MSc and Associated Programmes

in

Real Estate Investment & Finance

Real Estate Appraisal

Corporate Real Estate & Facilities Management

Module: Real Estate Funding

April 2009

Module Assessment

Real Estate Valuation

Submission Date: Friday, 21 August 2009

Lecturer: Prof. Neil Crosby

Part A

1 Organisations Contributing to Valuation Standards 1

1.1 Red Book, RICS – Royal Institution of Chartered Surveyors 1

1.2 White Book, IVSC – International Valuation Standards Committee 1

1.3 Blue Book, TEGoVA – The European Group of Valuers Associations 1

2 Main Concepts and Definitions of Value 2

2.1 Market Value – Comparative Method 2

2.2 Sustainable/Mortgage Lending Value 2

2.3 Property Investment Value 3

3 Property Valuation in the Context of Bank Lending 3

3.1 Conclusion of the Discussion 5

4 References 7
1 Organisations Contributing to Valuation Standards
Concepts and valuation standards for real-estate valuation in Europe are mainly specified,
maintained and regulated by three professional associations and the guidelines combined
into the Blue, Red und White Books. The following representation gives a short summary of
the respective contents and their distribution and recognition.

1.1 Red Book, RICS – Royal Institution of Chartered Surveyors

The Red Book of the RICS contains obligatory rules and guidelines for approved methods for
all members of the RICS which have to be followed for valuations of real estate and other
assets. Since it was first published in 1980 the Red Book has been repeatedly updated. The
standards contained in the book are subdivided into two main parts. The first part contains
the rules and guidelines which apply to all members worldwide. The second part contains
materials which refer to certain countries. At present, however, this part covers only the UK
and Ireland (RICS, 2009).

1.2 White Book, IVSC – International Valuation Standards Committee

The White Book was published in a revised, eighth edition on 31 July 2007. The Book
contains norms for the International Valuation Standards (IVS) which are considered to be
worldwide valuation standards by the IVSC. The aim is to identify existing differences
between national valuation standards and their practical application and to advance
harmonisation. Moreover, the IVSC is trying to work out indications for the assessment in the
context of external accounting. The IVSC thus regularly analyses announcements made by
the IASB and the International Public Sector Accounting Standards Board. In addition, the
IVS and supplementary regulations announced are to support valuers in fulfilling demands
made by external accounting (Ernstberger and Kraus, 2008).

1.3 Blue Book, TEGoVA – The European Group of Valuers Associations

The roots of TEGoVA go back to the seventies when discrepancies were recognised in real
estate valuation in Europe. Representatives of the property professions from all member
states of the EU and from other European countries are united in this association. TEGoVA
currently represents the only European holding organisation for experts working in the
valuation of property, accessories, fittings and equipment. The primary aim of the association
is in the wording and publication of valuation standards and in the distribution and
acceptance within Europe and the developing markets in Central and Eastern Europe. Since
1985 the guidelines of the TEGoVA have been published in the European Valuation
Standards (Blue Book), whose primary objective is the harmonisation of the valuation
practice in the different member states and the European Union (TEGoVA, 2009).

1
2 Main Concepts and Definitions of Value
The Blue Book has both a great accordance with the International Valuation Standards of the
IVSC and a strong dependence on the Red Book of the RICS. This can be explained by the
intensive cooperation with the two organisations and the international orientation of TEGoVA
(Leopoldsberger et al, 2004).

The definitions of market value, mortgage lending value and investment value are
harmonised by all three organisations:

2.1 Market Value – Comparative Method

“The estimated amount for which a property should be exchanged 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 each acted knowledgeably, prudently and without
compulsion.” (TEGoVA, 2009)

Market value is determined by the general circumstances which prevail on the property
market at the time of valuation. It is therefore a dimension dependent on time which is only
valid on the effective date of valuation. The condition of the property with regard to real and
legal qualities and also the situation on the real estate market are subject to continuous
change (Sommer and Kröll, 2005).

