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One of the most frustrating miscommunications that can occur when submitting a loan for land banking is the methodology of valuation.
This is because the treatment of the value of land varies depending of the type of loan required. This may seem strange, and a broker may be forgiven for thinking that the land value is simply the land value, but this is not the case.
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There are many methodologies a valuer can employ based on the instruction, which may include terms such as the ‘as-is’ market value or ‘as-if complete’ (for a property which is intended to be improved). Furthermore, the purpose of the valuation may be for ‘the fair market value’ or ‘first mortgage purposes’. These will affect the outcome because they are not the same thing. In our experience, the latter results in a tighter consideration because the risk to the valuer of a loss at sale by a mortgagee in possession is that there is a claim against its professional indemnity insurance. Though this involves a long and laborious legal process, there are precedents today that prove the financial risk to valuers that get it wrong. And insurance companies are very quick to raise the premiums of, or withdraw cover for, valuers that suffer such claims.
The biggest confusion that occurs in the estimated value of land in is the as-is value for property intended for development. I offer an existing example: we were asked to provide bridging finance of $1.78 million to a builder to complete an option contract and to perform civil works while securing presales, with the exit being his ability thereafter to obtain development finance from a bank. The broker completed an application stating the value of the land to be an as-is value of $3.2 million and offering an LVR of approximately 50 per cent.
An immediate investigation showed the contract price of the option for the land to be $900,000. When we asked the broker what constituted an immediate increase in the value, they advised that the builder had spent money obtaining a development approval (DA) for 16 homes that represented a gross realisation value (GRV) of $10.8 million and that the land with consideration for the DA was $3.2 million.
Apart from the principle that as a lender we would never provide funds to a borrower that has no financial risk in the project, the broker’s logic was misguided. As it turned out, the valuation had been poorly instructed allowing latitude in the application of value. That aside, what was happening in this case – and what often happens – is that the borrower used the land value portion of the future GRV of a development project, as represented in the reverse cash-flow methodology of a development feasibility – not the as-is value of the unimproved property.
Put simply:
• The option price was $900,000.
• The cost of civil works (averaged at $55,000 per unit) was $880,000. There were prior costs for DA of $440,000.
• The realisation value of the potential sale of the completed lots – at an average price of
$200,000 – was therefore $3.2 million with a total development cost of $2.64 million.
These are the numbers for the future value of the land once civil works are completed. If they were to then offer land and house packages with an average sale price of $675,000 they would achieve a GRV of $10.8 million, but this would require considerable development costs.
To assume a land value ‘as-is’ of $3.2 million assumes the development costs for civil works have been expended to improve the site value. Of course, they have not. To an incoming lender, the value of the land at outset is the price that would be achieved at auction today without improvements. The fact there is a DA for 16 homes may give it a premium uplift of 15 to 20 per cent, but this may also be lost if the property were sold by a mortgagee in possession. So the value of the land as-is would be between $900,000 and $1.08 million. This is very different to the future value of $3.2 million, which might be realised once costs have been incurred to conclude civil works.
Our advice regarding values is to look at the valuation methodology closely to determine if it was instructed for first mortgage purposes and on an as-is, where-is basis. If not, then there is likely to be some estimation for the future benefit that might only be achieved once development costs have been incurred.
