Standard ground value in the context of the harmonization of property valuation.
With the growing internationalization of the real estate industry, the pressure to harmonize property valuations is increasing. The International Valuation Standards Committee has addressed this need with the release of the International Valuation Standards. The standards have provided an internationally recognized market value definition, while the methods and practices of valuation remain in the discretion of the valuer. In spite of the general compatibility of valuation methods, a provision on ground value has been a continuing subject of discussion. The fundamental character of this aspect of valuation gives the discussion a pivotal role in the harmonization of property valuation. This article examines the methodological and quantitative impact of standard ground value, which inherently includes the application of remaining life. The subject of analysis is the German income method, which utilizes standard ground value. The methodological analysis examines the scope and limits of conventional income valuations as well as the amount of added information that can be derived from the standard ground value. The quantitative analysis is based on data provided by the Investment Property Databank (IPD). The data supports the conclusion of the methodological analysis that--in view of harmonized property valuation--standard ground value does not require an explicit provision, while offering added informational value in cases of short remaining building life.
The rapidly advancing internationalization of property investment and finance has created a multitude of transnational engagements of investors, financiers, and properties, and has changed property valuation from a national to a truly international discipline. (1) The differences in national valuation approaches present a severe limitation on the informational value and comparability of property values and form a barrier to competition among property service providers and valuers. (2)
These circumstances bring about the growing need for harmonization in the development of financial reporting and valuation standards for consolidated accounts. (3) This necessity is reflected in the agendas of organizations such as the International Valuation Standards Committee (IVSC) and The European Group of Valuers' Associations (TEGoVA). (4)
Agents and Concepts for Harmonization
Obstacles to harmonization include the varying national legal systems; professional standards; and language and terminology that have to be considered and adapted. (5) In this light, the limited success of efforts to achieve a comprehensive harmonization and the lack of establishment of an "international property valuation" come as no surprise. (6)
Despite its importance, the topic of international property valuation was scarcely the focus of scientific research until recently. (7) National standards have been examined as singular entities; supranational comparative analyses are still rare. (8) A noteworthy exemption is the dissertation of Baumunk, (9) which discusses the influence of economic globalization on property and its valuation. However, even there, the potential for harmonization is considered on only a rudimentary level and limited to British and German property valuation. (10)
The most promising agents for harmonization are the IVSC and to a lesser extent the TEGoVA. The mission statement of the IVSC is as follows:
The principal IVSC objective is to formulate and publish, in the public interest, valuation Standards and procedural guidance for the valuation of assets for use in financial statements, and to promote their worldwide acceptance and observance. The second objective is to harmonize Standards among the world's states, and to make disclosures of differences in standards statements and/or applications of Standards as they occur. It is a particular goal of IVSC that international valuation Standards be recognised in statements of international accounting and other reporting standards, and that Valuers recognise what is needed from them under the standards of other professional disciplines. (11)
A significant step towards these goals was taken with the adoption of the market value definition in International Valuation Standard (IVS) No. 1, which subsequently found its way into the RICS Appraisal and Valuation Standards (Red Book) of the Royal Institution of Chartered Surveyors (BICS). (12) This definition of market value is identical with the German Verkehrswert (13) (market value) and is recognized in the United States. (14)
There are differing views regarding the inclusion of methodologies in valuation standards. The British position opts for a separation as "methodologies are dynamic, changing with need, fashion, demand, and analytical techniques," therefore belonging to "textbooks, on an academic level, and in the valuer's toolbox, on a practical level." (15) In the light of valuations performed according to the International Financial Reporting Standards (IFRS) this view may have to change. (16) In Germany, valuation methodology has always been an integral part of standards, i.e., legislation. While deviations from the prescribed methods are possible, valuers' potential liabilities have generally ensured conformity. (17)
Aside from the professional issues concerning the international standardization of valuation methodologies, the academic question regarding feasibility remains. The different national valuation methods are predominantly compatible, as they adhere without exception to the three approaches of valuation and thus represent variations of a common theme. There are some peculiarities, however, which at first glance seem irreconcilable.
Standard Ground Value as a Stumbling Block for Harmonization
This leads to the topic of this article. A German peculiarity (18) is the concept of Bodenrichtwert, which roughly translates into standard ground value. In the context of the income approach, the provision for ground value in British and American property valuation is achieved through an adjusted yield. (19) German valuations account explicitly for ground value, figuratively separating ground and improvements for valuation. The rationale behind this approach lies in the assumed imperishability of land compared to the improvements' limited life cycle. (20) This approach also calls for the explicit allowance for the improvements' remaining life, while the British valuation provides for this also in the all-risk yield.
