Homing in on valuation methodology

RICS Valuation – Global Standards 2022 is mandatory for RICS members and represents good practice in valuation. Here we discuss Valuation Practice Statement 5 – Valuation approaches and methods – which applies International Valuation Standard 105 with the same title. What does VPS 5 cover? 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, “cost approach”. The definition is: “The cost approach is based on the economic principle that a purchaser will pay no more for an asset than the cost to obtain one of equal utility whether by purchase or construction.” (RICS Valuation Global Standards, p72). This definition should be included in compliant valuation reports along with an explanation of valuer reasoning. In practice, this usually means depreciated replacement cost and some crossover with residual method. The focus in this article is the depreciated replacement cost method of valuation. Valuation approach and method are not the same thing. There are three valuation approaches: market approach; income approach; and cost approach. And five valuation methods: comparable method (market approach); investment method (income approach); residual method (cost approach and market or investment approach); profits method (income approach); and depreciated replacement cost (cost approach). The cost approach is often taken to refer to the depreciated cost method of valuation, although this may, depending on circumstances, be applied to use of the residual method for valuing properties with development potential. When should depreciated replacement cost be used? The cost approach is often termed “the method of last resort” because of the inherent challenges with the methodology. The relevant market for the class of property is always the best indicator of value but sometimes there is no market and no profits. This method has most application in the public sector where buildings are not for profit but discharging a public duty, for example hospitals, or for some specialised privately owned complex buildings, for example, power stations. Although such properties come to market rarely, regular valuations are still needed for accounts and tax purposes. The valuation is hypothetical since it will probably not be tested in the market. The principle that depreciated replacement cost is based on is that, if the subject property was not available, the owner would have to acquire a new site and construct new buildings in order to provide the public service or keep the business operational. The cost of doing this represents the maximum amount the user would be prepared to pay. The method The cost approach is a real estate valuation method that estimates the price a buyer should pay for a piece of property that is equal to the cost of building an equivalent building. In the cost approach, the property’s value is equal to the cost of land, plus total costs of construction, less depreciation. Steps in the method: Find the estimated replacement cost of a modern equivalent building. Depreciate this cost to reflect the disadvantages of the actual property in terms of age and obsolescence. Add the land value, sourced from comparables. Stand back and look. Where does the replacement cost come from? This can be calculated working with a construction professional (building surveyor or quantity surveyor) or using a cost guide like RICS Build Cost Information Service. The replacement property is a modern equivalent, so the depreciation element in the valuation is the adjustment needed to make the modern equivalent the same as the subject property in terms of age and obsolescence. How is depreciation calculated? This can be calculated using the following formula: Depreciation factor = estimated remaining life of building / total life of the building from new. Alternatively, the valuer will use experience and judgment. The cost of the modern equivalent is depreciated under three main headings: physical depreciation; functional depreciation; and economic depreciation. Increasingly, environmental depreciation to reflect sustainability risk is also a factor to consider. In a more advanced valuation, these will be calculated separately. Challenges with DRC Cost and value are very different to a valuer and any cost-based method needs to be considered with reference to the economic big picture. The depreciation factor is difficult to establish and is often a guess – creating variations between valuations of the same property. Land value may totally distort the valuation if the land is in a valuable location and is zoned for a more valuable use, for example a city centre hospital zoned for housing in local planning. The occupation of such premises is often not on a financial basis (not for profit, discharge of duties). Viewing the occupation from a financial perspective can distort the usefulness and efficiency of the occupation. Cost-based approach in other valuation methods As mentioned earlier, cost does not equal value but cost often needs to be reflected in valuation. Cost of development is a fundamental factor in residual valuation. A cost-based approach helps to assess the effect of contamination on a valuation when combined with valuer judgment and market awareness. Valuers need the help of specialists to provide the clean-up costs to approach a contamination valuation. Cost approach can be helpful in valuing sustainable upgrades. Cost approach can help when analysing the payback period for upgraded fit out or void costs. Discounted cash flow is a useful method to articulate costs and benefits, and reflect market participants’ views via the discount rate. The cost and value paradox introduces an element of uncertainty and the thought process needs to be clearly recorded and communicated to the client. In summary The cost-based approach is a useful indicator of value where no other approach can fit and it needs to be reported clearly to the client using the vocabulary in VPS 5. The steps in the methodology are fundamentally simple but the inputs can be difficult to ascertain. It is the method of last resort for a reason: approach cost approach with caution. APC top tip Most APC candidates will not have experience of DRC, nonetheless the basic methodology should be understood for questions at level 1 (knowledge) because DRC is one of the five main methods of valuation. Potential pitfall DRC is a specialist method of valuation, so be careful not to step outside your level of competence. This article gives an overview for APC level 1 (knowledge). 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 © Jael Vallee/Unsplash