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Date Posted: 12:53:27 10/02/01 Tue
An introduction of property valuation
Chapter 13
Methods of valuation
There are five conventional methods of valuation: the comparative method(or comparison), the contractor's method(or summation),the residual method(or the hypothetical development method),the profits method(or the accounts method or treasury method), and the investment method(or capitalisation).
The names in brackets are those used in different countries in lieu of the traditional English names for methods,but the theory and practice remain the same wherever the methods are used.
The comparative method(Comparison)
This is probably the most widely-used method and even if one of the other four methods is used by a valuer he will still almost inevitably have recourse to comparison as well. The method entails making a valuation bt directly comparing the property under consideration with similar properties which have been sold in the past,and using the evidence of those transactions to access the value of the property under consideration.
Although this sounds simple and staightforward,there may be many pitfalls to trap the unwary.In using the method it is desirable that the comparison should be made with similar properties situated in the same area,and with transactions which have taken place in the recent past. The less the comparable property complies with these requirements,the less vaild will be the comparison.Often a valuer is able to get evidence of sales which do accord with these requirements, particularly when a valuation is of a property such as a semi-detached suburban house(a duplex). However, the more uncommon a property is,and the more specialised the type of property,The less likely is it that the valuer will be able to find good 'complete',and it is not unusual for there to be a complete lack of evidence of sales of comparable properties.
Even when properties appear to be similar,close inspection often reveals that they are in fact different.A row of apparently identical houses may on internal inspection prove to have many differences,and the skill of the valuer will be required to make an allowance in money terms for such difference in value caused by a different geographical location.
It is essntial in using this method to have as much evidence as possible readily available,and good office records are invaluable. Any valuer should ensure that there is an efficient filing system which is regularly kept up to date,and which contains as much information as can be obtained of each market transaction which is recorded.Modern computer filing systems greatly facilitate good record keeping and the almost instantaneous recall of information. However,for helpful records to be kept,there must be evidence of suitable comparables available,and unfortunately.in the real world,this is often lacking.
The word recent is a relative term. At some points in time a sale which took place a year earlier may be recent enough to be a vaild comparsion if the market has remained relatively stable in the intervening period.If the market has been volatile or has changed
in any way during this time,then market evidence might need to be much more recent for it to be a good comparable.Even if there have been no transactions in the recent past,a valuer may be able to get some guidance from considering market evidence over a period of earier years or months,as it is possible that a clearly defined trend of values might be detected.The valuer may decide that this tread would have continued through to the date on which the valuation is being done.
In using the comparable method a most thorough inspection of all the underlying factors in the market must be made in order to decide whether there have been changes in conditions since other transactions took place.For instance,changes in the general level of interest rates over a period of time may mean that what may at first appear to be useful comparable evidence has to be rejected because of the substantially different market conditions in which they occurred.
The method involves few dangers if the market is stable and active.When it is not stable,valuers may encounter problems in its use,and this may also be the case if there are few comparables,or if there are no true comparables,that is if the range of properties sold does not contain anything truly identical to the property under consideration.
Some differences may be relatively unimportant, and differences in architectural design,for example,may often make little difference to value.However,if a particular design reners a building inefficient in use,the difference may be very important,and in using the method the valuer should always consider such possibilities. The age of a building can be important in that it may be such as to render it either more or less fashionable and in may be such as to render it either more or less fashionable and in many instances the structural condition and state of repair will be directly related to the age ofthe building.Values should also pay consideration attention to the accommodation offered by different properties,and try to make allowances for variations in the amount of floor space and differences in the lay-out and the number of rooms provided.Allowance should also be made for differences in the quality of fixtures and fittings,and for differences in the size of the plots on which properties stand.Location is always very important,and the valuers should be wary of assuming that values should be similar simply because the size and accommodation of properties is identical.A slightly different location can make a vast difference to market value.
In using this method the valuer should always bear in mind the fact that property is heterogenous,and should always ask himself whether any special factors affected the market value of the comparables that he is using.or whether any special factors are likely to effect value of the property which he is considering.
