The Royal Institution of Chartered Surveyors in the United Kingdom - Research Paper Example

Property Investment Analysis Valuation is the process of estimating price hence determining the present (market) value of a future cash flow. The value of an investment is the discounted value of all estimated future liabilities and benefits (Stanley McGreal, 2004). Property valuation is necessary due to the heterogeneous nature of chattels as none is identical to the other while the locality of the property is also crucial in the final determination of the assessment. The valuer’s market valuation must also take into consideration the Highest and Best Use (HABU) of the investment property. This is done through determining the market value from existing historical data using an explicit model which is calculated based on the most likely bidder generally referred as the Discounted Cash Flow (DCF) model or an implicit model using the historical data modelled on similar sales referred to as the capitalisation All Risk Yield model. French and Gabrielli (2005) however argues that regardless of the method employed, the valuation will be affected by several uncertainties including current and future market conditions plus the uncertainty in the specific inputs used that translate into uncertainty in the output figure or the estimate price. The Royal Institution of Chartered Surveyors (RICS) is the organization mandated in the United Kingdom to vet property transactions. The respected property umbrella association is represented in all matters of property, construction and associated environmental issues. With a membership of over 86,000 chartered members (FRICS and MRICS) and 55,000 other members representing other categories in over 146 countries globally, the organization regulates, upholds, and embodies property professionalism worldwide. The organization issues guidelines through a booklet known as ‘the red book’ and periodically issues annual research reports that illustrate the market projections. Wyatt & Bretten (2001) in the RICS Foundation variance study 2001 observed that variance in property investment valuations for commercial lending within the UK is as result of the individual valuer’s behavioural influences’. They further noted the unusual fact that the parties to a valuation instruction generally accept the ‘margin of error’ principle. Similarly, Crosby, Newell, Matysiak, French and Rodney (1997) study on UK clients who had commissioned valuation reports from external valuers, established that they were on average content with the reports, nonetheless over 80 percent detected variations in the survey reports from differing valuers. The clients believed that they lacked a transparency in their methods. The cause of variance in the valuation reports is due to a number of factors. The most mentioned is due to the pressure from third-parties. Levy and Schuck (1998) and Kinnard et al (1997) argued that some valuers are susceptible to pressure from their client hence ‘doctored’ the valuation reports to conform with the latter’s wishes. This ‘opinion shopping’ was prevalent among mortgage brokers and bankers who intimidated the valuers by threatening to employ other experts. Murdoch and Murdoch (1997) citing the Banque Bruxelles Lambert SA v Eagle Star Insurance Co Ltd case [1994] 2 EGLR 108 and [1995] 1 EGLR 129 found clear evidence of a third party pressure from the client to the detriment of the other parties. Bretten and Wyatt (2002) cite the incidence of complexity of some properties especially the multi-let property that employ various short-term leases hence generating complex capricious factors. These types of property require a multifaceted approach in the valuation method while lacking appropriate historical data for comparative purposes. Levy and Schuck (1998) argue that this type of properties provide avenues for abuse whereby the valuer is under immense pressure to either over-value or under-value depending on whether the client intention is either sale or purchase respectively. Northcroft and Neale (1987) and Wolverton and Diaz (1996) discerned that there was a decidedly marked bias upon the part of the valuation when the sale price was clearly known prior to the valuation. This suggests that the sale price should be disregarded as evidence during the valuation exercise as it impends or influences the valuer. Wolverton (1996) and Gallimore and Wolverton (1997) study also agreed that prior knowledge of the property transaction price greatly affected the valuation. Black and Diaz (1996) in their research study concluded that the asking price sway the valuers due to “...cognitive shortcuts (called heuristics)” hence Levy (1997), Harvard (1996), and Diaz (1997) alluded that valuers merely use heuristics in property valuation: “Respondents use the figure obtained