Asset valuation under nonmarket conditions in transitional economies: the case of Ukraine.
Today, a country such as Ukraine cannot be characterized as a market economy. It can be characterized as an economy with economic interrelations that are to varying degrees "market like." Most importantly, the structure and conduct of business in Ukraine--and the legal and governmental systems that regulate it--still operate mostly in ways that distort economic efficiency, pricing, and valuation and result in the continuation of a large number of nonmarket conditions and behavior.
Although Ukraine has experienced real economic growth and relative macroeconomic stability in recent years, this growth has not occurred entirely as a result of a transition to a market economy. The rate of economic growth should not be equated with the degree to which market conditions or market behavior have developed. Ukrainian GDP is largely derived from the production, consumption, and export of primary goods, and goods production or export can increase without fundamental change toward a market economy. This situation is best illustrated by Russia. In Russia, economic growth has been even higher than in Ukraine, but largely based on increased production and export of oil and gas reserves with a continuing high level of state ownership and control and little change in how these commodity-producing sectors operate.
This article begins with a discussion of nonmarket issues, conditions, and behaviors that define the economic milieu of Ukraine. Next, the fundamental influences emanating from the current milieu that directly affect value, valuation concepts, and methodologies are examined. Understanding the economic and legal environments within which assets reside is crucial to the determination and interpretation of value.
Nonmarket Valuation Issues
Asset valuation in Ukraine is conducted under varying degrees of nonmarket conditions. The structure of the economic and legal systems, and the procedures by which these systems operate, significantly increase the difficulty of assigning defensible valuations to all asset types and valuation applications.
Important issues that contribute to the nonmarket conditions and are specifically relevant to the valuation of assets include: price distortions by region and market segment; the continuing prevalence of non-cash (barter trade), nonformal, or extra-legal transactions (the "shadow economy"); the still-significant degree of state ownership of assets; the high degree of state interference in economic decisions; uncertainty concerning basic ownership rights; and arbitrary enforcement of laws and regulations. These factors also influence risk and affect the choice of discount rate in ways that are difficult to quantify or defend.
At the same time, it is important to note that certain legal and regulatory changes have contributed positively to the development of a more market-oriented economy. These include: the passage of a national Law on Appraising in line with international norms, the adoption of international standards of appraisal as the legal foundation for valuation, and the creation of a national Ukrainian Society of Appraisers and accompanying certification requirements for practicing appraisers.
Nonmarket Conditions and Nonmarket Behavior
A fundamental principle of valuation is that the value of any particular asset is specific to its economic context. The overall economic environment of Ukraine, however, is not currently integrated to a degree that allows value to vary only according to its specific economic context. Therefore, it is necessary to discuss the economic milieu directly when discussing any particular asset valuation application. The challenge facing appraisers in Ukraine, particularly foreign appraisers, is to understand Ukraine's unique economic environment and evaluate how this affects asset valuation and valuation concepts.
In general, nonmarket conditions are significantly more prevalent in goods-producing sectors of the economy than in service-providing sectors. Service providing sectors are generally characterized by a significantly higher degree of market behavior. Examples include professional services such as advertising, accounting, auditing, appraisal, legal consulting, engineering consulting, management consulting, or remodeling services.
The primary reason for this higher degree of market behavior is the nature of the services themselves, which are based on human capital--intangible, often mobile, in high demand, with few and reasonable barriers to market entry, and in relatively unlimited supply. This creates price and quality competition for the provision of highly differentiated services. A secondary but still significant reason for the higher degree of market behavior is the fact that many of these services are new to the economy or are reconstituted occupations.
The administrative economy did not have a need for, or did not explicitly allow, certain professional services such as asset valuation or advertising. Likewise, engineering consulting or repair and remodeling services were in essence outside state-managed functions. Therefore, these industries in general do not carry as much "baggage" in the form of established modes of operation, control, and governmental relationships as the production of physical goods. However, certain service industries, such as telecommunications or electricity distribution, have complete or significant state ownership and operate under high degrees of nonmarket conditions and behavior.
The production of goods most often requires the use of fixed assets at fixed locations producing tangible products. A steel mill, for example, is not mobile nor in relatively unlimited supply. It produces and sells tangible products in a specific location using tangible assets within a sector of the economy. This sector has high and often insurmountable barriers to market entry, produces a limited range of nondifferentiated commodity products, and is very much constrained in its behavior by existing economic and governmental relationships.
