As a professor, I have probably spent a full decade of my life in the classroom trying to explain the concept, the detail, the assumptions and the need for market anchoring in all property valuations. The valuation figure is the end of a process and that figure is determined by the interaction of numerous economic drivers at a specific point in time. In other words, to understand the valuation figure, you need to understand the context of the derivation of that figure.
So valuation is a process; a market analysis. But it is also – once the market has been analysed and assumptions determined – a mathematical model. There are principally two models. There are an implicit capitalisation model and an explicit discounted cash flow (DCF) model. Both models do the same. Both estimate the Market Value of the property. It is the way in which they do so that is different. The implied model, as the names suggests, hides all the assumptions by using one capitalisation multiplier – x the rent – to estimate the Market Value. The other, the explicit DCF, uses all the same assumptions but it shows what those assumptions are within the valuation. Both will estimate the same Market Value but the explicit DCF model is simply more transparent.
Price and worth
What investors want to know is why the Market Value, as provided by the valuer, different from their own calculations of worth for the same asset?
Value and worth are different concepts driven by different assumptions. Market valuation decants market expectations, from comparable market evidence, and uses those assumptions in the valuation model either implicitly or explicitly. Worth calculations uses the investor’s own forecasts and return requirements in an explicit model to determine what the same asset is worth to them. If the market expectations are different to the investors own view of the future then, unsurprisingly, the Market Value will be different to the investor’s worth calculation.
This is often misunderstood and some investors believe that the Market Value should be the same as what they think it is worth. That is why we often hear investors saying, especially in market downturns, “That can’t be Market Value because we wouldn’t sell it for that price.”
The independent valuation review
In 2022, the RICS published the “Independent Review of Real Estate Investment Valuations”. Within that report, the principal author, Peter Pereira Gray, stated:
“I acknowledge that traditional measures of value can correctly identify the exchange price at which an asset will likely trade (the ARY is merely the mathematical summary of the many assumptions that go into a valuation), but the use of the ARY does not provide sufficient information and clarity to the client on the make-up of the value of their property […] instead, the models should be ‘explicit’ to achieve the required levels of transparency, understanding, and education.”
And this was the crux of the review. Property investors no longer are accepting of the valuation figure alone; they also want to know what are the underlying assumptions. If there is more transparency, then investors can see why the Market Value at any one point differs from their view of worth.
Once upon a time when markets were driven by a desire to be in a specific locality, the valuation adage was “location, location, location.” This changed, in subsequent recessions and downturns when the proliferation of bankruptcies led to the default of leases, to “covenant, covenant, covenant.” Today, where we are in a world of sophisticated investment decision modelling, I would suggest the adage now should be “transparency, transparency, transparency.”
The RICS DCF practice information
The RICS has accepted all of the review’s recommendations and most were implemented via various initiatives at the end of last year. One such initiative was to update the RICS’ guidance on the use of DCF valuations to incorporate, amongst other things, the recommendation to move toward explicit valuation models to increase transparency.
It also addresses, at length, the difference between value and worth, summarising this by saying:
“Market value is based primarily on market evidence and is not an entity specific value to the particular individual.”
So, apart from providing more overall information and guidance on the use and interpretation of explicit DCF models, there are two main takeaways from the RICS Practice Information: one is that the use of an explicit model won’t change the Market Value as that is determined by the underlying assumptions and they are the same in both the explicit and implicit models. The only difference is that the explicit model requires the valuer to reveal those assumptions. That is the benefit of the explicit model. It is transparent. The second takeaway is that Market Value is not the same as worth. They are two different concepts.
The confluence of the two is that explicit models, by being transparent, can show the investor where their own forecasts differ from the market expectations captured in the valuation.
DCF modelling is not a panacea. Market values will still rise and fall in line with the vagaries of the market. Valuers will still have days where comparable transactions are plentiful and the decantation of market assumptions is straight-forward. Conversely there will be downturns where market sentiment is more important due to the lack of transactional evidence. But in all cases, explicit models force the valuer to make explicit all those assumptions. And that was the battle cry of investors in the review.
To use an odd analogy, if a valuation is a water fowl, investors are saying: “don’t just tell us that it is a swan, tell us what is happening below the water too.”
