The Income Approach to Property Valuation A classic textbook that has guided generations of students through the intricacies of property valuation, The Income Approach to Property Valuation remains a keen favourite amongst students and teachers alike. This new edition has been thoroughly revised and updated to meet the increasingly international perspectives of modern Real Estate students. The links between theory and practice are clearly demonstrated throughout, with a range of new international case studies and practice-based examples. The Income Approach to Property Valuation teaches readers: how to analyse market rents and sales prices to derive market evidence to support an opinion of market value; the investment method of valuation and how it is applied in practice; how specific legal factors can impact on market value when they interfere with market forces; what the market and the profession may consider to be the right methodology in today s market place; and how to use spreadsheets in valuation. This extensively revised new edition is perfect both for students on Real Estate courses worldwide and for professional candidates working towards their final assessment of professional competence (APC) for the Royal Institution of Chartered Surveyors, needing to demonstrate a valuation competence at levels 2 and 3. Andrew Baum is Chairman of Property Funds Research and Newcore Capital Management, and Visiting Professor of Management Practice at the Saïd Business School at the University of Oxford. He was formerly Professor of Land Management at the University of Reading where he is now Emeritus Professor, Honorary Professor of Real Estate Investment at the University of Cambridge and Fellow of St John s College, Cambridge. David Mackmin is Emeritus Professor of Real Estate at Sheffield Hallam University. He was formerly Professor of Real Estate at Sheffield Hallam University, Visiting Professor of Valuation at the Technische Universität Wien and Course Director of undergraduate and postgraduate courses at the University of Reading. Nick Nunnington is Visiting Professor of Corporate Real Estate at Nottingham Trent University. He was formerly Principal Lecturer at Sheffield Hallam University, Sorouh Dean of Real Estate Management at the Higher Colleges of Technology in Abu Dhabi and subsequently an Associate Vice Provost for quality and curriculum development for professional courses across 17 colleges in the United Arab Emirates. He is now a freelance academic with a variety of roles including teaching blended learning courses on the Master of Real Estate programme at the University of Adelaide, Australia.
The Income Approach to Property Valuation Seventh Edition Andrew Baum, David Mackmin and Nick Nunnington
Seventh edition published 2018 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon, OX14 4RN and by Routledge 711 Third Avenue, New York, NY 10017 Routledge is an imprint of the Taylor & Francis Group, an informa business 2018 Andrew Baum, David Mackmin and Nick Nunnington The right of Andrew Baum, David Mackmin and Nick Nunnington to be identified as authors of this work has been asserted by them in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988. The copyright of chapter 12 is retained by Howard Day. All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. Every effort has been made to contact copyright-holders. Please advise the publisher of any errors or omissions, and these will be corrected in subsequent editions. Trademark notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. First edition published by Routledge & Kegan Paul 1979 Sixth edition published by Routledge 2014 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data Names: Baum, Andrew E., author. Mackmin, David. Nunnington, Nick. Title: The income approach to property valuation / Andrew Baum, David Mackmin and Nick Nunnington. Description: 7 Edition. New York : Routledge, 2018. Revised edition of the authors The income approach to property valuation, 2011. Includes bibliographical references and index. Identifiers: LCCN 2017019500 ISBN 9781138639621 (hardback : alk. paper) ISBN 9781138639638 (pbk. : alk. paper) ISBN 9781315637099 (ebook) Subjects: LCSH: Real property Valuation Great Britain. Real estate investment Great Britain. Classification: LCC HD596.B38 2018 DDC 333.33/20941 dc23 LC record available at https://lccn.loc.gov/2017019500 ISBN: 978-1-138-63962-1 (hbk) ISBN: 978-1-138-63963-8 (pbk) ISBN: 978-1-315-63709-9 (ebk) Typeset in Times New Roman by Keystroke, Neville Lodge, Tettenhall, Wolverhampton
Contents Preface Acknowledgements List of acronyms xiii xvii xix 1 The global framework 1 Introduction 1 Understanding property as an investment asset class 2 Comparing property to other asset classes 4 An international framework 4 International standards 6 Summary 8 2 The local framework 10 Introduction 10 The legal framework 12 Types of leases 13 Statutes affecting rights to let property 15 Planning or zoning 18 Impact of lease terms on value 18 Lease length 19 Rental terms 19 Repairing and insurance obligations 19 User restrictions 20 Alienation rights 20 Other considerations 20 Some examples 20 Summary 20 3 Fundamental financial concepts for the income approach 22 Introduction 22 The time value of money 22 The six functions of 1 23
vi Contents Compounding 24 Discounting 28 Mortgages 39 The interrelationship of the functions 42 Nominal and effective rates of interest 42 Continuous compounding 44 Incomes in advance and non-annual incomes 45 Incomes receivable quarterly or monthly in advance 46 Present value of 1 pa dual rate (YP dual rate) 47 Dual rate adjusted for tax 47 Summary 48 Spreadsheet user 50 Project 1 50 Project 2 52 4 Fundamental methodologies for the income approach 53 Introduction 53 Income capitalisation 53 Discounted cash flow 56 Net present value 56 Internal rate of return 59 Comparative use of NPV and IRR 63 The income approach DCF method 65 Basics of DCF 66 Summary 71 Spreadsheet user 71 Project 1 72 Project 2 73 Project 3 74 Questions: Chapters 3 and 4 74 5 Ethics, standards, practice and processes 76 Introduction 76 Registered valuers 78 Professional standards 78 Application of the RICS Valuation Global Standards or Red Book 79 Instructions 80 Basis of value 81 Valuation date 83 Valuation 83 Inspections, investigations and records 83 Inspections 85 Measurement 86 Condition 88 Planning 88
