Asset Valuations Capital valuations of property assets for

inclusion in company financial statements

Valuations for financial statements

• Required for:– Company accounts (balance sheet,

profit and loss and cash flow statements)

– Stock Exchange documents– Pension funds, trusts, investment funds,

insurance companies• Public domain, therefore tight regulation• Reports financial status of an “entity” to

provide information on performance• Useful to management, owners and other

stakeholders in making economic decisions

• Often required by statute

Regulation

• Accounting standards– The IASB (which replaced the IASC) publishes IFRS (which

replace IAS)!• These standards govern public companies

– The ASB publishes GAAP, FRS (and SSAP)• Can still apply to UK private companies

• Valuation standards– IVSC publishes IVSs

• IVS 300 – Valuations for Financial Reporting under IFRS– RICS Red Book

• These now defer to IVS

• Requires Valuers to follow IVA 1 for IFRS + a few additional requirements on report contents and disclosures not found in IVS

• Includes valuation requirements under UK GAAP

Two regimes for FR in UK

1. IFRSo All listed companies in EU have had

to adopt IFRS since 2005o May be used by private companieso Public Sector moving towards IFRSo Over 90 countries will have either

adopted, or recognise, IFRS

2. UK GAAPo Have developed since early 70so Used by private companies and

public sector

Differences between IFRS and UK GAAP

• Differences of terminology and presentation rather than substanceo Owner occupied property valued at

Existing Use Value (EUV)*o Specialised Property separately

categorised and report at DRC

*EUV based on different accounting measurement theory to IFRS but, in practice, often little difference to the MV assuming sale of whole entity as going concern

1. IFRS• Why valuations of property are required in financial statements

– Expensing share options (IFRS 2)– Establish value of assets acquired in takeover (IFRS 3)– Treatment of surplus assets (IFRS 5)– Report the carrying amount on balance sheet (IAS 16 and 40) – Measurement of lease assets and liabilities (IAS 17)– Calculate of depreciation charges and Impairment Reviews (IAS 36)– Measurement of embedded derivatives (IAS 39)

• In many cases use of value in financial report is an alternative option to historic cost, e.g.

– IAS 16 – Property, plant and equipment– IAS 40 – Investment property – although if cost adopted value must be shown in

notes to accounts• Only a minority of businesses use value option under IAS 16, although

importance increasing as IFRS 3 requires values to be shown after a business combination (merger)

IAS 16 Property, Plant and Equipment& IAS 40 Investment Property

• Accounting treatment for operational property assets• Initially reported at cost in the balance sheet but subsequently they can be

reported either at cost or at a revalued amount (fair value)• Choice of reporting measurement must be applied consistently to an entire

class of property• To determine fair value :

– use market evidence for non-specialised property– depreciated replacement cost method for specialised property

IVA 1 in IVS sets rules for valuers to follow: valuer will report MV

• Under IASs 16 and 40 this is the acceptable approach to determine fair value of property, plant and equipment, and investment property

• Valuer should discuss assumptions or qualifications to be made in applying MV basis with client and disclose them in the reporto No explicit guidance on those assumptionso This reflects current uncertainty caused by lack of precision in fair value definition in

IFRS and how it is applied in different situations

IVA 1 – key pointsA statement should also be made that the value for the alternative use takes no account of issues such as business closure or disruption and the associated costs that would be incurred in achieving the alternative use, and that these should be considered by the entity when deciding the appropriate amount to adopt as fair value.

Matters that valuer needs to discuss with client:– Is asset going to continue to be employed as part of a going concern?– Does additional value attach to it because it is part of a going concern?– Could the asset be sold on its own without disruption to the business? If so could

be it be classified as surplus?– Is the value of other assets employed in the business intrinsically linked to the

value of this asset?

These things need to be considered and appropriate assumptions made, and stated in report

2. UK GAAP

FRS 15: Tangible Fixed Assets• If an entity opts to revalue, there must be a programme of regular revals• Basis on which net current replacement cost varies depending on the nature of

the property asset– Non-specialised operational = EUV– Specialised operational = DRC– Surplus or held as an investment = MV– If the valuer believes that there is a significant difference between the MV and EUV

of a surplus property then both should be reported together with an explanation of the difference

– If a property used for the purposes of the business has been adapted the valuer should provide an estimate of EUV in its post-adaptation state or in its pre-adaptation state plus the DRC of the adaptation works.

