First principles: Comparables in the market

Sebastian Deckker goes back to the first principles of valuation to offer a vital refresher course for surveyors. We live in difficult and uncertain times: the aftermath of Covid-19, the invasion of Ukraine, the cost-of-living crisis, increases in energy bills and interest rates. Now more than ever, it is important to be robust in the valuation process as sales might not be all they seem. In order to calculate the value of a property, a valuer uses comparable evidence to assess the value of the property if sold on the open market at a given date. Comparable evidence is applicable for all types of land and buildings used for commercial, industrial, residential and agricultural. Comparable evidence comprises a set of similarities or differences when looking at local properties that are used in support of the valuation. A comparable is used during the valuation process as evidence in support of the valuation of different items of the same general type. Methods of valuation There are five methods of valuation, each using comparison to some degree: • Market approach – the value of one property can be found by comparing it with prices achieved on other similar properties. You will use this method of valuation for straightforward residential, rural and commercial properties. • Income approach – used to value properties that are let to produce an income for an investor. This can be split into two: investment or profits method. With the investment method, in simple terms the value is the product of the rental income multiplied by a yield. These inputs are derived using comparable evidence. So is the passing rent a market rent? What is the market rent? What yield should you adopt? All these will depend on the type of property, its use, location, demand and security of income. For properties where the value is derived from the trading potential of a business, say a hotel or a cinema, the profits method is adopted. This is quite a different approach, although comparison is used again to determine rates per room, void periods and yield. • Cost approach – can be divided into the contractor’s method and the residual approach. The contractor’s method is used to value properties that are rarely traded on the open market and thus no comparable evidence exists, say for public buildings like town halls or libraries. These valuations are based on two components: the cost of constructing the building and the value of the land, both of which can be established by comparison. For development sites, the residual method is used. In basic terms, this is the calculation of the completed development, or gross development value, less costs: build costs, fees, finance costs, developer’s profit, etc, all of which are derived by comparison to previous projects or to market evidence. Factors at play The complex nature of most properties affects the use of comparable evidence. A property’s value is the reflection of the collective impact of numerous factors. The more of these elements that are in common between the property you are valuing and your comparables the better: • Location – this is probably the most important factor. It can be on a macro level, for example postcode by postcode or village by village, or a micro level, for example street by street. • Age and condition – will have a clear impact on value. In other words, what would be the cost of bringing the property you are valuing from poor or derelict condition up to the market standard? • Tenure – this would be in terms of, say, freehold or leasehold. If the latter, what is the unexpired term? Does the property qualify for a lease extension or enfranchisement? What is the difference in value between a 35-year lease and a 28-year lease? Or perhaps an 85-year lease and a 75-year lease? Watch out for the marriage value trap below 80 years. Or perhaps the property is let. What are the terms of the tenancy agreement? What would you consider the difference in value to be between a property that has just been let on a three-year term with no landlord break to one where the tenancy is about to come to an end? Even if a property is freehold there may be restrictions on use either imposed through the title (restrictive covenants) or by the local authority. • Size – comparable properties should be of a similar size or, if not, adjusted accordingly for quantum. • Date – the transaction date is important as markets are fluid and subject to price fluctuations, often sudden and unpredictable. • Data – a further significant factor affecting the use of comparable evidence is that real estate markets lack transparency. Information about transactions is often secretive and, when it is available, it may lack important details about size, condition and so on. Evidence Information derived from relevant comparable market transactions will normally provide the best evidence of value. Of course, the quality of evidence is likely to be determined by its source. Direct evidence is the best and most reliable source of evidence. It is important that you have experience with the type of property being valued and its location. Speaking to local agents is invaluable. What is the actual market like? What is the demand? What type of buyers? There is no substitute for seeking the opinion of those who are dealing with sales on a day-to-day basis. Evidence from publicly available information sources, such as the Land Registry, may offer details of tenure, contract sum, date and title. But it does not include other relevant