Legal 88 Risk 88 Records 89 Taxation 89 Capital Gains Tax 94 Value Added Tax 95 The valuation 95 The report 96 Summary 97 Contents vii 6 Market valuation: basic principles 99 Introduction 99 Valuation process 99 The sub-markets 102 Assessing principal income approach inputs 104 Comparison of market rent 104 Net operating income (net income for valuation purposes) 107 Landlords expenses 107 Insurance 107 Management 108 Taxes 108 Running expenses 109 Repairs 109 Essential works 110 Averages and percentages 110 Units of comparison 111 Overall analysis 111 Arithmetic zoning 112 Natural zoning 114 Analysing sale prices to find the price per square metre/foot 115 Factors affecting investor yield requirements and market capitalisation rates 116 Analysing sale prices to find the capitalisation rate or equivalent yield 116 Analysis to find the capitalisation rate 116 Analysis to find the equivalent yield 117 Deriving a discount rate 120 Adjusting comparables 120 Quality of the legal title 121 Quality of the lease(s) 121 Quality of the location 122 Quality of the building 122 Quality of the tenant(s) 123 Voids 124 Purchase expenses 124 Basics of the income approach 125
viii Contents Income capitalisation or DCF 128 Summary 129 Questions 130 7 The income approach: freeholds 132 Introduction 132 The income approach 134 Capitalisation approaches 136 A fixed or level annuity 137 A stepped annuity 140 Conventional treatment of outgoings 144 Allowing for voids 145 A falling annuity over-rented property 148 A variable annuity 149 Discounted cash flow 156 Discounted cash flow and the over-rented property 157 Advance or arrears 158 UK statutory issues 160 A final adjustment 160 Practitioner s perspective 161 Summary 161 Spreadsheet user 162 Project 1 162 Project 2 164 8 The income approach: leaseholds 166 Introduction 166 Occupational leases 167 Investment leases 169 Medium to long term leaseholds at a fixed head rent 169 Fixed profit rent 170 Single rate analysis and valuation of leaseholds leasehold capitalisation 171 DCF valuation of leaseholds 174 Practitioner s perspective 176 Summary 177 9 The valuation of commercial and residential property reflecting UK landlord and tenant legislation 179 Introduction 179 Landlord and tenant negotiations 179 Premiums 179 Reverse premiums 182
Question 1: Premium 182 Future costs and receipts 183 Extensions and renewals of leases 185 Question 2: Surrender and renewal 190 Marriage value 190 Market rent, non-standard rent reviews, constant rent theory 195 Question 3: Non-standard rent review 196 Quarterly to monthly rent adjustment 197 Summary of landlord and tenant negotiations 198 UK statutory issues 199 Introduction 199 Business premises 199 Residential property 209 Mixed residential and business premises 216 Question 4: Landlord and tenant issues 217 Summary of UK statutory issues 217 Contents ix 10 Investment analysis 219 Introduction 219 Expected returns the cash flow 221 The discount rate 222 Some simple analytical measures 224 Initial yield 224 Yield on reversion 225 Equivalent yield 226 Reversionary potential 226 Performance measures 227 Income return 227 Capital return 227 Total return 227 Required return 227 IRR or expected return 227 Dealing with risk 228 The risk-adjusted discount rate 229 The sub-sector and property risk premium 229 The sector, or sub-sector, premium 229 The city (or location) premium 230 The property premium 230 Risk-adjusted cash flows: using sensitivity and simulation 231 Risk-adjusted valuations 236 Regression analysis 237 Questions 239 Spreadsheet user 239
x Contents 11 Development opportunities 242 Introduction 242 Incorporating a big picture approach 244 Garbage in garbage out 246 A case study illustration 247 Professional frameworks and methodologies 248 The highest and best use methodology 249 The method 249 RICS Valuation Information Paper No 12: The Valuation of Development Land 250 RICS Financial Viability in Planning 2012 252 Applying the highest and best use in practice 254 IVS 2017 255 The residual method 257 Exploring the main inputs to a residual appraisal 257 Completed development value 257 Rent and yield 257 Incidental costs 258 Costs 258 Developer s profit or risk 260 Sensitivity analysis 262 The need for adoption of the cash flow approach 264 The cash flow approach explained 276 Viability studies 279 Practitioner s perspective 281 Summary 281 Spreadsheet user 282 12 Profits based valuations 287 The rationale behind the use of the profits method of valuation 287 Fair maintainable turnover 288 Gross profitability 289 Costs 289 Fair maintainable operating profit 289 Commentary on use of actual accounts 290 Freehold valuation and sales 290 Licensed property 290 Pubs 292 Valuation approach: public houses and bars 293 Comparables and market information 296 Valuation approach: late bars/clubs 297 Valuation approach: restaurants 299 Valuation approach: hotels 300
