Journal of Property Investment & Finance: Risk and uncertainty

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12/05/2005

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ISBN 1-84544-150-8

ISSN 1463-578X

Volume 23 Number 3 2005

Journal of

Property Investment & Finance Risk and uncertainty

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Journal of

ISSN 1463-578X

Property Investment & Finance

Volume 23 Number 3 2005

Risk and uncertainty Editor Nick French

Access this journal online __________________________ 210 Editorial advisory board ___________________________ 211 Editorial __________________________________________ 212 The appraisal of urban regeneration land: a contemporary perspective allowing for uncertainty Alastair Adair, Norman Hutchison, Jim Burgess and Stephen Roulac _____

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Real estate portfolio construction and estimation risk Stephen Lee and Simon Stevenson _________________________________

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The reporting of risk in real estate appraisal property risk scoring Alastair Adair and Norman Hutchison ______________________________

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PRACTICE BRIEFING An investigation into the expression of uncertainty in property valuations Alexander Joslin ________________________________________________

269

Law briefing ______________________________________ 286 Reviews___________________________________________ 297

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CONTENTS

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EDITORIAL ADVISORY BOARD Professor Alastair Adair University of Ulster, Northern Ireland Dr Richard Barkham Grosvenor, London, UK Professor Andrew Baum The University of Reading Business School, UK Stephen Brown Royal Institution of Chartered Surveyors, London, UK Professor Peter Byrne The University of Reading Business School, UK Russell Chaplin UBS Global Asset Management, UK Professor Neil Crosby The University of Reading Business School, UK Eamonn D’Arcy The University of Reading Business School, UK Professor Julian Diaz III Georgia State University, Atlanta, USA Dr Tim Dixon College of Estate Management, Reading, UK Professor Paul Gallimore Nottingham Trent University, UK Professor Robin Goodchild LaSalle Investment Management, London, UK Dr Liow Kim Hiang National University of Singapore, Singapore Professor Martin Hoesli University of Geneva, Switzerland and University of Aberdeen, UK Geoff Keogh University of Aberdeen, UK Professor Tony Key City University, London, UK Professor Colin Lizieri The University of Reading Business School, UK Professor Bryan MacGregor University of Aberdeen, UK

Professor George Matysiak The University of Reading Business School, UK and University of Cincinnati, USA Dr Yu Shi Ming National University of Singapore, Singapore Dr Seow Eng Ong National University of Singapore, Singapore Professor John Ratcliffe Dublin Institute of Technology, Eire Dr Tim Richards Co´ras Iompair Eireann, Dublin, Eire Professor Jon Robinson University of Melbourne, Australia Professor Stephen Roulac Roulac Global Places, USA and University of Ulster, UK Dr Ed Schuck Frank Russell Company (NZ) Limited, New Zealand Dr Karen Sieracki KASPAR Associates, Tunbridge Wells, UK Andrew Smith Arlington Property Investors, London, UK Professor Dogan Tirtiroglu Concordia University, Quebec, Canada Dr Sotiris Tsolacos Jones Lang LaSalle, UK Professor Charles Ward The University of Reading Business School, UK Professor James Webb Cleveland State University, USA Dr Larry Wofford Harley Davidson, Tulsa, USA Professor Elaine Worzala University of San Diego, USA Dr Peter Wyatt University of the West of England, Bristol, UK

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Journal of Property Investment & Finance Vol. 23 No. 3, 2005 p. 211. # Emerald Group Publishing Limited 1463-578X

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Editorial In these matters the only certainty is that nothing is certain (Pliny the Elder,

AD

23-79).

This issue is a themed issue looking at “Uncertainty and risk in real estate”. Uncertainty is an integral part of real estate investment, valuation and development. The papers in this issue concentrates on the practical impact of uncertainty in real estate. The sources of uncertainty are rational and can be identified. Each paper, in a different way describes how risk and uncertainty can be addressed in a practical manner. The terms risk and uncertainty are often used interchangeably. Risk is seen as a euphemism for uncertainty. However, this colloquial use of the words is unhelpful in identifying the principal issues involved. It is important to define these words more precisely. Uncertainty is anything that is not known about the outcome of a venture at the time when the decision is made, whereas risk is the measurement of a loss identified as a possible outcome of the decision. It is generally agreed that uncertainty is due to the lack of knowledge and poor or imperfect information about all the inputs that can be used in the analysis. If we are unable to confirm the veracity of the inputs then the resulting outcomes is uncertain. However, if we are able to assign a probability to the input variables it will allow us to determine the range of possible outcomes. The output is therefore a measure of risk. This issue of the Journal of Property Investment & Finance presents three academic papers and a Practice Briefing on the same theme. The first paper by Adair, Hutchison, Burgess and Roulac, “The appraisal of urban regeneration land: a contemporary perspective for allowing for uncertainty” looks at the way in which uncertainty can be addressed in the regeneration process. The second paper, by Lee and Stevenson, looks at risk in the context of real estate portfolio construction, whereas the final paper, by Adair and Hutchison, considers risk assessment in valuation by a risk scoring system. The Practice Briefing is a survey of valuation practice and questions the way in which uncertainty is expressed in valuations. In each case, the papers are adding to an extensive literature on the subject. Uncertainty and risk are always present in real estate investment and valuation, the question is how can this be measured, managed and expressed? We hope that this issue is a small step to a better understanding of the uncertainty and risk in the decision making process. Nick French The University of Reading Business School, Reading, UK

Journal of Property Investment & Finance Vol. 23 No. 3, 2005 p. 212 q Emerald Group Publishing Limited 1463-578X

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The appraisal of urban regeneration land A contemporary perspective allowing for uncertainty Alastair Adair School of the Built Environment, University of Ulster, Newtownabbey, UK

Urban regeneration land 213 Received July 2003 Accepted July 2004

Norman Hutchison Department of Property, University of Aberdeen, Aberdeen, UK

Jim Burgess Chartered Surveyor, Holywood, UK, and

Stephen Roulac University of Ulster, Newtonabbey, UK and Roulac Group Inc., San Rafael, California, USA Abstract Purpose – The value of land for development is normally estimated by the use of the comparative method or the residual approach. The aim of the paper is to examine appraisal practice, in particular the bases of valuation, availability and utilisation of data, reporting of the value figure and the management of risk. Design/methodology/approach – The paper reports the findings of a survey of valuers from leading practices throughout the UK, bank lenders and developers. An example of an appraisal of an urban regeneration site is included in order to highlight the key issues within the discussion. Findings – A variety of reporting practices is found from a tightly drawn range of values to single-point estimates along with a detailed explanation of the assumptions employed. Developers and lenders favoured the latter, but they appeared to be open-minded about a range of values or an expression of uncertainty being reported, provided that there is a clear and well supported justification. Risk management approaches are underdeveloped within the profession. Originality/value – The valuation of urban regeneration land is said to be one of the most vexed issues in the appraisal of projects due to a lack of data transparency in urban regeneration markets, shortcomings in traditional appraisal methodologies and complexities of public sector grant procedures. Keywords Land, Property, Regeneration, Urban areas Paper type Research paper

1. Introduction The theory and practice of the property discipline, especially in the USA, has a bias towards “greenfield” in contrast to “brownfield” development and investment. Consequently, much of the property discipline and valuation practice, is directed to new urban development rather than inner city redevelopment. Since this emphasis is in the process of changing materially, as cities throughout the world, and especially in the USA, become more mature, the property profession is called to consider more explicitly inner city issues. In the UK the Government has set a target of 60 per cent of all new

Journal of Property Investment & Finance Vol. 23 No. 3, 2005 pp. 213-233 q Emerald Group Publishing Limited 1463-578X DOI 10.1108/14635780510599449

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homes to be developed on brownfield land by 2008 (DETR, 2000), consequently the valuation of these sites is likely to assume increased significance. Further, the renaissance of interest in cities (Roulac, 2001) and the growing business attention to the inner city (Porter, 1995) mean that there is an increasing priority for the property discipline to accelerate its knowledge and standards of practice concerning inner city redevelopment and urban regeneration themes. Among the significant challenges that inner city real estate presents to property researchers and practitioners is the most fundamental concern of appropriate property valuation theory and practice. Property valuation in the context of the inner city is especially significant for multiple reasons. First, government involvement can distort market function, through the application and consequences of various subsidies and incentives, leading to a “things are not always what they seem” condition of the property market. If valuers employ sales comparison or other market analysis techniques, the indicated transaction prices can lead to misinterpretation of the market, unless appropriate adjustments are made for the consequences of subsidies and incentives. Second, inner city valuation analyses often can be more complex, difficult, and resource-intensive than valuation assignments implemented in other settings. At the same time, many inner city properties are both perceived and actually are less valuable than properties possessing similar physical dimensions, but located in places that are considered to be more appealing and therefore more valuable. Although many consider that prejudice and bias largely contribute to depressed inner city real estate prices, an important explanation for lower inner city property values is the lack of apparent demand, resulting from inadequate and/or disproportionately low expenditures for such public/social services as safety, education and transportation. If more balanced levels of such services were provided, there would be more effective demand for properties in the urban regeneration areas, producing higher property values, leading to enhanced fiscal resources to public agencies to fund safety, education and transportation. Third, because of perceived risks associated with involvement in the inner city, in circumstances where risks are perceived to be greater, decision makers tend to endeavour to mitigate those risks by reducing their financial exposure, by paying less rather than more, for all purchases. This tension is a fundamental behavioural attribute of inner city property valuation, as explored in this research study, through an examination of the guidelines for the valuation of urban regeneration properties in the UK. The aim of the paper is to analyse the application of Guidance Note 5 of the RICS Appraisal and Valuation Standards (RICS, 2003a) in the appraisal of urban regeneration land and in particular, current practice relating to valuation methodology, market information, the reporting of ranges of values and treatment of uncertainty. It should be stressed that while this research considers UK market practice, the authors believe that many of the lessons learned are equally applicable to other urban regeneration locations across the world. Further, the paper provides insights into the practical challenges of appraisal implementation on urban regeneration land. In this regard, the paper contributes both to the property valuation literature and also the emerging literature of behavioural real estate, especially concerning appraisal practices. The paper is structured as follows. Section 2 provides an overview of the salient issues relating to the appraisal of urban regeneration land and precedes the discussion

of the methodology employed in the research. The results from the structured interviews in Section 3 provide a discussion of the bases and methods of valuation, market information, contamination and the reporting of values. In Section 4 an appraisal example comprising a valuation of an urban regeneration site is utilised to highlight the key issues, prior to a discussion of the conclusions arising from the research in Section 5.

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2. Appraisal theory and practice Attempts to explain the triggers to the redevelopment of land have been the subject of considerable theoretical and empirical analyses (Healey et al., 1992). Neo-classical approaches have been employed by Brueckner (1980), Wheaton (1982) and Munneke (1996) to determine the stage at which redevelopment becomes feasible. The approaches rely on pricing such land through the market, leading to the conclusion that the redevelopment of land occurs when the price of land for new development, exceeds the price of land in its current use, by the cost of demolition and clearance, the so-called “optimal redevelopment rule”. In other words, if the value of land in its redeveloped state increases relative to the value in its current use, then the probability of redevelopment is increased (Munneke, 1996). However, in urban regeneration areas, disadvantages arising from location, infrastructure, condition and other factors may lead to insufficient demand to make redevelopment readily feasible (DETR, 2000). Regeneration is required in locations where market forces are considered to be weak and display low levels of market efficiency (Ball et al., 1998). The perception of market failure in regeneration areas has been linked to lack of information, landowner inertia, unrealistic landowner “hope” valuations, misperception of returns, high transaction and information cost, risk aversion, externalities and low demand. The market failure that characterises regeneration arises where real estate markets are fragile, the private sector is cautious about investing and the level of economic activity is in a state of decline (Amin et al., 2000). Traditionally such areas have been considered by the private sector as zones of risk and uncertainty and require some form of public sector intervention to stimulate market activity (McNamara, 1993). In a study of inner Manchester, Adams et al. (1985) suggest that inadequacies surrounding valuation practices for example, over reliance on comparable evidence, tend to prevent the price of regeneration land in the inner city from falling, by retaining historical values even in the wake of decreasing demand for land. In other words, the valuation profession is blamed for inconsistencies and failure to reflect the risk and uncertainty associated with projects initiated on regeneration land (Syms, 1996). The appraisal of regeneration land is one of the most challenging tasks confronting the valuation profession today for a number of reasons. First, a lack of expertise among the profession in the valuation of regeneration sites is identified in the literature (Beattie, 1991). The nature and extent of influencing factors including planning, rental growth, yields, development costs, stigma, time and finance, result in the profession trying to value where there is considerable risk and uncertainty. Second, over the last two decades UK government policy on contaminated land has evolved as the extent of the problem became fully understood. For example, over this period, policy on the recording of contaminated sites and on the level of acceptable clean up has changed. It was only after the Environmental Protection Act (1990) that valuers began to appreciate the full impact of contamination on property values (Syms, 1997). This

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message has been emphasised further in the revised RICS guidance note Contamination and Environmental Matters Their Implications for Property Professionals (RICS, 2003b). Indeed the guidance note cautions that the majority of chartered surveyors will not have the specialist skills, competencies and professional indemnity insurance to advise on all aspects of investigation, testing and analysis involved in the assessment of contaminated land and environmental matters. Nonetheless the revised guidance note accepts that chartered surveyors cannot ignore the existence and effects of contamination given the evolution of environmental knowledge and legislation and the valuation response to these developments as contained in the RICS Appraisal and Valuation Standards (RICS, 2003a). Appraisal guidance on techniques to be adopted has not matched these changes with the result that valuation approaches could take various forms or even remain indeterminate. Syms and Weber (2003) have compared international approaches to the valuation of land and property affected by contamination and have found many similarities in the techniques adopted. In some cases the approaches have been highly theoretical whereas others are based on more factual information, however a common thread is the lack of transparency in property data relating to contamination and environmental issues. Richards (1995, p. 2) deplores the lack of clear valuation approaches and concludes that “There is therefore uncertainty as to which valuation methods to apply in the valuation of contaminated land and how these methods should be adapted for use in often unique circumstances”. Third, in the UK there is a scarcity of reliable data on regeneration projects, which includes for example, lack of information on rents and yields as well as the costs associated with remediation. This lack of transparency is often more prevalent in areas of weak demand. The paucity of data in the property market is a feature that distinguishes that market from other financial markets. Adair et al. (1998) emphasise that data deficiencies often lead valuers to work with secondary and incomplete information. The uniqueness of every property implies that a high level of data availability and analysis is required to facilitate increasingly analytical procedures. Data sources tend to focus on prime commercial properties often relegating secondary areas such as regeneration markets. In consequence, potential investors are discouraged from considering non-prime areas. Fourth, the potential volatility of land values has serious consequences for traditional comparative analyses as past evidence is quickly out of date. This exacerbates the risk and uncertainty regarding the level of returns from investments made. The valuation task becomes more difficult, given the severe limitations on the availability of information. Sawyers (1987) contends that the interpretation of market evidence demands a high skill in any valuation. Given the high risk associated with regeneration land, the need for more accurate valuation processes cannot be more pressing. 2.1. Appraisal guidelines for valuing land and property Appraisal guidance in the UK is contained principally in the RICS Appraisal and Valuation Standards (RICS, 2003a) (colloquially known as the Red Book), which aims to promote the consistent use of bases and assumptions on which valuations are provided. Guidance Note 5 of the Standards outlines the principles for the valuation of land in conditions of uncertainty such as a development scenario. The starting point, as with all valuation practice, is that the best evidence of value is the current price paid in

the market for similar sites in similar locations. However, due to the reasons outlined above there is often a marked lack of current and accurate valuation evidence in urban regeneration markets. In addition, Government has recognised for a long time that mispricing arises in the appraisal of sites using the comparable method where public sector subsidy has created the market for sites. Consequently urban regeneration agencies often admit that while they are good on estimating development costs, they struggle with the estimation of land values. Guidance Note 5 recommends that where the comparable method cannot be applied on a sound and rigorous basis, the residual approach should be adopted. The residual approach is broadly similar to the land residual technique employed in the USA (Appraisal Institute, 1998). The value of land for development is normally estimated by the use of the residual method, the traditional approach to development appraisal within the UK (Jones, 1996). In the residual calculation the expected development cost to create the scheme, including developer’s profit, is subtracted from the estimated capital value on completion of the project in order to derive the land value. Furthermore, Jones (1996) outlines the key variables which can be identified as the crux of any public sector appraisal, namely the level of developer’s profit, value of the land, and the valuation of the completed project. In this paper the term “residual valuation”, is used in a generic sense to encompass both the static residual method together with more dynamic cash flow approaches in which there is a detailed treatment of specific site elements over time. Guidelines for the appraisal of land are also published by the UK Government in the HM Treasury Appraisal and Evaluation in Central Government (the Green Book) (HM Treasury, 1997), although differences of emphasis with the RICS Valuation Manual are apparent. The Red Book does not specify valuation methodologies to be utilised in a valuation task, but rather concentrates on the principles to be employed. However, the Green Book, in outlining a number of appraisal principles for the valuation of land and buildings, highlights the role of cash flows in determining appraisal outcomes. Cash flow modelling provides an enhancement over the static residual method and more importantly is the only approach which facilitates the utilisation of rigorous appraisal indicators such at net present value and internal rate of return (Brown and Matysiak, 2000). Depreciated replacement cost may be used where there is insufficient relevant market information. Property appraisals can be undertaken in terms of either annual rental or capital values, however, it is normally appropriate to use capital values in appraising freehold property, those with development value and properties held on ground leases with more than ten years unexpired. Currently greater attention is being focused on making explicit the measurement of risk and uncertainty in valuation processes and in this respect the role of cash flow methodologies is increasing. In some cases, it may be incumbent on a valuer to perform an appraisal based on calculations of worth in order to reveal the underlying investment value of an asset (Baum et al., 1996; Hutchison and Nanthakumaran, 2000). This involves the estimation of worth of an asset to a specific individual or organisation. Calculations of worth are based on discounted cash flows to reflect the costs and benefits to the investor of holding the asset. It is an explicit estimation of risk-adjusted and time-discounted value of expected future income flows. Calculations of worth do not necessarily equate to market price or valuation due to inefficiencies in the market. In the case of regeneration

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land, particularly where a significant range of risk factors exist, the potential for a mismatch between market value and calculations of worth is greatly increased. 2.2. Risk and uncertainty in the appraisal of urban regeneration land Risk and uncertainty are inherent parts of the valuation process. Property pricing as a form of investment decision-making seeks to ascertain the present value of future income and expenditure flows. In this context risk can be defined as the probability that a target rate of return will not be realised. In other words, it assumes that all outcomes together with their probabilities of occurrence are known. While the term uncertainty is sometimes used interchangeably and confusingly with risk it however denotes situations where outcomes and their probabilities of occurrence are not known (Byrne, 1996; Hargitay and Yu, 1993; Knight, 1921). Such a significant distinction is of importance to both the valuer and the end user of the valuation if the correct investment decision is to be made. The need for a greater understanding of risk in the pricing of regeneration land is emphasised by Capozza and Sick (1994) who contend that the structure of risk in land and property development is poorly understood. They employ neo-classical methodologies to examine the spatial and temporal risk structure of land markets, by incorporating modern theories of risk into spatial models of land markets. The resultant integrated approach, they argue, provides new insights into both finance and urban land theory. Samworth and Lacey (1998) consider that the risk profile of redevelopment land is multi-faceted, being closely associated with the possibility of failure to generate expected returns to investment commitments. In this respect the principal elements of risk in the appraisal of urban regeneration land comprise planning, yield and rent, development costs, contamination and stigma, project duration and finance, and volatility. Prior to the granting of planning permission, where the end use of the site is uncertain, the land price includes an element of “hope value” and in this situation price is normally greater than the existing use value, but less than the alternative use value without any uncertainty. The granting of planning permission removes the uncertainty and can therefore raise land values even before any physical work is carried out on site. From both a planning and developer viewpoint, regeneration land presents additional difficulties compared with greenfield sites, due to increased infrastructure costs and the challenge of ensuring compatibility of uses. In consequence, the granting of planning permission may take time to achieve, with the risk that in the ensuing period the buoyant market which had encouraged the original application may have changed. The initial stages of the appraisal process involve making assumptions about the density and end use of a development project, which may prove inaccurate by the completion of the project. Local authorities are minded to remain flexible with the planning of regeneration areas in order to capitalise on potential development opportunities. As a result, plans and initiatives are amended, quite often at short notice (McNamara, 1993). This impacts adversely on land pricing decisions due to increased risk. McNamara (1993) contends that additional risk is created by the lack of transparency about rates of return from inner city investments or how they have varied over time, reflecting the limited information flows in urban regeneration property markets. Under these circumstances, investors are expected to demand higher

than normal yields. Furthermore, the shortcomings of traditional appraisal methodologies in yield unbundling, even in prime city centre markets where data are more readily available, mean that it is almost impossible to quantify accurately a risk premium for thinly traded urban regeneration properties (Lizieri et al., 1997). Certain inner city areas are likely to attract weaker tenancy covenants (small and newly formed firms), that are less able to afford accommodation in preferred locations. These firms are among the most prone to failure and, hence, cause disruption to rental flow. In addition, many investors do not wish to become involved in small value regeneration projects which carry a disproportionate management cost and that combined with a weaker covenant, necessitates the valuer to apply a higher yield as compensation for the higher risk (McNamara, 1993). The aggregate effects of changes in yield and rent are reflected in the gross development value. The yield is increased to compensate for the lower rental levels, intermittent rental income and poor rental growth prospects, thus reducing the gross development value of the projects. Prospects for lower development profits and investment returns also arise from higher than normal development costs associated with urban regeneration locations. Increased development costs result from the replacement and/or re-adaption of buildings which have been used many times over. Furthermore, many urban regeneration properties are characterised by former uses, obstructions due to existing derelict buildings, uncompacted fill and toxic waste, all of which create uncertainties in pricing development work and lead to higher contingency costs and unforeseen remedial works. Additional problems such as small sites, awkward access, the need to minimise inconvenience to neighbouring buildings, and higher design specifications to mitigate the adverse effects of adjacent land uses, add to the costs of developing the sites (Beattie, 1991). While urban regeneration sites generally incur low site acquisition costs these are more than offset by higher costs for site preparation and longer development periods compared with greenfield locations (Simons, 1998). These items are reflected in the project’s carrying costs in the form of higher financing charges. In addition, development financing terms may be more severe than in greenfield locations, reflecting the greater risk of lending in urban regeneration areas. Regeneration land may have some residual characteristics, or qualities, associated with preceding uses and these may pose a potential liability, particularly where contamination is present. As a result, regeneration land may be significantly stigmatised with the consequent lowering of its value (Chalmers and Roehr, 1993; Weber, 1997). Syms (1997, p. 179) defines stigma as “That part of any diminution in value attributable to the existence of land contamination, whether treated or not, which exceeds the costs attributable to the remediation of the subject property, the prevention of future contamination, any known penalties or civil liabilities, insurance, and future monitoring.” Stigma has been used to describe a variety of intangible factors from possible liability and fear of health hazards to fear of the unknown. Wiltshaw (1998) examines the market perceptions of stigma and categorises them into pre- and post-remediation. The latter refers to the difference between the value of land after remediation and the uncontaminated land value. In a way it represents some form of self-insurance cover should there be some as yet unidentified contamination, or that the site may require further remediation should an alternative use be proposed in the future. Thus, investors tend to associate some previously contaminated land with a higher risk than uncontaminated land. It is uncertain over what period of time the stigma persists.

