The Queens Moat debacle brought unprecedented media attention to bear on the shortcomings of UK valuation. In the latest of her American reports, Rachel Frampton finds out if there are lessons to be learnt from the US.
The highly publicised dispute over the Queens Moat hotel valuations has once again raised embarrassing questions for the surveying profession. Why should two respected firms of surveyors produce such widely differing figures on the same valuation? How do valuers arrive at their conclusions? Can the financial community and the public at large have any confidence in our valuation process?
The American property profession is generally believed to adopt a more sophisticated approach to property valuation. It routinely uses a variety of techniques, including discounted cash flow analysis, to assess value and to predict how individual investments will perform over a given time.
But the US profession has also come in for its fair share of criticism, most notably following the savings and loans catastrophe in the 1980s, when thousands of small financial institutions which had invested heavily in property went bust almost overnight.
As the valuation committee, instigated by RICS president Clive Lewis and led by Michael Mallinson, sits down to consider the quality and reputation of property valuation in the UK, it might also do well to review some of the strengths and weaknesses of the US approach.
Valuation in America has traditionally been governed by the Appraisal Institute. As is the case with the letters ARICS or FRICS, the letters MAI (Member of the Appraisal Institute) are intended to signify that an individual has the necessary professional training to carry out competent valuations.
It can take up to five years to qualify as an MAI. Training consists of a mixture of courses and on-the-job experience, during which valuers submit sample reports to the institute for assessment.
MAI appraisals typically consist of three separate valuations done on three bases: income; sales comparable; and replacement cost. The results of the different valuations are then used to deduce a “final answer”, usually with most emphasis placed on the income-based assessment of value.
An income approach that includes projected rental values is more common than the UK practice of applying an all-risks yield to the current rental value. This is because the shorter US leases, traditionally five or seven years with set rental uplifts, make the current income less meaningful during a 10- or 15-year period.
In addition to the shorter lease pattern in the US, however, there are other factors which make income assessment more complex than it is in the UK. There is no such thing as an FRI lease; the landlord is usually responsible for far more of the running costs, including cleaning and utilities bills, and charge expenses back to the tenants at separate rates.
Arriving at a net income for a single year or for a 10-year period is not straightforward, and it is against this background that the use of discounted cash flow analysis has become common.
At least four or five comparables are usually included to back up the sales comparable section of the MAI analysis, although there is no absolute requirement for this. Details of the deals have to be confirmed directly with a principal in the transaction. A price per square foot is derived from a study of the comparables, which is then used to value the subject property.
The cost approach consists of three elements: the land’s value if it were vacant; the current cost of replacing the building; and a deduction to allow for depreciation owing to physical or economic factors affecting the existing building. It is usually the least relied upon of the three valuations. The Appraisal Institute’s guidelines require each of the three approaches to be fully documented, with lengthy preambles explaining methodology and assumptions. This provides a comprehensive, if somewhat cumbersome, report to the client which can often be several inches thick, even for a relatively straightforward valuation.
UK-trained surveyors who have tackled MAI reports tend to be disparaging about the approach. The reports can often be stronger on quantity than on quality, they say.
Colin Elliott, who runs Jones Lang Wootton’s San Francisco office, reveals that the MAI designation is sometimes unkindly taken to mean “made as instructed”.
“Some MAIs are very clued in and have a good feel for the market, but by and large the standard is pretty poor,” he says. The attempt by the Appraisal Institute to lay down rigid laws governing the way in which valuations should be carried out has led to a ‘lowest common denominator’ effect,” he explains.
Robert Upton, principal at Knight Frank Baillieu’s San Francisco office, agrees. “The MAI valuation approach has been pretty well completely discredited during the past five years or so and the response has been to write even tougher rules.”
There is an unnecessary amount of narrative background information required, says Upton. Geographic and climatic influences on the building can seem to take precedence over the opinion of value. He cites one MAI valuation which began with the immortal words: “California is well-situated halfway between Canada and Mexico.”
“They are trying to make the appraisal process scientific, pretending it is a statistical process. They are denying the ability of the valuer to make a professional judgment, or to have a professional opinion,” says Upton.
The DCF technique has aggravated this problem because, while it relies on statistical analysis of many factors, it also calls for sound judgment on the part of the valuer as to likely rental growth, as well as what the appropriate discount and capitalisation rates should be.