Most goods-producing companies are not new companies producing new products or starting their economic life as a "blank slate." Most often goods-producing companies are older companies that inherited a corporate structure, with attendant conduct and performance characteristics, from the administrative economy. As a result, the transformation of goods-producing companies has been slow and difficult. Because a steel mill is but one part of a value-added chain from ore producers to metal fabricators, changing one part of the chain requires changing all the other parts as well; this alone is an inhibiting factor. Given the complex interactions of all the parts, one cannot transform the sector with but one or two changes.
It should be noted that the prevalence of nonmarket conditions under which firms operate is greater in some goods-producing sectors of the economy than others. Industrial goods companies, particularly those producing intermediate products, are in general characterized by higher degrees of nonmarket conditions and behavior than agribusiness or consumer goods companies that produce final products.
On the first day of Ukraine's national independence, all economic entities were owned by the state. One by one, in fits and starts, economic entities have been privatized (sold by the state) in their entirety or in share packages of less than 100% (usually the latter). For some entities, this occurred over a period of years, after first having been chopped up into any number of restructured legal entities to which assets were often assigned arbitrarily. Most importantly, the entities were sold at prices that by definition were not market prices. Indeed, each and every privatization of each and every economic entity and the underlying assets represented therein, were sold under nonmarket conditions. It could be no other way--in Ukraine or any other country of the former Soviet Union.
Privatizations in Ukraine are conducted by a single seller, the State Property Fund, with companies or share packages offered to a limited number of buyers (often limited by legal flat). These buyers operate without sufficient time or information to qualify as knowledgeable buyers. The purchases often have been anything but arms-length transactions. In addition, in most cases numerous nonmarket conditions have been attached to the purchases, such as paying off past taxes or other debts, provisions against laying off workers, or provisions for maintaining the same product line or expanding output.
Business valuations supporting privatizations have never met the market value definition, but one must wonder how they could have, given the economic context of the valuation process. Furthermore, business values and subsequent privatization prices often have been dictated beforehand by a predetermined buyer who, for prime assets such as metallurgical, chemical, or energy distribution companies, was (at that time) part of the political elite. The effect of extra-legal behavior on business and underlying asset values cannot be ignored; nor should it be vilified since these features are simply characteristics of the current economic and legal environments.
For example, consider the privatization sale of a typical metallurgical company. The metallurgical sector of Ukraine is large and highly profitable in absolute terms. Net profit margins as reflected in income statements are not high, typically less than 10%, and gross profit margins or the margin of earnings before interest and taxes are often lower than for other types of companies.
Metallurgical companies have high direct costs per unit of output. These high costs result from the age of assets and attendant physical depreciation, as well as gross inefficiencies arising from technological obsolescence of assets that results in high rates of functional depreciation. Input inefficiency is particularly evident in energy consumption per unit of output. Metallurgical companies sell mostly basic, nondifferentiated commodities, much of which is for export on a pure cost basis or internal sale at administratively influenced (and often higher) domestic prices. Furthermore, the ability in all large industrial companies to earn "profit as a cost" (whereby profit is taken out in a myriad of ways as a cost of business rather than retained or distributed to avoid high rates of taxation) is high and the practice is highly prevalent. The ability to earn money off the books is also well developed, including the ability to earn money through the resale of electricity, kickbacks on equipment and raw materials purchases, and barter trade at below-market exchange prices for later resale at higher prices by other entities under the same ownership or control. In addition, large industrial companies employ vast armies of workers; this grants the owners social and political influence that can also be directly or indirectly converted to income through government subsidization of energy, preferential taxation, and the selling of votes. These aspects of business conduct and performance are all holdovers from the old administrative system. Although their prevalence may be declining slowly, they are still integral to the system.
There are few comparable investments for those investors able to operate in the metallurgical sector, especially on a risk-adjusted basis. The additional direct or indirect income factors, coupled with the relative power of typical majority owners (well-entrenched, power elite), means that business valuation of a company and the underlying valuation of fixed assets must use a relatively low discount rate to accurately value the company within its existing economic context. This is one reason why open, transparent, and competitive tenders for the privatization of major industrial companies have often led to foreign bids that are much lower than domestic bids. Foreign bidders apply significantly higher discount rates in the process of business valuation, which reflect their perceptions of legal market risk and cash flow, as well as their much broader-based opportunity cost. In contrast, Ukrainian industrial investors are often willing to pay prices for industrial companies that are much higher than market-based valuations precisely because they can capture any number of nonmarket or even nonlegal benefits of ownership and convert them to income and face lower business and market risk profiles. Who can criticize a privatization process by which the highest bidder wins the tender?
The above provides a general understanding of the degree to which market principles have evolved within the Ukrainian economy and sheds some light on the concept of value itself as viewed from the perspective of different participants in the economy. The following sections deal with specific valuation issues for specific types of assets.