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Mundy (1992) suggests that the discount attributable to stigma should decrease over time as the market’s perception of risk subsidies. The methods currently employed to account for stigma are predominantly based on upwards adjustments to the all-risks-yield and percentage end deductions to value, which may produce unrealistic and erroneous results. Richards (1997) goes further and argues that the use of “rationally-based” (discounted cash flow techniques) is preferable. This would include the use of probability analysis and an objective analysis of stigma where appropriate. Projects undertaken on regeneration land tend to take longer to complete than greenfield sites, due to time-consuming initial processes such as site assembly, demolition, clearance and possible remediation (Adams et al., 1998). The aggregate effect of delays in completing the project and the possible extra costs, increase the cost of short term finance and expose the project to greater interest rate risk. A mistiming of the point at which redevelopment occurs could result in the project being completed at a time when demand is depressed, leading to poor covenants and low rental income. This has the affect of either reducing the land value where an extended development period is anticipated or reducing the developer’s profit should unanticipated delays occur once the land purchase has taken place. The volatility of regeneration land values causes additional risk with respect to the level of returns that may be realised. Since such markets are not first choice destinations for investment, upturns in demand for land are first experienced elsewhere and transcend to regeneration sites with considerable time lags. On the other hand, downturns in demand initially affect regeneration markets further increasing the risk of development in these areas (McNamara, 1993). Overall the problems surrounding the appraisal of regeneration land tend to exacerbate the risk and uncertainty behind current valuation practice. Both the availability and reliability of evidence that a valuer may use affects the integrity of the valuation. In many cases assumptions may be used, but these tend to facilitate the valuation procedures rather than remove risk altogether. In this respect the Carsberg Report (2002) has addressed the risk and uncertainty inherent within the valuation process. The risk surrounding valuation decision-making manifests itself particularly when a valuer determines a single point estimate of value. Each calculation made to produce the single valuation figure has the potential to increase risk. “The valuer will attempt to master this uncertainty in the eventual choice of figure but proper mastery is impossible, and compromise inevitable” (Mallinson and French, 2000, p. 24). In an effort to determine the “best price” it is inherent in the valuation process that less probable figures are discarded. While the discarded figures may appear less appropriate in the view of the valuer, they remain a possible outcome which is not reported to the client. If a range of variables is identified, then it will be possible to develop a matrix of single figure valuations. “Provided the extremes have been set correctly and realistically, all the possibilities will have been captured” (Mallinson and French, 2000, p. 24). Currently there is little agreement on whether clients would appreciate valuations expressed as a range of figures and accompanied by an explanation of the associated level of risk (Adair and Hutchison, 2002). 3. Structured interviews with market participants The research design is based on a qualitative analysis of valuer, developer and lender behaviour in the appraisal of urban regeneration land. More specifically, the

methodology comprised a scoping study to test the applicability of issues identified within appraisal theory and practice in section 2 in terms of a practical valuation context, followed by structured interviews with valuers, developers and financiers in order to explore the issues in greater detail. Furthermore, a case study valuation utilising a Monte Carlo simulation, is employed to highlight the applicability of the issues within an appraisal context. Structured interviews on a face-to-face basis were undertaken with a panel of 19 experts[1] in June 2000. The initial sample selection of valuers was based on the top five UK chartered surveying firms, but was subsequently widened to include the main valuation firms in London in particular identifying their principal valuation staff involved in the appraisal of urban regeneration sites. In order to provide a regional comparison, supplementary interviews were also conducted in Manchester in July 2000. Particular issues related to the utilisation of valuation bases involving open market value and calculation of worth; adequacy of market data to enable the comparable method to be employed; analysis of market data availability including by region and by sector; treatment of grant aid, clawback procedures and contamination; reporting of a single point estimate as compared with a range of values; quantification of risk; and application of the Green Book approach. The results from the structured interviews are considered under the four headings of bases and methods of valuation, market information, contamination and the reporting of the valuation. In each section the views of valuers, developers and lenders are considered in turn. 3.1. Bases and methods of valuation In advising a vendor or purchaser on the value of an urban regeneration site, all the valuers prepared calculations assuming the continuation of the existing use, with permitted uses and assuming best use. Only three of the valuers carried out a calculation of worth and then only occasionally. However, two key concerns about this process were raised by those interviewed. First, valuers expressed an initial reluctance to carry out open market valuations of urban regeneration sites due to the uncertainty surrounding the development prospects. Instead they preferred to give professional advice on the development options. Second, valuers thought there was a difficulty in preparing an open market valuation as defined in the Valuation Manual, as the latter assumes an unconditional sale in the market place, when in reality many urban regeneration land transactions are conditional on some future event, such as securing planning permission for a particular use, at a certain density, within a certain time frame. No significant differences in approach were noted whether the valuer was acting for the vendor or purchaser. However, valuers commented that as purchasers of redevelopment sites tend to be acquiring the site for a specific end use, it is often necessary to advise the client of alternative uses which may produce a higher offer price. Nine out of the ten valuers indicated that they would normally adopt the residual method when valuing urban regeneration sites and that this would be subsequently checked against any available comparable evidence. The tenth valuer relied on comparable evidence in the first instance. The use of comparables was the instinctive first choice of many valuers, but the unique characteristics of urban regeneration sites

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made it extremely unlikely that good comparable evidence was available with the possible exception of housing sites. However, if available, good close comparable evidence was considered to be a very important cross check to ensure that the valuation was in step with prevailing market sentiment. The residual method was the preferred approach for several reasons primarily relating to site-specific elements. First, the residual method facilitates the fine tuning of the valuation by adjusting for a matrix of planning assumptions including uses and densities. Valuers indicated that they would normally draw up a matrix encompassing optimistic, realistic and pessimistic scenarios and the likely impact on open market value. Second, where the site is contaminated, the costs of remediation plus a stigma allowance can be built into the valuation. This may be a crucial component, as the degree and cost of remediation may differ depending on the end use proposed and this can be adjusted in the calculation. Third, where the residual approach involves the preparation of a detailed cash flow, this enables the phasing of the development to be explicitly stated, thus providing further information both to the developer and the funding body. One of the valuers adopted a “calibrated” DCF residual approach where the inputs into the valuation are given parameters based directly on comparable evidence. It was argued that this helps to ensure that the residual approach fully reflects underlying market sentiment. As expected, all valuers excluded grant aid from their valuations in the first instance, to ensure that the true economic value of the land is estimated. If the land value turned out to be negative, this exposed the need for grant assistance. Where grants were available, the funding was then built into the residual approach in order to estimate the likely level of developers’ profit, assuming the purchase of the land at a given price. This level of profit may have been subject to a clawback provision which was allowed for in the cash flow at the end of the scheme. One respondent indicated that where the grant was subject to clawback procedures, scenarios would be built showing rates of clawback with varying levels of profitability. Despite the initial attempts to value in a “no grant world”, it was recognised that the availability of grants did tend to inflate land values as owners became aware of funding opportunities and raised their asking prices. Comment was made on the understandable reluctance of owners to accept a nil or negative value for their land, particularly where the land has a current beneficial use as a car park or as open storage. In these cases, the grant awarding authority may pay a nominal land value within a gap-funding appraisal – reported on one site as between £20,000 to £30,000 per acre – to achieve the sale. This “nominal value” or “willing vendor value”, is a negotiated figure which enables the land transaction to take place, but which is not calculated with reference to the underlying economic value of the land, but rather reflects the realities of the bargaining process. In addition, these nominal land values reflect the reluctance of grant awarding bodies to be seen as creating an artificial land market or escalating land values in urban regeneration areas. Criticisms of gap-funding grant aid were brought into sharper focus in December 1999, following a decision by the European Commission which ruled that the Partnership Investment Programme (PIP) was in breach of State aid rules and was not compatible with the principles of the common market. PIP would only be compatible with the state aid rules if it is restricted solely to assisted areas under the government assistance programme. Since then two new schemes have been approved which enable

Regional Development Agencies and English Partnerships to regenerate brownfield land in partnership with the private sector (DETR, 2001). More specifically, the new schemes support small and medium sized enterprises involved in a variety of regeneration projects. All of the lenders were high information seekers on the method employed and the market evidence used, with the clear expectation that a residual valuation would be carried out. The banks were keenly concerned with the exit strategy of the borrower and thus close inspection was paid on the constituent elements of the gross development value along with the cash flow profile. Whether the scheme was speculative or pre-let was considered the most important factor in assessing lending feasibility. Other significant risk factors included the track record of the developer, demand for the product, contamination, cash flow and capital value. Where comparable evidence existed this was required to be reported to support the valuation figure. On new lending situations, there was a consensus among the banks in requiring a specialist to undertake an environmental assessment as a check for contamination. The valuer would be asked for his comments on the results of the assessment in terms of the likely impact on value. Contamination stigma was viewed as a problematic area with the bank anxious to quantify the risk. Developers (both short-term traders and long-term investor developers) employed the residual method, with the two principal bases being open market value for existing use and for best use. Cash flow valuations were utilised primarily for appraising profitability and financial monitoring of projects. The interrelationship between developers and the valuation profession raised some interesting comment. The developers normally relied on valuers to provide current market analysis in terms of comparative rental levels, yields and capital values across all market sectors except leisure. In relation to the latter sector, there was a strong opinion that valuers generally are not sufficiently highly skilled in undertaking cash flow based appraisals. Moreover, valuers were considered to be weak in analysing operational business data within the cash flow approach. In such situations developers were looking to management consultants to provide advice. Retail valuations were also considered to lag retailers’ own estimations of value particularly from high turnover sites. In this context developers considered that they had superior knowledge of the market, obtained from their close working relationship with retailers. 3.2. Market information At a general level the majority of the valuers were in agreement that there was insufficient detailed information on comparable evidence to analyse according to Guidance Note 5 of the RICS Appraisal and Valuation Standards (RICS, 2003a) due to the unique characteristics of urban regeneration sites. Detailed comparable evidence on large-scale urban regeneration schemes, was considered almost impossible to obtain. This finding supports the conclusions of Syms and Weber (2003) regarding the lack of transparency in the UK and USA on property transactions in regeneration areas. While it was thought possible to value housing sites and industrial schemes directly from comparable evidence, it was felt that this became impossible where the proposed development is of mixed use or the site is contaminated. Nevertheless, even where a residual valuation was adopted in the first instance, the valuers were keen to point out

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that the residual approach is itself made up of individual pieces of comparable evidence and that there are useful “rules of thumb” which enable the valuer to check the resulting valuation. (For example, it was reported that the land value per sq ft for offices in the London core is expected to be within a certain band based on past transaction evidence.) The cost of construction is also used as a comparative benchmark. The survey confirmed differences in the level of information between sectors and within the property hierarchy. The prime retail, office and industrial markets were considered to be well covered, while information on leisure properties was viewed as scarce and data on some secondary locations severely limited. Comment was also made on the greater availability of information across the south and east, compared with the north and west of Great Britain. A lack of published information on land transaction prices was also expressed as a problem among valuers and developers. The respondents were then asked to score the level of market information which is available to undertake an appraisal on a five point scale ranging from 1 (no information is available) to 5 (all facts are known) (Table I). While statistical analysis cannot be undertaken due to small sample size, nevertheless, the results are indicative of clearly identified trends. Overall, the appraisers believed that they possessed a good level of market information on valuation/appraisal data (seven appraisers scored rental and yield levels/cap rates as 4 whereas one appraiser recorded a score of 5), building cost, professional fees, profit levels and disposal costs, a reasonable level of information on the density of permitted development, but only limited levels of information were available on parts of the construction data, including in particular, the costs associated with contamination remediation, site servicing and planning gain. This assessment of market information was broadly confirmed by the lenders, but with reliance placed on the valuer to provide the comparable evidence. However, across some elements of information, for example, the level of developer’s profit (three lender respondents score

1 A Valuation data Density of permitted development Construction data

Profit and disposal Table I. Respondents’ perceptions of the availability of market information

Level of information available 2 3 4 5 D A D A D A D A D

Rental levels Yield levels/cap rates

1 1

1 1

Gross external area Net internal area Site servicing Contamination remediation Building cost Professional fees Planning requirements Cost of finance Construction period Level of developers’ profit Legal fees Marketing costs

1 1 4 6

1 1 2 3 1 1 3 1 2 3 2 2

2

7 1

2 1

5 5 4 1 2 2 2 5 1 2 1

2 3

7 7

2 1

1 1 1

3 3 1

1 1

7 9

1 2 2

6 4 5 6 7

2 2 1 2 2 2 1 1 2

1 1

1

1

1 1 1

Notes: 1 ¼ No information; 2 ¼ Very limited level of information; 3 ¼ Reasonable level of information; 4 ¼ Good level of information; 5 ¼ All facts known; A ¼ Appraiser responses; D ¼ Developer/lender responses

this factor as a 2 whereas five appraisers score it as a 4), legal fees and marketing costs, the lenders’ and developers’ responses indicate a perceived lower level of data availability than the appraisers’ ratings. For one of the lenders the concern was whether appraisers were using all the available market information on credit worthiness to properly evaluate covenant strength. This was deemed to be a serious potential weakness which impacted on yield/cap rate selection.

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3.3. Contamination Valuers adopted a number of different approaches in their treatment of contamination. The predominant approaches were either to make an estimated (or accurate) cost deduction in the calculation, or to exclude the cost of remediation but include caveats warning of the potential liability. Other responses included a yield adjustment to reflect the reluctance of some institutional funds to purchase contaminated sites, thus reducing the liquidity of the investment. For the lenders, any possibility of contamination triggered a thorough investigation of the ground conditions. Where contamination was confirmed this did not automatically preclude a loan, but rather the lender sought to quantify the risk bearing in mind the track record of the developer in handling these issues, the location and proposed end use. The lenders relied on the valuer to make any necessary adjustments to the valuation to reflect the effects of stigma. Interestingly, one senior partner in a firm of surveyors commented that valuers were often acting under specific instructions from the owner to assume that contamination does not exist, even if this instruction does not reflect reality. In carrying out these instructions the valuer may be overstating the value of the land which may then be included in the balance sheet. If contamination is then found by a prospective purchaser and a lower valuation results, it was suggested that owners are then reluctant to sell at a price lower than the valuation previously reported. This introduces a degree of illiquidity into the land market, which is not the fault of the valuer. Overall the findings of this study support earlier research undertaken by Lizieri et al. (1995), Richards (1995) and Syms and Weber (2003) all of whom concluded that there was a lack of consensus on valuation approaches adopted to assess environmental risks. 3.4. Reporting of the valuation The reporting of the valuation as a single point estimate of value or a range of values produced a mixed response, depending on the purpose of the valuation and the role of the valuer. In cases where valuers expressed a reluctance to carry out open market valuations, professional advice would be tendered on the development options, incorporating a range of values reflecting a number of different scenarios such as the end use, letting conditions and a variety of construction cost estimates. However, concern was expressed that in order to retain credibility the range of values had to be tightly drawn. Others preferred to give single point estimates of value, along with a detailed explanation of the assumptions that have been made. Many valuers felt that the reporting of valuation risk under Valuation Manual guidance needs to be improved on. All of the valuers agreed that it was necessary to fully brief the client on the risk behind many of the inputs into the appraisal. Techniques applied to help quantify this risk included the use of sensitivity analysis, scenarios and Monte Carlo simulations. However, most valuers felt that risk management approaches were underdeveloped. As a basic step, the authors consider that the valuation profession should be moving

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away from traditional residual approaches to fully reasoned cash flow based valuations. It is also felt that intuitive and subjective linear approaches to ranking risk (say on a five point linear scale), could be enhanced by more probability based methods and an example of this approach is illustrated later in this paper. The authors found support for the publication of an RICS information paper on the valuation of urban regeneration land, comparable to those on investment properties and the calculation of worth. Such a publication would make the profession more aware of how to deal with complex valuation scenarios, inadequacies in the data and develop further understanding of quantitative aspects of risk measurement. The lenders favoured single point estimates of value, while recognising the need for a full explanation of the underlying assumptions. One of the lenders commented that where a range of values was reported, they would expect the range to be no wider than 5 per cent and that in practice they would tend to base their lending decision on the lowest figure reported. For this reason the developers preferred single point estimates, believing that this would result in a higher level of gearing. Where risk is reported, the lenders sought quantification of the risk and required further information on market conditions, position of the market in the property cycle, current and future demand, capacity and future price movements. Whereas the Valuation Manual does not prescribe a valuation methodology, the HM Treasury (1997) Green Book approach is highly prescriptive, and somewhat artificial, requiring a cash flow at a pre-determined discount rate (6 per cent real) although similar sensitivity analyses are advocated by both the Red and Green Books. Interestingly, respondents felt that the Green Book provided a much more rigorous assessment of risk than valuers were generally capable of undertaking and that there was a need for a standard methodology in the reporting of risk and hence the need for an RICS Information Paper as outlined above. 4. Appraisal example There are a number of risk adjustment techniques which can be adopted and these can be found in Byrne (1996). In this paper Monte Carlo simulation is used to illustrate the use of risk analysis. The Monte Carlo simulation technique is useful in development appraisal especially when the cashflows are difficult to estimate and are therefore risky. Variables which are likely to have a significant effect on the outcome (measured by changes in land value, profitability, NPV or IRR) of the appraisal can be identified by the use of sensitivity analysis. These variables are then ascribed probability distributions and the appraisal calculations are performed. The output from the exercise will usually be a distribution of the variable of interest (land value). Weber (1997) also advocates the use of Monte Carlo in the valuation of contaminated land, commenting that “the use of these techniques can result in a much better idea of the financial risk involved” (Weber, 1997, p. 392). In order to provide a realistic worked example, the paper uses the data from the valuation of an urban regeneration site in south east England which was undertaken in late 2000. In preparing a valuation of the site it was assumed that planning permission would be obtained for a retail warehouse of 600 m2 and that on completion of the nine month development period, the warehouse would be let to a good covenant for a period of 15 years on full repairing and insuring terms with upward only rent reviews every five years. The estimate of rental value was £167.50 m2, and it was further assumed

that a fully let investment of this type would attract investors willing to accept an initial yield of 6.5 per cent. The investment sale taking place sometime between month 10 and 18. Buildings costs were estimated at £405 m2, professional fees at 8.75 per cent, and the cost of borrowing at an effective rate of 7.50 per cent. Developers were anticipated to require a profit margin based on 12 per cent of the gross development value. The assumptions used in the appraisal of the site are outlined below: . Planning permission will be obtained for a retail warehouse of 600 m2 net. . The warehouse will be let to a good covenant for 15 years on FRI terms with upward only rent reviews every five years. . The current estimate of rental value is £167.50 per m2. . It is believed that a fully let investment of this type would attract investors willing to accept an initial yield of 6.5 per cent. . Building costs are estimated at £405 per m2, with a contingency allowance of 2.5 per cent. . Professional fees are taken to be 8.75 per cent. . Site purchase costs are estimated at 6 per cent, letting fees at 15 per cent and sale fees at 2 per cent. . It is expected to take nine months to complete the construction of the property. . Some letting of the property will take place immediately on completion of the construction work. It is expected that the investment sale will take place at some time between month 10 and month 18. . It is thought possible to borrow money to finance the site purchase and building costs at an effective rate of 7.50 per cent. . The developer is prepared to accept a profit margin based on 12 per cent of the gross development value.

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The Monte Carlo simulation was carried out using a Microsoft Excel spreadsheet with a risk analysis “add in” Crystal Ball (Decisioneering UK Ltd). For the purpose of illustration the net lettable area, rental level, building cost, short term finance rate and month of sale were treated as random variables, with the land value as the forecast variable. Crystal Ball offers a range of distribution functions but for simplicity a triangular distribution was used. The triangular distribution can mimic the moments of a number of popular distributions among statisticians and the inputs are easily understood by practitioners. The parameters of the triangular distribution are minimum, most likely and maximum value and the parameters used in the worked example are shown in Table II.

Net lettable area Rental level Building cost Short-term finance rate Month of sale

Minimum

Likeliest

Maximum

580 m2 £150.75 £364.50 6.75% 10

600 m2 £167.50 £405 7.50% 14

620 m2 £184.25 £445.50 8.25% 18

Table II. Parameters for the random variables

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The rental values, building costs and the short term finance rate were allowed to vary between þ /2 10 per cent of their likeliest value. The parameters for the net lettable area and the month of sale were based on the views of the valuer. Crystal Ball allows the valuer to set correlation coefficients but due to a lack of data on the relationship between the inputs (e.g. rental level and exit yield), the variables were allowed to vary randomly within the distribution ascribed. In order to increase the realism if the simulation model, preleasing is accommodated. (It is assumed that marketing will start at the commencement of construction.) This is accomplished through the use of an S-shaped absorption schedule (Figure 1). The schedule, (referred to as a logistic function) is derived from a function in which the log of the odds of occupancy is linearly related to the number of months the property has been marketed. This function is as follows: ln P=ð1 2 PÞ ¼ 24:291 þ 0:295 ðmonthsÞ where P ¼ the proportion occupied. The sale of the investment can occur after project completion with a range of occupancy possible. Based on the assumption that an investor will pay more for a fully let scheme compared to one only partially let, the exit yield was allowed to vary depending on the level of occupancy, within parameters set by the valuer of 6.50 per cent and 7.00 per cent. For example, where the occupancy level was only 16 per cent, the exit yield derived was 6.9 per cent, compared to 6.5 per cent if fully let. The spreadsheet allowed for the inflow of rental payments proportional to the degree of occupancy, from the month following the completion of construction, to the month of sale. A total of 50,000 calculations of the residual land value (NPV) were performed and the results from the simulations are shown in Table III and Figure 2. Table IV illustrates the probability distribution of the residual land value. While these figures still require interpretation by the valuer and the client, they certainly

Figure 1. Absorption rate

Land value

Table III. Results of the simulation

Mean Standard deviation Maximum Minimum

£784,376 £45,838 £924,892 £647,740

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Figure 2. Frequency chart

Probability 90 80 70 60 50 40 30 20 10

per per per per per per per per per

cent cent cent cent cent cent cent cent cent

Land value £723,653 £743,625 £759,217 £772,370 £784,311 £796,186 £809,460 £824,881 £845,366

provide more information compared to single point estimates produced by conventional methods. For example there is a 70 per cent chance that the value of the site is greater than £759,217 and this may provide some comfort to the client in deciding how much to bid for the site. In reality, the vendor of this site was not prepared to accept a figure of less than £1.0 million and some gap funding was needed in order for the scheme to go ahead. The calculations described above assumed a “normal”, level market, with neither a boom or bust period anticipated prior to the completion of the project. Developers and lenders are usually concerned with the “worst case” scenario and to illustrate this point a further simulation was undertaken assuming a severe downturn in the market. Following further consultations with the valuer, the rental values were allowed to vary between þ /2 20 per cent of the likeliest value. (No changes were made to the building cost distribution.) A further 50,000 calculations of the residual land value were performed and the minimum land value, the “worst case” scenario, was £550,698 which is a drop of over £233,000 from the mean value in the normal market scenario. The quantification of the downside risk, of particular interest to financiers, reinforces the highly volatile nature of urban regeneration land values in the downturn of the property cycle.

Table IV. Frequency probability of value being greater than indicated

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The authors recognize that the use of a Monte Carlo simulation is not a panacea for all the problems associated with development appraisals. However, the technique does force the appraiser to look more closely at the range and probability associated with the inputs and provides more information to the client on the level of risk inherent in the scheme. Recent years have seen renewed interest in the use of probabilistic approaches following the development of the value at risk technique in response to the financial disasters of the 1990s (Jorion, 2001). It is important that the appraisal profession embraces these techniques in order to safeguard their market position as advisors to those involved in real estate development and investment. 5. Conclusions The review of the literature indicates that the appraisal of urban regeneration sites is one of the most challenging tasks facing the valuation profession a view confirmed by this research. One of the most interesting findings is the reluctance of some valuers to provide open market appraisals of urban regeneration sites, preferring instead, to give professional advice on the development options. This finding arises from the mispricing which can occur due to data limitations and the intervention of government in creating property markets in urban regeneration areas. Consequently the appropriateness of the market value definition in such circumstances is questioned and second whether clients are sufficiently aware of the range of services available from appraisers. Wyatt (2000) argues that clients ask for an appraisal within the context of the RICS Appraisal and Valuation Standards (RICS, 2003a) because they perceive calculations of exchange price to be the standard service. The challenge for the profession is to educate clients in the range of services that are available from the appraiser. The normal valuation approach adopted by valuers and developers is the residual method which is subsequently checked against available comparable evidence. Many valuers indicated that the use of comparables was their instinctive first choice, but that the potential for mispricing due to the unique characteristics of urban regeneration sites made it extremely unlikely that good comparable evidence was available, with the possible exception of housing sites. However, where close comparable evidence was available this was considered to be an important cross check to ensure that the residual valuation was in step with prevailing market sentiment. The finding that approximately half of the residual valuations are cash flow based reflects the changes in practice that have occurred in recent years and confirms the view that valuations have become more explicit in the last decade. Nevertheless, it is considered that the skills base of valuers needs to be improved in undertaking cash flow valuations, particularly in utilising operational business data for leisure properties. In this respect the authors would argue that the limitations of the comparative approach in valuing urban regeneration land need to be recognized and that appraisers should move away from the static residual to fully reasoned cash flow based appraisal. While valuers generally considered that they possessed good market information on valuation data, profit levels and disposal costs, the developers and lenders did not share this perception. In contrast, developers were of the opinion that appraisers’ calculations of retail value, lagged retailers’ own estimations, particularly from high turnover sites. In addition, the developers considered that they had superior knowledge of retail market dynamics obtained from close working relationships with retailers.

Valuers considered that they had a reasonable level of information on the density of permitted development, but only limited levels of data on construction and contamination remediation costs, site servicing and planning gain. A key finding of the research is the urgent need to disseminate sources of data for development appraisal among UK appraisers, to highlight deficiencies in information and facilitate data sharing. The research highlights a variety of reporting practices involving, in many cases, a tightly drawn range of values whereas other valuers provided single point estimates along with a detailed explanation of the assumptions employed. Generally developers and lenders favoured the latter approach, but they appeared to be open minded about a range of values or an expression of uncertainty being reported, provided there is a clear and well supported justification. All of the valuers agreed that it was necessary to brief the client fully on the risk behind the inputs into the appraisal and the resulting estimate of value. However, it is clear that risk management approaches, for example sensitivity analysis, scenarios and Monte Carlo simulations are underdeveloped within the profession. In this respect the findings of the research reinforce the conclusions of the Investment Property Forum/IPD (2000) study, which highlights the need for more rigorous risk assessment measures within the property profession. As demonstrated by this research, techniques such as Monte Carlo simulation can be utilised to enhance the risk assessment advice provided on the appraisal of regeneration sites. It is essential that the appraisal profession embraces such techniques so that they can communicate risk and return advice more effectively to clients. Note 1. The panel included English Partnership, ten specialist valuers from the leading surveying firms, two property development consultants, three financiers and three property development companies.

References Adair, A. and Hutchison, N. (2002), “Risk and uncertainty in property pricing: the need for an alternative paradigm”, paper presented at the European Real Estate Society Conference, Glasgow. Adair, A., Berry, J., Deddis, B., McGreal, S., Keogh, G. and Key, T. (1998), “Barriers to data sharing in the surveying profession: implications for the commercial property market”, Journal of Property Research, Vol. 15 No. 4, pp. 331-46. Adams, C.D., Baum, A.E. and McGregor, B.D. (1985), “The influence of valuation practices upon the price of vacant city land”, Land Development Studies, Vol. 2, pp. 157-73. Adams, D., Disberry, A., Hutchison, N. and Munjoma, T. (1998), “Do landowners constrain urban redevelopment?”, Aberdeen Papers in Land Economy: Discussion Paper, No. 99-01, University of Aberdeen, Aberdeen. Amin, A., Massey, D. and Thrift, N. (2000), Cities for the Many, not the Few, Polity Press, Bristol. Appraisal Institute (1998), The Appraisal of Real Estate, 11th ed., Appraisal Institute, Chicago, IL. Ball, M., Lizieri, C. and MacGregor, B.D. (1998), The Economics of Commercial Property Markets, Routledge, London.

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Baum, A., Crosby, N. and MacGregor, B.D. (1996), “Price formation mispricing and investment analysis in the property market”, Journal of Property Valuation & Investment, Vol. 14, pp. 36-49. Beattie, R. (1991), “City grant”, Journal of Property Finance, Vol. 1 No. 4, pp. 588-92. Brown, G. and Matysiak, G. (2000), Real Estate Investment: A Capital Market Approach, Financial Times, Prentice-Hall, Harlow. Brueckner, J. (1980), “A vintage model of urban growth”, Journal of Urban Economics, Vol. 8, pp. 389-402. Byrne, P. (1996), Risk, Uncertainty and Decision Making in Property Development, 2nd ed., E.&F.N. Spon, London. Capozza, D.R. and Sick, G.A. (1994), “The risk structure of land markets”, Journal of Urban Economics, Vol. 35, pp. 297-319. Carsberg Report (2002), Property Valuation, The Royal Institution of Chartered Surveyors, London. Chalmers, J.A. and Roehr, S.A. (1993), “Issues in the valuation of contaminated property”, The Appraisal Journal, January, pp. 28-41. DETR (2000), Our Towns and Cities: The Future, Stationery Office, London. DETR (2001), “Gap funding schemes get the green light”, News Release, 0109, 1 March, DETR, London. Hargitay, S.E. and Yu, S. (1993), Property Investment Decisions: A Quantitative Approach, E.&F.N. Spon, London. Healey, P., Davardi, S., O’Toole, M., Tavsanoglu, S. and Usher, D. (1992), Rebuilding the City: Property-led Urban Regeneration, E.&F.N. Spon, London. HM Treasury (1997), Appraisal and Evaluation in Central Government (The Green Book), HM Treasury, London. Hutchison, N. and Nanthakumaran, N. (2000), “The calculation of investment worth: issues of market efficiency, variable estimation and risk analysis”, Journal of Property Investment & Finance, Vol. 18 No. 1, pp. 33-51. Investment Property Forum/IPD (2000), The Assessment and Management of Risk in the Property Investment Industry, Investment Property Forum/Investment Property Databank, London. Jones, C. (1996), “Urban regeneration, property development and the land market”, Environment and Planning C: Government and Policy, Vol. 14, pp. 269-79. Jorion, P. (2001), Value at Risk, McGraw-Hill, New York, NY. Knight, F.H. (1921), Risk, Uncertainty and Profit, Kelley, New York, NY. Lizieri, C., Palmer, S., Finlay, S. and Charlton, M. (1995), Valuation Methodology and Environmental Legislation: A Research Project for the RICS Education Trust, City University Business School, London. Lizieri, C., Crosby, N., Gibson, V., Murdoch, S. and Ward, C. (1997), “Right space: right price? A study of the impact of changing business patterns on the property market”, report to the RICS, Department of Land Management and Development, University of Reading, Reading, and DTZ Debenham Thorpe, London. McNamara, P. (1993), “Parameters for institutional investment in inner city commercial property markets”, in Berry, J., McGreal, S. and Deddis, B. (Eds), Urban Regeneration Property Investment and Development, E.&F.N. Spon, London, pp. 5-15.