from their previous valuation to assist in determining the result of their next valuation” (Levy, p.7). The case involving Craneheath Securities Ltd v York Montague Ltd [1996] 1 EGLR 126 hence surmised that: “Valuation is not a science; it is an art, and the instinctive ‘feel’ for the market of an experienced valuer is not something which can be ignored”. Hager and Lord (1985) concurred asserting that, “the success of the valuation relies extensively on personal knowledge and expertise and interpretation of the many variables which exist. A valuation therefore remains an expression of personal opinion.” (p.28) It is therefore common for most valuers to make estimates based on earlier figures or values and adjust to arrive at their final estimate, hence the original estimate or asking price (anchor value) tend to have a profound influence on the final estimate (confirmation bias) Gallimore (1994). It has been suggested that the Royal Institution of Chartered Surveyors (RICS) ought to evolve a standard approach to the ambiguity observed from various valuers’ when advancing an investment property valuation to stem the seemingly deviation in their reports and the uncertainty therein. Diaz, Gallimore, and Hansz (2008) reporting on the RICS Research valuations study commented on the enhanced global apprehension over investment fraud and the growing demand for transparency and reliability in all investment transactions in the wake of the failure over many investment banks and mortgages. In the United Kingdom (UK), RICS proactively set up the Carsberg Committee to evaluate and recommend the shortcomings and measures to deal with the crisis. The public apprehension over valuations particularly property estimates was therefore undergoing a confidence crisis. Diaz (2002) in the RICS Foundation publication Behavioural Research in Appraisal and Some Perspectives on Implications for Practice highlighted some of the valuation issues prevalent in the public sphere concerning valuation estimates and the effectiveness to counteract the incidence customer reassurance against issues of valuation misjudgements. RICS however has observed that the UK commercial property valuations are the most reliable when compared to other corresponding European markets. The RICS Valuation and Sale Price Report 2008 observed that the bulk of UK valuations were indicated a variance of within 10 percent of the actual sale prices. This was evident in 2007 whereby 60.4 percent of the UK valuations fell within 10 percent of sale prices while 84.5 percent were within 20 percent. In contrast, only 50 percent of Holland valuations fell within 10 percent of the sale price with Germany only recording 47.6 percent and France a mere 40.2 percent (Freestone, 2008). Hipwell (2008) considered this is commendable in view of that this was conducted within the background of the biting global credit crunch occasioned by the mortgage crisis. In the aftermath of the crisis, many tenants and property owners were forced conducting a risk re-assessment in late 2007 and the property market in disarray. RICS spokesperson Luay Al-Khatib retaliated this as he observed that, “With banks choking on the credit stranglehold, many investors were forced to sell below the valuation price as opportunists circled for a bargain.” He retaliated the importance of having more accurate valuations while asserting that with the ever changing property investment market, investors must retain faith in the valuations hence the, ‘annual report is a vital measure of valuations, ensuring that the relationship between valuation and selling price are closely monitored’. RICS analysts predict UK commercial property values to decline by an additional 25 percent within the next two years. This was attributed to the rapid drop in rents mostly in offices, rising defaults and credit spreads constraining the property investment market. However there are signs that the property investment sector is recovering with improved projections by RICS Commercial Property Survey quarterly report revealing mild recovery since the third quarter of 2007. However Oliver Gilmartin, RICS senior economist argued caution asserting that, “'whilst tenant demand in some areas improved modestly compared to the first quarter, the positive move was from extremely low levels.” Nevertheless the Rightmove House Price Index indicated a steady rise of 0.6 percent the fifth month increase this year. (Propertywire.com, 2009) The Royal Institution of Chartered Surveyors (RICS) Red Book recommends that valuers should report any abnormal uncertainties whenever there is a variance to the expected confines or degree of confidence in accuracy as normally expected. French and Mallinson (2000) argue that transparency in the issues of uncertainty contain information latently crucial to both parties (client and valuers). They therefore list six potential important informative items that should be revealed: the valuation estimate; the scope of probable examination; the likelihood of presumable scrutiny; the range of higher probability; 100% probability; and any errors in the probability (French and Mallinson, 2000).RICS in Red Book guidelines now obligates its members to research on whether a property owner received incentives while purchasing a property including proffer to offset the purchasers deposits, lawyer fees and transportation, or plus a cash-back. The Council of Mortgage Lenders (CML) has been at forefront in decrying the discrepancies in the valuation occasioned by fraudulent activities of the parties involved in the transaction largely blamed on the property valuers. The property valuers/surveyors are now required to query or have the seller or developer to disclose any incentives or ‘discounts advanced. According to Michael Coogan, CML director-general, ‘These measures to reinforce confidence in the accuracy of valuations of new-build properties will help underpin this segment of the market…accurate valuation, and help prevent fraud.’ (Farrow, 2008, p. 2) There is however a marked slowdown in the property owners valuation of rents globally and across Europe due to the current credit crunch crisis. A survey by the CB Richard Ellis of 49 office properties and a number of 26 prime rental facilities reveal a gradual decline from last year. The industrial rent index has declined by 1.5 percent within the last quarter to 5.3 percent for 2008. Richard Holberton, Director, EMEA Research, and CBRE. Observed that, ‘the downturn in real estate values across Europe has so far been predominantly driven by increases in yields… rents are the driving force behind the property value corrections’ (Property-wire.com, 2009). In the UK, the decline was in house values were put at 21 percent with some rather gloomy estimates projecting a 55 percent drop. A Numis Securities study, report anticipated record decline in ‘city centre flats’ and ‘new executive homes’ with the buy-to-let market heavily over saturated by sellers especially those dependent on the financial service segments. ‘Our core headline forecast is that UK property prices remain between 17% and 39% overvalued based on fair valuation. Prices could fall a further 40-55% if the over-correction was as bad as the early 1990s in our view’ Holberton retaliated (Knowles, 2009). Courtesy: Internationalpropertyinvestment.com Approximately half of all commercial properties in the UK are held as investments whereby the property owner leases to an occupying tenant. Byrne and Lee (2000) study of 392 locations throughout the U.K. which is based on a mean absolute deviation portfolio approach and reveal high mean income return in Edinburgh (8.05%) as compared to Glasgow (6.30%). According to Ball et al. (1998), investor demand for property is the predominant factor in driving the yield demand. They therefore assert that the higher the investor demand, the lower the yield as the risk premium decrease. Figure 4.1 Relation between investor’s demand and property yield. Investors Demand Yield, Capital Value Source: Ball et al. (1998). According to Dubben and Sayce (1991) yield levels are determined by several factors including: expected rental increase; investment value; expansion/restoration prospects; risk and relative profits. The ownership interest in the shop located at the upmarket location in the City of Edinburgh can be evaluated as follows. The rent is at FRI (Full Repairing and insuring) terms for a lease of £148,000 per annum with a provision for upward rent reviews based on open market values every five years until 2020. The current market rental valuation is £140,000 per annum with projected yields of 5.5 percent per annum while the investor expects a targeted return of 10 percent per annum. The Edinburgh rental shop rent review has been set at a periodic five intervals hence can be depicted as follows: To predict the expected average annual growth rate the following formula is used V/p-1 g Hence g = 5.14% g is the annual rent growth projection; y as the expected yield from similar properties; p the rent review period; r the approximate targeted returns. So the rental growth rate will grow as follows: 140,000 × (1+0.0514)1 = 147,196 140,000 × (1+0.0514)6 = 179,874 The major underlying factors in the all risks yield (ARY) evaluation model are income, capital risk, and potential growth. This are similarly affected by other economic and investment property factors including macroeconomic conditions like planning or taxation issues, the existing legislation on the sector, the chattels market, financial aspect of the property investment for the tenants/lessees, among others. The model is mostly effective when there