EUV (1)• “The estimated amount for which a property should exchange on the date of valuation

between a willing buyer and a willing seller in an arm’s-length transaction after proper marketing wherein the parties had acted knowledgeably, prudently and without compulsion, assuming that the buyer is granted vacant possession of all parts of the property required by the business, and disregarding potential alternative uses and any other characteristics of the property that would cause its Market Value to differ from that needed to replace the remaining service potential at least cost” (RICS, 2011: 140).

• Same as MV but with one additional assumption and a further requirement to disregard certain matters

– Additional assumption: buyer is granted VP but any parts of the property occupied by third parties should be valued subject to those occupations

– Disregard 1: any hope value for alternative uses, but the valuation may take account of “...any value attributable to the possibility of extensions or further buildings on undeveloped land, or redevelopment or refurbishment of existing buildings, providing that these would be required and occupied by the entity, and that such construction could be undertaken without major interruption to the current operation” (RICS, 2011, 141)

– Disregard 2: any other characteristics of the property that would cause its Market Value to differ from EUV

EUV (2)• The Red Book (RICS, 2011) gives the following examples of circumstances in

which EUV may differ from MV:– an occupier operating with a personal planning consent– an occupier holding the property under a lease and there are restrictions on

assignment or alternative uses– the property is in an unusual location, or oversized for its location– the presence of contamination that would depress the value for an alternative use– the existing buildings are old and of limited value if vacant but the replacement cost

of the remaining service potential to the occupier would be significantly higher– an industrial complex is overdeveloped and the extra buildings have either a limited

market value or detract from the market value but would need to be replaced to fulfil the service potential to the business

– Any value attributable to goodwill should normally be ignored (RICS, 2011: 142). If the property assets are held leasehold at rack rent or with short periods to expiry the valuer must discuss with the client as to whether they should be included or not

Company Accounts

• Company accounts comprise– Balance sheet– Profit and loss account– Director’s report and chairman’s statement

• Balance sheet reports value of fixed assets– Land and buildings– Plant and machinery– Fixtures, fittings, tools, equipment– Assets in course of development– Investments

• Fixed assets can be recorded at– Historic cost– Current value

Balance sheet (IFRS)

Public sector

Categorise assets – determine treatment

Different standards apply depending on how the property asset is classifiedo owner occupiedo leased o investment

Balance sheet (UK GAAP)

Public sector

Valuation basis

Categorise assets – determine valuation basis

*assumes that the asset is sold as part of the continuing enterprise in occupation

Accounting for depreciation• All companies (except prop invt cos) must depreciate the value of fixed assets

that have a limited economic life (prop invt cos value their fixed assets annually)

– Buildings on FH land and LH interests are wasting assets and liable to depreciation– Surplus or investment property is not depreciated

• The annual P&L account contains a depreciation charge in respect of the amount of depreciation suffered in any one accounting year

– The figure on which this depreciation charge is based is known as the depreciable amount

– To arrive at the depreciable amount, the reported value of the property asset must be apportioned between wasting and non-wasting elements – between building(s) and land respectively – so the depreciable amount can be allocated to the wasting element

• Deduct land value (in existing use) from total cost / value of asset• Assess net replacement cost of the buildings

• Depreciation charge is the depreciable amount divided by number of years of remaining economic life

Accounting for depreciation• To calculate the depreciation charge it is necessary to estimate

– The future useful (to the entity) life of the property– The residual value of the property (value of the asset, net of disposal costs, assuming it was already of

the age and in the condition expected at the end of its useful life)

• Depreciable amount = fair value / cost of asset - residual value• Depreciation charge = depreciable amount is spread, usually on a straight line basis,

over the useful life of the asset• E.g.