Mallinson, M. and French, N. (2000), “Uncertainty in property valuation: the nature and relevance of uncertainty and how it might be measured”, Journal of Property Investment & Finance, Vol. 18 No. 1, pp. 13-32. Mundy, B. (1992), “The impact of hazardous materials on property value”, The Appraisal Journal, April, pp. 155-62. Munneke, H.J. (1996), “Redevelopment decisions for commercial and industrial properties”, Journal of Urban Economics, Vol. 39, pp. 229-53. Porter, M. (1995), “The competitive advantage of the inner city”, Harvard Business Review, May/June. Richards, T. (1995), A Changing Landscape: The Valuation of Contaminated Land and Property, Research Report, The College of Estate Management, Reading. Richards, T. (1997), Is it Worth the Risk? The Impact of Environmental Risk on Property Investment Valuation, Research Report, The College of Estate Management, Reading. Roulac, S.E. (2001), Place and Property Strategy, Property Press, San Francisco, CA. Royal Institution of Chartered Surveyors (RICS) (2003a), Appraisal and Valuation Standards (The Red Book), Royal Institution of Chartered Surveyors, London. Royal Institution of Chartered Surveyors (RICS) (2003b), Contamination and Environmental Matter: Their Implications for Property Professionals: A Guidance Note, Royal Institution of Chartered Surveyors, London. Samworth, M. and Lacey, C. (1998), “Remove guesswork from spec work”, Estates Gazette, No. 9842, pp. 160-1. Sawyers, R.D. (1987), “The valuation of landfill sites”, Journal of Valuation, Vol. 6, pp. 119-26. Simons, R.A. (1998), Turning Brownfields into Greenbacks, Urban Land Institute, Washington, DC. Syms, P. (1996), “Perceptions of risk in the valuation of contaminated land”, Journal of Property Valuation & Investment, Vol. 15 No. 1, pp. 27-39. Syms, P.M. (1997), Contaminated Land: The Practice and Economics of Redevelopment, Blackwell Science Limited, Oxford. Syms, P.M. and Weber, B.R. (2003), International Approaches to the Valuation of Land and Property Affected by Contamination, Research Review Series, RICS Foundation, London. Weber, B.R. (1997), “The valuation of contaminated land”, Journal of Real Estate Research, Vol. 14 No. 3, pp. 379-98. Wheaton, W. (1982), “Urban residential growth under perfect foresight”, Journal of Urban Economics, Vol. 12, pp. 1-21. Wiltshaw, D.G. (1998), “Stigma, perception and the remediation of contaminated land”, Journal of Property Research, Vol. 15 No. 4, pp. 285-303. Wyatt, P. (2000), “An investigation into the nature of the valuation service offered to business occupiers”, RICS Cutting Edge Conference 2000, RICS, London. Further reading (The) Parliamentary Office for Science and Technology (POST) (1998), A Brown and Pleasant Land: Household Growth and Brownfield Sites, Report No. 117, Parliamentary Office for Science and Technology, London.

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Real estate portfolio construction and estimation risk

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School of Business, Centre for Real Estate Research (CRER), The University of Reading, Reading, UK, and

Stephen Lee

Received February 2004 Accepted October 2004

Simon Stevenson Department of Banking and Finance, Graduate School of Business, University College Dublin, Blackrock, Ireland Abstract Purpose – The use of modern portfolio theory (MPT) in the construction real estate portfolios has two serious limitations when used in an ex ante framework: the intertemporal instability of the portfolio weights; and the sharp deterioration in performance of the optimal portfolios outside the sample period used to estimate asset mean returns. Both problems can be traced to wide fluctuations in sample means. Aims to prove that the use of a procedure that ignores the estimation risk due to the uncertain in mean returns is likely to produce sub-optimal results in subsequent periods. Design/methodology/approach – This study extends previous ex ante-based studies by evaluating ex post optimal portfolio allocations in subsequent test periods by using methods that have been proposed to reduce the effect of measurement error on optimal portfolio allocations. Findings – While techniques designed to handle estimation risk in capital market studies have yielded promising results, they are not completely successful in improving out-of-sample performance in this case. It is hypothesised that such results are due to the cyclical nature of property and that the contrarian and mean-reversion effects picked up in studies of stocks and bonds are not captured when an asset such as direct property is examined. This conclusion is also supported by the strong performance of the tangency portfolios, and in particular the classical unadjusted Sharpe portfolio, over the shorter horizons, which would be consistent with a cyclical momentum effect. Originality/value – The results suggest that the consideration of the issue of estimation risk is crucial in the use of MPT in developing a successful real estate portfolio strategy. Keywords Optimization techniques, Portfolio investment, Risk management Paper type Research paper

Journal of Property Investment & Finance Vol. 23 No. 3, 2005 pp. 234-253 q Emerald Group Publishing Limited 1463-578X DOI 10.1108/14635780510599458

1. Introduction Investors in real estate have typically attempted to diversify portfolios through a process of naive diversification. Recently modern portfolio theory (MPT) has been advocated as a more rational approach to the construction of real estate portfolios to identify the “best” combination of assets to hold (Lee, 1992). In this approach, the importance of each asset is evaluated in terms of its individual relative risk and return characteristics, as measured by its mean and standard deviation, and its portfolio risk as characterised by its correlation with other assets. Given these parameters MPT will find that combination of assets that, for each level of risk, will offer the highest level of return. Such work typically uses historic ex post data to test the effectiveness of such portfolio strategies. However, historic data by its nature is certain; consequently the portfolio holdings are the “best” that could have been achieved in the past. This is equivalent to playing the portfolio investment game with a marked deck, Madura and

Abernathy (1985). Fund managers, however, are hired to construct portfolios, which yield high ex ante rather than ex post risk-adjusted returns, and are therefore forced to play with an unmarked deck. However, when the application of MPT has been tested in ex ante framework the ex post results tend to perform poorly. The classical approach to portfolio construction using MPT has two serious defects: (1) the intertemporal instability of the portfolio weights (Lee, 1998); and (2) the sharp deterioration in performance of the optimal portfolios outside the sample period used to estimate asset mean returns (Jorion, 1985). In effect, due to the fact that the inputted parameters are unstable, the estimated optimal allocations can differ markedly between periods. This is made even more acute as optimiser typically produce portfolios with extreme holdings in a limited number of assets with some assets taking zero weights while others have very large allocations. Black and Litterman (1992) refer to these as corner solutions. Although the resulting portfolios are optimal in the statistical sense, the results would be unacceptable to any prudent portfolio manager (Jorion, 1985). Such corner solutions portfolios quickly become sub-optimal with changes in the means over time, leading to a further reduction in ex ante performance. In addition such extreme portfolio allocations assets seem to be against the spirit of diversification, Michaud (1989). One way to control for such extreme holdings is to place constraints (upper and lower bounds) on the amount any one asset, or group of assets, can have in the optimum portfolio (Byrne and Lee, 1995; Stevenson, 2000a). Indeed papers such as Frost and Savarino (1988) and Chopra (1993) suggest portfolio optimisations, which are subject to such constraints, have better ex ante performance compared with unconstrained solutions. However, any constraints are likely to be arbitrary, leading to the results being hard to generalise. For example, one possible constrained portfolio is the equally weighted naı¨ve portfolio. Morrell (1993), however, argues that that it is generally not possible for property funds achieve equal-weighting in a portfolio and at the same time be represented in key market segments. In addition fund managers typically desire to maintain weights similar to a benchmark portfolio. Also at a practical level due to the indivisibility of property and the marked differences in lot size between say the office and industrial sectors an equal-weighted portfolio strategy would be impossible to implement. Thus an equal-weighted portfolio is therefore probably not a realistic, or even a desirable goal of fund managers. In addition such an approach fails to tackle the fundamental reason for the major shifts in portfolio allocations over time, the instability in the sample means. In contrast the estimation error in variances and covariances is not as much of concern since these parameters are relatively stable over time and therefore are more precisely estimated. Studies such as Kalberg and Ziemba (1984), Chopra and Ziemba (1993) and Stevenson (2001a) have found similar results. Thus the use of a portfolio selection procedure based on historical parameters that ignores the estimation risk due to the uncertain in mean returns is likely to produce sub-optimal results in subsequent periods. Indeed previous work on the application of MPT to the real estate portfolio shows this to be the case (Myer and Webb, 1991; Mueller and Laposa, 1995; Pagliari et al., 1995). The above discussion suggests that the consideration of the issue of estimation risk is crucial in the use of MPT in developing a successful real estate portfolio strategy. Therefore, following Eun and Resnick (1988) and Kwok (1990), this study extends

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previous ex post based real estate based studies by evaluating optimal portfolio allocations in subsequent test periods by using a method that have been proposed to reduce the effect of measurement error on optimal portfolio allocations. Furthermore, the mean-variance model used here does not allow for lending, short sales or borrowing. Lending, borrowing and short sales opportunities are eliminated, as their use is inconsistent with institutional investor’s portfolio management practices. In addition to which short selling significantly increase the adverse effect of estimation error on portfolio selection, Jorion (1992). Finally, no consideration of transaction costs and taxes has been included in this study. 2. Previous Studies A number of studies have investigated the ex ante performance of ex post portfolio efficient allocations in both equity and real estate markets. The first study by Logue (1982) used historical data on foreign country stock market indices to test a number of international portfolio management strategies. In particular, would a passive international portfolio strategy outperform the returns of a US index fund, or an actively managed international portfolio? To construct an ex ante optimal set of portfolio weights for any given year, Logue used the monthly returns, variances, and covariance for stock markets for the prior five years. This approach was based on the assumption that historical data, which are themselves a combination of market returns and currency fluctuations, provide optimal forecasts for the behaviour of security returns over the coming year. The analysis showed that the mean/risk ratio for optimal ex post international portfolios exceeded, by a wide margin, the corresponding ratio for ex ante international optimal portfolios and for the US index. The author therefore concluded that using a simple Markowitz (1952) portfolio selection technique, with historical data as input, produces ex ante optimal portfolios that are worse than those produced by ex post optimal portfolios. Thus if portfolio managers had followed a passive buy-and-hold strategy they would be better off than if they engage in an active investment strategy. Madura and Abernathy (1985) also examined the performance of global stock portfolios prescribed by ex post models. Using weekly stock market index returns for eight countries for the period, January 1978 to January 1981 the authors segmented the data into five sub-periods of equal length and for each period; a mean variance algorithm was used to generate ex post efficient portfolios. The ex post optimal portfolio weights then formed the basis for investment in the subsequent ex ante period. Thus all information for the ex ante strategy was developed from the previous period. Madura and Abernathy (1985) considered the performance of three mean-variance efficient portfolios. A low-risk portfolio which exhibited the least variance in an ex post basis, a high risk-portfolio produce which showed the highest expected return, and an intermediate risk portfolio which displayed the highest ex post return per unit risk Sharpe Ratio (Sharpe, 1966, 1994). For the ex ante strategy to be described as effective, it was expected to outperform a naive portfolio of the international stocks and the US index. In constructing these ex post optimal portfolios Madura and Abernathy (1985) observed that the returns and standard deviations in each country performed differently in the various sub-periods. In other words the data was not stationary. Consequently performance of the ex post based efficient portfolios behaved poorly in subsequent periods. In particular on an ex ante basis the analysis

showed that neither the naive nor the mean-variance international portfolios produced consistently higher returns relative to the US index. While in terms of risk, the mean-variance low risk portfolio was the only strategy, which consistently exhibited a lower standard deviation than the US index. Also no single strategy could be distinguished as superior when the risk-adjusted performance of the various strategies was compared. The authors concluding that the difference between “potential gains from an ex post analysis” and “realised gains from an ex ante analysis” may be substantial. Within the real estate market three studies have looked at the performance of MPT portfolio allocations in subsequent periods. The first by Myer and Webb (1991) analysed a ten-year period from 1978 to 1988 using NCREIF returns for Office, Retail, R&D/office, and Warehouses. Their portfolio optimisations found different mixes for different time periods. Warehouse and R&D/office was the strongest in the 1978 to 1983 sub-period, while during the 1983 to 1988 period Warehouse and Retail had the best risk/return. They concluded that returns move differently during different time periods and thus a single portfolio allocation strategy may not be optimal during different sub-periods. The second study by Mueller and Laposa (1995) investigated what allocation institutional investors should make to the different property-types: retail, office, apartments and warehousing using quarterly data in the USA. In particular Mueller and Laposa (1995) argue that property-type returns have gone through cycles in the past and estimating future returns depends on the cyclic movement within each property-type. In order to identify which property-type to invest in the future investors need to be aware of how each property-type as performed in different phases of the cycle. The authors therefore divided the NCREIF returns data into different periods based on three cyclic indicators: total returns, capital appreciation and GDP growth. They then constructed efficient frontiers in each of the sub-periods and found different allocations both in terms of assets chosen and portfolio weights during the different periods. Mueller and Laposa concluded that in developing their future allocations, investor’s need to be aware of the current and future phases of the cycle in order to determine future portfolio compositions. Finally Pagliari et al. (1995) set out to test whether the strict application of MPT offered superior returns to naive or average-mix (market weight) strategies for institutional investors. Using 15 years quarterly returns divided the data three, five-year sub-periods, the authors showed that while MPT yields optimal ex post portfolios, its use as an ex ante portfolio allocation strategy could lead to mixed results. That is, MPT portfolios constructed from ex post data and extrapolated into future periods may or may not outperform naive and average-mix strategies. Consequently like Madura and Abernathy (1985), the authors noted that while it is easy to determine the best portfolios ex post determining the correct mix in the future is more difficult. In other words the studies show that the effective application of an ex ante MPT based portfolio strategy depends heavily on the accuracy of the portfolio inputs. Consequently the successful application of MPT to the real estate portfolio construction process requires an optimisation procedure that explicitly takes account of estimation risk. The following section therefore uses one such approach[1], the Bayes-Stein shrinkage estimator in deriving the ex post weights of the portfolio with the highest return per unit risk, on the efficient frontier, and tests its performance to see

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if the reduction in estimation leads to greater ex ante performance in subsequent periods.

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3. Data The data used in this study are the monthly total returns for the three sectors: (1) office; (2) retail; and (3) industrial property. The property sector data divided into three “super regions”: (1) London; (2) the rest of Southern England; and (3) “the North” (the remaining peripheral areas). Eichholtz et al. (1995) argues that such a three-property type and three “super regional” classification provides a viable portfolio investment strategy for investors in the UK. In addition limiting the number of sector/regions to nine is also done to minimise optimisation errors with semi-definite matrices, as the number of observations used in estimating the portfolio parameters was only 24. The data covering the period 1987:1 to 1998:12, a total of 144 observations, broken down into six 24-month periods, the summary statistics of which are presented in Table I. As is to be expected the sector/region that performs “best” in each period changes from sub-period to sub-period. For example in period 1, 1987:1 to 1988:12, the highest returns were earned in industrial properties with the lowest risk achieved in the retail sector, especially the further away from London in both cases. In contrast in period 5, 1995:1 to 1996:12, the highest returns were achieved in the retail sector and the lowest risk displayed by offices, both in London. The data thus shows a degree of risk and return instability found in other studies. Indeed statistical tests of the data, not shown here, reject stationarity in the mean return vector and the variance/covariance matrix in practically all sub-periods; both adjacent and non-adjacent (see Lee, 1998 for an

Sector/region

Table I. The risk and return characteristics of sector and regional indices per cent per month 1987:1 to 1998:12

Period 1 Mean SD

Period 2 Mean SD

Period 3 Mean SD

Period 4 Mean SD

Period 5 Mean SD

Period 6 Mean SD

Retail London South East Rest of UK

1.88 1.41 1.37

1.11 0.77 0.57

0.02 0.08 0.11

0.83 0.90 0.77

0.06 0.28 0.42

0.45 0.48 0.42

1.16 1.23 1.43

0.96 0.99 1.01

0.66 0.34 0.54

0.40 0.39 0.34

1.27 0.92 1.11

0.53 0.35 0.38

Office London South East Rest of UK

2.20 1.68 1.88

1.03 1.26 1.27

0.17 0.47 1.33

1.34 1.39 1.77

2 1.13 2 0.49 0.08

0.57 0.39 0.48

1.02 1.10 1.10

0.98 1.14 1.06

0.64 0.41 0.39

0.30 0.43 0.32

1.18 1.16 0.82

0.47 0.31 0.28

Industrial London South East Rest of UK

2.14 2.39 2.49

1.54 1.00 1.31

0.76 0.82 1.13

1.63 1.26 1.43

0.30 0.07 0.68

0.59 0.62 0.53

1.16 1.03 1.54

1.01 0.86 1.18

0.62 0.52 0.52

0.31 0.41 0.35

1.30 1.24 0.98

0.41 0.34 0.29

explanation of the tests). Consequently it would be no surprise that ex post efficient portfolios perform badly in subsequent periods. 4. Methodology In order to test the effectiveness of ex post optimisation in subsequent periods efficient portfolios were formed in a number of sub-period and the portfolio weights held into the next period, as in the approach of Pagliari et al. (1995). However, unlike Pagliari et al. (1995), who analysed the whole efficient frontier in each period, only four ex post portfolios are examined here, following the approaches of Eun and Resnick (1988) and Madura and Abernathy (1985). The four strategies used are those suggested and thoroughly described by Eun and Resnick (1988). The first strategy is the equal-weighted naı¨ve portfolio. Eun and Resnick (1988) view this approach as a naive diversification strategy in the attempt to capture some of the potential gains from sector/regional diversification. The naı¨ve portfolio, as discussed above, also represents one of the many possible constrained portfolios and so should perform well in an ex ante framework as it “constrains” the impact of instability in the input parameters, Frost and Savarino (1988) and Chopra (1993). However, as also highlighted previously such a portfolio is both undesirable and generally impossible to hold. Nonetheless the naı¨ve portfolio provides a convenient benchmark of ex ante performance against which to test the other strategies. The second strategy uses the weights of the minimum-variance portfolio (MVP) as the optimal ex ante weights. Jorion’s (1985) simulation analysis suggests that the MVP is less prone to measurement error than the classical tangency portfolio because the optimal solution of the MVP depends only on the sample covariance matrix (and not the mean-return vector), which is relatively stable over time. Indeed the results of Pagliari et al. (1995) and Madura and Abernathy(1985) suggest that such a portfolio is qualitatively more stable, in its risk characteristics, than other portfolios on the efficient frontier and so is more likely to perform well in subsequent periods. This view has been supported in empirical studies such as Jobson and Korkie (1981) and Stevenson (2001b). Stevenson (2001b) analysed a total of 38 international equity markets including 15 emerging markets. Due to the non-normality present in emerging market returns, two alternative downside risk measures were also utilised in addition to the conventional variance. The results show that all three minimum risk portfolios out-performed the alternative tangency portfolios on an out-of-sample basis. The third method, called the certainty-equivalence tangency (CET) portfolio strategy by Eun and Resnick (1988) or the Classical Sharpe portfolio here, computes the weights of the ex post tangency portfolio and uses them as the ex ante portfolio weights, identified by the following maximisation problem: Maxu ¼

r
p 2 r f s2p

ð1Þ

Where r
p is the expected return on portfolio p, r f is the risk-free rate of return and s2p is the variance of the portfolio. The weights in this portfolio are then the ones offering the highest ex post mean return per unit risk. Furthermore the composition of such a tangency portfolio is independent of the investors’ preference structure, Tobin (1958). Note also that u in the above formulation is, in fact, the ex post Sharpe Ratio (Sharpe, 1966, 1994) performance measure. Consequently it is the portfolio that is most desirable

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to all investors. In conducting the analysis the risk-free rate of return was assumed to be zero for simplicity. The final portfolio strategy considered is the Bayes-Stein shrinkage estimator to calculate the expected returns vector. The use of Bayes-Stein estimators is designed to reduce the degree of estimation error and furthermore, decrease the tendency for asset allocation studies to arrive at corner solutions. A further advantage to the use of such estimators is that empirical evidence, such as Jorion (1985), Chopra et al. (1993) and Stevenson (2001a, b) have provided evidence that the ex ante performance of optimal portfolios improves substantially. The premise behind the Bayes-Stein approach is that due to the sensitivity of the estimated allocations to variations in the parameters, and to relatively extreme inputs, the means of the assets are “shrunk” towards a global mean. This effectively reduces the difference between extreme observations, thus aiding in the attempt to reduce estimation error. The general form for the estimators can be defined as follows: E ðr i Þ ¼ w
rg þ ð1 2 wÞ
ri

ð2Þ

Where E ðr i Þ is the adjusted mean, r
i is the original asset mean, r
g the global mean and w the shrinkage factor. Jorion (1985, 1986) shows that the shrinkage factor can be estimated from a suitable prior as follows: w^ ¼

l^ ¼

ðr 2 r 0

l^ ðT þ l^Þ

ð N þ 2ÞðT 2 1Þ 2 r g 1ÞðT 2 N 2 2Þ

1Þ0 S 21 ð
r

ð3Þ

ð4Þ

Where T is the sample size and S is the sample covariance matrix. Three slightly different techniques are used to shrink the data. The first simply assumes that the within group means for the office, retail and industrial sectors are equal to the overall IPD national mean. The second and third methods use the Jorion prior using alternative definitions of the global mean. The second uses the overall IPD Index, with all nine series shrunk towards this figure. The third uses each of the sector indices as the global mean. Therefore, the regional markets in each respective sector are shrunk in relation to the national sector index. This is consistent with the argument made by Jorion (1985) that the use of a single global mean is hard to reconcile with the idea that a risk-return trade-off exists. Therefore, if it were assumed that there exists a risk-return trade-off between the office, retail and industrial sectors, it would be appropriate to use each sectors mean return as the respective global mean. The weights of each portfolio strategy were derived using a 24-month estimation period. The optimal portfolio weights were then held over the next 24-month period. The performances of four investment strategies were then compared against each other and against that of the Investment Property Databank Monthly Index (IPDMI), which can be considered as the average-mix (market weight) consensus performance of investors in the real estate, for period 2-6. To evaluate relative performance of each real estate investment strategy the Sharpe performance index, ðm 2 Rf Þ=s, i.e. the ratio of mean excess return to standard deviation is used. In conducting the tests, the risk-free interest rate, Rf is set to zero.

The significance of the difference in Sharpe performance of any two portfolios a and b can then be tested following Z statistic, Jobson and Korkie (1981): Z¼

sa ðmb 2 Rf Þ 2 sb ðma 2 Rf Þ pffiffiffiffi Q

Real estate portfolio

ð5Þ

where: ma , mb are the mean returns of portfolios a and b and sa , sb and sab are estimates of the standard deviation and covariances of the excess returns of the two portfolios over the evaluation period and where Q is calculated as follows:   1 1 2 2 1 2 2 ma mb 2 2 2 2 2 2sa sb 2 2sa sb sab þ ma sb þ mb sa 2 ð s þ s a sb Þ ð6Þ Q¼ T 2 2 2sa sb ab

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where T is the number of observations. Jobson and Korkie (1981) show that the test statistic Z is approximately normally distributed with a zero mean and a unit standard deviation for large samples. A significant Z statistics would reject the null hypothesis of equal risk-adjusted performance and would suggest that one of the investment portfolio strategies outperforms the other. Note that the statistical power of the test is low: for a 5 per cent significance level, it fails to reject a false null 85 per cent of time (Jorion, 1985). Thus observing a statistically significant Z score between two portfolios can be seen as a strong evidence of a difference in risk-adjusted performance. Empirical analysis The empirical analysis undertaken in this study first examines the potential impact of estimation error. To assess the relative importance of errors in the mean, variance and covariance inputs, we use a similar methodology to that adopted by Chopra and Ziemba (1993) and Stevenson (2001a). Assuming that the historical estimates are the true population figures we estimate a base efficient portfolio. To assess the impact of estimation error in the mean, we replace the historical estimate r
i for asset i with r
i ð1 þ kzi Þ, where k is allowed to vary between 0.05 to 0.30 to assess the impact of different magnitudes of errors and z has a standard normal distribution. Similar corrections are then performed with respect to the variance and covariance. In each case the remaining two parameters are left unaltered, while the procedure is completed 100 times for each value of k for a different set of z values. The mean absolute difference from the historical estimates is then calculated for each value of k. Table II shows the results and it is immediately apparent that the mean is potentially responsible for a far greater degree of error than the two risk parameters. Whereas changes with the variance and covariance have minimal impacts on the performance of the optimal portfolios, at an error equal to k ¼ 0.3, the mean results in a mean absolute Z=

Mean (%)

Variance (%)

Covariance (%)

0.05 0.10 0.15 0.20 0.25 0.30

5.52 11.04 16.56 22.08 27.60 33.12

0.16 0.26 0.44 0.72 1.19 1.96

0.04 0.07 0.11 0.19 0.30 0.48

Table II. Impact of estimation error

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difference of 33.12 per cent. Not only does these findings confirm studies such as Chopra and Ziemba (1993) with regard to equities and Stevenson (2001a), who analysed real estate securities, but there also support the decision to examine the ex ante performance of the minimum-variance portfolio. As stated earlier, the attraction of analysing such a strategy is that the allocations are determined purely by the two risk parameters. Table III provides details of the initial empirical analysis of ex ante performance. The results show the out-of-sample performance of the various alternative strategies, over a two-year horizon. The results are shown for each of five two-year periods, thus the results for period 2, are for those portfolios based on data for 1987 and 1988, with their performance in 1989 and 1990. The results for the overall sample period are also displayed. Table III promotes the following comments. First if we consider the overall results it is clear that all the investment strategies, with the exception of Bayes-Stein III, offered greater returns than the IPDMI, but by no more than ten basis points per month. In addition in all but one case (Bayes-Stein II) the investment strategies offered these increased returns at lower risk. Consequently all strategies achieved higher risk-adjusted performance than the benchmark of market performance in the long run. In contrast none of the investment strategies produced higher returns than the naı¨ve portfolio. However, the investment strategies all showed lower risk and consequently higher risk adjusted performance. This performance however is not consistent across all sub-periods. In particular in Period 2 the naı¨ve portfolio and the consensus benchmark showed considerably higher returns with only limited increase in risk and consequently vastly superior risk adjusted performance than all the investment strategies. This may be due the fact that the portfolio weights used in Period 2 are based on the returns in Period 1, which as Table I shows corresponds with the market boom. Period 2 in contrast covers the start of the market decline thus the portfolio weights based on a boom period failed badly in a market decline confirming the results of Mueller and Laposa (1995), Myer and Webb (1991) and Pagliari et al. (1995). However, in Period 3 all the investment strategies show greater return performance than the naı¨ve portfolio and the market benchmark (IPDMI), as the portfolio weights (based on the performance of Period 2) are now reflecting the market decline. This reflects the fact that the naı¨ve portfolio contains both good and bad market segments, whereas the alternative strategies will be holding little or nothing in these segments. In the later periods the different investment strategies tend to produce results comparable with both benchmarks with no one strategy proving superior in all periods. Second, the results of the Jobson and Korkie (1981) tests, detailed in Table IV, indicate that there is no significant difference in risk-adjusted performance between any of the different investment strategies and the benchmarks of performance. However this is not too surprising as Jobson and Korkie (1981) and Jorion (1985) both note that the test does not have strong power and significant results are unusual. The results in Table III supposes that investors will only evaluate their portfolio every two years, whereas it seems more reasonable to assume that the fund manger will monitor their portfolios more frequently. This section, therefore, reassess the performance of the ex post investment strategies on a rolling basis. In other words a second analysis was performed with a rolling 24-month estimation period every three, six and 12 months. The use of different re-estimation periods it is hoped will give an indication of the trade-off of more frequent portfolio reviews against transaction costs.

