HYPOTHETICAL (NOTIONAL) DEVELOPMENT OF LAND
David Hornby

Hypothetical development is the notional or "paper" development of land. It applies established methods of valuation to the proposed building or subdivision to determine land value. This is carried out for a number of allowable competing land uses. The use that generates the highest land value after an appropriate allowance for profit and risk and the deduction of costs of development, is the highest and best use of the site.

The method consists of the following steps:

The expected gross realization (subdivision) or end value (building) of the proposed development is determined.

from the gross realization are deducted the agent’s and legal costs of sale. The resulting amount is called NET REALIZATION.

The developer requires a certain return or reward for his monies, labour, skill and entrepreneurialship in carrying out the project. This amount is known as the profit and risk and is usually stated as an overall percentage on the total cost to develop known as the profit and risk factor. For example, "the required profit and risk factor for the subject development is 25%".

The profit and risk is deducted from the gross realization using a formula that determined the profit and risk on the cost of development. The resulting amount is known as net realization after profit and risk.

The expected cost to develop is determined. This amount includes loss of interest and fees. This amount is then deducted from the net realization after profit and risk to find market value before transfer into the developer’s name.


The method can be summarized with the following formula:

LV = ((GR*100/(100+PR)) – CD)*(100/(100+CT))

Where:

LV = land value for a subdivision or end value for a proposed building.

PR = profit and risk factor expressed as a percentage eg 15%

CD = costs of development including loss of interest, and fees.

CT = costs of transfer including legal, holding charges and stamp duty expressed as a % of land value or starting market value.

PROFIT AND RISK OR RISK OF REALIZATION

The profit and risk factor is a function of the "risk" of the proposed development. Generally, the following factors determine risk:

The larger the project, the greater is the required return on development because the developer is subject to the risk of high exposure.

A pioneering land use requires a higher return on investment as compensation for the fact that the use is not "proven" and therefore, riskier than an established use.

The more complex the proposed development, the greater is the required return by the developer. Complex projects are more likely to be subject to delays, “hidden” costs and cost overruns.

As the "riskfree" Government Bond rate rises and falls there is a corresponding movement in the profit and risk factor.

The profit and risk factor should be substantially more than the "riskfree" rate because the development of land is not guaranteed by the government. A developer would not engage in the risks of building for example, an office block, if all that he/she were to receive for his/her efforts was a return about the same as that for the treasury bonds.

The hypothetical development method has been supported by a number of court cases. Therefore, the method has been approved by the powerful legal system and unlike discounted cash flow, is a valid method of valuation. Discounted cash flow was determined an "illegal" method when using the usual speculative land variables in Albany v Comm of Australia (1976) 12 ALR 201.

A simple subdivision of a small block of in globo land, for example, into 2 to 5 blocks would command very little risk and therefore, the developer would require a small profit and risk factor. On the other hand, a large pioneering land use would be extremely risky, as that use has not been tested in the market place. For example, the first theme park in a resort area would require a very high profit and risk as compensation for such a use being large, unproved and complex.

RISK OF REALIZATION

Risk of realization is the term used by the courts to describe the reward to the developer for developing the subject land and a return for the risk involved:

In considering this question, regard must be had to the fact that a buyer would give only such a sum for the land as would show him when sold in subdivision a percentage return on the purchase price and his expenditure in preparing and submitting it for subdivision - Maxwell J in Cranbrook Playing Fields v DG (1936) 4 The Valuer 246.

What I have said is, I believe, implicitly in the terms used by Roper J, in.. his judgment in Decentralisation v The Minister. His Honour spoke of a 'discount to cover the risk of the venture', of 'a margin of profit because of that risk' and of discounting the estimated returns to compensate for that risk. I do not think it matters what word one uses in this connection   whether one speaks of risk or of discount, or of profit   so being as one bears in mind that it is a "pure" profit'... and not a profit in the wider and more usual sense which includes other elements.

It is of course clear that a person purchasing land in globo for the purpose of subdividing it would not pay the sum of money, which is the present equivalent of that estimated return. To compensate for the risk involved in the venture the purchaser would certainly discount the estimated returns"   Roper J, Closer Settlement and Decentralization v Min (1942) 7 The Valuer 134.

Quoting Pike J: "This percentage allowance between the sale of land in globo and lots in subdivision is not a profit in the proper sense of the word but is the amount which the purchaser of land considers that he ought to realize for the risk of his investment and is very often termed the risk of realisation"   Sugerman J, Thistlethwayte v Minister (1953)12 The Valuer 316.