The following is an example of the comparative method in use.
Example1
A valuer has to value a four-bedroom house,which provides net usable space of 180 . Research receals that in the same street there have been sales of similar sized four-bedroom properties as fellows:
12months ago a house of 180 sold for £90000
8months ago a house of 170 sold for £86700
6months ago a house of 185 sold for £95275
3months ago a house of 175 sold for £91500
1months ago a house of 185 sold for £97600
After analysing these sales the valuer decides that whereas the first sale revealed a capital figure of £500 per of usable space,the last sale was a figure of£527.50per m of usable space.The valuer also notices there has been a consistent rate of increase of £2.50/ per month in the capital values of this style of house and therefore values the subject property at £95400(180 @£530 /).
This is a very simple example of the comparative method in use and in reality its use will normally be more complicated.It would be necessary to check whether the various houses provided similar numbers of rooms in total,whether their locations were of equivalent quality,whether their fixtures and fittings were similar and of equal quality,and also to check on other features of each of the properties. Adjustments in the analysis of each piece of market evidence would be necessary to allow for variations in such factors, and it is likely to be rare in the world that market analysis and use of the analysed information would be as straightforward as in the example above.
There is a great danger in the use of comparable evidence that the valuer may place too much faith in it,forgetting that while such evidence reflects what happened in the past his present task is to determine what the current value of property is.Current market value may be affected by different factors to those which affected past transactions and it could therefore be that past evidence might be of only very limited assistance or in extreme circumstances it might be positively mislending.
Perpaps the biggest danger in the use of the comparative method is the underlying and simple assumption that because in the past one person was prepared to pay a certain figure for a particular property, another person will also be prepared to pay a similar figure for a similar property. It may be that the purchaser of the comparable property had special reasons and specific personal circumstances which both prompted and enabled the purachase to be made, such reasons and circumstances being completely irrelevent to others in the market place.
An example of such a situation might be a person paying a high figure to buy a house near their own for occupation by an aged or infirm parent who can contribute a substanial amount of capital towards the purchase. Other potential purchasers of nearby houses may be quite unable and also unwilling to pay a similar price.In the retailing world,a retailer selling high-value goods with big profit margins may be able to pay a high rent or a high purchase price for retail accommodation.However,if the only potentail occupiers of nearby vacant and similar retail accommodation are trades who sell low-value goods at low-profit margins,it may be completely unrealistic to anticipate a high rent or high capital value for the vacant accommodation.
The simple assumption that,all other factors being the same, the market evidence of the value of one piece of property at a point in time is automatically a good indicator of the market value of another simpilar ,itself has to be treated with great caution. The valuer has to be extremely knowledgeable about the market for which valuations are to be made,and must make every effort to determine who is looking for property of the relevant type,what their precise needs are, and what their purchasing power is, Such factors could have a great influence on how comparable evidence should be used and whether it is indeed a reliable indicator of the prices likely to be paid in the current market.
However,in spite of the need for great care in the use of the comparative method and the frequent shortage of suitable comparable evidence,it is a method which the valuer will use regularly and which will give reliable results if used property and in the correct circumstances.
The contractor’s method(summation)
This is used to value the type of properties which seldom change hands and for which there are therefore few or no comparables. It must at this point be stressed that cost and value are rarely the same,but this method of valuation is based loosely on the assumption that they are related.It should be therefore be appreciated that it is a method used only infrequently,and which is something of a last resort.The basic theory of the contractor's method is that the cost of the site plus the cost of the buildings will give the value of the land and the buildings as one unit.
With the majority of properties there is ample evidence to show that this proposition is not correct,but the contractor's method id used to value properties for which there is little gerenal market demand and which are consequently rarely sold.The types of property for which it could be appropriate are hospitals,town halls,schools,libraries ,police stations,and other such buildings.although the use of the method is not necessarily restricted to the public buildings alone. Cost is normally only one factor of many which may affect supply and demand and which therefore affect value, but it is probably true that with this type of building it is a predominant factor. It would always be possible for the would-be users of such buildings to acquire alternative sites and to construct new buildings rather than purchase an existing property at a greater overall cost. Competition between rival potential users would be unlikely and it is therefore reasonable to assume that cost and value are not unrelated with such specialist buildings.