Return

Risk

Sharpe

Real estate portfolio

Period 2 Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III MVP Naı¨ve Market

0.17 0.12 0.10 0.12 0.09 0.54 0.38

0.97 0.83 0.78 0.82 0.78 1.18 1.08

0.17 0.15 0.12 0.15 0.12 0.46 0.35

243

Period 3 Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III MVP Naı¨ve Market

0.41 0.22 0.36 0.07 0.33 0.03 2 0.03

0.46 0.53 0.35 0.62 0.37 0.32 0.33

0.90 0.42 1.02 0.11 0.89 0.09 20.1

Period 4 Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III MVP Naı¨ve Market

1.39 1.26 1.54 1.23 1.20 1.20 1.24

1.03 0.97 1.18 0.96 1.00 0.97 0.97

1.34 1.29 1.31 1.28 1.20 1.24 1.27

Period 5 Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III MVP Naı¨ve Market

0.54 0.54 0.56 0.55 0.54 0.52 0.51

0.34 0.34 0.35 0.37 0.37 0.29 0.31

1.60 1.60 1.57 1.49 1.46 1.75 1.63

Period 6 Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III MVP Naı¨ve Market

1.18 1.13 1.12 1.13 1.12 1.11 1.19

0.35 0.32 0.32 0.32 0.32 0.29 0.3

3.37 3.57 3.52 3.57 3.52 3.77 3.93

Overall Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III MVP Naı¨ve Market

0.73 0.65 0.73 0.62 0.66 0.89 0.63

0.82 0.79 0.86 0.82 0.76 0.95 0.83

1.10 1.04 1.00 0.93 1.15 0.94 0.76

Period

Table III. Risk return performance

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Table IV. Jobson-Korkie statistics for two-year holding periods

Market

Naive

MVP

Sharpe

BS I

BS II

2 0.0296

Period 2 Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

2 0.1232 0.2456 0.2136 0.2165 0.2448 0.2135

0.3699 0.3370 0.3400 0.3690 0.3371

20.0294 20.0272 20.0008 20.0304

0.0021 0.0285 20.0011

0.0264 2 0.0032

Period 3 Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

2 0.2150 2 1.1546 2 1.2556 2 0.6984 2 1.3471 2 0.3061

20.9638 20.9309 20.4003 21.1319 20.0248

20.0667 0.8538 20.1861 1.8967

0.5296 20.1766 0.9537

2 1.0368 0.3385

2.0263*

Period 4 Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

0.0355 0.0785 2 0.0791 2 0.0208 2 0.0459 2 0.0154

0.0429 20.1145 20.0564 20.0815 20.0509

20.1578 20.0996 20.1254 20.0941

0.0579 0.0342 0.0634

2 0.0244 0.0054

0.0300

Period 5 Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

2 0.1301 0.0674 0.0392 0.0392 0.0676 0.1602

0.1990 0.1684 0.1684 0.1992 0.2887

20.0261 20.0261 0.0002 0.0877

0.0000 0.0263 0.1149

0.0263 0.1149

0.0875

Period 6 Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

2 0.2171 0.0558 0.2237 0.0035 0.0560 2 0.0012

0.2762 0.4406 0.2251 0.2764 0.2205

0.1634 20.0499 0.0002 20.0545

20.2137 20.1632 20.2184

0.0501 2 0.0045

2 0.0547

Overall Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

2 0.0578 2 0.1125 2 0.1438 2 0.0678 2 0.1046 0.0039

20.0535 20.0848 20.0082 20.0447 0.0642

20.0306 0.0443 0.0091 0.1169

0.0734 0.0397 0.1451

2 0.0351 0.0694

0.1083

Note: * Significant at the 5 per cent level

That is more frequent re-estimation should provide greater portfolio performance while the longer review periods will minimise transaction costs. The results in Table V like Table III show a number of features of interest. First as the review period decreases the return performance improves, as is to be expected, but

Three-monthly review Return Risk Sharpe

Six-monthly review Return Risk Sharpe

Yearly review Return Risk Sharpe

Period 2 Market Naı¨ve MVP Classical Bayes-Stein I Bayes-Stein II Bayes-Stein III

0.38 0.54 0.27 0.39 0.37 0.29 0.37

1.08 1.18 0.84 0.88 0.86 0.84 0.85

0.35 0.46 0.33 0.44 0.43 0.35 0.44

– – 0.22 0.31 0.30 0.24 0.30

– – 0.80 0.86 0.83 0.79 0.81

– – 0.28 0.36 0.36 0.30 0.38

– – 0.15 0.20 0.18 0.16 0.18

– – 0.75 0.82 0.81 0.75 0.82

– – 0.20 0.25 0.22 0.22 0.22

Period 3 Market Naı¨ve MVP Classical Bayes-Stein I Bayes-Stein II Bayes-Stein III

2 0.03 0.03 2 0.03 0.60 0.38 0.57 0.28

0.33 0.32 0.38 0.52 0.50 0.54 0.54

2 0.10 0.09 2 0.07 1.16 0.75 1.06 0.53

– – 0.03 0.57 0.36 0.58 0.28

– – 0.44 0.52 0.49 0.53 0.51

– – 0.06 1.10 0.74 1.08 0.54

– – 0.10 0.51 0.32 0.42 0.23

– – 0.37 0.44 0.46 0.42 0.48

– – 0.28 1.17 0.70 0.99 0.47

Period 4 Market Naı¨ve MVP Classical Bayes-Stein I Bayes-Stein II Bayes-Stein III

1.24 1.2 1.24 1.52 1.36 1.33 1.25

0.97 0.97 1.07 1.22 1.16 1.07 1.04

1.27 1.24 1.16 1.25 1.17 1.24 1.21

– – 1.26 1.54 1.39 1.38 1.26

– – 1.04 1.21 1.14 1.04 1.01

– – 1.21 1.27 1.22 1.34 1.24

– – 1.22 1.47 1.32 1.41 1.18

– – 0.99 1.19 1.07 1.02 0.93

– – 1.23 1.23 1.23 1.38 1.27

Period 5 Market Naı¨ve MVP Classical Bayes-Stein I Bayes-Stein II Bayes-Stein III

0.51 0.52 0.57 0.58 0.57 0.57 0.56

0.31 0.29 0.34 0.32 0.33 0.34 0.35

1.63 1.75 1.69 1.83 1.72 1.65 1.62

– – 0.55 0.56 0.56 0.55 0.55

– – 0.34 0.33 0.33 0.34 0.35

– – 1.64 1.72 1.68 1.61 1.57

– – 0.53 0.53 0.54 0.53 0.53

– – 0.36 0.34 0.35 0.36 0.37

– – 1.49 1.53 1.54 1.49 1.44

Period 6 Market Naı¨ve MVP Classical Bayes-Stein I Bayes-Stein II Bayes-Stein III

1.09 1.11 0.98 1.03 0.99 0.98 0.99

0.30 0.29 0.28 0.30 0.28 0.28 0.28

3.57 3.77 3.47 3.44 3.52 3.47 3.52

– – 0.99 1.03 0.99 0.99 0.99

– – 0.29 0.31 0.29 0.29 0.29

– – 3.39 3.34 3.40 3.39 3.40

– – 1.07 1.13 1.07 1.07 1.07

– – 0.30 0.32 0.30 0.30 0.29

– – 3.62 3.51 3.64 3.62 3.64

Overall Market Naı¨ve MVP Classical Bayes-Stein I Bayes-Stein II Bayes-Stein III

0.63 0.89 0.61 0.83 0.73 0.75 0.69

0.83 0.95 0.80 0.83 0.80 0.76 0.76

0.76 0.94 0.76 0.99 0.92 0.98 0.91

– – 0.61 0.80 0.72 0.75 0.68

– – 0.79 0.84 0.80 0.76 0.75

– – 0.77 0.95 0.90 0.98 0.90

– – 0.62 0.77 0.69 0.72 0.64

– – 0.76 0.84 0.79 0.77 0.75

– – 0.81 0.92 0.87 0.93 0.85

Real estate portfolio

245

Table V. Rolling risk return performance

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not by any significant amount. For example the returns of the Bayes-Stein II strategy do not change from the three to six month review periods and only declines by 30 basis points to 0.72 per cent per month for the yearly review. Indeed for the two-year review period shown in Table III the returns once again increase to 0.73 per cent per month. Similar results can be seen for the other strategies. In addition, reducing the review period as little or no impact in reducing portfolio risk. Indeed there is generally a slight increase in risk the greater the frequency of review. This implies that increasing the frequency of the review period as little impact on risk-adjusted return performance. Thus any benefit from more frequent reviews would be easily eliminated by increased transaction costs. Second, as seen in Table III there are marked differences in performance in the sub-periods, especially in Periods 2 and 3. Once again all the investment strategies generally show poor performance in Period 2 especially against the naı¨ve portfolio with the switch from boom to decline. But as expected this is less so for the three-month review strategy, as such an approach will be reacting more quickly to the market change, consequently the longer the review the worse the performance. In Period 3 as suggested by the results in Table II with the exception of the MVP strategy, for the three-monthly review period, all the alternative investment strategies now not only out perform the IPDMI benchmark but also show better performance than the naı¨ve strategy. Finally in line with the results in Table III the MVP investment strategy tends to under-perform, while the tangency portfolios tend to outperform other strategies, however, not the two benchmarks[2]. The results also provide further support to the argument that the reason that the MVPs performs so well in the equity and fixed income markets is due to the picking of contrarian effects, while the more long term nature of real estate cycles, means that such a strategy has little advantages over such short horizons. The results also support the findings of Stevenson (2000b) in his analysis of the NCREIF indices in the USA. This study found that out-performance only occurred at longer horizons of around five years, at which point the MVP approach started to out-perform both the tangency portfolios and the benchmark indices. Finally two clear differences can be found between the results here and those studies which have examined similar strategies in equity and fixed income securities. Previous studies, such as Jorion (1985), Chopra et al. (1993) and Stevenson (2001a, b), have found similar results in that the classical tangency portfolios performs worst ex ante, and while the use of Bayes-Stein estimators does lead to improvements in performance, the best performance comes from the minimum-variance strategy. These findings are however, not confirmed by the current study and are consistent with the findings of Stevenson (2000b) in his analysis of the US real estate market. None of the alternative strategies consistently outperform the naı¨ve or market benchmarks, indeed in the individual periods the minimum variance portfolio tends to perform worse than either of the benchmarks and the alternative tangency portfolios. In only one time period, 1989-1990 constructed using 1987-1988 data, does the MVP portfolio outperform on a risk-adjusted basis, any of the other strategies. In contrast, in each of the five individual periods the Sharpe tangency portfolio performs the best of the alternative strategies, although, in line with previous real estate studies, it generally still fails to outperform either of the two benchmarks.

The contrast with the findings from the capital markets is apparent. The attractiveness of the minimum-risk strategy and the poor performance of the classical tangency approach have been linked to the financial economics literature on contrarian strategies and mean reversion (Richards, 1997; Stevenson, 2001a, b). However, due to the differing characteristics of real estate in comparison to capital market assets, and in particular property’s cyclical nature, it would be unlikely that performance could reverse over such short holding periods. This cyclical nature may also be responsible for the strong performance of the tangency portfolios, and in particular the classical Sharpe portfolio, which may be due to a momentum effect in property, which would again tend to last longer than corresponding effects in the equity or bonds markets. Conclusions Madura and Abernathy (1985) conclude that there is a vast difference between “potential gains” from an ex post analysis and “realised gains” from an ex ante analysis. This is true for equity, fixed income and securitised real estate portfolios alike and is confirmed in this study for the direct real estate market. However, techniques such as Bayes-Stein estimation and the use of the MVP, which have yielded promising ex ante results in capital market studies, are not completely successful in improving out-of-sample performance in this case. It is hypothesised that such results are due to the cyclical nature of property and that the contrarian and mean-reversion effects picked up in studies of stocks and bonds are not captured when an asset such as direct property is examined. This conclusion is also supported by the strong performance of the tangency portfolios, and in particular the classical unadjusted Sharpe portfolio, over the shorter horizons, which would be consistent with a cyclical momentum effect. Possible extensions of this work would be investigate the effect of shortening the ex post time horizon over which the portfolio weights are estimated thereby hopefully making the results more sensitive to recent market conditions. This approach, however, has the disadvantage that the number of time periods used to estimate the portfolio inputs will be less than the number of asset classes leading to problems of rank in the covariance matrix and the inadmissibility of its use in the optimisation, see Ong and Ranasinghe (2000). However, recently Ledoit (1999) has developed a flexible Stein based estimation method that not only allows for the covariance matrix too be calculated in the face of such a situation but significantly improves the sample covariance estimation and the stability of MPT optimisation. In addition, research by Lee and Stevenson (2003) suggests that a number of return-weighting schemes that gives greater weight to the most recent data can be used within the portfolio context with good results in ex ante performance, without reducing the estimation period. In particular it was found that not only did the adaptive-weighted returns out perform the IPDMI benchmark portfolio but showed greater performance than both the unweighted return approach and the naı¨vely constrained portfolio. Incorporating these adaptive weighted-returns into the Bayes-Stein approach therefore may improve the ex-ante performance of these investment strategies, especially as the market moves from boom to bust. The analysis could also be extended by taking into consideration the effects of transaction costs and taxes on the gains from diversification within the real estate portfolio. The issue of transaction costs is of particular importance when one is concerned with a rolling strategy as used in this study. However, the results above in

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Table V indicate that there is little benefit to be gained by reducing the review period and so increasing the transaction costs. Furthermore, in order to robustly analyse the transaction cost issue would involve the incorporation of a number of assumptions concerning investor behaviour. In particular it would be necessary to examine in detail the most appropriate holding period for real estate and to accurately assess realistic costs, which to a large degree would be guided by the issue of illiquidity. The illiquid nature of real estate means that assumptions would have to be made concerning the level of movement that would be allowed within each specified holding period. For example, in the rolling analysis it would be totally unrealistic to assume that changes in the allocations could occur immediately, especially with the one-year analysis. It would therefore, be required to place further restrictions on the percentage change that would be feasible within the specified holding period and to assume that such a change occurred gradually over the same period. If the analysis were to be extended into a multi-asset scenario then further issues would arise, such as the different holding periods the assets are held over and the issue of time diversification, which remains a controversial subject itself within the finance literature. Notes 1. A number of methods have been suggested to handle estimation risk within a portfolio context, see Michaud (1998) for a review. 2. The Jobson and Korkie statistics are contained in the appendix for the three holding periods and as with the two-year analysis, are mostly insignificant. References Black, F. and Litterman, R. (1992), “Global portfolio optimization”, Financial Analysts Journal, October, pp. 28-43. Byrne, P.J. and Lee, S.L. (1995), “Is there a place for property in the multi-asset portfolio?”, Journal of Property Finance, Vol. 6 No. 3, pp. 60-83. Chopra, V.K. (1993), “Mean-variance revisited: near-optimal portfolios and sensitivity to input variations”, Journal of Investing. Chopra, V.K. and Ziemba, W.T. (1993), “The effect of errors in means, variances and covariances on optimal portfolio choice”, Journal of Portfolio Management, Winter, pp. 6-11. Chopra, V.K., Hensel, C.R. and Turner, A.L. (1993), “Massaging mean variance inputs: returns from alternative global investment strategies in the 1980s”, Management Science, Vol. 39, pp. 845-55. Eichholtz, P.M.A., Hoesli, M., MacGregor, B.D. and Nanthakumaran, N. (1995), “Real estate diversification by property-type and region”, Journal of Property Finance, Vol. 6 No. 3, pp. 39-62. Eun, C.S. and Resnick, B.G. (1988), “Exchange rate uncertainty, forward contracts, and international portfolio selection”, Journal of Finance, Vol. 43, March, pp. 197-215. Frost, P.A. and Savarino, J.E. (1988), “For better performance: constrain portfolio weights”, Journal of Portfolio Management, Fall, pp. 29-34. Jobson, I.D. and Korkie, B.M. (1981), “Performance hypothesis testing with the Sharpe and Treynor measures”, Journal of Finance, Vol. 36, September, pp. 544-54. Jorion, P. (1985), “International portfolio diversification with estimation risk”, Journal of Business, Vol. 58, pp. 259-78.

Jorion, P. (1986), “Bayes-Stein estimators for portfolio analysis”, Journal of Financial and Quantitative Analysis, Vol. 21, pp. 279-92. Jorion, P. (1992), “Portfolio optimisation in practice”, Financial Analysts Journal, January-February, pp. 68-74. Kalberg, J.G. and Ziemba, W.T. (1984), “Mis-specification in portfolio selection problems”, in Bamberg, G. and Spremann, A. (Eds), Risk and Capital, Springer-Verlag, New York, NY. Kwok, C.C.Y. (1990), “The numeraire problem, forward hedges, and international portfolio selection”, Global Finance Journal, Vol. 1 No. 2, pp. 95-120. Ledoit, O. (1999), “Improved estimation of the covariance matrix of stock returns with an application to portfolio selection”, paper presented at the Institute for Quantitative Research (INQUIRE) Conference, Edinburgh, March. Lee, S.L. (1992), Emerging Concepts for the Management of Portfolios and the Role of Research: Property in the Portfolio Context, Society of Property Researchers, London. Lee, S.L. (1998), “The inter-temporal stability of real estate returns: an empirical investigation”, Working Papers in Land Management and Development, No. 04/98, p. 23. Lee, S.L. and Stevenson, S. (2003), “Time weighted portfolio optimisation”, Journal of Property Investment & Finance, Vol. 21 No. 3, pp. 233-49. Logue, D.E. (1982), “An experiment in international diversification”, Journal of Portfolio Management, Vol. 9 No. 1, pp. 22-7. Madura, J. and Abernathy, G. (1985), “Playing the international stock diversification game with an unmarked deck”, Journal of Business Research, Vol. 13, pp. 465-71. Markowitz, H.M. (1952), “Portfolio selection”, Journal of Finance, Vol. 7 No. 1, pp. 77-91. Michaud, R.O. (1989), “The Markowitz optimisation enigma: is ‘optimized’ optimal?”, Financial Analysts Journal, January/February, pp. 31-42. Michaud, R.O. (1998), Efficient Asset Management, Harvard Business School Press, Boston, MA. Morrell, G.D. (1993), “Value-weighting and the variability of real estate returns: implications for portfolio construction and performance evaluation”, Journal of Property Research, Vol. 10, pp. 167-83. Mueller, G.R. and Laposa, S.P. (1995), “Property-type diversification in real estate portfolios: size and return perspective”, The Journal of Real Estate Portfolio Management, Vol. 1 No. 1, pp. 39-50. Myer, F.C.N. and Webb, J.R. (1991), “Estimating allocations for mixed-asset portfolios using the bootstrap technique”, paper presented at the American Real Estate Society Meeting, Sarasota, FL. Ong, S. and Ranasinghe, M. (2000), “Portfolio variance and correlation matrices”, Journal of Real Estate Portfolio Management, Vol. 6 No. 1, pp. 1-6. Pagliari, J.L., Webb, J.R. and Del Casino, J.J. (1995), “Applying MPT to institutional real estate portfolios: the good, the bad and the uncertain”, The Journal of Real Estate Portfolio Management, Vol. 1, pp. 67-88. Richards, A.J. (1997), “Winner-loser reversals in national stock indices: can they be explained?”, Journal of Finance, Vol. 52, pp. 2129-44. Sharpe, W.F. (1966), “Mutual fund performance”, Journal of Business, Vol. 39, January, pp. 119-38. Sharpe, W.F. (1994), “The Sharpe ratio”, Journal of Portfolio Management, Fall, pp. 49-58. Stevenson, S. (2000a), “Constraining optimal portfolios and the effect on real estates allocation”, Journal of Property Investment & Finance, Vol. 18 No. 4, pp. 488-506.

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Stevenson, S. (2000b), “The out-of-sample performance of optimal portfolios: empirical tests with the NCREIF”, paper presented at the American Real Estate Society Annual Meeting, Santa Barbara, CA. Stevenson, S. (2001a), “Bayes-Stein estimators and international real estate asset allocation”, Journal of Real Estate Research, Vol. 21 No. 1, pp. 89-103. Stevenson, S. (2001b), “Emerging markets, downside risk and the asset allocation decision”, Emerging Markets Review, Vol. 2 No. 1, pp. 50-66. Tobin, J. (1958), “Liquidity preference as behavior towards risk”, Review of Economic Studies, Vol. 25, pp. 68-85. Further reading Best, M. and Grauer, R. (1991), “On the sensitivity of mean variance efficient portfolios to changes in asset means: some analytical and computational results”, Review of Financial Studies, Vol. 4, pp. 315-42. Effron, B. and Morris, C. (1973), “Stein’s estimation rule and its competitors: an empirical Bayes approach”, Journal of the American Statistical Association, Vol. 68, pp. 117-30. Effron, B. and Morris, C. (1975), “Data analysis using Stein’s estimator and its generalizations”, Journal of the American Statistical Association, Vol. 70, pp. 311-19. Jobson, J.D., Korkie, B. and Ratti, V. (1979), “Improved estimation for Markowitz portfolios using James-Stein type estimators”, Proceedings of the American Statistical Association, Business and Economics Statistics Section, American Statistical Association, Washington, DC. Lee, S.L. and Byrne, P. (1998), “Diversification by sector, region or function? A mean absolute deviation optimisation”, Journal of Property Valuation & Investment, Vol. 16 No. 1, pp. 38-56. Stein, C. (1955), “Inadmissibility of the usual estimator for the mean of a multivariate normal distribution”, Proceedings of the 3rd Berkeley Symposium on Probability and Statistics, University of California Press, Berkeley, CA.

