Development Valuations – is one method adequate?

Development Valuations – is one method adequate?
December 4, 2019 Ben Driller

Financial Institution frequently instructs valuers to provide, an “As is” property development site valuation, solely based on one method, the direct comparison method.

An investment in property development is high-risk and involves both business and financial risk.

In relying solely on the direct comparison method to establish what a most probable buyer would pay for the site is risk assessment based on adopting the market value definition, which incorporates the knowledgeable and prudent buyer and seller notion.

For buyer and sellers to display the above buyer and seller traits, we are romanticising with the idea that the property market is efficient, where according to the Efficient Market Hypothesis (EMH) stock prices fully reflect all available information about stocks. Property acquisitions are not made under those conditions.

The inefficiency of the property market is due to, to name a few but not limited to, the spatial separation of the market participants, the immobility of property and specifically the lack of accurate and timely property data.

The scarce data available could also be misinterpreted due to bias confirmation, the seeking of information that confirms prior beliefs and ignoring contradictory information. This happens because many internal and external factors are affecting the decision making of people in property development. One reason would be, no developer can sit on cash too long.

Another problem presents itself in sample size neglect. Due to the low sales activity of development property, there usually is only a limited sample of sales data, but it is reasoned to be a representative sample, which could be proven to be wrong.

Add to the above factors, the tendency of people to overestimate the precision of their beliefs, ideas and their abilities. In one famous survey, 90 % of drivers in Sweden ranked themselves as better-than-average drivers.

It follows that any development sites assessed only by the direct comparison method and resting on the assumption of fully informed unbiased buyers and sellers paying and accepting prices which represent the intrinsic value are unreal.

To recognise the shortcomings of using only one method, the International Valuation Standard Committee decided to revise International Valuation Asset Standard 410 Development Property.

The new asset standard 410. 120.2 directs that a valuer should apply a minimum of two appropriate and recognised methods to valuing development property for each valuation project, as this is an area where there is often “insufficient factual or observable inputs for a single method to produce a reliable conclusion”.

Additionally, and continuing from the above the new IVS asset standard 410. 120.3 requires the valuer to produce an “As is” and an “As if proposed” valuation, both usually assessed by the direct comparison method.

To adhere to the requirement of two methods, the other method needs to be either an income approach ie. DCF or the static residual method.

My interpretation is that to comply with the new asset standard inclusions, a property development valuation should consist of:

  1. an “As is” and “As if proposed” valuation, the direct comparison method.
  2. a residual land value method either in a static or dynamic concept (DCF).

The Australian Property Institute API has indicated that it will provide further advice and guidance to Members, in particular, those undertaking mortgage valuations on an ‘as if complete’ basis in response to the additions of paragraphs 120.2 and 120.3 of IVS 410 Development Property.