In the comparative method the market value of property is derived by a contemporary

comparison with realised selling prices for properties under arm’s length conditions. The
comparative method is regarded as the theoretically best method. Prerequisite for the
application of the comparative method is the availability of contemporary prices for
comparable properties. The evaluation of comparability is only given if largely corresponding
properties can be identified. Besides objective items such as size or year of construction,
subjective qualities also have to be fulfilled to arrive at market-driven comparables. One
comparable property is not sufficient; several are needed. It has to be checked whether or
not the respective market price was influenced by unusual or personal conditions (Sommer,
1995).

Selling prices of similar properties may have deviations of up to ± 15 percent. Therefore as

many adequately corresponding comparables as possible should be identified (Johnson et
al, 2000).

2.2 Sustainable/Mortgage Lending Value

“The value of property as determined by a prudent assessment of the future marketability of
the property taking into account long-term sustainable aspects of the property, normal and
local market conditions, the current use and alternative appropriate uses of the property.
Speculative elements shall not be taken into account in the assessment of the Mortgage
Lending Value.“ (TEGoVA 2009)

Despite cross-border mortgage lending and the European Mortgage Lending Value (EMLV)
of the European Mortgage Federation, merely the definition is consistent. If one compares
the definitions and the concepts of the market and the mortgage lending value (MLV), the
MLV is in many respects very similar to the market value. However, the MLV as a "long-
lasting/sustainable" value introduces additional parameters to smooth market trends. This for
example is made by adaptation of the rental income to a stable obtainable rent level,
adjustment of the capitalisation rates to the long-term development of the market and
customisation of the administration and management costs. Valuation is to be based on
transparent methods and only be carried out by experts with the required expertise (Reif,
2006).

2
(Mortgage Lending Value compared to Market Value, Reif, 2006)

The graph shows that the MLV does not pursue the market cycle. It stands out from the
varying market value as a stable line. The MLV in stable markets will hardly differ from the
market value.

2.3 Property Investment Value

“The value of property to a particular investor, or a class of investors, for identified
investment or operational objectives. This subjective concept relates specific property to a
specific investor, group of investors, or entity with identifiable investment objectives and/or
criteria” (TEGoVA, 2009)

The investment method is used to estimate the present value of future cash flows arising
from a freehold or leasehold. Besides the professional experience of the valuer and its
interpretation of the market conditions with respect to the property and the comparables,
additional factors play a significant role. Cash flows, quality, location and the leases have to
be taken into account. So it is not unusual to adjust the capitalisation factor by up to one
percent up or down (Baum et al, 2006).

Furthermore the choice of capitalisation factor is not only influenced by property comparison
but also by the capital market. Investment in government bonds as well as ordinary shares
should be considered. A valuer of the property should therefore pursue a change of return in
the investment market to be able to judge the attractiveness of a property and the individual
return demanded by the specific investor (White et al, 2003).

3 Property Valuation in the Context of Bank Lending

A significant proportion of bank lending in the UK is secured with commercial property and
valuations play an important part in this process. Following the tradition of the case law, there
are no legal regulations with respect to the valuation of properties in the UK. The
development of rules and their implementation in practice is incumbent on the professional
organisations; the RICS is leading here (Thomas, 1995).

Valuation reports in the context of bank lending serve particularly:

- as a basis for the assessment of the lending limit

- as a calculation base for terms and conditions
- as a basis for the decisions regarding equity base and other regulatory issues

In the following abstract the individual valuation methods are discussed with regard to their
use for bank lending:

3
The central disadvantages of the investment value are the implicit economic assumptions of
the individual investor. The investment value therefore contains a considerable proportion of
subjective measure of value. Net operative income and capitalisation rate are the dominant
factors for an assessment. Relatively insignificant changes of these indicators have
considerable consequences. The following concerns generally arise:

- The rate at which discounting is to be carried out is only vague with regard to the risk
premium.
- The use of constant growth rates is doubtful and neglects the problem of a
dynamically developing economy.

