Valuation of Property - Article Example

VALUATION OF PROPERTY INTRODUCTION The valuation of any property often referred to as Real e appraisal, property valuation or land valuation isthe practice of developing an opinion of the value of real property, usually its Market Value. The need for appraisals arises from the heterogeneous nature of property as an investment class: no two properties are identical, and all properties differ from each other in their location - which is the most important determinant of their value. So there cannot exist a centralized Walrasian auction setting for the trading of property assets, as there exists for trade in corporate stock. The absence of a market-based pricing mechanism determines the need for an expert appraisal/valuation of real estate/property. A real estate appraisal is performed by a licensed or certified appraiser (in many countries known as a property valuer or land valuer and in British English as a surveyor). If the appraiser's opinion is based on Market Value, then it must also be based on the Highest and Best Use of the real property. For mortgage valuations of improved residential property in the US, the appraisal is most often reported on a standardized form, such as the Uniform Residential Appraisal Report. Appraisals of more complex property (e.g. -- income producing, raw land) are usually reported in a narrative appraisal report. ERRORS IN VALUATION (U.S. Government Accountability Office, 2008) The derailed residual valuation of the proposed site as provided by the landowners agents and supplied as part of the negotiations relating to the sale of the site was seen to contain a series of calculative errors on checking the calculations. The site value provided by the landowners is found to be 'excessive'. The list of calculative errors contained in the appraisal of the site and the inherent flaws in the land valuation is now listed below for perusal: The significant errors of omission and commission were committed either individually/collectively. There were numerous technical errors. The price escalation of the building materials and the building cost escalation were not accounted for. The ancillary costs were not fully included in the appraisal calculation. The recent sale of a similar site for 5,000,000 pounds was not accounted for. The rate of interest for a short term housing loan is closer to 13%. Calculative errors: This is the appraisal as submitted by the landowners' agents which was found to contain a series of calculative errors and inherent flaws. Detailed Residual Valuation Development Income Shops 800m2 *95% 760 * 250m2 '190,000 Offices 6,750m2 *90% 6,075 * 200m2 '1,215,000 Total Income '1,405,000 YP in 2 years 7% 14.28 Gross Development Value '20,063,400 Development Costs Building Cost Shops 800m2 * '500m2 '284,000 Offices 5,400m2 * '850m2 '4,590,000 Subtotal '4,990,000 Ancillary Costs ' 150,000 Subtotal '5,140,000 Professional Fees 12.50% '642,500 Subtotal '5,782,500 Short Term Finance say 12% on ' total costs for 24 months '2,891,250 *(1.12)^2 - '2,891,250 '735,533 Subtotal '6,518,033 Letting Fees 15% of Income '210,750 Subtotal '6,518,033 Developers Profit, 20% of '5,782,500 '1,156,500 Total Development Costs '7,674,533 Residual Value '12,388,867 Site Value on completion: Site Value Calculation 1.03x (1.12)^3 = 1.45 12,388,867 / 1.45 '8,544,046 Corrected Calculations: This is the alternative 'more accurate' valuation of the site. Detailed Residual Valuation Development Income Shops 800m2 *95% 760 * 250/m2 '190,000 Offices 6,750m2 *90% 6,075 * 200/m2 '1,215,000 Total Income '1,405,000 YP in 2 years 7% 14.28 Gross Development Value '20,063,400 Development Costs Building Cost Shops 800m2 * '550m2 '440,000 Offices 5,400m2 * '900m2 '4,860,000 Subtotal '5,300,000 Ancillary Costs ' 300,000 Subtotal '5,600,000 Professional Fees 12.50% '700,000 Subtotal '6,300,000 Short Term Finance say 13% on ' total costs for 24 months '3,150,000 *(1.13)^2 - '3,150,000 '872,235 Subtotal '7,172,235 Letting Fees 15% of Income '210,750 Subtotal '7,382,985 Developers Profit, 20% of '6,300,000 '1,260,000 Total Development Costs '8,642,985 Residual Value '11,420,415 Site Value on completion: Site Value Calculation 1.03x (1.13)^3 = 1.50 11,420,415 / 1.50 '7,613,610 Thus, we see that the corrected valuation of the site is closer to 7.5 million pounds and not 8.5 million pounds as suggested by the landowners' agents in their appraisal. So their appraisal is found to be faulty and the inherent errors and series of calculative errors are identified and corrected. SIGNIFICANCE OF SALE The significance of a sale of a similar nearby property for 5,000,000 pounds is relatively significant in the appraisal and calculation of the land value, if the site has been developed for similar purposes as the current site under perusal. If the site has also been developed for offices and shops and if the appraisal of the site has been carried out by approved site engineers and site valuers, then this amount should definitely be taken into consideration as a comparable sale with a different highest and best use as a basis for the value conclusions of the new site. METHODS OF VALUATION (Home & Land Appraisal Services, 2008) In today's current office market, the standard forms of valuing an office buildings is undertaken namely through two traditional methods, either the capitalization of income or the discounted cash flow approach. A property valuer analyses and interprets current sales and lease transactions and the characteristics of comparable buildings involved against the subject buildings to make accurate assumptions of the current market climate and it's impact upon the value of the subject building. This is where the initial problem lies, the lack of sales and lease transactions for sustainable buildings, worldwide, makes identifying the link between sustainable buildings and it's inherent market value difficult to define. The use of current