Market value: 500,000Less: value of land (£) 200,000Value of building (£) [or can be estimated using RC approach] 300,000Useful life – as determined by entity 20 yearsFuture economic life – estimated by valuer 40 yearsResidual Value:Valuer’s estimate of current value of building assuming it was 20 years older with a remaining economic life of 20 years (£)

100,000

Depreciable Amount of building (£) 200,000

The entity must allocate the £200,000 over 20 years and the resulting annual amount is charged to the profit and loss statement in the annual accounts

Valuation of non-specialisedowner-occupied property assets

• A factory of 1,000m2 is owned and occupied by your client for industrial use

• The premises were built 17 years ago when it was estimated that their economic life would be 50 years

– Current replacement building costs are £220/m2

• The MR is £25,000 per annum and yields on newer premises are 8.5%

• Your client also has planning permission to redevelop the whole site providing for 2,000 m2 of new industrial floor space which (s)he is confident of pre-letting

– Construction would take one year and would let at approximately £40/m2

– Total construction costs are estimated to be £220/m2

• Value these premises for your client's company accounts

Valuation of non-specialisedowner-occupied property assets

Valuation figure for balance sheet purposesEstimated Rental Value 25,000YP perpetuity @ 9.5% 10.5263EUV £263,158

Calculation of depreciable amount in respect of the wasting element of the asset •Calculated by estimating the gross replacement cost of the building

•Then depreciating the this using a ‘straight-line’ method of depreciation to arrive at a net replacement cost:

Gross Replacement Cost (1,000m2 @ £220/m2) 220,000

Estimated Economic Life (years) 50

Age (years) 17

Depreciation factor 33/50

Net Replacement Cost 145,200

Valuation of non-specialisedowner-occupied property assets

Alterative use valueEstimated rent (2,000 m2 @ £40/m2) 80,000YP perpetuity @ 8.5% 11.7647Gross development value (GDV) 941,176Less:Demolition costs (estimate) 10,000Building costs (2,000m2 @ £220/m2) 440,000Fees @ 1.25 % GDV 11,765Finance @ 7% for 1 year 32,324Developer's Profit @ 10% GDV 94,118Development costs 588,207Balance 352,969

x PV £1 at 7% for 1 year 0.9346

329,878

less acquisition costs (say 4%) 317,190

This figure would be included in the valuer’s report since it is significantly different from EUV

Valuation of specialisedowner-occupied property assets

• Depreciated replacement cost method• Gross replacement cost (cost of erecting a modern equivalent building) less

a depreciation allowance. The latter can be calculated in several ways– Straight line (future economic life of the building is divided by the total life

expectancy of a modern equivalent)– Declining balance (fixed percentage)– Sinking fund

Example– Glass works on a ten hectare

site held freehold. Land values is £250,000/ha…

Valuation of specialisedowner-occupied property assets

Description Date

built

Life ofmodernbuilding

Life ofExistingbuilding

GRC Depreciationfactor

NRC Value

Main glass works 1967 60 20 6,000,000

20/60 2,000,000

Laboratory and toilets

1972 60 20 1,000,000

20/60 330,000

Canteen and offices 1976 30 5 800,000 5/30 130,000

Finished-product w/hse

1982 60 40 10,000,000

40/60 6,667,000

DRC of buildings 9,127,000

Plus Land Value 10 ha

@ £250,000

Per Hectare 2,500,000

Valuation 11,627,000

Property implications of reporting MVrather than historic cost

• Income statement– More volatile earnings figs for property invt co’s as valuation surpluses and

shortfalls appear on the income statement (to the extent that they exceed any previous respective shortfall or surplus)

– Records net proceeds from disposals and profit will look higher if carrying amount was historic cost

– Will incorporate realised profits (losses) and unrealised valuation gains (losses)

• Balance sheet– Higher fair value of property assets for business occupiers will mean

• Increased shareholders’ funds & NAV leading to stronger capital-raising base (but a fall in return on shareholders’ equity)

