WHAT IS RESIDUAL VALUE AND HOW TO CALCULATE IT

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INTRODUCTION

In real estate, it is not uncommon to see two developers offer to pay two wildly different sums for the same exact property. How can one justify the price compared to the other? A lot of this has to do with how the developer intends to use the property—i.e. how they plan to redevelop it and for what purposes.

Determining what a property is “worth” is no easy task, whether it is a piece of undeveloped land or a building that has recently been vacated by a long-term tenant. In this article, we explore the concepts of residual value, resale value, and residual land value – three terms that are often confused but have decidedly different meanings and purposes. Some scenarios will justify the use of one vs. the other, so it is important for investors to understand the distinctions between each.

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DEFINING RESIDUAL VALUE

Residual value refers to the value of a fixed asset after that asset has fully depreciated. In real estate, residential properties depreciate over a 27.5-year period whereas commercial properties depreciate over a 39-year period. In theory, a property’s residual value would therefore be its value at the end of these lifespans.

In practice, most real estate investors do not refer to a property’s residual value as a property’s value is generally not explicitly tied to whether it has been fully depreciated. That is because most commercial properties are sold well before the end of their “useful” life, and those who hold properties will generally make significant improvements to the property that serve to enhance their value. Moreover, most real estate tends to appreciate in value over time. Therefore, real estate assets are rarely thought of in terms of their residual value.

Of course, there are exceptions to this rule.

EXCEPTIONS

For example, residual values are sometimes applied to properties with long-term, NNN leases. This is especially true if the space was fit-out with specific equipment to meet that tenant’s needs. The value of these properties generally depends on the value of the cash flow generated by the tenant each month, as well as ancillary factors such as the tenant’s creditworthiness and the risk profile of that business. An alternative way to value the property, particularly if that tenant is nearing the end of its lease period, is to consider the residual value of the vacated space including the value of all equipment and fixtures left behind. The residual value would be the estimated worth of the property at the end of that tenant’s lease term.

Residual values are often used when leasing single-tenant retail properties. Most regional and national retailers choose to lease their business property. A property that has been outfitted with state-of-the-art fixtures and equipment is considered more valuable than a core-and-shell building that needs to be built out from scratch. The incremental value associated with these fixed assets is generally a factor when negotiating lease terms with prospective tenants.

Properties can have both appreciating and depreciating residual values, depending on the perceived value of the equipment and fixtures left behind. In cases where the fixed assets are outdated or obsolete, this could lower a property’s residual value as the assets would need to be removed from the facility to make way for more modern equipment and systems—all of which comes at a cost.

Residual value is sometimes also referred to as a property’s “salvage value”.

HOW IS RESIDUAL VALUE CALCULATED?

Residual values are calculated based on the amount that the asset’s owner would earn by selling the asset, minus any costs incurred during that asset’s disposal.

Let’s say a warehouse has been leased to a single tenant for 10 years. At the beginning of the lease term, the owner invested $50,000 in different racking systems to support the warehouse operator. Over the course of the lease period, the owner uses straight-line depreciation to offset the cost of the racking system (1/10 of $50,000 per year). At the end of the ten-year lease term, the racking system has been fully depreciated.

Moreover, by the time the lease term ends, warehouse equipment has become more advanced and the value of this equipment is closer to $8,000. The landlord tries to re-lease the warehouse to other businesses, but those businesses view the racking system as an outmoded barrier to their operations. The landlord decides to remove the racking system from the warehouse at a cost of $2,000. The residual value of the racking system is therefore $6,000 – the value of the racking system, less expenses, after the asset has been fully depreciated.

Landlords must factor in the residual value of a property’s fixed assets when they calculate the total depreciable sum to be claimed on their tax returns. The most effective way to calculate an asset’s residual value is by hiring a third-party to conduct a cost-segregation study, which will assign a “useful life” to each of the property’s fixed assets that can then be depreciated accordingly.

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RESIDUAL VALUE VS. RESALE VALUE

Residual value and resale value are two different concepts. The residual value of a fixed asset is its value either after the end of its lease term or at the end of its depreciable life. The resale value, meanwhile, is simply the market price for an asset upon resale.

For simplicity’s sake, let’s look at the difference between a car’s residual value and resale value. A car’s residual value is equal to what the car is worth at the end of the lease term. It is used to determine the purchase price if the lessee decides to buy the car at the end of the lease period. The residual value is generally based on the Manufacturer’s Suggested Resale Price, or MSPR, as well as a predetermined residual value (expressed as a percentage). For example:

$40,000 MSRP x Residual Value of 50% = $20,000 value after 3-year lease term

Adjusting the terms of a lease, such as length or mileage, can impact residual value (positively or negatively).

That same car may sell for more or less on the open market. The resale value is based on many factors, such as the condition of the car, consumer preferences, and consumer demand. A car with low miles in pristine condition may sell for more than its residual value, all else considered equal.