However,if an alternative building were constructed it would be a new property,whereas with an existing property it is obvious that there would be some wear and tear resulting from its previous use and there might also be a degree of obsolescence which had arisen since it was new.In using the contractor's method the valuer must therefore make a deduction to allow for both depreciation of the buildings and obsolescence of design.The basic valuation approach then becomes as below:
Cost of site
plus Cost of building
less Depreciation allowance and obsolescence allowance
=value of existing property
This method is most frequently used for rating purposes where rates are levied on the value of buildings and sities together and it is also sometimes used in valuations for compensation when property of a specialist nature has been compulsority acquired.
The following illustrates the typical use of the contractor's method of valuation.
Example2
A public library which occupies a site on the fringe of a town centre has to be valued.The building is about 100-years old,built in a rather ornate style and shows some evidence of deterioration.
The valuer using evidence and his own judgement decides that an equivalent site would today cost£800000,that a 500
building in the same style would cost £1250/ to build today ,and that considerable allowances should be made for deterioration and obsolescence.He accordingly values as follows:
Cost of site...£800000
plus building cost 500 @£1250/ ...625000
=1425000
less 25% obsolescence allowance(based on building cost)...156250
=1268750
less 15% depreciation allowance(based on building cost)...93750
Value of existing property...£1175000
Expressed as a hypothetical example in a book, the method appears simple to use. In reality all the inputs to such a valuation are likely to be difficult to determine, even the building costs which will be far from clearcut in the case of the unusual types of building for which the method is used. In particular, the precise allowances to be made for depreciation and obsolescence are very difficult to determine and very much dependent upon the judgement of the individual valuer.
The residual method (hypothetical development method)
This is used when a property has development or redevelopment potential. It is needed when there is an element of latent value which can be released by the expenditure of money on a property. Residual valuations are quite regularly made by people who purchase residential properties which they consider could be made more valuable if money were spent on improvement and modernisation. This would-be purchaser may look at a house and decide that it is worth £50000 and that it needs expenditure of a further £20000, after which it will have a market value of £90000. A quick inspection of the figures shows that latent value of £20000 has been released by the expenditure on improvements. This is a very simple example of the method in use, but even when much more complicated calculations are involved, the basic approach to the method is still exactly the same.
Value of the completed development less
Total expenditure on improvements or development(including developer’s profit)
=Value of site or property in its present condition(Residual Value)
The value of the completed development is sometimes referred to as the Gross Development Value, or as the Gross Realisation.
The use of the residual method involves considerable skill and it is first necessary to decide what is the best form of development suitable for a site or property, and then to predict the value of such a development after it has been completed. This is not an easy tank, as apart from the skill involved in choosing the best use for a site, the valuer also has to estimate the value of a building which does not as yet exist. He has to cast his mind forward to some future date and imagine the building in existence on the site before he can begin to estimate the Gross Development Value.
Even when this has been done with great skill and accuracy, all the costs of improvement and development must then be estimated. These may include such items as the cost of site clearance, architects’ fees, site engineer’s fees, quantity surveyor’s fees, and all other professional fees incurred in creating the development. The costs of building must be estimated, and these could well increase during the timelag between the acquisition of the property and the completion of the development. Once a property has been developed it has to be let or sold, and the valuer must make an allowance for all costs which would be incurred in letting or disposing of the property he envisages as one day standing on the site. These costs will include estate agents' fees, advertising fees and the solicitor's fees and legal expenses. To purchase the site and subsequently develop or redevelop it will usually require a considerable amount of finance, and the costs of obtaining this must be deducted as a development cost. No one will wish to take all the risks involved in a project without reward, and a developer's profit must be allowed.
