The Residual method is a way of valuing a property that has development potential.

Whether a particular property has good potential to be developed will depend upon the
increase in property value exceeding the cost of building work. The project can be studied to
establish the overall financial viability of it before committing to a detailed financial analysis
of costs and expected benefits.
In most cases, the comparable method of valuation will be used to obtain reasonably
accurate values for Sq Ft or Sq M. Recent transactions can be analysed and the selling price
or annual rent compared to the property in question. Although the comparable method is not
flawless, it is about the most accurate method available. However if no comparable values
are available, the residual method is used.
The primary use for a residual appraisal is to produce a figure for land purchase, in addition it
can also be used to:
1. Establish a required profit from a project and place that figure into the calculation.
2. Consideration of the maximum value available for build costs, above which the
project will become less financially attractive.
The basic formula for a residual appraisal is:
Gross Development Value or Value completed
Less
Costs and Profit
Equals
Amount available for Land Purchase
The amount available for land purchase is the absolute maximum that the developer would
pay for the undeveloped project. In practice however, the developer is likely to pay less than
this because he has to:
1. Allow for professional fees and SDLT or property taxes.
2. Pay interest charges on any money borrowed to fund the development.
The undeveloped property might be:
1. Brownfield or Greenfield land where buildings have never stood.
2. A cleared site where the property has been demolished.
3. A property that requires renovation or conversion to a lesser or greater degree.
Gross Development Value (GDV) can be defined as
The value of the completed proposed development if the property is sold to a willing
purchaser on the open market.

If the proposed use is residential, then comparable values from similar sold properties can be
used to calculate an overall scheme value. If the development is planned to be Office,
Industrial or retail then comparable similar rental rates (per sq ft/M) and yields can be used to
establish an appropriate value.
Build costs could include:
1. Site clearance. If the site has an existing property, it will need to be demolished and
taken away. If this property is occupied, then tenants will need to be compensated for
the premature ending of the lease.
2. Construction costs. These can vary by a massive amount. It will depend on end
quality of the property (i.e Grade A offices or lower-end Industrial), the region/area
its being built in and whether the contractor is a main one or not. As a very
approximate guide, high-end office property will cost upwards of 100(around $150)
per sq ft or 1,000($1,500) per sq M.
3. Contingency sum. This is often around 5% of total build costs.
Professional fees for Architect, Legal, Quantity Surveyor and Structural Engineer often
come to around 12% of total building costs, without VAT.
Finance costs cover the expense of borrowing money for the project. This will not be for a
very long term, but is likely to be from commencement of construction to the eventual sale or
let of the property. The cost of borrowing will depend on the amount of capital put into the
project, the construction period, and the rate of interest applied to the loan.

 Copyright Robin Webster and licensed for reuse under this Creative Commons Licence

Most medium sized projects will be constructed within around 12 months. If the building
period is 12 months, the cost of borrowing would not be 12 months worth of interest though.
This is because the contractor would be paid as the work progresses, not in a single lump-sum
at the beginning. Also, there is likely to be a void between the completion of the property
and the point of sale or let. So to calculate the financial liability of the project:
12 month construction period 2 (say) = 6 months interest, plus 6 months occupancy void =
12 months worth of interest
Therefore for a combined construction and void period of around 18 months, 12 months
worth of repayments might be a figure to adopt.
The rate of interest adopted for the appraisal could be around 2%-5% above current base
rate. However in the case of large projects where an investment company is contracted to
purchase the property when its completed, the developer might be able to borrow funds at a
more favourable rate than from a bank.
Large residential development projects can often offset the amount borrowed from a bank, by
selling properties that are completed early on in the programme.
Letting fees for commercial properties are often 10% of the annual rent figure.

The profit gained through a development project is often around approximately 20% of total
build costs or 15% of GDV. This should hopefully be enough to cover 2-3 years rent. Profit
is vital to the ongoing business of property development, but it is the first place developers
look when they are pushed to pay more for land or costs. The profit can easily be squeezed
out in order to be competitive.
If the land price is already agreed, an alternative to the residual appraisal formula stated
above is:
Gross Development Value
less
All costs (including land, taxes and fees)
equals
Profit
The residual method can be used to get an idea of all the particular aspects that go into the
development appraisal. It uses an equation that can be simplified to such a degree as to allow
very approximate appraisals to be carried out mentally.