Sustainable valuation: benefits to property and valuation markets
When market value is not enough
21 January 2016
Sustainable value offers many benefits to
both the valuation and property industry, providing a reality check in times of
over-inflated optimism and hope when markets bottom out, argues Joshua Askew
The notion of sustainable valuation emerged in the real estate industry in the aftermath of the most recent global downturn, when it became obvious that some properties had been overvalued, in part due to overly optimistic assumptions about future performance. Market value, a snapshot of value based on a combination of evidence and market sentiment at a given point in time, seemed to have let the industry down. Many proclaimed it no longer fit for purpose, and dismissed it as being too volatile and unreliable.
Perhaps it is now time to revisit these claims dispassionately. Most of the earlier discussions centred on the 'true' value of a property, and valuers were called to reconsider their approach. Some argued that when market values plummet by 20%–40%, an asset's 'underlying fundamentals' are not fairly represented by market value. The valuation industry was roundly blamed for failing to foresee an overheated market and reported values were too high.
Some valuers responded by refusing to lower their valuations, citing a lack of evidence of transactions at lower levels, whereas in reality, landlords who were not distressed simply did not want to sell at basement values. Others rightly considered market sentiment in addition to the scant evidence of deals and dropped values accordingly.
Mortgage lending value
In response to the crisis, seasoned investors called for a longer-term approach focused on value over time, without the volatility of the boom and bust cycles. The notion is not new and has already been put to use in some jurisdictions, most notably in Germany, where mortgage lending value (MLV), a more cautious and conservative value, is a widely accepted model.
The framework for determining MLVs considers a secure value which is "as long term and sustainable as possible" and attempts to smooth out the peaks and troughs as real estate markets wend their way between cycles. The MLV calculation is "unattached by temporary, e.g. economically induced, fluctuations in value on the relevant property market and excluding speculative elements … by taking into account the long-term sustainable aspects of the property, the normal and local market conditions, the current use and alternative appropriate uses of the property" (Quentin, 2009).
Valuers using historic trend data should be able to produce sustainable values
Detractors criticise the MLV methodology for being overly formalistic, rigid, arbitrary and academic, but it also contains many novel ideas. Its strength lies in its '2-pillar' approach, in which the valuation is determined both on the cost and income/comparable methods, and there must be a reasonable correlation between the land value, cost value and income/comparable value.
Another MLV innovation is that, in the income approach, the land and building values are split. The land value is assessed independently, with income apportioned to the land valued into perpetuity, but income for the building is capitalised only for the remaining economic life of the physical structure.
In the UK, there is no real alternative to the MLV. There is the vacant possession value (VPV), a market value under the special assumption that the asset is fully vacant, but this is fraught with its own weaknesses. Speak to any valuer and they will tell you that the VPV is a highly hypothetical model with very limited use. Only the very large clearing banks have a practical use for VPVs, and most funders ask for them rather as a matter of habit not because of their particular efficacy.
But VPVs should not be dismissed altogether: it is a metric for determining a worst-case scenario for an asset, particularly in instances involving a single-let asset to a potentially risky covenant.
Apart from VPV, there is no clear answer. Valuers using historic trend data should be able to produce sustainable values, or a range of values, for a property asset – and ought to do so.
In the context of providing independent opinions and promoting trust in the profession, does it not fall to valuers to give a view as to the long-term value of an asset when giving a snapshot of market value? This approach would immediately place any market value in an historic and ethical context, rather than reflecting only the in extremis moment of valuation. Sustainable value gives a wider economic perspective; a normative baseline on which investment decisions can be judged. Without this, such decisions may be divorced from a rational benchmark – they act as a reality check.
One potential objection to the creation of a new basis of value may be the professional indemnity insurance implications. It is true there is an element of risk in this approach that will require scrutiny and thought, but I am not aware of any negligence claims arising out of the provision of investment value (worth) as a basis of valuation. A sustainable value would surely be akin to the Red Book reporting output: a valuation number based not entirely on market evidence or market assumptions, but rather on forecast econometric data, the subjective expertise of the valuer involved and provided as a guidance figure without reliance.
Conceptually, two broad approaches to sustainable value have been suggested and applied. The first approach is that market averages or trend values in rent and yields over time should be examined and applied with all property/business cyclical variations smoothed out in the valuation, and all speculative elements that could affect value are ignored. A potential and uncertain redevelopment or extension of a property, for example, would count as a speculative element.
Long-term average/trend rents and yields are applied to determine the sustainable value, an approach championed by MLV valuers, although they would argue that an MLV is far more sophisticated and complex.
The second approach, which deserves more scrutiny, is to turn the idea of valuation unaffected by market cycles on its head. Volatility is embraced to reflect the sustainable value in an ever-changing and unpredictable market, rather than propagating the fantasy of order and equilibrium as the underlying valuation reality. Averages are disregarded, and long-term value is ascertained by adopting a less extreme version of boom and bust in the valuation cash flow, reflecting historic rises and falls of real economic and property cycles.
Seasoned investors called for a longer-term approach focused on value over time
This approach is more practicable in discounted cash flow (DCF) valuations, in which rental growth, costs and discount rates can be made to increase and decrease across the investment horizon (over 10 years, for instance, although any timescale could be adopted) as the market moves from a growth to a contraction phase. The exit yield could also be adjusted to reflect the expected position in the property cycle at exit, so it would be lower during a stable or growth phase of the property cycle or higher during a contraction phase. All the resulting net annual income streams across the cash flow are then discounted at one (or more) discount and rates, which also reflect the market cycle in each year.
For example, for a property valued at present on a 10-year DCF on the assumption of a 2- to 3-year continued growth cycle, rental growth is applied and a lower discount rate is used to determine the present values of these income streams during this period. A period of stabilised inputs could then be assumed for a further two years, before a three-year contraction (downturn) in which annual growth is reversed, new leases are at lower rents, and the discount rate increases to reflect risk.
In the final two years of the cash flow a slow recovery is assumed, with growth and discount rates (and other inputs) between the early upper peak and later lower wavelength trough. The exit yield would be higher than the initial yields evidenced by transactions as at the time of valuation. The resulting sustainable value will vary depending on the current position of the market in the property cycle at the time of valuation. Assumptions as to the wavelength and magnitude of the cycle will also affect value.
Sustainable value is a responsible and forward-looking concept. It attempts to produce a more rounded value and offers an opinion on the asset's long-term value prospects. The advantages of applying sustainable value in the property industry are numerous; it is a fitting companion to market value in any report and ought to be explored and embraced by RICS and the property industry.
Joshua Askew is Associate Director, Compliance & Valuation Advisory at JLL
- Quentin, J. (2009) The subprime crisis – implications for property valuation, Deutsche Hypothekenbank.
- This feature is taken from the RICS Property journal (December 2015/January 2016)
This feature raises important questions for the valuation profession. RICS is working on a number of projects in this area including an insight paper on mortgage lending value.
Ben Elder, RICS International Director of Valuation