Application of the Residual Approach to Value

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1 August 1993 Application of the Residual Approach to Value The method most appropriate for the valuation of vacant sites with development schemes in place is the Residual or Development Approach. The method is also known as Subdivision Analysis, although this term is less desirable as it gives the impression that the method is suitable only for subdivision development. In its most simple form, the Residual Approach allows site value to be estimated by deducting from the value as developed, construction costs (either site servicing or building costs, depending on circumstances), marketing costs, finance costs, professional fees, developer s profit and other costs, to derive a Residual Value that is then expressed as the site value. Use of computer-based analysis and spreadsheet programs has allowed the residual to develop a sometimes very sophisticated form but, whether simple or complex, the technique has to be applied correctly. It needs to be recognized that the residual method has attracted some criticism, notably from the courts, but this has generally been the result of misunderstanding of the technique. In recent years, the residual method has been refined to a degree that has eliminated most of the problems associated with its use and it now has wide acceptance, both in the development industry and in the courts. One of the problems associated with the Residual Approach has been that development projects generate cash flows different from most properties. They typically involve heavy outlays of cash over an extended period and generally shorter periods of cash surpluses, either as actual sales revenues or assumed values of properties taken into inventory. There are essentially three main purposes for which the residual approach is appropriate. 1. To estimate the most probable price of a development site based on the highest and best use of the site. This can then be used to judge the most likely purchase price and perhaps as a basis for obtaining financing. However, the Residual Approach in this instance should only be utilized when development of the site is not too distant, there is obvious demand for the resultant product, and there is a least some documentary evidence that such a development will be approved. It is not

2 desirable to take a piece of raw land, assume a potential development, and proceed to the Residual Approach. 2. To calculate the likely level of profit from a development scheme given a known site purchase price and a known cost of development. This can be used to judge whether the level of profit is acceptable, given the profit requirements of the developer. It is, in effect, a Feasibility Analysis of the proposed development scheme. 3. To establish the construction cost ceiling given a known land cost and the minimum acceptable level of profit. This enables the developer to judge whether market requirements for the level of finish in a development can be met. Additionally, it would be useful in the development monitoring process to ensure that any changes in the development scheme during construction do not adversely affect viability. In using the Residual Approach, it is good appraisal practice to clearly spell out in the Letter of Transmittal, the Assumptions and Limiting Conditions, as well as in the body of the report, that the analysis is based upon the development scheme described in the report and that any deviation from the scheme as described would invalidate the value conclusions. Similarly, detailed notes as to information used in the report, such as servicing or building cost estimates, fees, absorption studies, etc., should be kept on file, and it is also appropriate to identify such sources in the report. Additionally, the degree of reliance on such information should be revealed within the Assumptions and Limiting Conditions. In appraisal practice, the most common use of the residual approach to value is to derive a site value. However, it has to be recognized that, for many, the residual approach to value is regarded as the method of last resort, and it tends in practice to be used only for unusual or highly specified situations. Its lack of use in everyday practice has been the cause of many errors in the valuation of development sites. It is preferable that any residual valuation be accompanied by at least an attempt at a Comparison Approach, as this is a good check on accuracy. Such a process does, to a great degree, eliminate the excesses of a poorly prepared residual. Because the method requires the appraiser to consider in some detail the potential demand for the development on completion, the various elements of cost, as well as the time frame to construct and market the development, a wide range of appraisal skills is required. Unlike investment analysis, these skills are not as theoretical, and have a more practical base to their application. 2

