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Real estate valuation - a transatlantic perspective.

In recent years, a number of articles have appeared on valuing property in a global market and diversifying real estate portfolios internationally. A comparison of the relevant distinguishing features of the property valuation professions in Britain and the United States has not yet been pursued, however. This article outlines those features and extends the comparison to the valuation of two hypothetical, identical office buildings located in London and New York City, respectively.

Differences in valuation practices, lease structures, and industry standards all affect the individual values of the properties in a portfolio. While only some of these distinctions are significant, familiarity with them will provide a good sense of how and real estate is valued in each country.

PROFESSIONAL

AFFILIATION

An appraiser in the United States is likely to be a member of the Appraisal Institute, with one or more of the following designations: MAI, SRA, SRPA, SREA, and RM. In Britain, valuers are usually members of the Royal Institution of Chartered Surveyors (RICS) and are referred to as chartered valuation surveyors. While such designations as MAI indicate expertise in the practice of appraisal only, RICS professionals may also sell, lease, and manage properties.

Encompassing both practical and theoretical aspects of appraisal, the Appraisal Institute's candidacy period incorporates two required courses, a demonstration report, seven required exams, a comprehensive exam, and experience credits. Although appraisers are not currently associated with any governing bodies, federal legislation has recently required every state to test and license or certify appraisers in an effort to more tightly control procedures and ethics. This action was sparked by the savings and loan crisis caused by the extensive lending on inflated values of commercial properties that occurred in the late 1970s and 1980s.

The RICS is recognized as the main property-related professional association in Britain and throughout many parts of the world. Its members are required either to pass direct entrance exams or to earn relevant degrees in such subjects as land economy or estate management. Candidates must have knowledge of town and country planning law, economics, and building construction as well as specific expertise in property valuation for statutory and nonstatutory purposes. It generally takes about five years to qualify. Three years are spent on a full-time degree course, followed by two years of practical experience and a test of professional competence.

THE REPORT

U.S. appraisal reports fully disclose details of comparable property sales that support a particular conclusion of value. It would be highly unusual, however, to find appendices containing comprehensive information about similar properties in a British valuation, because details about property transactions are not in the public domain in Britain.

In the United States, an appraiser collects comparable data by contacting local brokers and other appraisers. In addition, appraisers can directly contact local tax assessors' offices to gather data, as sales of real property in most states are a matter of public record. Valuers in Britain typically rely on sales agents within their own firms, and may also gather information on recent sales from brokers they know in the market as well as from online property databases. In collecting rental data, both appraisers and valuers use local brokers as sources.

In the United States, a value conclusion is usually presented in a "letter of transmittal" followed by a report that contains supporting data, while in Britain, the presentation varies according to the requirements and purposes of a valuation. Both reports, however, are likely to include the following items.

* The basis of the valuation.

* A detailed description of the property, including services and location, along with details of the physical locality and the local economy.

* Legal tenure and the presence of any restrictions or covenants.

* Details of planning permissions and planning potential.

* A description of property construction and the state of repair.

* An analysis of the relevant property market in terms of supply and demand.

* The valuation of the property, including data, assumptions, and basis.

U.S. appraisal reports usually include an introductory section in which the property, the type of ownership interest to be valued, and the highest and best use of the property are described. In addition, descriptions of the three generally accepted approaches to value (i.e., the income approach, the cost approach, and the market or sales comparison approach) are included, followed by the valuation itself and supporting data. While much of the report is interesting from an academic perspective, many U.S. professionals argue that such reports contain more data than are necessary to render a reliable opinion of value.

VALUE

In Britain, a valuer determines a property's "open market value"; in the United States, "market value" is calculated. Although terminologies differ, the concept of value is basically the same in the two countries, and thus both terms are used interchangeably throughout this article.

Market value is defined in the United States as the most probable price at which a property will sell, assuming

* A reasonable exposure in a competitive market under all conditions requisite to fair sale.

* Both parties are acting prudently, knowledgeably, and for self-interest, and neither is under undue duress.

Implicit in the Appraisal Institute's definition of market value is the understanding that a transaction is negotiated under all conditions requisite for a fair sale.

Open market value in Britain, whether for "existing use" or "alternative use," is defined in the RICS Guidance Notes on asset valuation as the best price at which an interest in a property might reasonably be expected to be sold the date of the valuation, assuming

* A willing seller.

* A reasonable period in which to negotiate the sale, taking into account the nature of the property and the state of the market.

* Values will remain static during that period.

* The property will be freely exposed to the open market.

* No account will be taken of any additional bid by a purchaser with a special interest.

The RICS stresses that if a valuer considers it appropriate to apply any qualifying words to market value, the meaning of those words should be discussed with the client and agreed to before instructions are finally accepted. The RICS also requires any unusual circumstances considered to be stated in the letter of transmittal.