Valuing other types of property by the profits method 303 Cinemas and theatres 303 Care homes 303 Petrol filling stations 304 Golf courses 304 Racecourses, racetracks and stadia 304 Tenant s improvements under the profits method 305 Summary 307 Contents xi 13 The historical development of the income approach 308 Introduction 308 Freeholds 308 Variable yields in a capitalisation 310 The modified or short-cut DCF 314 DCF and over-rented property 320 Lease changes 320 Processes and technology 321 Summary of the development of freehold income capitalisation methods 321 Historic development of leasehold valuation methodology 322 Summary of leasehold valuation history 325 14 Contemporary issues for valuation practice 327 Introduction 327 Sustainability and its impact upon value 328 Productivity and its impact upon value 333 The application of mass computerised valuation and artificial intelligence 338 The need to be aware of local factors in a world of global standards 340 China 340 United Arab Emirates 343 Cyprus (and Greece) 345 The valuation of new complex and volatile cash flow property products 349 Co-working 351 What are co-working spaces? 351 How are co-working spaces priced and how do you value them? 352 Summary 353 Appendix A Illustrative investment property purchase report 355 Appendix B Illustrative development site appraisal report 361 Appendix C Solutions to questions set in text 368 Index 377
Preface The first edition in 1979 could have been described as having a theme of raising awareness. Andrew and David were conscious of the fact that much of the methodology of the income approach was at that time rote taught and applied according to a specific set of rules such as: always adjust yields by one to two per cent to reflect security of income; analyse sales in the same way to establish multiple yields varying by one to two per cent; allow for repairs, insurance and management using percentages of rent, rarely clarified in terms of rent reserved or rental value and clouded in subjectivity in terms of the percentages to use; and value leaseholds using dual rate or dual rate adjusted for tax at two per cent above the equivalent freehold rate. In the UK the use of Years Purchase (YP) prevailed often without any appreciation of the fact that YP was the present value of 1 per annum. Andrew and David wanted to encourage valuers to explore alternative approaches that reflected more closely the behaviour of investors. They also wanted to emphasise that much of valuation is about identifying and evaluating risks and they wanted to make this process much more explicit. A great deal has changed since then: the property market has grown into an international market; it has grown in scale with prices for the best city centre properties selling for hundreds of millions of pounds, dollars or whatever; property has become a recognised investment class with mixed portfolios looking at about 15 per cent in land and buildings and with many billion pound plus property-only funds. At the same time investors have become more cautious requiring the services of qualified professional valuers with strong ethical beliefs and seeking greater global consistency in valuation standards, value definitions, basis of property measurement and application of the income approach. We also recognise that university education has changed dramatically in this time with a much greater emphasis on application and employability. Students need to be prepared for placements/internships or graduate jobs that throw them in at the deep end. Those placements are increasingly international and expectations of what an intern can do are much higher than before. They need to be able to manage the application of valuation theory, not just regurgitate it, and be able to balance consistency of purpose and professional standards with local context and client requirements. Investment advisors now analyse property purchases using the internal rate of return (IRR) and look for valuations and appraisals which are discounted cash flow (DCF) based, with the potential net operating income clearly identified over say a 10-year period and then
xiv Preface discounted using present value factors. Income flows can be with or without assessment of income (rental) growth over the holding period. As we explore in Chapter 14, increasingly complex occupier-focused property products with greater volatility and multiple income streams are expected to reinforce DCF as the valuation tool of the future. Some things take longer to change and so even UK software continues to express the present value of 1 per annum as YP and refer to annual in arrears discounting as Parry s basis which refers back to a pre-digital era when ready-reckoners such as books of investment or valuation tables (Parry s Valuation Tables are still in print) were the valuer s greatest support tool. But dual rate seems to have finally disappeared as its basic assumptions no longer apply to the real world. Reflecting so much change has necessitated a rethink of some of the book s structure and content. In revising the structure we have taken note of reviews submitted to our editor as well as our perception of how the market has altered. For these reasons and many others we have decided to begin this edition with an overview of the frameworks, both global and UK specific, within which the income approach operates. These are not only the regulatory and professional standards but the economic and legal contexts within which valuation takes place. This is followed by familiar material revised and reset covering basic financial concepts and the two forms of the income approach recognised by the International Valuation Standards (IVS) capitalisation and DCF. We have expanded our consideration of professional and ethical issues; updated on International Property Measurement Standards (IPMS); and provided a more robust section on market analysis and property inspection. Our objective being to set valuations in context to help those new to the subject to see how a professional valuer works within international and national standards and how set processes are followed before arriving at the measurement of market value. More familiar chapters follow on freehold and leasehold valuations of residential and commercial income-producing