The residual method of land and site evaluation is used to predict the profitability of land and buildings that are to be purchased for development or redevelopment. This is a risky method and should be used cautiously.
What Is the Residual Method?
There are several methods for valuation of sites, land, and property. One of these methods is the residual method, which is used to estimate the value of land or buildings that are going to be developed and/or redeveloped. This is used to attempt to calculate the potential profitability of the property after development. Specifically, the method calculates the residual land value, which is the value of the site or land after development has been completed, minus the cost of purchase, plus developing, maintaining, or reselling the land.
The method does have its drawbacks, and should only be utilized by knowledgeable and experienced professionals. It's best done with a team of individuals who are experts in their specific areas of the process, whether it be the real estate transactions, the development, the maintenance of the property, or any other factor in the development project.
When to Use the Residual Method
This method is ideal when an individual or entity wants to develop or redevelop property, most often to be resold or utilized in some other way to make a profit. This is done with both residential and commercial properties. This method is often used before buying or developing the land to determine whether or not the purchase and development will be profitable after calculating what will be paid for the developmental land.
It's important for developers to use this method when purchasing land/property so that they do not buy the land at a cost that would stand to make them lose money instead of profiting from the project. A development analysis should be completed to determine the ideal budget to make the purchase and development project profitable. The residual method is a crucial part of this development analysis and can involve calculating many varying costs that come along with land development. Some of these considerations include (but are certainly not limited to) cost of construction, building period, investment yield, rent, fees, property taxes, finance costs, and any other additional costs.
Residual Method Example
If land is bought for $20,000, and development, maintenance, and reselling total $100,000, and it is sold for $200,000, then the residual value of the land is $80,000. This is calculated by totaling the cost of purchase plus the cost of development, maintenance, and reselling, then subtracting that total from the final selling price. The equation for this example would look as follows:
20,000 + 100,000 = 120,000
200,000 - 120,000 = 80,000
200,000 - (100,000 + 20,000)
200,000 - 120,000 = 80,000
If land is bought for $50,000, and development and maintenance total $200,000, and it is sold for $300,000, then the residual land value of the land is $50,000. The equation for this example would look as follows:
50,000 + 200,000 = 250,000
300,000 - 250,000 = 50,000
300,000 - (50,000 + 200,000)
300,000 - 250,000 = 50,000
If land is bought for $75,000, and development, maintenance, and reselling total a cost of $450,000, and it is sold for $700,000, then the residual land value of the land is $175,000. The equation for this example would look as follows:
75,000 + 450,000 = 525,000
700,000 - 525,000 = 175,000
700,000 - (75,000 + 450,000)
700,000 - 525,000 =175,000
Disadvantages of the Residual Method
As with most valuation methods, the residual method does have its drawbacks. For one, it isn't always as simple as the formulas shown above. It is important to consider any expected appreciation or depreciation of the development for a more accurate estimation of the residual value. You'd then want to subtract the total development costs from this appreciation or depreciation to find the true residual value. The total development costs include every step of buying, developing, and reselling the property. This can be anything from financing and interest, to taxes, to the developer's/contractor's profit margins.
Another setback to this method is that the people conducting the analysis using the residual method will have to make assessments about future expectations. There may end up being additional costs to development, or the property may not sell for what was expected. There can be many factors that can be difficult to predict when using this method of valuation, and it should be used cautiously. It also involves the opinions and predictions of many individuals since there are many aspects to determining all costs associated with developing property. These individuals should also be very knowledgeable and experienced in their areas of expertise.
Let's take a couple of moments to review what we've learned. The residual method of land and site valuation is a risky method used to determine the potential profitability of real estate property since it's used to estimate the value of land or buildings that are going to be developed and/or redeveloped. The method determines residual land value by subtracting purchase and development costs from the final selling cost (or potential selling cost) of the property. It includes any and all costs to complete the development project and should be used cautiously; however, it has a lot of use and should always be considered as an option.