Most people will simply calculate the total amount they paid for their house (i.e. cost of buying the vacant parcel/plot plus their total construction cost) and assume that’s the Market Value of their property. Well, I’m sorry to be the one to say that that’s not true! I’m sure many will argue that it should be true since that’s the cost. Unfortunately, cost is not value.
Simply explained with an example, the cost of building anything up in the mountains is relatively more than the cost of building that same unit down in a city centre…… Why? Because that ‘minor’ essential product called concrete needs to be carried miles further, meaning more costs; because the bricks also need to be carried that same distance; and because the construction company needs to travel all those miles every day for a couple of years to build that unit (unless the construction company, the concrete company, the brick company etc. are all based up in the mountains).
That was a very simple explanation of cost compared to value. Now let’s assume I manage to get a building license to build a beautiful house in an agricultural area or in an area where there are farms around my property compared to a similar house being built only a few miles further, in a residential area. Let’s also assume same cost for building the two units. Well, some may argue that the house next to the farm has an advantage since it’ll have that great “piggy smell” from the farm next door when enjoying your evening drink on the veranda, or the fact that the owner will need to drive through a dirt road for a couple of miles before they can find an asphalted main road, or even the fact that the farmer next door will provide with fresh eggs for breakfast every morning.
That said, the value of the two properties is not based on the construction cost, but simply put, on how much the market is willing to pay for them!
Similarly, when developing a vacant parcel/plot, the investor should analyse the Highest and Best Use of that property/parcel. This would be considered as the legal use of a property that yields the highest present value. A feasibility study of all permissible uses of the property can be processed and the financially feasible use that produces the highest financial return can be considered as the highest and best use. Based on the above, if I decide to build a two-storey house upon a plot located on a commercial avenue, with a permissible use for a potential six-storey commercial building, won’t make me look as a very good investor. This automatically changes the use of the property, from a commercial to a residential use, since I had the ‘fantastic idea’ of building a two-storey house on a commercial plot which could be developed into a six-storey commercial building. I have therefore affected the value of the plot and generally the property.
The same applies when investing in a property where there are buildings already upon the parcel. There are two main factors to look at here; Current Use vs Development Potential. Whichever is higher is the best investment option to proceed with. If, for example, there is a single-storey 30-year-old house on a commercial plot, the investor will look at his options. Current Use (keep as is) Vs Development Potential (demolition of current buildings and development of vacant parcel). Let’s give some inside info here….’go for the second option’! The investor will therefore give no value to the current buildings upon the plot as these will simply be costs for demolition.
What if that same parcel is already fully developed into six storeys, with the building being relatively new but the ‘use’ of the buildings not considered as the highest and best use of the parcel? Remember Janice from the Friends series?? “Ohh Myyyy Goddd”
Well unfortunately, whatever the construction costs may have been for developing that parcel (with the wrong use), it will affect its total value! This is where the importance of market analysis comes in the equation; only before the actual development.
About the author
Angelos Georgiou FRICS, FCIArb
Managing Director – KTESION | Real Estate & Asset Advisory
Chartered Valuation Surveyor
Fellow of the Royal Institution of Chartered Surveyors (RICS)
Fellow of the Chartered Institute of Arbitrators (CIArb)