Residual Method

Information on the Residual method for real estate appraisal

In many areas, inside or outside the city plan, properties that are not fully developed can be identified and can gain bigger value if transformed with appropriate capital.

The residual method is used to determine the value of the property through the potential available after a scenario of exploitation. A typical example of the residual method is the possible demolition of an old house and the creation of a brand new building in this location. It is realized that the value of the land in this case is changing.

The residual method calculates the market value of the property in its present form by following the procedure whereby the development or reconstruction costs and the developer’s profit are deducted from the completed development value of the implemented scenario.

Completed Development Value refers to the calculation of all sales revenue after applying the probable scenario that the valuer chooses to apply with the residual method and is usually calculated using comparative data on similar properties or leased capital.

Development Costs refer to the amount of capital required to implement the scenario and include the costs of construction / reconstruction, other costs as well as the fees of the contracting parties.

Developer’s Profit refers to the revenue generated by the total sales of the implemented scenario and is expressed as a percentage of it.

The relation expressing the residual method is as follows:

Residual Value = Completed Development Value – Development Costs – Developer's Profit

Cases of application of the residual method

The Residual method can be applied in a number of cases. The valuer chooses whether to use the residual method and whether to apply it in combination with another method to weight the final result. Tthe residual method can be applied on the follow cases:

1. Land: The residual method is mainly applicable to the determination of the value of land, which make sense to develop, for which comparable data are lacking, however, there are available rental or sale data. The residual method calculates the maximum value of an unfinished plot, since it has been theoretically fully and optimally developed. The best-case scenario of the residual method is directly related to the location of the land and existing planning legislation, where the estimator through the residual method selects the optimal use. The residual method logic is based on the maximum price that an investor would be willing to pay for a property.
2. Land with unfinished buildings: The use of the residual method for unfinished buildings is preferred in cases where the existing building has fully or largely utilized the building factor. Also, the residual method can be applied if the building is at an advanced stage of construction readiness or while maintaining the bearing body in good condition. In cases where the above does not apply, when applying the residual method, the demolition of the existing building is assumed, and the cost of this is calculated and included in the development costs. However, before deciding to demolish the existing building, the existing building conditions should have been checked and if they have changed and are more unfavorable to those in force during the period when the existing building was erected. Then demolition may not be optimal scenario of exploitation as it would significantly reduce the future construction area of ​​the plot.
3. Land with buildings which need reconstruction or redevelopment : The residual method is applied in cases where the existing use of the buildings is not the same as the optimal use of them while the scenario of redevelopment or reconstruction of the building will achieve future maximization of revenue after it is placed on the market. A typical example of the residual method in such cases is the conversion of old office building, located in a residential area, into apartment building and this change of their use, increase their value. In each case, the possibility of demolishing the building is checked before determining the optimal scenario for the use of the residual method and then calculates the capital required for the implementation of the scenario.
4. Preserved buildings in need of renovation: In cases where the residual method is used to determine the value of preserved buildings in need of renovation, it is emphasized that their demolition is prohibited. In these cases the construction balance shall not be taken into account, unless there is a construction permit. By applying the residual method the valuer chooses the optimum utilization of the existing building.
5. Special cases: The residual method can be used in many cases, such as determining the profit after implementing a scenario and determining the value of the finished product to be marketed. The residual method also calculates the cost of implementing the scenario, so that an investor can calculate the total costs and benefits that the scenario will bring. The residual value calculated through the residual method enables the investor to determine the amount of the price that he could allocate for the purchase of the land.

Stages to apply the residual method

The residual method follows some basic steps in its implementation which are:

1. The first stage of the residual method concerns the choice of the scenario for optimal utilization of the estimated property.
2. The second stage of the residual method is the calculation of the proceeds from the sale of the product that will result after the development scenario is implemented.
3. The third stage of the residual method is the calculation of the total cost of implementing the selected scenario as
   • Construction / reconstruction costs
   • Demolition costs, landscaping and special constructions
   • Project insurance costs, usually estimated at 1% of construction costs
   • Engineer fees, usually estimated at 5% of total construction costs
   • Notary fees, usually calculated at 1% of total construction costs
   • Lawyer fees, usually calculated at 1% of total construction costs
   • Real estate agent fee is usually calculated at 2% of total construction costs
   • Exceptional costs that are difficult to predict are usually estimated at 5% of total construction costs
   • Borrowing costs which calculated
     (α) Interest on capital
     (β) Mortgage costs, which is usually calculated as 130% of borrowing capital
     (γ) The expenses of the dossier that the bank is likely to keep in the event of a loan
4. The fourth stage of the residual method is the calculation of the expected return on investment calculated as a percentage of revenue. The expected profit that the valuer is required to calculate through the residual method depends directly on the investor's decisions and on a number of factors such as
   • The uncertainty of sales, and specifically if the expected sales prices of the finished product will be achieved.
   • The time of completion of sales, whether pre-sale at the stage of construction or sale at the completion of development, in order to release capital and return on investment.
   • The bad estimation of the cost of construction, which is related to the revaluation of building materials, salaries and other
   • Other contingencies that may delay the completion of the project such as a) archaeological findings b) arbitrariness complaints c) problems with the subsoil during the excavation stage
5. The fifth stage of the residual method is the calculation of the residual value of the estimate determined by subtracting the development costs and business benefits from the estimated growth value resulting from the sales.

   Residual Value = Completed Development Value – Development Costs – Developer's Profit

6. The sixth stage of the residual method is the present value / present value calculation, where the discount rate is applied which takes into account the opportunity cost of proportionally sized investments and is defined as follows:

Analyzing the stages of the residual method, it is found that each stage is calculated as a future investment such as the purchase of a vacant plot, the implementation of the most efficient investment scenario, the costs required to complete the project, and the income the investment will generate. However, when applying the residual method many difficulties arise and therefore the final result should be checked for its correctness or weighted with the result of another method.

Furthermore, the scenario chosen when using the residual method may be quite different at the final design stage in order to issue the definitive construction permit. Significant changes may also have occurred in the real estate market if it has not been completed within the time estimated by the appraiser, with consequences for the current value of the appraised property. Implementation costs are also an important factor in the residual method, and if they change, they will affect the level of profits, with the present value being reduced even negative.

Example of applying residual method

Estimate the value of the land by applying the residual method for the following projections for this development:

• Office building scenario of 5000 sq.m.
• Offices will be rented monthly for 10 € / sq.m.
• The return on investment will be 8%
• The construction cost is estimated at 700 € / sq.m.
• The project developer will have a profit of 20%

Solution

The valuer using the residual method, firstly calculates the total revenue of the implemented scenario and then subtracts the development costs and the developer’s profit. Development costs and Developer’s profit are displayed in red font. The results are shown in the table below:

Development Value

Total Constructed Area	5000 sq.m.
Estimated Market Rent	x 10 €/sq.m.
Estimated Annual Market Rent	50.000 € x 12 months	600.000 €
Capitalised 8%		/ 0.08
		7.500.000 €

Less Development Costs

Construction Costs	5000 sq.m. x 700 €/sq.m.	3.500.000 €
Profit on construction costs	20% x 7.500.00 €	1.500.000 €
Residual Land Value		2.500.000 €

The residual method differs from the other methods in estimating a non-constructed property. As shown in the example above, the residual method is mainly used to estimate the land that can be developed.

Summary

In conclusion, the residual method is considered a sensitive method where small changes in the choice of assumptions can significantly affect the final result. The valuer choosing the residual method should have appropriate planning experience and be aware of the approximate costs of implementing the scenario in order to make the correct assumptions in the best possible way. There are usually many difficulties with the use of the residual method and therefore the residual method must be evaluated for the correctness of the result.

Some of the advantages of the residual method are:

• The residual method takes into account any possible borrowing and the additional costs that may arise.
• The residual method takes into account the costs of utilizing a vacant land and the potential costs to be incurred.
• The residual method takes into account the developer’s profit

The weaknesses of the residual method include the following:

• The residual method is applied in combination with another method
• The total number of assumptions and adjustments of the residual method, lead to the unreliability of the final result.
• The result obtained by the residual method is often weighted by the result of another method.