There may be other items of expense to consider, and the more variables there are more difficult it will be to maintain an acceptable degree of accuracy in the calculations. However, a skilled valuer with a specialist knowledge of the type of development for which he is valuing, who is touch with the market and who is familiar with the costs of development, can use this method with a considerable degree of accuracy.
There will doubtless be instances in which, in retrospect, a purchaser will be seen to have paid too much for a property because the figures on which the residual valuation was based have changed in the period since the property was purchased.The method is nevertheless acceptable for finding market value, as it must always be remembered that this value is the figure which would be paid in the market at a definite point in time, taking into account future expectations. It is not unusual in any aspect of life for retropective consideration to show that an earlier decision was based on false assumptions, and the fact that a residual value may subsequencetly be shown to have been optimistically calulated does not alter the fact that in the light of circumstances at the time of purchase the estimate of market values was correct.
The method is often critcised as being clumsy and containing too many variables, but there is little doult that it is the only real method of valuation applicable when there is latent value in a property.
The following simple example illustrates the way the method in used in practice.
Example 3
A site with approval for the development of four houses of 160 each is to be auctioned and a developer wishes to know how much he can afford to bid for it.He estimates it will take one year to complete and sell the development,that he will have to pay 16% pa interest on borrowed money,and that the houses will cost £400/ to build including all site works and the provision of services.He also decides that he will require a profit of £15000 per house,each house having an anticipated market value of £115000.
His detected houses at £115000 each
Gross Development Value……………………………..£460000
Less Costs of development:
(1)Building costs:4 houses 160
@£400/ =£256000
(2)Professional fees(architect’s,planner’s
quantity surveyor’s)@10% of building costs =25600
(3)Cost of borrowing half of (1)+(2)
=22528
(4)Legal expenses on sale of houses say 12000
(5)Agent’s fee on sale of houses say 8000
(6)Advertising costs on sale say 1000
(7)Developer’s profit= 60000
Total development costs…………………………£385128
Residual Sum…………………………………….£74872
On the above calculations the developer considers the sum of £74872 is available to cover the purchase price of the land, all the expenses he will incur on the land purchase,and the interest charges he will incur on holding the land from the date of purchase until the development scheme is completed and sold. He will calculate these costs and his bid price for the land will be reduced below £74872 by the amount of these costs.
All the costs he uses in this valuation will be carefully assessed by the valuer in an effort to calculate a realistic figure for the land value. However, because they are all predicted figures the accuracy of the valuation will depend upon the skill and judgement of the valuer.
The selling price of the houses will be based on his market knowledge, while items (1) and (2) will be based on his knowledge of costs and perhaps even on the preliminary estimates of builders and professional advisers.
Until the development is built and sold the developer will incur the cost of interest on money borrowed to complete the development, or alternatively he will sacrifice interest earnings if he uses his own money. As a general rule, a realistic estimate of the amount of money a developer will need on average throughout the development period is half the cost of building and half the cost of professional fees, as calculated at (3).Clearly, Such a calculation is only an approximation of interest charges, but it is nevertheless a useful approach for initial development appraisals.
In reality, most development schemes usually involve lower levels of expenditure in the early stages of the scheme than in the latter stages,and this type of initial assessment may therefore tend to over-estimate the costs of finance. However,it is nevertheless a useful approach for initial appraisal purposes.
items (4),(5)and(6)are costs which are likely to arise with any development and the valuer will assess them on the basis of recent experience of such costs.
The developer's profit is the return for his expertise and the reward for risks he takes, and there is no fixed rule for the calculation of this figure.It is sometimes calculated as a percentage of Gross Development Value, sometimes as a percentage of Building Costs,or it may be calculated by other methods thought appropriate by individual developers,such as the profit per house used in the above example.
The residual sum found is based on the anticipated sale of the completed development at a future date, in the above example 12 month's time.If the developer bids for the land he must therefore allow for the professional fees and legal costs he will incur on purchasing the land, and also on the interest charges he will incur during the development period on borrowing the money for the land purchase and the associated costs.
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