Appunti di Evaluation and Management of Real Estate

Evaluation of real estate

Lesson 2 - The evaluations (I valori di stima)

Evaluation activities are fundamental for the development of multiple activities and strategies of management practice carried out during the development process of real estate investing. Valuation: the expression of a judgement of equivalence, under certain conditions and certain circumstances of time, between the degree of usefulness of an economic good being valued and given amount of money.

The scope

Real estate evaluation aims to answer specific questions about a real estate parcel's value, marketability, usefulness or suitability including real estate financing, listing real estate for sale, investment defined in: analysis, property insurance, the taxation of real estate and more.

• Micro-estimate (private property)
• Macro estimate (public property)

In order to:

• Facilitate the transfer of ownership of real property
• Help prospective sellers determine acceptable selling prices or prospective buyers decide on offering prices
• Establish a basis for the exchange or reorganization of real property or for merging the ownership of multiple properties
• Financing and credit (establishing a value of security for a mortgage loan)
• Help resolve legal or tax issues (estimate the market value of partnership interests, estimate damages created by environmental contamination, gift or inheritance taxes)
• Help in investment counseling (All subjects involved in trading activities: in the acquisitions, sale, spin-off, heritage or expropriation of capital assets, SGR, Funds, Leasing company, institutional and private investors)

The institutional actors

In the United Kingdom, operate actively associations RICS (Royal Institution of Chartered Surveyors) and RIBA (Royal Institute of British Architect) that bring together professionals working in particular in the processing and enhancement of the area, in real estate management and asset valuation in real estate, construction, environment-related technologies.

1) RICS (Royal Institution Chartered Surveyors)

Is an international professional engaged in the real estate and construction. The key roles of RICS are to:

• Regulate and promote the profession of chartered surveyors
• Maintain the highest educational and professional standards
• Protect clients and consumers through a strict code of ethics
• Provide impartial advice, analysis and guidance

RICS Valuation - Professional Standards (the 'Red Book') contains mandatory rules, best practice guidance and related commentary for all members undertaking asset valuations.

2) The International Valuation Standards Council (IVSC)

Is an independent, not-profit organisation that acts as the global standard setter for valuation practice and the valuation profession, serving the public interest. Its core objectives are to:

• Develop high quality International Valuation Standards (IVS) which underpin consistency, transparency and confidence in valuations across the world
• Encourage the adoption of IVS across the globe, along with professionalism provided by Valuation Professional Organisations

3) Tecnoborsa and the Italian Property Valuation Standard

Organization of the Chambers of Commerce System for the Development and Adjustment of the Real Estate Economy. It is a non-profit consortium, established by the Chambers of Commerce and Agriculture. Established in 1997 to contribute to the development, regulation and transparency of the Italian real estate market.

The value (I valori di stima)

The evaluation process is based on specific evaluation activities that require different features:

• The quality standard: abandon empirical methods, namely those based only on the experience and sensitivity of the evaluator; draw up an assessment based on the data estate truthful; adopt scientific methods of calculation, based on objective criteria and in accordance with the main valuation standard
• The transparent valuations: real estate data on time; descriptive skill demonstration, supported by calculations from arguments and opinions; for the mortgage, reliable estimate of the Loan to Value (LTV)
• The ethical principles: integrity, objectivity, competence, confidentiality, professional behaviour
• The pillar of valuation: the assessment should take scientific character, use real estate data transparent, apply methods reproducible and clear with discipline

The real estate data consists in the certain source for values real value of the transaction's values provided by institutional sources/authority.

The first distinction of real estate valuations

Represent the difference between:

• "Voluntary" (cognitive or precautionary): The customer requires the evaluation freely and voluntarily.
• "Involuntary" (bound): The customer requires an assessment on the advice of legal rules binding and enforceable as in the Real Estate Fund which is required for the bi-annual evaluation on the basis of the regulation of collective investment management issued by the Bank of Italy.

In any case, the purpose of evaluation is always dictated by the developer and is an individualistic response to specific conditions.

The comparison methods

In order to evaluate a specific asset, the science methodology is based on the comparison and defines three different methods:

• Market approach
• Cost approach
• Income approach (is the financial approach)

- Direct capitalization or Yield capitalization

- Discount Cash Flow Analysis

The specific terminology

Price: is the amount asked, offered or paid for an asset. Because of the financial capabilities, motivations or special interests of a given buyer or seller, the price paid may be different from the value which might be ascribed to the asset by others.

Cost: is the amount required to acquire or create the asset. When that asset has been acquired or created, its cost is a fact. Price is related to cost because the price paid for an asset becomes its cost to the buyer.

Value: is not a fact but an opinion of either: the most probable price to be paid for an asset in an exchange, or the economic benefits of owning an asset.

Worth: is a specific investor’s perception of the capital sum that would be prepared to pay (or accept) for the stream of benefits which he expects to be produced by investment.

Identifying the purpose and the choice of the value category

The valuation method is basically a forecasting estimation that approximates a monetary value of an asset before this good is transacted on the market. There are many possible reasons for valuing property:

• To buy or sell
• To let or take a lease or agree a rent review
• To assess tax or business rates payable
• For insurance or to obtain compensation payment
• To borrow money using the property as "security"
• To show its value as a fixed asset on a company balance sheet
• To develop or redevelop

What are the subjects of the valuation?

