The Income Approach to Property Valuation

Andrew Baum, David Mackmin, Nick Nunnington

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781317266990
• Edition: 7
• Topic: Business
• Subtopic: Valuation
• Index: Business

A classic textbook that has guided generations of students through the intricacies of property valuation, The Income Approach to Property Valuation remains a keen favourite amongst students and teachers alike. This new edition has been thoroughly revised and updated to meet the increasingly international perspectives of modern Real Estate students. The links between theory and practice are clearly demonstrated throughout, with a range of new international case studies and practice-based examples. The Income Approach to Property Valuation teaches readers:

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• how to analyse market rents and sales prices to derive market evidence to support an opinion of market value;

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• the investment method of valuation and how it is applied in practice;

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• how specific legal factors can impact on market value when they interfere with market forces;

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• what the market and the profession may consider to be the 'right' methodology in today's market place; and

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• how to use spreadsheets in valuation.

This extensively revised new edition is perfect both for students on Real Estate courses worldwide and for professional candidates working towards their final assessment of professional competence (APC) for the Royal Institution of Chartered Surveyors, needing to demonstrate a valuation competence at levels 2 and 3.

1 The global framework

This chapter considers the global requirements for the professional valuation of real estate and the global frameworks within which valuers operate.

Introduction

This book considers the application of the income approach to the assessment of the market value of real estate. Market value is explored in Chapter 5, but as this fundamentally underpins the entire book, the internationally accepted definition is given here:

Market value is the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion.

(International Valuation Standards 104)¹

Whilst this is a key definition it needs a contextual framework before considering the global requirements for market valuations.

Cairncross (1982), in his Introduction to Economics, expresses the view that ‘economics is really not so much about money as about some things which are implied in the use of money. Three of these – exchange, scarcity and choice – are of special importance’.² Legal interests in land and buildings, which for our purposes will be known as property, are exchanged for money and are scarce resources. Individuals fortunate enough to have surplus money have to make a choice between its alternative uses. If they choose to buy property they may have rejected the purchase of other goods, services, alternative investments such as stocks and shares, or of simply leaving their money as savings or doing nothing. But a choice will have been made and having chosen to use their surplus money to purchase property they may then have to make choices between different properties. Pension funds, life assurance funds, investment funds, governments and corporate bodies around the world are also making investment choices, often on behalf of individual investors, between various investment opportunities including property. How do they make those choices and who advises them?

Valuation is the applied discipline within economics that attempts to aid that choice, in terms of the market value of property and the yields obtainable from property investments. Value in this context usually means market value (value in exchange), but it may mean investment value or worth (Chapter 5), and valuers are the individuals who provide advice on market value of property and offer advice on the sale and acquisition of property. For a property to have value it must have utility. If that utility is solely in terms of the current owner then it may have value to that individual but no market value.

In the context of this book a valuer would normally be a member of the Royal Institution of Chartered Surveyors (RICS), or one of the other valuation professional organisations (VPOs) approved with the agreement of the RICS, who meet the qualification requirements set out in the RICS Valuation – Global Standards 2017 (Red Book) Professional Standard (PS) 2 2.1–2.8, and who acts with independence, objectivity and confidentiality as specified in PS 2 3. But in other countries, similar professional bodies such as The European Group of Valuers’ Associations (TEGoVA) and/or licensing requirements (as in Singapore) exist to control or monitor the work of valuers.

The following definition of ‘valuer’ is given in the IVS Glossary:

A “valuer” is an individual, group of individuals or a firm who possesses the necessary qualifications, ability and experience to execute a valuation in an objective and competent manner. In some jurisdictions, licensing is required before one can act as a valuer.

Property is purchased for use and occupation or as an investment. In both cases the purchaser measures the expected returns or benefits to be received from the property against the cost outlay. The valuer’s task is to express these benefits in monetary terms and to interpret the relationship between costs and benefits as a yield or rate of return, thus allowing the investor to make a choice between alternative investment opportunities.

Since 1945, the property and construction industries have grown in importance; investing in property has been indiscriminately considered to be a ‘safe’ investment. The position, post the banking crisis in 2007, aptly illustrated how dangerous it can be to make such an assumption. The growth in pension schemes, life funds, property unit trusts, as well as direct investment by individuals, has completed the transition of the property market into an international multi-billion pound industry. As a result, there has been a growth in demand for property to be valued in order to establish market value, and for it to be re-valued for portfolio and asset management purposes. It should be noted that the evolution of property investment markets has added significant complexity to the valuation process, with new forms of investment, occupation and globalisation challenging the traditional approaches.