properties in the UK; investment appraisal; development appraisal; and profits based valuations. We conclude with a brief review of UK valuation history how we got to where we are to-day and an exploration of the current issues facing the valuation profession. In the final chapter on contemporary issues we look at some of the challenges of changing property products such as co-working and some examples of international valuation issues to emphasise that even in a globalised world a valuer must understand the local nuances, or as many companies such as Jones Lang LaSalle (JLL) state Think Global, Act Local. We very much appreciate the help Howard Day has given on the specialist application of the profits approach. For this edition we thank our editor, Adam Baldwin, who has provided us with editorial input and many helpful observations from a practitioner s point of view. One of our main aspirations for this edition was to examine both the theory and its application in practice and this could only be done with the aid of someone actually doing just that. Professor Nick French in a review of the Sixth Edition commented that this is still the best introductory text on the market... Ignore the plethora of other textbooks that purport to be good introductions to the topic. Just buy this book, you will not regret it. We have made a lot of changes that we felt were essential to maintain the standing of our book and trust that all readers will still find it the best with something of interest for everyone. We end this edition in a very different way to previous editions in looking forward to some of the change we see as having significant impact upon the way valuation is undertaken and the context within which valuations are made. Whilst this final chapter is new it also returns us to the beginning and our early theme of provoking valuers to think, not to simply follow. Changes in geopolitical risk, global
Preface xv economic forces, social structures and the blending of work and leisure, together with the application of artificial intelligence and other technology are explored in Chapter 14. All of these, and many other change factors demand that the valuer must: step outside the office; step into a global society and property investment market; step away from the familiar; expect rapid change, greater obsolescence, increased volatility and the unexpected; and consider the breadth of work, life, technology and social changes which are impacting on building design and usage. All of these factors can and do impact the perceptions and reality of future rental income and cash flow. They inevitably move a valuer s consideration from market capitalisation and the inherent implied assumptions to a market-driven DCF approach, which makes explicit all of the potential impacts upon the future cashflow including those we explore briefly in the final chapter. Andrew Baum David Mackmin Nick Nunnington Oxford, Wales and Portugal Note: This revised text is based on IVS 2017, RICS Valuation Global Standards 2017 and Stamp Duty Land Tax as at April 2017. SDLT has been replaced by a Transaction Tax in some parts of the UK at rates which may differ to those used in the text.
Acknowledgements Andrew and David remain indebted to Peter Byrne and David Jenkins for their support when at the University of Reading in 1978 they first suggested that it was time for a new book on valuations; they, like many other Reading alumni were saddened to learn of Peter s death in 2015. So in memory we hope this seventh edition will be as popular as the edition he inspired in 1979. The content of this edition has been enhanced by the substantive contribution of Howard Day BSc. FRICS, MAE, MCIArb, FAVLP with his revised Chapter 12 on the profits method. Howard has advised on leisure property for the majority of his career, which spans four decades. He is currently a Director of Davis Coffer Lyons who are leading specialist advisors to the leisure property sector. For this edition we have also been fortunate to have had the help of Adam Baldwin BA (Hons) MSc MRICS, who as contributing editor, has assisted us with the editing process, integrated a practitioner s perspective into many sections and provided valuable support throughout. Adam works as part of a cross-sector real estate capital markets team based in London, advising institutional investors on their core commercial real estate investment strategies within the UK. Adam currently sits on the committee of several real estate-related entities. He holds a BA (Hons) in Industrial Economics from the University of Nottingham (UK) and an MSc (with distinction) in Real Estate from the University of Reading (UK). Adam has also published a range of real estate-focused papers, with his current interest being in asset pricing and market cycles. We have used a number of software packages and are very grateful to both EstateMaster and Argus for allowing an illustration of how their products support valuers. We are also extremely grateful to the contributors of the international perspectives, set out in Chapter 14. Sunny Han CFA MRICS MCIREA, Director, CBRE, Valuation & Advisory Services, Shanghai, China. David Cockerton BSc FRICS FInstCPD FCMI MCIArb Principal, Hyperion Consulting Group Limited, Real Estate Investment & Development Consultancy Services Lecturer, Heriot-Watt University, Edinburgh & Dubai. Board Member, RICS Global Education & Standards Board and Panel Member of the RICS MENA Market Advisory Panel. Thomas Dimopoulos MRICS, M.Eng., MSc, MPhil, CEO of ΑΧΙΑ Chartered Surveyors and Lecturer in Real Estate at Neapolis University. Board member of the RICS Cyprus, Expert Scientist at Cyprus University of Technology and board member of the Association of Property Valuers of Cyprus. Finally, for the many hours proofreading and checking for consistency, Nick s wife, Mandy.