Real estate portfolio

Appendix

Market

Naı¨ve

MVP

Sharpe

BS I

BS II

Period 2 Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

2 0.1232 0.0230 2 0.1012 2 0.0921 0.0016 2 0.0978

0.1485 0.0252 0.0337 0.1276 0.0271

20.1223 20.1133 20.0210 20.1199

0.0085 0.1005 0.0021

0.0918 2 0.0065

2 0.0988

Period 3 Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

2 0.2150 2 0.0436 2 1.6481 2 1.0822 2 1.6047 2 0.8091

0.1926 21.3003 20.7712 21.2743 20.5147

21.5483 20.9871 21.5998 20.7440

0.4662 0.1091 0.7757

2 0.3952 0.2452

0.7414

Period 4 Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

0.0355 0.1138 0.0229 0.1046 0.0277 0.0701

0.0783 20.0130 0.0687 20.0081 0.0345

20.0920 20.0098 20.0863 20.0438

0.0811 0.0049 0.0479

2 0.0764 2 0.0343

0.0423

Period 5 Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

2 0.1301 2 0.0665 2 0.2300 2 0.0982 2 0.0180 0.0073

0.0728 20.0881 0.0387 0.1187 0.1425

20.1510 20.0309 0.0438 0.0671

0.1195 0.1947 0.2178

0.0747 0.0979

0.0232

Period 6 Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

2 0.2171 0.1162 0.1514 0.0606 0.1155 0.0619

0.3492 0.3850 0.2937 0.3486 0.2950

0.0323 20.0502 20.0006 20.0490

20.0830 20.0329 20.0819

0.0496 0.0012

2 0.0485

Overall Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

2 0.0578 0.0003 2 0.2544 2 0.1684 2 0.2403 2 0.1549

0.0597 20.1939 20.1085 20.1798 20.0956

20.2494 20.1650 20.2350 20.1527

0.0785 0.0144 0.0922

251

2 0.0648 0.0118

0.0777

Table AI. Jobson-Korkie statistics for three-month holding periods

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Table AII. Jobson-Korkie statistics for six-month holding periods

Market

Naı¨ve

MVP

Sharpe

BS I

BS II

Period 2 Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

2 0.1232 0.0778 2 0.0108 2 0.0101 0.0562 2 0.0317

0.2025 0.1145 0.1149 0.1814 0.0928

20.0875 20.0866 20.0215 20.1080

0.0006 0.0654 20.0209

0.0647 2 0.0214

2 0.0865

Period 3 Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

2 0.2150 2 0.2093 2 1.5758 2 1.0684 2 1.6088 2 0.8244

0.0437 21.2266 20.7588 21.2838 20.5340

21.3322 20.8514 21.4535 20.6312

0.4060 0.0223 0.6650

2 0.4243 0.2116

0.7256

Period 4 Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

0.0355 0.0689 2 0.0005 0.0559 2 0.0701 0.0317

0.0335 20.0363 0.0201 20.1057 20.0039

20.0704 20.0135 20.1392 20.0374

0.0561 20.0698 0.0327

2 0.1258 2 0.0241

0.1018

Period 5 Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

2 0.1301 2 0.0073 2 0.0971 2 0.0513 0.0211 0.0699

0.1283 0.0386 0.0827 0.1550 0.2015

20.0849 20.0416 0.0263 0.0721

0.0429 0.1112 0.1566

0.0681 0.1134

0.0456

Period 6 Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

2 0.2171 0.2196 0.2828 0.2115 0.2191 0.2121

0.4537 0.5175 0.4460 0.4532 0.4465

0.0559 20.0077 20.0004 20.0072

20.0636 20.0563 20.0631

0.0072 0.0004

2 0.0068

Overall Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

2 0.0578 2 0.0076 2 0.2105 2 0.1456 2 0.2387 2 0.1451

0.0520 20.1500 20.0859 20.1783 20.0859

20.1975 20.1348 20.2244 20.1351

0.0587 20.0253 0.0591

2 0.0849 2 0.0007

0.0851

Market

Naı¨ve

MVP

Sharpe

BS I

BS II

Period 2 Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

2 0.1232 0.1642 0.1078 0.1362 0.1428 0.1439

0.2890 0.2329 0.2613 0.2684 0.2688

20.0551 20.0271 20.0216 20.0191

0.0278 0.0333 0.0357

0.0054 0.0079

0.0025

Period 3 Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

2 0.2150 2 0.4724 2 1.5884 2 1.0037 2 1.4059 2 0.7397

20.2226 21.2674 20.7087 21.1595 20.4595

21.1557 20.5559 21.0090 20.2787

0.5396 0.2224 0.8632

2 0.4430 0.2465

0.8937

Period 4 Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

0.0355 0.0449 0.0458 0.0396 2 0.1132 2 0.0013

0.0093 0.0095 0.0035 20.1483 20.0370

0.0001 20.0059 20.1583 20.0462

20.0059 20.1599 20.0471

2 0.1537 2 0.0407

0.1119

Period 5 Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

2 0.1301 0.1611 0.1086 0.0967 0.1613 0.2162

0.2909 0.2360 0.2238 0.2911 0.3413

20.0467 20.0585 0.0002 0.0535

20.0115 0.0468 0.1001

0.0586 0.1116

0.0534

Period 6 Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

2 0.2171 2 0.0539 0.0647 2 0.0754 2 0.0537 2 0.0768

0.1743 0.2912 0.1538 0.1745 0.1525

0.1122 20.0198 0.0002 20.0212

20.1321 20.1119 20.1334

0.0201 2 0.0013

2 0.0214

Overall Naı¨ve MVP Sharpe Bayes-Stein I Bayes-Stein II Bayes-Stein III

2 0.0578 2 0.0459 2 0.1714 2 0.1144 2 0.1853 2 0.0944

0.0136 20.1113 20.0547 20.1260 20.0350

20.1209 20.0664 20.1341 20.0475

0.0527 20.0138 0.0727

2 0.0676 0.0187

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0.0873

Table AIII. Jobson-Korkie statistics for one-year holding periods

The Emerald Research Register for this journal is available at www.emeraldinsight.com/researchregister

The current issue and full text archive of this journal is available at www.emeraldinsight.com/1463-578X.htm

JPIF 23,3

The reporting of risk in real estate appraisal property risk scoring

254

Alastair Adair

Received October 2003 Accepted June 2004

School of the Built Environment, University of Ulster, Newtownabbey, UK, and

Norman Hutchison Department of Property, University of Aberdeen Business School, Aberdeen, UK Abstract Purpose – Aims to examine financial risk management. The UK valuation profession has been criticised for inconsistencies and failures to reflect risk and uncertainty in certain valuation assignments such as the pricing of urban regeneration land. Also the Investment Property Forum/Investment Property Databank specifically concluded that a new approach is needed which combines conventional analysis of returns uncertainty with a more comprehensive survey of business risks. This debate has been brought into sharper focus by the publication of the Carsberg Report, which emphasised the need for more acceptable methods of expressing uncertainty, particularly when pricing in thin markets. Design/methodology/approach – The paper commences with an examination of risk analysis within investment decision making and the property industry, drawing on the findings of the most recent literature that assesses the utilisation of risk management approaches. Findings – Financial risk management is examined and the workings of the D&B credit rating model illustrated. The paper explains the decision-making framework within which the property risk score is applied. Originality/value – The aim of this paper is to present an alternative paradigm for the reporting of risk based on techniques utilised within business applications. In particular it applies a standard credit-rating technique, based on the D&B model, to report the level of risk within property pricing – property risk scoring (PRS). Keywords Uncertainty management, Risk management, Real estate, Asset valuation, Property, Market value Paper type Literature review

Journal of Property Investment & Finance Vol. 23 No. 3, 2005 pp. 254-268 q Emerald Group Publishing Limited 1463-578X DOI 10.1108/14635780510599467

1. Introduction Risk and uncertainty are inherent parts of the valuation process as often the valuer is unable to specify and price accurately all current and future influences on the value of the asset. While the final single point estimate of value may become a statement of fact in the minds of the users of the valuation it nevertheless remains the opinion of an expert. Indeed the large number of academic and practice based studies into valuation variance confirm the subjective nature of property asset pricing (Adair et al., 1996). In those circumstances where risk and uncertainty are reported according to the RICS Appraisal and Valuation Manual (RICS, 1996) or Red Book the valuer can claim, with some justification, that best practice has been satisfied. However, despite such prescribed standards the profession has been criticised for inconsistencies and failures

to reflect risk and uncertainty in certain valuation assignments such as the pricing of urban regeneration land (Syms, 1996). In addition the Investment Property Forum/Investment Property Databank (2000) highlighted the need for more rigorous risk assessment measures within the property profession. More specifically they concluded that a new approach is needed which combines conventional analysis of returns uncertainty with a more comprehensive survey of business risks. This debate has been brought into shaper focus by the publication of the Carsberg Report (2002), which emphasised the need for more acceptable methods of expressing uncertainty, particularly when pricing in thin markets where information is deficient. To this end recommendation 15 of the report exhorts that professional bodies representing both valuers and end users should agree an acceptable methodology for reporting uncertainty within the valuation, which can be readily communicated to third parties. It is stressed that the methodology adopted must enhance the decision-making process and not confuse end users. Interestingly the term risk does not appear in recommendation 15 however an understanding of the difference between risk and uncertainty is central to rigorous investment decision-making (Knight, 1921; Hargitay and Yu, 1993; Byrne, 1996). The aim of this paper is to present an alternative paradigm for the reporting of risk based on techniques utilised within business applications. In particular it applies a standard credit rating technique, based on the D&B, formerly Dunn and Bradstreet, model to the determination of risk within property pricing – property risk scoring (PRS). The paper commences with an examination of risk analysis within investment decision-making and the property industry drawing on the findings of the most recent literature which assesses the utilisation of risk management approaches. Financial risk management is outlined as applied through the D&B credit rating model and a similar technique is applied to real estate through the development of a property risk score. The paper explains the decision-making framework within which the property risk score is applied and examples are advanced across each of the principal commercial sectors. 2. Risk and uncertainty in property pricing Investment decision-making is concerned with choosing optimal levels of both return and risk; the risk return trade off. Consequently the principal source of uncertainty is time as the forecasting of future events is difficult and becomes more unreliable as time elapses. Uncertainty arises therefore from a lack of knowledge and information and on this premise Hargitay and Yu (1993) construct a spectrum of uncertainty. The spectrum ranges from certainty (full knowledge) at one end to total uncertainty (lack of knowledge) at the other. In between there are two further points namely, risk and partial uncertainty. Risk is defined as a situation where alternative outcomes and their probabilities are known whereas in the case of partial uncertainty some of the alternative outcomes are known but not their probabilities. Risk and uncertainty are inherent parts of the valuation process. Property pricing as a form of investment decision-making seeks to ascertain the present value of future income and expenditure flows. In this context risk can be defined as the probability that a target rate of return will not be realised. In other words, it assumes that all outcomes together with their probabilities of occurrence are known. While the term

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uncertainty is sometimes used interchangeably and confusingly with risk, it however denotes situations where outcomes and their probabilities of occurrence are not known (Byrne, 1996; Hargitay and Yu, 1993; Knight, 1921). Such a significant distinction is of importance to both the valuer and the end user of the valuation if the correct investment decision is to be made. The premise underpinning the remainder of this paper is that the valuer must utilise this theoretical distinction between risk and uncertainty in order to advise on the former, but not the latter. A large part of the confusion between risk and uncertainty arises from interchangeable terminology. This ambiguity is demonstrated in the fourth edition of the RICS Red Book (RICS, 1996) Practice Statement 7.5.32 recognised that the valuation process contains an inherent degree of subjectivity which varies in different market conditions and by type of property. Practice Statement 7.5.32 further distinguished abnormal uncertainty, which the valuer must report as such, and normal uncertainty. Abnormal uncertainty arises when some aspect of the property or the market means that the valuer is unable to value with the normal or expected level of confidence. Examples of abnormal uncertainty were presented in the manual such as financial market turmoil or some legal difficulty related to the property. In reporting the valuation to the client full information should be presented so that the client can be fully informed of the degree of certainty and the valuer’s confidence in the reported figure. In some circumstances the Practice Statement noted that the valuer may choose to report a range of values to the client rather than a single figure, however, conventional practice indicates that valuers and lenders prefer the single point estimate. Within the context of Practice Statement 7.5.32, Mallinson and French (2000) have examined in-depth the reporting of normal uncertainty, which they refer to as uncertainty, to the client. Unfortunately, their analysis does not distinguish uncertainty from risk and while they accept that the estimation of value is about balancing probabilities (risk) and managing uncertainty the two terms are used interchangeably. In addition they contend that uncertainty can be identified and described in a rational way which will benefit the client and enhance the valuation. However, this assertion runs contrary to the accepted definition of uncertainty outlined above. In line with Practice Statement 7.5.32 they recommend that the valuer should, where necessary, expand on the context of the valuation highlighting the dynamics of the data and uncertainty relating to the inputs. Mallinson and French (2000) discuss the historical context of the debate highlighting that one of the principal objectives of the Mallinson report in 1994 was to improve the quality of valuation practice in particular communication between the client and the valuer. In this respect the 1996 Red Book seeks to lay down clear standards and guidelines which will assist both the valuer and the client in interpreting the valuation in the correct context. It is somewhat surprising therefore that the 5th edition of the Red Book (RICS, 2003) fails to clarify the distinction between risk and uncertainty and does not provide any guidance on this issue. Despite their failure to distinguish risk from uncertainty, Mallinson and French (2000) adopt a statistical approach to the resolution of the issue. They contend that the valuation of a prime property in perfect condition let at a provable open market rental value will generate a considerable spread of values. In order to assist the valuer they recommend that the range of values should be thought of as a bell curve comprising the lowest and the highest estimates of value and somewhere between these the most probable or likely market value. The shape of the curve and more particularly the point

at which the valuer places the market value figure contains significant information about the valuer’s perception of the market. They present a model for describing uncertainty which in reality measures risk. Their model is based on six items of information which in their opinion must be conveyed in a valuation namely: (1) the single figure estimate; (2) the range of the most likely observation; (3) the probability of the most likely observation; (4) the range of higher probability; (5) the range of 100 per cent probability (in other words the full measure of risk); and (6) the skewness of probabilities. In relation to the range of the most likely observation it is recommended that the valuer should set the upper and lower figure within a fairly tight limit of 2.5 per cent to 5 per cent either side of the single figure. In terms of reporting the value to the client, Mallinson and French (2000) argue that a single figure at the end of an extensive valuation report is potentially misleading and unhelpful. They further argue that reporting a single figure makes the valuer unnecessarily defensive if the property transacts at a different figure or the valuation is challenged. In contrast the reporting of a range of values, which recognises the inherent uncertainty within the valuation, would they argue contain information potentially valuable to both clients and valuers. Hutchison and Nanthakumaran (2000) examine issues relating to market efficiency, individual and market worth, and risk analysis. They argue that by explicitly focussing on the risks associated with the estimation of the variables valuers and investors obtain a better understanding of the nature of the investment and the range of the outcomes. The risk of mispricing in the property market primarily arises from differential access to available information or from the inefficient use of the information. All valuations are subject to uncertainty therefore the main problem with the approach is the accuracy of the estimates. Errors in the estimation of rental values and discount rates tend to exacerbate errors in the calculation of worth especially when longer holding periods are used. The assessment of the discount rate is usually based on the nominal risk free rate of return plus a risk premium. Whereas in the stock market, pricing models have been developed to identify the required rate of return from risky investments, a risk premium of the order of 2 per cent is usually suggested for property. While this figure may apply to the market as a whole, at the individual property level the premium will vary depending on the risks attached to the cash flows. In the absence of a robust pricing model and data limitations it is likely that discount rates for property will continue to be estimated subjectively. Consequently errors in the estimation of discount rates tend to exacerbate the error in the worth calculation especially when longer holding periods are used. The Investment Property Forum/Investment Property Databank (2000) highlighted the need for more rigorous risk assessment measures within the broad property investment industry comprising asset and fund managers and advisors. More specifically they concluded that a new approach is needed which combines conventional

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analysis of returns risk with a more comprehensive survey of business risks. In effect they are calling for a better toolkit of risk analysis techniques. Conventionally valuers appear to be unwilling to utilise the wide range of statistical techniques for reporting risk primarily on the grounds that these would be confusing to clients. In the IPD study a simple three-stage approach to modelling property risk is utilised. First, risks are identified at three levels namely, the asset level, at the portfolio level and in blending property into a mixed-asset class investment strategy. Second, the individual risks are measured or assessed either through quantification or less formally at the level of the individual asset, the portfolio or potentially the mixed-asset class investment vehicle. Third, some of the risks identified are subject to explicit management control. The survey sought to analyse controls applied at this third stage. Conventional investment theory focuses most attention on the first and second stages namely risk identification and measurement whereby the total risk of an asset or a portfolio is normally equated with the volatility of its long run returns. Volatility is quantified through the measurement of variance or standard deviation. The 124 respondents identified a total of 1,590 specific property, portfolio or wider risks which were reduced down to 57 separate varieties. The most widely shared concerns were the income security of the properties held and related lease structure and tenant covenant strength factors. The next highest risk identified was that of functional/economic obsolescence. The most utilised methods of formal assessment or precise measurement of risk was an annual risk appraisal followed by tenant credit rating. Modern portfolio theory utilises the capital asset pricing model to define risk for the purposes of measurement and management. Total risk is partitioned into systematic risk (market risk) and unsystematic risk (specific components). The most significant market risk identified in the study relates to the scarcity of information at the local market level. More than half the risks identified as specific risks were located at the asset rather than the portfolio level. The study notes that there is a dearth of measurement and management methods available through which to process the rich variety of specific risks. Current risk analysis appears to be imposing a sort of “funnel restraint” through a highly restricted and perhaps inappropriate set of measurement and management techniques. While trends indicate that fund managers are becoming more strategic in their approach, adopting risk analysis techniques utilised by business particularly in the equities market, the property market is becoming more heterogeneous and more complex. Consequently it is likely that market advisers including valuers will require more powerful risk assessment and control methods. The study recommends that a much tighter measurement framework is required that is designed to operate initially at least at the level of the individual asset rather than one drawn from conventional theory which operates primarily at the portfolio level. Such an approach would be enhanced if it could be combined with a more open and flexible decision-tree approach to the aggregation of individual asset risks, which is routinely applied for business risk management. In relation to specific property risks the approach could involve the rigorous attachment of risk scores to key property attributes such as lease profiles, covenant strength levels, void rates and lease renewal probabilities. The Carsberg Report (2002) has brought the debate about risk into shaper focus in particular the reporting of the valuation to end users. While Carsberg uses the terms uncertainty it is in effect referring to risk, which is identified as a normal market

feature that varies by type of property and market location. The report accepts that all valuations are an estimate appropriate to the valuation definition and that courts and tribunals across the world recognise the risk as attaching to this figure. Carsberg supports the Red Book requirement for the valuer to report a single figure of value rather than a range but at the same time, if it is material to the client, reporting on the risk attaching to this figure. Analysis of legal cases indicates that a margin of error exists within which the valuation can vary without being considered negligent. As risk is present in all valuations it must therefore be managed. The issue arises as to how the risk is communicated to the client. Carsberg identifies the complexity of this issue drawing from an earlier debate in the Mallinson Committee in 1994. The report emphasises the need for more acceptable methods of expressing risk, particularly when pricing in thin markets. To this end recommendation 15 of the report exhorts that professional bodies representing both valuers and end users should agree an acceptable methodology for reporting risk within the valuation, which can be readily communicated to third parties. It is stressed that the methodology adopted must enhance the decision-making process and not confuse end users. In reality the failure to set risk within a proper theoretical framework which distinguishes it from uncertainty is likely to be more confusing to both valuers and clients. While quantitative techniques have been taught for a long time in property courses valuers still appear to be reluctant to utilise and report statistical measures of risk. In these circumstances the authors of this paper argue that a new approach is required. This paper now presents an alternative paradigm for the reporting of risk based on techniques utilised within business applications. In particular it applies a standard credit rating technique, based upon the D&B model, to the determination of risk within property pricing – property risk scoring (PRS). 3. The D&B model D&B UK Ltd are a wholly owned subsidiary of D&B Corp. and are the largest commercial rating company in the UK. In 2001, the D&B UK database held records of 3.2 m active businesses and dormant companies. In producing their ratings and credit recommendations D&B rely on a wide range of data sources to inform their decision-making. These are summarised in Table I. D&B produce a financial strength rating and a risk indicator for every business that is trading in the UK. The ratings may be solicited or unsolicited. The main difference is that a solicited rating is a cooperative process, in that the issuer provides information of both a public and a confidential nature, whereas an unsolicited rating relies almost exclusively on information which the agency is able to compile on its own, typically information in the public domain. (Fight, 2001) The financial strength rating, which is based on the financial statements of the business, is divided into bands as shown in Table II. The D&B risk indicator, which is the key interest of this paper, is based on a four-point scoring system, 1 to 4, which represents risk of failure over the next 3-12 months. The categories are as follows: . 1: minimal risk; . 2: low; . 3: greater than average;

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Source

Type, use and approximate volume of data

Electoral roll Bank data Telephone numbers D&B call centre Customer files Royal Mail London and Edinburgh Gazettes and other official sources

Director address verification Verification of information supplied Verification of information supplied 6,000 business interviews per day Data matches and new records 4,000 postcode changes p.a. Liquidations, receiverships, administrations, bankruptcies, petitions, detrimental notices, (estimated at 35,000 p.a.) 350,000 judgments p.a. 12,000 newsworthy events p.a. 3.9 m references p.a. 24,000 debts placed for recovery p.a. 1.6 m companies (975,000 active) 1.1 m financial statements 2.6 m directors’ names and addresses 7 m directorships and associations 1.1 m shareholder statements 1.2 m company secretaries 350,000 mortgages and charges

County Courts News and Media Payment experiences Companies House

Table I. Examples of D&B main data sources

Table II. Financial strength bands

Source: D&B (2002)

Band

Financial strength based on tangible net worth

5A 4A 3A 2A 1A A B C D E F G H N O NB NQ

£35 million þ £15 million to £34 million £7 million to £15 million £1.5 million to £7 million £700,000 to £ 1.5 million £350,000 to £700,000 £200,000 to £350,000 £100,000 to £200,000 £70,000 to £100,000 £35,000 to £70,000 £20,000 to £35,000 £8,000 to £20,000 £0 to £8,000 Intangible net worth No net worth New business Not quoted – ceased trading . .

4: high and – : insufficient information.

Underpinning this 1 to 4 “headline score” is a 1 to 100 failure scorecard. The latter is based on a statistical model, which attributes weightings to different company characteristics. Data on tens of thousands of companies are included in the database,

with at any one time around 1.5 per cent of the database, being information on companies which have failed. Every item of available data is recorded and the model then tries to identify which items of data are predictive of failure. The aim is to correlate information which has led to either final unfavourable closure or the start of legal proceedings which have led to closure. D&B indicate that around 30 to 40 pieces of data are represented on the failure scorecard at any one time. D&B stress that they are not attempting to predict voluntary closure but only occasions where debt has been left behind. Examples of the type of data which have shown to be a significant indicator of risk of failure include the age of principals in a company, levels of association with failed businesses and changes in payment habits. The failure score is translated to the headline score using the conversion chart outlined in Table III. The statistical model accounts for 95 per cent of the assigned ratings with a further 3 per cent based on expert rules (e.g. detrimental auditors report) and 2 per cent based on manual ratings (e.g. following mergers and acquisition). The ratings are dynamic and updates are triggered by the emergence of new data. The database is updated on a monthly basis for ageing measures such as whether the accounts are now overdue. To illustrate the type of ratings produced, detailed below are the financial strength ratings and risk indicators for four UK companies as at 1 May 2002 (Table IV).

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4. Application of the D&B model to property Theoretically the conventional measure of a single asset’s risk is the standard deviation of the distribution of future returns. Because the future return distribution is not directly observable, the volatility of future returns must be estimated. A standard approach is to measure the volatility of past returns and assume that the future will resemble the past (Hendershott and Hendershott, 2002). Alternatively, estimates of Failure scorecard

“Headline” 1 to 4 risk rating

86 to 100 51 to 85 16 to 50 1 to 15

Company

1 2 3 4

D&B rating Explanation

Specsavers Optical Superstores Ltd

3A1

Carphone Warehouse Ltd

5A3

Starbucks Coffee Holdings (UK) Ltd

N3

Dixons Group Holdings Ltd

5A2

Source: D&B (2002)

Table III. Failure score conversion chart

A financial strength of £7-£15 million and an overall condition which is strong (minimal risk) A financial strength of £35 þ million and an overall condition which is fair (slightly greater than average risk) A financial strength which is negative and an overall condition which is fair (slightly greater than average risk) A financial strength of £35 þ million and an overall condition which is good (low risk)

Table IV. Financial strength ratings and risk indicators for four UK companies

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future volatility can be generated from forecasts. The analysis of past returns may be relatively easy for those standing investments which have been held in a portfolio for some years. The net income will be known and it is likely that regular capital valuations will have been undertaken, thus enabling the total return to be calculated. However, where a new property asset is being acquired, information on past performance may be difficult to obtain with any degree of accuracy and this is especially true in secondary and tertiary property markets. Thus, it is questionable whether there is sufficient data to consistently calculate the standard deviation of returns for each property in the market. Partial reporting would not seem a satisfactory outcome. Moreover, the Carsberg report recommended that the methodology adopted for reporting uncertainty and risk within the valuation must be readily communicated to third parties, enhance the decision-making process and not confuse end users. This paves the way for the introduction of a risk scoring system, which would be easily understood and be applicable across all property. 5. Property risk scoring Property risk scoring (PRS) as proposed in this paper, involves the analysis and scoring of the total risk of a property asset, which is then reported to the client under the following four key headings: (1) market transparency risk; (2) investment quality risk; (3) covenant strength risk; and (4) depreciation and obsolescence risk. These headings were chosen based on the findings of the Carsberg Report (2002) and of the Investment Property Forum/Investment Property Databank (2000). Both indicated that these headings were the areas of greatest concern. In the design and implementation of PRS, three key concepts are crucial: (1) calibration; (2) consistency; and (3) validity. Calibration PRS builds on the D&B model by adopting a five-point scoring system, 1 to 5, which represents the risk assessment at the particular time when the investment decision is made. The categories are as follows: . 1: minimal risk; . 2: lower than average risk; . 3: average risk; . 4: greater than average risk; . 5: high risk; and . – : insufficient information. Informing the score will be all the risks inherent in the property asset. These are, of course, implicit in the “all risk yield” which is used to capitalise the net income in

perpetuity in the conventional approach to valuation. The intention here is to make the risk components explicit. As with the D&B model, underpinning the 1 to 5 headline score for each heading, will be a “risk scorecard”. The compilation of the risk scorecard requires extensive consultation with the valuation community in order that the components of the scorecard and their calibration are agreed. The latter could be based on a statistical model, which would attribute weightings to the different characteristics of the property asset. The calibration of the weightings would be based on the views of the valuation/investment community on the level of risk associated with each specific characteristic and these views would need to be updated regularly as attitudes change. If this statistical approach was thought too difficult to implement then varying degrees of sophistication are possible in order to produce a scorecard which will adequately reflect the risk components of the property. For example, under the investment quality risk heading, an upward only rent review clause and a full repairing and insuring lease will score highly, indicating lower risk. It is not thought appropriate or desirable to attempt to amalgamate the four separate headline scores into one overall risk score, due to the potentially differing ways that the four separate risk scorecards may be calibrated. Such amalgamation could result in a misleading overall score. Consistency In order to gain acceptance by the valuation and client community, PRS must produce consistent results. The PRS model must be designed in such away that it can be adopted by both large and small practices. Whatever the sector or location of the property, for example, retail or office, urban or rural, prime or tertiary, PRS must produce consistent results which the client can both understand and trust. Such consistency would best be achieved if PRS was to become an integral part of the RICS Red Book. A relatively simple model will assist client understanding, and some form of client briefing note would aid its initial implementation. Validity The risk scorecard must accurately record what it purports to record – current risk perception in the market place. To remain accurate the emphasis placed on particular risk characteristics will need to be regularly reviewed. This may well be a role for the Valuation Faculty or Property Valuation Forum. Importantly, it needs to be understood that PRS is not attempting to evaluate whether or not the market price valuation is “correct”, based on a comparison with a calculation of worth or a review of the returns some time in the future. PRS is recording current risk perception to assist the client fully understand the current state of the market for the subject property and its unique attributes. Some of the characteristics which are likely to be included under each heading, are detailed below. Market transparency risk This heading is a direct consequence of the Carsberg Report which emphasised the need for more acceptable methods of expressing risk, particularly when pricing in thin markets. The volume and currency of transaction evidence reflects the vigour of the

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market and is often dependent on the phase of the property cycle. The academic literature (e.g Brown and Matysiak, 2000) points to the trade-off between reducing comparable sample error, the number of directly comparable transactions, and comparable lag error, the currency of the transactions. The Carsberg Report cites a specific example of the risk created by market transparency. The case is where a portfolio is valued on two occasions. On the first occasion the market is dynamic with abundant transaction evidence and the valuer can be confident of the value figure to within 5 per cent or less. In contrast on the second occasion the market is flat with sparse information therefore the risk is greater. Under this heading valuers would be able to indicate whether there was a plentiful supply of comparable evidence, a score of 1, or whether the valuation was carried out with little transaction evidence, a score of 5, indicating the additional risk of mispricing. The score will reflect the market sector and the range of evidence normally available together with the impact of the property cycle. Thus, the risk scorecard will be a function of time and the volume and quality of evidence. Investment quality risk The principal risk factors for a property investment are outlined by Hoesli and MacGregor (2000) and comprise falling net rent, unexpected repair costs, capitalisation rate rises, lower expected income growth and illiquidity. Many of these significant factors arise from transformations in the nature of work which alter the demand for business space. Consequential changes arise in the aggregate level of demand, in the location of that demand, in the physical nature of space required and in the type of occupation desired by firms. Lizieri et al. (1997) examined each of these aspects of change. Changes in lease structure have arisen from an over-supplied market in the 1990s as well as the growth in serviced offices. During the first half of the 1990s average lease lengths have fallen from around 25 years to approximately 15 years. Overall standardisation in terms of traditional lease structure has been replaced by diversity and variety. The principal factors considered to influence the investment quality are outlined below and it is likely that these would need to be included in the risk scorecard. . income security; . rental growth; . lease length; . rent review clause; . user clause; . repairing obligations; . location (prime, secondary etc.); . sector bias; . liquidity issues; . management issues; . overall economic context; . national market factors; . local market factors;

. . . . . .

yield level/shift; asset volatility; lettability; business risk; legislative risk; and void period risk.

