What is Residual Land Valuation & Why is it Useful?
If you wish to know the value of land with development potential, you would use the residual method of determining that value. Unlike other methods of estimating value, it is used at the beginning stages of development or redevelopment in order to:
- Build your budget
- Identify projected expenditures
- Thoroughly and accurately pre-plan a commercial real estate (CRE) project
If you haven’t purchased the property yet, the residual land and property valuation can show you what you can afford to pay for the land you plan on developing. This is especially important because you want to make a profit after all development costs are paid. If you end up paying too much money for the land or exceed development expenses, you could end up losing money.
Calculating the residual land value helps determine the potential profitability of the property once all development costs are paid.
Gross Development Value: Deciding the Highest & Best Use
The first step is to examine the viability of the development plan. To do this, determine the gross development value (GDV), or the highest and best use, by examining the site and studying market trends. The information you find when digging into the market will have an effect on the value. In addition to examining the types of properties already in the area, demographic patterns, geographical data, and general market trends, you’ll also want to look at interest rates, consumer attitudes, and the general state of the economy in that area.
Physical Land-Use Factors
Before developing, it’s imperative to consider the physical land-use factors of the parcel. For example, if you’re redeveloping a gas station property into a retail store, zoning laws, easements, and environmental factors will play a role in whether it’s legally possible.
Land size or acreage. This will have an effect on what can be built while still leaving room for parking, loading/unloading, and easements.
Width, depth, and shape. Oddly shaped parcels of land are harder to utilize to their full potential, therefore generally have a lower resale value.
Topography. This is fairly obvious to spot if there is a slope or steep grade, which, like an oddly shaped lot, can affect the ability to build without extra expenses and potential liability.
Environmental or geotechnical attributes. Wetlands, woods, protected areas, potential contamination, and soil quality are attributes to know about when determining what can be done and how costly it would be to remedy any issues before buying or redeveloping.
These highest-and-best-use factors affect the feasibility of your development plans, as well as the sale and lease prices, and ultimately, the residual value.
The GDV provides the final capital value of a projected, completed property upon its sale at a specific time.
Create Rough Draft of Anticipated Property Improvements
The next step is to identify what improvements you’ll need to make in order to achieve your goals and what they will cost. At this stage, conceptual drawings are fine, but you’ll also want to get some good estimates of the amount of saleable space as well.
This stage can be quite expensive, as you’ll need to hire surveyors, planners, architects, civil engineers, and other specialists like environmental and traffic engineers.
As a property developer, it is your job to take all the information you receive and put it together in a workable, marketable plan. At that point, the plan, along with documentation, will be submitted to the local planning department for approval.
Calculate the Property Value
Before you calculate the residual value, calculate the property value and estimate expenses. These include:
- Site work and building construction (build costs)
- Rough grading and clearing
- Constructing roads and utilities
- Environmental Protection
- Sophisticated computer programs to estimate the volume of earth to be moved, lengths of road, and utility lines to be built
- Construction costs
- Architect fees
- Real estate commissions
- Financing charges
- Developer’s (your) profit
Now you can calculate what the value of the property will be once it’s completed. The easiest way is to use the income approach of appraisal. By estimating the net operating income (NOI) you expect from the property, you can determine the maximum value of the property.
It’s a pretty simple formula: the value of the property is equal to the property’s annual net income, divided by its capitalization rate (cap rate).
With the income approach, the cap rate and estimated value have an inverse relationship—lowering the cap rate increases the estimated value.— Investopedia
Now Calculate the Residual Value
(Gross Development Value) – (Construction + Fees + Profit) = Residual Value of Land or Property
Although the residual method of calculating land value does have its cons, such as the need to use experienced professionals who are experts in their particular specialty, it can be a powerful method. The calculation is also important when obtaining financing for a project since it gives accurate estimates of the most important aspects of the project while presenting a clear, financially sound approach to development or redevelopment.
To Wrap it Up – Residual Land Value Method
Unlike other methods of estimating value, the residual land or property value method will help build your budget, identify projected expenditures, and pre-plan a CRE project as thoroughly and accurately as possible. This method will also guide you on what you can afford to pay for the land or property you plan to develop or redevelop.
If you have questions about the residual land value method or would like to learn about recession-resistant, reliable, triple-net lease investing, feel free to contact Westwood Net Lease Advisors for a no-obligation conversation. Our buyer representation is always free. 314-997-5227