Acronyms Acronyms are used throughout the text to simplify the presentation of valuation terms in regular use and to avoid the unnecessary repetition of the names of organisations, regulations and standards. Whilst this is mainly provided for the valuation examples, we have included all acronyms for completeness. It will help readers who like to chapter hop rather than those reading from beginning to end as acronyms are used consistently after the first introduction of the relevant expression. ACV ADR AER AI AI ALMR APC API APR ARY ASF AST AT AWP BBPA BCIS BREEAM BVI CE CLRA CoMP CPD CGT CQC CSR CV DCF DRC EBITDA Asset of Community Value Average Daily Rate or Average Room Rate Annual Equivalent Rate Appraisal Institute Artificial Intelligence Association of Licensed Multiple Retailers Assessment of Professional Competence Australian Property Institute Annual Percentage Rate All Risks Yield Annual Sinking Fund Assured Shorthold Tenancy Assured Tenancy Annuity 1 Will Purchase British Beer and Pub Association Building Cost Information Service Building Research Establishment Environmental Assessment Method Bundesverband Investment und Asset Management Certainty Equivalent Commonhold and Leasehold Reform Act Code of Measuring Practice Continuing Professional Development Capital Gains Tax Care Quality Commission Corporate Social Responsibility Capital Value Discounted Cash Flow Depreciated Replacement Cost Earnings Before Interest Taxation Depreciation and Amortisation
xx Acronyms EBITDAR Earnings Before Interest Taxation Depreciation Amortisation and Rent EC European Community ERV Estimated Rental Value EU European Union FMOP Fair Maintainable Operating Profit FMT Fair Maintainable Turnover FRI Full Repairing and Insuring (terms) (of a lease) FVIP Financial Viability in Planning GDV Gross Development Value GEA Gross External Area GDV Gross Development Value GFA Gross Floor Area GIA Gross Internal Area GOEF German Open-Ended Funds HA Housing Act HBU Highest and Best Use HMO House in Multiple Occupation IASB International Accounting Standards Board IBFC Income Before Fixed Charges IES International Ethics Standard IFRS International Financial Reporting Standards IR Internal Repairing IRFY Inflation Risk Free Yield IRI Internal Repairing and Insuring Lease IPMS International Property Measurement Standards IPMSC The International Property Measurement Standards Coalition IR Internal Repairing Lease IRR Internal Rate of Return IRRV Institute of Revenue Rating and Valuation ITZA In Terms of Zone A IVSC International Valuation Standards Council IVS International Valuation Standards LEED Leadership in Energy and Environmental Design LLC Limited Liability Company Lmi Leesman Index LRA Leasehold Reform Act LRHUDA Leasehold Reform Housing and Urban Development Act LTA Landlord and Tenant Act MDR Multiple Dwelling Relief MLV Mortgage Lending Value MR Market Rent (IVS) MV Market Value (IVS) NDV Net Development Value NER Net Effective Rent NIA Net Internal Area NPV Net Present Value NOI Net Operating Income pa Per Annum (per year)
PE PESTEL PLC PPM PRS PS PV Pv 1pa QS RA RADR Red Book REO RevPAR REITs RFR RICS RP RPI RV SCORFA SDLT SF SFR SIA SREA SSSI TEGoVA TEY TR TUPE UAE UBR UKVS USPAP VAT VP VPGA VPO VPS VRS WALE WAULT WAULTC WGBC YP Acronyms xxi Price Earnings Political, Economic, Social, Technological, Environmental and Legal Public Limited Company Planned Preventative Maintenance Private Rented Sector Professional Standards Present Value Present Value 1 per Annum Quantity Surveyor Rent Act Risk-Adjusted Discount Rate RICS Valuation Global Standards Reasonably Efficient Operator Revenue per Available Room Real Estate Investment Trusts Risk Free Rate Royal Institution of Chartered Surveyors Risk Premium Retail Price Index Rateable Value Special Commercial or Financial Advantage Stamp Duty Land Tax (Replaced by a Transaction Tax in parts of the UK) Sinking Fund Sinking Fund Return Security Industry Authority Standards for Real Estate Appraisals Site of Special Scientific Interest The European Group of Valuers Associations True Equivalent Yield Total Return Transfer of Undertakings (Protection of Employment) United Arab Emirates Uniform Business Rate UK Valuation Standards Uniform Standards of Professional Appraisal Practice Value Added Tax Vacant Possession RICS Global Valuation Practice Guidance Applications (RB) Valuation Professional Organisations Valuation Technical and Performance Standard (RB) Valuers Registration Scheme Weighted Average Lease Expiry Weighted Average Unexpired Lease Term Weighted Average Unexpired Lease Term Certain World Green Building Council Years Purchase (UK valuers term for PV pa)
1 The global framework This chapter considers the global requirements for the professional valuation of real estate and the global frameworks within which valuers operate. Introduction This book considers the application of the income approach to the assessment of the market value of real estate. Market value is explored in Chapter 5, but as this fundamentally underpins the entire book, the internationally accepted definition is given here: Market value is the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm s length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion. (International Valuation Standards 104) 1 Whilst this is a key definition it needs a contextual framework before considering the global requirements for market valuations. Cairncross (1982), in his Introduction to Economics, expresses the view that economics is really not so much about money as about some things which are implied in the use of money. Three of these exchange, scarcity and choice are of special importance. 2 Legal interests in land and buildings, which for our purposes will be known as property, are exchanged for money and are scarce resources. Individuals fortunate enough to have surplus money have to make a choice between its alternative uses. If they choose to buy property they may have rejected the purchase of other goods, services, alternative investments such as stocks and shares, or of simply leaving their money as savings or doing nothing. But a choice will have been made and having chosen to use their surplus money to purchase property they may then have to make choices between different properties. Pension funds, life assurance funds, investment funds, governments and corporate bodies around the world are also making investment choices, often on behalf of individual investors, between various investment opportunities including property. How do they make those choices and who advises them? Valuation is the applied discipline within economics that attempts to aid that choice, in terms of the market value of property and the yields obtainable from property investments. Value in this context usually means market value (value in exchange), but it may mean investment value or worth (Chapter 5), and valuers are the individuals who provide advice on market value of property and offer advice on the sale and acquisition of property. For a
