Eliminating Uncertainty in Commercial Property Valuation - Essay Example

ELIMINATING UNCERTAINTY IN COMMERCIAL PROPERTY VALUATION due: Table of Contents Bibliography12 Introduction The valuation of commercial property is an important element in real property management. In simple terms, valuation can be defined as the unique amount for which a property is to transact on a specific date. Fundamentally, valuation plays a key role in generating accurate estimates of the market price of properties. Adopted models ought to reflect the market backgrounds and conditions during the time that valuation is performed suggesting that the accuracy of valuation standards are actually defined by the closeness of the valuation to the exchange price in the marketplace (Blackledge 2009, pp. 27). Under normal circumstances, real estate refers to land, its general improvements, and whatever things of permanently or temporarily nature over and under it. Valuation of real estate is an important element that determines the “quantitative measure of the benefit and liabilities accruing from the ownership of real estate” (Pagourtzi et al., 2003, pp.383). The statement of concern in this paper is that uncertainty in valuation is a global phenomenon whose sources are logical and identifiable. As a result, description of such uncertainties will help in improving the credibility of property evaluators. The paper will concentrate upon the different types of uncertainties, reasons for their prevalence, their pleasant and unpleasant elements, and how they can be eliminated. 1.1. Uncertainty: Definition Researchers have found inconsistencies and inaccuracy in valuations based on the adoption of maximum margin errors and applied statistical methodologies (see for example Bräutigam et al., 2003, pp. 1-18; Newel and Kishore 1998, pp. 1-2 and Joslin 2005, pp. 269-285, Martin et al., 2007, pp. 1). Within the context of professional commercial property management, this paper will adopt Byrne and Cadman’s definition of uncertainty as “anything that is not known about the outcome of a venture at the time when the decision is made” (quoted by French (2007, p. 2). Evaluators’ work towards achieving accurate valuation which is well acknowledged as based on interpretation and opinion. Thus, as suggested by Joslin (2005, pp. 273), every person “associated with valuation, whether an evaluator or client, knows of the inherent risk of valuation”. Estimation in valuation is affected doubts, referred to as uncertainties (Kucharska-Stasiak 2013, pp. 20), which are shaped by the unavailability of comparable information available, vagueness in current and potential market conditions and ambiguous subject property inputs. Uncertainties translate to insecure and doubtful output figures that guide the valuation process in property management that are dependent on present market variables. 1.2. Categories of valuation 1. Valuation Bias Individual reasoning and information processing is limited by the amount of storage and processing of the short-term memory that enables them to produce rules (referred to cognitive or simply heuristics) that solve complex problems (Diaz and Hansz 2002, pp. 7). Thus, information processing means may lead to systematic errors due to judgmental biases. For example, an evaluator valuing a suburban property located in a developed region may miss out steps in the normative evaluation process (such as high and low land value opinion and market analysis) and advance to the sales comparison approach. In the event that unusual market signs are detected in the data, evaluators may revisit the prior evaluation phase and consider re-investigating existing market trends. From their education and experience, they develop practical production rules that simplify the valuation predicament. Firms lack standard forms of expressions force evaluators to explain to the client the possibility of property fluctuation based on market conditions. This calls for valuation bias that may be caused by inconsistencies in either overvaluing or undervaluing properties (Joslin 2005, pp. 276). The expression of uncertainty in valuation is commonly used to enhance decision making by aiding users to understand the valuation basis. Therefore, most evaluators apply the clause of using estimated figures that are prone to change rather than the exact figure laying emphasis on the non-guaranteed standard of a certain figure and subject to eternal variables (French and Gabrielli 2006, pp. 15). In such circumstances, valuation biases arise from evaluators who alter and misjudge market conditions positively or negatively by overvaluing or undervaluing properties. 2. Valuation Error Behavioral research into real estate valuation process also identify the interaction of the complex task environment (including market data such as sales information, pending sales rates and relevant market information) with the human processing system (both short-term and long-term memory) as a leading factor to increased uncertainties caused by information processing that differs among individuals (Diaz and Hansz 2002, pp. 5). Valuation errors occur due to sale price valuation, selection biases, statistical methods of analysis and reporting, and the timing of sale prices (Crosby et al., 2003, pp. 4). Valuation errors may occur when there is the lack of information available to be used by evaluators, or if the data available is inadequate (Joslin 2005, pp. 277). Therefore, it is wise to believe that valuations based on available ad reliable information are more accurate than those that lack accurate comparable evidence. For example, faults may also arise in cases where evaluators lack a particular point of reference regarding a property they are supposed to value. This highlights a major problem faced by the industry that makes evaluators make mistakes and faults arising from unreliable sources or their own knowledge and opinions. There lacks tangible evidence as they arrive at values basing facts on their own intelligence. 3. Valuation Variation The level of accuracy expected from two or more evaluators working on the value of the same property differs depending on the mathematical formulae and calculations used. Additionally, evaluators may also be guided by self-interests through exercising their opinion basing their knowledge on the nature of the market and their interpretation of facts (Blackledge 2009, pp. 26). Diligently practiced valuation functions are prone to several factors that may be open to subjective opinion. As a result, the final value suggested by an individual evaluator may differ due to valuation variation elements arising from differentiated opinions. If there is no assurance that reasonable care was taken during the valuation process, then calculations are termed to have been purely based on “proven principles” and “logical argument” (Blackledge 2009, pp. 26). Therefore, in any negotiation, neither of the evaluators can be determined to have either produced the correct or wrong value as both figures might be visible in either side’s point of view. Additionally, the value agreed would be open for negotiations between all involved parties and thus presenting a valuation error. 