Valuation of Fixed Assets for Financial Reporting
According to International Accounting Standard Number 36 (IAS 36), "Impairment of Assets," a company tests for asset impairment by comparing value in use to carrying amount. If value in use is less than carrying amount, the company must recognize a loss or reverse a previous year's gain. If value in use is more than carrying amount, the company recognizes a gain or reverses a prior year's loss. The underlying, yet powerfully unspoken, assumption in IAS 36 is that "carrying amount" represents the market value of assets from a prior point in time determined according to the classical definition of market value.
However, many companies have carrying amounts for fixed assets that do not, and never did, represent market value. Carrying amount is often simply a given historical cost less depreciation that for many assets (particularly buildings) was administratively derived and at the time of first recognition bore no relation to any concept of market value. Worse yet, carrying amount most often contains a jumble of administratively derived and market-derived historical cost data that represent depreciated values derived entirely from the tax system rather than from market-based concepts of physical or functional depreciation, or economic obsolescence. This is one reason why companies undergoing their first audit to international standards opt for the alternative treatment allowed under IAS 36 to directly revalue fixed assets according to international valuation standards to determine market value (or more precisely, fair value for financial reporting). Asset valuation almost always results in substantial restatement of balance sheet and income statement values, often to the dismay of company owners. In effect, the revaluation of fixed assets results in a "first recognition" of previously recognized assets. This is but one example of the mental gymnastics with which the valuation and auditing professions must contend in transitional economies.
Valuation of fixed assets following international standards of appraisal must address three forms of depreciation: physical, functional, and economic (or external) obsolescence. In a transitional economy such as Ukraine, economic obsolescence presents both the most significant valuation challenge and accounts for the most significant variation in asset valuation through time.
A typical example can be taken from international audits involving electricity distribution companies. Currently, there is one electricity distributor for every oblast (province) within Ukraine. A typical distributor has around 30,000 individual assets including approximately 50,000 kilometers of electric power lines and a very large number of transformers, many of which have very high capacities.
Transformers have a minimum and maximum capacity utilization owing to technical reasons; between these parameters the variation in utilization can be quite substantial on a year-to-year basis. Beginning in the early 1990s, economic output contracted significantly, energy consumption (in this case electricity) declined, and capacity utilization rates for electrical transformers and electrical lines declined.
Economic obsolescence is thus directly reflected in capacity utilization rates of electrical transformers and electrical lines, since electricity consumption is itself a direct indicator of external economic conditions. Declining utilization of these electrical assets increased the measure of economic obsolescence that in turn decreased the valuation of these assets for purposes of financial statements. For each regional electricity distribution company, economic obsolescence can be determined on a regional basis.
Beginning in mid-1999, economic growth and particularly industrial output steadily increased with growth rates for industrial output exceeding 9% in each of the past several years. As capacity utilization of industrial assets has increased nationwide, utilization of electrical transformers and electrical lines has increased and economic obsolescence has decreased, thereby increasing overall asset value. The variable pace of these changes during the last decade has in itself presented an ongoing valuation challenge. As such, it is necessary to revalue these assets (and of course all assets in this asset group) every two years. It must also be noted that some assets were built at such a capacity that they embodied economic obsolescence upon first recognition and this obsolescence remains a noncurable feature of the assets.
A similar statement could be made for other industrial firms with a large base of fixed assets. At many machine-building companies, for example, economic obsolescence remains a significant factor. Output at these plants has increased only slowly, owing also to the high degree of functional obsolescence imbedded in their fixed assets. At many metallurgical and some chemical plants, capacity utilization has increased significantly and remains at relatively high levels. Many agribusiness companies achieved high rates of capacity utilization earlier than industrial companies; one reason is that agribusiness companies have operated under a much higher degree of market conditions and have benefited directly from rising per capita disposable incomes.
In general, fixed assets in Ukraine, particularly in industrial enterprises, have high degrees of physical and functional depreciation. This is especially so where capital reinvestment costs are high or where demand for the company's products has significantly declined. This situation at some companies has continued to worsen owing to a severe shortage of investment funds.
Of the three valuation methods, depreciated replacement cost (DRC) is the most reasonable and defensible valuation method for buildings and much equipment, particularly given that much equipment has functional obsolescence or is part of a production process that is specialized in use. Certain short-lived assets, such as computers, office equipment, and transportation assets can readily be valued using direct market data. There is a very competitive market in Ukraine for the sale of short-lived assets, which is open to direct and abundant foreign competition. Indeed, markets for computers and cars in particular are dominated by imports.
