We have compiled a list of the most commonly used terminology, concepts, and methods, explained in simple terms.
Property Valuation
A formal process, conducted by a qualified valuer, using accepted methods and standards to determine the value of a property independently and objectively.
Appraisal
An “informal” estimate of the value / price of a property usually provided by a registered real estate agent.
Valuation Assignment (Report)
A valuation report is a document that details the purpose, scope, key assumptions, analytical process applied, the valuation method applied, and provides an objective informed opinion of the value of the subject property in conformance with the valuations standards applicable to the subject property. Where appropriate, it should give details of comparable- and other market information used in the valuation. The valuation report must contain sufficient detail to cover all the items, terms and conditions agreed to with the client, to ensure that no misunderstanding of the real conditions and situation of the subject property can be construed.
Therefore, as a matter of good practice and to avoid any future misunderstandings or legal disputes, the valuer must ascertain the client’s exact requirements and the nature of the assignment by asking all the pertinent questions, and at times, advise the client on the assignment requirements most appropriate for the property and circumstances.
It makes common sense that the requester of the valuation will immediately turn to the page that gives the value of the property. However, the user should read the report taking into consideration the above and ensure that there is a good understanding of the terminology used in the report as well as the considerations and reasoning described by the valuer to derive to the value.
Valuation Approaches:
1. Comparable Sales Analysis / Market Approach
The comparison method or market data approach is based on the principle of substitution, where it is argued that a prospective buyer is not likely to pay more for a particular property than the price at which a similar property offering similar functional utility can be acquired. It involves an analysis of market behaviour through information generated from property transactions involving identical or comparable properties in a competitive market. The value of the subject property is benchmarked against recent property transactions of comparable properties for which price information is available. Appropriate adjustments are made for differences between the subject -and the comparable properties, for time since comparable transactions, and for example, cost to cure.
Our Courts have held that this method is the most acceptable and reliable method of determining most property values but also cautioned that the comparative sales transactions must be “worthy of comparison” and these transactions and other market information must be applied, with the necessary care and circumspection.
2. Income Approach
Two main variants exist, namely:
The Discounted Cash Flow method (DCF) and
The Capitalisation of Earnings method (Income Cap)
In easy terms, the difference between the Discounting- and Capitalisation methods is that Capitalisation uses a single income figure e.g. the most recent annual net income or an average of several years. Discounting on the other hand, is run on a sequence of annual income numbers (cash flow) for each year in the forecast. The Net income or forecasted cash flow are then discounted with the applicable Cap Rate and Discount Rate to determine the current value of the property. The accuracy of these methods is dependent on the objective (market based) determination of the property’s annual income, and a realistic capitalisation rate (Cap Rate) or discount rate.
Research found that a large majority of South African valuers preferred the Capitalisation method for the valuation of income producing properties. Many valuers use DCF only to confirm market value that was determined using direct capitalising. However, both methods are appropriate when used in applicable circumstances. A general guideline could be that Direct Capitalisation is most fitting for properties with stable earnings while the DCF method is probably better suited for properties expected to have fluctuating net earnings.
Valuers should pay attention to those instances where the currently contracted rental is much higher or lower than the prevailing market rents. Top – or bottom slicing is the process where the difference between the contracted rental and the market related rent, positive or negative, is discounted and added to or subtracted to the market value of the property.
The Income Cap- and the DCF method and the market approach are not completely distinct. For Income Cap the net income of an income generating property could be determined based on the comparable market related earnings and expenditure. It entails research and analysis of the rental rates, expense ratios, risks, yields, and capitalisation rates of comparable properties in comparable markets. The DCF will use and adopt assumptions and data from the market to establish a rate of return to assist in determining income growth and to establish the lifespan of an asset .
3. Cost Approach
The cost approach finds application where little to no market evidence or identifiable income streams are available and when the type of property does not readily transact due to its unique design, size, configuration, and location (e.g. specialised properties). The market value will be determined by calculating the cost to replace or reconstruct the physical structures. A ‘subjective’ adjustment (deduction) to account for obsolescence and depreciation of the existing improvements, relative to that of the new hypothetical improvements, will be made to get to a depreciated replacement cost (DRC). The market value of the land, as if undeveloped, will then be added to come to the market value.
The Royal Institute of Chartered Surveyors (RICS), with several members in South Africa, see the cost approach as a method of last resort, only to be used if it is not possible to derive a reliable valuation by other methods. However, the cost approach cannot be disposed of completely as it could give a good indication of value in certain instances.
Types of Values
There is a long list of defined types of values. Below are the values that are probably the most important:
1. Market Value
Market value tends to be the most common value determination assignments that valuers are assigned. The IVSC defines Market value as:
“… 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 (IVSC, 2017”.
Market value is determined on the valuation date without knowledge of future unforeseen events. It equals the highest and best use and is not affected by whether the owner is putting the property to its highest and best use at the time of valuation.
Market value is as an opinion of a property’s selling price in a competitive market.
Market value also applies to market rent studies that are used during new rent negotiations, rent renewals, or during investment decisions to assess e.g. the sustainability of rental income and future escalation rates.
2. Replacement or Insurance Value
Insurance value refers to the value that is covered by the property owners’ insurance policy and could be based on either the reproduction value or the replacement value. Reproduction value refers to the cost to do an exact reproduction of the property while replacement value is the cost of replacement of similar utility with current technology, building materials, and methods. An example of reproduction would be the replacement of a historical building with an exact replica, using the original masonry and building materials.
In common terms, insurable value is the cost to reconstruct a property based on current construction cost (i.e., current technology, -building material, and -methods) taking into account the size of the property, its special features, age, and other features that impacts on the replacement cost. It includes the cost of clearing debris, preparing the site, design – and other professional fees, inflationary provisions, all the building materials, and the cost of hiring the contractors to build the replacement property, but excluding the cost of the land acquisition.