exists a robust property market as it requires veritable comparable transactions to correctly conduct evaluations. In an ARY approach, the present (capital) value, V is the pv PV $1pa YP whereas the rational (short cut DCF) valuation model uses the growth-explicit DCF techniques. The ARY core and top-slice technique, uses corresponding yields, the model generates this ensuing valuation whereby the ARY growth-implicit techniques y = r – g: y is the ARY (all-risks yield), r is the investor’s projected return and g representing the annual rent; hence Market rent rate (MR) @ £140,000 Years’ purchase (YP) perpetuity @ 5.5% Core (market) rent is @ 140,000 YP in perpetuity @ 10% 15.5556 2,177,784 Top-slice (overage) 8,000 YP 11 years @ 10% 10.4987 83,990 Valuation 2,261,774 Years’ purchase (YP) perpetuity or the investor’s targeted return and therefore comparable with other investments. The short-cut DCF valuation is clear on the objective rate used plus the growth rate hence correctly gives a proper valuation in the reversionary investment model. Using the growth-explicit short-cut DCF valuation method, the valuation is as follows: Term (contract rent) 148,000 YP 6 years @ 10% 4.2305 626,114 Reversion to MR 140,000 FV 6 years @ 5.14% 1.2848 YP in perpetuity @ 5.5% 15.5556 PV 6 years @ 10% 0.5346 Valuation 1,495,820 2,121,934 Using a reversionary valuation, whereby the rent is below the MR i.e. freehold reversionary model can be used for the Edinburgh prime shop which has a rent obligation of £140,000 per annum, a 5.5% and a projected investor target of 10% per annum. The ARY and reversion valuation is as follows: Term (contract rent) £148,000 YP 1 year @ 5.5% 1.514 £224,072 Reversion to MR 140,000 YP in perpetuity @ 10% 15.5556 PV £1 in 1 year @ 10% 0.10 Valuation £1,197,781 £1,421,853 Another method utilise the following equation: n represents the next rent review period; p the actual rent review period This model can be utilised to portray a reversionary property investment, hence an ARY core and top-slice technique, corresponding yields, will reveal: V=  Conclusion Variance in property evaluation has now become an accepted fact with debate and acrimony leading to litigious actions and a minimum variance of ± 10 percent has become the sine qua non. The evaluation variance can be traced from clients issuing instructions, conciliations, peripheral pressure, human error occasioned by undue heuristics, complexity of the property, insufficient resources, among other factors. Valuers have valiantly tried to curb the discrepancies witnessed and in the UK, the Royal Institute of Chartered Surveyors regularly issues guidelines to its global members notably through the Red Book. Its annual reports and surveys also serf as a bench-back to the property valuers. Due to the complaints over property evaluation reports, RICS commissioned the Carlsberg Valuation Report in 2002 to evaluate various issues raised including the accuracy and credibility of the valuation reports from valuers. RICS has also issued guidelines on the appropriate methods to use in evaluation. The evolvement of the conventional valuation models to the complex full DCF, and to the less intricate short-term DCF continue to alleviate the discrepancies in valuations among the various investment property valuers, the consuming public and other stake holders. References Adams, A. a. (2002). Towards A Transparent Approach to the Appraisal of Over-Rented Property. London: The University of Edinburgh. Barratt, C. (2008, November 5). UK Valuations score best for accuracy. from www.rics.org: http://www.rics.org/rics_ipd_valsales_report_.htm [Accessed July 23, 2009], Black, R. a. (1996). The Use of Information Versus Asking Price in the Real Property Negotiation Process,. Cutting Edge Conference. London: Royal Institution of Chartered Surveyors. Connellan, S. S. (2001). The Valuation of Non-profit Orientated Leisure Property. RICS Foundation . Crosby, N. a. (2008). Property Investment Appraisal, 3rd Edition. Oxford, United Kingdom: Blackwell Publishing. Crosby, N. G. (1997). Client Perceptions of PropertyInvestment Valuation Reports in the UK. Journal of Property of Property Research 14 , 27-47. Crosby, N. S. (2003). Valuation accuracy: reconciling the timing of the valuation and sale. Helsinki: European Real Estate Society. Diaz, J. I. (2002). Behavioural Research in Appraisal and Some Perspectives on Implications for Practice. London: RICS Foundation. E, L. D. (1997). 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Institutional Real Estate Investment in Ireland and Great Britain: Returns, Risks and Opportunities. Journal of Real Estate Portfolio Management , 1-12. Wyatt, P. &. (2002, May). Variance in property valuations for commercial lending. RICS Foundation Research Paper Series , pp. Volume 4, Number 9. Read More