• Increased fig for capital employed leading to reduced ROCE– Balance sheet strength will rise and fall according to movements in property

market as well as trading performance

Valuations for loan security

Introduction

Regulated by the Red Book... Appendix 5: Valuations for commercial secured

lending Appendix 8: European Mortgage Federation

paper on mortgage lending value UKVS 3.1: Residential property mortgage

valuations UKVS 3.9: Secured lending valuations for

registered social landlords UK Appendix 10: RICS residential mortgage

valuation specification UK Appendix 11: Application of RICS residential

mortgage valuation specification to related purposes

UK Appendix 13: Valuation of registered social landlords’ stock for secured lending purposes

Main areas of concern

Conflicts of interest Enquiries regarding

recent transactions

Valuations for commercial*secured lending

• Appendix 5 of the Red Book• If instruction received from a party other than lender (e.g. borrower or

broker) and the identity of the lender is not known, then the valuer must state in the ToE that the valuation may not be acceptable to the lender

• The valuer must enquire as to whether the property was recently sold or if a price has been agreed pending a sale. If it has, then the valuer must investigate the price paid (or agreed), the extent of marketing and the nature of any incentives

*Excludes buy-to-let and owner occupied residential

• Conflicts of Interest must be disclosed – does the valuer have a current /recent (i.e. last 2 years) fee-earning involvement with the property to be valued, with a borrower or prospective borrower, with any party connected with the transaction for which the lending is required?

• If the valuer or the potential client consider that the disclosed involvement does create a conflict then the instruction should be declined

• If the valuer or potential client can agree arrangements to avoid the conflict, these should be recorded in writing, set out in the terms of engagement and referred to in the report

Valuations for commercial*secured lending

Conflicts of interest

• Which of the following are conflicts of interest?– Acting for the buyer and the seller of a property in the same transaction– Undertaking a valuation for a lender where the valuer’s firm has other fee-

earning relationships with the client– Valuing a property recently valued for another lender– Undertaking a bank valuation for a member of your family– Undertaking a bank valuation on a property where your firm had

undertaken a rent review for the owner 3 years earlier• Would you advise a commercial lender to lend against ‘hope Value’?

Loan valuationsTypes of commercial property• Owner-occupied• Investment• Development or refurbishment• Operational entity

Valuation bases• Market Value• Market Value with Special Assumptions

– On completion of a development or refurbishment– New letting on given terms– A restricted period to sell the property– Planning consent granted for a particular use or development– Contamination or other environmental hazard is to be ignored– There is a special purchaser, which may include the borrower

Valuation basis• What about EUV?

– Not relevant as owner-occupied properties valued on VP basis– Owner may be part of market but any special advantage that the occupier may derive

(which may be reflected in value of the business) should be separated from value of property

• Specialised properties– Limited marketability and derive value from being part of business so may not be

suitable individually as security for loans– If offered for security (individually or collectively), should be valued assuming VP

• Specialised trading properties– Note any sig. diff. in value should future operating performance be impaired, e.g.

• business ceases trading• inventory removed• licenses/franchises/etc. removed or suspended• Vandalism

– Note any risk to profit

• Alternative uses– Should include comment on potential demand for them

Valuation methods• Specialised properties

– Don’t usually use replacement cost method• Specialised trading properties

– Profits method• Development land and properties

– Residual method– Can assume construction is complete but consider market movements

between valuation date and estimated completion date– Use current estimates of costs and values– Comment on costs, contract procurement and viability of scheme– Illustrate sensitivity to assumptions made– Comment on implications on value of any cost overruns or delays– Indicate whether plans and costs have been provided by an architect and

quantity surveyor respectively

Lease terms: Tenant, guarantor

Length of terms

Break options

Alienation – prohibition or easy to assign/underlet

Pre-1995 lease? If not, AGA?

Landlords liabilities – FRI/IRI/Non-recoverables

Rent review provisions

User – restricted?

Covenant Strength: Financial standing

Tenure: Freehold or Leasehold?

Property Characteristics: Location, repair, etc.

Main factors affecting investment value

• Must include all matters set out in Appendix 6 of the Red Book*...

• ...plus, dependent upon the lender’s requirements

The marketability of the property

Potential end demand for alternative uses

Valuation methodology adopted

Details of significant comparable transactions relied upon

Suitability of the property as security for mortgage purposes

Environmental or economic designation

There will be more specific questions depending upon the type of valuation being undertaken for example, with investment property, covenant strength of tenants is significant

Reporting

Comment on purchase price against MV if applicable

Development – comment on costs, viability, sensitivity, etc.