valuation methodology enables only limited aspects of sustainability to be incorporated, thus not identifying the added value in sustainability. Thus, as Lutzkendorf and Lorenz stated in their work into the valuation of sustainable buildings, 'Relying on historical valuation methods will lead to an unbalanced approach for determining a property's exchange price or market value'. Current promotional research of sustainability tends to assume that the incremental capital expenditure on sustainable attributes increases the market value of the building on a basis of a dollar of capital expenditure another dollar of value. Commonly used for calculating cost value and potentially insurance valuation, the cost approach is used to determine value. The Australian Property Institute (2006) defined the 'cost approach' as 'a set of procedures through which a value indication is derived for the fee simple interest in a property by estimating the current costs to construct a reproduction of, or replacement for, the existing structure plus any profit or incentive; deducting deprecation from the total cost; and adding the estimated land value'. This however is not a current practice when determining the market value of an income producing office building that is treated in the property market as an investment vehicle. Registered valuers undertake current valuation practice by the calculation of the present value of future income streams, this influences the emphasis of investment and development decisions. The crucial nature of decisions made in the finance industry requires a standardized methodology for the determination of a property's market value. Traditionally valuation practice in the western world is a combination of the capitalization of income and discounted cash flow approaches to effectively determine the value of an office building. However for the determination of market value using the Income Approach requires accurate market data to be obtained to correctly ascertain the market value of a building. In the current market for sustainable office buildings, this empirical evidence is difficult to find, as the maturity of the current market for these buildings is still developing. The valuation industry uses a number of approaches for evaluating buildings and Armitage (1997) succinctly identifies the five methods of valuation, being: 1. Comparison Approach; 2. Contractor's cost, or summation approach; 3. Residual method or developer's test; 4. Profits method; and 5. Income or investment approach. These methods are now explained below in sufficient detail. COMPARISON APPROACH (Surrinder Ahitan, 2007) This is used for most types of property where there is good evidence of previous sales. This is analogous to the sales comparison approach. The sales comparison approach (SCA) is one of the five major groupings of valuation methods, called the five approaches to value, commonly used in real estate appraisal. This approach compares a subject property's characteristics with those of comparable properties which have recently sold in similar transactions. The process uses one of several techniques to adjust the prices of the comparable transactions according to the presence, absence, or degree of characteristics which influence value. As such, all sales comparison approach methods are variations on hedonic-type measurements, which determine the value of something as the sum of the value of the various components which contribute utility. The sales comparison approach is based upon the principles of supply and demand, as well as upon the principle of substitution. Supply and demand indicates value through typical market behavior of both buyers and sellers. Substitution indicates that a purchaser would not purchase an improved property for any value higher than it could be replaced for on a site with equivalent utility, assuming no undue delays in construction. The comparison approach of valuation is used mainly for residential property. The approach applies to capital values. The purchases are not usually for investment purposes, but rather for occupation by the owner. The direct comparison of capital values is used for the valuation of property that is vacant. Any dissimilarity between properties' capital values should be assessed carefully, together with the pros and cons of each property, to arrive at a fair comparison. CONTRACTOR'S APPROACH OR SUMMATION APPROACH The cost approach was only formerly called the summation approach or the contractor's approach. The theory is that the value of a property can be estimated by summing the land value and the depreciated value of any improvements. The value of the improvements is often referred to by the abbreviation RCNLD (reproduction cost new less depreciation or replacement cost new less deprecation). Reproduction refers to reproducing an exact replica. Replacement cost refers to the cost of building a house or other improvement which has the same utility, but using modern design, workmanship and materials. In practice, appraisers use replacement cost and then deduct a factor for any functional disutility associated with the age of the subject property. In most instances when the cost approach is involved, the overall methodology is a hybrid of the cost and sales comparison approaches. For example, while the replacement cost to construct a building can be determined by adding the labor, material, and other costs, land values and depreciation must be derived from an analysis of comparable data. The cost approach is considered reliable when used on newer structures, but the method tends to become less reliable for older properties. The cost approach is often the only reliable approach when dealing with special use properties (e.g. -- public assembly, marinas). RESIDUAL METHOD OR DEVELOPERS TEST (Southwark Property, 2005) The residual method is only used when valuing development sites and properties suitable for redevelopment. The