The accurate determination of the insurance value is important as insurance premiums could be a substantial cost element impacting the net profit and as such the value of a commercial property. However, it could be the most detrimental in case of disaster if the value were calculated incorrectly.
3. Auction- or Forced Sale Value
IVSC defines “Forced Sale Value”as “The amount that may reasonably be received from the sale of a property within a time frame too short to meet the marketing time frame required by the Market Value definition. It might involve an unwilling seller and a buyer or buyers who buy with knowledge of the disadvantage of the seller.”
Distress auctions of properties usually lead to rather big discounts below the market value. Research and published property reports indicates discounts from market value to range between approximately 35 to 40% and even as high as 50% on sheriff’s auctions.
4. Value in Use
Value in use is the utility value of the subject property, being that cost that it will take to replace a property when an owner will be deprived of its use. Where market value is what an asset would sell for, value in use is what an asset is worth to a particular owner or party, based on the particular needs, tastes and opinions of the owner or party. Use value assumes a specific use which may or may not represents the highest and best use and is not determined from the current owner’s perspective only. If highest and best use is that use that maximises the property’s value, it follows that use value can never be greater than market value but only equal to, or less to it.
5. Fair Value
Fair value is fairly similar to market value. International Financial Reporting Standards (IFRS 13) defines Fair Value as:
“… 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”.
Based on this definition the price (value) will be an exit value that represents the proceeds to be realise if a property (asset) or business were to be sold.
6. Business Value (Going-Concern Value)
Business Value is the market value of an operating business including its property. It represents the entire value of the business including the real estate (tangible) and enterprise value (intangible). The valuer must determine the value of the tangible assets which include the real estate, plant, machinery, and furniture and fittings which must be added to the calculated value of the intangible assets including goodwill, management experience, patents etc. Although referred to as “value” it also refers to the assumptions with regards the status of the business as being a viable operating entity or not. It entails a sort of business risk analysis and requires insight on whether the enterprise has the required assets, inventory, work force and know-how in place, and that the doors are open for business, without any imminent threat of discontinuance as a going concern.
7. Residual Value
Residual value refers to the estimated value of a property or asset at the end of useful life or at the expiry of its lease – the amount that a property owner would realise when disposing of it, after deduction of estimated disposal costs. This value mostly sees application in financial reports as it constitutes the amount of an asset’s cost that should not be depreciated. It is the future economic value, at the end of the useful life of an asset, after it has been put to use for its intended purpose. The cost of the asset, less the residual value, equals the amount that should be depreciated over the useful life of the asset.
Highest and Best Use
IVSC defines “Highest and Best Use” as “The most probable use of a property which is physically possible, appropriately justified, legally permissible, financially feasible and which results in the highest value of the property being valued”. It assumes the use of an asset “…that maximises its productivity…” whether through continuation of current use or through alternative use or uses.
It may be its existing use but if the Highest and Best use differs from the current use, the cost to convert the property to its optimum use will impact on the value of the property. The valuer must bear in mind the permissible uses in terms of the town planning scheme and demand for specific uses.
Capitalisation Rate (Cap Rate)
In simple terms, the Cap rate is the rate of return that will be used to value an investment property by dividing the net income of year one by the applicable Cap rate. The Cap Rate (R) measures an income generating property’s yield in a one-year time frame as opposed to multi-year estimates of the DCF method. Cap rate is the ratio between operating income (I) generated by a property, and the price (P) of the property.
Cap Rate (R) = Annual flow of Income generated by the property (I)
Transaction Price (P) (or current market value)
For application on the valuation of a specific property, the Cap rate is determined from market data reflecting the market rate of return for a particular similar market segment. Data for the determination of the applicable Cap rate to apply should be sourced from properties which is similar in nature, location, functional condition, and other features that has an effect on value.
Determining the Cap rate requires a good understanding of the specific segment of the property market, the workings of the investment market, the local- and macro economy and the role it plays in current- and future values, and an understanding of the risk factors, and the extent and impact of such risk factors.
Discount Rate
Discount rate is also known as the required rate of return and represents the expected change in the value of money invested in the property or the business over time. For corporate investors this required rate would generally be the weighted average cost of capital or WACC. WACC represents the rate of return that a company must achieve on its money to stop investors from putting their investment money somewhere else. IVS, gives guidelines to apply and items to consider when determining the discount rate. Valuers may use any reasonable method for the development of the discount rate which includes WACC, IRR, WARA, CAPM and any other method that would lead to the development of an applicable reasonable rate. They should also consider the risk associated with the cash flow projections taking into account the type of asset to be valued, the type of cash flow, the geographical location of the asset and the market the asset will trade in. The required return or discount rate will be specific to each investor and must be derived from the market i.e. a rate that realistically reflects what can reasonably be expected in the market.
Freehold Property, Sectional Titles, and Freehold in an Estate
Freehold entitles a buyer to the full ownership rights to the property, consisting of the land and all the structures thereon. The owner manages and maintains the property.
Sectional Title refers to form of ownership of a unit within or forming part of a group-owned development or complex. The owners of the units have to contribute to the upkeep and improvements of the shared/communal property and services, and must comply with the rules of the complex.
Freehold in an estate (or cluster) refers to full ownership of the house and the land on which it stands. The owner will have to comply to certain rules of the Home Owners Association and even contribute towards certain services and upkeep of specified areas e.g. roads, clubhouse etc.
The three forms of ownership all offer certain benefits and have their drawbacks. Before making a buying decision it will stand you in good stead to speak to an estate agent or other property specialist to understand the pros and cons and the associated costs.