The goal of this analysis is to either establish the relevance of the parameters for standard ground value and remaining life or prove their negligibility. This will be done by means of substitution of the concerned parameters as well as by comparison between the Ertragswertverfahren (German income approach) and the vereinfachtes Ertragswertverfahren (German simplified income approach), which omits standard ground value and remaining life. If either substitution or comparison shows substantially differing results, the relevance of the parameters can be concluded. If the results do not substantially differ, then the concerned parameters can be considered negligible.
German Income Approach
In order to understand the rationale for the parameter substitution, a short introduction to the German income approach is necessary. This valuation approach can be expressed in a simple formula:
CIV = (NOI - GV x i) x AF + GV (1)
CIV = capitalized income value
NOI = net operating income
GV = ground value
i = overall capitalization rate
RL = remaining life
AF= annuity factor = [(1 + i).sup.RL] -1/[(1 + i).sup.RL] x i
Fundamentally the income value is derived from the capitalization of the property's net operating income over the remaining life. The underlying-and somewhat unrealistic-theoretic assumption is that the net operating income will remain stable until the end of the assumed lifetime and then drop to zero. A property valued at the end of its life cycle would be reduced to the ground value, as the annuity factor would be reduced to zero for remaining life (RL = 0), thus eliminating the first term of the formula. For a consistent integration of the ground value, the imputed interest on the ground value must be deduced from the net operating income. This is generally, but not necessarily, done at the identical overall capitalization rate. (21)
To better illustrate the impact of ground value, the ground value term can be isolated as follows:
CIV = NOI x AF + GV x (1 - i x AF)
Substituting the annuity factor formula in the ground value term results in the following formula for ground value as a proportion of overall value:
CIV = NOI x AF + GV/[(1 + i).sup.RL]
respectively CIV = NOI x AF + GV x [(1 + i).sup.-RL] (2)
With increasing remaining life, the proportion of ground value falls on a diminishing scale. For RL [right arrow] [infinity] the ground value term approaches zero, while the annuity factor becomes the reciprocal of the overall capitalization rate respective to perpetuity. The resulting equation resembles British and American direct capitalization in the following form: (22)
CIV = NOI x 1/i (3)
Furthermore, the equation shows for remaining-life periods > 0 and < [infinity] a significant shift from the decreasing ground value term towards the income term, which increases drastically with the annuity factor. A further factor is the overall capitalization rate (t). With an increasing capitalization rate and constant remaining life, the annuity factor as well as the ground value term fall. Figure 1 and Figure 2 show an overview of the mathematic relations.
Guidelines for Remaining Life
In order to realistically assess the impact of ground value on total value in applied valuation, assumptions regarding typical overall capitalization rates and remaining-life periods have to be made. The parameter for remaining life results from the subtraction of the age of improvements from their total economic lifetime. (23) Even if evidence of the economic lifetimes of differing property types can be found, (24) ultimately the market situation determines the actual parameter value. In Germany, Appendix 4 of the Wertermittlungs-Richtlinien (valuation guidance notes) lists the total economic lifetimes for various improvement types. These values can be considered an absolute upper limit. (25) Especially for modern office and administration space in prime inner-city locations, economic lifetimes of 15-20 years are considered in line with the market due to high tenant demand. (26)
[FIGURE 1 OMITTED]
Furthermore, the determination of remaining life requires the consideration of assumptions regarding remaining life for the property transactions that underlie the deduction of the overall capitalization rate. The overall capitalization rate is derived from documented property transactions for which the income approach formula is solved in retrograde. As the capitalization rate cannot be isolated, it must be derived through iteration. This task falls into the responsibility of the Gutachterausschuse (boards of expert valuers) in Germany, which determine and publish (among other property market-related data) the overall capitalization rates for individual markets and property types as well as the standard ground value maps, from which the ground value for each property can be determined.