Functional depreciation presents a valuation challenge that exemplifies the effect of the economic milieu on the determination of value. There has been relatively little technological change in Ukraine in the past twenty years in comparison to the Western world. Transformers produced in Ukraine today embody virtually the same technology and functional characteristics as those produced twenty years ago. When estimating functional depreciation, therefore, one must look at the asset under valuation compared to the same Ukrainian asset new and not compared to a new Western transformer, since that would lead to a large overestimation of functional depreciation.
In addition, many industrial assets that would normally be expected to have an economic life of twenty-five years are often kept in use for up to fifty years. Most industrial firms have workshops for repair and maintenance that are an overhead cost. These workshops can and do fix virtually anything, albeit often in a jerry-rigged way, since the cost (especially labor cost) to do this and extend the life of the asset is less than the cost of a new asset. Issues of asset performance are not as vital as in more highly competitive and technologically sophisticated economies. New assets often cannot be purchased given the cost or the lack of debt financing. For similar reasons, there is high demand in Ukraine for used equipment. This ongoing process greatly alters the value of assets in use as compared to their historical cost. The difficulty for foreign appraisers in valuing most forms of fixed assets is a basic unfamiliarity with the type, condition, and use of fixed assets. Appraisers from outside Ukraine also are not familiar with the technology and production processes employed at industrial facilities in Ukraine and do not have an economic understanding of the context and general milieu in which the assets reside.
Another complicating issue confronting asset valuation to international standards is the dearth of reliable and consistent data concerning companies' fixed assets. Information systems in general are very poor. The flow of information within companies typically lacks horizontal communication and coordination, leading to contradictory technical data between functional departments. Information itself often is closely held and not accurately maintained, updated, or even verified. Transaction time to prepare all the technical data needed for fixed asset valuation to international accounting and valuation standards is frequently quite long and the process of verification quite challenging.
The Valuation of Land: A Case Study of the City of Kiev
Perhaps no other valuation is influenced more by nonmarket conditions than the valuation of land. With the major amendments to Ukraine's Land Code beginning especially in 2001, land other than agricultural land can now be purchased, sold, traded, or transferred. Obviously, the recent date of these fundamental economic changes in law governing land ownership means that the database of comparable land sales is very limited, and use of the sales comparison method for valuation of land is essentially untenable. This is particularly problematic since the sales comparison method is a primary method for appraising land value.
According to international standards of valuation, land value is determined by consideration of its highest and best use. The concept of highest and best use requires the appraiser to consider alternatives that are physically, financially, and legally feasible. In Kiev, city-owned land (the vast majority of land) is valued according to the city's legislative methodology that establishes a normative value for land based entirely on nonmarket principles. The legislative methodology also arbitrarily sets land taxation and land rent based upon the intended use of the renter (residential, commercial/retail, or public uses, as defined) with modification according to its location. The following case study of the city of Kiev delves into these valuation issues in detail.
The primary market for land in Kiev consists solely of the Kiev City Administration, acting through or with other agencies of government to privatize (sell) land to buyers who are willing and able to buy land, or as explained below, who are essentially coerced into buying land and canceling existing rental agreements.
Since land privatization has been legal for only a short time and because so few plots of land have been privatized within the city of Kiev, there is in effect no secondary market for land. To date, the vast majority of land involved in secondary transactions has been very small plots of land with dachas (cottages), or small plots of land used for such things as petrol stations, supermarkets, or fast food restaurants.
Most importantly, no land has been sold by the Kiev City Administration for residential use in the form of apartment buildings, which is the dominant form of real property. It is noteworthy that even though a large number of major apartment building projects are underway within the city, not one land plot was purchased; rather, these plots of land are being rented under the nonmarket-based land tax and land rent system described below.
Normative Value, Land Taxes, and Land Rent
Valuation of land in Kiev for the purpose of assessing land tax is made in accordance with the procedures contained in a document entitled "Money Appraisal of Land in Kiev." This document was approved by the Kiev City Rada (parliament) by No. 104825 from 27 April 2000. Federal law fixes land tax at 1% of normative value. Land rents are based on arbitrarily assigned percentages of normative value, and these percentages vary significantly depending upon land use.
Normative value also varies significantly depending upon land use. The normative values are the maximum prices that must be paid to the city budget for land, but actual total selling prices always exceed normative value owing to a bewildering array of additional fees and compensations.
Rents paid for land under residential use are small relative to those charged for land used for commercial or retail purposes and are very small relative to the determined normative values for land under residential use.
The normative value of each specific land plot is defined first by using a basis value of one square meter of a certain land category for the corresponding economic-planning zone. A ratio is then applied that includes functional use of the land and also local ratios that take into account actual placement of the land plot within the borders of each economic-planning zone. The city of Kiev is divided into no less than 180 economic-planning zones. There are, however, no zoning laws per se; permitted use is determined for each individual land plot.
