How do you calculate Residual Land Value
In economic terms, land is worth what someone will pay for it. As land is a limited resource, the person who can pay the most for a piece of land will win when competing against others. The process by which the land price is arrived at is a key difference between housing associations and private developers.
Private developers trade in land; housing associations are investors in property. This fundamental difference means that they have different criteria for assessing land value, which sometimes favours the private developers, and sometimes the housing associations.
Historically, the more agile nature of the private developer has usually been to their advantage as there is more freedom placed with the land buyer, plus, the assessment of the land value is typically more straightforward. Speed is not the only factor though. Vendors want to maximise the sale value, so the housing association sometimes has an advantage here, as the assessment method they use can lead to a higher land value than the private developer. Before we get into how such situations arise let’s take a look at the typical private developer valuation process.
Firstly, the private developer will research their market thoroughly and choose a mix of properties that have the highest value in the most marketable configuration, whilst considering planning constraints. They spend a lot of time on this part of the process. The outcome is the gross development value, or, the total sales receipts from selling those properties.
The next stage is to work out how much it will cost to build the properties. These costs can be broadly categorised into works costs, technical fees, abnormals, marketing, etc. Every cost is analysed to make sure nothing is spent that doesn’t need to be. In addition to the actual costs the developer will make an allowance for an acceptable profit margin, usually around 20%, but varying according to the risk.
The residual land value is what’s leftover once you deduct the costs/profit margin from the gross development value. For a private developer, the maths is easy: sales income less expenditure equals residual land value. Once the properties are sold then they move on to the next development.
For a housing association there is another key consideration – many of the properties will be rented and/or shared ownership. So, the future rental income (and possible staircasing) needs to be taken into account, as does grant from any funding bodies.
The way we value future incomes and costs is by using the concept of net present value (NPV). This is the process of assessing the future value of the net rent as if you had received all the income on day one. A housing association can, therefore, convert 30+ years of future net rental income into a single value in today’s money. The NPV of the net rent can be combined with grant income and initial sales tranche (if shared ownership) to produce a proxy gross development value (“GDV”):
Gross Development Value = NPV of Net Rent + Grant + Initial Sales Tranche
From this point onward the maths is the same as for the private developer; costs are subtracted from GDV to establish the residual land value:
Residual Land Value = Gross Development Value – Build Costs – Professional Fees – Interest
So how do the differing approaches make some sites more suited to private development and some to social development? The answer is that the sites with the greatest potential sales value will usually look better in the private model. It’s the sites that would command the lower house prices that will generally look better to the housing associations, because they can take into account the future rental stream, plus they may also receive grant for such sites. Luckily for the private developers, these future income streams are capped, so if there is sufficiently high value in outright sales, it will exceed the value of the future income.
The science on this is straightforward, the art is in determining the best possible mix of units for a site. Getting this mix right is the domain of the land buyer, not the architect, and is the key to maximising the residual land value, which will in turn give the housing association the best chance of a successful bid.