Valuation of Property as a Basic Guiding Force for Real Estate Development - Essay Example

Property Development Introduction Valuation of property is a basic guiding force for real e development. It can be simply defined as the processof calculating the market value of a real estate project at a particular time. Property developers and acquirers evaluate value of property for several purposes such as selling and buying, taxation, leasing and transfers etc. however property valuation is a complex task due to involvement of several factors, most of which are either intangible or changes frequently over time. The objective of this paper is to provide a brief overview of different valuation methods. The paper will critically analyze pros and cons of various methods and try to present a holistic valuation approach. With the help of a case example the paper will mainly highlight the merits of traditional residual valuation approach over other valuation methods. Property Valuation Property valuation and different property valuation techniques has been a subject of intense discussion between researchers, academicians and developers. Different approaches to property valuation have been widely contested between different stakeholders. The issue of property appraisal often takes socio-political color due to the range of stakeholders directly affected by the process. According to Williams and Ventolo (2001, p-65), market value means the most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably and assuming the price is not affected by undue stimulus. Though the theoretically property valuation is defined by some others Hamid (1996)"as means to interpret market without the personal bias, value, emotion and poor assumption", property appraisal is often looked from a personal perspectives of buyers and sellers. Kahr and Thomsett (2005; p-48) states that valuation is distinguished via attributes of properties and markets; further classification of value are based upon the priorities of investors or owners, including cash flow and potential rental income tax benefits or limitations and perception of future growth in market value. Principles that guide the valuation are: Progression: this principle implies that the value of property will increase due to market demand and better locality. Regression: this principle implies that opposite of above principle also holds true when the value of a property may decrease due to negative market sentiments. Conformity: The principle states that valuation of property tends to appreciate with the similar properties in a similar location. Substitution: This principle implies that a property's greatest potential market value is also limited by the valuation of similar properties in a similar locality. Change: This principle tells that all variables used for valuation tend to change resulting in changes in value of the property. Anticipation: This principle implies that valuation depends upon the expectation of future growth. Contribution: This principle states that the investment on an existing property may contribute in valuation, though it is not necessary that increase in valuation is equal to investment. Plottage: This principle implies that the consistency in ownership, zoning and usage of land tend to increase the value of land. Highest and best value: This principle states that the value of a land is maximum when the land is utilized in best possible manner. Competition: This principle implies that the valuation of a property varies according to supply and demand of properties in market. Property appraisal aims to determine different type of values such as market value, value in use, investment value, insurance and taxable value, and liquidation value, which gives rise to need of different valuation methods and standards. These valuation systems also vary in different countries according to their laws and economic practices. In, UK five valuation methods are used which are discussed in following sections whereas in US valuer categorizes valuation methods in three categories. All the valuation methods and standards are based on three basic approaches for value calculation that are: The cost approach: This approaches focuses on the calculating total cost of building a property on a bare land. The value of land and other components are summed up to calculate total cost of development. Added with the developer's margin of profit this gives the overall value of a property. The sales comparison approach: This approach relies on the valuation of other similar properties in a similar location. The income approach: In this approach, valuation of land is estimated depending upon a perception of future income from the property. Calculating Site Value According to traditional Residual valuation method site value equals Gross Development Value (GDV) less all costs and profit requirement. For the given case it is assumed that construction cost as provided with the problem statement include all development cost such as fees of architects, and engineers and many other expenses that generally occur during construction. Following table summarizes the input variables: Input Variables Grass Development Area Shops 1,200 square metres Offices 2,600 square metres Expected Current Rental Value Shops 250 per square metre Offices 290 per square metre All Risk Yield 7.5% Cost of finance 8.0% per annum Construction cost Shops 450 per square metre Offices 840 per square metre Ancillary costs 78,000 Construction period 12 months Void period 3 months Table: Input variables Residual Valuation of Land Residual value = Gross Development Value - Total Development Costs. Grass Development Value is calculated by adding total rental income with the all risk yield. The all risk yields in the following table is calculated by dividing the