The investment value is hardly used for the bank lending process because of the individual
input parameters of the respective investor.

At first sight a market value seems suitable for bank lending due to the market referenced
basis. But the selling prices obtained on the market must be compared with the property to
be estimated. This is quite secure as long as prices are not influenced by special
circumstances. A corresponding number of comparison prices and qualitative information
about these comparisons are needed. Due to the financial crisis, the missing comparables,
the heterogeneity of real estate and the dynamic change, these requirements are not given,
particularly in the current situation.

- The main disadvantages of market value are the implicit approaches. All sorts of
aspects, such as demand forecasting, changing economic conditions etc., are
covered by the all risk yield (ARY).
- The method is solely comparable based - no comparables, no basis for valuation.

The mortgage lending value (MLV) plays an essential role in connection with mortgages as
collaterals for loans. It assesses the sustainable value for a time period which is as long as
possible. Originally the MLV goes back to a German initiative. The use of the MLV for legal
requirements according to Basel II and the solvability guideline in 1997 meant that the
significance extended beyond the scope of the pure mortgage bank industry.

Considerable doubts, particularly from the UK, are specified against the MLV (Baum and
Crosby, 2007; Crosby et al, 2000), but there are also critical voices from Germany (Bienert
and Brunauer, 2006; Kierig, 2006; Kleiber 2005):

- It is not clear why some MLV approaches differ from those of the market value.
- The effort made is out of all proportion in view of additional MLV findings over those
of the market value.
- There is no recognisable economic concept.
- The definition of MLV is incomprehensible, there are questions regarding timing of the
valuation and unclear expressions such as “future marketability“ or “speculative
elements”

To protect oneself against future lawsuits by disappointed banks, a valuer should make very
conservative assumptions to ensure that the MLV covers even a worst case scenario.

From the previous explanations for market value and mortgage lending value it is already
clear that both values serve different purposes in the bank lending process. The market
value is a snapshot. It aims at giving the owner of property or a potential buyer an objective
idea of the value of the property at a particular time. The MLV, however, represents a so-
called sustainable value and therefore aims at offering the mortgage lender a maximum
amount of security during the term of a loan. The MLV may not exceed the market value.

4
However, in terms of the harmonisation striven for by international as well as European
associations, the market value has taken a central role.

3.1 Conclusion of the Discussion

The lack of a theoretical foundation and integral orientation has to be criticised as a
disadvantage of all three value concepts. The explanations already given also show the great
significance of the reports for the respective addressee. Because of the legislative integration
of the MLV the concept will surely be found in Mainland Europe at least, but the MLV is not
an optimal solution. The current sub prime crisis shows clearly that the current bank lending
process needs further developments.

As complementary components to the quantitative methods it seems reasonable to award an

even stronger weight to the qualitative risk analyses. In this respect, for example, the concept
of Salber and Stöfer (2008) “Multi-Tier Application Model for Qualitative Risk Analyses”
which is outlined below offers a method of resolution. It is less the approach of new methods
or instruments but all about a coherent use of these possibilities:

(Qualitative Risk Analyses, Salber and Stöfer, 2008)

1. Level: Macroeconomic analysis

Based on the business strategy of the bank it is all about building up a system for assessing
macroeconomic developments. This system requires regular examination with the respective
national economies which considerably extends beyond choosing some numbers such as
gross national product, inflation and unemployment rates.
2 Level: Macro- and micro analysis
Relevant regional markets follow as the next level in a multistage analysis. As in the area of
macroeconomic analysis, the challenge in a market analysis is not availability of data. Aim is
the evaluation and transition into a forecast.

5
3 Level: Property analysis
At property level it is all about the results of the approved instruments of the valuation report
and the cash flow analysis. A model of possible scenarios should be created.

A valuer must however pay attention to the choice of alternative methods of valuation. If the
performance of the property should not meet the expectations of the addressee in the future,
a high lawsuit risk will arise (Crosby, 2009).