Derivation of Value, Tax, and Rent of Land by the Kiev City Administration
To explain and evaluate this methodological system and its nonmarket-driven effects on land valuation, an example of an actual land plot valued both by the Kiev City Administration and independently by an appraisal firm can be compared.
The example land plot is one that could be used for residential, commercial, or retail use and is located in economic-planning zone No. 14 and comprises 49,000 [m.sup.2] or 4.9 hectares.
According to the city's appraisal method, the value of the land plot ([V.sub.L]) is determined according to the following formula:
[V.sub.L] = [V.sub.B] x [R.sub.t] x [S.sub.L] x [R.sub.i]
[V.sub.B] = Basis value of 1 [m.sup.2] of the appraised land plot depending on the ratio that takes into account functional use of the land lot ([R.sub.f]) in Ukrainian hryvnia
[R.sub.t] = General local ratio that includes special placement of the land plot within the borders of the economic-planning zone
[S.sub.L] = Area of the land plot
[R.sub.i] = Indexation ratio
The basis value of a land plot ([V.sub.B]) is determined according to one of five possible scenarios of its functional use:
* Land plot planned for or undergoing construction
* Land plot used for social buildings
* Land pot used for apartment buildings
* Land plot used for mixed apartment and commercial buildings
* Land plot used for commercial buildings
The numerical factor of functional use corresponding to each of the five functional use classifications ([R.sub.f]) are defined as follows:
[R.sub.f] = 0.5 Land for recreation use and other open land (land with current or planned construction, other open land within the borders of the city with no buildings)
[R.sub.f] = 0.7 Land for social use (by state and local government; defense, educational, cultural organizations; environment protection and social services; public, religious, or extraterritorial organizations)
[R.sub.f]= 1.0 Land for residential use (1- to 2-story houses and multistory apartment buildings)
[R.sub.f] = 1.5 Land for mixed use (land with apartment and commercial buildings, land with apartment and social buildings, land with commercial and social buildings)
[R.sub.f] = 2.5 Land for commercial use (used for transport technical services and petrol stations, for wholesale and warehouses, for retail trade and commercial services, markets, or other commercial activities)
The general local ratio ([R.sub.t]), which includes placement of the land plot within the economic-planning zone equals:
[R.sub.t] = 1.07 x 1.08 x 0.9 = 1.04
[R.sub.t1] = 1.07 Local ratio that takes into account placement of the land plot within walking distance of the city metro
[R.sub.t2] = 1.08 Local ratio that takes into account placement of the land plot nearby to highways
[R.sub.t3] = 0.9 Local ratio that takes into account a ventilating shaft servicing the underground metro system that occupies the far north end of the land plot thereby reducing possible options of land use
An indexation ratio ([R.sub.i]), is calculated to account for inflation. On the date of appraisal this ratio was:
[R.sub.i] = 1.13 x 1.182 x 1.02 = 1.36
1.13 = Indexation ratio according to the decree of the Cabinet of Ministers of Ukraine No. 782 from 12 March 2000
1.182 = Indexation ratio according to the letter of the State Land Committee of Ukraine No. 14-22-7/132-182 from 15 January 2001
1.02 = Indexation ratio according to the letter of the State Land Committee of Ukraine No. 14-22-6/186 from 10 January 2002
The normative value for this land plot under residential use according to the methodology of the Kiev City Administration is:
[V.sub.L] = 680.5 x 1.04 x 49,000 x 1.36 x 1.0
= 47,162,577 Ukrainian hryvnia, or as of the date of appraisal
= 8,898,577 U.S. dollars
The normative value for this land plot under commercial or retail use is:
[V.sub.L] = 1,701.25 x 1.04 x 49,000 x 1.36 x 2.5
= 117,906,152 Ukrainian hryvnia, or as of the date of appraisal
= 22,246,444 U.S. dollars
Note that the two variables that differ in these equations are the basis value of land and the functional use factor. Here, the land tax is 1% of normative value for any functional use, the land rent for residential use is based on 0.3% of normative value, and the land rent for commercial use is 4% of normative value.
Critique of Methodology
Any critique of this methodology must start by stating two facts: (1) the valuation methodology is entirely devoid of any market value considerations, and (2) the methodology itself is complete nonsense. This methodology, by introducing very strong nonmarket valuation influences at the most basic level of land valuation, creates problems that ripple throughout a long chain of decision making based on these initial values.