Understanding property as an investment asset class

Property as an investment is different to other forms of investment. The most obvious difference is its fixed geographical location, hence the importance of the quality of that location for the land’s current or alternative uses as determined by its general and special accessibility, and its interrelationship with other competing and complementary buildings, locations and land uses. More recently, the connectivity of real estate, such as the quality of its Internet infrastructure in terms of capacity and speed, has begun in some cases to erode the importance of its physical location. Once developed, the quality of the investment is influenced by the quality of the permitted planning use and the quality of the physical improvements (buildings) on the site. In addition, and essential to the assessment of exchange value, is the quality of the legal title. Is it the equivalent of the UK freehold, or is it time restricted in the form of a leasehold title? The owner of a freehold title effectively owns all the land described in the title deeds in perpetuity, including everything below it to the centre of the earth and everything above. Freehold rights may be restricted by covenants in the title and/or by the rights of others, such as rights of way or by law, whereby certain mineral and other rights may be vested in the state. A leaseholder’s rights are limited in time (the length of the lease) and by the terms and conditions (covenants) agreed between landlord and tenant and written into the lease, or implied or imposed by law or statute. The market value of a tenanted freehold property will also be affected by the quality of the tenant in terms of their covenant strength, and the quality of the lease in terms of the appropriateness of the lease conditions to that type of property used for that purpose in that location. In many countries, the legal framework evolves slowly and has a long history and tradition. In other countries, for example the United Arab Emirates (UAE), laws can and do change overnight, and this introduces the concept of the risk framework within which an asset sits. In the UK, for example, the risk of fundamental land tenure rights being changed is low, but in other countries these can change almost overnight making the risks associated with the legal framework a very different proposition.

To be competent, the valuer must be aware of all the factors and forces that make a market and which are interpreted by buyers, sellers and market makers in their assessment of market price. In an active market, where many similar properties with similar characteristics and qualities are being exchanged, a valuer will, with experience, be able to measure exchange value by comparing that which is to be valued with that which has just been sold. This direct or comparative method of valuation is used extensively for the valuation of vacant possession, freehold, residential property; for the valuation of frequently sold and easily compared commercial, industrial and agricultural property, and to assess the market rent of all property. Differences in age, condition, accommodation and location can all, within reason, be reflected by the valuer in the assessment of value. Differences in size can be overcome by adopting a unit of comparison such as price per hectare, price per square foot/metre or rent per square foot/metre.

The more problematic properties are those for which there is no ready market, those which display special or unique characteristics, those which do not fully utilise the potential of their location and are therefore ripe for development, redevelopment or refurbishment, those that are tenanted and are sold as investments at prices reflecting their income-generating potential and leasehold properties.

For each of these broad categories of property, valuers have developed valuation approaches that they feel most accurately reflect the market’s behavioural attitude and which may therefore be considered to be rational methods. Three approaches are recognised internationally: Cost Approach, Income Approach and Market Approach (IVS 105 RICS VPS 5).

In the case of special properties, such as oil refineries, glassworks, hospitals and schools, the usual valuation method is the cost or contractor’s method. It is the valuer’s method of last resort, and is based on the supposition that no purchaser would pay more for an existing property than the sum of the cost of buying a similar site and constructing a similar building with similar utility written down to reflect the physical, functional, environmental and locational obsolescence of the actual building. This approach is sometimes referred to as a Depreciated Replacement Cost Approach or DRC for short.

Properties with latent development value are valued using the residual or development (developer’s) method (see Chapter 11). The logic here is that the value of the property (site) in its current state must equal the value of the property when developed or redeveloped to its highest and best use (legal, physical et al.), less all the costs of development including profit but excluding the land. In those cases where the residual sum exceeds the value in its current use, the property is considered ripe for development or redevelopment and, in theory, will be released for that higher and better use.

All property that is income producing, or is capable of producing an income in the form of rent, and for which there is both an active tenant market and an active investment market, will be valued by the market’s indirect method of comparison. This is known as the investment method of valuation or the income approach to property valuation and is the principal method considered in this book.

The income approach and the income based residual approach warrant special attention if only because they are the valuer’s main tools for valuing the most complex and highly priced investment properties.

Comparing property to other asset classes

There are three main investment asset classes – stocks and corporate bonds, equity shares and property.

An investment can be described as an exchange of capital today for future benefits, generally in the form of income (dividends, rent, etc.) and sometimes in the form of capital. The investment income from property is the net rent paid by tenants. The market price of an investment is determined in the market by the competitive bids of buyers, for the available supply, at a given point in time, under market conditions prevailing at that time. Short supply and high demand that is scarcity will lead to price (value) increases, whilst low demand and high supply will lead to falls in prices and values.

The definition of market value requires the valuer to express an opinion of the market price that the valuer believes would have been achieved if that property had been sold at that time under the market conditions at that time; hence the importance of market knowledge and market comparables.

The unique characteristics of property make property investment valuation a more complex art and science than that exercised by brokers and market makers who are in the market for stocks and shares. In the stock market, sales volume generally allows for price (value) comparison to be made minute-by-minute. As stocks, shares and property are the main investments available, there is bound to be some similarity between the pricing (valuation) methods used in the various markets and some relationship between the investment opportunities offered by each. A basic market measure is the investment yield or rate of return. The assessment of the rate of return allows or permits comparison to be made between investments in each market and between different investments in different markets. There is a complex interrelationship of yields and patterns of yields within the whole investment market. In turn these yields reflect market perceptions of risk and become a key to pricing and valuation methods.

An international framework

Having looked briefly at the general economic principles underlying market value and the practice of valuation, we now need to consider the growing and changing international framework within which valuers must increasingly operate.

The first edition of Real Estate Valuation in Global Markets³ was published in 1997 and the second edition in 2010. Over the intervening 13 years the book expanded from covering valuation practice in 21 countries to covering valuation practice in 47 countries. So what is happening to real estate worldwide, and what is the framework within which valuers and appraisers operate?

Several important changes have occurred which will continue to influence the level of demand for real estate worldwide and hence the demand for v...