Lending ratios• Initial LTV is typically 60-70%• Interest cover ratio (or income cover)

– Annual net rent divided by annual interest payment– Will vary between 115-150% depending on tenant covenant and length of

lease• Rent cover ratio

– Annual net rent divided by annual interest and capital repayment– Will also vary between 110-125% depending on tenant quality

• Objective is to maximise LTV while staying inside income and rent cover ratios

Valuation of building to facilitate conversion loan on right hand side and car park

Example valuation

• Highbridge– Former 4 bay workshop to rear of

industrial estate converted into modern office accommodation

– Close to Junction 22 of M5– 30,000sq ft LHS modern offices over 2

floors, open plan, Cat 5 cables, Cat 2 lighting, recessed floors, comfort heating and cooling system. RHS steel frame and beam and block floor, build to be let/sold as whole or in 4 parts. Proposal to increase parking to 83 spaces

Building disadvantages• Still has external appearance of industrial building on industrial estate• Floor plate too big; occupier requirements up to 3,500 sq ft, smallest

floor plate is 4,400sq ft• Floor depth 23m, usually anything >18m creates issues with natural

light if partitioned within the centre of building• Car parking ratio 1:350 planning guidance out of town 1:300• Limited demand for offices in this location, usually to business centres

of Bridgewater or Taunton• Likely void of 9-24 months to achieve full occupancy

Evidence and analysis

Evidence• Headline rent

– Blackbrook in Taunton £16psf– Express Park Bridgewater, £12.50psf

• Capital value:– Bridgewater;

• small new suites 3,500sq ft, £150psf• second hand space no parking £100psf

– Blackbrook £190psf

• Yield:– Converted industrial building Almondsbury approx 6.75% - reflects good covenant and

location

Analysis• Rent - £10psf• Capital Value - £100psf• Yield - 8%

Valuation method• Valuation date = 30 Jan 2007• Assumptions

– 14 month void period– Then a lease for 5 years with a 3 month rent-free period– Rent = £45,000 p.a. (£10psf) on term and reversion– Another 14 month void will follow expiry of 5-year lease– Yield = 8% with no adjustment between term or reversion as location,

likely covenant and market assumed to remain constant throughout period

• Valuation:– Term CV = £45k p.a. for 4.75 years @ 8% deferred 1yr & 5mths– Reversion CV = £45k p.a. in perp PV’d for initial void, 5 year lease and subsequent

void

Valuation for 1of 6 tenantsAggregate valuation for the 6 tenants

Development valuation:information requirements• Floor plans

– measure on a gross internal floor area basis– must relate to planning consent

• Elevation details• Site plan

– defines boundaries confirms is any likely ransom strip which could have significant impact on value

• Planning permission and other related documents– onerous conditions, some could have an impact on cost i.e. Section 106

contribution– things which could prohibit delay development (slow worms, bats, badgers)

• Ground Investigation report– contamination, type of foundations required, any natural gases– could impact on cost and time if remedial work required

Development valuation: information requirements• Construction costs including fees

– most developments undertaken on JCT fixed price contract inclusive of professional fees (architect, project manager)

– cost is not really fixed if there is a change in specification, etc. over build programme

– Also looking to see if developers aspiration on timescale is appropriate

• Utility connection– usually £4,000 per unit for all mains services– Check relevant permission from authorities to link in to site

• Specification– fixtures and fittings, parking circulation, etc. – impact on GDV of a scheme

• Abnormals– remedial work as a result of a ground investigation report

Development valuation

• Small residential development south of Bristol

• Planning permission for four 4-bedroom houses

• 9 month development timescale• Construction costs of £80 psf• Profit = 20%• S.106 contribution of £4,000

Worked examples to demonstrate what happens if there is a variation in cost to developers profit assuming land purchase of £365k

What if costs and timescale overrun?

• 18 month development timescale

• Construction costs of £100 psf