A list of nonmarket conditions, influences, and resulting effects on economic decision making that are present in or derive from this valuation, taxation, and rental methodology includes the following:
1. The normative value is by definition an administratively derived nonmarket value, beginning with an arbitrary assignment of basis value per square meter according to intended use. No one can explain the derivation of numbers as precise as 1,701.25 Ukrainian hryvnia for one square meter of land intended for commercial use. Normative value calculated with this methodology increases rapidly, starting from the arbitrary basis values as one proceeds from land use for public or social functions, to residential use, to mixed residential and commercial use, and to entirely commercial use.
Normative value of the example land plot is $8.9 million for residential use and $22.2 million for commercial use, but these values are administratively determined ex ante to any valuation of the land's highest and best use. If we assume that residential use is the highest and best use for this property, then one would naturally expect that land value under residential use would be higher than for commercial use. This is not the case, however, and even the possibility is defined away ex ante. There is no rationale for determining in advance that land for commercial use has value 2.5 times greater than for residential use (note factor [R.sub.f] in the two formulas above).
2. Land tax is 1% of normative value for each of the respective uses. For the example plot, annual land tax would be $88,986 for residential use and $222,460 for commercial use. Thus, annual land tax also varies by a factor of 2.5.
3. Land rent for the example plot would range from $26,696 per year for the rent of land for residential use to $889,858 per year for commercial use. In total, land tax and land rent for commercial use exceeds $1.1 million per year. This creates a very strong economic incentive to rent rather than buy land if that land is going to be used for residential purposes. For the example plot, the city's normative value is $8.9 million for residential use but land rent would be only $26,696 per year. Therefore, the normative value equals 333 years of land rent in undiscounted terms.
4. The methodology creates a very strong incentive to rent vacant land under the premise of residential use but then hold onto this land in perpetuity as a "land plot planned for or undergoing construction" since land rent is then reduced by 50%. The incentive to do this and the prevalence of this practice become all too apparent when one decides to actually buy a plot of land in the city and finds that every square meter of vacant land or land with improvements of no value has already been rented by "potential" developers of residential apartments. To buy the land from the city means first to compensate the current renter, who is almost always a front man for the City Administration bureaucrat with authority to approve the sale. In reality, the vast majority of "renters cum potential developers" are not actually renting the land (although a rental contract will appear quickly if one shows serious intent to purchase), but rather are simply holding the authority or ability to make sure the sale occurs by having the potential buyer sign a contract for "representational services" on their behalf vis-a-vis the City Administration. One's imagination can run wild contemplating the personal profit-making potential of such an arrangement.
5. If the land were purchased for residential use, the purchaser would still have to pay an annual land tax of 1% of normative value ($88,986 per year) that would not be paid if the land were rented. This would be a loss-making decision because land rent for residential use is only 0.3% of normative value (or $26,696 per year) and because the cost of annual land tax exceeds the cost of land rent by $66,290.
6. Purchased land, if subsequently resold, is sold through the secondary market. This market is currently small in Kiev and operates under market conditions, albeit modified by the economic milieu. It can be stated with certainty that a land plot purchased for $22.2 million and improved by the construction of a typical commercial office building could not later be sold for anywhere near the land purchase price much less for the purchase price of the land plus the depreciated value of improvements.
Thus, it is obvious why land is rented but not purchased, especially for residential use, and why many of the land "sales" that have occurred have resulted from various forms of coercion on the part of the city. The incentive to rent rather than purchase is very strong across all land use categories.
Ultimately, there is no economic rationale for such a price and value system. Determining the value of land based on nonmarket conditions and methodologies means that the outcome of highest and best use analysis is essentially predetermined. The functional use of land is, in effect, predetermined by taxation and rental values, and somewhat circularly, the normative values themselves.
Nonetheless, the land plot referred to in this example was valued using the income capitalization approach based on standard consideration of highest and best use, which was clearly for use as residential apartments. The land also was valued under the assumption that Class B commercial space would be constructed and rented at market rates and current levels of occupancy by a Ukrainian developer. The income approach was taken as the most reliable approach for determining land value in this circumstance since the sales comparison approach, although used, was later rejected owing to the very small number of comparable sales and the nonmarket prices for which that land was sold. The income method by contrast can be applied quite reliably in Ukraine when valuing income property (land and improvements).
The valuation for residential use (the highest and best use) was at least 25% lower than normative value and for commercial use it was at least 80% lower than normative value. Therefore, whereas the value for residential use was at least 65% greater than the valuation for commercial use (hence it represented the highest and best use), the city's normative value for commercial use is 150% greater than normative value for residential use, an opposite conclusion. This clearly demonstrates not only the nonmarket nature but also the nonrational nature of the city's valuation methodology. In addition, any potential buyer of this land plot would have to pay at least several million dollars in compensation to the current renter Kyivmis'kbud (which is an open joint-stock company whose majority shareholder is the City of Kiev and which holds a near-monopoly on the construction and sale of new apartment buildings in the city) for giving up its development rights. This resulted in a final potential purchase price of this land for residential use that was almost double the valuation estimate.
