Talk Through 5 methods of vals

Question 1

Explain Depreciated Replacement Cost (DRC) - in as much detail

Answer 1

DRC also known as ‘The Contractors Method’ is a valuation used where there is limited or unavailable market evidence.

Typically used for owner occupied, specialised properties such as Schools & Lighthouses - for accounts purposes and rating valuations.

There are 2 steps to the method:
1. Value of land in its existing use - with the assumption planning permission exists
2. Using BCIS, add replacement costs and fees less a discount for depreciation and obsolescence

When estimating the depreciation and obsolescence in the final part of the method it is important to understand the differences between Physical, Functional and Economic.

Physical = Result of wear and tear over the years
Functional = when the design of the building no longer fulfils its function
Economic = due to changing market conditions for the use of the asset

When considering DRC as a method of valuation it is critical to follow the Red Book Global to comply with their standards. For example:
1. DRC can’t be used as Red Book Valuation for ‘Secured Lending Purposes’.
2. DRC can be used for calculating market value for specialised properties but ONLY for financial statements.
3. The valuer must state if there is any alternative uses when they report the valuation

The valuation must also be subject to separate conditions dependant whether it is in the ‘Private Sector’ or the ‘Public Sector’.

Private - Subject to adequate profitability of the business
Public - Subject to the viability of the continued occupation + use

Question 2

Explain the residual method - in as much detail as possible

Answer 2

The Residual Method is a form of development appraisal which focusses on finding the market value of a site, with all market inputs taken from the date of the valuation.

It can be based upon a simple residual valuation or the DCF method.

Its methodology is relatively straightforward - you have the Gross Development Value (GDV) of the site, incorporate the costs and then the developers profit and establish the market value.

To further break this down you essentially:

1. Start with GDV which is the MV of the completed development at todays date - this can be found through comparables on the rents and yields and assumptions on void periods and rental incentives.
2. Next is the Total Development Costs and this includes Site Prep, Planning, Construction Costs, Prof. fees, contingency, marketing costs + fees, and finance.
3. Lastly you put in Developers Profit, this is a percentage of the GDV typically around 20% but varies dependent on the risk associated with the scheme.

The key area with this valuation method is finance. It is calculated in the method as follows:

1. Assumes 100% debt financing - lending money from a bank
2. The Site Purchase & Hold costs (once development completes), are both calculated on a straight line basis, using compound interest over the length of the development period
3. But the construction costs are financed half of the time period as you don’t need to have the money all the time and can draw down when required - this can be shown using an ‘S’ curve.

Profit erosion is the time it takes to lose profit from holding costs (due to interest rates and loss making).

QUESTION: Can you tell us more about Development finance?

Development finance itself contains 2 main methods: Debt Finance & Equity Finance (selling shares in a company). Loan to Value (LTV) is typically 60% but in harsh markets lenders adopt a Loan to Cost (LTC) approach. Interest is calculated on a rolled up basis (added to the loans as the project proceeds).

Senior Debt is the first level of borrowing which takes precedence over secondary and mezzanine funding (additional funding). Other methods of financing include: JVs and Forward Sales.

A swap rate is the market interest rate for fixed rate, fixed term loans.

QUESTION: What is an Overage?

It is an arrangment for sharing any receipts received over the profits originally expected as agreed in pre-agreed formula - it is also known as a ‘claw back’.

QUESTION: What are the disadvantages of this method?

Importance of accurate information is needed / It doesn’t consider timing of cash flows / very sensitive to minor adjustments / Always need to cross check with comparables.

Question 3

Explain Investment Method of Valuation - in as much detail

Answer 3

Investment method is used for properties with an income stream attached to the value. Essentially the rental income is capitalised to produce a capital value.

The conventual method is simply the rent received (or MR) X the years purchase = Market Value - like all the methods there is an importance of comparables for the rent and yield.

Term & Reversion is used for reversionary investments - where the passing rent is below the market rent and can be exploited at a near lease event. Essentially the term is valued to the next lease event at an initial yield and the reversion is valued in perpetuity at All Risks Yield.

Layer / Hardcore method is used for over-rented investments and essentially the income flow is divided horizontally. The hardcore layer is the income which doesn’t change and is valued into perpetuity at a lower yield (safe income). The top slice is the initial rent which is going to decrease at the lease event - this is valued to the next lease event at higher yield (ARY) to reflect the risk.

Discounted CashFlows (DCF) project cashflows over an assumed investment holding period, plus an exit value (arrived at by an ARY). The cashflow is discounted back to present day at a discount rate which reflects the risk - known as a ‘desired rate of return’.

You should use a DCF when dealing with short leaseholds, phased development projects, to understand growth explicit inputs.

The method includes 4 steps:
1) Estimate the cash flow (income less expenditure)
2) Estimate the exit value
3) Select and use a discount rate to the cash flow
4) Value is the sum of the DCF - known as NPV

Question 4

Explain the Profits Method - in as much detail

Answer 4

Profits method is used for valuations of trade related property - where the properties value depends on the profitability of the business.

Essentially the value of the property isn’t based off the ‘Bricks & Mortar’ but the profit generated.

Examples of types of properties include: Self Storage, Pubs, Leisure centres and more.

For the Profits method a valuer would require audited accounts of the last 3 years but if not available estimates and business plans can be used.

The methodology is relatively simple as you are working through the businesses accounts to find the Fair Maintainable Operating Profit (FMOP):

1) Annual Turnover - costs = Gross Profit
2) Gross Profit - reasonable working expenses = unadjusted net profit
3) UNP - Operators remuneration = adjusted net profit.

Adjusted net profit is the FMOP.

Using comparables you find an appropriate yield and capitalise it against the FMOP to achieve Market Value.