Valuation: following the golden rules

Kate Taylor sets out best practice when applying the market approach to valuation. Market approach is part of the global valuation vocabulary from the International Valuation Standards. The language and associated methodology do not always match up in UK valuation practice. This article will explain the origins of the vocabulary and what it means in practice for valuers. The International Valuation Standards Council is the independent global standard setter for the valuation profession. It is a council made up of valuation profession organisations, including the RICS. IVSC creates IVS which promote consistency and professionalism in the public interest. The RICS is a key member of IVSC and the RICS Valuation Global Standards 2022 (commonly known as the Red Book) is fully aligned with the IVS. So far, so good, but this can result in vocabulary that works internationally yet has limited application in different jurisdictions. The Red Book is vitally important to all registered valuers and is the yardstick for compliance in valuation. This means the mandatory parts of the Red Book should be adhered to.  One of the mandatory parts of the Red Book is Valuation Practice Statement 5 – Valuation approaches and methods. This applies IVS 105 with the same title. This title builds on the common misconception that the Red Book is a valuation manual; it isn’t. The Red Book represents high-level processes to follow with some technical guidance at the back in the Valuation Practice Guidance Applications. VPS 5 is about the process for explaining valuation approach and methodology to a client in a valuation report. The Red Book’s overall purpose of consistency, objectivity and transparency means it encourages standardised vocabulary. In this case “market approach”. The definition is: “The market approach is based on comparing the subject asset with identical or similar assets (or liabilities) for which price information is available, such as a comparison with market transactions in the same, or closely similar, type of asset (or liability) within an appropriate time horizon.” This definition should be included in compliant valuation reports, and that is pretty much all there is to VPS 5. To most valuers in the UK this means, in more familiar vocabulary, comparable method. Call it what you will, it is all about the same basic valuation principles that underpin almost all valuation methodology. Comparable analysis is used to some extent in almost all valuations, and it is a fundamental skill for valuers at any stage of their career. When should we use the comparable method? The comparable method should be used whenever there are comparable transactions available. The comparable method should also be used as a cross check with all other methods of valuation. The comparable method works on the substitution principle that the value of one property can be derived by comparing it with prices achieved from transactions of similar properties because a buyer will not pay more than the cost of acquiring an equivalent substitute. The starting point in application For any valuation, there is a lot of due diligence before the main task can begin and a key part of this will be establishing the basis of valuation. This represents the fundamental scenario underpinning the valuation. The choice of basis of valuation depends on the purpose of valuation. Most market approach valuations will be on the basis of market value but if the purpose of the valuation is for accounts prepared under International Financial Reporting Standard 13, it will be fair value. This is very similar in practice but defined in accountancy language from IFRS. Here, market value is used as the starting point. Market value  This is defined by Valuation Practice Statement 4 in the Red Book as: “The estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction, after proper marketing and where the parties had each acted knowledgably, prudently and without compulsion.” What does market value actually mean?  It’s a hypothetical scenario. Imagine a potential purchaser coming fresh on the scene, what bid are they likely to make for the property at the valuation date? They represent the typical non-specific market participant as envisaged by IVS.  The valuer needs to put themselves in the shoes of the potential purchaser. To do this, a valuer must understand what they think, feel and know about the property. They have no special knowledge, no desperate need to buy. They are not connected to the fictional vendor and there has been an appropriate marketing period for the character of the property.  World of valuation concept  The mind of the potential purchaser is a busy place, and the valuer will need an awareness of economics, demographics, sociology, technology, fashion, taste, politics, law and other random factors like Brexit, banking crises or pandemics. In other words, to consider everything that might affect value to the potential purchaser. A good valuer understands the whole world they operate in. This will help the valuer to estimate what bid the non-specific market participant might make for the property.  Basket of evidence  This is where the analysis will come in. The principles of good comparable evidence are well explained in the RICS Guidance Note Comparable Evidence in Real Estate Valuation 2019 and I won’t repeat them here. Suffice to say, using another old legal principle, that all evidence is admissible. The goodness or badness of it goes to weight (Garton v Hunter [1969] 2 QB 37).  The valuer needs to gather a basket of evidence and decide which is the most useful in order to try and guess what bid the potential purchaser might make for the property. This basket can include:  direct transactional evidence from capital values and rents;  lease events;  market sentiment;  automated valuation model outputs;  historic evidence;  indices;  asking prices; and  valuer opinion (gut instinct). The subject property and the comparables will differ in all the myriad ways real estate can differ, for example physical characteristics, location and lease terms. Comparable analysis The valuer can break the evidence down and adjust for the differing characteristics to look at the comparable on the same terms as the subject property. Comparable matrix technique This is usually done by a comparable matrix. This is a table where the amount of analysis varies from a simple breakdown into rent or capital value per square foot/metre to a complex analysis with percentage adjustments for individual factors like: rental incentives – headline rent to net effective rent; location;  floor level; state of repair; and weighting. The valuer overview and justifications of adjustments can be included within a matrix in a remarks column. It is helpful to include thumbnail photographs in a matrix address column and plot on a map. For record keeping, use comments to make the thought process clear for any adjustments made. Be careful to adjust the comparables to the subject in the right way, for example – do not add for a better location than the subject, deduct for a better location to express the comparable on the same terms as the subject. The purpose of analysis is to imagine what the comparable would have transacted at if it was the same as the subject property.  The matrix can add value to clients, so include one in any valuation report. Do not underestimate the value of notes – justify how useful each comparable is, using weighting remarks. Keep the matrix on file for six to 12 years. It can be a useful addition to a valuer’s database and helpful in the event of any queries. Points to keep in mind I am going to finish with one of valuation’s golden rules – the more adjustments a valuer needs to make to the evidence supporting a valuation, the less weight can be attached to it. This is because every adjustment is subjective. A market approach/comparable method valuation takes real skill. Valuation is often described as an art and not a science and I think this is best demonstrated by market approach. It is very rare to have perfect comparables and the valuer’s skill is needed to interpret and analyse. This is a technical skill and requires a strong understanding of the relevant market. Valuers need to understand the drivers of supply and demand in the relevant market sector to make sense of the comparables. This is why so many valuers get on the phone to agents to confirm comparable details and discuss the market. Good relationships and market awareness are a critical skill in applying the market approach.  To come full circle to where we started, remember that it is good practice to include the market approach definition from VPS 5 of the Red Book in any valuation report. The terminology is not universal, but the techniques are. The comparable method step by step Look at subject property Search for comparables Adjust and analyse comparables Weight comparables Value subject property Stand back and look Resources International Valuation Standards Council   RICS Valuation Global Standards 2022 (the Red Book) Valuation Practice Statement 5 – Valuation approaches and methods  RICS Guidance Note Comparable Evidence in Real Estate Valuation 2019 Kate Taylor FRICS is author of RICS APC Commercial Real Estate Revision Guide from https://apctaylormade.wordpress.com Image by Shutterstock