It is also worth noting that the valuation used a discount rate of 12%, which may seem low, but as later explained is an appropriate rate for the valuation given the economic context.
Discount Rate Considerations Under Nonmarket Conditions
The choice of appropriate discount rate is especially problematic for 'all valuation purposes in transitional economies. International Appraisal Standards require that the discount rate used for any particular valuation purpose must represent "a typical return expected by a typical market participant." The problem is that there are no "typical market participants" in a nonmarket economy. The term "typical" further carries an underlying assumption of an unlimited number of participants, yet one feature of nonmarket economies is that market participants are limited, often by necessity or by flat.
Continuing the land valuation example, a discount rate of 12% was used when considering highest and best use under the scenario of building a number of new apartment buildings on the example land plot. The valuation assumed that the project developer would be similar to the city's Kyivmis'kbud. Therefore, it was assumed that all factor inputs to construction would be of local origin, the apartments would be built to typical Ukrainian standards, and sold to a typical Ukrainian buyer.
Several factors come immediately into play. First, investment alternatives available to Kyivmis'kbud (its opportunity cost) are constrained by flat rather than being theoretically unlimited. Second, feasible or risk-acceptable investment alternatives within Ukraine are very limited. Third, a large majority of available investment options in the economy carry much higher levels of risk than building and selling residential apartments; one reason is that apartments are presold prior to construction of the building since it is from these funds that the developer obtains working capital. Fourth, demand for new flats in Kiev is very strong, per capita incomes are rising, and the city is expanding. A return of 12% for Kyivmis'kbud accurately reflects risk and opportunity cost.
By contrast, a foreign property developer may make equally valid but different assumptions, such as that a European firm would develop the property using local construction companies but retain design, engineering, and management control. The apartments would fully meet European standards and would be sold perhaps to resident expatriates or to Ukrainians in higher income brackets. The opportunity cost to the European developer and a minimal quantification of risk would likely yield a discount rate of around 30%. In all likelihood, the valuation of the example land plot under these assumptions would yield an even lower value than computed. One significant problem with this particular approach, however, is that a foreign developer would not be granted permission to build on a vacant site in a prime location in competition with the city's own construction company. Thus, the market for this particular site is limited by a strong bias (though not explicit) in favor of one participant. This hardly makes a market and renders the concept of a typical return to a typical market participant irrelevant. The underlying development assumption behind this alternative valuation, although theoretically feasible, would not in reality be feasible as required by the definition of highest and best use.
In the appraisal report for this property, the client was provided with not only the valuation of the land plot under its highest and best (residential) use but also the valuation placed within its full economic and legal milieu. This included an analysis of how the city would determine normative value for the land plot under various functional use options, determination of what attendant land rent would be under the various functional use options for this land plot, and an evaluation of the effects of these values on the decision to rent or purchase the land. Additional fees and compensations had to be determined to arrive a full potential purchase price for comparison to the valuation, and the legal and logistical feasibility of the client being able to rent or purchase this plot of land given the city's modus operandi had to be evaluated. Such analyses had to be conducted in order for the client to fully understand all the limiting factors affecting the valuation and potential purchase, rent, or development of this land plot so they could make the most well-informed decision.
Discount Rates Applicable for Other Valuation Purposes
When valuing other types of investment, such as portfolio or direct equity investments, choice of discount rate is even more problematic. The Ukrainian equities market is very narrow and thin, and turnover is very small. These factors mean that any average return, especially an attempted risk-adjusted return, is wildly inaccurate for application to a specific share investment.
Discount rates appropriate to business valuations are also problematic. Very much depends upon risk adjustments made to reflect the sector of the economy in which the business operates and the issue of ownership control
The agribusiness sector in Ukraine is one market segment that has experienced a large degree of transition to market conditions. The industry is highly competitive, facing both domestic and foreign competition. A high degree of product differentiation and dependence upon advertising, packaging, and choice of sales and marketing strategy characterize agribusiness. Agribusiness also has the highest percentage of completely private entities, with very little government ownership. This development itself is of interest since the high degree of private ownership in the agribusiness sector stems less from demand for these assets than from the willingness of the government to part with them through privatization. Many companies in this sector have been private since the early 1990s and have therefore had the most time to learn experientially about how to prosper in a competitive environment.
Today, there are many profitable agribusiness companies in Ukraine. Ironically, agribusiness companies most often must be valued using a relatively high discount rate, perhaps as high as 30% or more. The reason lies not in opportunity cost or normal business or market risk. The risk lies in the ability of the owners, who most often are not part of the power structure of the country, to defend their ownership rights.