annual rent, as though it had been received as a single sum at the year end, by the capital value or sale price of the property. The 'all risks yield' is a simple benchmark which the property market uses to assess the comparative attractiveness of different properties. It is the ratio of rental income to capital value and is expressed in terms of the open market rent of a property as percentage of the capital value. All risk yields at the rate of 7.5 percent can be calculated using following equation: Gross Development Value = (Total rental income *100) / 7.5; Following table shows key calculations used to determine the site value: GROSS DEVELOPMENT VALUE Rental Income Shops 1200 * 250 = 300,000 Offices 2600 * 290 = 754,000 All Risk Yield 7.5% TOTAL GDV 14,053,333 Building Cost Shop 1200 * 450 = 540,000 Office 2600 * 840 = 2,184,000 Ancillary costs 78,000 Total 2,802,000 FUNDING OF CONSTRUCTION Interest rate (per qtr) 2% Average time of borrowing is half of build period + void 3 qtr TOTAL FUNDING COSTS 171,505 Total Cost Building Cost + TOTAL FUNDING COSTS 2,973,505 Developer's Profit 15% 446,026 Total Development Costs 3,419,531 Residual Value 10,633,802 Table: Residual value calculation Site Value Calculation Site Value = Residual Value / (1 + .08/4)^4*1.25 = 10,633,802 / 1.104080803 = 9,631,362 Fall of Rental Value and Delay in Post Construction Letting (Increase in Void) GROSS DEVELOPMENT VALUE Rental Income Shops 1200 * 220 = 264,000 Offices 2600 * 255.2 = 663,520 All Risk Yield 7.5% TOTAL GDV 12,366,933 Table: Grass Development Value after fall of Rental Value Keeping all other factors constant, Total Grass Development Value (GDV) after 12% fall in rental value = 12,366,933 To developer's profit fall below 1% of GDV i.e. 123,669, total development cost should be 12,366,933 - 123,669 = 12,243,264; If the building cost is same, total funding cost will increase to 9,441,264. Keeping the interest rate constant it will take a maximum of 222 months to fall developer's profit below 1% of GDV. Methods of Valuation In the UK, valuation methodology has traditionally been classified into five methods as discussed below: 1. Comparable method Comparable method, also known as Inferred Analysis, estimates the value of a property by comparing it with the value of other similar properties sold in the similar location within a certain period of time. This method is based on the assumption that value of a property is what it is sold for; and if a similar property can be located in a similar location that has been sold in near past, this method provide a straightforward valuation of the property. This is also assumed that value of the property will be similar to the property with which it is compared. This valuation method is commonly used for valuation in residential housing market. Though, it is a most simplistic evaluation method, there are certain constraints which make this method unsuitable for property valuation. For example, most of the time it is difficult to find out enough numbers similar properties sold in the same or similar area to draw a realistic evaluation. It is also possible that the value of properties previously sold do not reflect real market value due to developer's personal preferences or mutual understanding between developers and buyer. This method also does not take in to account the intrinsic value of the property which makes it difficult to assess if at current market scenarios the property is worth its valuation. 2. Investment/income method This method also known as fundamental or intrinsic method is based on the discounted cash flow (DCF) model to determine the present value of the property. The value of the property is determined on the basis of projected future returns from the property if the buyer wishes to rent or resale this property. This method is commonly used for valuation of investment oriented commercial and residential property. This method requires current estimated rental value of the property as a benchmark to estimate future earnings from the property. Investment or income method of evaluation determines the intrinsic value of property and involve a detailed analysis of variables that determine the income from the property. This method produce more objective result than the comparable method and helps in deciding the profitability of investment on the property, however this method is more complex than the comparable method. Other variables of the method that determine expected future returns vary greatly even on small variation in assumptions. Assumptions are generally made according to current market conditions which may considerably change after a certain period of time. This method also ignores actual market value of property which may result in over valuation of the property if it is supposed that the future yield will be higher. 3. Contractor's/cost method This method is based on the assumption that the value of a property equals to the sum of cost of all the components such as land and building taken individually. This method combines comparable and income methods. The value of a property is determined by adding the free market value of the land as if vacant which is generally done using comparable valuation to the reconstruction cost of the building, minus depreciation suffered over the years in comparison to a new building. This method have some certain advantage over above two methods as it determines the actual cost of the property however it ignores the fact that the resultant value of property may be higher than the sum of individual cost of its components. It may also result in lower valuation of property as the future income from the property could be much higher than the actual cost of the property. This evaluation method is generally used for the purposes other than the selling or buying in market; for example banks may use this valuation method to assess the value of a property while seizing it in case of a loan default. 