Please could you explain how to allow for future costs and liabilities in the valuation of freehold and leasehold interests in property?
Karl Wiggins, in the Property Valuation Handbook (Section A1 — “Principles of Valuation”, published by the College of Estate Management) summarises this issue in the following terms:
Sometimes a leaseholder is liable to pay a premium at some future date, or an owner may incur a major capital sum such as street works charges or replacement of boilers. This type of expenditure can be treated in one of two ways:
(1) An annual equivalent sum can be set aside against such liability, in which case an “annual sinking fund” can be deducted from the income.
(2) The future cost is deducted from the capital value, but is first discounted at an appropriate rate of interest, which is usually the discount rate for the property investment.
However, the continuance of inflation as a major economic problem suggests that replacement cost should be adjusted upwards before being annualised or discounted.
There must be many practising valuers who were taught to handle future costs at the rate appropriate to the property and liabilities at the accumulative rate, but this approach is totally inappropriate today. Student scripts would also suggest that there are still many who cannot distinguish between costs and liabilities, and who have difficulty in handling the final point on inflation made by Karl Wiggins.
In every valuation it may be necessary to make an adjustment for sums of money to be paid out or received in the future. The first question to be asked is whether the amount is fixed and certain, or variable and uncertain.
Examples of fixed sums include future premiums and foreseeable compensation due under the Landlord and Tenant Act 1954 Part II.
Example
Value the freehold and leasehold interests in shop premises where the tenant has agreed to pay a rent of £5,000 per annum net plus a premium of £5,000 due in two years’ time. The full rental value is £7,500 and the rent is due for review in three years. The freehold market capitalisation rate is 7%.
In this case it is important to note that the future premium of £5,000 has been determined and written in to the lease so that the payment date is certain. Any rational buyer of the freehold would recognise that the £5,000 represents additional value but should equate that future sum to a present sum which could accumulate for certainty to £5,000 in two years’ time. The acquisition today of any two-year dated government stock is the acquisition of a known certain return on cost if held to redemption — this level of return can sensibly be adopted as the rate to use for discounting this future certain sum.
The use of money market rates is more logical than the property rate, because it would be illogical to place a different present value on this £5,000 simply because it is to be paid by the tenant of a 7% property rather than the tenant of a 5% or 10% property.
Thus the freehold conventional valuation might appear as:
A traditional approach to the leasehold would have appeared as:
This case produces a negative value of £550. The question to be asked is whether a buyer of the leasehold has the same investment opportunities as the buyer of the freehold, or would he be restricted to the fiction of the 4% fund. The rational view is that if a buyer of the leasehold wanted to provide for the £5,000 liability in two years’ time he could do so on the same favourable yield terms as are available to the freeholder, in which case the value becomes £4,072 – £3,986 = £86. Thus the guaranteed yield from short-dated stock is an acceptable rate to use. At worst one should use a typical building society net-of-tax rate. This argument can easily be developed to question the whole methodology of dual rate valuations, and would leave one with the only defence for using this method being that “that is what the market does”. (Perhaps this is the clearest case of valuers making the market.)
The same approach could be adopted in valuations where it is known that Landlord and Tenant Act 1954 loss of security of tenure compensation is to be paid to a tenant in a few years’ time.
A more complex problem exists when dealing with the less certain issue of future costs. Following detailed inspection of a property a valuer might conclude that a new boiler or new roof will be needed in five years’ time. Obviously there is a major difference between theory and practice, but logic would suggest the following approach in, say, a residential valuation.
Example
Value the freehold interest in a semi-detached house. The surveyor’s report indicates that the boiler is 10 years old and will need replacement in five years’ time. The current cost of supplying and fitting a replacement boiler is £2,500 based on evidence relating to other similar properties on the same estate. Comparable properties with new boilers are selling for £40,000, those with old boilers with future lives of three to five years are selling for £38,000.
Here the answer is simply £38,000. The full cost of £2,500 has not been deducted from the £40,000 because some value still attaches to the existing boiler with an estimated life of five years.
In the commercial and industrial markets the same problem is complicated by the absence of comparables. Comparable evidence will generally be available on rental and capitalisation rates, but rarely available for an identical unit with a new boiler.
Example
A freehold office block is to be valued. The surveyor’s report indicates that the central heating plant will need replacement in five years’ time. Today’s cost would be £25,000. The market value ignoring this factor is £500,000. The liability rests with the freeholder.
The well-advised buyer will not pay £500,000 because of the known — but uncertain — liability. How much will, or should, the value be affected by this fact? Until very recently the solution would appear as:
In the first place any rational buyer making a lump sum provision or setting up a sinking fund will do so at market rates. Hence, as above, a market rate of, say, 12% might be used. But £25,000 is today’s cost, when logic demands that it is the cost in five years’ time that must be provided for. What will be the cost in five years’ time? This is one element of the uncertainty: it will probably be more than £25,000 because of inflation — but how much more? The point here is whether boiler replacement costs will rise faster than inflation and money market interest rates, or slower than such rates? The second element of uncertainty relates to the replacement date — supposing it breaks down completely in a year’s time?
Fortunately for this article we happen to know that replacement boiler costs are rising by 6% pa and we can invest at safe net rates of 9.5%. So:
OR that costs are rising by 15% per annum:
In these conditions the valuer’s judgment is all-important. Logic suggests that if the existing boiler still has some life it would be wrong to reduce the value by the full £25,000. It also suggests that if future costs are rising faster than one can save money then there is no point in deferring the replacement, so that the full £25,000 should be deducted. It finally suggests that if costs can safely be assumed to be rising at a slower rate than savings then a sum less than £25,000 should be deducted and replacement deferred as long as possible.
What we can conclude is that the methods of treating future costs and liabilities illustrated in the textbooks published before the recent inflationary era cannot be used at the present time. The valuer must be aware of the implications of inflation to all valuations. Second, but perhaps less obviously, there is no real sense in treating costs and liabilities to freeholders and leaseholders differently merely because one is an owner and the other is a tenant.
