In the previous article on asset valuations (March 23, p 123), the definition of “open market value,” as applied to non-specialised property assets, was considered. This article looks at the alternative basis of valuations, depreciated replacement cost (DRC).
The depreciated replacement cost basis of valuation is usually appropriate to the valuation of specialised properties where it is difficult to apply the open market value definition because the property is of a type which is rarely, if ever, sold on the open market. The basis will be applied to large industrial installations such as chemical works, oil refineries, power stations and dock installations and other properties which, by virtue of their size, construction, location or arrangement, are unlikely to be sold in the open market for the continuation of their existing use.
This will be a familiar concept in the context of valuations for rating using the contractor’s test method and requires an estimate of the gross replacement cost of the buildings, subject to allowances to reflect the differences between the existing property and its new replacement. This is then added to the value of the land in its existing use. The valuer should be concerned with the cost of a modern substitute building of the same floor area, using modern building techniques and materials, and not an identical replacement. In some cases, because of technological change, it may be necessary to assume a replacement building of smaller size. The replacement cost will take account of professional fees and finance charges, which may be considerable in the case of very large complexes that would take many years to develop. Any grants or other concessions which might be available should be reflected, as appropriate, after consultation with the client. Specific reference should be made to such items in the report.
The replacement cost thus established needs to be adjusted by appropriate allowances, under the headings of economic and functional obsolescence and environmental factors, to take account of the quality of the existing building when compared with its notional replacement. These adjustments will reflect the age and condition and maintenance costs of the existing building compared with its modern equivalent and will take account of its suitability for the present use.
The open market value of the land for its existing use is then added to the adjusted replacement cost to give the total value of the asset. In valuing the land it will be normal to assume the benefit of a planning permission which could reasonably be expected to be granted. This may amount to planning permission for the replacement of the existing or modern substitute buildings; alternatively, where such a use cannot be assumed, it may be appropriate to assume a planning permission for a use prevailing in the vicinity. SAVP 3(*) provides the example of the valuation of the land element of a museum standing in a residential area where the land should be valued with the benefit of planning permission for residential development. Again, this will be a familiar concept to those involved in the valuation for rating purposes of properties such as schools.
DRC valuations must always be qualified as being subject to the “adequate potential profitability of the business compared with the value of the assets employed” (SAVP 3). Specialised buildings enable a company to operate its business and generate profits. It may be that the business is not sufficiently profitable to carry the property in the balance sheet at the full DRC, and in such cases it may be necessary to adopt a lower figure to provide an adequate return. It is not, however, the responsibility of the valuer to make this determination but that of the directors of the company. The valuer is simply required to make his DRC valuations subject to potential profitability. This adequate potential profitability test will not apply to many specialised public sector buildings which are not operated for a profit and here DRC valuations should be made subject to “the prospect and viability of the continuance of the occupation and use”. Other special considerations applying to the public sector are outlined in Information Paper 14.
Valuations made on the DRC basis should be separately identified in the report and the valuer should give an indication in the certificate as to whether the open market value of the property is likely to be higher or lower than the value reported.
Depreciation
For profit and loss accounting purposes most companies are required by law to depreciate fixed assets with a limited useful life, over their estimated economic life expectancy. The amount of depreciation suffered by all assets over the accounting period needs to be charged to the profit and loss accounts.
Depreciation is defined in SAVP 18:
Depreciation is defined as the measure of the wearing out, consumption or other reduction in the useful economic life of a fixed asset whether arising from use, effluxion of time or obsolescence through technological or market changes.
It is clear that the majority of buildings, both specialised and non-specialised, will suffer from some form of depreciation, but that in most cases land (with the exception of leasehold interests and mineral assets) will not. It will usually be necessary, therefore, to apportion the value of assets so that the depreciation on the wasting element can be calculated. This is known as the “depreciable amount” and will be calculated either by deducting the existing use value of the land from the valuation of the asset or by assessing the net replacement cost of the buildings. The depreciable amount is then divided by the number of years of future economic useful life to find the amount of depreciation suffered during the accounting period. Valuers will therefore be required to make some assessment of the future economic life of buildings to be valued.