Covenant strength risk Previous research by the authors (Adair et al., 2001), questioned whether valuers were using all the available market information on credit worthiness to properly evaluate covenant strength. As much of investment valuation centres around cash flow risk, it would seem vital that the valuer makes every effort to fully acquaint themselves with the covenant strength of the party contracted to pay the rent. It is accepted that lease arrangements may not be straightforward and may, for example, include parent company guarantees or assignments but as the valuer has to take a view on cash flow risk, to value the property, it must surely aid the design making process of both the valuer and the client, to fully investigate the financial standing of the tenant. The authors deduce that at the present time the profession is not silent on this matter and that where only limited investigations are done on covenant strength this is reported to the client as matter of course. It is anticipated that covenant strength risk information will be obtained directly from a credit rating agency such as D&B. It is recognised that this is a direct cost to the valuer which would need to be passed onto the client in the form of a higher fee. This should not be a problem where the valuer is being asked to undertake a single valuation, for say the purchase of a property, as the valuer is offering an improved service which the client should be prepared to pay. However, cost recovery may be more problematic where the valuer has been requested to prepare a year end valuation of a portfolio of properties for an overall fee and increasing the fee may lead to the loss of the instruction. This may result in a two-tier level of report, with or without PRS. That said, if the reporting of covenant strength risk was a Red Book requirement, all valuations firms would be faced with the same level of overhead recovery on this item, thus having a neutral impact on fee competitiveness. Depreciation and obsolescence risk Hoesli and MacGregor (2000) note that of all the variables in the valuation framework depreciation has the least precise meaning in everyday usage. Consequently the terms depreciation and obsolescence are often used interchangeably. Depreciation can be defined through its effects in terms of a reduction in rental or capital value. A second definition of depreciation offered by Hoesli and MacGregor (2000) relates to the proportion of stock which is removed from the market. The removal of stock from the market may lead to redevelopment of the site. This second definition incorporates the concept of age or vintage of the stock which tends to become obsolete over time or due to changes in business practices and technology. The two broad causes of depreciation are identified as “deterioration” which is directly linked to the passage of time, wear and tear or the impact of environmental factors, and “obsolescence” which is defined as

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a decline in utility not directly linked to physical usage or environmental factors. Hoesli and MacGregor (2000) further argue that much of the utility of a property comes from the location of the site which can also be affected by depreciation. Changes in business organisation and activity have been examined in detail by Lizieri et al. (1997). Such changes include greater locational flexibility; a focus on core business with outsourcing of ancillary services, delayering and downsizing; greater use of telecommuting, hot-desking and homeworking; a shift towards team-working and separation of administrative functions into satellite offices such as call centres. Each of these represent a significant source of obsolescence particularly in the office market. Table V lists the risk factors which may need to be considered when evaluating the risks associated with depreciation and obsolescence. 6. Conclusions Risk is recognised as an inherent element within the valuation process and in the absence of perfect data across the property market it is likely that this situation will pertain to varying degrees. If risk cannot be eliminated the valuer is required to manage the analysis of risk within the valuation process so that its impact is minimised and the end user of the valuation can have confidence in the value estimate. The literature indicates that the overall management or control of risk can be broken down into discrete activities namely, identification, measurement, management and reporting. The literature further indicates that there are significant shortcomings in current valuation practice across each of these aspects of risk management and control. The current debate has been fuelled by two major reports into the application of risk analysis within the property investment industry. The first report undertaken by Investment Property Forum/Investment Property Databank (2000) focused primarily on the identification, measurement and management of risk. The key finding of the research is that the property industry needs a more powerful risk assessment and management toolkit. A new approach is required which combines a conventional

Table V. Depreciation and obsolescence risk

Office

Retail

Industrial

Wear and tear of building fabric Declining neighbourhood Environmental factors Contamination Obsolete plant Air-conditioning Changed layout e-wiring Changed location Outsourcing Downsizing Restructuring Business process re-engineering Hot desking Home working Team working

Wear and tear of building fabric Wear and tear of building fabric Declining neighbourhood Declining neighbourhood Environmental factors Environmental factors Contamination Contamination Obsolete plant Obsolete plant Air-conditioning Air-conditioning Changed layout Changed layout Changed location Eaves height Changed location Outsourcing Downsizing Restructuring Business process re-engineering

analysis of returns risk with a more rigorous treatment of business risks flowing from the property asset. The second report (Carsberg Report, 2002) concentrated on the reporting of the value estimate to the client and concluded that a more acceptable method is employed which enhances the decision-making process and does not confuse end users. This paper builds on the findings of these two reports by applying a business risk management model in order to enhance the analysis and reporting of property investment risk to end users. Credit rating models as a measure of investment risk are well known in the business world. The D&B risk indicator is a widely accepted and dynamic measure of business risk which is based on a four point scoring system. The simplicity of the scoring system enhances the communication of business risk to end users. This paper adapts the D&B model through the application of a four point property risk score encompassing the principal dimensions of real estate risk namely market transparency, investment quality, depreciation and obsolescence and covenant risk. The paper explains the decision-making framework within which the property risk score is applied and examples are advanced across each of the principal commercial sectors. The next stage of the research will involve the development of the property risk score to arrive at an accurate scoring of each of the individual risk factors. The initial focus will comprise a practical perspective involving structured discussions with key market participants in order to determine the scoring methodology and the feasibility of its implementation for both valuers and end users. A rigorous methodology will be achieved through a focus group or panel discussion with selected experts in the valuation profession. Key outputs will focus on the form of the scoring system whether a subjective 1-5 point score or a more detailed composite figure and its application across differing market conditions and property types. The detailed composite figure is likely to involve the application of a statistical approach comparable to that utilised by the D&B model. One particular area of concern is the calibration or scaling of the risk factors which may be employed by different valuation firms. In the same way that different credit rating firms employ different rating scales a similar situation may arise for valuation firms. However, the fact that the majority of valuations are undertaken by a few major firms, the top five being responsible for undertaking 79.6 per cent of the valuations for the IPD Monthly Index (Carsberg Report, 2002), is likely to reduce significantly the degree of variability. Another area of concern relates to the measurement of covenant strength and in this respect the utilisation of credit worthiness ratings and other available data will be assessed. Overall it is believed that the property risk score represents a potential method of applying a business risk indicator which is simple for end users to understand thereby fulfilling part of the objectives of the Investment Property Forum and Carsberg reports.

References Adair, A.S., Hutchison, N.E. and Burgess, J. (2001), “The valuation of urban regeneration land: a contemporary perspective”, European Real Estate Society Conference, Alicante, Spain. Adair, A.S., Hutchison, N.E., MacGregor, B.D., McGreal, S. and Nanthakumaran, N. (1996), “An analysis of valuation variation in the UK commercial property market”, Journal of Property Valuation and Investment, Vol. 14 No. 5, pp. 34-47.

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Brown, G.R. and Matysiak, G.A. (2000), Real Estate Investment: A Capital Market Approach, Financial Times Prentice Hall, Harlow. Byrne, P. (1996), Risk, Uncertainty and Decision Making in Property Development, 2nd ed., E. & F.N. Spon, London. Carsberg Report (2002), Property Valuation, The Royal Institution of Chartered Surveyors, London. D&B (2002), High Wycombe. Fight, A. (2001), The Ratings Game, J. Wiley & Sons, Chichester. Hargitay, S.E. and Yu, S. (1993), Property Investment Decisions: A Quantitative Approach, E.&F.N. Spon, London. Hendershott, P. and Hendershott, R. (2002), “On measuring real estate risk”, Real Estate Finance, Vol. 18, pp. 35-50. Hoesli, M. and MacGregor, B.D. (2000), Property Investment, Longman, Harlow. Hutchison, N.E. and Nanthakumaran, N. (2000), “The calculation of investment worth”, Journal of Property Investment & Finance, Vol. 18 No. 1, pp. 33-51. Investment Property Forum/Investment Property Databank (2000), The Assessment and Management of Risk in the Property Investment Industry, Investment Property Forum/Investment Property Databank, London. Knight, F.H. (1921), Risk, Uncertainty and Profit, Kelley, New York, NY. Lizieri, C., Crosby, N., Gibson, V., Murdoch, S. and Ward, C. (1997), Right Space: Right Price?, The Royal Institution of Chartered Surveyors, London. Mallinson, M. and French, N. (2000), “Uncertainty in property valuation”, Journal of Property Investment & Finance, Vol. 18 No. 1, pp. 13-32. RICS (1996), Appraisal and Valuation Manual, Royal Institution of Chartered Surveyors, Incorporated Society of Valuers and Auctioneers and Institute of Revenues Rating and Valuation, London. RICS (2003), RICS Appraisal and Valuation Standards, Royal Institution of Chartered Surveyors, London. Syms, P. (1996), “Perceptions of risk in the valuation of contaminated land”, Journal of Property Valuation & Investment, Vol. 15 No. 1, pp. 27-39.

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PRACTICE BRIEFING

An investigation into the expression of uncertainty in property valuations

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Alexander Joslin Savills Commercial Ltd, London, UK Abstract Purpose – Valuation is a “snapshot” in time. It is an assessment of the market price at a single point in time. It is an estimate and any estimate is uncertain. This paper aims to investigate how the property profession conveys this uncertainty to their clients. Uncertainty must be dealt with in a professional manner in order to offer a reputable service to the general public. It is argued that uncertainty must be expressed within the valuation to offer each party a thorough understanding of the circumstances that surround that particular valuation. It is suggested that the Royal Institution of Chartered Surveyors (RICS) should develop a standard approach to uncertainty expression, not only for the valuer’s peace of mind, but in order to offer the best possible service to the general public. Design/methodology/approach – The paper reports the findings of a survey of valuers from leading practices throughout the UK. Examples of uncertainty are included in order to highlight the key issues within the discussion. Findings – The concept of uncertainty within a valuation is poorly understood and is rarely conveyed to the client in any coherent form. Originality/value – “What additional information does one need a valuer to provide, apart from the figure of his valuation?” In the majority of cases, the valuer’s expression of uncertainty is integral, whereby one must express the amount of uncertainty present when undertaking a valuation. In order to offer a client an accurate valuation, the valuer should make clear the background to the value presented and offer evidence about which factors may affect the figure, with regard to variation. Keywords Uncertainty management, Assets valuation, Market value Paper type General review

Introduction In 1994, the Royal Institution of Chartered Surveyors (RICS) published the Mallinson Report (RICS, 1994). The main content of the report was to assess the, then, current valuation practices and to recommend a number of changes that would allow the valuer to offer an enhanced service to the client. The Mallinson Report was a response to the general criticism, post the property crash of the late 1980s, that valuations in many cases have been unsupported and insubstantial. A valuation is a “snapshot” in time and is an estimate of market price. As such, it is uncertain. Unless a property is actually sold to determine market price, any estimate is uncertain. The role of the valuer is to assess current market conditions and from a “sea of uncertainty” produce a single judgement (RICS, 1994, p. 14). Depending on both the property and the market, valuers will be more or less certain about the valuation. A valuation is based on probability of outcome and the corollary of this is uncertainty of

Journal of Property Investment & Finance Vol. 23 No. 3, 2005 pp. 269-285 q Emerald Group Publishing Limited 1463-578X DOI 10.1108/14635780510599476

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output, the valuation figure. Recommendation 34 of the Mallinson report specifically addressed this issue by stating: Common professional standards and methods should be developed for measuring and expressing price trends and expressing uncertainty.

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How should probability or uncertainty be expressed? The Mallinson Report concluded that in most cases an indication of valuation variability is favoured within the context of a single figure of valuation. One of the principal criticisms that was addressed by the Mallinson Report was that valuers generally failed to provide credible explanations of the valuation figure. They were reluctant to give crucial background information such as market assumptions or the dynamics of the market at the time of the valuation. A response to this failing would be to introduce a set standard for the expression of uncertainty. French and Mallinson (2000), argued that these failings would be overcome if valuers had a common technique for reporting uncertainty: The solution must lie in the creation of some format description, accepted as a norm, which conveys the essence with simplicity, but is capable of expansion and interpretation. This would need to be presented in a prescribed professional standard, and would always be appended to the valuation figure.

It would appear obvious that the industry needs to strive to make the expression of uncertainty part of the valuation process, not something that is merely mentioned at the end of a conversation of dropped subtly into a meeting summary. If action is to be taken, the subject area must be thoroughly investigated and a plan of action devised. The most recent study relating to property valuation was the RICS Carsberg Report (RICS, 2002a). Like the Mallinson Report, the Carsberg Report raises issues and concerns about the industry and finally makes a number of recommendations. Recommendation 15, refers to uncertainty and reads: RICS should commission work to establish an acceptable method by which uncertainty could be expressed in a manner which will be helpful and will not confuse users of the valuation. RICS should also seek to agree with appropriate representative bodies of those commissioning and using third party valuations the circumstances and format in which the valuer would convey uncertainty.

In the formal response to the Carsberg Report (RICS, 2002b), it was stated: At present, the valuer can readily express this [uncertainty] to a single client, but there is no robust and understood mechanism for him to do so. . . therein lies the scope for misunderstanding. The RICS feels unable to recommend a particular method for reporting uncertainty around the single valuation estimate, but it considers that clients deserve more information than they normally receive at present.

This response would suggest that individual valuers must take the issue into their own hands and offer the client what they feel is their best price estimate. The subject of expressing uncertainty is a complex topic and there are many arguments for and against it, however it is now well established that it plays an important role in valuation. One must consider the client’s needs and the importance of being told not only the valuation, but also the factors that impact on the valuation.

The research This research project, “Uncertainty expression in valuations” is an extension of the work carried out in the RICS Mallinson Report and will primarily answer the following questions: . What exactly is uncertainty pertaining to valuations? . How should uncertainty be categorised? . How should uncertainty be expressed? . Should there be a universal approach to the expression of uncertainty? . Should the expression of uncertainty be a mandatory act? . Can and should a client accept a professional’s view on uncertainty? The principal aim of the research project is to get an insight into the risk involved in commercial property valuations and how valuers currently address the issue in their valuation reports. Uncertainty in valuation What is uncertainty? “There are optimistic valuers and there are pessimistic valuers” (Brett, 1990, p. 60). In other words not everyone would put the same value on something; valuation is a personal opinion and can vary from valuer to valuer. Scarrett (1991, pp. 113 – 14), states: The valuer aims for accuracy in valuation although it is well accepted that valuation is based on interpretation and opinion, and the view of one competent valuer is not necessarily the same as that of another equally competent valuer.

This suggests that in general everybody associated with valuation, whether a valuer or client, knows of the inherent risk of valuation. Principally the valuer must offer an explanation within the valuation report, which would contain an expression of uncertainty surrounding the particular case. “Identifying uncertainty is not an escape route from responsibility” (RICS, 1997, p. 26). It is merely the valuer’s way to explaining that the outcome is not an exact figure of value and could be subject to increase or decrease depending on market performance. There are three principal ways of dealing with the issue of uncertainty (Enever and Isaac, 2002): (1) ignore it; (2) express it verbally; and (3) express it numerically. The most obvious explanation of uncertainty is a clause before or after the valuation figure explaining the outcome is subject to market conditions at the time of sale. Indeed, in the 2003 edition of the RICS Appraisal and Valuation Standards (Red Book), UK Guidance Note 5 address the issue of uncertainty in valuation. In this guidance it states that: All valuations are opinions of the price that would be achieved at the valuation date. The degree of certainty will vary significantly. These variations can arise because of the inherent features of the property, the market place or the in the information available to the valuer. Where uncertainty could have a material effect on the valuation, the valuer should draw attention to this, indicating the cause of the uncertainty and the degree to which this is reflected in the reported valuation.

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Yet, contrary to the recommendations of Mallinson and Carsberg, there is no suggestion of a standard way of reporting this uncertainty to the client. By inference, the Guidance note is suggesting that the valuer reports uncertainty in valuation to the client in a form of words within the report but it does not suggest an acceptable form of words nor any prescribed format for the measurement of the said uncertainty. For a full discussion on the possible forms for expressing uncertainty in valuations, see French and Gabrielli (2004, 2005). This paper concentrates on a survey of valuers in the UK to determine how valuers currently express valuation uncertainty in their valuation reports. Questionnaire survey A questionnaire survey of 100 valuers in the UK was undertaken in the summer of 2003. The survey was divided geographically and by size of company. The areas of study chosen were areas which have witnessed major property value fluctuations within the preceding 12 months. These areas were: . North East England; . Edinburgh, Scotland; . South East; . South West England; and . London. Firms (1) (2) (3)

and individuals were divided into three main categories: Small – individual, 1-5 members of staff. Medium – 5-50 members of staff. Large – 50 þ members of staff.

The questionnaire universe was divided equally between each category in order to get a broad view from the industry’s professionals. A total of 100 questionnaires were sent out and five one-to-one interviews carried out. The questionnaire .

.

. .

.

. .

Do you think it is possible for a valuer to be totally accurate to open market sale price? Do you feel that there is uncertainty present during valuations? What factors affect a valuations certainty? Do you, as an individual or company express uncertainty? If so, how do you express this uncertainty? (Personal comment) Does your firm have a standard form of expression? Valuations are only as accurate as the evidence on which they are based. Do you feel it is possible to get sufficient evidence in any particular case to have a totally accurate valuation? Why? What happens when there is no real evidence? Does one rely on assumptions? A valuation is a valuer’s estimate of value, subject to a set of assumptions. Which types of assumptions have to be made during valuations? Do you think they should be standardised by the RICS or valuation forum?

. . .

.

.

How accurate are your valuations? (Personal comment). Have you ever had a client(s) complain about a valuation’s accuracy? If so, why? Do you think that there is adequate support on expressing uncertainty in valuations, for instance from the RICS? Why? Do you feel it is acceptable to express valuations within a certain tolerance, such as 5 per cent, 10 per cent or 15 per cent? If so, should this be standardised throughout the industry? Would you like to see more guidance on the expression of uncertainty in valuations available from the RICS? Why?

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The questions above produced both “qualitative” and “quantitative” data. The “qualitative” data consists mainly of key quotes taken from the interviews and questionnaires indirect questions, which asked for a comment rather than a simple “yes” or “no”. They are compared and contrasted with the results from the quantitative analysis to give a general overview in the analysis. The “quantitative” data is principally an opinion put into a numeric presentation model; this would be in response direct, yes or no type questions in a questionnaire or during an interview. A pie type graph clearly reveals any patterns and obvious trends. These results are compared with the qualitative results during the analysis. The quantitative data is classed as nominal or categorical data (classification) and ranked or ordinal data (comparison). Question 1 Do you feel it is possible for a valuer to be totally accurate to open market sale price? – Quantitative (yes/no) Figure 1 shows clearly that the majority of the candidates are realistic and do not feel valuers are able to be totally accurate with 83 per cent of candidates indicating “No”. This does not mean to say a valuer cannot be accurate in the slightest, it just means that 100 per cent accuracy is almost impossible. This is a significant result because the uncertainty has to be expressed. It is interesting to point out that two of the candidates that indicated yes to being totally accurate work for the same company, under different names and at different locations.

Figure 1.

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Question 2a Do you feel that there is uncertainty present during valuations? – Quantitative (yes/no) The results for this question are very convincing; with every candidate indicating that there is definitely uncertainty present during valuations (see Figure 2).

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Question 2b Factors that affect a valuations certainty: (1) Comparable evidence: . quantity and quality of comparable evidence; . differing views on comparable evidence, differing availability of comparable evidence; . uncertainty will arise where there is a lack of comparable evidence. . .; . values are all variable . . . comparables available; . . . . the quality of the bare data provided (e.g. full lease, title documentation, accurate floor plans, etc), comparable evidence. . .; and . the value of a property is emotive and can only be based on comparable evidence. If a valuer does not have experience or comparisons, they are not able to value accurately. (2) Market condition: . supply and demand also affect uncertainty; and . changing markets, market confidence and perception of change. (3) Unusual/unique property: . . . . when dealing with unusual or unique property. . .; and . unusual nature of a property. (4) Particulars: . size, condition, location. . .; and . plans for development around the property.

Figure 2.

(5) Valuer’s opinion: . the valuer’s perception of a property’s pros and cons will vary; . valuations are based on opinion therefore quite subjective and open to error; and . market value (MV) assumptions under Red Book do not always reflect market.

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The results of the data collection would suggest that the range of comparable evidence available is the most common factor to affect a valuations certainty. Over 75 per cent of the candidates mentioned that comparables were a major factor. This is deemed to be the most logical method of valuation and is widely used within the industry, however “. . . the valuer will not be 100 per cent certain of the impact of the input [variables] figure” (French and Mallinson, 2000), so uncertainty is present from the beginning. What happens when there are little or no comparables available? If this is the case there is normally a lack of reliable, comparable transactional evidence, thus the valuer must use his professional expertise and experience to overcome this problem, this usually takes the form of realistic assumptions. Market conditions are constantly changing, these uncertainties will vary according to the “. . . level of market activity; the more active a market, the more credence will be given to the input information” (French and Mallinson, 2000). In the world of valuation there are different companies that deal with different types of property, such as residential agents, fine art auctioneers and agricultural land agents. When valuing, whether for sale, purchase, insurance purposes or just out of interest the end figure is affected by another market force which is commonly known as “demand”. Demand is closely related to a property’s particulars, such as location, style, size and age etc. In present day it is the unforeseeable which cause the most concern. To briefly sum up the outcome of this question; within the valuation profession there will always be “Uncertainty in the comparable information available; uncertainty in the current and future market conditions and uncertainty in the specific inputs for the subject property” (French and Mallinson, 2000).

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Question 3 Do you as an individual or company express uncertainty? – Quantitative (yes/no) The general feeling from this result, which again is very credible is that the industry make an effort to express uncertainty (see Figure 3), but not in a standard from, purely a small comment at the end of an appraisal. See question 4 for details on these expressions.

Figure 3.

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One may say that the 18 per cent of candidates who do not express any uncertainty are asking for trouble, by not making it obvious that valuation figures are subject to fluctuation due to forces beyond their control. Question 4 How do you and/or your company express uncertainty surrounding valuations? . Not standard, each case usually bespoke. . No standard form of expression. On the odd occasion when uncertainty is expressed, reasons for it are explained. . We would express it differently depending on the circumstances. Personal comment within the valuation or marketing report. . Comment on market condition at the time of valuation. . Price ranges. . No, but we always include caveats as to what we have assumed and what investigations we have/have not undertaken. . The firm does not have a standard form of expression but a valuer must always indicate to the client that a property is always subject to fluctuations in market conditions. The expression of uncertainty is reported to “. . . enhance the decision making process and aid the valuation users understanding of the valuation” (French and Mallinson, 2000). Most candidates use a guide or a range clause, which simply states that the figure is an estimate and may change, rather than an exact figure. The main reason behind this expression is to emphasise that no figure is guaranteed and subject to all external variables (as discussed in question 2). It is more than likely to alter, either positively or negatively. Another method of expression is a disclaimer within the valuation report expressing that there is a chance that the figure may change due to external factors. Valuation certainty “. . . identification and description will greatly assist many clients, and will improve the content and credibility of the valuer’s work” (French and Mallinson, 2000). This type of approach offers the client a full description of all that surrounds the valuation of his/her property and gives the valuer peace of mind knowing that any uncertainty has been stated. Only 35 per cent of the candidates have a standard form of expression. One may ask whether a standard approach is needed? One must understand that each valuation is different and the uncertainty which surrounds each one will be different, however a standard form of expression would be designed to help valuers’ be as accurate as possible and offer the client full understanding of the value outcome. Question 5a Is it possible to get totally sufficient evidence to have a totally accurate valuation? – Quantitative (yes/no) Of the candidates, 67 per cent indicated that it is not possible to get sufficient evidence in any particular case to have a totally accurate valuation (see Figure 4). This is interesting as in Question 1, 83 per cent of the candidates stated that they felt it was not possible to be totally accurate to open market sale price, however here it is only 67 per cent that feel it is not possible to gather adequate information to get a totally

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277 Figure 4.

accurate valuation figure. The result of this question when compared to Question 1, proves that not all valuers consider why their industry is uncertain and are not realistic in their view of accuracy. Question 5b Why? (1) Yes: . In some cases the evidence is very well established. . Yes, where there is lots of comparable evidence. . . . . your evidence needs to be as close to the subject property, however in reality one has to make assumptions based on experience. (2) No: . Evidence to give an opinion, but there is never a totally accurate valuation. . Only within the evidence available. Striving for accuracy, but there are no absolutes. . Not possible to be totally accurate in any valuation. A valuation is an assessment of what the market would pay. . Because it is still someone’s opinion which may vary from another. . Because price is subjective and not two properties are exactly the same. . Lack of open market deals [comparable evidence]. The majority of candidates were realistic and admitted that it was extremely hard and in most cases impossible to gain a 100 per cent accurate valuation. However, a valuation is only as accurate as the evidence on which it is based, so the valuation figure all depends on the amount and quality of information available. Strangely some candidates felt that it is possible to value something totally accurately, however only if there was adequate comparable evidence available. This highlights the exact problem the industry is facing. Where comparable evidence is relied on, whether plentiful or not, there is always uncertainty because the evidence is made up of variables. These variables are subject to change, thus cannot be totally relied on. The valuer must make use of resources available, however must be realistic in saying that they can never be totally accurate. There are some cases that are easier to value than others, such as residential accommodation in an urban area due to the availability of comparables.

