Valuation &
Development Business
2. Valuation activity:
Methods
Prof. Mikhail M. Soloviev
2015
1.
VALUATION
METHODS
• Classification groups of valuation
methods.
• The valuation methods analytical
review, samples & tasks.
• Logic of the methods choice.
Different classification groups
of Valuation Methods
(0) Normative methods
(1) Expenditures basis
(2) Analogous approach
– market comparing
(3) Income methods –
capitalization of profit
(Σ) Combine methods
• Comparative methods
(market value approach)
• Statutory valuation
• Depreciated
replacement/rebuilt cost
• Discount cash flow
methods
• Others – according to
other bases of valuation
(value in use, limited
market, liquidation, etc.)
Classification groups
of Valuation Methods
(0) Normative methods
(1) Expenditures basis
(2) Analogous approach – market comparing
(3) Income methods – capitalization of profit
(Σ) Combine methods
=====================================================================
Which approach is closer to the real market
value? Recommendations for method choice.
(0) Normative Methods
of Valuation
• Normative valuation methods follow to
definite rules and algorithms approved by
legislative and other official acts.
The rules and algorithms are obligatory for
conditions indicated in the documents.
• Foreign (English language term) analogue
is – Statutory Valuation
*Normative Methods – national
samples (e.g.: Book-keeping)
RUSSIAN FEDERATION (RF) SAMPLE:
1. Valuation for Accounting (Book-keeping)
- Price of the object acquisition
- Prime cost of building (creation) process
- Market value on the date of the object
present (the 1st book-keeping record)
- Linear amortization for every object.
=========================================================================================
WAITING FOR SAMPLES FROM OTHER
NATIONAL REGULATIONS
**Normative Methods – other
RF samples
2. Valuation for Property Taxation.
3. Free Privatization (in the RF) for the
Residential Real Estate.
4. Algorithms of the start auction price for:
- State Property selling
- Municipal City Sites renting, etc.
==========================================================================================
WAITING FOR SAMPLES FROM OTHER
NATIONAL REGULATIONS
(1) Expenditures’ Valuation
basis: DRC methods
1. Depreciated Rebuilt Cost
(DRbC)
(The valued object “rebuilding” with exact analogy).
2. Depreciated Replacement Cost (DRpC)
(The valued object whose “replacement” is mainly
with a functional analogy).
Co
DRC: Depreciation
A whole the Depreciated
Cost is a reflection of an
obsolescence (physical
and/or moral) process
during the valued object
lifecycle.
t
Depreciated Rebuilt Cost
The necessary cost data are possible from the
valued object building project - prime estimate,
or from exact analogous object project data.
Depreciated rebuilding (rebuilt) cost – is the
object’s value according to its accumulated
obsolescence on the valuation date.
*Depreciated Rebuilt Cost
Basis formulas
for the Depreciated Rebuilt Cost:
{Соe * (T-t) / T}
if the obsolescence function is linear;
{Coe * F(t,T)}
if the function is non-linear one;
Coe – prime rebuilt cost, defined from:
- the valued object project data
- full analogous object project data,
- statistic data for similar objects (e.g. in [$/m²])
**Depreciated Replacement Cost
The necessary cost data are possible from
the functional analogous object project
data (prime estimate).
Depreciated replacement cost – is the
functional analogy value with calculation of
its accumulated obsolescence on the
valuation date.
***Depreciated Replacement Cost
Basis formulas
for the Depreciated Replacement Cost:
{Соf * (T-t) / T}
if the obsolescence function is linear;
{Cof * F(t,T)}
if the function is non-linear one;
Cof - prime functional analogy cost - from:
- functional analogous object project data,
- statistic data for the functionally analogous
objects, e.g. in [$/m²]
Problems of the DRC-methods
1. Argued definition of the lifecycle duration T.
2. Kind and characteristics of the valued
object’s obsolescence function.
3. Exact analogies absence (excl. some mass and
other standard objects / building & premises):
• for building analogies – size, location, etc.
• for functional analogies – in content and quality of
functional components.
Main reason of the absence – individual character
of valued objects (e.g. real estate objects) and
conditions of operations with them, in principle.
Ways for the DRC problems solving
•Quantitative corrections of the prime value
according to the exposed deviations
Сх = [Со*(T- t)/T] * ∏(ki), e.g.
through:
– corresponding coefficients ki for every
deviation i;
– more sophisticated way - combine
algorithms (with special functional
combinations of the different coefficients i
influence).
+Ways for the DRC problems solving
•Expert conclusion of an experienced valuator
in concern with the duration T or integrated
obsolescence F.
