Appraisal is the process of valuing the real value of properties, and in most cases the value that is sought is the property Market value. Appraisal is important because most properties differ from each other in the place they are located and this is considered as an important factor in value determination. Appraisers are needed as advisers on the property value, and in most cases they provide written reports on the value. The most used approaches in development appraisal are discount cash flow and residual method.
Residual method is used to calculate the value of a site with development, and represents the maximum bid a developer should normally make and if the property site is financially viable. It is used to compute the value of the site with refurbishment. The value that is first established in residual method is the Gross Development Value (GDV).This the initial capital that the property is supposed to cost when sold on the open market, and should always be based on the values of the property in the present market.
Amount available for development=Gross Development Value-(Development value+ Fees+ Required profit).
Where the total amount available for development is the maximum value the developer should consider paying.
The residual method of appraisal is used for the following purposes:
Calculate the expected profit margin, in a situation where GDV, the costs of site development is already established.
When finding the maximum value for development, incase profit and GDV of the property is known.
Establishing a maximum price that the property will cost when all the other values are known.
Example of residual calculation
Development of three exhibitions flats.
Total value flats $100000
Construction cost
Professional fees
Interest on borrowed sum of $500000
$36000 per annum
Agent `s fees on flats
Estimated on profit
Therefore, from the table, we can be able to estimate the expected value as shown:
Amount available for
Undeveloped property cost=GDV – (Development Costs +Fees +Profit)
750,000-(450,000+22,500+36,000+12,000+100,000)
Amount available for
Undeveloped property cost =$129,500
In this method, residual represents:
The maximum value a developer can be able to pay for development of a site.
Highly personal input data especially a situation where development takes a much longer time, this shows that the interest rates charged will vary.
Although residual method is used by different firms in appraisal, it is highly inaccurate because in calculation the cost of development the interest is overstated and the Gross Development Value is always estimated since the developer predicts the exact value of the property, and this value is not real. Also in most cases the residual method fails to account for the S curve of development because it becomes more costly at the end of the development project. The main limitation that hinders many to use this method in appraisal is because it is individual in nature in the following ways:
Base on the calculation of worth not property value.
It is applicable in negotiation than in valuation.
Lastly, it requires comparables with a keen analysis to support valuation.
As an alternative to residual method the discounted cash flow is used in most appraisal cases, in this method is where investments are appraised. This approach operates on future expected earnings, by determining how much money would have to be invested currently at a given rate of return, with the aim of yielding the cash flow in future. The discounted cash flow works using the concept of money available at a given time since it is worth more than an identical sum in the future values and is mostly used because it enables an individual to apply an objective standard other than the company`s stock price.
The mathematical formula used in discounted cash flow method is derived from the future value method of computing the time value of money and the rate of returns. It is given by:
DPV=CF1/(1+r) 1+CF2/(1+r)2 +.CFn/(1+n)n
Future Value=DPV. ( 1+i)n
Hence from this equation, the discounted present value for one cash flow in one future period is generally expressed as:
DPV=FV/ (1+i) =FV (1-d)n
DPV - discounted present value of the future cash flow
i-the interest rate.
n- Time mostly in years before the future cash flow occurs.
FV-the total nominal amount of a cash flow expected in the future period.
d-the discount rates charged at that particular time.
Example of Discounted Cash Flow
Henry buys a house for $200000.Four years later, he expects to be able to sell for $300000.
This means that the total value of his profit from this transaction is $300000-$200000=$100000.If that $100000 is amortized over the four years, the return rate will be 16%.
Using the discounted present value, FV=$100000,i=0.05,n=4,the value $300000 received at the end of four years is the present value. We assume that $100000 is the best estimate of the sale price that he will be in position to receive after four years.
Also we can use the NPV to determine the future value of a property under development. Example, a group of investors company pays $100,000 for an investment that gives in return $30,000 after a period of 1 and 2 years, and $40,000 after years 3 and 4.The interest rates charged on the original loan of $100,000 is 12%.After the period of four years, will the investors incur loss or profit? This can be demonstrated using the table below:
NET PRESENT VALUE
Year
Cash flow($)
present value of multiplier
Present Value of
$1 multiplier at 10%
the cash flow
($100,000)
Total Net Present Value
It is true that, the investors will get small profit if the cost during borrowing is 12%.In the case where the cost is 10%, the respective multiplier figures would be much higher. This will subsequently yield a both high present value figure and the net profit value.
The use of DCF has the following advantages when used:
The effect of depreciation is considered at its maximum.
All the timings of expenditure and returns can be looked at.
The effects of inflation and tax can also be considered.
It is easy to estimate any period of time within the investment span.
Elements of risk are incorporated into calculation.
Discounted cash flow model is the most powerful method over the residual method despite the few shortcomings.
In conclusion, discounted cash flow approach is more powerful than the residual approach and is merely a major tool used in appraisal of development sites.