FORCED SALE VALUE

"Forced sale value" in both the United States and Britain is open market value as defined earlier when a vendor has imposed a time limit for completion that cannot be regarded as a "reasonable period." This concept has been challenged in the United States, however, especially in areas hit hardest by the savings and loan crisis. In cities such as Denver and Houston, often the only comparable transactions that occurred during the late 1980s wee sales of properties taken over by banks in foreclosure and sold at auction. Under normal circumstances, such sales would not be considered representative of market value. Some appraisers, however, have argued that if these are the only sales that occur in a market they are representative of market conditions, and thus are an indication of market value.

The nature of the British property markets has not given rise to such a controversy. Although real estate markets in Britain do experience downturns and recessions, the total land area is so small that a crash as severe as those experienced in the southwestern United States has never occurred. In addition, Britain has greater population density and considerably tighter controls on development and land use than the United States.

USE OF PROPERTY

The Appraisal of Real Estate, ninth edition, defines a property's highest and best use as "the reasonably probable and legal use of vacant land or an improved property, which is physically possible, appropriately supported, financially feasible, and that results in the highest value." (1) If a stated value does not represent a property's highest and best use, the appraiser is required to explain why in the letter of transmittal.

In Britain, the RICS presents two main types of value; open market value for existing use (EUV) and open market value for alternative use (AUV). EUV assumes the property will remain in its existing use and is generall used in the valuation of company assets. AUV takes into account alternative uses of the property and redevelopment potential on the assumption that necessary planning consents will be granted.

METHODS

In both countries, the following three basic methods of valuation are used regularly: income approach, cost approach, and sales comparison or market approach.

The income approach

The income approach is most widely used when investment-grade properties are considered. Value is determined by projecting a property's income benefits based on the actual leases that encuber a building, and by projecting market rents.

In the United States, a capitalization rate is used to define the relationship of income to value. Thus, if a property's income is known, a capitalization rate can be used to determine value. The overall or first-year capitalization rate (R) is extracted from a sale by dividing its net operating income (I) by its sale price or market value (V) and is illustrated by the formula:

R = I/V

An appraiser selects a typical holding period of, say, 10 years and discounts all cash flows as well as the reversion at the end of the holding period into a present value, considering lease-up projections, cost to finish the interior space for each tenant, cost of leasing commissions, and general operating expenses. The cash flows over a projected holding period as well as the terminal value in the last year are discounted to present value to arrive at an indication of value.

The process is almost the same in Britain, except that instead of discounting each year's cash flow to the present, the valuer projects only until the existing lease expires or until the existing rent is reviewed and increased to market. This is accomplished by multiplying the first year's income by the purchase factor. (The purchase factor is equivalent to the American annuity factor.) The cash flow in the final year of the holding period is capitalized into a sale price and discounted to present value using one investment yield. (The British investment yield equates to the U.S. capitalization rate except that the investment yield also discounts the reversion to present value.)

Discout rate

In both countries, consideration is given to the quality and location of the real estate being appraised, the reliability of the data used as a basis for the cash flow projection, and the quality of the leases on the property in selecting an appropriate discount rate.

In the United States, the discount rate employed is also determined by comparing the property with alternative investments to real estate. This method is based on the premise that a real estate investment must compete in the capital markets with yields offered by other investments of similar risk and holding period. Typically, low-risk investments are used for comparison. For instance, when a 10-year U.S. Treasury bond paying a 9% annual return over the holding period is compared with a U.S. real estate property paying a 9% annual return over the same holding period, it would not make sense to invest in the real estate, because it has a higher risk.

The cost approach

In the cost approach, the value of a property is assumed to be close to the cost to replace it with an identical property. This approach is used when the property is only rarely exposed to the market and thus no comparable transactions exist. Examples of properties best valued by the cost approach are: owner-occupied buildings; proposed developments in which the amount of income is uncertain; oil refineries and chemical works in which the buildings are not more than structures or cladding for highly specialized plants; power stations and dock installations in which the building and site engineering works are related directly to the business; properties located in geographical areas for special reasons; and properties whose size, design, or arrangement make it difficult to determine a value frome evidence of other market transactions.

In the cost approach, both valuers and appraisers estimate the market value of land in its existing use and the modern replacement cost of the building and other site improvements. Deductions are made for age, condition, functional obsolescene, and environmental and other factors that cause the building to be worth less than a new, identical building. Careful attention is paid to the selection of appropriate levels of depreciation and it is generally helpful if the valuer has an in-depth knowledge of the particular business involved. The land value is determined by comparing it with recent sales of similar vacant parcels in the neighborhood.

In the United States, the cost approach is often used to value newer buildings in developing areas where vacant land sales have occurred, and is least reliable in valuing an older building. This is because it is difficult to determine an appropriate amount of depreciation to subtract from the replacement cost.