Valuation procedure
The appendix to SAVP 1 contains a useful checklist of the main areas which should be considered by the valuer in carrying out an asset valuation, but will also be of general interest to valuers carrying out valuations in addition to those covered by the Guidance Notes.
The valuer must always confirm the instructions with the client. It will be necessary to establish the purpose of the valuation, the properties to be valued, plant and machinery to be included in the valuation of buildings, and the valuation date. The valuer should also identify with the client the classification of different properties.
An inspection of the properties to be valued will normally be carried out to establish all those physical factors affecting value. This will include the characteristics of the locality, communications and other facilities.
For each building it will be necessary to establish the age, description, use, accommodation, construction, installations, amenities and services as well as appropriate dimensions and areas of all buildings and land. The condition, state of repair and site stability will also be noted.
Additional relevant factors which cannot be determined by inspection will need to be established by reference to other sources of information. These will include legal matters such as the nature of the interest, tenure, terms of leases where appropriate, easements and restrictions, along with details of lettings and any other occupations as well as any outgoings and rating assessments. Inquiries will be made with the appropriate authorities covering other matters including town planning, highways, statutory requirements and notices.
As with any valuation, once the facts relevant to the property have been established it will be necessary to consider market conditions and trends and to identify comparable market transactions. Where the DRC basis is to be used it will also be necessary to consult evidence of building costs and factors to be used in quantifying obsolescence.
Valuation certificates
The opinion(s) of value will be reported in a valuation certificate and, if it is to comply with the Red Book this must include a statement to the effect that the valuations are made in accordance with the statements of asset valuation practice. Any departure from this must be clearly stated with reasons.
The basis of valuation must be identified and any qualifying words should be explained. Sources of information should be identified and any assumptions made should be stated explicitly and fully explained.
The certificate will identify whether structural surveys or service tests have been carried out and reference to the general state of repair will be made. Comment will be made on latent defects and deleterious or hazardous materials. The certificate must include a clause which prohibits publication without consent and will normally include a saving clause regarding third party liability.
Where there are a number of properties involved it is normally necessary to set the valuations out on a schedule to be appended to the certificate. These will generally be summarised within the certificate itself, dividing the properties into their individual categories. The categorisation of individual properties will be determined by the client but, on receipt of instructions, the valuer should satisfy himself that these are consistent with normal accounting and valuation practice. It is up to the valuer to seek clarification where any doubt exists.
Appendix 1 to SAVP 4 provides a check list of items which would normally appear in the valuation certificate, and Appendix 2 gives examples of schedules to be appended to the certificate.
The asset valuer
The valuation certificate will be dated and this will normally be the date of valuation. It will be signed by the valuer, identifying name, address and qualifications. The asset valuer is defined in SAVP 8 as a corporate member of one or more of the three bodies, RICS, ISVA or IRRV, and he must in addition have appropriate post-qualification experience and knowledge of valuing land, buildings and, where appropriate, plant and machinery, in the class and category of asset concerned.
Where the asset valuer is acting as an independent valuer, as is required in certain cases, it is the valuer’s responsibility to ensure that he has no other connection with the property to be valued or with any interested parties. It is also up to the valuer to seek sufficient information from the client to ensure that there is no danger of a conflict of interests arising. This is no mere formality as, in any case, the new regulation requires the valuer to make a statement in the valuation certificate confirming that he conforms to the requirements of SAVP 8.
The table (above) summarises the application of the different bases of valuation as applied to the different categories of fixed asset.
Although the contents of the Red Book are directly concerned with valuations carried out for a range of specific purposes that will normally be the province of the specialist valuer, they should be regarded as essential reading for any valuer concerned with the valuation of property assets, for whatever purpose. A number of useful illustrations of asset valuations, including calculations of the depreciable amount, can be found in Valuation Principles into Practice, by W H Rees, Chapter 16.
Acknowledgement
Extracts from the Statements of Asset Valuation Practice and Guidance Notes are reproduced by kind permission of the RICS.
The “Red Book” is available from RICS Books, 12 Great George Street, London SW1P 3AD.
(*) RICS Statements of Asset Valuation Practice and Guidance Notes (The Red Book).