aspects such as condition, arrangement and floor area, which are vital when trying to compare one property to another. Asking prices do not provide reliable evidence of value and should treated with caution. They may be “client-led”, reflecting expectation rather than reality, and will usually vary from the price achieved on exchange in the open market. Historic evidence can be helpful if combined with market trends and indices. As a valuer specialising in a particular area, you may be asked to value the same property more than once and this previous knowledge is invaluable. What has the market done since your last valuation? Has the property been improved or extended? Has the lease been extended or freehold acquired? Indices are a useful tool. They are usually derived from aggregated information about market values or transactions. For commercial investment property, the best known is the Investment Property Databank. For residential property, the RICS, Nationwide and Halifax all produce indices, as well as the major firms. It goes without saying that the evidence used to arrive at an opinion of value should be recorded carefully. It is good practice to ensure documents are kept. Analysis Having gathered all this information, it will be useless without you taking the final step: analysis. The process of analysis converts the raw data you have accumulated into supporting evidence. The first step is establishing a common measuring standard so as to compare like with like. The RICS Code of Measuring Practice indicates different units of measurement depending on the type of property being valued. It is rare to find two identical comparables, so you should make adjustments to allow for differences in the various factors that may affect value. These may include location and tenure. Other adjustments may be harder to define and will come from your knowledge of the type of property and location. Such variables may be judged as having a positive or negative effect on value. But to what degree? 5%? 10%? What is the difference between a south and north-facing garden? What about the difference between a first-floor flat or a fifth-floor flat? And now those same flats in buildings with or without lifts? Analysis should be kept to a minimum. The more adjustments that are needed, which after all are subjective, the less comparable that property will be to the one you are valuing. It is not uncommon for there to be a shortage of evidence available: an inactive market, so few transactions, or a fast-moving market where transactions can be quickly become out of date. Why this matters Comparable evidence is at the heart of virtually all real estate valuations. All five methods use comparison to some degree. Comparable evidence will never be a “perfect match” for the property subject to valuation and there will always be a range of values suggested. It is often said that “valuation is an art not a science” and thus it is your skill as a valuer to analyse and interpret the data and use it to provide guidance for the valuation figure to be reported. It is important to start with the correct method of valuation. In contrast to the market for publicly quoted company shares, which have an exact price at a given date, you may find the number of transactions for any category of property limited. The volume of comparable evidence may be reduced further because no two properties are identical. Two houses on a new estate may, at first sight, appear to be similar but there will probably be differences in aspect, condition and arrangement. It is these differences that can have an impact on value and it will be your skill as a valuer to determine which differences are relevant and which are not. The process of identifying, analysing and applying comparable evidence to a property is fundamental to producing a sound valuation. Your opinions will have to withstand scrutiny from your client, the market and even the courts, say in the case of being an expert witness or in the course of a claim. Treat indices with caution. They can be a useful guide to general trends in the market against which the performance of the property being valued can be judged. However, they cannot assist in markets that are inactive or where transactions are scarce. In addition, they can be very generic and may not be suitable for the every type of property you value. I do not believe the actual analysis of comparable evidence can be taught because there is seldom a right or a wrong answer. Each valuation you do will be different, for different clients, and for different purposes. Important qualities of comparable evidence Comparable evidence is only as good as the information provided. It should always be: Comprehensive – you should obtain a number of comparables. Some lenders require at least three, rather than just a single transaction which may have been a “one off”.  Similar – are your comparables similar to the item being bought or valued?  Recent – are your comparables current? If not, do you know what has happened to the market since?  Arm’s length – were they open-market transactions or the result of a specialist purchaser? What is the background to that sale?  Verifiable – can they be confirmed?  Further reading Comparable Evidence in Property Valuation (1st edition, RICS): This guidance note is designed to cover the use of comparable evidence in the valuation of all types of landed property Sebastian Deckker FRICS is a director in the Savills valuation department based in London Image © Jason Dent/Unsplash