While this is a simple example, the same can be applied to real estate. For example, the residual value of a single-family home is its projected value after taking its lease term into account. At the end of a lease term, an owner has to decide whether they want to re-lease the property or sell it, depending on both its residual and resale values. A home that experienced significant wear and tear will have lower residual value than one that was kept in great condition by tenants. An owner may need to invest in renovations or improvements in order to sell for the property’s true market value.

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WHAT IS THE DIFFERENCE BETWEEN RESIDUAL VALUE AND RESIDUAL LAND VALUE?

There is an important distinction to be made between “residual value” and “residual land value”. Residual values, as discussed above, are used to determine the value of fixed assets at the end of their depreciable life.

Residual land value is an entirely different concept, one used primarily by developers trying to gauge what a parcel of undeveloped land is worth.

WHY DEVELOPERS RELY ON RESIDUAL LAND VALUES

One of the primary challenges developers face is placing a value on a piece of undeveloped land. In its natural, unimproved state, undeveloped land has little inherent value. For example, millions of square miles of rural land has virtually no economic value because they are of no economic use.

Ultimately, land gets its value based upon how it can be used—i.e., what an owner can build on the site. However, developers are often forced to make offers on property without knowing for sure what they will be able to entitle.

For example, a housing developer may be willing to pay $250,000 per acre of undeveloped land if they assume they can only build one single family home on each acre. Meanwhile, another housing developer might be willing to pay $1 million per acre for that same undeveloped land if they assume they can build 20-units of housing per acre. Until they bring the site through a rezoning and permitting process, there will remain uncertainty as to what they can actually build – which again, influences the value of the undeveloped land.

But that doesn’t stop developers from making offers on undeveloped land.

Gauging the Value of Undeveloped Land

There are a few ways for developers to gauge the value of undeveloped land. The simplest method is to compare the plot of land to other similar plots which have recently sold and assume that the plot in question should sell for approximately the same price. This is an application of what appraisers call the “direct sales comparison” and can be very efficient, as long as there are sales of similar properties for comparison’s sake. However, it can be difficult to apply this approach if the property in question is unique or if there are no similar sales. For instance, if the property in question is very large, has unique views, or is in an isolated area, it is possible that there will be no relevant comps to compare.

Finding comps for undeveloped land can be challenging, especially in urban areas. For example, an acre of undeveloped land in one neighborhood might be worth significantly more or less than an acre of land located just a few streets over if one of the sites is zoned differently than the other (e.g., for warehouse instead of residential).

Instead, developers will use residual land value to estimate what a property is worth.

In other words, if a developer is planning to buy this piece of land in order to build something and then sell it for a profit, how much would they be willing to pay for the land? The maximum a developer would want to pay for the land would be just enough so that the land cost, plus the cost of improving the land, exactly equals the expected proceeds of selling the property (with a developer’s profit baked into the cost of improving the property). The maximum payment for the land is therefore the amount left over after paying all other costs associated with the development, i.e., the residual land value.

Using this method of valuation, any improvement that increases the value of the land’s final use increases the land’s residual value. For example, if house prices are increasing, with other costs remaining constant, land prices should rise. Similarly, anything that raises the costs of development would lower the land residual, and therefore lower the residual value.

CALCULATING RESIDUAL LAND VALUE

Residual land value is found by subtracting all of the expenses associated with the development, including profit, from the total development cost.

Residual Land Value = (Gross Development Value) – (Construction Costs, Fees, Profit)

The gross development value (GDV) is the estimated value of the property upon completion, lease-up and stabilization. This is what the property would be worth upon refinance or re-sale.

Construction costs include everything from making undeveloped land developable (e.g., clearing the site, constructing the roads and utilities, obtaining permits), to actual construction costs (labor and materials) as well as financing costs, real estate commissions, architect fees, developer fees and more. Therefore, as one might imagine, construction costs and interest rates can have a direct impact on a property’s residual value.

Calculating residual land values is difficult. It requires a precise understanding of future revenues, expenses and risk. A developer must be able to forecast cash flows into the future, something even the most experienced developers struggle with at times. The strength of the end use market has a great impact on value. Consumer preferences, interest rates, and the general state of the economy will also impact what people will pay, which affects sales prices and filters down to land residuals. As part of this process, developers will want to assess both the minimum and maximum future sales proceeds to create different scenarios that would influence a property’s residual land value.

Related: Case Study: Creating Value in Lease Renewal

CONCLUSION

Residual value is a concept used occasionally by real estate investors. It pertains most to investors of single-tenant properties that have been fit out with specific fixtures and equipment needed to run that business. This equipment can have more or less value, depending on the nature of the business and the useful life of those assets.

Residual land value, on the other hand, is a concept frequently used by real estate developers. Someone evaluating a site for multifamily or senior housing development, for example, will use the residual land calculation to back into a price for a piece of undeveloped land that they intend to redevelop for higher use.

In real estate development, estimating both costs and revenues is a critical task for any sponsor. Someone who underestimates costs or overestimates revenues may find themselves overpaying for land, and in turn, eroding investors’ profits. Anyone considering investing in real estate development will want to ask a sponsor about their approach to land valuation. We hope this guide today will be useful to that end.

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