Valuation: Following the principles

Kate Taylor goes back to basics on the income approach to valuation. RICS Valuation – Global Standards 2022 (The Red Book) is mandatory for RICS members and represents good practice in valuation. This article is about Valuation Practice Statement 5: Valuation approaches and methods. This applies International Valuation Standard 105 with the same title. 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, “income approach”.  This definition should be included in compliant valuation reports, along with an explanation of valuer reasoning. This can be more challenging than market approach because the income approach includes several technical valuation methods that can be harder for a lay client to follow.  The UK National Supplement to the Red Book has UK Valuation Practice Guidance Applications, which may also be relevant to your valuation. This is a complex subject and if you wish to study this subject in more detail than the overview provided here, I recommend The Income Approach to Property Valuation (7th ed, Baum, A, Mackmin, D and Nunnington, N). Income approach principle Income approach is based on the conundrum of the time value of money and uses financial formula, like present value of £1 and years purchase, to calculate how much less money received in the future is worth than money received today to reflect inflation, risk, return and expectations of growth. The basic formulae Years purchase in perpetuity 1/i Present value of £1 1/ (1+i)^n Years purchase for n years or PV £1 pa 1-PV/i Income approach uses these formulae (among others) in several methodologies: Traditional method of investment valuation  Discounted cash flow Profits method of valuation This article concentrates on the traditional method of investment valuation. When should valuers use income approach? Income approach is appropriate whenever there is an income to be capitalised and the property will change hands in the investment market.  Potential pitfall There is a potential pitfall for APC candidates who default to income approach for all commercial property. When a commercial property is vacant, the first-choice valuation approach should be market approach or comparable method. Capitalising market rent can be a useful cross check, but the valuation becomes more uncertain as assumptions are made about value, significant aspects of a potential lease, void costs and letting incentives. What is yield? Yield is the “i” in the equation and represents risk, return and expectations of growth. There are many different types of yield and choosing the correct type of yield and appropriate figure from analysis is a crucial part of preparing for an income approach valuation. The most common yield is the net initial yield and this can be found by dividing rent by sale price plus purchaser’s costs. Practical tips This can appear daunting to new valuers lacking in confidence with maths. In common with all methodologies, a logical step-by-step approach and back-to-basics philosophy can steer a valuer through a complex scenario. There are simple techniques to help valuers keep track of all the elements in an income approach valuation, like creating a visual aid in the form of a graph or using Excel. There is, of course, some excellent software to support valuers in applying the income approach.  It’s important for valuers to understand the thought processes behind the software inputs and remember that valuation software is a tool, a big complex calculator. The valuer is still responsible for the outputs and may need to explain it to a client (or an assessor for APC candidates). Don’t underestimate how useful Excel can be with income approach valuations. I recommend valuers play with the formulae and create their own Excel spreadsheet that can function as a simple tool. A sheet created for each formula can make playing with different income assumptions to get a holistic overview easier. The stand-back-and-look holistic overview is very important in income approach – it is easy to get bogged down in calculations. Income flows In an income approach valuation, the valuer is capitalising income flows and expressing the right to receive that income flow as a capital sum. The income flow can be sliced and diced a variety of ways but the capitalisation principle remains the same. Make notes on every assumption and calculation element in the valuation to make the thought process clear for yourself and others. Drawing a quick graph of income flows can be very helpful to identify when income stops, starts or changes, aligned with lease events. This helps to scope the structure of the calculation and identify the appropriate income approach technique. In traditional investment valuation, the technique will vary depending on whether the property is under rented or over rented.  Term and reversion An under-rented property is currently at less than market rent, in which case term and reversion is appropriate. In most cases, with upward-only rent reviews, the reversion to plot on the graph will be rent review. A different yield is used to distinguish between term and reversion to reflect risk, return and growth. The term yield will be lower. Hardcore and top slice If a property is over-rented, paying more than market rent, then a hardcore and top slice approach is appropriate: hardcore represents the market rent and the top slice is the over rented portion. A different yield is used for the hardcore income and the top slice. The hardcore will be lower. This technique is less common because of upward-only rent reviews but becomes more common during a recession. Hardcore and layer If a property is prime property and clearly investment market only, changing hands between funds and professional investors, then hardcore and layer with equivalent yield (same yield for hardcore and layer) is appropriate. The hardcore is the passing rent and the layer is the extra slice that will be payable at next lease event. The complexity of equivalent yield analysis makes the technique a good candidate for valuation software. Summing up In income approach, a valuer can capitalise the income however they wish as long as it can be justified and explained. The basic principle for all income approach valuations is the same – finding the capital sum that represents the right to receive that income flow. Spending time understanding the income flows is key to success. The established practice techniques provide a useful structure for beginners. It can be daunting but remember, however you choose to approach income approach, follow the money. Definition of income approach “The income approach is based on capitalisation or conversion of present and predicted income (cash flows), which may take a number of different forms, to produce a single current capital value. Among the forms taken, capitalisation of a conventional market-based income or discounting of a specific income projection can both be considered appropriate depending on the type of asset and whether such an approach would be adopted by market participants.” Source: RICS Valuation Global Standards, p72 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 Photo © Aaron Lefler/Unsplash