Market value: a singular definition

Citation

French, N. (2006), "Market value: a singular definition", Journal of Property Investment & Finance, Vol. 24 No. 2. https://doi.org/10.1108/jpif.2006.11224baa.001

Market value: a singular definition

In the last issue of the Journal of Property Investment & Finance, the first article in the Education briefing discussed the concept of Market Value. This is the accepted international definition of value and is defined as:

The estimated amount for which a property should exchange 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.

This is the definition adopted in the Royal Institution of Chartered Surveyors (RICS) Appraisal and Valuation Standards (The Red Book) which contains mandatory rules, best practice guidance and related commentary for all RICS members undertaking valuations. In previous guises (1995 onwards), the Red Book has contained up to 14 different definitions, or bases, of value. Many of these were exclusive to the UK and to very specific purposes. However, in 2004, it was agreed that the Red Book would dovetail completely with the standards published by the International Valuation Committee (IVSC). In this context, the revised NEW Red Book (5th Edition) was published in May 2003 included the full IVSC standards to better reflect the increasing international status of RICS and to implement the RICS policy of adopting and supporting International Valuation Standards. In that edition of the Red Book, there were only two capital value definitions; Market Value (MV) and Depreciated Replacement Cost (DRC).

However, in January 2005, The IVSC determined that Depreciated Replacement Cost is not a BASIS of valuation but a METHOD of valuation to determine Market Value that may be used where direct market evidence is limited or unavailable.

There is a new definition of DRC:

Depreciated Replacement CostThe current cost of reproduction or replacement of an asset less deductions for physical deterioration and all relevant forms of obsolescence and optimisation.

The RICS thus deleted DRC as a basis of valuation in the Red Book. This deletion of has happened with little fanfare. The new arrangement suggests that the valuer reports the result of a DRC valuation as Market Value subject to the test of adequate profitability or service potential. This suggestion has caused a lot of debate and consternation in the UK where the DRC approach has always been considered as a method of last resort and not a Market Valuation. However, in continental Europe the cost approach (DRC) is often the principal method of valuation and has always been considered to produce Market Value.

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 it wasn’t a market valuation.

The issue is simple. In the UK, valuers have often hidden behind the DRC as a basis of valuation, arguing that it wasn’t particularly robust figure as it was only an accountancy valuation. It didn’t relate to Market Value. Yet, the opposite was always the case. DRC was simply a method that gave a figure that was more uncertain than those produced by the more favoured comparable and investment methods.

The deletion of DRC as a basis of value in the Red Book is, I believe, totally appropriate. The DRC valuation should be used when there is no evidence of a market for an asset separated from its business context. But that does not exonerate the valuer from estimating the price that would be agreed between willing and knowledgeable parties. What else does DRC attempt to do? Arrive at a price that would not be agreed between the parties?

DRC is open to subjectivity and conjecture, but that often has to be part of the process. But the same uncertainty can be equally true of an investment property (valued by comparison) in a depressed market. Just because the valuer is uncertain of the resulting figure doesn’t change the fact that he/she is trying to estimate the amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller. DRC is market value. Indeed, if the valuer is aware of market evidence that gives different values from the DRC valuation, then DRC should not be the preferred method of valuation.

Nick FrenchThe University of Reading Business School, Reading, UK