Nick French

Real estate appraisal: a review of valuation methods

The valuation of real estate is a central tenet for all businesses. Land and property are factors of production and, as with any other asset, the value of the land flows from the use to which it is put, and that in turn is dependent upon the demand (and supply) for the product that is produced. Valuation, in its simplest form, is the determination of the amount for which the property will transact on a particular date. However, there is a wide range of purposes for which valuations are required. These range from valuations for purchase and sale, transfer, tax assessment, expropriation, inheritance or estate settlement, investment and financing. The objective of the paper is to provide a brief overview of the methods used in real estate valuation. Valuation methods can be grouped as traditional and advanced. The traditional methods are regression models, comparable, cost, income, profit and contractor’s method. The advanced methods are ANNs, hedonic pricing method, spatial analysis methods, fuzzy logic and ARIMA models.

The uncertainty of valuation

Valuation is often said to be Ian art not a scienceo but this relates to the techniques employed to calculate value not to the underlying concept itself. Valuation is the process of estimating price in the market place. Yet, such an estimation will be affected by uncertainties. Uncertainty in the comparable information available; uncertainty in the current and future market conditions and uncertainty in the specific inputs for the subject property. These input uncertainties will translate into an uncertainty with the output figure, the valuation. The degree of the uncertainties will vary according to the level of market activity; the more active a market, the more credence will be given to the input information. In the UK at the moment the Royal Institution of Chartered Surveyors (RICS) is considering ways in which the uncertainty of the output figure, the valuation, can be conveyed to the use of the valuation, but as yet no definitive view has been taken. One of the major problems is that Valuation models (in the UK) are based upon comparable information and rely upon single inputs. They are not probability based, yet uncertainty is probability driven. In this paper, we discuss the issues underlying uncertainty in valuations and suggest a probability-based model (using Crystal Ball) to address the shortcomings of the current model.

Discounted cash flow: accounting for uncertainty

Purpose – Valuation is the process of estimating price. The methods used to determine value attempt to model the thought processes of the market and thus estimate price by reference to observed historic data. This information is utilised in the discounted cash flow (DCF) valuation model to determine the single point valuation figure. However, the valuation will be affected by uncertainties: uncertainty in the comparable data available; uncertainty in the current and future market conditions and uncertainty in the specific inputs for the subject property. These input uncertainties will translate into an uncertainty with the output figure, the estimate of price. This paper discusses ways in which uncertainty can be incorporated into the DCF model.Design/methodology/approach – This paper looks at the way in which uncertainty can be incorporated into the explicit DCF model. This is done by recognising that the input variables are uncertain and will have a probability distribution pertaining to each of them. T...

Uncertainty in property valuation – The nature and relevance of uncertainty and how it might be measured and reported

There will always be a degree of uncertainty in any valuation, but it should be incumbent upon the valuer to report “abnormal uncertainty”. This arises when some particular condition of the market or the property leads to the valuer being unable to value with the confidence of accuracy which might normally be expected. Abnormal uncertainty now features in the RICS Appraisal and Valuation Manual and later in this paper we consider how the valuer might identify and measure the degree of abnormal uncertainty. But this paper is predominantly concerned with “normal uncertainty”, which hereafter we will term only as “uncertainty”. The thesis of this paper is that uncertainty is a real and universal phenomenon in valuation. The sources of uncertainty are rational and can be identified. They can be described in a practical manner, and, above all, the process of identification and description will greatly assist many clients, and will improve the content and the credibility of the valuer’s work. Common professional standards and methods should be developed for measuring and expressing valuation uncertainty (Recommendation 34, Mallinson Report, RICS, 1994).

Market information management for better valuations

In March 1994 the Mallinson Working Party on commercial property valuations produced their report outlining a number of initiatives which the RICS should undertake to help improve the standing of the valuation survey within the business world. The recommendations related to the need to improve the technical element of the valuers’ skill by updating and extending the mathematical models; extending the access to and the use of data and revising the way in which they express their judgement. As information availability increases, the role of the valuer will need to change to provide the client with more analysis, interpretation and professional judgement. To be able to do this effectively, the profession will need to adopt new valuation techniques to utilize better the information available. Part I provides an exposition of the range of valuation techniques available.