•Using the statistic (specific, average) data for
the valued kind of objects, e.g.:
Со = q(£/ m²)*S(m²)
•Exclusion of over-functional components ∑Cj
from compared objects:
Сх = (Co-∑Cj) * (T- t) / T.
Depreciated Rebuilt Cost – Task 1
The task conditions
To define the DRC for office with characteristics:
S=2 000 m², lifecycle T=60 years, age t=12 years,
statistic data for the type office building is $350/m²
The task solution
1) Estimation for the new analogous building Co:
Co = 350 $/m²* 2 000 m² = 700 000 $.
2) The Depreciated Rebuilt Cost is defined by
calculation of the object Co linear obsolescence
during 12 years of the object lifecycle 60 years:
DRC = $700 000 * [(60 – 12) / 60] = $560 000
Result:
DRC = $560 000.
Depreciated Replacement Cost – Task 2
The task conditions
To define the DRC for a hospital with characteristics:
t=20 years, improved by some shops (incl. books,
drugs, flowers) for $300 000, lifecycle (here - defined
by experts) T=80 years.
Analogous hospital (functions, scale, etc.) prime cost
is Co=$4500 000
The hospital obsolescence function is linear.
Solution:
DRC=($4500 000 - $300 000)*[(80-20)/80]=$3150 000
Result:
DRC = $3150 000
Preferences and opportunities
of the DRC-methods (1)
• Simplicity and clarity of the DRC
concept and estimating algorithms.
• Convenient instrument for expressvaluation and operative value results.
Preferences and opportunities
of the DRC-methods (2)
• Really DRCs are not market methods
but:
- there are opportunities for alternative using
the building project and statistic (market) data.
- summary the DRC-methods can be used
rather efficiently:
– as a preliminary express-value before detail
valuation by other more sophisticated methods,
– as an opportunity to have the definite value result
if all the other opportunities are absent.
Analogous (comparative)
methods – market approach
The object value is defined from
completely analogous market data:
1) analogous objects with analogous characteristics:
functional,
physical,
economical,
property rights, etc.
2) analogous conditions of deals / operations, incl.:
type of dealing
dates factor
environmental and other conditions, etc.
Conceptual preferences
of the analogous methods
• The analogous methods value is
the very close approach to the Market
Value of the valued object because of just
the market data are in the information
base of the methods.
•If the market information exists in the
sufficient quantity & quality the analogous
methods’ value results are the most
argued as the market value.
Conceptual problems
of the analogous methods
The analogous / comparative methods’
problems follow to the main demands
of the complete analogies – the information
limits (difficulties to find, insufficiency, etc.)
because of:
– small representative groups of completely
analogous objects (real estate objects are mainly
individual objects with non-coincident location,
physical characteristics, property rights, etc.).
– coincidence of deal conditions are seldom too.
Ways for the problems
overcoming and new problems
of the analogous methods
The limited representative market data are
artificially widened through:
– direct data of more widen classification groups;
– specific / statistic indexes from the widened
classification groups;
– separate correcting coefficients: Сх = Сa * ∏(ki);
– using sophisticated calculations algorithms.
==========================================================================================
?! Subjective character (difficulty proved) of the
data base widening, and used calculating algorithms.
Analogous Method: Paired Comparison
VALUATION OF THE INDUSTRIAL OBJECT
CHARACTERISTICS \ OBJECTS
Valued Object
ANALOGY 1 ANALOGY 2
ANALOGY 3
1. LOCATION
SATISFACTORY
GOOD
SATISFACTORY,
SATISFACTORY
2. TOWN PLAN ZONE
(LIMITS)
3. PROPERTY RIGHTS
MIXED
YES
FREEHOLD,
INDUSTRIAL,
NO,
FREEHOLD
INDUSTRIAL
NO
LEASEHOLD,
MIXED
YES
LEASEHOLD
4. INFRASTRUCTURE
GOOD,
GOOD
SATISFACTORY
GOOD
180
150
Σ SPECIFIC PRICE of DEAL [$/m²]
Х=?
200
INFLUENCE DISTRIBUTION (of 100%)
PRIME VOLATILITY = 200-150 = 50 [$/m²],
QUALITY of LOCATION
TOWN PLAN ZONES LIMITS
PROPERTY RIGHTS
INFRASTRUCTURE
(BECAUSE OF DIFFERENT CHARACTERISTICS)
= 30% (0,3)
= 20% (0,2)
= 40% (0,4)
= 10% (0,1)
==========================================================================
COMPARISON with ANALOGY 1: 200 – 50*0.3 – 50*0,2
= 175
DECREAISNG VOLATILITY
COMPARISON with ANALOGY 2: 180 – 50*0,2 + 50*0,4 + 50*0,1 = 195
(TWICE):
COMPARISON with ANALOGY 3: 150 + 50*0,4
= 170
[170-195] [$/m²].