3 In the application of the Residual Approach, the appraiser may well be required to see the potential in a site, to draw upon knowledge of market values and rents, possess a good knowledge of building costs, understand development control legislation, apply financial factors and inducements, and factor in the requirements of many other consultants in the development process. It is also necessary that the appraiser be able to recognize the different perspectives of potential owners and tenants and, most importantly, be able to distinguish the quite possible from the wholly possible. However trained the appraiser, the application of the Residual Approach is impossible without a good knowledge of zoning and planning issues as they relate to the development. A thorough site inspection is important to ascertain any constraints to the development process that might have been overlooked by other professionals employed in the development process. Discussions with planning officials may elicit some information that could either benefit or harm the development scheme envisaged. Building controls should not affect the appraiser, as architects or engineers are more qualified to assess the implications of this form of control over the development process. However, the process itself can be time-consuming, and it is essential that an accurate time frame for the process be put into the Residual. In today s society, environmental concerns can have a very significant impact on any development scheme. Such issues can either derail the scheme altogether or, at best, create a further delay in the development process. Heritage and historical aspects can have a similar effect, requiring that development schemes be abandoned, altered or delayed. Additionally, as part of the investigation, consideration needs to be given to whether the development project should be enlarged by incorporating adjoining properties or, conversely, whether the project would be better served by being reduced in scope or developed in phases. Adjoining uses can also affect the development by creating an immediate environment that could be considered detrimental. In residential and some commercial development, adjacent obnoxious uses, such as heavy industry and food processing facilities, are obvious examples of detrimental influences, but such a simple issue as shadow zones can also be a problem. In northern climates, heavy shadows can bring an aura of gloom to a development and increase heating costs, whereas, in southern climates, the lack of shading can increase cooling costs and/or make the internal environment unbearable. Site topography and, specifically, drainage considerations can also affect the development scheme and its ultimate acceptance in the marketplace. Development sites on a downward slope, unless associated with view potential, can be a problem to market. Heavy tree cover can create either ambience or a sense of gloom, depending on the overall treatment of the site. Similarly, 3

4 low-lying areas of poor drainage can either be an attractive feature, if incorporated into planned water- courses, or a breeding ground for mosquitoes. Any site-specific requirements or restrictions should be thoroughly reviewed. Onerous parking standards may destroy the viability of a development. Similarly, end-user restrictions, such as requiring a percentage of lower income housing in a residential development, or even restricting unit sizes, may affect marketing and, thereby, value. When dealing with building developments, some knowledge of design is also required, as it relates to saleable or leaseable areas. Not all of a building, unless it is designed for single occupation, can be leased or sold. The net saleable or rentable area of apartment-style is typically 88% of the Gross Building Area or less. Office buildings, however, can effectively reach 100% by the grossing up process, if this is the method of marketing chosen by the developer. Obviously, such considerations apply equally to the comparables that form the basis of the analysis. It is important not to over estimate sales revenues or eventual project value. The best method of establishing potential price levels is by the comparison method for the subdivision analysis, and unit residential or commercial/industrial sales and the income approach for investment properties. Inherently, this is less of a problem where there is a degree of homogeneity, such as is typically the case for residential lots, condominiums, and single family homes. In order that the demand for the development can be ascertained, it is necessary that the development scheme be sufficiently detailed so that the appraiser can judge the market acceptability of the project. This market acceptance goes beyond the type of development into such issues as styling, finishing standards, sales or leasing inducements, etc. The development, of course, must suit its intended market. This applies equally to finish as to the overall concept, as such building cost estimates must allow for the type and extent of internal finish required by a discriminating market. This market would respond to local issues. A typical example of such factors is whether a residential condo unit should or should not have a fireplace, or should the project as a whole have certain recreational facilities. Allowances should be made for both existing and planned competition. A condo project coming on line in two years time, when the development is marketing, can be far more significant than competitive-type projects marketing at the time the development is in the planning stage. The estimated sales period can be a critical part of the analysis, as the sellout can make the difference between a profitable development and one that rapidly escalates into a troubled one. The first step in developing an estimated absorption period is to analyse the demand for the development in the context of the overall market demand for similar projects. The typical buyer or lessee needs to be identified, and the development scheme reviewed to see whether the project meets the demands of the likely market. 4

