Following his article on the comparative method, Sebastian Deckker examines the other traditional methods of valuation
The income approach is used to value properties that are let to produce an income for an investor. This can be split into two: the investment method and the profits method.
Investment method
In investment method terms, the value is the product of the rental income multiplied by a yield. These inputs are derived using comparable evidence.
Key questions that need to be asked by the valuer, are: is the passing rent a market rent; what is the market rent; what yield should be adopted? Answers to these questions will depend on the type of property, its use, location, demand and security of income.
For example, assume a that a bank is lending against a shop in a typical high street. Now suppose that shop is between a kebab house and a launderette. Does its position make it more or less attractive to a tenant? How does this affect the yield? The better the tenant and the location, the more secure the income will be. As a consequence, the yield will fall.
What about a block of bedsits? There is likely to be a high turnover of occupants, potential default, high management costs and wear and tear. The yield will be high, say 9%-10%, to reflect the risk. At the other end of the scale, the yield on a refurbished house in Chelsea may be as low as 3% but there is greater potential for capital growth.
Discounted cash flow (DCF) techniques are also frequently used in the appraisal of investment property.
Again, comparison is used to derive values for many of the key inputs in the calculation including not only rent and yield but also the growth rate, discount rate, costs and disposal price.
Profits method
For properties where the value is derived from the trading potential of a business, for example, a hotel or a cinema, the profits method is adopted. This is a very different approach, although comparison is used again to determine rates per room, void periods and yield.
In terms of how to calculate property values using the profits method, valuers need to first establish the key financials derived from the occupying business.
The first stage in the valuation process is to obtain the financial accounts for the business for the last three to four years as a minimum, then carefully examine them. These accounts should be accurate and reliable, allowing a valuer to quickly identify the financial stature of the business both currently and historically.
When using this method, it is prudent to bear in mind the following simple calculations:
Gross earnings – purchases = gross profit
Gross profit – working expenses = net profit
Gross earnings represent the total yearly revenue that the business generates. This gross earnings figure does not include for any costs. It is simply the money that the business generates without taking anything else into account.
Gross profit is often confused with gross earnings. Yet gross profit is defined as the final financial figure that is generated after deducting the business purchase costs from the gross earnings.
Purchases are the materials that need to be bought in order for the business to exist and perform its day-to-day activities.
Working expenses and net profit are the two final financial factors that should be carefully understood. Working expenses do what they say on the tin. They are the expenses that occur daily and are integral to the running of a business, for example, telephone, water, gas, electricity and business rates. Net profit is the final financial figure, and for many investors, it is the most important to bear in mind.
After all expenses and daily outgoings have been deducted from the gross earnings, the net profit figure will show how profitable a business really is.
Contractor’s method
Other approaches to valuation concern the cost of the building, either as a new development, or in substitute of an active market. This can be divided into the contractor’s method and the residual approach.
The contractor’s method is used to value properties that are rarely traded on the open market and for which no comparable evidence exists, for example, public buildings like town halls or libraries. These valuations are based on two components: the cost of constructing the building and the value of the land – both of which can be established by comparison.
Why isn’t the contractors’ method as highly recognised as other approaches? Generally, it is because the other methods can be used for the majority of properties where there is a more active transaction market.
However, the aforementioned valuation methods can’t be used for all types of properties. Some buildings, for instance, are extremely specialist in their nature and very rarely change hands on the open market. This means that there is very little comparable evidence available for an investor to be able to use to compare and contrast.
Similarly, some buildings were never designed for commercial use, meaning that it may not be appropriate to use these commercial methods for valuation.
This is where the contractors’ method comes in. This method is normally used if none of the other valuation approaches are appropriate for the property in question.
The contractors’ method is fairly simple and operates on the basis of the cost of the land, plus the cost of the properties on it, equals the worth of the property in general.
A word of warning though: there are doubts as to whether this is an accurate enough method.
The formula for the contractors’ valuation is: the cost of the building, plus the cost of the site, equals the entire cost of a similar building (less a sum for depreciation, obsolescence and such like), which then finally results in the value for the property.
To apply this formula, a valuer would apply build costs, at a rate per sq ft at the date of valuation, and discount this by a percentage to make allowances for depreciation (for example, 10%).
Valuers then need to calculate the revised total build costs, add this to the land value (incorporating the costs of remediation, site preparation works and any other additional fees) and the result would give the contractors’ value of the property.
Generally, the contractors’ method is an alternative if none of the other property valuation methods are applicable to the circumstances.
However, this method of valuing does have its limitations and is not overly reliable. It is normally recommended that this approach is used as part of a more comprehensive valuation approach.
Residual method
The residual method, used to assess development site values, requires calculation of the value of the completed development, which will be reached by comparison with market transactions, while the assessment of development costs will also require comparison to be made with build costs, fees, finance costs and many other elements in similar projects.
In the case of a site in central London, the gross development value (GDV) has been calculated from comparable evidence at £20m and all the costs at say £10m. It stands that the developer can afford to pay £10m for the site.
But what if the GDV was £18m? The developer could either cut his outgoings, for example, build costs or profit, to £8m and still pay £10m. Or offer £8m for the site. In this competitive environment, what is the likely outcome?
For development sites, the residual method is used. In basic terms, this is the calculation of the completed development, or GDV, less costs: build costs, fees, finance costs, developers profit, etc, all of which are derived by comparison to previous projects or to market evidence. There are several bespoke computer programmes dealing with residual appraisals, such as Circle Developer.
Care should be taken with the inputs as small variances in one or two can make a big difference in the outcome, for example, GDV down by 5%, costs up by 5% can interfere with the viability of a scheme, especially for say a large block of flats in the Docklands where the sums concerned are in millions of pounds.
Why this matters
While the comparable method (12 September, p94) is useful, it is more commonly used as the basis of complex forms of valuation that reflect the way a purchaser looks at the asset.
For investors looking to hold a property for its income, establishing the correct rent, void, rent-free period, lease length and yield are just some of the factors to be considered. Each will be based on comparable evidence with similar properties. The analysis of both lettings and sales evidence will inform the correct inputs within the valuation.
This will be relatively easy for a high street shop or a West End office, but what about those properties without such an active transactional market?
It is important to adopt the correct method and look at factors pertaining to the cost. This will again rely on comparable evidence, for example, of land sales and cost of materials. This is most explicitly seen with the contractor’s method where the approach is used precisely because there is a limited active market. However, the assumptions relating to the basic inputs such as the land and build costs, are still derived from comparable evidence.
Similarly, the residual method used for development sites is based on reasoned assessments of the many various inputs, including build costs. Once the site value is derived it can be crosschecked against similar land/site sales by using the comparable method.
Problems can arise where an asset has one or more uses with potential for an alternative use, eg an office block with scope for residential conversion. This may require an initial valuation on the basis of the investment value as an office but also a residual value assuming conversion to residential. Both approaches will rely on comparable evidence to check the inputs.
In an increasingly complex market, selecting the right approach is vital. However, it may be that more than one approach is required to accurately reflect how the market will assess the asset. Look for comparable sales.
Further reading
Shapiro, E, Mackmin, D and Sams, G, Modern Methods of Valuation (11th ed, Taylor and Francis)
Wyatt, P, Property Valuation (2nd ed, Wiley-Blackwell)
Scarrett, D, and Osborn, S, Property Valuation – The Five Methods (3rd ed, Taylor and Francis)
Sebastian Deckker is a director in Savills’ valuation department
