TOM DUNNE explains the terms used in relation to the valuation of property, and the need for common understanding among all parties using those terms.
In discussions about property the words value and valuation are often used on the assumption that all involved have a clear understanding of what is meant by them. This can result in misunderstandings and can be unhelpful when seeking solutions to property problems. In the world of business, and particularly in the nexus between real estate and banking, a clear understanding of valuation terminology is required by participants who will often be making decisions involving considerable amounts of money with significant financial consequences. It seems to me that ambiguity and a lack of commonly understood definitions of what is meant by value and valuation contributed to over lending on property and to the crisis in our banking system.
This happened before. In the UK in the 1970s, bad property lending nearly brought down the banking system and one of the lessons learned was a need for standards in property valuation and agreed definitions for terms such as market value. This led to the creation of what has come to be known as the RICS Red Book, which contains mandatory rules, best practice and related commentary for members carrying out asset valuations. Since the 1970s, the RICS/SCSI and international bodies such as the International Valuations Standards Council (IVSC), have put much thought into achieving clarity about terms such as market value and the circumstances where it is appropriate to use more precisely defined terms.
While practising valuers will understand the nuances in the meanings of value and terms used when reporting on the value of property, they should remember that many clients may assume that these have meanings more in harmony with their ordinary use of the word value. Lay people, including seasoned bankers, may not be aware of the ambiguities inherent in the word value and may not pay close enough attention to the definitions stated in reports.
Only objective word is price
A dictionary will give the meaning of the word value as being the amount of money that is considered to be a fair equivalent of what is being assessed. Other meanings include intrinsic worth and, more likely, the amount of money that something is worth. Often the words value and worth are regarded as synonyms and the price paid for a property in a market transaction is often taken to be a precise indication of either or both. The word fair is very ambiguous and will depend on the circumstances of the particular parties to a transaction. The only objective word in the triumvirate of price, worth and value, is price. It is the amount either asked or paid and can be established as a matter of fact from market evidence. Worth and value are essentially matters of opinion but nevertheless may need to be established to aid decision making. When expressing an opinion it is wise to remove as much ambiguity as possible to get clarity.
Lay people may not be aware of the ambiguities inherent in the word value, and may not pay close enough attention to the definitions stated in reports.
Valuations are required for many purposes including the sale or purchase or letting of a property interest; development feasibility and appraisal; and, alternative use valuations. Valuations for secured lending and financial reporting may also be required and these will require special provisions and additional requirements. Fundamental to the assessment of value by a Chartered Valuation Surveyor is clarity about the purpose of any valuation. It will come as a surprise to many of their clients that the RICS Valuation Professional Standards specifies 15 items that should be included in a letter confirming valuation instructions. Patently, property valuation is much more complex than is commonly imagined.
Once the purpose of the valuation is established, a valuer must determine the appropriate basis for the valuation and the RICS Professional Standards define four important bases of valuation. These are: market value; market rent; fair value; and, investment value. The definitions for these are drawn from the International Valuation Standards Council and are as set out here:
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.
The estimated amount for which an interest in real property should be leased on the valuation date between a willing lessor and a willing lessee on appropriate lease terms in an arm’s length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion.
The value of an asset to the owner or a prospective owner for individual investment or operational reasons.
Just to complicate issues there are two definitions of fair value which are of importance.
The IVSC definition states that it is “the estimated price for the transfer of an asset or liability between identified knowledgeable and willing parties that reflects the respective interests of those parties”. The definition from the International Accounting Standards Board states that it is “the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date”.
Break-up and other values
Common to all definitions is preciseness about dates and a presumption that the parties to a transaction were prudent and knowledgeable and were willing and, importantly, not obliged to transact.
It is worth noting that each of these definitions have up to eight conditions and arguably any one might not be met in actual market transactions. In deriving these definitions it has been decided that adding words such as open, full or fair before market adds nothing to help clarity.
The definitions presume that properties are not sold in groups or bundles. Particular groupings of properties can sell for more or less than the aggregate of valuations based on the above valuations. Breaking up a group of properties to produce a breakup value can be time and resource consuming and may throw up a sum larger than the selling price for the group sold as a unit. On the other hand, a particular grouping of properties can command a premium higher than the aggregate of valuations using the above definitions for the individual components. Similarly, valuations using these definitions will ignore synergistic or marriage values, or indeed ransom values that can arise from joining two property interests together, such as combining adjoining properties or buying in leases to create a freehold with vacant possession.
The market value arrived at using the above definitions will be different to a price that would be achieved by a forced sale carried out under coercion or against a time limit, perhaps shorter than a willing purchaser would allow if they were not in the predicament causing the sale; hence a forced sale valuation would be different to the market value using the above definition. A forced sale would throw up a lower price due to the particular circumstances of the sale, that would not comply with the requirement for the proper marketing of the property, which, in the case of some particularly large or distinctive properties, might take a long number of months or even years. In the case of residential property, for example, does proper marketing require that a property be properly presented and that money be spent on small improvements or redecoration that an agent might advise would enhance the price by much more than the cost of undertaking them? Another example would be where a property has development potential should planning permission be obtained to meet the optimum marketing conditions. These lending on secured property need to be aware that the market value can be above the price they will achieve following repossession and reflect this in the loan-to-value ratio.
Better decision making will flow from a clear understanding of the terms used by parties to a transaction and their advisers.
A fire sale valuation would be an extreme version of a forced sale that would limit the market to purchasers with ready access to cash and would be likely to result in a much reduced price.
Often properties can have hope value where there is an expectation of some change in the surrounding infrastructure or indeed planning circumstances beyond the valuation date, and whereas the definition of market value might reflect an element of such hope, value the definition requires that only things that could be reasonably known, as of the valuation date, can be taken into account.
Beyond these definitions of value there are many statutory definitions given in legislation, which may require nuances in valuation or define what might or might not be taken into account. Examples of this can be found in compulsory purchase legislation and rates legislation.
Perhaps the definition most familiar to most is the ‘Advised Market Value’ given in the Property Services (Regulation) Act 2011. This is “the licensee’s reasonable estimate, at the time of such valuation of the amount that would be paid by a willing buyer in an arm’s length transaction after proper marketing where both parties act knowledgeably, prudently and without compulsion”. This corresponds with the definition of market value above and should not present particular difficulties. This definition usefully allows a price range to be given.
Given the difficult circumstances in the market over the past few years, often decisions have to be made without the ability to examine all the details of properties or groups of properties that come up for sale given the timescales and the volume of properties involved. Parties can ask for estimates of realisation prices to be provided to aid their decision making but for bank lending, valuations to Red Book standards with all the required rigour will still be needed.
Better decision making will flow from a clear understanding of the terms used by parties to a transaction and their advisers. Chartered Surveyors should remember, particularly when dealing with nonspecialists, that many people, even experienced business people, use terms involving the word value more loosely than might be thought, and that this can give rise to misunderstandings and compromise the quality of advice given by them.