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However, an ongoing problem for the profession is the subject of unique or individual properties. It is here that the problems start, because of a lack of comparable transactions of the same type of property. Question 6a What happens when there is no real evidence? (1) Yes: . Experience in these situations will be called on, with reference to “open market” you may test the market with “guide” prices to see/judge the markets reaction. . You have to clearly state the assumptions on which you have relied and in certain categories of property adopt alternative methods of valuation . . . . (2) No: . If there were no suitable evidence I would feel unable to rely on assumptions, so would not be able to do the valuation. To date this has not happened. . You can only rely on real evidence, from there on you can utilise your experience and consider the prices that prospective purchasers are prepared to pay. Mixed responses came from this question, however a pattern emerged whereby assumptions are used when evidence is scarce or non-existent, but this is always stated to the client to avoid conflict at a later date. As well as assumptions, the candidates indicated that professional experience is an integral part of the valuation profession. The feeling is that if one is not totally happy about making assumptions, one can rely upon experience, or a culmination of both. Question 6b Does one rely on assumptions? – Quantitative (yes/no) Here the candidates had to give an indication of what they do when there is not enough suitable evidence. It is interesting to learn that some 29 per cent feel that without adequate information they can still make an accurate figure. The other 71 per cent are quite sensible in using a professional assumption in the valuation (see Figure 5). It is also evident that most feel it only correct to explain these assumptions.

Figure 5.

Some candidates stated that rather than rely on assumptions they would rather rely on experience. However, to rely on experience means one must make experience orientated assumptions in order to come to a valuation figure. Question 7a Which types of assumptions have to be made? . Valuation does not imply or include a (structural) survey; therefore general assumption about overall condition (must be made). . Whether “freehold of leasehold, no onerous comments or restrictions, clear title and boundaries”. . They vary and must be agreed with client beforehand. Such as, date of valuation, vacant possession, no contamination, building structurally sound etc. The types of assumptions most commonly made are about the invisible parts of a property and its surroundings. These include whether the building is structurally sound, deeds are legitimate, and that land is not contaminated. There is an element of trust within the valuation industry, but thorough investigation on the part of the valuer is integral too. If the property and its past/present are not properly investigated, one must prepare for a hiccup, whether old or new, property always has its faults and they must be uncovered to prevent any conflict and produce an accurate valuation. Question 7b Should they be standardised? . No real way of standardising. . Standardisation would help. . Standard assumptions could be made but need to be set out . . . Candidates felt that standardisation would be beneficial to the industry, mainly due to lack of guidance on the subject. It would seem that this would be to ensure everyone is following the same guidelines thus making the profession a fair one. Although the RICS Red Book does have guidance for valuations within, they are not regulation and do not have to be followed. Approximately 50 per cent of the candidates stated that they did not feel it was necessary to standardise the way assumptions are used. Question 8 How accurate are your valuations? . Accurate by doing research on values before going to the valuation. . þ /2 5 per cent or less. . Within acceptable tolerances – I am always happy with my figure. . They are thorough and researched, but are liable to market conditions. This question was excellent at finding out how optimistic, pessimistic and realistic the industries professionals portray themselves to be. The majority of the candidates were willing to admit that they were not always 100 per cent accurate and that their figures are subject to variables out of their control. One must remember that a valuation is an opinion of value and can vary from valuer to valuer. Some candidates took this opportunity to express their accuracy within a certain tolerance or range. This is

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interesting as there is no regulation tolerances set by the RICS, however they seem to be a popular method of expression. It would seem that the candidates are basing their accuracy on the type and quality of evidence available. This brings us back to the problem of uncertainty, whereby the valuation is only as accurate as the evidence allows.

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Question 9 Have you ever had a client(s) complain about a valuation’s accuracy? . No. . No . . . prospective clients are more likely to have complained (unofficially) if our opinion is the value was less than their own expectations. . Yes, one case where clients were concerned that a probate valuation was going to be higher than the (future) sale price, due to their view of the condition of the property and concern that the market was falling. The general response to this question whether on a questionnaire or interview situation was “yes” and “more than likely” because a client was not happy about the amount their property had been valued. The supporting of valuations and the information that surrounds them is integral and is part of the answer to uncertainty expression within the valuation industry. This together with educational support from the RICS regarding customer would offer the industry a more satisfied turnover. Question 10a Do you feel that there is adequate support on expressing uncertainty in valuations, for instance from the RICS? – Quantitative (yes/no). Interestingly the candidates seemed to feel that there was adequate support from the RICS. Question 10b Why? (1) Yes: . Yes, you are able to offer assumptions. . As long as all valuers in practice are intellectual and have appropriate training; support is not entirely necessary.

Figure 6.

The new RICS Red Book provides fairly clear advice as to the process for undertaking valuations, the assumptions to be made and therefore guidance on uncertainty. (2) No: . I do not believe it is adequately recognised by the RICS or by most clients. . No, because valuation is the formation of an opinion and should be backed up with comments as to how one has arrived at a particular figure . . . . No, RICS Red Book is there for guidance, however is not obligatory. Would be good to have a checklist. . If you express uncertainty in a report, you are not completing your duty to the client. I do not think the RICS should support uncertainty. .

As the quantitative results show, over 60 per cent of candidates feel that there is adequate support from the RICS (see Figure 6). This is an interesting discovery as many of the candidates in question 7 stated that standardisation would help . . . surely this is related to support from the RICS? One interesting point states that as long as valuers are intellectual and have undergone appropriate training, support is not entirely necessary. On the other hand some candidates felt that the RICS do not offer enough support and guidance. Question 11a Is it acceptable to express a valuation within a certain tolerance (5 per cent, 10 per cent or 15 per cent)? – Quantitative (yes/no) Question 11b If so, should it be standardised throughout the industry? . No, as it puts one into a hostage type position. An owner will not take factors into consideration if valuation is wrong, they will be looking for compensation. . No, a valuer should be submitting a figure, however one usually uses a range in agency work, formal valuations use a figure. . We should all try to be as accurate as possible, but also need the comfort of knowing there is some tolerance because the valuation of property is not exact science. . Yes, there should be scope to do so if the valuer feels it is appropriate and depending on the purpose of the valuation. However, it still relates to the value on a particular date and there is no control over future market conditions. Should this tolerance be standardised? . Yes, ought to be allowed. . . Note: “allowed” indicates thumbs up to standardisation. . I believe this already exists on professional work to a 10 per cent value. . 10 per cent accepted by most lending institutions but would not be understood by the public. . A standard approach is needed.

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Definitely, but it should be remembered that each type of valuation calls for different requirements. Sometimes one requires the offering of a value with a “price bracket”, not a fixed price.

The use of tolerances offers the valuer some peace of mind, knowing that alongside their figure is a “give or take” type clause stating that the figure may rise or fall slightly either side of the amount. This question produced mixed responses, whereby some thought that standardisation would be beneficial and others not. The interesting aspect is that 67 per cent of the valuers questioned stated that a tolerance is a good thing and helps to take away some of the pressure of the job (see Figure 7). However, not many want to see it standardised. The position a valuer is in is not an easy one and is subject to much scrutiny. However one must understand that the standardisation and guidance proposals are hoping to help rather than disadvantage the valuer. Question 12a Would you like to see more guidance from the RICS on the expression of uncertainty in valuations? – Quantitative (yes/no) (see Figure 8). Question 12b Why? . As where appropriate, it will allow valuers and their clients to have a firm understanding of why such expressions of uncertainty are to be used.

Figure 7.

Figure 8.

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The “. . . need for support, that is a ‘personal’ opinion . . . not cast in stone”. Far better to leave it to individual valuers to deal with issue. The Red Book and descriptions of OMW, MV etc, go some way to doing this anyway. No, valuation is an art – not a science. Yes, the more they can do to help, the better. Do not do RICS Red Book valuations much these days as too complicated and too expensive for the client. Would not be a bad idea, if the client is signing an agreement, whereby the valuer is giving his/her “best shot” in a difficult world of varying market forces. Good to have some organisational backing, if all goes wrong! Yes, this would probably cut out unnecessary uncertainty. (RICS guidance) not particularly important so long as existing advice in Red Book is followed and proper experience is adopted. If that experience is not available, the instruction should be declined. Valuers train and are paid to do a job, if they are unable to, then they should not be undertaking those instructions.

The response to the question indicates that no more guidance is deemed necessary from the RICS with regard to the expression of uncertainty. The opinions of the candidates with regards to RICS support on the expression of uncertainty are diverse. No true patterns have emerged and it would seem that some candidates are really not that worried about the topic. It is evident that it is a personal opinion, whereby guidance in some situations may be needed whereas in others experience takes over. Conclusions It is “. . . obvious that the profession recognises both normal and abnormal uncertainty, yet we are still in a professional environment where we don’t provide the user of the valuation with any information on the uncertainty of the valuation in normal market conditions” (French and Mallinson, 2000). The valuer can only make an expert estimation using all the knowledge and experience available. The lack of standardised approach to the expression of uncertainty is an ongoing difficulty within the industry and thus “. . . lie the seeds of misunderstanding” (French and Mallinson, 2000). One can argue that “Uncertainty is a normal market feature deriving from the nature of property, which should be openly acknowledged. It is variable from property to property and from market condition to market condition. It is something to be managed as it cannot be removed” (RICS, 2002b). The customer’s knowledge of the uncertainty that surrounds any type of valuation must be comprehensive in order to gain understanding between client and valuer. It is clear from the research that the expression of valuation uncertainty is not standardised in most companies and seems to be left to the valuer’s judgment. In light of this evidence it would seem applicable for the RICS or another governing body to offer a range of standards to adapt to all valuation requirements. Guidance pertaining to assumptions and their use would be a positive step for the valuation industry. Uncertainty is unavoidable in valuations, especially unique and individual properties, thus guidance or even standardisation of assumption use would

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help to control the level of uncertainty present. The use of tolerances by the industry’s professionals is realistic and offers the valuers a method of pre-adjusting the final valuation figure. “This recommendation is still being considered and was re-addressed by the RICS Carsberg report in 2002” (French and Mallinson, 2000, p. 3). “It was the view of Carsberg that the RICS should commission work to establish an acceptable method of expressing the inherent level of uncertainty within a valuation” (French and Mallinson, 2000, p. 4). Past reports such as the Mallinson and Carsberg aimed to “. . . establish an acceptable method by which uncertainty could be expressed in a uniform and useful manner. This would require agreement on the expression of the uncertainty of the inputs and agreement on the output information that must be conveyed with each valuation” (French and Mallinson, 2000). However, this issue is still outstanding and is continuing to cause valuers unnecessary problems. It is clear that there is still a feeling within the profession that uncertainty is not fully and comprehensively conveyed to the client within the valuation report and, where it is, this is down to the individual valuer to make the necessary comment. Guidance Note 5 of the Red Book requires the valuer to explain the uncertainty pertaining to the valuation in the report, yet this is not in a prescribed form and it is clear that different valuers approach this in different ways. If the RICS strive “. . . to establish an acceptable method by which uncertainty could be expressed in a uniform and useful manner . . . presented in a prescribed professional standard” (French and Mallinson, 2000) it would benefit the profession throughout.

References Brett, M. (1990), Property and Money, Estates Gazette, London. Enever, N. and Isaac, D. (2002), The Valuation of Property Investments, 6th ed., Estates Gazette, London. French, N. and Gabrielli, L. (2004), “The uncertainty of valuation”, Journal of Property Investment & Finance, Vol. 22 No. 6, pp. 484-500. French, N. and Gabrielli, L. (2005), “Discounted cash flow: accounting for uncertainty”, Journal of Property Investment & Finance, Vol. 23 No. 1, pp. 76-89. French, N. and Mallinson, M. (2000), “Uncertainty in property valuation”, Journal of Property Investment & Finance, Vol. 18 No. 1. Royal Institution of Chartered Surveyors (RICS) (1994), The Mallinson Report: Report of the Presidents‘ Working Party on Commercial Property Valuations, Royal Institution of Chartered Surveyors, London. Royal Institution of Chartered Surveyors (RICS) (1997), Calculation of Worth – An Information Paper, Royal Institution of Chartered Surveyors, London. Royal Institution of Chartered Surveyors (RICS) (2002a), Property Valuation: The Carsberg Report, Royal Institution of Chartered Surveyors, London. Royal Institution of Chartered Surveyors (RICS) (2002b), Response to Carsberg Report, Royal Institution of Chartered Surveyors, London, November. Scarrett, D. (1991), Property Valuation: The 5 Methods, Routledge, London.

Further reading Baum, A., Mackmin, D. and Hunnington, N. (1997), The Income Approach to Property Valuation, 4th ed., Thompson, London. French, N. (1996), “Investment valuation developments from the Mallinson Report”, Journal of Property Valuation & Investment, Vol. 14 No. 5. Hurd, R.M. (1924), Principles of City Land Values, The Record and Guide, New York, NY. Isaac, D. (1998), Property Investment, Macmillan, London. Isaac, D. and Steley, T. (2000), Property Valuation Techniques, 2nd ed., Palgrave, Basingstoke. Joyce, L. and Norris, K. (1994), Valuers’ Liability, 2nd ed., The Australian Institute of Valuers and Land Economists, Inc., Deakin. Millington, A.F. (2000), An Introduction to Property Valuation, Estates Gazette, London. Murdoch, J. (2002), Negligence in Valuations, RICS Books, Coventry. Piantanida, M. and Garman, N.B. (1999), The Qualitative Dissertation – A Guide for Students and Faculty, Sage, London. Royal Institution of Chartered Surveyors (RICS) (2002), Commercial Property, Property Solutions: A Practical Guide for Your Business, Royal Institution of Chartered Surveyors, London. Royal Institution of Chartered Surveyors (RICS) (2003), Chartered Surveyors Regional Directory 2003, Royal Institution of Chartered Surveyors, London.

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LAW BRIEFING Compulsory purchase and compensation update

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Gary Sams Legal Editor Introduction Last year’s House of Lords decision in Waters v. WDA is one of the most important legal decisions concerning compensation for compulsory purchase for many years. It summarises the correct approach to the valuation of land taken, and significantly changes the application of the Pointe Gourde rule. It does not, however, go as far as suggested by one of the Law Lords, and abolish the rule altogether. Because of its importance, the main part of this year’s briefing is devoted to an analysis of the Waters case, and a subsequent Lands Tribunal decision which was among the first to adopt the principles it established. It is particularly interesting that both cases appear to place some reliance on the proposed amendments to the law which are being considered by the Law Commission, even though these currently have no legal standing. There is also consideration of two lands tribunal decisions concerning disturbance claims in respect of short leasehold interests. In the second of these the Tribunal adopts a wrong approach by following the first, even though the facts of the two cases were different. As a result it had to reconsider its decision in an addendum to the original report, though it was able to avoid altering its compensation award. Finally I refer briefly to a rare decision in which the acquiring authority successfully argued that a claimant was acting unreasonably in deciding to close down rather than relocate.

Journal of Property Investment & Finance Vol. 23 No. 3, 2005 pp. 286-296 q Emerald Group Publishing Limited 1463-578X

The planning assumptions and Pointe Gourde rule In the case of RMC (UK) Ltd and Case Electrical Distributors Ltd v. London Borough of Greenwich (2005) the Lands Tribunal considered the planning assumptions to be made in the event of compulsory purchase, and decided that the application of the Pointe Gourde rule has been significantly altered by the recent House of Lords decision in the case of Waters v. The Welsh Development Agency (2004). The House of Lords case concerned the compulsory purchase of an area of agricultural land in order to create a wetland nature reserve. The nature reserve was needed to replace an important area of natural wildlife habitat which would be lost as a result of the construction of the Cardiff Bay barrage. This project had been delayed for many years as a result of environmental objections concerning the loss of nationally important bird habitats, and it was only eventually approved on condition that suitable new wetland habitats would be created to replace those which were lost. The question for the House of Lords to consider was whether compensation should be assessed based on market value (the higher of agricultural value or nature reserve value) or on a ransom value basis having regard to the fact that the acquisition of this and other land was the key which allowed the barrage development to proceed. The claimant, of

course, argued for the ransom value approach. This was always likely to be a difficult case to argue given the many hurdles to be overcome if such a claim was to be substantiated. It is not so much the fact that the claimant’s argument was rejected which is of interest, but the fact that in doing so the House of Lords set out a comprehensive summary of the correct approach to the valuation of land for compulsory purchase. This includes six rules which are to be considered when deciding what exactly the scheme comprises in each case. These rules are likely to prove extremely valuable to the Lands Tribunal as, as I have noted regularly in previous updates, it has been difficult to ascertain any pattern to previous decisions. The six rules to be followed when identifying the scheme The specific point to be considered was “whether the scheme underlying the acquisition is the intended use of the subject land is a nature reserve or the construction of the Cardiff Bay barrage; and whether or not it is necessarily to discount for the purposes of valuation any increase in the value of the subject land due to the need to acquire it as a palliative measure because of the environmental consequences of the Cardiff Bay barrage” following the Pointe Gourde rule. The decision of Lord Nicholls of Birkenhead commences with a definition of market value for compulsory purchase purposes and confirms this is “value to the owner, not value to the purchaser”. It is then necessary to separate from the market value “any enhancement in value which is due solely to the presence of the acquiring authority in the market as a purchaser of the land in exercise of its statutory powers”. He then explores the difficult concept that, although the specific scheme for which statutory authority has been obtained must be left out of account, it is necessary to take into account the potential of the land for a scheme of that nature “even if the only likely purchaser is the acquiring authority itself”. “Potentiality is to be assessed and valued as matters stood before the particular scheme, of which the subject land’s acquisition is part, came into being”. Rule 3 requires the purpose underlying the acquisition to be left out of account, where that purpose requires statutory powers. Rule 3 should, however, be interpreted so narrowly that it has effectively become redundant. Lord Nicholls then goes on to consider the Pointe Gourde principle which states that it is necessary to leave out of account any increase or decrease in value directly due to the scheme underlying the acquisition. He states that: . . . notoriously the practical difficulty with the Pointe Gourde principle lies in identifying the area of the “scheme” in question . . . a major development project of a general character, covering a wider geographical area, may proceed in several phases, each phase taking years to implement, and the detailed content and geographical extent of each phase being subject to change and finalised only as the phase nears the time when the work will be carried out. Is that one scheme or several?

Section 6 of the 1961 Land Compensation Act was intended originally as a replacement to the Pointe Gourde rule and sets out in great detail how a scheme should be defined. However, its complexity is such that it has caused more problems than it has resolved and when this case was considered in the Court of Appeal Carnwath L.J. commented that “there can be few stronger candidates on the statute for urgent reform, of simple repeal, and section 6”. The main difficulty with s.6 is that it requires the scheme underlying the acquisition to be left out of account insofar as its purpose is implemented on land other than that which is the subject of the compensation claim.

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However, it makes no references to disregarding the scheme to the extent that it affects the subject land itself. Can parliament really have intended that, when valuing land for compensation purposes, the part of the underlying scheme taking place on other land should be ignored, but the part taking place on the land itself should be taken into account? In order to avoid the apparently anomalous result of such an interpretation, the courts have continued to apply the Pointe Gourde rule, which requires the whole scheme to be left out of account. While the courts are generally reluctant to allow a common law principle to override a specific statutory provision, “this is less repugnant as an interpretation of the Act than the alternative”, according to Lord Nicholls. His fellow Law Lords did not, however, wholely accept this interpretation. In interpreting the Pointe Gourde rule, another question needs to be considered. Take the scenario in which planning consent is granted for the construction of an office building providing it is set back from the public highway as a result of plans for future road widening. The offices are built and many years later the local authority makes a compulsory purchase order on the forecourt in order to widen the road. There are two possible ways to ignore the scheme. One is to imagine what the position of the subject land would be at the valuation date if the scheme had never existed. This approach was commended by Lord Denning in Myers v. Milton Keynes Development Corp (1974) 1 WLR 696 when he referred to the valuer are having to “conjure up a land of make-believe and let his imagination take flight to the clouds”. On this basis the land would be valued as if available for office development. The alternative is to imagine that the scheme has been abandoned immediately prior to the valuation date. The land should be valued rebus sic stantibus in its actual physical condition at the valuation date, having regard only to what could be done with the land in the future, taking into account, where appropriate, the proposals of the acquiring authority. On this basis, which appears to be preferred by the House of Lords, the forecourt would be valued as it is – an undevelopable piece of amenity land. The main difficulty with the Pointe Gourde rule is, however, establishing the extent of the scheme which is to be left out of account. In the words of Lord Nicholls: This goes to the very fairness of the Pointe Gourde principle as currently applied. The wider the scheme, the greater the potential for inequality between those outside the area of acquisition, whose land values rise by virtue of the scheme, and landowners whose properties are acquired at a value which disregards the scheme. Conversely, the narrower the scheme, the greater the potential for an authority being called upon to pay compensation inflated by its own investment in improved infrastructure or other regeneration activities. Holding the balance between these conflicting interests is preeminently a subject for decision by Parliament. But, as matters stand, there are indications that in some cases the application of the Pointe Gourde principle has become too wide-ranging.

Reference is made to the recent Law Commission report which recommends that in the future a narrow interpretation of the scheme will be preferred, unless such an interpretation produces a compensation figure which is patently unfair. Although this proposal is not strictly relevant to the current compensation code, the Law Lords appear swayed towards a similar approach. They also bring into the open as a firm principle the historical practice of defining the scheme in each case in whichever way will produce a compensation figure which is fair to the claimant. Lord Nicholls sets out the following principles which should be considered when applying the Pointe Gourde rule:

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The Pointe Gourde principle should not be pressed too far. It should be applied in a manner which achieves a fair and reasonable result. A result is not fair and reasonable where it requires the valuation exercise which is unreal or virtually impossible. The valuation result should be viewed with caution when it would lead to a gross disparity between the amount of compensation payable and the market values of comparable adjoining properties which are not a being acquired. The Pointe Gourde principle should be applied by analogy with the provisions of the statutory code set out in section 6 of the 1961 Act. In the type of case covered by class 1 of section 6 the area of the scheme should be interpreted narrowly. In other cases Parliament has spread the “disregard” net more widely. Normally the scope of the intended works and their purpose will appear from the formal resolutions or documents of the acquiring authority. But this formulation should not be regarded as conclusive. When in doubt a scheme should be identified in the narrower rather than the broader terms.

Ransom value Lord Nicholls then goes on to consider the question of “ransom” value. He confirms that where land has “ransom” value solely in respect of the scheme underlying the acquisition, such value must be left out of account. Where, however, “ransom” value predates the scheme, or would exist in its absence, it must be taken into account as it forms part of the market value of the land on the basis of “value to the owner”. In the application of the above principles to the subject case Lord Nicholls expresses the view that the acquisition of this land for a nature reserve is an integral part of the barrage project stating that it is highly unlikely that the barrage could have been built in the absence of governmental assurances that a compensatory nature reserve would be provided. The scheme to be disregarded was, therefore not only the nature reserve but also the construction of the Cardiff Bay barrage. “When assessing compensation payable for the claimant’s land the authorities needed to acquire the land as a palliative measure necessary as a result of the environmental consequences of the Cardiff Bay barrage is to be disregarded.” Ransom value was not, therefore, an appropriate basis of valuation and the appeal was dismissed. Overruling the Pointe Gourde principle Lord Scott of Foscote also dismissed the appeal, though on slightly different grounds, as he had a somewhat different view with regard to the application of section 6 and the Pointe Gourde rule. In his opinion Parliament knew exactly what it was doing when it drafted section 6. It fully intended the scheme to be left out of account so far as it affects other land, but taken into account in respect of its impact on the subject land itself. The decisions of earlier courts to remedy the perceived failings of section 6 by reviving and expanding the Pointe Gourde rule were both wrong and unnecessary. While lower courts were bound by the previous decisions, the House of Lords had the authority to overrule these precedents. This case presented an ideal opportunity “for a careful re-examination of the basis and justification of the judge-made additions to, and to

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some extent substitutions for, the statutory principles”. Lord Scott then considers in detail the history of the “no scheme rule” and makes a very convincing case for his argument that, while section 6 could have been far better drafted, the courts have been wrong to override its original intention. In his view rule 3 still has an important role in requiring the acquiring authority’s scheme to be left out of account, where that scheme is reliant on statutory powers. Otherwise section 6 states that the scheme should not be disregarded to the extent that it affects the land being acquired, and the courts have exceeded their authority in the cases where they have decided otherwise: “a landowner is entitled to be compensated for his expropriated land on the basis of disregards enacted by Parliament and not disregards constructed by judges in substitution for the statutory disregards”. In this case the land taken was specially suited to constitute part of the compensatory nature reserve and only the government, or some other state authority, could exploit that particular suitability. As such, this special suitability should be disregarded as it “falls squarely within rule 3”. Also, any additional value as a nature reserve could only be exploited by a purchaser who was a statutory authority. Any such value did not, therefore, fall within the definition of “value to the seller” as defined by rule 2. The appeal could, therefore, the dismissed on two grounds without even considering section 6 or the Pointe Gourde principle. Too late for change Of the three remaining Law Lords, two agreed wholeheartedly with Lord Nicholls. The third, Lord Brown of Eaton-under-Heywood, also supported the view of Lord Nicholls, but added some comments of his own. In his view the opinion expressed by Lord Scott was well argued, but it was now too late in the day to decide that the Pointe Gourde rule should have died with the enactment of section 6 of the 1961 Land Compensation Act. A vast body of case law has developed on the assumption that the Pointe Gourde rule remains active, and the Law Commission consultation process has proceeded on the basis that the existing law comprises case law in addition to the statute. Even Parliament has accepted this, because in amendments to the no scheme rule it has referred to “any rule of law”, in addition to section 6. Most importantly, however, many of the court decisions made over last 45 years have provided valuable clarification of the complex and often confusing language of section 6. To wipe away this body of case law at this stage would mean “subjecting the next generation of litigants to the very real problems which that language has itself created”. While Lord Brown agrees that in the past rule 3 has been too narrowly interpreted, he again feels that it is too late to turn back. From now on it will be necessary to proceed on the basis of a virtually redundant rule 3, and an almost all-encompassing Pointe Gourde principle. Lord Brown then goes on to express his approval for the reforms to the no scheme rule proposed by the Law Commission in its recent consultation exercise, though it is hard to see the relevance of the these future plans to the case in question. These proposals, considered in some detail in previous annual updates, include the replacement of the vague term “scheme” with the perhaps equally vague “relevant project”. This will be interpreted narrowly as only the works taking place on land included in same compulsory purchase order as the subject property, except where either party is able to show that these works are part of a larger project. The four to one majority view of the Law Lords was, therefore, that rule 3 of section 5 of the 1961 Act has become virtually redundant, and the Pointe Gourde principle has

effectively taken over the role of section 6. While Lord Scott made a strong case for his minority opinion, it can surely not be fair that the part of a scheme which takes place on the subject property should be taken into account, while the remainder is disregarded. The Millennium Dome CPO Returning now to the Lands Tribunal case of RMC and Ace v. Greenwich, and how Waters v. WDA influenced this decision. The case concerned two plots of land which were the subject of compulsory purchase for the Millennium Dome complex. The claimants argued that the scheme to be disregarded was simply the Millennium Dome, and the plot of land should be valued taken into account the benefit of the comprehensive infrastructure and development works taking place in the surrounding area. The acquiring authority argued that the Dome was only part of a wider scheme which had to be left out of account and which comprised the comprehensive development of the Greenwich peninsula. In the opinion of the Tribunal: Waters gives rise to a fundamental change in the way that the Pointe Gourde principle is to be applied. The approach is no longer first to identify the scheme and then to pursue, possibly in relentless detail, a hypothetical reconstruction of what would have happened in the no scheme world. The role of the principle, as we understand the decision of the House of Lords, is to supplement the provisions of the Land Compensation 1961 to the extent that is necessary to ensure that the claimant receives no more or less than fair compensation. Whether the application of the principle is needed for this purpose, how the scheme is to be identified in order to achieve it and the extent to which features of the no scheme world need to be constructed will depend on the facts of the particular case.