NEXT DECREASING:
e.g. by WEIGHED AVERAGE
Income (future profit) methods
• Basis concept of the income approach and
its algorithms are defined through future
profits provided by the valued object*.
• The future profits information includes
prognostic (prospected) data about waited
incomes and necessary expenditures
concerned with the valued object.
=================================================================================
*The valued object is commercial one.
Income Methods assumptions
1) The used prospected profit data are
determined as some average meanings
of the future periods
(mainly as average annual data).
2) The future profit data have a stable
character during all the prospected time
(for many years).
Fundamental algorithm
of the Income methods
Capitalization algorithm (1)-(3)
(1) to find data for the future operational profit
(net income)
Net Present Income - NPI;
(2) to determine (to find the reliable
professional information) data for the
capitalization rate / yield - Y;
(3) to estimate the object Capitalization Value:
CV = NPI / Y
Operational profit NPI determining
- Future operational (average annual)
income data – PI, e.g. because of real estate
rent business concerned with the valued object.
- Future operational (average annual)
expenditures – PE, incl.: maintenance and
management, protection, taxation and insurance
payments, etc.
- Future profit (Net Present Income) – NPI:
NPI=PI-РЕ
REMARK: rent payments and profit
– Earlier rent contracts tendency was to provide the
rent income as a net profit of owner. The tendency
was to replace majority of the operational payments
onto the real estate object tenant.
– New tendency in the rent business is a flexible
redistribution of the operational payments in depend
on preferences of owner and tenant (e.g. in the
Sale-Leaseback & Public-Private Partnership).
==========================================================================================
Σ
Rent index statistic data (what is its content):
We must be very attentive to lease contract conditions
such as operational payments distribution.
Yield (Y) in the Capitalization
algorithm
Capitalization algorithm:
CV = NPI / Y
What does it mean - yield (Y)?
Yield plays role similar the bank %.
Can we define the deposit value if we know
annual bank payment (similar NPI) and
bank’s claimed % (similar Y)?
Capitalization rate (yield - Y)
direct calculations
Capitalization algorithm: CV = NPI / Y
Direct calculation concept:
– to use all the market purchases and rent data
during the year;
– to divide the integrated net rent incomes (as the
NPI i) onto the integrated prices of bargains SPi
for all the sold objects i = 1, … Q
Y = ∑(i) (NPIi / SPi) / Q
Capitalization rate (yield – Y)
cumulative approach
Capitalization algorithm:
CV = NPI / Y
Cumulative Approach - Expert Approach
It is a consistent increasing the prime
(basis) non-risk rate Yo (e.g. state bonds
rate) by definite portions in correspondence
with different type of risks j=1…J
Y = Yo + ∑(j) Yj
Risk factors in the Cumulative
approach (e.g. by portions [0%-5%])
• Quality of management & personnel (of valued
business / company or RE commercial object).
• Market and general economy state & tendencies
• Company scale, ranks, income, and profitability
• Diversification of activities, goods & services,
consumers & producers.
• Resources suppliers stability.
• State and regional risks, e.g.: the general
financial data: GDP, inflation, etc.
Y = Yo + ∑(j) Yj
Sample of the Yield
(Capitalization rate)
comparative dynamics
dependently on
different level of risks
(political, economy, etc.)
for the European states
and Russia
%Yield
15
RF
East
Eur.
10
West
Euro
5
Data (2006) of the
CB RE Noble Gibbons
2002 2003
2004
2005
2006
«EuroProperty» Data (2004)
Sample of the Capitalization
algorithm using (rent business)
CHARACTERISTICS / DATA
DESIGNATIONS
RENT (annual)
RENTING SQUARE
USING SQUARE
OPERATIONAL INCOME
g
S
I
giS
($/m2)
(m2)
(%/100)
($)
400
2000
0,8
640 000
MAINTENANCE (annual)
OTHER FACILITIES (annual)
OPERATIONAL EXPENDITURES
J(S)
F
F+J(S)
($)
($)
($)
100 000
60 000
160 000
giS-(F+J(S)) ($)
480 000
FUTURE PROFIT
CAPITALIZATION RATE (yield)
CAPITALIZATION VALUE
k
MEANING
(%/100)
A=(giS-(F+J(S))/k
($)
0,12
4 000 000
Capitalization and Discount Rates
Y (yield) and k identity
Capitalization of the Profit (Net Present Income)
Capitalization Value CV is defined according to data
of Net Present Income NPI and Capitalization Rate Y:
CV = NPI / Y
Future Incomes Discounting:
Current Value PV0 (t=0) for every future income step Cn
(of the date t=n) is PV0 = Cn * [1 / (1+kn)ⁿ],
k – discount rate.
