Please could you outline the main points of the Royal Institution of Chartered Surveyors’ research report on “Property Valuation Methods”.
This report has grown out of the initiative taken by the RICS in 1975 to investigate valuation practice. As Tony Johnson says in his foreword to the report (the intention was) “… to seek out the way in which valuers went about their work and to suggest practical improvements to those methods”. Andrew Trott, the appointed research officer, continues by emphasising “the need to identify practical solutions usable in the day-to-day work of the valuation surveyor and within the ability of the average practitioner”.
The appointed research institution was the Polytechnic of the South Bank and it was here that initial studies were undertaken culminating in an interim report in June 1980. The interim report (which is not generally available) was followed by further investigations into specific topic areas. The current report contains a resume of the earlier findings and reports on the selected topic areas. The full report of 171 pages is available from the RICS at £20. The comments that follow are intended for students who may not have the money or the time to spare to read the report, but who could be expected to have some knowledge of the report. It is not a review of the report.
First, the diligent student can relax in the knowledge that there is little in the report that is entirely new, although in the topic areas there is now some research to support views expressed by academics in published material and in unpublished higher degree theses. In particular we can note the early pathfinding ideas of Dr Greaves and Dr Wood in their Reading University theses of 1972 supported by the broad findings of this research project.
For students it is perhaps simplest to address the issues of freehold and leasehold valuations and to indicate the research findings relative to each. While doing so it is important to remember that market value represents the present worth of future net benefits of ownership as seen at a point in time and as perceived by those in the marketplace. Thus the underlying issue is not “should future benefits be discounted to arrive at their present worth” but “are the methods used in the practice of undertaking such a discounting exercise acceptable” and if not can they be improved upon and yet remain “within the ability of the average practitioner”.
The issue then, as recognised by economists for generations, is that of assessing net benefits and selection of interest rates for use in the discounting process. Practising valuers appear to have established their own ways through this extremely complex issue and it is those practice routes which have been studied and which under some market conditions have been found to be lacking rational explanation.
At the interim stage the research looked at a number of different valuation methods used in practice for valuing freehold interests in property. In particular, hardcore (layer) approaches, equivalent yield, equated yield, real value, Greenwell’s compound-interest method, as well as the purer DCF techniques, were considered.
Each of the practice techniques is a method of assessing the present value of an investment and thus each, as noted by the report, is a form of DCF. The difference lies in the assumptions implicitly and/or explicitly made in each approach.
Students today are well aware of the dangers of using implicit methods in the absence of direct comparables where the specific investment falls outside a normal income review pattern and/or when a valuation is required of an abnormal property and/or when a valuation is required in abnormal market conditions. The problem is one of insufficient comparable data, and inaccurate valuations can arise if reliance is placed on subjective adjustments made to the incomparable in an effort to make it comparable.
Because much of this discussion was covered in the interim report and only cross-referenced in the current report it is necessary for us to illustrate a few of the issues in our own way.
The investment valuer actively engaged in a strong market will know that a specific class of rack-rented freehold property will sell on a 7% basis. This figure of 7% is known as an all-risks yield (ARY) and reflects all the bad points and all the good points; it will reflect expectations of income changes in the future in line with lease provisions and is a reflection of expected changes flowing from changes in the national, regional and local economy. It is market-derived and applied, like a price earnings (PE) ratio, to the current rack-rent passing in perpetuity to derive capital value.
If the subject property differs in any way, then the valuer endeavours to overcome the differences by adjusting the ARY in whole or partially in respect of a particular tranche of income. Such adjustments may well be superficial and largely meaningless but can, if misapplied, produce erroneous valuations. This point has been recently considered in these columns (May 31 1986).
But for the sake of completeness we will look at £10,000 a year 7% property and consider its valuation if let at £8,000 a year with two years to the review. (See top table below.)
Some valuers, believing there to be more security attached to a lease rent than the open market rental value at review, seek to reflect this in their valuation. In effect arguing that the purchaser, who will buy rack-rented property on an ARY basis of 7%, will be willing to pay more than the loss of two amounts of £2,000 at 7% would suggest. (See bottom table below.)
