Why the value of development land is determined by what can be built, what it will cost and what the finished development is worth.
For anyone considering the purchase of development land, one of the most important questions is also one of the easiest to misunderstand:
How much is the land actually worth?
An asking price does not answer that question.
A comparable sale does not necessarily answer it either.
For development land, value is often determined by working backwards from the completed development. The process considers what can realistically be built, what the finished development could be worth, the costs of delivering it and the return required by the developer.
This is the basis of a residual land valuation. The principle is relatively straightforward. The difficulty lies in getting the assumptions behind the calculation right.
A small change in sales values, build costs, affordable housing requirements, finance costs or developer profit can have a significant effect on the amount that can be paid for the land.
That is why a development land appraisal should not simply ask whether a site looks expensive or cheap. It should establish whether the proposed land price works within the economics of the
development.
What is residual land value?
Residual land value is the amount theoretically available to pay for development land after allowing for the value of the completed development and all the costs and returns required to
deliver it.
In simplified terms:
Gross Development Value – Development Costs – Finance – Developer’s Profit = Residual Land Value
The calculation is more detailed in practice, but the principle is important.
The land is effectively the residual.
If the completed development is worth £5million, but the development costs, finance and required developer profit total £4 million, there is approximately £1 million available for the land and
associated acquisition costs.
If the landowner is asking £1.5 million, the developer has a problem. That does not automatically mean the land is overpriced. It may mean that the assumptions used in the appraisal are too
conservative, or that another buyer has identified a different development opportunity.
Equally, it may mean that the asking price has little relationship to what the site can actually support.
Step one: Establish the Gross Development Value
The starting point is normally the Gross Development Value (GDV). GDV represents the value of the completed development.
For a residential scheme, this might involve estimating the value of each proposed house or apartment and adding those values together.
For example:
• 8 houses at £400,000 each = £3.2 million
• 4 houses at £450,000 each = £1.8 million
The total GDV would therefore be £5 million.
However, establishing GDV is not simply a matter of finding the highest asking prices for similar properties on a property portal.
A proper assessment should consider:
• Location
• Property type
• Size and specification
• Number of bedrooms
• New-build premiums
• Recent achieved sales
• Competing developments
• Local supply
• Market conditions
• Absorption rate
• Sales incentives
• Affordable housing or other tenure requirements
There can be a substantial difference between the advertised price of a new-build property and the price that a developer can realistically achieve.
The more optimistic the GDV, the more the residual land value increases. That makes GDV one of the most sensitive assumptions in the entire appraisal.
Step two: Establish the build costs
The next major consideration is the cost of physically constructing the development.
Build costs can vary significantly according to:
• Building type
• Specification
• Size
• Location
• Contractor availability
• Site access
• Ground conditions
• Construction method
• Programme
• Market conditions
A site that appears straightforward from the outside may have significant construction implications.
For example, a relatively simple residential site might have a conventional construction cost, while another site could require retaining structures, extensive drainage works, difficult access
arrangements or specialist ground remediation.
Using an overly optimistic build cost can create a misleading residual land value.
If a scheme is assessed at £1,500 per square metre when the realistic cost is closer to £1,900, the difference can materially reduce the amount available for the land.
Professional and planning costs
Development is not simply about buying land and paying a builder. There will normally be professional and planning-related costs, which can include:
• Architects
• Planning consultants
• Structural engineers
• Civil engineers
• Quantity surveyors
• Ecologists
• Transport consultants
• Legal costs
• Building control
• Surveying
• Project management
• Planning application costs
These costs need to be incorporated into the appraisal rather than treated as an afterthought.
A development that requires substantial planning work, technical reports or design changes may carry considerably higher professional costs than a straightforward consented scheme.
Finance costs
Finance is another important component.
A developer may need funding for the land purchase and construction, with interest and other financing costs accumulating throughout the development period. The longer the project takes, the more important finance becomes.
A scheme that looks profitable on a static spreadsheet can look very different once realistic finance costs and the development programme are included.
For example, delays caused by planning, technical issues, construction or sales can increase the period over which finance is required.
This is particularly relevant where a developer is using bridging finance or other relatively expensive funding.
Infrastructure and abnormal costs
One of the biggest dangers in development appraisal is treating a site as if it were a blank piece of land with no complications.
Abnormal costs can include:
• Difficult ground conditions
• Contamination
• Flood mitigation
• Retaining walls
• Significant levels changes
• New access roads
• Drainage infrastructure
• Utility diversions
• Reinforcement of existing services
• Demolition
• Asbestos removal
• Ecological mitigation
These costs can have a direct impact on residual land value.
A site with an apparently attractive planning allocation may therefore be worth substantially less than another site with similar development potential but fewer physical constraints.
This is one reason why planning potential should never be considered in isolation from site deliverability.
Section 106 and affordable housing
Planning obligations can also materially affect the residual value.
Depending on the development and local planning policy, a scheme may be subject to obligations relating to matters such as:
• Affordable housing
• Highways
• Education
• Open space
• Community infrastructure
• Other local infrastructure requirements
Affordable housing is particularly important because the value attributed to affordable units may be lower than the value of equivalent open-market units. The effect therefore needs to be incorporated into the appraisal.
For example, a developer may initially calculate the value of 20 houses at open-market values. If the planning policy requires a proportion of those units to be delivered as affordable housing, the
resulting GDV may be lower than the initial headline figure.
The precise effect depends on the local policy, tenure requirements, viability position and the details of the scheme.
Developer’s required profit
A developer is not simply looking to recover costs. The development needs to provide an appropriate return for the capital, risk and time involved.
Developer’s profit is therefore a fundamental part of a residual appraisal.
