3. Explanation of terms:
a. Gross Development Value (GDV) V
In Hong Kong, the Building (Planning) Regulations (First
Schedule referred to in BPR 20 and 21) determine the possible
development of the site.
Once the scheme of development is determined, the present
capital value of the estimated future income from the property
concerned is arrived at by normal market comparison. Thus in the
case of a residential development scheme which is for sale, the
capital value is based on direct capital comparison with the prices
of flats similar to that in the locality; where commercial
development for long term investment is proposed, the rental
value will be ascertained by comparison with lettings of similar
properties, and the appropriate yield applied to arrive at the capital
value. The value is known as the GDV.
The net (or saleable, lettable) area of the building is used to
determine the value of the development.
b. Cost of Development C
i. Building cost: The cost of erecting the buildings, roads and
services. The cost of erecting the building is based on a
price per square meter or per square foot, and is basically a
price applied to the gross floor area. The unit price of the
various types of building can be obtained from quantity
surveyors.
ii. Professional fee: Fees for the architect, quantity surveyor,
structural engineer and building services engineer range
from about 5% to 10% of the building costs, depending upon
the scale of the scheme.
iii. Contingency sum: To allow for possible variations, a sum
amounting to 5% of the building cost is reserved.
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iv. Cost of finance: The developer relies on funds to pay the
building cost. The cost of borrowing this money can be
estimated by assuming interest on the total building cost for
half the period of building construction because the
contractor would only be required to pay as the work
proceeds. He is not obligated to pay the whole sum on day
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c. Developer’s profit and risk P: a broad guide is 10 to 15% of the
gross development value (GDV), or 15 to 20% of the
development costs and land costs.
d. Residual amount for land L: When the total costs of development
are subtracted from the gross development value, the balance
represents the sum available to the developer to spend on the
development site. The sum is deferred for the total period of
development at the developer’s borrowing rate. The discounted
amount represents the sum available for purchase the site, plus fee
and stamp duty.
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4. Example:
A developer wishes to know the residual value of an industrial site
where total rental income from completed buildings is expected to be
$100,000 p.a., total building costs including all fees incurred are
expected to be $700,000, the building period is expected to be 2
years. The yield for similar industrial building is 8% while the
prevailing interest rate is 15% per annum.
Gross Development Value V
Income $100,000 p.a.
YP perp @ 8% 12.5
Capital value $1,250,000
Cost of Development C
Construction costs (inc. all fees) $700,000
Short term finance over half
Building period @ 15% p.a. $105,000
$805,000
Return to Cover Risk & Profit P
@ say 20% of capital value $250,000 $1,055,000
Residual Value L
Maximum site value (on completion
of development) $ 195,000
PV 2 years @ 15% p.a. 0.7561
Land Value & Acquisition Costs $ 147,440
Costs of Acquisition (5% of Land Value) $ 7,021
Land Value $ 140,419
Say, $ 140,000
AV $140,000/GFA
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5. Criticisms of residual valuations:
a. Unrefined mathematics.
b. Variations between estimates in the variable elements produce
substantial divergence in the end result.
c. It is not adequate to deal with a more complex development
situation where the expenditure and income are being made and
received at different times and particularly over a longer time
scale.
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BUILDING (PLANNING) REGULATIONS – FIRST SCHEDULE