The research studies included this and related issues. For our readers we must point out that the sophistication introduced by the valuer in the term and reversion is not easily supported in practice, as here the difference in opinion (£203) is marginal and would be lost in the valuer’s overview figures of, say, £140,000. The sophistication is questionable when (a) the ARY of 7% was in the first instance an opinion not fact and when (b) the £10,000 rental value is an opinion not fact. In the case of the layer method the danger is obvious — this loss of £2,000 a year for two years has resulted here in a valuation £6,000 higher than the comparable rack-rented property. Certainly it is possible by trial and error or by reference to the term and reversion finally to produce rates per cent which will produce a figure of £139,437. But the market does not work like that. For this reason and others the RICS research argues that the hardcore method should not be used — if in its use the rate per cent is changed as between tranches of income.
There are historical reasons, which may reappear, for wishing to do something to the rates used. In the depression of the 1930s rented property was more secure. In the 1970s, current rent during the period of the rent freeze was more secure than rent on review. But the 1930s case has to be examined in the light of the 1930s money and investment market. The 1970s case must be similarly examined and in hindsight can be seen to be only part of the valuer’s dilemma at a time when the market ceased to operate as a normal market.
When the specific investment falls outside a normal income pattern, such as when the reversion is in 10 years, then the subjective adjustments to yields adopted by valuers in the absence of market comparisons become even more questionable, and it is doubtful whether any traditional valuation method can handle the problem sensibly.
Where a valuer uses the term and reversion method or the hardcore method and keeps the same rate per cent throughout, the approach probably complies with the RICS research report’s recommendation of using the equivalent yield method. Students will be aware that every investment given a specified cash flow has an internal rate of return. The method used by a valuer to value is, in part, immaterial to the investor who analyses to find the IRR. Thus, given that the investors decide to buy because the IRR is acceptable, then valuers might sensibly in terms of comparable properties value on a same or equivalent yield basis, ie on the basis of the IRR.
The report also considers the nature of the valuation tables used by the majority of valuers. In particular, while noting the tendency for valuers to use (as we have) Parry’s Valuation Tables, a considerable element of the report is taken up arguing for the use of more relevant quarterly in advance tables to handle quarterly in advance rents. An important issue but one which does not go far enough as articles in this series and by David Bornand of Sheffield Polytechnic(1) have suggested is, it is not a question of which table to use but a question of handling correctly the specific cash flow in each case. Thus for most properties it is a question of “when is the next rent due” and “how many months are there to the next rent review”. Nevertheless the underlying issue is valid — valuers must understand what they are doing when they use specific methods, specific tables and specific computer programs.
The report restates a number of recommendations in respect of freehold valuation methodology. In the following list we have indicated in brackets the original section number from the report.
1.(14) The conventional term and reversion method . . . is to be preferred to the hardcore method . . .
2.(15) The use of equivalent yields should be encouraged.
3.(16) A net of income tax approach is not currently acceptable for the open market valuation of either freehold or leasehold interests (see Part II for Leaseholds).
4.(18) The methods of valuation which allow for Capital Gains Tax are not practical.
5.(19) The use of valuation tables based upon the receipt of income quarterly in advance should be encouraged.
6.(1) A standard definition of the equated yield should be prepared and it should be distinguished from the equivalent yield (see Estates Gazette “Glossary of Terms”).
7.(2) Equated yield analysis is a practical and simple method of making explicit assumptions as to future value change . . .
8.(4) Equated yield analysis is the best means of comparing the returns on property with those of gilt-edged stock.
9.(5) Dr E Wood’s “real value” approach is too complex for most practitioners to use in their day-to-day work . . .
Interestingly, “real value” approaches have been written about as being too complex for the profession. One sincerely hopes that the medical profession adopts a more professional approach to new methods of surgery if proven to be better even if they are more complex! The question should not be one of making life as easy as possible for the valuer, but of providing a proper service which fulfils at law the valuer’s duty of care to the client. Since Dr Wood put forward his real value approach in the early 1970s there has been a continuing discussion in the academic world and the research work of Dr Neil Crosby — much of which is due to be published shortly in conjunction with Andrew Baum by Routledge & Kegan Paul — will throw more light on this debate; meanwhile see “Mainly for Students”, August 23 1986, p 756.
Equated yield methods, that is a capitalisation approach where rents on review are expressed in future money terms not in current market terms, are recommended when valuing for a specific purchaser. Again criticism is levelled at this approach by valuers because it is not a market method. Such criticism misses the point that at its present stage of development it merely expresses explicitly what is implied in the conventional term and reversion valuation, indeed in the absence of current market capitalisation methods it is difficult to see how it could be used. Currently it is a useful tool of analysis for comparing property investments with government stocks. It is also a useful alternative method of valuation where the subject property is outside the normal market income pattern — such as when the first review is in eight years’ time not two years’ time.