1.3. Elements of Uncertainty 1. Desirable Elements Differences in opinion encourage property evaluators to activate the market with reasonable varying prices that can be compared and debated upon. In such an environment, evaluators negotiate among themselves by arguing how the noted facts should be interpreted, and a figure is finally decided. In the end, both sellers and prospective buyers are able to get into willing transactions that suit them financially. Carsberg (2002, pp. 28) refers to uncertainty surrounding property as a “normal market feature varying from property to property and from market condition to market condition”. Thus, uncertainty also acts as a symbol of expressing personal opinions which may help and guide evaluators into arriving at right and appropriate conclusion pertaining property value. Actually, desirable elements of uncertainty have won a wide acceptable perception including the legal context, which gives evaluators the capability of valuing to “up to ± to 10%” of the existing market price (Gambo and Anyakora 2013; Grenfall 2003). Opinions introduce a platform through which evaluators debated and created a market by determining the value and worth of property basing their facts to the preparedness of individual purchasers and lessees. The desirability in this uncertainty also provides a market through which sellers and buyers are able to equip themselves with existing market trends and the value of a property. Thus, both parties can make current and future financial decisions. 2. Undesirable Elements Valuation uncertainties pose serious practical implications in markets where the phenomenon is unreal and unacceptable. In economics, valuation errors arise from imperfect objectification of values that are caused by the need to assess premeditated phenomena and the researcher’s attitude and approach. The observation method of study exposes an evaluator to limited features of assets and their relations, and thus carries the risk error owing to apparent biases in observation. For example, in a case exposing negligent land valuations, an Ireland court held two auctioneers guilty for acting negligently in providing land valuations (Dunleavy 2014). The plaintiff had wished to purchase lands adjacent to his farm through a public auction which he intended to finance by selling a separate plot of land. On seeking valuation from valuators, two different auctioneers arrived at estimated values of 10-11 million and 6.9 million. Basing his facts on the provided values, the plaintiff provided the bank with the valuation estimates and was awarded a bank loan of 7.7 million to finance the purchase, subject to the sale of his plot. After successfully bidding at 5.9 million and paying the required deposit, the highest value he got from his land was 1 million. He was unable to complete the purchase of the adjacent land and had to surrender his deposit. In this scenario, the plaintiff relied on the estimates provided by valuators, which were also relied on by the bank. On the other hand, one valuator claimed that they did not offer the exact valuation estimates but rather “thinking of selling” letter in good faith while the other claimed the plaintiff had not included him in the transaction. While deciding the case, the judge noted that nothing was stated in the letter that indicated that it was not to be used in the valuation. Additionally, the valuation was negligently prepared as it violated the internationally recognized standards in the red book that oblige evaluators to provide their clients with warnings of uncertainty. Even though valuation does not have to be precise, the figures offered were clearly beyond the permissible margin errors nor were any advice such as the risk inherent zoning factors assessed. The plaintiff also contributed to negligence by delaying to sell his plot before purchasing the adjacent lands. Therefore, the parties were jointly liable for the losses suffered. Generally, the presence of uncertainties in the process of valuation is less helpful to a client and thus challenges the reliability and reputation of evaluators. In reference to this element, Kucharska-Stasiak (2013, pp. 24) notes that the RICS Professional Standards, 2012 turn down evaluators who treat statements expressing less confidence as admission of weakness, and gives a potential customer the idea that “greater weight could be attached to the opinion than is warranted” and thus the report is treated as misleading. It is indeed undeniable that professional guidelines that guide variation exist (for example the red book point of reference used by the judge and the RICS Professional Standards). However, their existence and use as references in the profession ignore the fact that uncertainty inputs are actually uncertain because they lack sufficient information about true but unknown values (French and Gabrielli 2006, pp. 20). Possibilities of variation errors are linked to evaluators’ attitudes influenced by presuppositions which lead to selective choice of observed facts (Kucharska-Stasiak 2013, pp. 18). Referring to the case above, it is clearly evident that discrepancies between valuation outcomes introduce random deviations arising from exogenous and endogenous differences arising from potential asset assessment, and market indicators. Systematic deviations are also represented by the over-estimation of property value which may be affected by external influences of client’s expectations, and previous value estimates facts (Kucharska-Stasiak 2013, pp. 24). Additionally, the emergence of deviations is dependent on the anchoring effect that places the evaluators under the influence of previous valuation data. This leads to either under estimation of overestimation of values depending on market conditions. 