PROPERTY JOURNAL

APC: the five valuation methods

What do candidates need to do to achieve the Valuation competency in their APC? The latest in our series on core commercial competencies explains the basics of the five valuation methods

Author: Jen Lemen

07 August 2020

Valuation has been a core competency to Level 2 on the Commercial Real Estate APC pathway since August 2018, as it was on the previous Commercial Property pathway. It is also an optional competency on various other related pathways, including Corporate Real Estate, Planning and Development and Valuation. 

It is often taken to Level 3 by Commercial Property pathway candidates, providing that they have sufficient depth and breadth of experience to satisfy the competency requirements. Candidates will need to have prepared and provided properly researched valuation advice, made in accordance with the appropriate valuation standards, enabling clients to make informed decisions.  

This article will focus on a fundamental valuation issue; selecting the correct valuation method. It will explain the methods available to candidates and when they may be appropriate to apply.  

Comparable method

The comparable method is the most widespread valuation method, typically to assess the market rent and market value of both commercial and residential properties. It can also be used to assess the market value of farms, farmland and land with development potential.  

Candidates should be familiar with the principles outlined in the RICS guidance note Comparable evidence in real estate valuation 1st edition. Essentially, the comparable method can be used where there is a good body of recent, reliable comparable rental, yield or sales evidence. A comparable is defined as an item of information used during the valuation process as evidence to support the valuation of another, similar item.

Candidates need to be able to collate, analyse and adjust comparable evidence to reflect differences with their subject property. This may include calculating net effective rents or carrying out a zoned analysis . The hierarchy of evidence should also be considered to ensure that appropriate weighting is applied, based on the type of transaction, for example, open market letting vs quoting rent.

Typical sources of comparable evidence include published databases, internal records, discussions with other agents and direct involvement in deals. Comparable evidence should always be verified with the parties involved and a suitable range of evidence compiled to avoid over-reliance on just one piece of evidence.

Challenges that candidates may face when using the comparable method include: limited transaction, lack of up-to-date evidence, existence of a special purchaser – which may lead to a price paid which is above the market tone due to circumstances specific to one party – lack of similar evidence given the complex nature of real estate, and limited market transparency.  

Investment method

The investment method is used where there is an income stream to value, i.e. the property is tenanted. This can include commercial, residential, retail, industrial and agricultural properties.

To use the investment method, candidates will need to be able to assess rental values (market rent) and a market-based yield. A yield can be simply defined as the annual return on investment expressed as a percentage of capital value.  

The investment method can reflect income streams which are under-, rack- and over-rented by incorporating risk within the yield choice (i.e. an all risks yield) and by structuring the calculation appropriately, for example a term and reversion for under-rented income streams and a hardcore and topslice for over-rented income streams. This will require the valuer to reflect risk in each element of the calculation, e.g. increasing the yield above the market in the topslice to reflect the added risk of an above market rent being paid for a specified period, or reducing the yield in the term to reflect that a below market rent is being paid until the reversion is due.

Candidates need to understand that these ‘traditional’ approaches are typically referred to as being growth implicit, meaning that rental growth is built into the choice of yield and not explicitly modelled within the calculation.  

The alternative approach is to use a growth-explicit discounted cash flow (DCF), where the cashflow is explicitly modelled incorporating a wide range of valuer-inputted assumptions. Typically the rate of return used in a DCF will reflect a risk-free rate plus a property risk premium. If a DCF is based on client data rather than market data, then it will represent investment value rather than market value.  

"This will require the valuer to reflect risk in each element of the calculation"
Profits method

The profits method, or receipts and expenses or income and expenditure method, is also used for income-producing properties. However, these are typically referred to as being specialist properties, such as hotels, golf courses, petrol stations, care homes and some restaurants.  

These types of properties are only usually sold as part of a business and are designed specifically for the intended use. Their value will depend on business profitability and trading potential, also known as intangible goodwill.  

This introduces the concept of market value vs. investment value; the latter relating to the ‘measure of the value of the benefits of ownership to the current owner or to a prospective owner, recognising that these may differ from those of a typical market participant’.  

Only candidates carrying out specialist valuation work will have experience of this method, although it is important for all candidates to have a good theoretical knowledge of the process behind it. The profits method involves establishing fair maintainable operating profit (FMOP) capable of being generated by a reasonably efficient operator (REO). This is based upon assessment and analysis of fair maintainable turnover (FMT), requiring sound knowledge of accounting principles and market norms for the specific industry sector. A market-based profit multiplier is then used to convert FMT into a capital value

Depreciated replacement cost/contractor’s method

The depreciated replacement cost (DRC) method is used for owner-occupied or specialised property that is rarely sold on the open market. It is also known as the method of last resort and should not be used where there are market sales of comparable properties. It could, of course, be used as a check valuation against another method.  

Again, this is a specialist area of valuation that many candidates will not have experience of. However, they will need to understand the basic process and be aware of when it could be applied; example assets include oil refineries and airports.
The DRC method is based upon the assumption that the market will pay no more for the existing property than the amount it would cost to buy an equivalent site, plus the cost of constructing an equivalent building.

The basic steps involved include assessing the cost to replace the land and the building – with a modern equivalent, including all associated costs – before making appropriate deductions for depreciation and obsolescence.  

Residual method

The residual method is typically used for property or land with development potential. The output is market value of the land and it requires valuers to make a variety of assumptions around input costs.

Candidates need to understand the difference between a residual land valuation (i.e. output of market value of the land) and a development appraisal (i.e. output of profitability or viability).  

Candidates need to understand the difference between a residual land valuation (i.e. output of market value of the land) and a development appraisal (i.e. output of profitability or viability).  

To apply the residual method, candidates need to first assess the development potential of the land, i.e. highest value use. They then need to calculate the value of the finished scheme, i.e. gross development value (GDV) based on market comparables. All development costs are then deducted from GDV, including developer’s profit and finance costs

The output, market value of the land, can be very sensitive to the inputs used. This means that sensitivity analysis can be used to advise clients on the impact on the output of minor changes to the input. Candidates should also cross-check their valuation using the comparable method based on land sales, as per the requirements of the RICS guidance note Valuation of development property.

Conclusion

Having a robust understanding of the five valuation methods and when they should be applied will help candidates to meet the requirements of the Valuation competency. Ideally, they will be able to draw on Level 2 and 3 examples of at least two valuation methods and be able to explain the theory behind the others.  

jen@property-elite.co.uk

Related competencies include: Valuation, Valuation of businesses and intangible assets
 

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