4. Accounts/profits method Accounts/profits method is closer to income method of evaluation however this method to not involve the assumption of future income from the property. It considers the current operating income of property using profit and loss or income statements. Valuation of property in this method is not market driven and uses inherent characteristics of the property. 5. Development/residual method Development/residual method is considered best property appraisal method generally used for properties developed on a bare land. It helps developers in determining the worth of their assets after a certain period of time taking in to account the future returns such as sale price or rents of their property. Residual method is suitable for the circumstances where there is not sufficient evidence of sales of similar development land or the development involve specialized property and is so unusual that it is not possible to determine the value of the site by direct comparison with other sites. This method focuses to estimate capital value of a property after a certain period of time in future and helps in determining viability of the project. Residual method is useful in determining site value developer's profit by considering Gross Development Value, and all construction costs. Grass development value is calculated by determining future rental or sale income from the developed property and all risk yields of the investment. Whereas the construction cost include all the cost incurred by developers such as cost of raw materials, fee of architects, engineering and sales agents. The residual method of valuation can be summarized as Gross Development Value (value of the completed development) less costs of development less developer's profit equals land value. The residual method offers several benefits over the other valuation methods. It provides a objective calculation of real value of a development project over a period of time. The valuation does not depend on the previous sales or rental income of similar properties in the area. The other valuation methods do not consider the buyers' and sellers' preferences and expectations but these factors can be accommodated in residual method in form of changes in variables. For example in other valuation methods the buyers and sellers need to just consider what the other properties are earning around, they cannot argue that because of better location or design their property should be valued at a higher rate. Other valuation methods also do not offer any solution in case of any disputes between the buyers and solutions. These factors make residual method more acceptable in property valuation, especially in development projects in organized sector. Though this method sounds simple and straight forward, it involves complex mathematical calculations. There are a large number of variables that most often adjusted according to developer's perception of market condition. With evolution of computer technology and spreadsheet software, this method has become a standard method of property appraisal among developers. Accuracy of the residual method generally depends upon the numbers of variables considered for the calculations and the accuracy of estimations of other market variables such as rentals or sale value of the property after a period of time. Since the method involves large number of variables and the end result is generally highly sensitive to small changes in these variables, other valuation methods such as comparable method are also considered as a reference and a tolerance level is defined for the final valuation. The tolerance level is generally agreed upon by both buyers and sellers and is between the highest and lowest possible valuations. The valuation tolerances in any particular case depend on the individual circumstances of the case and the available facts. The residual method is considered by many researchers and experts as inherently flawed due to its high degree of variance over several variables. It is noticed that major of the input variables are generally not able to reflect a realistic future market condition, instead they reflect the perception of developers. Developer as an owner of property may manipulate these variable according to their interest. For example all risk yield of the property are which greatly influence the grass development value are always decided upon the preferences of developers, it leaves the valuation of a property single sided. One can consider that this valuation is not actually for determining the real value of land instead it determines how much benefit the developer can earn from the development. This inherent flaw, on one hand, makes residual method a preferred method for developers but on the other hand it is generally considered as a last resort where valuation involves a small property such as a single house. Conclusion From the above discussion it can be inferred that though the Development/residual method is open to inaccuracies due to involvement of numerous variables and sensitivity of final appraisal values towards even smaller changes in these variables, from the developer's point of view, the adoption of a consistent methodology and assumption of realistic variables helps in determining the real value creation out of a development project. It is up to the valuer to decide most appropriate method according to the particular circumstances and acceptability of buyers and sellers. It can be concluded safely that the valuation methods for a property need to be selected according to particular case and acceptance of various stake holders. 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