When it comes to the current sub prime crisis it is not all about valuation; banks were keen
on making the deals. The whole process of bank lending has to be reviewed to avoid such
real estate bubbles.

6
4 References

Baum, A. and Crosby, N. (2007). Property Investment Appraisal 3rd edn. Blackwell
Publishing, Oxford.

Baum, A, Mackmin, D, Nunnington, N (2006) The Income Approach to Property Valuation 5th
edn. International Thompson Business Press, London.

Bienert, S. and Brunauer, W: (2007) The mortgage lending value: prospects for development
within Europe. Journal of Property Investment & Finance, 25 (6): 542-78.

Crosby, N. (2009) The aims of valuation. Property week, 24 July 46-7.

Crosby, N., French, N. and Oughton, M. (2000) Bank Lending Valuations on Commercial
Property: Does the European Mortgage Lending Value add anything to the process? Journal
of Property Investment and Finance, 18 (1): 66-83.

EMF (2007) Study on the Valuation of Property for Lending Purposes. European Mortgage
Federation, Brussels.

Ernstberger, J. and Kraus, C. (2008) Immobilienbewertung nach den Vorschriften des IVSC
und deren Anwendbarkeit nach IFRS. Zeitschrift für internationale und kapitalmarktorientierte
Rechnungslegung, 6: 388-400.

Johnson, T., Davies, K., Shapiro, E. (2000) Modern Methods of Valuation 9th ed. Estates
Gazette, London.

Kierig, J. (2006) Zum neuen Pfandbriefgesetz und dem Entwurf der

Beleihungswertermittlungsverordnung (BelWertV). 14, Jahreskongress für
Bewertungssachverständige. January 2006, Fulda, WertermittlungsForum Akademie, Sinzig.

Kleiber, W. (2005) Babylon schreitet voran. Grundstücksmarkt und Grundstückswert, Köln, 6:

1-2.

Leopoldsberger, G., Thomas, M. and Naubereit, P. (2004) Immobilienbewertung. In: Schulte,

K.-W. (eds.): Immobilienökonomie, Band 1 3rd edn. Oldenbourg, München-Wien. 455-527.

Reif, A. (2006) The Regulation on the Determination of the Mortgage Lending Value –
Greater Safety in Valuation for Mortgage Purposes. In: Real Estate Banking 2006.
Association of German Pfandbrief Banks, Berlin. 41-46.

RICS (2003) RICS Appraisal and Valuation Standards 5th edn. Royal Institution of Chartered
Surveyors, London.

RICS (2009) [online] Available from:

http://www.joinricsineurope.eu/de/articles/view/das-red-book-247 [20 July 2009]

Rüchardt, K. (2001) Der Beleihungswert. Fritz Knapp Verlag, Frankfurt am Main.

White, D., Turner, J., Jenyon, B. and Lincoln, N. (2003) Internationale Bewertungsverfahren
für das Investment in Immobilien 3nd edn. Immobilienzeitung Verlagsgesellschaft,
Wiesbaden.

7
Salber, M. and Stöfer, F. (2008) Consequences of the Financial Market Crisis for Risk
Management in Property Finance. In: Real Estate Banking 2008/2009. Association of
German Pfandbrief Banks, Berlin. 15-23.

Sommer, G. (1995) Bodenwert. In: Sommer, G. and Piehler, J. (eds.) Gründstücks- und
Gebäudewertermittlung für die Praxis. Rudolf Haufe Verlag, Freiburg im Breisgau. 1-34.

Sommer, G. and Kröll, R. (2005) Lehrbuch zur Grundstückswertermittlung. Luchterhand,

München.

TEGoVA (2009) European Valuation Standards 6th edn. The European Group of Valuers
Associations, London.

Thomas, M. (1995) Income Approach versus Ertragswertverfahren. Pt. 1.

Grundstücksmarkt und Grundstückswert, 1: 35-38.

Thomas, M. (1995) Income Approach versus Ertragswertverfahren. Pt. 2.

Grundstücksmarkt und Grundstückswert, 2: 82-90.