2 The global framework property to have value it must have utility. If that utility is solely in terms of the current owner then it may have value to that individual but no market value. In the context of this book a valuer would normally be a member of the Royal Institution of Chartered Surveyors (RICS), or one of the other valuation professional organisations (VPOs) approved with the agreement of the RICS, who meet the qualification requirements set out in the RICS Valuation Global Standards 2017 (Red Book) Professional Standard (PS) 2 2.1 2.8, and who acts with independence, objectivity and confidentiality as specified in PS 2 3. But in other countries, similar professional bodies such as The European Group of Valuers Associations (TEGoVA) and/or licensing requirements (as in Singapore) exist to control or monitor the work of valuers. The following definition of valuer is given in the IVS Glossary: A valuer is an individual, group of individuals or a firm who possesses the necessary qualifications, ability and experience to execute a valuation in an objective and competent manner. In some jurisdictions, licensing is required before one can act as a valuer. Property is purchased for use and occupation or as an investment. In both cases the purchaser measures the expected returns or benefits to be received from the property against the cost outlay. The valuer s task is to express these benefits in monetary terms and to interpret the relationship between costs and benefits as a yield or rate of return, thus allowing the investor to make a choice between alternative investment opportunities. Since 1945, the property and construction industries have grown in importance; investing in property has been indiscriminately considered to be a safe investment. The position, post the banking crisis in 2007, aptly illustrated how dangerous it can be to make such an assumption. The growth in pension schemes, life funds, property unit trusts, as well as direct investment by individuals, has completed the transition of the property market into an international multi-billion pound industry. As a result, there has been a growth in demand for property to be valued in order to establish market value, and for it to be re-valued for portfolio and asset management purposes. It should be noted that the evolution of property investment markets has added significant complexity to the valuation process, with new forms of investment, occupation and globalisation challenging the traditional approaches. Understanding property as an investment asset class Property as an investment is different to other forms of investment. The most obvious difference is its fixed geographical location, hence the importance of the quality of that location for the land s current or alternative uses as determined by its general and special accessibility, and its interrelationship with other competing and complementary buildings, locations and land uses. More recently, the connectivity of real estate, such as the quality of its Internet infrastructure in terms of capacity and speed, has begun in some cases to erode the importance of its physical location. Once developed, the quality of the investment is influenced by the quality of the permitted planning use and the quality of the physical improvements (buildings) on the site. In addition, and essential to the assessment of exchange value, is the quality of the legal title. Is it the equivalent of the UK freehold, or is it time restricted in the form of a leasehold title? The owner of a freehold title effectively owns all the land described in the title deeds in perpetuity, including everything below it to the centre of the earth and everything above. Freehold rights may be restricted by covenants in the title and/ or by the rights of others, such as rights of way or by law, whereby certain mineral and other
The global framework 3 rights may be vested in the state. A leaseholder s rights are limited in time (the length of the lease) and by the terms and conditions (covenants) agreed between landlord and tenant and written into the lease, or implied or imposed by law or statute. The market value of a tenanted freehold property will also be affected by the quality of the tenant in terms of their covenant strength, and the quality of the lease in terms of the appropriateness of the lease conditions to that type of property used for that purpose in that location. In many countries, the legal framework evolves slowly and has a long history and tradition. In other countries, for example the United Arab Emirates (UAE), laws can and do change overnight, and this introduces the concept of the risk framework within which an asset sits. In the UK, for example, the risk of fundamental land tenure rights being changed is low, but in other countries these can change almost overnight making the risks associated with the legal framework a very different proposition. To be competent, the valuer must be aware of all the factors and forces that make a market and which are interpreted by buyers, sellers and market makers in their assessment of market price. In an active market, where many similar properties with similar characteristics and qualities are being exchanged, a valuer will, with experience, be able to measure exchange value by comparing that which is to be valued with that which has just been sold. This direct or comparative method of valuation is used extensively for the valuation of vacant possession, freehold, residential property; for the valuation of frequently sold and easily compared commercial, industrial and agricultural property, and to assess the market rent of all property. Differences in age, condition, accommodation and location can all, within reason, be reflected by the valuer in the assessment of value. Differences in size can be overcome by adopting a unit of comparison such as price per hectare, price per square foot/metre or rent per square foot/metre. The more problematic properties are those for which there is no ready market, those which display special or unique characteristics, those which do not fully utilise the potential of their location and are therefore ripe for development, redevelopment or refurbishment, those that are tenanted and are sold as investments at prices reflecting their income-generating potential and leasehold properties. For each of these broad categories of property, valuers have developed valuation approaches that they feel most accurately reflect the market s behavioural attitude and which may therefore be considered to be rational methods. Three approaches are recognised internationally: Cost Approach, Income Approach and Market Approach (IVS 105 RICS VPS 5). In the case of special properties, such as oil refineries, glassworks, hospitals and schools, the usual valuation method is the cost or contractor s method. It is the valuer s method of last resort, and is based on the supposition that no purchaser would pay more for an existing property than the sum of the cost of buying a similar site and constructing a similar building with similar utility written down to reflect the physical, functional, environmental and locational obsolescence of the actual building. This approach is sometimes referred to as a Depreciated Replacement Cost Approach or DRC for short. Properties with latent development value are valued using the residual or development (developer s) method (see Chapter 11). The logic here is that the value of the property (site) in its current state must equal the value of the property when developed or redeveloped to its highest and best use (legal, physical et al.), less all the costs of development including profit but excluding the land. In those cases where the residual sum exceeds the value in its current use, the property is considered ripe for development or redevelopment and, in theory, will be released for that higher and better use. All property that is income producing, or is capable of producing an income in the form of rent, and for which there is both an active tenant market and an active investment