The required level of profit will depend on factors including:
• Development risk
• Planning position
• Funding structure
• Market conditions
• Development type
• Project duration
• Developer’s own requirements
A site with detailed planning permission and straightforward delivery may carry less risk than an unconsented site requiring significant planning work.
That difference should be reflected in the appraisal.
If the developer’s required return increases, the amount available to pay for the land falls. This is one of the most important points for landowners to understand. The developer’s profit is not an optional amount that can simply be removed to justify a higher land price.
Without an appropriate return, the development may not be commercially viable.
Contingency
No development proceeds exactly according to plan. A contingency is therefore normally included to allow for unforeseen costs. This might cover construction cost movements, unforeseen site issues or other expenditure that could arise during the project. The appropriate allowance will depend on the level of uncertainty and the stage of the project.
A scheme with incomplete surveys and significant unknowns should not necessarily be assessed using the same contingency as a fully investigated site with detailed design information.
A simple worked example
Consider a hypothetical residential development with the following assumptions:
Development 10 house
Estimated GDV £4,500,000
Build costs £1,900,000
Professional and planning costs £300,000
Infrastructure and abnormal costs £200,000
Section 106 and other planning obligations £150,000
Finance costs £250,000
Contingency £100,000
Developer’s required profit £900,000
The calculation would be:
£4,500,000 GDV less £1,900,000 build costs less £300,000 professional and planning costs less £200,000 infrastructure and abnormal costs less £150,000 planning obligations less £250,000 finance less £100,000 contingency less £900,000 developer’s profit
Residual land value = £700,000
On these assumptions, approximately £700,000 would be available for the land before considering acquisition costs and any other relevant transaction expenses.
Now consider what happens if the developer can only achieve £4.2 million rather than £4.5 million in sales.
The residual falls to approximately £400,000. A £300,000 change in GDV has therefore reduced the theoretical land value by £300,000. This illustrates why land value can be extremely sensitive to relatively small changes in the underlying assumptions. Why the seller’s asking price may have little relationship to development value. A landowner may have an asking price based on several different factors.
They may have:
• Paid a particular price for the land
• Based their expectations on a neighbouring transaction
• Seen an advertised land price elsewhere
• Been advised that planning permission could create substantial value
• Received an informal valuation
• Calculated what they need to achieve from the sale
None of these necessarily determines what a developer can afford to pay.
The seller may be valuing the potential of the land.
The developer needs to value the deliverable development.
Those are not always the same thing.
This is where an independent assessment can be valuable. It allows the buyer to understand the economics of the opportunity before becoming anchored to the seller’s expectations.
How changes in assumptions affect land value
Residual land valuation is not a fixed calculation.
It is a model based on assumptions.
For example:
Change Likely effect on residual land value
Higher sales values Increases land value
Lower sales values Reduces land value
Higher build costs Reduces land value
Lower build costs Increases land value
Higher finance costs Reduces land value
Longer development period Usually reduces land value
Higher abnormal costs Reduces land value
Greater affordable housing requirement Can reduce land value
Higher developer profit requirement Reduces land value
Additional planning obligations Reduces land value
This is why a single residual figure should not be treated as an absolute answer.
A good appraisal should test different scenarios.
For example:
Base case: £700,000 residual land value
Downside case: £400,000
Upside case: £850,000
The purpose is not to manufacture a preferred answer. It is to understand how robust the opportunity is.
If the development only works when every assumption is optimistic, the buyer should treat the headline land value with considerable caution.
What should a buyer actually pay?
The residual land value provides an important indication of what the development can support.
It does not necessarily mean that the buyer should automatically offer that exact amount.
There may be acquisition costs, taxes, legal expenses, holding costs and other transaction-specific considerations. More importantly, the buyer should consider the risk associated with the assumptions.
An experienced property investor will therefore ask:
What has to be true for this land price to work?
If the answer includes achieving the highest possible sales values, keeping construction costs at the lowest end of the range, obtaining planning permission without delay and encountering no abnormal
costs, the proposed price may carry substantial risk.
If the scheme remains viable under more conservative assumptions, the position may be considerably stronger.
Frequently asked questions
Is residual land value the same as market value?
No. Residual land value is an appraisal of what the development economics may support. Market value can be influenced by competition between buyers, alternative uses, planning expectations and the circumstances of the transaction.
Can residual land value be calculated before planning permission?
Yes. A residual appraisal can be undertaken using an assumed development scheme. However, the greater the planning uncertainty, the greater the risk that the eventual development and value will
differ from the assumptions.
Does planning permission automatically increase residual land value?
Not necessarily. Planning permission can remove some uncertainty, but the value still depends on what has been approved, the costs of delivering it and the value of the completed development.
Why can two developers offer very different prices for the same site?
Developers may have different funding costs, construction costs, profit requirements, development strategies and views of the market. They may also have different assumptions about the planning or
development opportunity.
Should a landowner carry out a residual appraisal?
It can be useful. Understanding the development economics can help a landowner understand how a buyer may approach the site and whether an asking price is supported by the underlying
opportunity.
Conclusion
Residual land value is one of the most useful tools for understanding the economics of development land.
Its central principle is simple:
The land is what remains after the value of the completed development has been used to pay for the costs and returns required to create it. The challenge is establishing the assumptions correctly.
GDV needs to reflect realistic sales values. Build costs need to reflect the actual development. Planning obligations, affordable housing, infrastructure, professional fees, finance and
contingencies all need to be considered. The developer also needs an appropriate return for taking the development risk.
Most importantly, the calculation should be stress-tested.
A land opportunity should not be considered viable simply because the numbers work on one optimistic set of assumptions.
For a property investor or developer, the more useful question is not simply,
“What is the seller asking?”
It is:
“What can the development realistically afford to pay for the land?”
That is the figure that deserves to be understood before negotiations begin.