Decision theory and real estate investment

Explains that the focus of decision theory is on the mathematical models. These may be probability based; loss functions or other forms of statistical representations of judgements. Yet, much of decision theory does not lie entirely within any one discipline: it draws on psychology, economics, mathematics, statistics, social sciences and many other areas of study. Investigates investors’ perceptions and attitudes towards real estate. Highlights the important difference between theoretical exposure levels and pragmatic business considerations. Suggests a prescriptive model to explore judgements, beliefs and preferences of decision makers and to inform decision making. Examines the concept of risk and its place in developing a prescriptive model. Maintains that a decision must be judged on factors other than the risk of a single outcome.

Uncertainty and feasibility studies: an Italian case study

Purpose – Uncertainty affects all aspects of the property market, but one area where the impact of uncertainty is particularly significant is within feasibility analyses. Any development is impacted by differences between market conditions at the conception of the project and the market realities at the time of completion. This paper sets out to address this issueDesign/methodology/approach – The feasibility study needs to address the possible outcomes based on an understanding of the current market. This requires the appraiser to forecast the most likely outcome relating to the sale price of the completed development, the construction costs and the timing of both. It also requires the appraiser to understand the impact of finance on the project.Findings – This allows the appraiser to address the issues of uncertainty involved and thus provide the decision maker with a better understanding of the risk of development. This technique is then refined using a “two‐dimensional technique” to distinguish between...

The valuation of specialised property: A review of valuation methods

Provides a brief overview of the methods that used in real estate valuation with a particular emphasis on the valuation of specialised property. Proposes that the underlying requirement is to estimate market value and that the role of the valuer is to choose the method that is the best model to achieve this objective. Concludes that a valuer must work with the recognised techniques and, in the case of specialised property, these are methods that go back to analysing value from first principles by identifying the value of the property to the business.

The valuation of upwards‐ only rent reviews: an option pricing model

The upwards‐only rent review is a characteristic feature of the institutional property lease in the UK. It has been subject to increased attention by investors and regulators in the 1990s with various proposals which sought to make upwards‐only rent reviews illegal. Applies an arbitrage method based on market pricing which enables consistent valuations of different investment opportunities to be compared in a rigorous yet consistent approach. In this way the value of the upwards‐only option can be assessed. Uses the arbitrage approach to value the difference between a lease in which the rents are reviewed upwards‐only and that in which rents can be reviewed upwards or downwards. Starts by applying the arbitrage approach to a simple lease in which rent may take only two values. This simple approach is well established in the finance literature when analysing options, and the valuation of the upwards‐only lease may be seen as a multi‐option contract.

Bank lending valuations on commercial property – Does European mortgage lending value add anything to the process?

This paper reviews a number of alternative bases of valuation which can be applied for lending purposes. In early 1999, the European Mortgage Federation suggested that the philosophy of a European Mortgage Lending Value (EMLV) should be based on “sustainable” values and this recommendation is compared to the current basis used for bank lending valuations, mainly market value. This comparison is of both concepts and applications. In addition, concepts and applications of worth valuations are considered. The paper concentrates on commercial property but many of the principles also apply to residential property valuations. The paper concludes that the EMLV concept of sustainable values is itself unsustainable. There are a number of reasons for this view, not least that the concept itself cannot be closely defined and will be interpreted differently by those who apply it. It lacks the objectivity of market value and the rationality of concepts of worth. The paper also questions whether any concept of value can apply over a period of time and suggests that all other “values” do not have a shelf life and relate to one specific point in time only. In application, in the absence of any meaningful conceptual basis, sustainable value appears to have been applied as a conservative market value. It may give the illusion of having some extended time horizon attached to it but this is the major danger. The reality is that it is just another product of the endless search for a single valuation figure which can give lenders the holy grail of longer‐term protection from lender default. This it will fail to do as all other bases applied so far to lending valuations have done. The recommendations of this paper are that all European institutions and valuer/appraisers resist this latest incursion into the fruitless search for the perfect loan valuation basis and concentrate on the other aspects of the valuation which can truly help lenders make their decisions. These are the economic, property market and occupier issues which should be considered by the appraiser and included as major items in valuation reports, many of which would be explicitly included in a full discounted cash flow approach to commercial property loan valuations.