4 The global framework market, will be valued by the market s indirect method of comparison. This is known as the investment method of valuation or the income approach to property valuation and is the principal method considered in this book. The income approach and the income based residual approach warrant special attention if only because they are the valuer s main tools for valuing the most complex and highly priced investment properties. Comparing property to other asset classes There are three main investment asset classes stocks and corporate bonds, equity shares and property. An investment can be described as an exchange of capital today for future benefits, generally in the form of income (dividends, rent, etc.) and sometimes in the form of capital. The investment income from property is the net rent paid by tenants. The market price of an investment is determined in the market by the competitive bids of buyers, for the available supply, at a given point in time, under market conditions prevailing at that time. Short supply and high demand that is scarcity will lead to price (value) increases, whilst low demand and high supply will lead to falls in prices and values. The definition of market value requires the valuer to express an opinion of the market price that the valuer believes would have been achieved if that property had been sold at that time under the market conditions at that time; hence the importance of market knowledge and market comparables. The unique characteristics of property make property investment valuation a more complex art and science than that exercised by brokers and market makers who are in the market for stocks and shares. In the stock market, sales volume generally allows for price (value) comparison to be made minute-by-minute. As stocks, shares and property are the main investments available, there is bound to be some similarity between the pricing (valuation) methods used in the various markets and some relationship between the investment opportunities offered by each. A basic market measure is the investment yield or rate of return. The assessment of the rate of return allows or permits comparison to be made between investments in each market and between different investments in different markets. There is a complex interrelationship of yields and patterns of yields within the whole investment market. In turn these yields reflect market perceptions of risk and become a key to pricing and valuation methods. An international framework Having looked briefly at the general economic principles underlying market value and the practice of valuation, we now need to consider the growing and changing international framework within which valuers must increasingly operate. The first edition of Real Estate Valuation in Global Markets 3 was published in 1997 and the second edition in 2010. Over the intervening 13 years the book expanded from covering valuation practice in 21 countries to covering valuation practice in 47 countries. So what is happening to real estate worldwide, and what is the framework within which valuers and appraisers operate? Several important changes have occurred which will continue to influence the level of demand for real estate worldwide and hence the demand for valuations of real estate to be
The global framework 5 undertaken on a consistent basis by qualified valuers. These can be listed in no particular order as: faster communications; freer accessibility to knowledge; freer movement of labour; increased corporate demand for property worldwide, i.e. companies operate globally not federally; emergence of China and India as major economic players; faster transportation of materials and finished goods; and international growth in money exchange and financial services. A few examples illustrate these points: n n n n n n n n pension and investment funds are no longer investing solely in their country of origin, they are investing through stock markets and in property on a worldwide basis; rich individuals are looking to buy property in countries they visit on a regular basis, and expect to find the same products and services away from home as they do at home; corporate organisations are moving manufacture to countries with lower labour rates, thus providing increased employment opportunities and consumer expenditure; other corporate organisations are franchising or marketing their goods and services on an international basis, for example fast food outlets whether selling burgers, coffee or sushi can be found in developed and developing countries. This extends beyond fast foods to banking, luxury clothing and office demand from insurance and other financial services providers; mergers and takeovers mean that multi-billion dollar enterprises have real estate requirements around the world; air transportation means that international agric-industries can take advantage of crop production far from traditional market places; the most recent phases in mobile electronic communication allow populations around the world to buy and sell in ways not heard of 20 years ago; and international airports are a microcosm of these changes where the familiar international brands are on display competing with the less familiar national products. This change in the way land and property is demanded on an international rather than a national basis means that users and owners need reassurance on a range of matters. They need to know that: descriptions of property in terms of floor areas and gross build area have the same meaning throughout the world. The issue is whether a square foot/metre of office space is the same in New York as in Delhi or Bucharest. when a valuation of property is provided, be it a capital value or rental value, it is on a consistent international basis and that the value is clearly and precisely defined; market value is always market value unless otherwise defined; valuers are licensed or members of a professional body are qualified, and so will act with integrity and within an ethical code; and all other professional advisors, such as architects and engineers advising on aspects of construction and condition, are qualified and professionally responsible.