In its simplified form it appears very much like a term and reversion valuation but with essential differences:
The o/c% is frequently taken to be 1% to 2% above the medium-dated redemption yield of gilts. A point which is considered by Richard Emary in his unpublished Reading University dissertation entitled “Property Risk Premia”(2). The future projected rent is assessed by determining a growth rate for the rental value of the property. This is found by making explicit the growth rate implied in the market’s ARY% (see Baum and Mackmin The Income Approach to Property Valuation, RKP 2nd reprint edition, 1986). Thus, very simply, with gilts showing 12% and with an ARY% of 7%, purchasers of property would need a rental growth of 12% – 7% = 5% per annum with annual in advance rent reviews. With five-year reviews being normal for property the growth rate needs to be in excess of 5% pa. Dr Crosby’s Real Value Method (see Journal of Valuation vol 4 no 2 and 3) also reflects this factor.
Equated yield calculations largely take account of the criticisms that the Greenwell report levelled at the surveying profession, which in turn was part of the reasoning behind the RICS initiative to research valuation practice.
Students and practitioners are in great danger of producing false valuations if they switch from equivalent yield to equated yield methods without a full understanding of the methods. It is all too easy to take account for growth twice and to grossly overvalue the property.
Two other points from this part of our consideration of the research report should be noted. First, hybrid methods for allowing for capital gains tax have been dismissed — if, as the report suggests, they were ever used in practice or were ever anything other than a theoretical concept. The research postcript also notes (p 39, para 7) that the indexation provisions of the Finance Act 1985 have come into operation since such hybrid methods were put forward. It is, however, important to note that higher-rate taxpayers are more interested in capital growth investments because of the indexation factor, annual CGT exemption allowances and the 30% tax rate, and for this reason may bid up the price of early substantial reversionary properties. (This argument is one that again some valuers would adopt in favour of a net of tax approach in this segment of the market.)
Finally we would mention for students the report’s consideration of the concept of equated rents. “How much more should a tenant pay by way of rent for a property let with rent reviews at 10-year intervals than for the same property with five-year rent reviews?” Jack Rose and others wrote extensively on this inflation issue in the 1970s and the concept of uplift rents is now well established. However, the tenant market is still reluctant to do more than pay x% over and above the normal rental value, and therefore, while the DCF-based methods of determining such rents are potentially the more correct, they may in fact only play a part in such negotiations. Uplift rents are part of the inflationary economy but in a divided country such as the UK it is possible to find the opposite occurring where rents over time are falling owing to a decline in a local economy. In these cases a landlord might be willing to let at less than market rent to secure an income for a longer term rather than risk a fall in rent after, say, five years.
The basis of all investment valuation is DCF. The debate on freehold methodology is a debate heightened by the problems of valuing in times of inflation and economic change. The valuer’s traditional 14 years’ purchase is no more wrong than the stock market’s price earnings ratio of 14. What is essential is that those working and advising in such markets know what is implied by such measures. That they know of the need to examine in detail “the property” or “that company” to see whether that which is implied is achievable. In the case of property, physical, legal and economic factors are important: 14 YP will not reveal that in six years’ time the tenant will vacate, that the building will be obsolete and that redevelopment will be necessary. These points can only be allowed for in a valuation if the valuer is willing to develop DCF techniques. For thorough analysis DCF is the only solution; it is the only tool that can incorporate all the variables and the only technique that permits sensible incorporations of probability and sensitivity analysis — two areas for further investigation noted by the report.
Andrew Trott concludes his topic paper 1 on pp 54/55 with the following paragraphs, which provide a useful conclusion to the first part of this look at the report in terms of freehold valuations. Part 2 will consider some of the issues raised by the report in respect of leasehold valuations:
Conventional methods are likely to be used for many years to come, notwithstanding the criticisms made of them. They have the advantage of being widely understood, universally applied and have withstood the tests of time. These methods are at their weakest during periods of rapid change in rental income ….
It is wrong to consider conventional methods of valuation and discounted cash flow as being mutually exclusive. Both methods can, and often should, be used when undertaking the open market value of a property investment.
(1) “‘Quarterly in advance’ closely observed”. David Bornand (Estates Gazette, August 24 1985 p 690). Also see “How effective are tables”. David Mackmin (Estates Gazette July 4 1981 p 23).
(2) Currently some observers would suggest that this should be nearer 4% above gilts owing to incomes running 4% above inflation and inflation being 7% below gilt yields.
