Real estate finance and property valuations take place across national borders. National methods diverge despite having the same value definitions. Do differently structured real estate markets need individual methods and approaches? How much harmonization can and should be available in the valuation? Which (standard-)methods are accepted in Europe and worldwide, nor enforced or long overdued?
Even equal Market Value definitions may have a different understanding about the duration of the valid period of time. Nicolas Sarkozy "defined" the period of validity by exclusion: "the ... value ... does not change from one second to another, nor every minute, nor every hour ..."1)
The price is negotiated between seller and buyer and after agreement it is fix forever. The market value has a short period of validity, weeks or months, maybe years. Even if there is a valuation date the mortgage lending value is valid for years, maybe decades, if no thresholds were broken during the loan. The investment worth respectivly the Special Value (IVS-2011) always reflects particular attributes of an asset that are only of value to a special party, "which confusingly is sometimes called investment value"2). The concept of value and worth is known in Germany as "objektive and subjektive Wertlehre".3)
Trespass through the definitions of the market value
In the following cascade of definitions for the basis of valuation "Market Value" a trespassing is possible upward, stepping left or right and down again. The only difference between the definitions of market value by the two umbrella organisations is one expression: 'property' and 'asset or liability', which is at least 'subject of the valuation'. The national definitions originated mainly by professional bodies, only a few countries have legal definitions, like Germany.
Nearly every country is under one umbrella, either IVSC or TEGoVA, through at least one professional body, very few countries are represented in both umbrella organisations. Consequently, a valued market value is a market value everywhere, independent in which country it is reported, no matter what (standard-)method is used, a professional and experienced valuer provided.
There is no standard-method defined on umbrella organisation level. And on national level we have all the diversity we enjoy in our holidays. Whilst the RICS "does not instruct valuers on how to value in individual cases"3) we have methods normed by law (codified by legislation) in Germany and the valuer decides which method is applied. The normed methods are at least obligatory only for valuations at the court. Every valuer is allowed to use not-normed methods, i.e. direct capitalisation, but you never know when you have to defend your valuation report at court and explain it to a judge. An English saying: "If you are in doubt, go without."
All professionals know the three approaches for valuation and use it according to the subject of valuation and the market. One problem for international valuations in cross border business is that no methodology is defined as standard on the afore mentioned umbrella organisation level, only national definitions are given by professional bodies or codified by national legislation, like in Germany.
Investment Method in Germany
In Germany the valuation law with its normed methods and models forms a cicular system for all valuers. The administrative regional experts committee (Gutachterausschuss) derives from real transaction prices the valuation relevant figures (VRF, für die Bewertung erforderliche Daten) as indirect comparables and reports these figures regularly (annually) to the public. The period of validity gets significant here. These figures are criticized, i.e. from RICS-valuers as reflecting the past and being too old for a mark-to-market assessment of the MV with a (very) short period of validity, as the RICS understand the market value (MV).
On the other hand these regional figures (VRF) do not sway as much as valuation parameters in other countries and markets, due to the models used. If a valuer in Germany chooses a not-normed-(standard-)method, he may suffer under the lack of reliable indirect comparables for his selected model. And if the valuer in Germany still has his doubts and goes without, how shall he explain the result and method to the client?
The income approach in Germany with the split capitalisation model (§ 17, par. 2, no. 1 ImmoWertV, allgemeines Ertragswertverfahren) has a long tradition and is unique in the world. Therefore it is necessary not only to draw the report in a foreign language but also to translate the German valuation method into an international (standard-)valuation method. The client understands his language and is familiar with his methods. The valuer is the local expert and carrying out valuations cross border requires expertise not only in the market but also in the methods. The skill to transfer an only locally used standard valuation method into the foreign clients grammar is usually not present by the client.
YP(years@yield) = years purchasefor years with yield (YP, Diskontierungssummenfaktor)
MV. Split Capitalisation = GAE * (1- OpEx+VCL)/100) * [YP({}@PY) * LS + YP(RUL@PY) * (1-LS)]
MV. Direct Capitalisation = GRI* (1- OpEx/100) * YP({}@ARY)
So let us explain how you get an income approach using the normed German split capitalisation model (Ertragswertverfahren) by using the property yield (PY, Liegenschaftszins) transformed into a direct capitalisation model with an all risks yield (ARY). The resulting market value (MV) is without purchaser's cost due to the derived parameters (VRF) from transactions. To explain the differences we concentrate on the main subjects, minor differences are neglected. If rack rented both methods start with the gross rental income (GRI, Bruttomieteinnahmen) respectivly the gross annual earning (GAE, Jahresrohertrag) and end with the market value. The differences are in the steps between.
The German investment method starts with the gross annual earning (Jahresrohertrag), deducts the non-recoverable operating costs (NonReCo, Bewirtschaftungskosten) with management (Mgmt, Verwaltung) and maintenance/repair/refurbishment (MRR, Instandhaltungskosten) and vacancy and collection loss (VCL, Mietausfallwagnis) receiving the net annual earning (NAE, Jahresreinertrag).