Property rights in Ukraine are not guaranteed, but rather are provisionally held based on relative political power. Owners are at risk of losing control of their companies if they become too overtly profitable or lose political support, as well as any number of other nonmarket-based reasons. During the last ten months, for example, ownership of nine electricity distribution companies has changed three times, with some companies having been sold back to their original owners. Holding companies in Ukraine have a tendency to appear like mushrooms, only to disappear and perhaps to rise again when conditions are right.
Risk included in the computation of an appropriate discount rate under nonmarket conditions will differ significantly from that computed under purely market conditions. Risk cannot be inferred from an analysis of financial statements or a study of the market or general economy. Financial statements in Ukraine often do not reflect the true financial position of a company, since internal trade barriers may limit access to regional markets, and prices within regions are subject to government manipulation. Risk increases to the extent that ownership rights are held provisionally and appraisers must also consider whether the potential investor (as opposed to a typical investor) is of domestic or foreign origin.
Summary and Conclusion
As discussed in this article, the most significant issues and characteristics that affect asset and business value in transitional economies include at least the following:
* High levels of physical and functional depreciation and economic obsolescence
* Nonmarket derived initial values that affect follow-on valuations
* A dearth of available and reliable data to support the valuation process
* A lack of typical market participants and typical expected returns
* Provisionally held ownership rights and risk inherent therein
* Nonformal and extra-legal sources of income that can be converted to cash
* The narrow and thin structure of the equities market
* Insufficient liquidity within the economy and the high cost of capital
* Certain behavioral characteristics affecting perception of value
Although this article has focused on the deficiencies of the economic system and their effects on value and valuation methodology, it must nonetheless be stated that Ukraine's economic system has evolved significantly over the last decade toward a more market-oriented system. Progress has been uneven, however, with service industries evolving faster than goods-producing industries, major cities evolving faster than small cities or rural areas, and the agribusiness or consumer goods industries evolving more than the industrial or energy sector. State enterprises have evolved the least, and government interference in the economy, particularly in ways that directly affect value or price, continues to cause strong economic distortion and inefficiency.
Valuation of assets or businesses must confront issues as diverse as lack of information, nonformal sources of income, arbitrary enforcement of laws that are value distorting, and risk and return issues that are strongly influenced by behavior. All of this is not to suggest that valuation of assets and businesses cannot be performed adequately, but rather that the choice of methodology and interpretation of valuation results may be dictated by the economic milieu more than the specific economic context; for example, the inapplicability of the sales comparison method to valuation of land or the heavy reliance on the depreciated replacement cost method for valuation of fixed assets.
As in all things, action proceeds from intent. Ukraine's enactment of a national Law on Appraising and the adoption of international standards of valuation by the Ukrainian Society of Appraisers are welcome developments. It will simply take time for all vestiges of the administrative economy and the value-affecting influences to wither away and for the culture to find new ways of connecting economic return to economic value that are not as subject to overt manipulation by the government or by those that control it. Progress during the last decade has been astounding given the circumstances of economic decline, and political and social instability. Although the economic and legal systems leave a lot to be desired, they are continuing to evolve, and the more egregious economic inefficiencies inflicted on the country are one by one being improved if not as yet rectified.
The theme of the World Valuation Congress X has been stated as a question: "Is there a future for the valuation profession?" In the case of Ukraine, given the importance of the transformation underway from a nonmarket economy toward a more market-based economy, this rhetorical question could be restated as "Is there a future without a valuation profession?"
Paul R. Thomas is president of IRE (Ukraine) L.L.C., an appraisal firm licensed to practice in Ukraine. He specializes in the valuation of land and intangible assets, and corporate financial appraisal. Prior to joining IRE, he was vice president and acting president of the Economics Institute of the American Economics Association, where he was responsible for international business development and worked directly with a large number of foreign government ministries, financial institutions, and private businesses around the world. Thomas also conducted international mineral supply analysis for the United States Bureau of Mines. He has provided consulting services for companies around the world and has authored numerous publications on industrial economics and asset valuation. Thomas is a founding member and vice president of the Ukrainian Valuation Institute and an honorary member of the Ukrainian Society of Appraisers. He has taught numerous seminars for professional appraisers and business managers in Ukraine on behalf of the Ukrainian Society of Appraisers and on behalf of company clients including the United States Agency for International Development (USAID) and the United States Department of Energy. Contact: T 38-044-243-7300; E-mail: firstname.lastname@example.org
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|Title Annotation:||international appraising|
|Author:||Thomas, Paul R.|
|Date:||Oct 1, 2003|
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