The secret concept of professional real estate developers

First things first, there is no secret. Now that we have this catchy title out of the way let’s dive into valuing a plot of land.

Some of you might already be familiar with this concept. It is quite well-known and widely applied. At least here in Europe.

The concept of valuing a plot of land is especially interesting for developers. So for everyone who does fix and flip or buy and hold, this article might only be of minor interest. But that’s okay.

In my daily job in the financing sphere I come across the residual value concept regularly. Other names also include something like development calculation. The reason is that developers often use this concept to value how much they can pay for a plot of land.

Concept of residual value

We can split the whole calculation into 2 distinctive steps:

  1. Figuring out the market value of the finished property
  2. Figuring out your total development costs

The “odd” part of the residual value concept is that you start from the end. This means that you first figure out how much your finished property is worth. To do this you have to know how much rental area you can generate in your future property and what rents you can charge your future tenants.

Next you apply a multiplier (US folks can use a cap rate) to come up with a market value. The interesting part here is obviously what your assumptions will be. Your assumptions on rents and exit multipliers are the key figures that financing people look at. Are the underlying rents achievable in the market and location? How did the developer come up with these figures? What often helps is when you derive your assumptions from a comps table. That means that you look at past transactions/lettings and compare these figures to your own numbers.

A simple example could look like this:

Rents and market value
Rents and market value

Here I assumed that the finished asset has a total rental area of 15,000 sqm with office and retail usage. We could say for example that there are retail areas on the ground floor. The upper floors are offices. I can see assets like this almost everywhere close to city centres.

Office tenants have to pay on average EUR 12.5 per sqm and month, whereas the retail area is much more expensive and costs EUR 55.0 per sqm and month. (Btw, these figures are made up)

A weighted multiplier of 20.8x (18x for the office and 22x for the retail area) results in a market value of EUR 99.6m.

Once you derived a realistic market value we go to the next step, figuring out how much you will pay for the total development of the asset.

A common method is to use cost groups. Here in Germany there are defined cost groups that summarize various costs such as costs for the construction (hard costs), or costs for architects and engineers (soft costs).

These cost groups look something like this

Real estate development cost groups
Real estate development cost groups

Make sure that you account for all costs that will occur not only during your construction period, but also before until you reach a building permit. Often soft costs appear before you actually “build” something because architects will work from the very beginning on.

Here is an example of how different costs could look like: (Btw, these figures are also made up)

Our final step is to put the pieces together. Our achievable sales price of EUR 99.6m is reduced by the incurred costs of EUR 48.9m. Besides the costs we also would like to earn something. Otherwise there is no reason to even start a development. I assumed a 15% margin that we would like to see from such a project. Deduct the development margin and your result is the residual plot value. Here, EUR 35.7m.

Residual plot value
Residual plot value

In summary that tells you that you could afford to pay up to EUR 35.7m for the plot and you would still make a 15% profit on the transaction. Obviously, the reality will always differ from the theory. Costs will change, exit assumptions will change etc. To allow for all possibilities you included a contingency positon. A “common” contingency is about 5% of all construction related costs. In our case it is c. 5.4%.

What about you? Are there any developers among you? Did you come across the residual value?

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