The direct capitalisation model
The international investment method for rack rented properties is the direct capitalisation model (DC), and starts with the gross rental income (Bruttomieteinnahmen) deducts the operating expenditures (OpEx, Betriebsausgaben), which omits the vacancy and collection loss. This risk is covered in the all risks yield. Continuing with the net rental income (NRI, Nettomieteinnahmen), which is different to the net annual earning (Jahresreinertrag), it is direct capitalised to perpetuity and we receive the MV.
The German investment method uses the property yield (PY, Liegenschaftszins) for capitalisation. Due to non-recoverable operating costs the lower net annual earning (Jahresreinertrag) is divided into a part for the ground (Bodenwertverzinsung), which is capitalised to perpetuity. This present value (PV, Barwert) is the land value and the land share in percent (LS, Bodenwertanteil) of the MV is used later on.
The other part of the net annual earning remains for interest & amortisation of the building (Verzinsung der baulichen Anlagen) and is capitalised to the estimated remaining useful life (RUL, Restnutzungsdauer) of the building (Gebäudeertragswert). The sum of the two present values, land & building, is the MV.
MV. Split Capitalisation =
PV. Land({}@PY) + PV. Building(RUL@PY)
Different mathematics but the same result. Is this magic? No it is tradition in different cultures. The corresponding ARY can be calculated with the market value from the split capitalisation model:
ARY= (1 - OpEx) / (MV. Split Capitalisation/GAE) = PY + Risk Premium
The interpretation of the ARY as PY plus RP (risk premium) shows that the risk premium is a function of VCL (vacancy and collection loss), RUL (remaining useful life) and the LS (land share). Besides the property yield (PY) and the market rent (rental income), these three components are the main value drivers.
Therefore the PY is more stable, than the ARY. Growth implicit ARY as in PY, and yields are not the target rate (return on investment) and is therefore not comparable with other investments. For worth (special value) calculations the capitalisation rate (CR) is used in the recommended DCF(NPV) as net present value or DCF(IRR) with an internal rate of return. As a rule: CR >= ARY >= PY
Transformation of PY to ARY
The previous example starts for simplification with an annual earning of 1 Euro. The market value (MV) is calculated with the normed German split capitalisation model using the reported parameters by the administrative experts committee derived from real transactions. In a second step the all risks yield (ARY) is calculated and in the right column initalic style (PY-2-ARY) the equivalent risk premiums are presented.
The segregation into risk premiums due to VCL, RUL and LOC (location) is calculated with an approximate calculation without partial differentiation, just to take advantage of the transparency instead of a black box ARY in one figure only.
Internationalisation
Where are the international (stan- dard-)methods defined? The "Immo-WertV-2010" tried to introduce the much more sophisticated DCF-model. But the regulated method "periodisiertes Ertragswertverfahren" is not a
DCF-model for special values, because it prerequesites the periodical cash-flow in the understanding of gross annual earning (GAE, Jahresrohertrag), which is mostly different from the real annual rental income. Furthermore, it is discounted with the property yield and considers the land value to perpetuity.
Since the German legislation in coordinance with professional bodies failed to introduce an international property investment valuation model it is clear, that future adaptions of the national valuation regulations can not introduce any other international method, like direct capitalisation, even if they are much more easier. This is not necessary either, like the above presented short-hand transformation to direct capitalization to perpetuity showed.
For the future a professional body on umbrella level may define the major method for the three approaches, of course without instructing the valuer on how to value in individual cases. But more sophisticated are the translation of expressions associated with a certain meaning in different legal frameworks and markets. The lack of international definitions of expressions is the main reason for misunderstandings and misinterpretations.
In the German market more and more international players take part and influence the market, with movements and acceleration. At the end all markets work with the same mechanisms, but have a different history, legal or professional framework, use different tools to estimate the market value - but the value is equal. Equal definitions are the foundation for standard expressions, standard methods and standard models to grow.
The benefit of variety and foreign culture we enjoy on holidays is now in daily business. We all use the same definition of market value. But it is the responsibility of the individual valuer to demonstrate methodological competence and the last little difference can be explained with the period of validity, following Nicolas Sarkozy.
Footnotes
1) Nicolas Sarkozy, President of the French Republic, Opening speech of 40th World Economic Forum, Davos - Wednesday, January 27, 2010, https://members.weforum.org/pdf/Sarkozy_en.pdf P
2) Modern Methods of Valuation, E. Shapiro, K. Davies, D. Mackmin, 10th edition, 2009, EG Books, p. 183
3) Bewertung von Unternehmensimmobilien, Eduard Paul, MRICS in Praxishandbuch der Unternehmensbewertung, Peemöller (Hrsg.), 5. Aufl. 2012, p. 853.