1.4. Eliminating Undesirable Forms of Uncertainty Uncertainty in valuation is a change among properties and market conditions that can be managed and improved (RICS, 2002b). This section will analyze the extent to which uncertainty in property valuation can be eliminated through regulatory methods and better information provision. a) Regulations In his article, Joslin (2005, pp.283) notes that it would seem applicable to valuation marketing bodies to “offer a range of standards to adapt to all valuation requirements”. The provision of guidance in relation to the assumptions and application methodologies would positively change the valuation industry. The RICS acts as a major regulatory body that has gone to the extent of embracing the use of tolerance in the industry (French and Mallinshon 2000, p.3). Reports and opinion documents have been carried out to establish acceptable methods that should be adopted by governing bodies when expressing uncertainty (Carlsberg, 2002; Hakala et al., 2013). The intensity of this issue continues to cause damaging problems to evaluators who lack basic regulatory reference points when expressing how they developed their valuation. As noted by Joslin (2005, pp.283), Guidance Note 5 of the Red book has a requirement that places an obligation to the evaluator to “explain the uncertainty pertaining to the valuation in the report”. No prescription form is detailed nor are any guidelines of the approach given, yet most evaluators apply different approaches. The regulation suggest that valuation errors arising from incompetent valuation procedures can be reduced to writing, yet a client is entitled to the assumption that all violations presented to them are professionally prepared, and are compliant with generally acceptable practices and guidelines adheres to by professional evaluators. Yet again, when reduced to writing, opinions or letters contained in the document places values on properties. This may be regarded to be valuation even in the existence of the word “valuation” of the provision of related options. Therefore, the provisions by the law appear to encourage validity errors, place property sellers, and buyers under the mercy of evaluators and promote valuation errors. The establishment of governing bodies would eliminate such problems by establishing acceptable methods to express uncertainly uniformly. One of such governing bodies is the International Valuation Standards Council (IVCS) which develops valuation international technical and ethical standards relied on by investors. In UK, for example, the 1995 Investment Property forum carried out sale processes that identified efficiency structures to increase liquidity of its commercial property market. The recommendations of the report significantly reduced the transaction process by introducing more standardized legal documents (Crosby et al., 2003, pp. 4). Uncertainties created by valuation errors are mainly tied to the property sales process that may require regulatory and legal formalities to be finalized. In such situations, the actual sale price is determined at advanced stages of the completion date. Activities undertaken during the advanced stages should also implement legal processes that aim at confirming all transactions to be made and dates for agreement and contract sighing such as the case is in UK (Crosby et al., 2003, pp. 4). The existence of variables in market analyzes will always be evident and cannot be eliminated by gathering more information. Therefore, separation of concepts during the simulation process by evaluators is a must step that enables them to eliminate errors accurately by accurately detecting variation values that may have been affected by natural variability of the measure. b) Provision of Better information Research into behavioral valuation experts have expressed the introduction of process tracing, controlled experiments and filed surveys that not only provide evaluators with better and reliable information, but also eliminate errors associated to human factors (Diaz and Hansz 2002, pp. 9). Survey methodologies often generate large sample sizes by assigning either controls or treatments to the group. The control groups exclusively receive the experimental evaluation that is used as a comparison benchmark to the treatment groups. Treatment groups also receive additional pieces of information and manipulation prior and throughout the experiment. This model carefully controls information from randomly assigned participants and thus enables the researcher to attribute differences between received responses (mean or median measures). Designed to control extraneous, evaluative statistical methods used are very reliable, and researcher are able to assign participants to groups and control related factors, and thus eliminating prejudice and biases. However, while the use of such controlled experiments establish strong bonds between manipulation and response, the experiment overlooks external validity through generalization of results across settings, people and time. Provision of better information would highly eliminate uncertainties in valuation. Sensibly, information in this context would be better through the development of technical information papers (TIP) that guides valuation professionals. Developed guidance also provide a platform through which valuation users are alerted about the existence of the existence of uncertainty in any valuation on which they rely for reference. IVSC is an international body that develops TIP’s that operate on the principal objective of reducing diversification in practice by “identifying commonly accepted processes and procedures and discussing their use” (IVSC 2012. pp. 1). While striving to eliminate uncertainty, the guidance serves the purpose of defining, identifying, measuring and disclosing valuation uncertainty as concerned with preparing and reporting valuation as per the market value defined by its framework and other values set by similar market based bases (IVSC 2012. par. 1). Standardized methods do not operate solely but work adequately when combined together. Primarily, regulating authorities need to determine the methods to be used or a combination of several methods. For example, in UK, common used methods include market orientation through determination of fair market prices followed by evaluation criteria, and finally determination of choice methods. Each step has a guiding principle that is dependent on market behavior and property participants. This process is tasking and hard and would encourage evaluators to skip a particular step and thus introduce an error. While a number of valuation standards exist among markets and individuals, it is important that regulatory authorities design a universal method that results to the right value. Conclusion The use of comparable valuation method has been used as the best and most precise valuation method that is applicable in all property markets and real property purchases. 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