04.03.2018

Residual value calculation: land is worth for its development potential

Considering that the land and its location are the most influential elements in real estate development, the challenge of listing them becomes transcendental.

Considering that the land and its location are the most influential elements in real estate development, the challenge of listing them becomes transcendental.

 

Fortunately, there is the residual value method, which consists of calculating the cost of a property after obtaining its development potential. It starts from the premise that a land is worth what can be built on it with the best and most profitable of its uses.

 

Of course, it also depends on the asset class, since a property destined for housing is not as promising in its profitability in comparison with one of the mixed uses.

 

It is called “residual” because the value to be paid for the land is what remains after quantifying the possible income from the development and subtracting the costs assigned to it and the desired profit margin.

 

In order to make this calculation, the case is analyzed from back to front: first, one needs to consider what can be earned, and in the end, the value that deserves the property in an initial investment is obtained.

The steps, in simplified form, are as follows:

 

  1. Identifying the development potential according to the market study, regulations, design and business viability.
  2. Building the financial model based on the development potential with its sensitivity analysis; that is, project the costs of executing it.
  3. Adding desired profit margins. Currently fluctuate between 10% and 20%, depending on the asset class and the purpose of the investment (asset vs. quick realization).
  4. Obtaining a residual value of the land in the financial model according to the runs based on the development potential and desired profitability.

 

The analysis can be complex as in a financial run of discounted flows or a simple mathematical analysis, as shown in graph A.

 

In this example, the value of the land, starting from a potential income of $100 pesos, is $15 pesos or 15% of the sales.

 

The residual value is a proven method in the industry, and it’s also simple enough for anyone to know an approximate of the implicit expenditures in a project.

A
A