6 The global framework Currently, assurance on these and other matters has to be clarified as and when property is sought for purchase or to lease in each and every country, or needs to be valued for purchase, sale or to meet international financial reporting standards (now on the basis of fair value). An international framework is emerging and instructions can be couched in terms of these emerging standards. International standards The following international standards are being adopted worldwide, and this allows users of valuations to specify the standards that are to be applied. 1 The International Valuation Standards (IVS) The IVS are standards for undertaking valuation assignments using generally recognised concepts and principles that promote transparency and consistency in valuation practice. The IVSC also promotes standards for the conduct and competency of professional valuers. 4 The IVS covers: IVS 101 Scope of Work; IVS 102 Investigations and Compliance; IVS 103 Reporting; IVS 104 Bases of Value: this includes Market Value and Market Rent, Equitable Value, Investment Value/Worth, Synergistic Value, Liquidation Value and Fair Value for various reporting requirements (IFRS, OECD, etc.); and IVS 105 Valuation Approaches and Methods including Market Approach, Income Approach and Cost Approach. The RICS Valuation Global Standards 2017 (Red Book) is IVS compliant. In Europe most countries have membership or certain European Professional Valuer bodies are members of TEGoVA who recommend through their own standards compliance with IVS, unless contrary to state requirements. The increased awareness of IVS through professional bodies and governments around the world means that there is growing acceptance of the IVS definition of market value; adoption of ethical codes following the International Valuation Standards Council (IVSC) principles; and the recognition and application of the three principal valuation approaches. However internationally there are considerable variations in the measurement of buildings and space and in the way each approach is applied. One significant change has been the gradual shift in emerging markets such as South America, East European countries and Far East countries away from a belief and sometimes government requirement for value to be based on cost towards the two market based approaches. 2 International Property Measurement Standards (IPMS) The International Property Measurement Standards Coalition (IPMSC) is a group of 70 professional and not-for-profit organisations from around the world, working together to develop and implement international standards for measuring property. 5 IPMS is not about how to measure, indeed in many countries the only individuals allowed to measure buildings and spaces within buildings are qualified architects,
The global framework 7 engineers or those qualified in geomatics/surveying. It is about the area that has to be measured for different property types for different purposes. Currently this could mean that a property s floor area could vary by as much as 24% 6 depending on which basis is being used. A typical variation is encountered in the case of office space. In one country this might be measured by taking the area between the external faces of external walls including balconies and immediate hard surrounds and including all internal circulation space; whilst in another country it might be measured from the internal surface of external walls excluding balcony areas, columns, toilet and kitchen areas. Unless specifically covered in a valuer s report, the client could lease space, agree a rent for space or a purchase price expecting a building to provide a particular amount of usable space (undefined for the moment), only to find the actual space is 20% smaller than expected. Clearly this also makes for problems in comparing rents per square foot/metre. Certain trades require a specific amount of retail space to display their range of merchandise and might find the space rented a thousand miles away is too small or too big. It could also be the case in some countries that measured areas are different for different purposes. So measurements for assessing space for local taxation purposes might not be the same as for valuation purposes. IPMS Office Buildings has been published and adopted in the UK by the RICS (see Chapter 5 for details). In time IPMS will be rolled out for all other property types and hopefully IPMS will begin to be adopted globally. This may lead to dual methods being followed until the new IPMS replace all existing state requirements. Meantime it is important for definitions of areas used to be defined for international clients. 3 International Ethics Standards (IES) The IES has published a set of ethical principles which relate to a range of professions involved with real estate and construction. This embraces the general principles covered by the IVSC Code of Ethical Principles and is recognised by the RICS (PS 2). 4 International Financial Reporting Standards (IFRS) Many organisations, corporations and funds are required to prepare annual financial reports or statements of account, for example companies and entities such as Nestlé, Apple, Starbucks, HSBC, Canadian Teachers Pension Fund and many thousands more. These organisations have operational property and/or investment property in various locations around the world. Many will prepare accounts in accordance with the IFRS as these are those recommended by the International Accounting Standards Board (IASB). Whether applying IFRS or other national standards, it is a normal requirement to include a statement as to the value of assets and liabilities. IVS Asset Standards cover: Business and Business Interests (IVS 200); Intangible Assets (IVS 210); Plant and Equipment (IVS 300); Real Property Interests (IVS 400); Development Property (IVS 410); and Financial Statements (IVS 500). IFRS and IVS provide for value to be on the basis of fair value (Chapter 5) in appropriate circumstances, which is similar to market value but expressed in accounting terms. It is an increasing requirement of accountants instructing valuers around the world to require valuations to be prepared in accordance with IFRS and to do so requires them to follow IVS.