Market value and depreciated replacement cost

Citation

French, N. (2005), "Market value and depreciated replacement cost", Journal of Property Investment & Finance, Vol. 23 No. 5. https://doi.org/10.1108/jpif.2005.11223eaa.001

Market value and depreciated replacement cost

Market value and depreciated replacement cost

I think that I must be getting old. Once upon a time, I remember I was a young academic who argued for only one definition of value as a basis of valuation and that the basis of “Depreciated Replacement Cost” (DRC) was not a basis at all but simply a defined method[1]. Both those views fell on deaf ears and, in the last ten years, we (in the UK) were blessed with a plethora (at one time 14!) of awkward definitions of valuation bases (including DRC), the virtues and nuances of which were proffered by an annual RICS valuation roadshow to educate and inform the membership. But now the world has changed and as of January 2005, there is only one basis of valuation and DRC has been “demoted” to the role of humble method. And the amazing thing is that this has all happened slowly and quietly and without any major consternation. So what happened?

In January 2005, the International Valuation Standards Committee (IVSC) published the International Valuation Guidance Note No. 8 (GN8) entitled The Cost Approach for Financial Reporting – (DRC). This guidance note provided a background to the use of DRC in connection with International Valuation Application 1 (IVA1), Valuation for Financial Reporting and suggested that the valuer reports the result of a DRC valuation as market value, subject to the test of adequate profitability or service potential. As previously mentioned, in the UK, the DRC approach has always been considered as a method of last resort and not a market valuation and thus it was distinguished from the same by bestowing upon it the exalted benefit of being classed as an alternative basis to market value. Yet, in Continental Europe the cost approach (DRC) is often the principal method of valuation and has always been considered to produce market value. It is this latter view that has now won the day.

As the RICS were fully involved in the development of GN8, it needed to be consistent and PS 3.3 of the Red Book, which referred to DRC as a basis, was in conflict with GN 8 and needed to be deleted from the Red Book. The Red Book now confirms that DRC is not a basis of valuation but a method of valuation that may be used where direct market evidence is limited or unavailable.

And that logic is both consistent and valid. One of the principal tenets of DRC as an approach is that it assesses the value of a brand new build of the same property and then makes allowances for depreciation. It is therefore market value in an existing state. In theory, if there were a buyer in the market then they would assess what they would have to pay for a new build on a similar site and then, taking into account the depreciated state of the actual property, discount their offer for the actual building. It is market value. There is a paradox in this analysis as the valuer uses DRC because there is no market, yet the underlying assumptions of the valuation is that there is a willing buyer and a willing seller. But this is the same problem of valuing a non-specialised building by comparison when there is no market activity, yet no one would argue that that was not a market valuation. This change can only be welcomed as it reinforces the principal tenet of valuation; we are estimating price.

Nick FrenchThe University of Reading Business School, Reading, UK, May 2005

Note1. French, N., A Question of Value, CPD Foundation Millennium 2000 Merit Award 1995.