HYPOTHETICAL DEVELOPMENT  BUILDING EXAMPLE

The market value of development land that has the highest and best use as a commercial building can be found as follows:


Expected net annual income on completion: $5 153 218

Expected net capitalization rate: 5%pa

CAPITALIZE NET ANNUAL INCOME:
$

5153 218 * 100/5 103 064 360

Less legal and commission on sale @ 5%: 5% * 103 064 360
(5153218)

NET REALIZATION: 97 911 142

NET REALIZATION
AFTER PROFIT & RISK @ 20%
$97 911 142 * 100/(100+20)
81 592 618

DEDUCT COSTS TO DEVELOP

Expected period of construction: 36 months

Cost of money:15% pa or 1.25 % per month

Replacement Cost New (RCN): 22 500 000

Fees: 2 700 000

Loss of interest on the RCN + Fees
1.25% for 1/2 period (18 months):
22.5% * 25 200 000

5 670 000


TOTAL COST TO DEVELOP:

(30 870 000)


NET REALIZATION AFTER PROFIT AND COST TO DEVELOP:


$50 722 618


LOSS OF INTEREST ON LAND, HOLDING CHARGES & COSTS TO PURCHASE:



Holding charges

@ 1 % for 36 months: 36%

Legal on purchase: 1%

Stamp duty: 2%






TOTAL: 84%

LAND OR MARKET VALUE

$50 722 618 *100/(100+84)


27 566 640

say $27 600 000


PROOF

The following is the proof of the above method. This follows the development through, step by step leading to a gross realization sufficient to cover profit and risk, cost to develop and loss of interest:


PURCHASE PRICE OF

DEVELOPMENT LAND:

$ 27 566 640


Cost to convert into developer's name and pay holding charges:


Legal on purchase: 1%

Stamp duty: 2%

Total: 3% *27 566 640


826 999


VALUE IN DEVELOPER'S

NAME:

28 393 639


ADD COST TO DEVELOP

Building:

22 500 000

Fees:

2 700 000

Loss of interest on construction:

5 670 000


TOTAL:

30 870 000


Loss of interest/holding charges on land value for 36 months (81%): 81 % *27 566 640


22 328 978


TOTAL COST TO BUY LAND AND DEVELOP:


81 592 618


DEVELOPER'S PROFIT AND RISK ON THE COST TO DEVELOP @ 20% 20% * 81 592 618



16 310 524


REQUIRED NET REALIZATION:


97 903 142


Legal and commission on sale @ 5%: 100/(100  5) * 97 903 142


103 055 939



The difference in the final figure is due to rounding.


HYPOTHETICAL DEVELOPMENT  IN GLOBO LAND


The following is an example of the hypothetical development method for residential in globo land. The land can be subdivided into 16 residential lots:


EXPECTED GROSS INCOME:

$


16 lots @ 84 000 average price:


1 344 000

Less legal and commission on sale @ 5%: 5%*1 344 000:

(67 200)


NET REALIZATION:

1 276 800


AFTER DEVELOPER'S PROFIT & RISK @ 20%

1 276 800 * 100/(100+20)


1 064 000


DEDUCT COST TO DEVELOP




Expected period of construction: 12 months


Cost of money @ 15%pa or 1.25% per month


Survey/engineering:

16 000


Open space contribution:

51 000

Council fees:

4 000

Roads and drainage:

150 000

Electricity:

21 000

Telecom:

2 000

Water:

53 000

Sewerage:

34 000


TOTAL:

331 000


Loss of interest for ½ period @ 1.25%: 6 * 1.25 = 7.5%

7.5% * 331 000



24 825


TOTAL:

(355 825)


NETREALIZATION AFTER

PROFIT & COST TO DEVELOP:


708 175


LOSS OF INTEREST ON LAND, HOLDING CHARGES & COSTS TO PURCHASE:


Loss of interest @ 1.25% for 12 months: 15%


Holding charges @ 1% per month: 12%


Legal on purchase & stamp duty:

3.50%


TOTAL:

30.50%


LAND OR MARKET VALUE

100/(100+30.5) * 708175


542 663

say 543 000


PROOF

$


PURCHASE PRICE OF IN GLOBO LAND:



542 663


Legal on purchase & holding charges @ 3.5%: 3.5% * 542 663


18 993


VALUE IN DEVELOPER'S NAME:

561 656


ADD COST TO DEVELOP



Construction costs:

331 000

Loss of interest on construction costs: 6 * 1.25% = 7.5%


24 825


Loss of interest on land:

12 * 1.25% = 15%


81 399

Holding charges @ 1%:

65120


TOTAL:

502 344


TOTAL COST TO BUY LAND AND DEVELOP:

1 064 000


DEVELOPER'S PROFIT AND RISK ON THE COST TO DEVELOP @ 20%

20% * 1 064000



212 800


REQUIRED NET REALIZATION:

1 276 800


REQUIRED GROSS REALIZATION


Legal and commission on sale @ 5%:

100/(100 5) * 276 800


1 344 000


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