Editorial
Wearing my “editorial hat”, I am always happy to receive letters and comments form the readership. As an academic journal, this is the perfect forum for academic debate.
I was therefore pleased to receive a letter from Peter Wyatt of the University of the West of England concerning a paper published in Volume 25,Number 5 of the Journal of Property Investment & Finance. However,the letter was a repost to the paper “Market value and depreciated replacement cost: contradictory or complementary?” by French and Gabrielli,and wearing my “author’s hat”, there were a number of points raised in the letter with which I disagree. However, it is important that a contrary point of view is proffered in these pages and I have therefore published the letter in full below. What I should stress, however, is that the interpretation of depreciated replacement cost (DRC) discussed in the original paper conforms to the interpretation of the method as agreed by both the Royal Institution of Chartered Surveyors (RICS) and the International Valuations Standard Committee (IVSC). The basis of valuation is “market value”and DRC is only a method to try to estimate the price of exchange in the market. Perhaps, in the original paper, the counter view that prevailed prior to the change that DRC cannot be market value was not sufficiently discussed. Wyatt’s letter addresses this point.
Nick French
A note on “Market value and depreciated replacement cost: contradictory or complementary?”
I was interested to read French and Gabrielli’s paper in French and Gabrielli (2007). Valuers running scared and hiding behind the facts– this is exciting stuff, at least in the world of property valuation! The central argument of the paper is that a method for estimating building cost or,more specifically, depreciated replacement cost can, when added to an estimate of the value of the land on which the building sits, be regarded as an acceptable method of determining market value. The purpose of this note is to look at this argument from two different angles and see if it holds up.
The first angle begins with the distinction between cost and value. Cost refers to the (usually financial) amount that must be surrendered in order to acquire or produce something. As far as we are concerned here depreciated replacement cost refers to the cost of a replacement building less an allowance for depreciation. Value, on the other hand, refers to the amount that something might exchange for. The exchange of goods and services usually takes place in a market and that is why we often see the adjective “market” in front of it. So market value is an estimate of how much a property might exchange for in a market and the International Valuation Standards Committee (IVSC), the Royal Institution of Chartered Surveyors (RICS), politicians, lawyers and many other stakeholders have deliberated over the precise basis, definition and assumptions on which such an estimate might be given. For the purposes of this note let us stick with the IVSC definition, to which the RICS now defers.
UK valuers now only have one basis on which to report the capital value of a property and this is “market value”. But a valuer using the depreciated replacement cost (DRC) method produces an estimate of, rather unsurprisingly, depreciated replacement cost. Is this the same as market value?French and Gabrielli state that “DRC … assesses the value of a brand new build of the same property and then makes allowances for depreciation.”This is not true. The assessment is of cost not value. It should not, therefore,be regarded as “market value in an existing state” as French and Gabrielli suggest in their paper. The problem boils down to the difference between cost and value: DRC is an assessment of replacement cost suitably adjusted for depreciation. Market value is an assessment of value; an estimate of the exchange price between a willing buyer and a willing seller under market conditions. Trying to marry a method of assessing cost to a basis or definition of market value is confounding. French and Gabrielli try to rationalise the application of a cost assessment to a value definition by suggesting that a similar paradox arises when a valuer is asked to value a non-specialised property by comparison when there is no market activity, asserting that “no one would argue that this was not a market valuation.” As a valuer this example worries me because I don’t know the purpose of the valuation and why there no market activity for the non-specialised property. Notwithstanding these concerns let us take office space as an example of non-specialised property and assume it is being valued for accounts purposes. If, say, occupiers suddenly stopped buying office space in the locality in which the offices are situated then a valuer would be justified in reporting that the market value for this particular use is zero because one of the assumptions underpinning market value no longer holds – there are no willing buyers. There may be alternative uses for which there would be a market; residential for example, but let us assume that planning permission for a change of use would not be forthcoming. With no market the valuer must look to the method of last resort. This is DRC and the estimate would not be zero because it is an assessment of replacement cost. It is this precise point that highlights the incompatibility between a cost assessment and a market value definition: the exchange price estimate and replacement cost estimate are two different figures.
French and Gabrielli’s paper points out that, prior to the publication of the current edition of the RICS Red Book in 2005, depreciated replacement cost was regarded as a separate basis of value. Whilst I am very happy to see that back of estimated realisation price and estimated restricted realisation price, were we right to abandon depreciated replacement cost as a separate basis? It is worth considering why we need to value properties for which there is no market. The main reason is to report the financial value of company assets. But French and Gabrielli assert that it is wrong to regard depreciated replacement cost as an accountancy basis, separate from market value. But maybe that is exactly what it is.
The second angle is valuation practice. French and Gabrielli state that“[i]n continental Europe the cost approach (DRC) is often the principal method of valuation and has always been considered to produce market value”. How can the method of valuation that has no reliance on market evidence for valuing the building and limited reliance on evidence for valuing the land be the principal means of estimating market value? In fact, whilst valuers in continental Europe might consider their cost-based valuations to produce market value, the reality is different. For many years UK valuers have been principally concerned with market-based assessments of property value for lending purposes and property investment activity. And that’s why depreciated replacement cost, as a cost-based assessment, was regarded as something different: a means of estimating the replacement cost or deprival value of company and public sector property assets for which there is no market. As national valuation practices converge under the umbrella of international valuation standards, that is no excuse for us to accept, just because continental European valuers regard their cost-based valuations as market valuations, that it is true. If it were we might not need a valuation profession; quantity surveyors could do the job perfectly well. Not everything can be market value. Indeed, Basle II provides for two valuation bases; market value and mortgage lending value. Whilst I agree with Crosby et al. (2000) that the latter is a very unsatisfactory definition of value, the existence of two valuation bases cannot be refuted. If a valuer chooses to use the depreciated replacement cost method to value a property then he or she is assuming that there is no market for property being valued. Since this violates an assumption underpinning the definition of market value, then you cannot arrive at a market value. You arrive at a deprival value, a depreciated replacement cost!
To summarise, if the only basis on which valuers are permitted to report the capital value of a property is market value then a method that starts from the premise that there is little or no market for the property being valued would seem to be incompatible. French and Gabrielli state that “the aim of a DRC valuation is to assess the likely transaction price in the market.” No it is not. That is the aim of the market value definition. Actually, later in the same paragraph, French and Gabrielli suggest that DRC is a means of estimating“deprival value”. This is an accountancy definition used to describe the amount of money that a business would need to expend to replace a property asset in order to allow the business operation to continue. The basis of deprival value would seem to be compatible with the DRC method of valuation. However, whereas French and Gabrielli believe deprival value to be synonymous with market value, this may not be the case: the money that a business might spend to replace a property asset will not necessarily equate to its exchange value. Deprival value and market value are conceptually different. To end with a quote “… depreciated replacement cost (DRC) combines market and non-market elements and cannot be regarded as market value. The different cost applications must not be confused or misconstrued in making, presenting or applying market value estimates” (Adair et al., 1996,p. 23).
Peter Wyatt
