Valuations for financial statements

1. Asset ValuationsCapital valuations of property assets for inclusion in company financial statements

2. 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

3. 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

4. Two regimes for FR in UK Differences between IFRS and UK GAAP Differences of terminology and presentation rather than substance Owner occupied property valued at Existing Use Value (EUV)* 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 • IFRS • All listed companies in EU have had to adopt IFRS since 2005 • May be used by private companies • Public Sector moving towards IFRS • Over 90 countries will have either adopted, or recognise, IFRS • UK GAAP • Have developed since early 70s • Used by private companies and public sector

5. 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)

6. 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 report • No explicit guidance on those assumptions • This reflects current uncertainty caused by lack of precision in fair value definition in IFRS and how it is applied in different situations

7. IVA 1 – key points A statement should also be made that the valuefor 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

8. 2. UK GAAP

9. 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.

10. 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

11. 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

12. 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

13. Public sector Balance sheet (IFRS) Categorise assets – determine treatment • Different standards apply depending on how the property asset is classified • owner occupied • leased • investment

14. Public sector Balance sheet (UK GAAP) Categorise assets – determine valuation basis Valuation basis *assumes that the asset is sold as part of the continuing enterprise in occupation

15. Accounting for depreciation • All companies (except prop invtcos) must depreciate the value of fixed assets that have a limited economic life (prop invtcos 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

16. 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. 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

17. 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

18. Valuation of non-specialisedowner-occupied property assets Valuation figure for balance sheet purposes Estimated Rental Value 25,000 YP perpetuity @ 9.5% 10.5263 EUV £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

19. Valuation of non-specialisedowner-occupied property assets Alterative use value Estimated rent (2,000 m2 @ £40/m2) 80,000 YP perpetuity @ 8.5% 11.7647 Gross development value (GDV) 941,176 Less: Demolition costs (estimate) 10,000 Building costs (2,000m2 @ £220/m2)440,000 Fees @ 1.25 % GDV 11,765 Finance @ 7% for 1 year 32,324 Developer's Profit @ 10% GDV 94,118 Development costs 588,207 Balance 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

20. 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…

21. Valuation of specialisedowner-occupied property assets

22. 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

23. Valuations for loan security

24. 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

25. 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

26. Valuations for commercial*secured lending • 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

27. 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’?

28. Loan valuations Types of commercial property 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 • Owner-occupied • Investment • Development or refurbishment • Operational entity

29. 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

30. 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

31. Main factors affecting investment value Lease terms: Tenant, guarantor Length of terms Break options Alienation – prohibition or easy to assign/underlet Pre-1995 lease? If not, AGA? User – restricted? Landlords liabilities – FRI/IRI/Non-recoverables Rent review provisions Covenant Strength: Financial standing Tenure: Freehold or Leasehold? Location, repair, etc. Property Characteristics:

32. Reporting • 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 • Suitability of the property as security for mortgage purposes • Details of significant comparable transactions relied upon • Environmental or economic designation Comment on purchase price against MV if applicable Development – comment on costs, viability, sensitivity, etc. 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

33. 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

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

35. 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

36. Evidence and analysis Evidence Analysis Rent - £10psf Capital Value - £100psf Yield - 8% • 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

37. 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

38. Valuation for 1of 6 tenants Aggregate valuation for the 6 tenants

39. 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

40. 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

41. 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

43. What if costs and timescale overrun? • 18 month development timescale • Construction costs of £100 psf