Debunking Common Valuation Myths

Tue, 20 Feb 2024 14:57:44 +0200

Sometimes we need to set the record straight and inform the uninformed, or simply share a nugget of wisdom. I’ve collated some of the most common myths that are found on the internet and shared some of my own insights. I’ve done this hoping that you as a property owner may gain a better understanding of the world of property.

The value of my property can only increase!

Surprise, this is not true! Much like capital and investment markets, the property market also fluctuates as it operates in an open market. While a decline in value is less common, it does occur. Some of the reasons why the value of a property might decrease include:

Urban Decay in my experience is one of the most common causes of a decrease in property value. It is the decay and deterioration of an urban area due to neglect or age.
High-risk areas that are prone to natural disasters.
Excessive listings in an area.
A less desirable economic climate or increases in interest rates, higher taxes etc.
Deferred property maintenance which means more capital expenditure is required for repairs thus deducting from value.
A change in the neighbourhood demographic.
A change in the proximity to amenities or facilities.
Increased levels of crime.
A less desirable kerb appeal.
Functional obsolescence.

The bigger my property, the higher the value.

A larger 6-bedroom home will not necessarily achieve a higher value compared with a 3-bedroom home in the same area. The building configuration would need to fit into market expectations. Ever wonder why that large house down the road has been on the market for years?

Commercial properties are similarly affected by market expectations. A large warehouse rental might stand vacant for some time in an area where the market demand is for smaller mini-factories. What is typically seen is that tenant installation/retention comes at the expense of rental income. This directly impacts the bottom line and in turn the overall value. Reduced income equals lower value.

The value of renovations proportionately increases the value of a property.

One of the most ridiculous things I’ve seen as a Valuer is another “Professional” Valuer telling a homeowner, and in writing, that if they spend X amount on improvements, the value of the home will increase proportionately. No, it doesn’t work like that - we look at the current market trends in the area which dictate a potential value range. A discerning Valuer may include a small premium for the renovations. Have a look at our blog on Property Valuer Misconceptions.

The value of a property is the same as its Replacement Cost.

This is not true, the Replacement Cost is the amount that it would cost to rebuild or reproduce a property with the same or similar materials and specifications. This is usually the amount for which the property is insured. The value on the other hand is the amount that a property is worth on the open market. The Replacement Cost and value may differ due to various reasons such as physical depreciation, and obsolescence whether in terms of functionality or utility. In most instances, the Replacement Cost of a property is higher than its market value. This applies to both commercial and residential properties.

Commercial property value is fixed and stable.

The value of a commercial property can change over time due to various factors. Picture a retail centre and consider for a moment that the investment-grade anchor tenant won’t be renewing their lease agreement due to relocation plans. This will directly impact the risk considerations made in the valuation calculation. It is one of the reasons why commercial property values are periodically reviewed.

This is clearly not an exhaustive list, but it highlights some of the more common myths out here. What are the most common valuation myths you’ve come across?

Understanding the Discounted Cash Flow

Thu, 08 Feb 2024 16:07:01 +0200

When I was a young Valuer in training, the Discounted Cash Flow Method always seemed to be so intimidating. The mere mention of it still makes me cringe to this day. This despite having mastered it, pun intended, through a masters programme (MSc Real Estate) some years back. To put my mind at ease, I figured why not write more about the topic so that whenever I feel a cringe coming along, I can refer to my blog and see that it is in fact not as intimidating as I had once thought it to be.

The Discounted Cash Flow (DCF) is a valuation method that falls under the Income Approach as defined in the International Valuation Standards (IVS) Framework. The method is applied to a wide range of asset types/classes. It is a vital concept and can be regarded as the most important of all the techniques used in the finance industry.

The method encompasses determining present values, future values and analysing unequal and equal cash flow streams. This is done to determine the various financial measures of return.

When is it Used?

The DCF method can be used to value most assets that generate a cash flow. It may provide a better indication of value than other methods where:

The asset or business is experiencing significant growth or has yet to reach a mature level of operation. Examples include new business ventures or an investment property under construction (e.g. include hospitality, retail centres, filling stations etc).
Cash flows are likely to fluctuate from period to period in the short term, e.g. fluctuations to rental income generated by an investment property due to leasing terms and conditions or to a business’ income because of cyclical changes in demand for its products; or
The asset has a limited life, e.g. assets and businesses in the energy and natural resource sector.

Principles of this Method:

The value of any asset is a reflection of the present value of the net benefits expected to be derived from that asset as of the specified valuation date. Although there are distinct terms and inputs used when applying the DCF method to valuations of real property and businesses, the basic principles of the method are the same.

The DCF method results in an indication of value whereby forecasted cash flows are discounted back to the date of valuation, resulting in a present value of the asset or business. A terminal value at the end of the explicit forecast period is then determined and that value is also discounted back to the valuation date to give an overall value for the asset or business.

Key inputs that are required for this method:

Determination of the explicit period over which the cash flows will be forecast;
Cash flow forecast for that period;
The asset or business value at the end of the forecast period, i.e. the terminal value; and,
The appropriate discount rate to apply to the forecasted future cash flows which includes the terminal value.

The duration of the forecast period requires careful consideration and is normally determined by one or more of the following criteria:

Where cash flows are likely to fluctuate, the length of time for which changes in the cash flow can be reasonably predicted.
The length of time to enable the business or asset to achieve a stabilised level of earnings;
The life of the asset; or
The intended holding period of the asset.

The selection criteria will depend upon the purpose of the valuation, the nature of the asset, the information available and the requirements of the valuation. For an asset with a short life it is more likely to be both possible and relevant to project cash flows over its entire life.

For some asset types there may be an accepted norm among market participants regarding the length of the forecast period which is typically the basis for market value.

The period over which an asset is intended to be held may be the most appropriate factor in determining the explicit forecast period if the objective of the valuation is to determine its investment value.

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