It is noted that both parties defined the scheme as something significantly larger than the area of the CPO itself. While the CPO extended to some 19 acres, the Millennium Dome (the claimant’s scheme) took up some 181 acres while the local authority’s scheme extended to 294 acres. The Tribunal noted the House of Lords view that the Pointe Gourde principle had come to be interpreted too widely, and had regard to Lord Nicholls’s six rules to be considered when applying the principle. It took the view that the starting point should be a narrow view that the scheme is only what takes place on the CPO land itself; there are therefore three possible definitions of the scheme in this case. The planning assumptions There then followed a detailed consideration of the planning assumptions to be made following sections 14 to 17 of the 1961 Act. Under section 14 account is to be taken of any actual planning permissions in force. In this case the only planning permission was for the Millennium Dome, which was not considered to add anything to value as it relates to a much larger area of land than the subject sites in isolation. Section 16 requires assumptions of planning permission based on the statutory development plans. As in previous cases, the Tribunal comments on the difficulty in applying section 16 to the modern planning system, given that it was drafted before the old-style development plans were replaced by the 1968 Town and Country Planning Act. There was agreement by both parties that planning permission for high-density residential development was to be assumed, though there was disagreement as to whether this arose from sub-section 2 of section 16, which relates to land allocated primarily for a

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use specified in the development plan, or sub-section 3 which relates to land which forms part of an area shown the current development plan as allocated for a range of two or more uses specified in the plan. Both of these assumptions are, however, subject to the proviso that planning permission could reasonably have been expected in the absence of the scheme. Given the real-world circumstances of the comprehensive leisure and commercial developments taking place on the Greenwich peninsula the Tribunal found it impossible to accept that in the absence of the scheme planning permission would have been permitted on these plots of land “as an island of residential land” amid the Millennium Dome uses. However, section 14 also requires that, in addition to the specific planning assumptions, regard should be had to any development for which planning permission might have been expected in the absence of the scheme. The tribunal therefore had to consider whether residential planning permission could have been expected in the no scheme world. To some extent this could depend on which of the three possible definitions of the scheme is adopted. Fortunately for the claimants, however, both plots of land were close to existing road and rail links. In the Tribunal’s view both sites would be well suited to residential development in the absence of the scheme. If that scheme comprised just the CPO land, the site would benefit from a new road system and enhanced surroundings. If either of the two broader definitions of the scheme were adopted the subject land “would have been virtually uniquely well positioned in terms of access and the frontage, albeit its surroundings will have been somewhat desolate”. Many matters of detail had to be considered including whether a deferment was appropriate, and whether the plots were capable of development in isolation, or only in conjunction with adjacent land. There was, however, a more substantial question. Even if planning permission for residential use is to be assumed, this will only add to the value of land if that land is capable of being developed. In the real world the only access road was to be closed and used as part of the Dome development. The sites would, therefore, only have development value if the Dome development had to be excluded as being part of the scheme underlying the acquisition. The Tribunal noted, that based on their own definition of a scheme, the acquiring authority and claimant had each “constructed the requisite features of the no scheme world, postulating, for example, what would have happened in terms of planning and the grant of permissions, the rate at which remediation would have occurred, including what grant aid would have been available and when, where on the peninsula development would have occurred, what it would have been and when it would have been carried out”. In the view of the Tribunal this reflected the conventional application of the Pointe Gourde rule prior to Waters v. WDA. Following Waters, however: The question to be asked for the purpose of applying the Pointe Gourde principle is not “what is the scheme underlying the acquisition?” But “how should the scheme underlying the acquisition be defined as an adjunct to the statutory disregards in order to give the claimant compensation that is neither more or less than what is fair?”

It concludes that the Pointe Gourde rule should be applied simply so as to leave out of account any increase in value of the reference lands resulting from the changes to the locality caused by the Dome development. It forms this conclusion having regard to the six principles set out by Lord Nicholls in the Waters case. The Tribunal decided that it should seek to confine the scheme to the area of the CPO unless an extended definition

of the scheme is necessary in order to establish fair compensation. It was in no doubt that it is not appropriate to treat the scheme as extending to the whole of the Greenwich peninsula, as contended by the acquiring authority. This would breach the second of Lord Nicholls’s principles, as it would be impractical to construct such a no scheme world. To treat the scheme as simply the CPO land itself would, however, allow the claimant to benefit from the urgent infrastructure works undertaken in respect of the nationally important Dome development and benefiting from the availability of lottery funds. This would result in a compensation payment in excess of that which is fair, and therefore the scheme to be left out of account should be extended beyond the CPO land to include the Dome but not so far as to include the complete redevelopment of the Greenwich peninsula. As in the House of Lords case, the Land Tribunal adds that if the proposed changes contained in the Law Commission report had been in force, it could have reach the same conclusion, but at a very great saving in time and cost. It is clear that when applying the Pointe Gourde rule in the future “the scheme” will be defined in whichever way is necessary to enable the courts to arrive at a compensation figure they consider to be fair. It is a matter of opinion as to whether this represents a significant change or merely an open statement of what has previously been a hidden agenda. Short leasehold interests and disturbance Two recent Lands Tribunal cases have considered disturbance claims in respect of businesses which occupied their premises under lease agreements which were due to expire shortly after the valuation date. As such, both claims were made under s.20 of the 1965 Compulsory Act, which gives a right to compensation to interests comprising an annual tenancy or less. Bishopsgate Space Management Ltd v. Teamworks Karting Ltd (2004) RVR 89 considered preliminary points of law: whether it should be assumed that the lease would terminate at the earliest possible opportunity and if so, whether this applied only to the valuation of the leasehold interest, or also to disturbance. In Myers v. South Lakeland District Council (2004) the Tribunal followed the precedent set by the Bishopsgate case even though the circumstances were rather different. As a result it was forced to backpedal somewhat in an addendum to its original decision. The Bishopsgate case In the Bishopsgate case there were two leases, both of which were terminable by either party on giving six months notice, and both of which were contracted out on the security of tenure provisions of 1954 Landlord and Tenant Act. The narrow preliminary issue for the reference was whether it is necessary to assume, in assessing compensation, that the landlord would serve notice to terminate the leases at the earliest possible opportunity, or whether regard should be had to any prospect that the lease would be renewed or extended. The Lands Tribunal decided that it was, indeed, necessary to make such an assumption following, among others, the case of Greenwood’s Tyre Services Ltd v. Manchester Corporation (1972) 23 P & CR 246. This case established that the unexpired term or interest under section 20 is the period between the date on which possession is taken and the earliest date on which the annual tenancy could have been determined by notice to quit given on the date of possession. Therefore, even if in the real world a tenancy is likely to be renewed

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indefinitely, for compensation purposes it is necessary to assume that it will be terminated at the earliest possible date. It can be argued that this interpretation is absurd, as it would place short leasehold claimants in a worse position than licensees who qualify under section 37 of the 1973 Land Compensation Act. Section 37 states that in assessing compensation regard is to be had to the period for which the land occupied might reasonably have been expected to be available for the purpose of the trade or business. The Tribunal points out that this apparent anomaly is removed by section 47 of the 1973 Act which requires the rights of renewal set out in the 1954 Landlord and Tenant Act also to be taken into account. Where, therefore, a tenant claiming under section 20 could expect to obtain a new lease of the 1954 Act, this prospect of continuance will be taken into account in assessing his disturbance claim. The problem in the Bishopsgate case was that both leases were contracted out of the 1954 Act provisions and therefore no such continuance could be assumed. For the claimant it was argued that even if this is correct, the assumption applies only to the valuation of the leasehold interest and a different assumption could well apply in respect of other heads of claim such as disturbance. Reference was made to the case of Minister of Transport v. Pettitt (1968) 20 P & CR 344 in support of this argument. However, the Lands Tribunal again referred to the Greenwood Tyres case in which it is said: What was decided in Pettitt’s case, as I understand it, was that the assumptions underlying the assessment of compensation in respect of Lands Not Taken need not correspond with the assumptions underlying the assessment of compensation in respect of Lands Taken. In the present case however the whole of the compensation is in respect of Lands Taken, and the assumption which underlies the claim for “any loss or injury” must in my opinion be the same assumption as underlies the claim for the “unexpired term or interest”.

In other words, disturbance compensation forms part of the compensation payable in respect of lands taken and, unlike compensation payable for severance and injurious affection, cannot be the subject of different assumptions. The Myers case The Myers case concerned a compensation claim in respect of tenant who had an annual tenancy terminable on three months notice. There was a substantial disturbance claim and in assessing it the Tribunal had regard to the conditions of disturbance compensation as defined in the judgment of Lord Justice Nicholls in Director of Buildings and Lands v. Shun Fung Ironworks Ltd (1995) 2 AC 111: . causation: the loss must have been caused by the compulsory acquisition; . remoteness: the loss must not be too remote; and . duty to mitigate: the claimant must act reasonably in seeking to mitigate his loss. Valuers for both the acquiring authority and claimant had assessed compensation assuming that the business would have had a reasonable prospect of continuance in the absence of the scheme underlying the acquisition. The Tribunal, however, thought that this was rather generous on the part of the acquiring authority. Referring to the earlier Bishopsgate case in some detail it decided that the same principles applied and that the compensation payment should have regard to the assumption that the lease would terminate around three months after the valuation date. As the case concerned a

relocation this was not critical to any of the items claimed though, in the view of the Tribunal member “this must, in my judgment, affect the ‘other losses’ items claimed”. In giving this decision the Tribunal appears to have failed to notice the substantial distinction between the Myers and Bishopsgate cases: in Myers the lease was not contracted out on the 1954 Act and the prospect of the tenancy continuing with the benefit of the protection afforded by that Act should have been taken into account. It was not, therefore, correct to assume that the lease would terminate around three months after the valuation date. The decision of the Lands Tribunal was substantially in favour of the acquiring authority as it was clear that the tenant had singularly failed to act reasonably in seeking to mitigate his loss. The aggrieved tenant made representations subsequent to be decision regarding the Tribunal’s application of Bishopsgate to this case. As his advisor pointed out “the tenants in Bishopsgate had ‘precarious interests’ by virtue of having no protection under the Landlord and Tenant Act 1954, whereas here Mr Myers did have such protection”. The tenant suggested that by not drawing this distinction the award of compensation under various heads might have been affected. The Tribunal member appears to have accepted that his application on the Bishopsgate case was wrong, but stated that: whilst I am bound to accept that the circumstances in this case are different to Bishopsgate, I do not think that that fact affects my conclusions in terms of quantum. I am grateful to the claimant for bringing the differences applicable to the Bishopsgate case to my attention, and the Council for their response. However, having given the matter due consideration, I am satisfied that the compensation awarded in your decision fairly represents the claimant’s due entitlement.

He declined to amend his compensation award in spite of his earlier statement that his interpretation must affect some of the items of loss which were claimed. I suspect this is as close as we are ever likely to get to an admission of fallibility from the Lands Tribunal. Total extinguishment or relocation A common source of dispute between local authorities and claimants is the question of whether the claimant should move to alternative premises following compulsory purchase, or whether he should close down completely. As the latter is usually substantially more expensive for the compensating authority, they will often find themselves in disagreement with a claimant who decides to close down. The problem facing acquiring authorities is that in order to succeed they will need to demonstrate, firstly that alternative premises are available, and second that the claimant could have traded successfully from those alternative premises. In Knott Mill Carpets v. Stretford (1973) 227 EG 336 the Lands Tribunal had to settle such a dispute in relation to a carpet retailer who had been offered a unit in a modern Arndale Centre. It took the view that Knott Mill Carpets probably knew rather more about carpet retailing than the local authority, and that if it took the commercial decision that its business would not be viable in the new precinct, its opinion was much to be preferred to the alternative view expressed by Stretford District Council. Following the logic of that case it will always be very difficult for an acquiring authority to argue that it knows how to run a business better than the claimant, and cases where they have won such an argument are rare. Kwik Save Stores v. Stockton (2004) was such a case. A supermarket was the

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subject of compulsory purchase and a replacement site was offered in a new development. The acquiring authority also identified two other premises which it considered to be suitable. However, the authority’s development partner in the new shopping centre eventually became frustrated by Kwik Save’s failure to commit to the new scheme and offered the unit to Lidl. Kwik Save then claimed compensation on a total extinguishment basis, on the grounds that no appropriate alternative premises were now available and it had been forced to close down. The Lands Tribunal first set out the three principles of a disturbance claim from the Shun Fung case above, stressing the third rule: the claimant must act reasonably in seeking to mitigate his loss. It felt that the two alternative premises referred to by the acquiring authority were entirely unsuitable, and that in some respects the developer and the acquiring authority “can be criticised in respect of some of their actions”. However it noted that whereas the claimant argued that it had been provided with insufficient information to commit to the new development, over 20 other tenants had felt able to make such a commitment, including Lidl who took the unit earmarked for Kwik Save. The tribunal felt bound to ask the question “If they could do so, it begs the question, why could the claimant not?” and concluded that “the claimant was prevaricating (or behaving unreasonably), as a result of which it lost out on the opportunity to relocate to the new unit”. The Tribunal therefore took the unusual step of deciding in favour of the acquiring authority, and against the claimant, in respect of the “relocate or extinguish” argument, and awarded compensation on the basis of the notional cost of relocating.

Reviews International Handbook of Land and Property Taxation Edited by Richard M. Bird and Enid Slack Edward Elgar 2004 311 pp. ISBN: 1 84376 647 7 Review DOI 10.1108/14635780510599485 I have found the book International Handbook of Land and Property Taxation a very meaningful and enlightening book to read. The editors Bird and Slack have developed a theoretically sound framework, backed by economic conceptions in order to attempt a comprehensive treatment on tax administration on land and property. Specifically and yet more broadly, they have to their credit managed to throw light of sufficient depth on key issues that include the tax base and rate, the tax burden and the tax policy decision makers. The international dimension is just as imperative to consider and the editors have effectively succeeded to render an in-depth treatment in this regard. This imperative is also a unique and important contribution to empirical real estate studies within the tax discipline, and the editors should be highly commended in this effort. I am very encouraged with the academic rigor of this book publication on the following grounds: (1) The book on the whole demonstrates intellectual cohesion and consistency, and there is rigor in the book’s conceptualization. (2) The international dimension of the book covers five regions (with five countries per region) – the OECD, Central and Eastern Europe, Asia, Africa and Latin America. Thus, 25 in all are analyzed in terms of its land and property taxation review. In essence, this book proposal represents on a per-county basis a “critical instance case study” that probes in-depth, the behavioral institutional taxation structure unique to each different countries. This probing would test theories and notions in the book’s conceptualization, in order to highlight new insights and a fuller story of the lessons learned. (3) Perhaps, what is the book needs (and seems to be lacking) is a thoughtful “Conclusion” chapter that is able to provide a comprehensive round-up of the country case studies, in the same manner as the book has provided a comprehensive treatment of the 25 countries. It should also have a punch-line to emphasize some key learning points for the reader, such as the following below, to name a few: . regulations enforcing contracts and promoting competition; . honest and independent judiciary; and . educating a new generation in basic and applied research along the book’s topic. David Ho Department of Real Estate, National University of Singapore, Singapore

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Journal of Property Investment & Finance Vol. 23 No. 3, 2005 pp. 297-301 q Emerald Group Publishing Limited 1463-578X

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Essays in Honor of William N. Kinnard, Jr Research Issues in Real Estate Volume 9 Editors: C.F Sirmans and Elaine Worzala Sponsored by the RICS Foundation Kluwer December 2003 ISBN 1-4020-7516-2 Review DOI 10.1108/14635780510599494 Introduction Many of you from outside the USA will not have heard of William N. Kinnard Jr, yet his contribution to the discipline of valuation worldwide was immense. Bill (as he preferred to be called) was a quiet unassuming man blessed with an extremely sharp and analytical mind. He published extensively both in the academic and professional journals and his work always centred on pragmatic applications of academic techniques and concepts. To him, a theory without an application was only half an argument. He was a pragmatist who believed that every problem had a solution and that the route of that solution would be found in the fundamentals of academic theory. It was this belief that set him apart from many consultants and made him highly sought after as an expert witness. He had an uncanny gift for thinking laterally and identifying the “wood” of a problem when others could only see the “trees”. Sadly, Bill died in April 2001 but he left us a rich legacy of articles and influences. The “best” of his articles have now been collected together in one volume supplemented by a number of new papers by friends and colleagues who have all benefited from his influence. This new collection, co-sponsored by the RICS Foundation, was published in 2003 as part of the ARES Research Issues series. It is, without doubt, a valuable and important tome and a fitting tribute to the memory of Bill Kinnard. The Kinnard philosophy What is particularly interesting about Kinnard’s philosophy with regards to valuation is that he understood the holistic nature of the discipline. Valuation is the end result. It is the quantification of an understanding of the market; the legal impact; the physical constraints; the planning regime; the availability of finance; the demand for product and the general economy all influence the value of property. This mirrors the UK/Commonwealth experience that, through the RICS, has always proffered an all-encompassing approach. Yet, appraisal practice in America had historically been driven by the single discipline of finance. Real estate appraisal was seen as a sub-set of finance and treated accordingly, with definitive and rigid mathematical models being applied. Kinnard[1] was one of the first commentators[1] who began to advocate that the role of Appraisal was much more interdisciplinary and that a new holistic approach should be adopted. This became known as the “New school of appraisal thought” and was instrumental in moving the American profession away from an exclusive financial perspective of value. It was against this background that Kinnard published his seminal work, Income Property Valuation (1971). This became a classic text for real estate appraisal in

America and similarly sits proudly in my own bookcase alongside the best texts from the UK and the commonwealth. Indeed, I had a feeling of both surprise and affirmation when I first read this particular book. My own views and understandings of valuation had come from reading the UK and Australian literature. I had digested and distilled the principal points to form, what I believed, was a new interpretation of the role and function of valuation particularly with regards to the definition of value. I was therefore surprised and encouraged that Kinnard had come to the same conclusions some 30 years earlier on the other side of the Atlantic Principal concept of value Kinnard (1971) stated: Value is a price. It is a price that would tend to prevail under specified market conditions as a result of the interaction of the forces of supply and demand. This price reflects the capacity of an economic good to command other goods in exchange. This is the basis for Value in Exchange. Value is also the present worth of future benefits anticipated or forecast to be receivable from the ownership of an asset. This is the basis for Value in Use. Rights in real estate represent ownership of an asset. Their Value in Use is measured in appraisal analysis by Investment Value. In the perfect market of economic theory, informed and rational buyers would pay no more, and informed and rational sellers would accept no less, than the present worth of the anticipated future benefits from ownership of an asset (discounted at market-determined rates). Thus, all transactions would take place at prices that reflected Value in Use, and represented Value in Exchange. Value in Use would equal Value in Exchange, and Price would be synonymous with Value.

This equates exactly with the understanding of value, price and worth as proposed by the RICS in the late 1990s (RICS, 1997a, b): Price (Vt)

is the actual observable exchange point in the open market;

Market value (Vp) is an estimation of the price that would be achieved if the property were to be sold in the market; and Worth (Vs)

is a specific investor’s (or occupier’s) perception of the capital sum that he/she would be prepared to pay (or accept) for the stream of benefits that he/ she expects to be produced by the property.

In the language of economics used by Kinnard, worth (Vs) can be considered as value in use, whereas price (Vt) or market value (Vp) can be considered as value in exchange. As Kinnard (1971) stated: . . . market value can be regarded as the price that a willing buyer would pay, and a willing seller would accept, with each acting rationally on the basis of available market information, under no undue pressure or constraint, with no fraud or collusion present. It represents value in exchange for interests in Real Estate.

This is equates to the international definition of market value (RICS, 2003). Given that I have been involved in at least 20 years of debate about the use of definitions in valuations, it is perplexing that there was any such argument when we have such a clear exposition from Kinnard, which not only stands the test of time, but also applies internationally.

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The history of classical value theory Value theory is a central tenet of all economics literature. Value is a driver in production, investment, and the measurement of utility. In the book, Austin Jaffe and Ken Lusht have traced the history of value theory from the earliest works of the Greek through to the work of the classical economists such as Adam Smith, David Ricardo and Thomas Malthus in the eighteenth and early nineteenth centuries. Most importantly, it recognised that real estate valuation is firmly steeped in economic tradition and thought. It was the Greek philosopher Aristotle (1257) who was the first to distinguish between “value in use” and “value in exchange”. This distinction forms one of the major cornerstones of modern value theory. However, there was little written about value theory during the Roman period, through the mediaeval and middle ages. The defining economic text relating to value was Adam Smith’s (1776) The Wealth of Nations. However, much of the discussion in his text brings together the theories and economic writings or economists from the preceding 200 years. Few economists are as well-cited as Adam Smith. His seminal book The Wealth of Nations, sets out an elaborate value theory drawing on the labour theory of the preceding years he develops the historical differences between “exchangeable value” and what he termed “natural value”. The notion of natural value based on the labour cost became a cornerstone of Adam Smith’s theory of value. For Smith, the natural price was “the central price, to which the prices of all commodities” continued to move towards: . . . the actual price at which any commodity is commonly sold is called its market price. It may either be above, or below, or exactly the same with its natural price.

Thus, to Smith, the market price was determined by the particular supply and demand conditions at any given time and place. In the long run, this price would “gravitate” towards the “natural” level. This gives rise to the modern idea of a long-run equilibrium value. It was left for David Ricardo and Thomas Malthus to develop further this classical economics approach. In Ricardo’s (1817) book The Principles of Economy and Taxation, he develops the theme concerning the difference between value in use and value in exchange. Ricardo’s theory of value differs from Adam Smith’s by fitting together a theory of rent with the labour theory to get a theory of profits. This is s related through the story of the production of corn. If the price of corn is high then the price of agricultural land will correspondingly be high. The third of the principal classical economist to be credited with developing value theory was Thomas Malthus (1836). He developed the ideas of Smith and stated in his book Principles of Political Economy the distinction, and relationship, between price and worth: The price which fulfills these conditions (cost of labor, capital, rent on land) is precisely what Adam Smith calls the natural price; and when a commodity is sold at this price, he says it is sold for precisely what it is worth.

The very concepts that are being proffered today as price (value in exchange) and worth (value in use). This theme is central to the papers presented in the Kinnard monograph. A review of Kinnard’s work Apart from being a wonderful tribute to Kinnard’s life, the new text Essays in Honor of William N. Kinnard is an excellent book in its own right. Anyone wanting to

understand valuation is strongly urged to read this text. The original essays by Jaffe/Lusht (discussed in full above), French and Colwell/Beron all contribute to the academic literature. The papers by Clapp/Giaccotto, Jackson and Aycock discuss practical application. It is an first-rate mix of papers that reflect the philosophy and thinking of Kinnard. The editors are commended for their insightful choice of papers. In particular, the paper by Jaffe and Lusht traces the history of economic definitions of value and provides the reader with clear and detailed exposition of valuation theory. This should be recommended reading for all valuers. Modesty forbids me from recommending the second paper by French, but the paper does flow well from the previous essay and develops and clarifies the definitions of value in the context of the current market. Similarly, the paper by Colwell and Beron (written with Kinnard before his death), perfectly illustrates Kinnard’s philosophy of academic theory underpinning practical application. A theme that is developed in the more practical contributions of the other authors in this section. The second section of the book is the work of Kinnard himself. Here there is a wealth of knowledge born from a lifetime of experience. The papers range from a consideration of uncertainty in valuations (ironically, a subject which is still being debated today) to the practical problems of acting as an expert witness. I was privileged to have known Bill personally, but I must be honest that it only since his death, and particularly through this book, that I have been able read his work in depth. In life we are all offered the opportunity to learn something new each day. It is clear that Kinnard had such inquisition and through these essays we are all able to share in the knowledge that this thirst for answers has provided to us. I recommend this book to anyone who is involved in valuation. Nick French The University of Reading Business School, Reading, UK Note 1. The principal proponents of the “New school of appraisal thought” were Ely, Ratcliff and Graaskamp from the University of Wisconsin. While their work stemmed from the 1930s and resulted in seminal books such as Urban Land Economics (Ratcliff, 1949), much of their work on definitions was by article and was not published in a comprehensive form until the 1970s. References Aristotle (1257), Politica, Vol. 10. Malthus, T.R. (1836), Principles of Political Economy, London. Kinnard, W.N. (1971), Income Property Valuation, Heath Lexington Books, Lexington, MA. Ratcliff, R. (1949), Urban Lane Economics, McGraw-Hill, New York, NY. Ricardo, D. (1817), On the Principles of Economy and Taxation, London. Royal Institution of Chartered Surveyors (RICS) (1997a), Commercial Investment Property – Valuation Methods: An Information Paper, Royal Institution of Chartered Surveyors, London. Royal Institution of Chartered Surveyors (RICS) (1997b), Calculation of Worth: An Information Paper, Royal Institution of Chartered Surveyors, London. Royal Institution of Chartered Surveyors (2003), RICS Appraisal and Valuation Manual, Royal Institution of Chartered Surveyors, London. Smith, A. (1776), The Wealth of Nations, London.

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