method involves making estimates regarding the total cost of the project and of the gross development value created. After making a reasonable allowance for profit and contingency, the difference between the gross development value and costs (including profit and interest accrued on capital borrowed over the development period, build costs and professional fees) represents the value of the land. It must be stated that the residual method of valuation is open to possible inaccuracy, as a small variation in any input can lead to large variation in the end result. The adoption of a consistent methodology using assumptions based upon realistic property market scenarios reduces uncertainty and risk. An over-view of the residual method is set out below: Overview: Gross Development Value (Market Value of Completed Scheme) LESS: Construction and Landscaping costs, Professional Team Fees, Finance Costs, Marketing Costs, Contingency Allowance, Developers Profit and Purchasers Costs. EQUALS: Land Value. The following is a summary of the elements of a residual valuation that must be estimated to calculate land value: - Gross development value of the completed scheme - Build costs - Unit sizes - Construction period - Build period - Void period - Finance rate - Professional Fees - Developers profit - Purchaser Fees PROFITS METHOD (Robert Fray, RICS) The accounts or profits method is used for trading properties where evidence of rates is slight, such as hotels, restaurants and old-age homes. A three-year average of operating income (derived from the profit and loss or income statement) is capitalized using an appropriate yield. Note that since the variables used are inherent to the property and are not market-derived, therefore unless appropriate adjustments are made, the resulting value will be Value-in-Use or Investment Value, not Market Value. The "profits method" of valuation is highly adaptable to circumstances where property markets are immature, where there is a new class of business property emerging, or where there is imperfect access to comparable information - all circumstances that apply to worldwide emerging markets. It particularly applies to retail and service offerings that are location-specific such as leisure activities, as compared with goods and services that the internet can deliver virtually from any location. INCOME OR INVESTMENT METHOD (Wikipedia, 2007) The Income Approach is one of five major groups of methodologies, called valuation approaches, used by appraisers. It is particularly common in commercial real estate appraisal and in business appraisal. The fundamental math is similar to the methods used for financial valuation, securities analysis, or bond pricing. However, there are some significant and important modifications when used in real estate or business valuation. While there are quite a few acceptable methods under the rubric of the income approach, most of these methods fall into three categories: direct capitalization, discounted cash flow, and gross income multiplier. Direct Capitalization: This is simply the product of dividing the annual net operating income (NOI) by the appropriate capitalization rate (CAP rate). For income producing real estate, the NOI is the net income of the real estate. The CAP rate may be determined in one of several ways, including market extraction, band-of-investments, or a built-up method. Discounted Cash Flow: The DCF model is analogous to a net present value estimation in finance. However, appraisers often mistakenly use a market-derived cap rate and NOI as substitutes for the discount rate and/or the annual cash flow. Gross Rent Multiplier: The GRM is simply the ratio of the monthly (or annual) rent divided into the selling price. If several similar properties have sold in the market recently, then the GRM can be computed for those and applied to the anticipated monthly rent for the subject property. Short-cut DCF: The Short-cut DCF method is based on a model developed by Professor Neil Crosby of the University of Reading. The Short-cut DCF is an adaptation to property valuation of the DCF method, which is widely used in finance. In the Short-cut DCF, the passing rent, which is constant (in nominal or real terms) for the duration of the rent period, is discounted at an appropriate rate of return CONCLUSION The accurate valuation of the site under consideration has been presented and also, the inherent flaws and the series of calculative errors in the appraisal of the landowners' agents has been listed and pointed out. The impact of a sale of a similar property has also been explained and the five methods of valuation have been explained and critically evaluated. References Georgia Myers, Richard Reed, Jon Robinson, 2007, The Relationship between Sustainability and the Value of Office Buildings, retrieved 14 May 2008, [Online]. Available at : Home & Land Appraisal Services, 2008, Appraisal FAQ, retrieved 14 May 2008, [Online]. Available at : James Kimmons, Real Estate Business, retrieved 14 May 2008, [Online]. Available at: Robert Fray, RICS, The Profits Method of Valuation, retrieved 14 May 2008, [Online]. Available at: Southwark Property, January 2005, Affordable Housing Valuations Research, retrieved 14 May 2008, [Online]. Available at: Surrinder Ahitan, 2007, An Introduction to the Valuation of Propert, retrieved 14 May 2008, [Online]. Available at: U.S. Government Accountability Office, 2008, Interior's Land Appraisal Services: Actions Needed to Improve Compliance with Appraisal tandards, Increase Efficiency, and Broaden Oversight, retrieved 14 May 2008, [Online]. Available at: Wikipedia, the Free Encyclopedia, 2007, Income Approach, retrieved 14 May 2008, [Online]. Available at: Wikipedia, the Free Encyclopedia, 2008, Real Estate Appraisal, retrieved 14 May 2008, [Online]. Available at: Wikipedia, the Free Encyclopedia, 2008, Sales comparison approach. retrieved 14 May 2008, [Online]. Available at: Read More