The sales comparison or

market approach

In the sales comparison or market approach, an appraiser bases value on prices of comparable properties recently sold in the open market, making adjustments for location differences and relevant leasing or planning conditions. This approach is given the most emphasis in the United States for properties occupied by owners and in markets where prices are changing rapidly, and should be supported by at least one of the other approaches. In down markets in which no recent sales of similar buildings have occurred, the sales comparison approach is used only as support for one of the other approaches. In Britain, this method is widely used and probably accounts for the majority of all valuations. In both countries, this approach to valuation may use either a capital or rental basis.

In using the market approach, it is particularly important to have ready access to accurate and up-to-date comparable transaction details. Its effective application not only depends on a thorough evaluation of the property but on a detailed knowledge of comparable properties and the circumstances surrounding these transactions.

HYPOTHETICAL

VALUATIONS:

ASSUMPTIONS

Two identical 20-story office buildings are located in London and New York City. Each building contains 150,000 square feet, was built in 1960, and was refurbished in 1980. Each is occupied by two tenants under complete net leases (in Britain, on a fully repairing and insuring basis). All expenses are fully recovered by the landlords in separate service charges. The market rent for each building at the valuation date is estimated at $22.50 per square foot. Market rent is expected to remain flat during the next two years as a result of the recession. The basis of valuation is open market value for existing use and the valuation date is January 1, 1991. It is assumed that $1 = 1 pound sterling to simplify the comparison.

One tenant, a law firm, occupies 100,000 square feet. The space was originally leased in 1967 for a 25-year term with rent reviews every five years to full market rent. The term of the lease is January 1967 to December 1992 (fiscal years). The current rent of $2,000,000 per annum was reviewed in January 1988 and equates to $20 per square foot. The current rent is effective for the remaining two years of the lease.

The second tenant, an accounting firm, occupies 50,000 square feet on a 25-year lease granted from January 1973 that expires December 1998 (fiscal years). It also provides for five-year rent reviews. The current rent of $900,000 per annum was reviewed in January 1988 and equates to $18 per square foot. This rent will be increased to market value at the next rent review in January 1993.

British valuation

A British valuer would typically expect an investor to require an appropriate return over the known term rented and also over the period of reversion to open market rent. In this particular case, the reversion will depend on the reviewed rent of space occupied by the accounting firm as well as a new lease to the law firm or a new tenant.

Assume that the law firm pays $2,000,000 per annum and the accounting firm pays $900,000 per annum over the next two years. On January 1, 1993, the rent for the accounting firm will jump to market rent ($1,125,000) and the rent for the law firm or possible alternative tenant will increase to $2,250,000, resulting in a total rent of $3,375,000 for the whole building.

The valuer has selected a 9% discount rate for the term calculation based on the following factors: 1) the term period is based on actual income; 2) the building is city fringe and regarded as a secondary investment by institutions; and 3) the yield reflects the general loss of confidence in property by institutions as of January 1991.
 Present Value of Rent
Term 1/91 until 1/93
Law firm $2,000,000
Accounting firm 900,000 $2,900,000
Years purchase* for 2 yrs. @ 9% 1.76
Present value of rent $5,133,000
 (*) Holding period


Reversion

The British valuation is based on the assumption that in January 1993, the 100,000-square-foot space will be re-leased to the law firm or leased to an alternative tenant at $22.50 per square foot. The January 1993 rent review for the accountants is also assumed to be $22.50 per square foot. The reversionary rent is capitalized in perpetuity. The investment yield (equivalent to a capitalization rate in the United States, except that the investment yield also discounts the reversion to present value) has been increased to 9.5% to account for: 1) the risk of not re-leasing the 100,000-square-foot portion, causing a possible rent void; 2) the anticipated growth in rental values in perpetuity; 3) the risk of not achieving $22.50 from the accounting firm or review; 4) the cost of fully repairing and insuring leases; and 5) the expenses and out-zoning not fully recovered by service charges. In Table 1, the reversion is calculated.

[TABULAR DATA OMITTED]

AMERICAN VALUATION

The American valuation may be accomplished assuming either of two scenarios: one of complete net leases in which the tenants pay for all expenses directly, the other in which the tenants pay for all expenses over base-year expenses. The latter type of lease is more commonly found in the New York City market. During early 1990, a net rent of $22.50 per square foot would have been found in one of the newer class A office buildings. A gross rent of $22.50, assuming the tenants pays for escalations in base rents over the base year, would be found in older class A buildings.

