The valuation of investment properties can lead to significantly different results depending on methodology. In a commercial setting, the valuation methodology used might result in a significantly different final value. How does a business reconcile its investment property estimates with the rest of the market? In this article, we’ll look at the different types of valuation methodology, and explore what commercial property firms can do to ensure that their internal valuations match up with the expected market values.
History of Valuation Methodology
Valuation is, at best, an inexact science. Many of the ideas behind valuation are based on subjective thinking. Thus one valuator is likely to have a different point of view regarding the value of a property compared to another valuator. Over the years, humans have developed several ways to attempt to standardize valuation so that it can be applied to properties more or less consistently. These methods have started from the assumption that all individuals value property the same way, which may be considered a fallacy.
Thus, the idea of what a “fair” valuation is changes from individual to individual. The market value approach, for example, could be done in one of three ways. The property’s potential or actual income could be considered (if a rental or a commercial/industrial property) which can then be used to value its capitalization and cash flows. Alternatively, a valuator may look at the cost of liquidation on the market and use that as the basis for his or her valuation determination. There are several comparative methods that a valuator may use in determining the value of a property, namely:
- Comparison: The comparison method is the most common method that valuators use. It focuses on using leases or sales of recent properties that are comparable with the principal property. The best comparable factors between the properties are selected and used as a basis for determining the final value.
- Residual: Residual valuations look at the potential of a property to appreciate and focus on vacant lots or properties going through a change-of-use. The residual sum is calculated by taking the gross development value and removing the cost of development. The residual sum makes up the capital that the property can stand for on its own.
- Profits: The profits method for quartz countertop deals primarily with properties that don’t have a comparable value to anything else. Institutions such as bars, nursing homes, and hotels are most likely to be valued using this methodology. The profits method takes into account the total income from the property, and deducts working expenses (not including rent). The remaining value can then be shared between the property owner (as rent) and the proprietor.
- Investment: This particular valuation deals with the profit potential of a particular piece of property. It is primarily used where a tenant is providing the landlord with an investment income. Comparable properties are analyzed to determine revenue, and this value is combined with the profit to determine the future rental income from the property. This future rental income is discounted back to the present day to give the final value.
- Contractor: When comparative, investment or profit methods can’t be used, the contractor’s method is a default fallback position. It typically applies to specialist properties, where the property doesn’t have a lot of market action going on for comparative values to be determined. It’s highly unreliable and is termed the “method of last resort” for a good reason.
Methods of Valuation
The two primary valuation methods that valuators use for investment real estate are:
Ø Deprecation Replacement Cost (DRC) Method: According to the Royal Institute of Chartered Surveyors (RICS), the DRC method deals with the cost of replacing the asset with another current asset of equivalent value, less that lost in deterioration, obsolescence, and optimization.
Ø Fair Value Method: The Journal Of Information Systems & Operations Management notes that fair value methodology takes the value of the property as it can be exchanged, traded, or settled as a liability.
These valuation methods can produce varying values for the amount that a particular investment property is worth. While most valuators rely on the DRC method as their go-to valuation, new research suggests that, with the change in paradigm presented by a global pandemic, we may need to rethink how we look at real estate valuation.
Buying behaviors have changed drastically, and with more individuals working from home, the demand for office space is likely to decline. In such a case, these properties would need to be evaluated to account for the change in their value on the market. Conversely, living spaces may see an uptick in value as more people look for those with alcoves to turn into workspaces.
As we already mentioned before, research has shown that external valuators tend to give a more conservative estimate for a company’s investment holdings. External parties may be best suited to performing fair-value valuations. However, this raises another issue with how this data is transmitted to shareholders. With all the data, the shareholders are likely swamped in information. Thus, the valuator or investment company must pare down the information presented to the shareholder to the very minimum.
One of the more critical points that arose from the investigation of valuation methodologies is that businesses that don’t have extensive annual reports tend to opt for the traditional DRC method of valuation. If the company has more diversified ownership, it may positively impact whether it chooses to go with the fair-use valuation model over DRC. Internationally, companies from the UK and Scandinavia tend to use fair-value reporting more often as opposed to DRC. The aim should be to increase the value of the report without adding extraneous information that runs the risk of confusing the investor. Using an external valuator may have as profound an impact on a company as hiring a large audit firm to go through the valuation after the fact. Knowing the actual value of a property may well be worth it.