5 It is certainly advantageous to review the history of past similar developments, as they can show typical absorption trends. Information on residential absorption, be it condos, single family units or building lots, is generally fairly readily available from either local real estate boards or from the various levels of government. For office-type development, most of the larger cities have published material relating to the level of office vacancies and absorption. In many cities similar information is available for industrial and retail-type properties. Notwithstanding any information gathered above, it is typical that projects market best in the first few months of sales or leasing activity. In a successful development, absorption is likely to be greatest in the earlier months, and gradually reduce as the better units are sold or leased and choice becomes more limited. A less successful development may see slow absorption at first, followed by a flurry of activity as prices are reduced and marketing efforts increased, and then a reduction of activity as the market loses interest. One criticism of the Residual Approach in the past has been that it is extremely vulnerable to input error or, worse still, input advocacy. Realistically, the criticism is unfounded, as the method is inherently no more susceptible to error than other methods of appraisal. Additionally, it can also show which components of the Residual are most sensitive to change. The most sensitive element is the end unit price, either in terms of the unit price or investment price. In the latter case, the capitalization rate and rental rates are the most critical elements. The next most sensitive item is construction cost, but the sensitivity is likely less than for unit price. Typically, a 10% variable in unit price may influence the site value by 30% to 50%, whereas a similar 10% variable for building cost may influence the value by 30% to 40% Actual percentages, of course, would vary with individual circumstances. The remaining elements of the Residual are significantly less sensitive, as a 10% variance in finance costs would likely influence the result less than 10%. Despite the emphasis placed on absorption, a reasonable variance in the sellout or lease-up period would affect the result less than a similar variance in end prices or construction costs. However, if absorption is delayed due to nonacceptance of the product in the marketplace, then the whole analysis can be invalidated. The selection of a Discount Rate also has less effect on the result than would initially be expected. This is only true, however, when the development and marketing period is relatively short, as is normally the case. The remaining elements, such as professional fees and marketing costs, are unlikely to vary greatly and, even with significant variances, would not necessarily materially affect the end value. It is obvious that a Residual, to be accurate, requires more accuracy in the unit price and building cost sections. Yet logic would dictate that these sections are just as critical in the Comparison, 5

6 Income and Cost Approaches. In such circumstances, how can the Residual Approach be less accurate than the more traditional methods? Indeed, in the Residual, the most sensitive area of the Cost Approach, depreciation, is not a factor. In essence, therefore, there is every reason to use the Residual Approach when circumstances merit. The skills to prepare an accurate Residual-based appraisal may require a greater depth of knowledge, but the result would be no less, and probably more, accurate than any other properlyapplied method of appraisal. For a more extensive overview of the Residual Method and the application in a number of case studies, see the article entitled Concepts of Residual Valuation in the Spring 1993 edition of Canadian Appraiser. The author would also like to receive any comments you may have on the Residual Approach itself, the Canadian Appraiser article, or this Claim Prevention Bulletin. CUSPAP References Highest and Best Use Appraisal Standard In the report the appraiser must define and resolve the highest and best use; Appraisal Standard Comment The report must contain the appraiser s opinion as to the highest and best use of the real estate, unless an opinion as to highest and best use is irrelevant. If the purpose of the assignment is market value, the appraiser s support and rationale for the opinion of highest and best use is required. The appraiser s reasoning in support of the opinion must be provided in the depth and detail required by its significance to the appraisal, based on the relevant legal, physical and economic factors. As land is usually appraised as though vacant and available for development to its highest and best use, opinions are required both as to: i. the land, as if vacant, and; ii. the property, if improved. Practice Notes Highest and best use may be defined as: That reasonably probable and legal use of vacant land or an improved property which is physically possible, appropriately supported, financially feasible, and that results in the highest value. 6

7 The highest and best use of a property is an economic concept that measures the interaction of four criteria: legal permissibility, physical possibility, financial feasibility, and maximum profitability Estimating the highest and best use of a property is a critical appraisal component that provides the valuation context within which market participants and appraisers select comparable market information An appraiser considers highest and best use of the property as if vacant separately from the highest and best use of the property as improved. This is because the highest and best use of the site as if vacant and available for development determines the value of the land, even if the property s existing improvement does not represent the highest and best use of the site Highest and Best use of land or a site is the use among all reasonable alternative uses that yields the highest present land value, after payment for labour, capital and co-ordination. The conclusion assumes that the parcel of land is vacant or can be made vacant by demolishing any improvements If for valid reason, as explained in the report (e.g. rent review, value in use, insurance coverage,) a highest and best use is irrelevant; no Extraordinary Limiting Condition is required. Note: As with all professional practice bulletins, this publication is not intended to set out all professional/ethical responsibilities or regulatory requirements, nor to identify all valuation or theoretical aspects of the subject matter. The purpose is simply to raise areas of potential liability exposure in ordinary day-to-day practice to the attention of members, and to suggest professional practices that can help avoid liability insurance claims. Members are encouraged to suggest topics and/or writers for future bulletins by contacting the AIC offices at 7

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