In order to provide correct valuations and to avoid violation of model conformity, the guidelines of the Gutachterausschuss for determining the remaining life of the transaction properties must be identical to that of the valuers. (27) It should be noted in this context that 70% of the Gutachterausschusse do not determine the overall capitalization rate on their own, but rather utilize other sources. Therefore, it can be assumed that the guidelines for determination of remaining life generally are not adequately disclosed. (28)
[FIGURE 2 OMITTED]
Thus, the root of the problem does not lie in the actual determination of the remaining life, but rather the conformity of the Gutachterausschusse and the applying valuer, with the main deficit being on the board's side. (29) The shortcoming can partially be explained by a limited number of documented transactions and lack of time for appropriate evaluation as well as a manpower shortage in the boards of expert valuers. (30) As a remedy, a standardization of services and a comprehensive digital integration of the boards of expert valuers should be pursued. (31)
Theoretical Impact of Ground Value
The primary advantage of the integration of ground value into property valuation comes into play with short remaining-life periods and high proportions of ground value to total value. Conversely, the impact and error potential diminish for long remaining-life periods and adequate use of the property, which leads to a smaller quotient of ground value to total value. (32)
In British valuation, short remaining life is reflected in the valuation through adjusted yields or corresponding comparable properties. The individual adjustment musk however, implicitly consider the ground value components of the valued property as well as the transactions on which the yield is based. For a high ground value, the yield needs significantly less adjustment. This is because the main value driver--the ground--has an unlimited remaining life. Without explicit assumptions for ground value, as is most often the case in British and American property valuation, (33) the yield adjustments are not transparently reproducible. (34)
The theoretical impact of ground value can be illustrated effectively through the quotient of net operating income to ground value. It can be shown that a variation of this quotient within realistic boundaries (NOI/GV = 0.1 to 0.5) does not have a significant impact on the relationship of income value to net operating income (CIV/NOI) for remaining-life periods and overall capitalization rates in line with the market. Figure 3 gives an overview of this relationship. The four lower layers represent the quotient of capitalized income value over ground value as a function of the quotient of net operating income over ground value. The spacing between the layers shows that the ground value quotient has an impact on this ratio. The four upper layers, however, which represent the ratio of capitalized income value to net operating income, are grouped closely together, independent of the ground value quotient. The quotient shows a significant impact only for very short remaining-life periods.
To verify the theoretical analysis, the model can be tested with empirical data. The Investment Property Databank GmbH provided a representative data sample of 57 commercial investment properties. The geographic focus lies on Frankfurt; further locations are Hamburg, Cologne, and Munich among others. The dominant use of the properties in the data sample is office space; this is followed by mixed-use and retail space. The data sample includes the following empirical parameters for each property:
* Capitalized income value
* Remaining life
* Ground value
* Net operating income
* Overall capitalization rate
* Total lifetime
[FIGURE 3 OMITTED]
The mean of the quotients of net operating income over ground value in the data sample is 0.3051, which lies in the middle of the assumed values of the theoretical analysis, having a standard deviation of 0.1365. The distribution of the quotients is shown in Figure 4.
To test the assumption that the quotient has no significant impact on the total income value, the empirical data was included into the model. In the illustration (Figure 5) only the predicted layers for a quotient of 0.3--in conformity with the empirical mean--are plotted for reasons of simplicity. The empirical data sample shows the expected deviations in the ratio of income value to ground value (lower layer of Figure 5). The empirical values for the ratio of income value to net operating income, however, closely match the predicted layer (upper layer of Figure 5), independent of the individual underlying quotient of net operating income over ground value. If the individual relationship of net operating income to ground value for each property has no significant influence on the resulting ratio of income value to net operating income, it can be concluded that ground value has no significant impact on income valuations. The empirical data supports this assumption.
[FIGURE 4 OMITTED]
[FIGURE 5 OMITTED]
The ratios of net operating income to income value in the empirical data sample have a coefficient of correlation with the modelled function of a fixed quotient for NOI/GV = 0.3 of 0.9511, with a coefficient of determination of 0.9046. The mean relative error (35) amounts to merely 3.09%. Even more important is the fact that even for relatively high ground values the correlation remains intact. If the model function is based on the lowest quotient in the data sample (NOI/GV= 0.0742) the coefficient of correlation for empirical and prognostic ratios for income value to net operating income remains a high 0.9361 and has a coefficient of determination of 0.8762. The mean relative error amounts to 6.47%.