“DCF was widely used in the 1980s and got a lot of people into a lot of trouble because it all depends on the assumptions you make. When the market was generally assuming around 5% annual growth in rents, some people were assuming 10%,” explains Upton, adding: “A lot of appraisers use DCF legitimately, but the damage was really done when buyers started hiring MBA graduates to sit in front of computers and churn out pages and pages of assessments that were flawed by the quality of the analysis.”
For valuers to make accurate assumptions, they need to be in close contact with the market. In the US, however, the appraisers are often totally isolated from the brokers who are involved with letting and selling buildings. Even in large firms such as Grubb & Ellis, C B Commercial and Cushman & Wakefield, there can be little contact between the appraisers and the brokers. Because brokers are working on their own account and are entirely transaction-motivated means there is little incentive for them to share information on comparables with their appraisal colleagues.
Even between different appraisers, trading comparables is no simple matter. Agencies have been set up which specialise in selling comparable information to valuers at $20 a throw, reveals Colin Elliott.
“The appraisal industry by and large in the US is a kind of cottage industry,” says Elliott. He points to one-man shops that have no involvement in the brokerage market. Large pension funds putting together year-end valuations of property which they own throughout the country can get a fragmented view. Pension funds are taking a national view, but they are being focused by up to 10 different local appraisers.
The fragmented nature of the industry has, in the past, created plenty of opportunity for questionable valuations, Elliott believes. “In the late 1980s, developers put incredible pressure on local appraisers to give them the answer they wanted. Some of the reports I have seen were clearly corrupt.”
Since the savings and loans collapse, the US government has stepped in to provide more regulations governing property valuation. Under the 1989 Financial Institutions Reform, Recovery and Enforcement Act, each state is required to license valuers according to standards set by the Appraisal Foundation, an independent body based in Washington.
Only state-licensed valuers may conduct valuations of “federally related real estate transactions”. Since most banks and lending institutions are regulated by federal agencies, this means that, in practice, a significant proportion of commercial property investments fall under the FIRREA rules.
The Appraisal Foundation has issued 10 Uniform Standards of Professional Appraisal Practice to date, as well as a number of statements which expand on points such as DCF, confidentiality and reasonable exposure time for assessing market value. These USPAPs are the closest equivalent that the US has to the RICS Red Book.
The definition of market value used by the foundation is: “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 . . .”
Despite the litigious nature of business in the US, the fallout from the savings and loans collapse has not generally landed appraisers in the courtroom. “It’s a cottage industry,” repeats Elliott. “There’s nothing to sue.” Even appraisers working for large national firms are working on their own account; their firms have only a limited liability for professional negligence. “That is partly why MAIs follow these lengthy procedures. Their answer is ironclad, even if it is wrong,” remarks Elliott.
In contrast to the UK, fees for valuation work may not reflect the value of the property being assessed. Most valuations are undertaken for a flat fee, which can be as low as $4,000, according to Elliott. At the top end of the scale, MAI valuers charge up to $25,000.
International firms such as Knight Frank Baillieu and Jones Lang Wootton try to avoid lengthy MAI valuations. “It’s not worth our while,” says Upton. They tend to use a hybrid of UK methods while still including the type of income analysis that is necessary in the US market. Fees are usually agreed up front, based on an hourly rate.
Information technology is making its own mark on the US valuation profession. It is common practice, says Elliott, for clients to ask appraisers to hand over their computer disks showing the workings of their valuations. One of the most widely used programs is PROJECT, which has become something of an industry standard, according to Elliott. Chicago-based PROJECT claims to have more than 50% of the US valuation software market, and is used by most of the leading firms. It crunches figures on a number of bases, including cash flow, occupancy patterns and market statistics. It is installed in 4,000 companies around the country and has sold some copies into the UK market, albeit mainly to US companies.
Elliott believes that the emphasis on detail in American appraisals is an important lesson for the UK. “In Britain you are starting to see much more back-up and supporting evidence as to how you got to your answer. Clients want more and more detail on comparables, rental levels and so on, and the industry as a whole has to be client-led,” he comments.
“The lesson we are learning is that, at the end of the day, we are a service industry. The client doesn’t want a big report. What they do want is an intelligent, well-argued report that gives them enough back-up.”