Usually, in RE, the subject of the evaluation are the different typologies of properties:

• Residential (Detached and semi-detached houses, Flats, Etc.)
• Commercial (Offices, Logistic, hotels, leisure, shopping centers, etc.)
• Land

The basis of value

Expressed in the following International Valuation Standards and most are in common use:

• Market value
• Market rent
• Investment value (or worth)
• Fair value or equitable value
• Synergistic value

A) The market value (valore di mercato)

The International Valuation Standards Committee (IVSC), Royal Institution of Chartered Surveyors (RICS) and The European Group of Valuers' Associations (Tegova) definition:

“The market value corresponds to the sum of money for which the property could be bought and sold: at the moment of the estimate, by a buyer and a seller both interested in the transaction in the absence of particular interests, after proper marketing assuming that both the parties act freely, prudently and in an informed manner.”

The market value represents the most probable price at which the asset should be bought and sold at the time of the valuation. Since market conditions could change, the market value estimated for other times (e.g. in the future) could be incorrect or meaningless. The valuation should reflect the market conditions at the time of the valuation, without taking into consideration past conditions or possible changes that could take place in the future. For this reason, the date of the valuation should be specified in the valuation report.

The clear evaluation assumes that the parties involved in the transaction are in standard positions:

• The transaction takes place between two parties who have no relationship between them (e.g., family) and between subjects who act independently from each other.
• The buyer is inclined to make a purchase, i.e., that the valuation refers to a buyer who is willing, and not compelled or otherwise influenced. He is not willing to buy at any price, but to purchase the asset under normal market conditions.
• The owner in effect willing to sell means that the seller is seriously oriented toward the sale, willing to sell at the best market price that can be obtained after proper marketing of the property, whatever the price is that the market will pay at that time.

The subjective conditions must not be taken into consideration (not provide for the condition of a seller forced to sell or willing to sell at any price). All conditions that could lead to the formulating of a special value are excluded, where special value is understood as a value that is unusual and greater than the market value. The estimate excludes particular conditions of inflation or deflation, atypical financial conditions, and particular sale contract conditions. The marketing period duration depends on the market conditions and must be sufficient for raising the interest of an adequate number of potential buyers. The estimated market value does not therefore take into consideration either marketing expenses or taxes.

The market value corresponds to the sum of money for which the property could be bought and sold:

• At the moment of the estimate
• By a buyer and a seller both interested in the transaction
• In the absence of particular interests
• After proper marketing
• Assuming that both the parties act freely, prudently, and in an informed manner.

B) Fair value (or equitable value)

Is defined as a fair price at which an asset could be exchanged, or a liability settled, between knowledgeable two parties acting a distant transaction. It differs from market value in:

• The price must be fair to both parties having regard to all the circumstances
• There is no requirement to assume that the asset has been exposed to the whole market
• The price should reflect any special advantages or disadvantages to either party
• Market value does not need to be fair to either buyer and seller

C) Synergistic value

The synergic value is the result of a combination of two or more assets or interests where the combined value is more than the sum of the separate values. If the synergies are only available to one specific buyer then, synergistic value, will differ from market value, as the synergistic value will reflect attributes of an asset that are only of value to a specific purchaser.

D) Investment value

The investment value corresponds to ‘the value of an asset to a particular owner or prospective owner for individual investment or operational objectives.’ In contrast to market value, this basis of value does not envisage a hypothetical transaction but is a measure of the value of the benefits of ownership to the current owner or to a prospective owner, recognising that these may differ from those of a typical market participant. It is often used to measure performance of an asset against an owner's own investment criteria.

E) The open market value (valore di libero mercato)

Is the best price obtainable for the sale of an interest in property on the date of valuation, assuming that:

• There is a willing seller
• Prior to the date of valuation, there had been a reasonable period for the proper marketing of the interest
• No account is taken of any additional bid by a prospective purchaser with a special interest
• Both parties to the transaction had acted knowledgeably, prudently and without compulsion
• There is more than one party interested in the purchase.

The main distinctive feature of the “open market value” is its identification in the “best price” that the valuator feels can be obtained at the time of the sale on an open market. The “open market value” differs, therefore, from the “market value,” which instead expresses the most probable market value.

Assumptions for open market value

The valuator must therefore formulate hypotheses regarding what he or she considers to be a “reasonable period of marketing,” providing a logical and reasonable explanation. The property being evaluated must be marketed in a proper manner, in the commercial channels considered appropriate for the market to which it belongs. It is of fundamental importance that an appropriate number of potential buyers is reached during the marketing period. These buyers must have the time to obtain the information on the property necessary for formulating an adequate bid which, if accepted, leads to the purchase and sale.

F) Estimated realization price (valore di realizzo)

Is an opinion as to the sum of money, before deducting the selling costs, which, at the moment of the valuation, can reasonably be expected to be obtained from a future completion of an unconditional sale of the property under the assumption of:

• A seller interested in selling
• The transaction will take place on a future date specified by the valuator, to allow a reasonable period for proper marketing (having regard to the nature of the property and the state of the market)
• No offer on the part of a buyer with particular interests is considered
• Both the parties act freely, prudently and in an informed manner.

The valuator’s duty to formulate a hypothesis regarding the period necessary, starting from the valuation date, for marketing the property to reach the best price, without extending this period, however, to the expectation of a change in market conditions. The valuator must discuss the hypotheses formulated in the valuation and indicate the hypothetical date for the future transaction.

G) Estimated restricted realization price

The characteristic which distinguishes the “estimated restricted realization price” from the “estimated realization price” is that the date of reference for the future sale is set by the client. Consequently, the marketing period is not established by the valuator based on the objective of obtaining the best price, but rather it is established by the client based on the client’s own considerations.

H) Depreciated replacement cost (valore di costo di riproduzione deprezzato)

Is the sum of the value of the land and of the cost of rebuilding the properties, with the latter being opportunely depreciated based on the age and general conditions of the property, its functional, economic or environmental obsolescence, and other factors considered relevant. This cost is used to estimate the value of the property in its current use in the case of properties which are unusual or for which there is no significant market.

I) Book value (valore di libro)

It is the value of a property, or...