The Capitalization rate and Discount rate are identity
for stable net incomes on the endless interval t→∞.
Future income discounting
and business value forecast
Σ t
1
2
…
tn
…
T-1
T
NPI 1
(1+k1)
Σ
NPI n
(1+kn)ⁿ
NPI+RV
(1+kT) T
Proof the Y (yield) and k (discount
rate) identity
If the k and C (annual income) are constant,
the ΣPresent Value: PV0Σ = C*∑(n)(1/(1+k)ⁿ)=
= C*(1/(1+k) + 1/(1+k)(1+k) + 1/(1+k)³ +…)
Multiplying both parts of the equation onto (1+k):
PV0Σ *(1+k) = C*(1 + 1/(1+k) + 1/(1+k)² + 1/(1+k)³ +…)
PV0Σ *(1+k) – PV0Σ = C (subtraction for endless interval)
PV0Σ * k = C
PV0Σ = C / k
Negative & Positive factors
in the Capitalization algorithm
Using the cumulative concept
of the capitalization rate definition:
= inflation «q» and other negative factors
PV0 = C / (k + q)
= positive factors «m»
PV0 = C / (k – m)
Combined Methods
RESIDUAL METHOD
Used for a valuation of argued expenditures (D) in
concern with land site purchase for the RE development.
Essence of the Residual Method’s algorithm
D ≤ A – (B+C) [deducting; so the D is a “rest”]:
А – market value of the RE development project result
(waited cost of the developed object selling);
В – project expenditures (excluding land site bargain),
С – developer’s needs (as salary, etc.) during the project.
The method combines income method (A valuation)
and expenditures approach (B calculations).
Residual Method’s variations
(i) For an argued future value of the developed
object market selling (e.g. if the land site price is
known and fixed)
A≥D+B+C
(ii) For express-valuation for the building and
other development project expenditures
B ≤ A - (D+C)
(iii) For express-valuation for the own “scale of
salary” during the project realization
C ≤ A – (D+B)
Contractor’s Method
Essence of the Contractor’s Method
The contractor’s cost of the valued object (CC) is
defined as a sum of:
MVL – the value of land site with existing use, and
DRC – the current cost of constructions as the
depreciated rebuilt cost of the building on the site:
CC = MVL + DRC
The contractor’s method is considered as a very
approximate and used in situations with real estate
market data absence, and if the building and land
site separate value is possible in principle.
Sample of the Combined Method Task
Office complex (1000 m²) is in lease contract, built 10 years
ago. Its lifecycle is 50 years.
Analogous offices: rent rate is $200/m², yield k=0.2(20%),
specific (statistic) building expenditures are $750/m².
To define: the capitalized value (CV), depreciated rebuilt cost
(DRC), and land site residual cost (LRC).
Solution:
The capitalized value CV (assumptions: rent is a clean profit
of owner, and the office average filling percent is 90%)
CV = $200/m² * 1000 m² * 0.9 / 0.2 = $900,000.
The depreciated rebuilt cost (DRC) (assumption – linear
character of the obsolescence function):
DRC = $750/ m² * 1000 m² * (50-10)/50 = $600,000.
So the land site residual cost (LRC) will be
LRC=CV-DRC = $900,000 - $600,000 = $300,000.
RESULTS: CV=$900,000, DRC=$600,000, LRC=$300,000.
General remarks about different
value approaches combining
In general context the different approaches
combinations take place in the majority of
used algorithms, e.g.:
• In normative and expenditures and analogous
methods – we use specific coefficients which are
defined mainly from market (statistic) data.
• In DRC – we use characteristics of analogies in
order to define the replaced / rebuilt objects data.
• In analogous methods – we use some norms for
correcting differences & compares, etc.
Valuation Purpose,
kind of Objects and Bargains
1. Legislative Base: YES
Statutory regulations
NORMATIVE
METHODS
NOT
2. Market Data Base
YES
ANALOGOUS
METHODS
NOT
3. Commercial
conditions
YES
INCOME
METHODS
NOT
EXPENDITURES
METHODS
Valuation Methods - Choice Logic
1. If there are Statutory regulations (for the definite kinds &
objects dealing) – it is necessary to use the corresponding
Normative Methods. Differently it will be law infringement.
So it is a LAW-ABIDING rule.
2. If the statutory norms are absent, and we look for the
market value – the best way is to use Analogous Methods
as the market data approach in principle.
3. If the necessary market data and other conditions make
difficult to use market approach – there are two alternatives
dependently on the valued object and bargain kinds, e.g.:
- for commercial objects – Income Methods,
- for non-commercial objects – Expenditures Methods.