The strong coherence between empirical and modelled ratios is not surprising, as the impact of ground value is expected to be limited due to the long remaining-life periods of the properties in the data sample. The ground value term (depicted in Figure 1) falls with increasing remaining life and overall capitalization rate according to the following equation: (36)
The discounted ground value for the remaining-life periods of the properties in the data sample represents a negligible portion of the total value. The average percentage of total value amounts to 2.74% with a standard deviation of 3.67% ; the maximum percentage for the data sample is 18.95% with a remaining life of 21 years. (37) The ground value percentage is lower than 5% of the total value in 89.47% of the documented valuations in the set. The ground value percentage exceeds 10% of the total value in only 7.02% of the valuations. For one-third of the valuations, the ground value portion is lower than 1%.
The redundancy of the inclusion of ground value into valuation can also be shown through the application of the vereinfachtes Ertragswertverfahren (simplified income approach), which neglects standard ground value and remaining life. Comparison of the empirical income values with income values gained through the simplified income approach shows that the average absolute deviation amounts to 3.74%, with a maximum deviation of 16.29% and a standard deviation of 3.80%. The coefficient of correlation for the normal and simplified income approach is 0.9989, with a coefficient of determination of 0.9978. Therefore, the simplified income approach reproduces the normal income approach to a very high degree for the given data sample. (38)
In the context of harmonization, this analysis shows that an income approach for commercial properties neglecting ground value and remaining life offers results in line with the market by German standards. Therefore, the explicit consideration of ground value and remaining life does not represent a goal for the harmonization of property valuation and should be abandoned for the benefit of a quicker convergence of valuation standards.
Despite the factually limited impact on income values, ground value and remaining life represent important aspects of a property and should, if not explicitly included into the valuation, be disclosed in the valuation report. This allows for better transparency in valuation and gives the addressee of a report insight into the valuer's approach, especially regarding the determination of the yield. Furthermore, the imputed interest on ground value is a significant indicator regarding the highest and best use of a property, particularly if the net operating income does not exceed the imputed interest.
This article is the winner of the Appraisal Journal Prize for Best Paper on Real Estate Valuation at the 14th Annual European Real Estate Society Conference in 2007.
(1.) Karl-Werner Schulte, "Internationalisierung der Immobilienbewertung," Der Sachverstandige 30, no. 3 (2003): 50.
(2.) Clare Mcparland, Alastair Adair, and Stanley McGreal, "Valuation Standards--A Comparison of Four European Countries," Journal of Property Investment & Finance 20, no. 2 (2002): 128.
(4.) Karl-Werner Schulte, "IAS/IFRS Immobilienbewertung und--rechnungslegung--Es wird internationaler," Immobilien Zeitung no. 26 (December 12, 2003): 10; Wolf-Eberhard Schulz-Kleessen, "Neue Regeln fur die Bewertung von Immobilien in Europa," Der Sachverstandige 28, no. 1 (2001): 10.
(5.) John A. Edge, "The Globalization of Real Estate Appraisal--A European Perspective," The Appraisal Journal 69, no. 1 (January 2001): 86.
(6.) Wolfgang Kleiber, "Was sind eigentlich die sog. Internationalen Bewertungsverfahren?" Grundstucksmarkt und Grundstuckswert 15, no. 4 (2004): 195-197.
(7.) Sarah Sayce and Owen Connellan, "Convergence of Valuation Standards: An International Perspective," The RICS "Cutting Edge" Conference (September 6-7, 2001), 2; Stephen Roulac et al., "The Emerging Global Real Estate Appraisal Research Agenda--Evidence from the ARES, ERES, PPRES and RICS Cutting Edge Conferences," Journal of Real Estate Literature 12, no. 2 (2004): 148-149.
(8.) McParland, Adair, and McGreal, 128; and Roulac et al., 148, 152.
(9.) Henrik Baumunk, Immobilien und Immobilienbewertung im Zeitalter der Globalisierung (Dresden, 2004).
(10.) Ibid., 180-213.
(11.) International Valuation Standards Committee, "Committee Purpose," http://www.ivsc.org/purpose.html.
(12.) The adoption of the market value definition by the RICS also effectively ended the discussion revolving around the differences between the open market value and the Verkehrswert (market value), as the best price versus most probable price controversy was resolved.
(13.) Kleiber, 193-194.
(14.) Appraisal Institute, The Appraisal of Real Estate, 12th ed. (Chicago: Appraisal Institute, 2001), 23-24.
(15.) Edge, 84.
(16.) Joseph J. Vella, "Key to Success: A Profession Speaking with a United Voice," Canadian Appraiser 49, no. 1 (2005): 32.
(17.) Wolfgang Kleiber, WertR 02--Wertermittlungsrichtlinien 2002, Nachdruck der 8. Auflage 2003 (Koln 2003), 6.