Scenario one--the complete net

lease

This valuation is almost identical with the British valuation in which future cash flows are discounted along with the reversion. The analysis is completed in spreadsheet form, however, and the projected holding period (i.e., investment period) is ten years rather than three years. Table 2 shows the sample building cash flow for this scenario, and Table 3 illustrates the discounted cash flow analysis. The appraiser has selected a ten-year period to reflect the most likely behavior of a typical investor. The reversion is taken in the eleventh year, when both existing leases have expired and the building is occupied by new tenants.

This analysis projects market rent, the cost of management fees, and alterations and commissions when a new tenant moves in throughout the holding period. In addition, the sale costs at the end of the holding period are projected. Leasing commissions are based on 20% of the first year's income for new leases and 10% of the first year's income for renewals. Tenant improvements have been based on $25 per square foot for new leases and $12.50 per square foot for renewals. Upon expiration of the existing leases, it is assumed that there will be an 80% chance that the tenants will renew and a 20% chance that they will vacate. These probabilities have been applied to the commissions and tenant improvements to simulate market behavior.

A higher discount rate, 10.5%, thus was selected for all cash flows--in the earlier as well as in the later years. The overall rate is taken from actual sales as is the case in Britain, but the rate is reduced to account for appreciation over the holding period. The reversionary capitalization rate is 7%.

According to this scenario, the American value equals $35,000,000, which is the same as the British value.

Scenario two--tenants pay for

expenses over base year

The second scenario also is based on a ten-year discounted cash flow (DCF) analysis and assumes the same base rent, discount rate, reversionary capitalization rate, and cost of sale. The main difference is that the tenants do not pay for all operating expenses. Instead, they are responsible for all escalations in expenses over the base year (the first year of the lease).

Obviously and appropriately, this scenario produces a lower value because the owner is responsible for part of the operating expenses and earns a lower return than is the case in the first scenario. The value in this instance is $26,000,000. Such lease structures are not common in Britain.

SUMMARY

This comparison reveals that the primary difference between British and American methods of valuing properties is in the terminology used. Although both the valuer and appraiser discount future cash flows to present value, Americans use a discount factor and the British use a purchase (i.e., annuity) factor. The primary difference in determining the present value of the reversion is that Americans complete two steps, first capitalizing the income at the end of the holding period and then discounting the reversion into a present value, while the British capitalize the income and discount the reversion in one step using an investment yield. There is also a difference in the projected holding period. The British project only until the leases roll over to market. Americans usually select a longer holding period--in this case, ten years.

In summary, the same value was derived with both techniques using complete net leases (in which the tenant pays for all expenses). A real difference appeared when the American appraiser used a lease structure more commonly used in

[TABULAR DATA OMITTED]

New York City in which the tenant pays only for expense escalations over the base year. In that case, using the same base rent, the value dropped significantly. This circumstance reveals how important it is the terminology and lease terms be clearly defined.

CONCLUSION

Many observers feel that the biggest challenge facing international valuation firms is the growing number of multinational property investments as well as the lack of uniform requirements and regulations. Recently, some attempt has been made to establish a certain degree of international uniformity. Two important moves in this direction were the formation of the International Assets Valuation Committee, sponsored by the International Real Estate Federation (FIABCI, whose initials represent the original French name) and the International Committee, sponsored by the Appraisal Institute.

Differences in the corporate organization of valuation firms in the United States and Britain (as well as in most other European and Asian countries) occasionally lead to concern about conflicts of interest. Although this has traditionally been viewed as an "American" issue, in the past two years independent valuation conclusions have become increasingly attractive to non-U.S. investors. To some extent, this is a result of international investors' exposure to the U.S. markets, and is expected to continue and even accelerate.

The globalization of appraisal and valuation services will also require that careful attention be paid to uniformity of the three approaches to value. In addition, an understanding of local markets and customs is necessary to provide clients with an accurate assessment of value tailored to their particular requirements.

This analysis of valuation and appraisal methodologies used on both sides of the Atlantic has, on the whole, revealed more similarities than substantial differences. What is vital is that the definition and basis of valuation be clearly stated in the valuation report together with full disclosure of all assumptions used to determine value.

(1). American Inst. of Real Estate Appraisers, The Appraisal of Real Estate, 9th ed. (Chicago: American Inst. of Real Estate Appraisers, 1987), 269-270.

Nancy A. Noveilli is a manager in the Valuation and Appraisal Group, KPMG Peat Marwick, New York. She received a BA, from the University of Texas and a Masters of Philosophy degree in economics from the University of St. Adrews in Scotland.

Andrew Procter is a principal consultant and head of Property Group, KPMG Management Consulting, London. He received a BS in estate management from Reading University in England.
COPYRIGHT 1992 The Appraisal Institute
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Author:Novelli, Nancy A.; Procter, Andrew
Publication:Appraisal Journal
Date:Apr 1, 1992
Words:4112
Previous Article:Classifications for commercial real estate.
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