APC: valuation approaches and methods

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 other related sector pathways, including Corporate real estate, Planning and development, Residential, Rural and valuation.

Valuation is often taken to Level 3 by Commercial Real Estate 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 focuses on a fundamental valuation issue: selecting the correct valuation approach and method.

It explains the approaches and methods available to candidates and when they may be appropriate to apply.

Under VPS 3, the valuer is responsible for adopting and justifying their valuation approach and method, taking account of the asset type, purpose and use of the valuation and any specific statutory or jurisdictional requirements.

In many cases, the valuer may decide to use more than one approach and method to cross-check and provide a fully reasoned valuation.

In addition, the valuer should always record in writing why they chose a specific valuation approach and method.

Candidates need to be aware of the International Valuation Standards (IVS), which are published by the International Valuation Standards Council and provide global guidance on valuation. 

RICS sets its own professional valuation standards for members and regulated firms in the Red Book Global Standards, which incorporate the IVS in full.

The IVS define a valuation approach as 'a generic term for the use of the cost, income or market approach' and a valuation method as being 'within a valuation approach, a specific technique to conclude a value'.

There are three key valuation approaches in VPS 3: market, income and cost. The five valuation methods then sit within these approaches.

• Market approach relies on the use of comparables to ascertain a value. See the comparable method below for further details.
• Income approach requires the conversion of future income streams into a present value, or the value of an asset in terms of project costs and cost savings. This incorporates the investment and profits methods.
• Cost approach is based on the economic principle that a purchaser will pay no more than the equivalent cost of a similar property. This incorporates the residual land valuation and depreciated replacement cost methods. 

Delving further into the three approaches are the five valuation methods with which candidates should be familiar.

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 RICS' Comparable evidence in real estate valuation professional standard.

Essentially, the comparable method can be used where there is a substantial 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 must 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, e.g. open market letting versus 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
• limited market transparency.  

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- (i.e. below the market rent), rack- (i.e. at the market rent) and over-rented (i.e. above the market rent) by incorporating risk within the yield choice (i.e. an all-risks yield).

Income streams can also be reflected by structuring the calculation appropriately, e.g. a term and reversion. 

For under-rented income streams, a term and reversion can be used. The term will reflect the passing rent and the reversion the market rent.

For over-rented income streams, a hardcore and top slice can be used. The hardcore will reflect the market rent and the topslice the over-rented element.

This will require the valuer to reflect risk in each element of the calculation, for example:

• by 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
• by 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, it will represent investment value rather than market value.

However, these are typically referred to as specialist properties such as hotels, golf courses, petrol stations, care homes and some restaurants.

These types of property are usually sold only 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 versus 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' (VPS 2 section 6). 

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 a fair maintainable operating profit capable of being generated by a reasonably efficient operator. 

This is based on 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.

Candidates should be familiar with the principles outlined in RICS' Depreciated replacement cost method of valuation for financial reporting professional standard.

DRC 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 on 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.

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.

In addition, candidates should avoid using the term residual appraisal as it is confusing for all involved.

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.

As the output – market value of the land – can be highly sensitive to the inputs used, sensitivity analysis can be employed to advise clients on how minor changes to the input can impact the output.

Candidates should also cross-check their valuation using the comparable method based on land sales, as per the requirements of the RICS' Valuation of development property professional standard.

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.

A version of this article was originally published on 7 August 2020.