(18.) Jorg Zurhorst, Internationale Bewertungsverfahren, "Es ist hochste Zeit fur einheitliche Standards"--Methodische Unterschiede konnen zu abweichenden Bewertungsergebnissen fuhren, Immobilien Zeitung no. 23 (November 4, 1999): 12.
(19.) Rudolf Siegesmund, "Angelsachsisch ist nicht international--Deutsche Sachverstandige kontra britische Bewerter," Immobilien Zeitung no. 1 (January 13, 2000): 8.
(20.) Jurgen Simon and Wolfgang Kleiber, Schatzung und Ermittlung von Grundstuckswerten--eine umfassende Darstellung der Rechtsgrundlagen und praktischen Moglichkeiten einer zeitgemassen Verkehrswertermittlung, 7. uberarb. und erw. Aufl. (Neuwied, 1996), 202.
(21.) Wolfgang Kleiber, Jurgen Simon, and Gustav Weyers, Verkehrswertermittlung von Grundstucken, 4. vollstandig neu bearbeitete und erweiterte Auflage (Koln 2002), 1098.
(22.) As the assumptions that reduce the German income approach to a direct capitalization are inconsistent with normal British valuation scenarios, equivalence cannot be concluded.
(23.) Economic lifetime describes the period in which a property can be successfully marketed. It is clearly distinguished from technical lifetime, which usually spans much longer periods.
(24.) Kleiber, Simon, and Weyers, 1511.
(25.) WertR 2002, Anlage 4.
(26.) Gerrit Leopoldsberger, Matthias Thomas, and Philipp Naubereit, "Immobilienbewertung," in Immobilienokonomie--Band I: Betriebswirtschaftliche Grundlagen, 3, Karl-Werner Schulte (Hrsg.), vollstandig uberarbeitete und erweiterte Auflage (Munchen, 2005), 453-528,487.
(27.) Kleiber, Simon, and Weyers, 999.
(28.) Melanie Walter, "Der Liegenschaftszins--wird er uberhaupt ermittelt?" Grundstucksmarkt und Grundstuckswert 11, no. 1 (2000): 6; Rainer Rau, Immobilienbewertung--Prognose: "Break-Even Rendite schlagt Liegenschaftszins," Immobilien Zeitung no. 16 (July 31, 2003): 14.
(30.) Klaus-W. Moller, "Liegenschaftszinssatze," Grundstucksmarkt und Grundstuckswert 6, no. 6 (1995): 346-347.
(31.) Helmut Schmalgemeier, "Grundstucksmarkttransparenz--sind die Gutachterausschusse 'am Puls der Zeit'?" Grundstucksmarkt und Grundstuckswert 16, no. 6 (2005): 350-357.
(32.) Christian Linke, "Fehleranfalligkeit des Ertragswertverfahrens," Grundstucksmarkt und Grundstuckswert 6, no. 6 (1995): 338-345,339.
(33.) Siegesmund, 8.
(34.) Jurgen Simon, "Quo Vadis?--Deutsche Verfahren der Grundstuckswertermittlung auf dem Prufstand," Grundstucksmarkt und Grundstuckswert 7, no. 3 (1996): 136.
(35.) Defined as the means of the absolute values of the difference between modelled and empirical quotients.
(36.) Compare with Formula 2.
(37.) The shortest remaining-life period in the data sample is 18 years. The ground value percentage of total value, however, only amounts to 16.47%.
(38.) Of further interest is that the sometimes-deemed-unprofessional simple capitalization of net operating income with the overall capitalization rate (NOI/i) has a mean relative error of only 8.77% and a coefficient of correlation of 0.98. However, the maximum deviation is an unacceptable 36%.
Philipp Naubereit researches and analyzes valuation and real estate--related issues in the Special Assignments Real Estate division of the MEAG Munich Ergo AssetManagement Group. He received his Diplom-Kaufmann (MBA equivalent) from the European Business School Oestrich-Winkel. Subsequent to his MBA, he became research assistant to the chair of real estate economics, Professor Dr. Karl-Werner Schulte. Naubereit successfully completed his thesis on "international Harmonization of Real Estate Valuation Approaches" at the University of Regensburg in spring 2008. He also has a bachelor's degree in computer science from the James Madison University in Harrisonburg, Virginia. Contact: Naubereit@t-online.de
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|Date:||Jun 22, 2008|
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