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Are Property Valuers Too Conservative?

Property Valuers are often perceived as being out of touch because they "value" our properties for less than what we think they are worth to procure finance; yet most Property Valuers do not estimate a property's true intrinsic value at all.

Market Price, Not Value

The definition of Market Value from one of the Australia's most reputable property valuers is "the estimated amount for which a property should exchange for on the date of valuation between a willing buyer and a willing seller in an arms length transaction after proper marketing wherein the parties each acted knowledgeably prudently and without compulsion."

Whereas the dictionary definition of valuation talks about worth and makes no mention of price, the property valuer's definition for market value has nothing to do with worth and everything to do with price. Market Value as defined in property valuation is an estimate of what a property might sell for in present market conditions, it is an opinion on price not worth or value.

Whilst the definition of value and worth are basically synonymous, value to me is the worth of something compared to its price. We say something represents good value when its worth to us exceeds the price we paid for it. Since we each have different criteria for measuring worth, value is then relative to both price and our own estimate or perception of worth.

As Warren Buffet says "Price is what you pay, value is what you get."

Property valuations (market price opinions) are done for banks and financiers not because they want to know what something is worth (they have no real interest in owning the property); they want to know what the relative market price is so they can quickly sell the property and recover their loan if the borrower defaults. Nothing wrong with that but let's call it what it is.

In reality what we call valuations are really market price estimates to protect the financier in case of default. It has nothing to do with the intrinsic value of the property.

Is It Really Worth What Someone Is Willing To Pay?

The basic principle behind property valuations is that "something is worth what somebody is willing to pay for it" because that is what property valuers' real clients, the banks, want to know. (Don't think that because you paid for a valuation you are the client, the bank that issued the instruction to the valuer and on whose panel the valuer sits is the valuer's real client.)

Roger Montgomery, in my opinion one of Australia's best value investors, tells the story of a company that changed its name from Professional Recovery Systems Ltd to Corp at the beginning of the .com boom period. As Professional Recovery Systems their shares were trading at less than 50c and their SEC filing at the time read "the company is not currently engaged in any substantial business activity of any description and has no plans to engage in any such activity in the foreseeable future... it has no day to day operations at the present time. Its officers and directors devote only insubstantial time and attention to the affairs of this issuer at the present time, for the reason that only such attention is presently required."

As Roger tells the story "the company was a shell offering the promise to do something maybe one day". At its peak in the .com boom the shares traded at nearly $9. Along with many other .com companies the shares eventually delisted.

Was a company that did nothing and wasn't planning on doing anything ever worth $9? The price may have been $9 but its worth was zero or maybe less depending on debt.

How Do We Assess A Property's Real Value?

Establishing an investment property's worth is easier than establishing the worth of our home. The first, if done properly, is reasonably objective and rational, the other can be highly subjective and often emotive.

Assessing the value of an investment whether it's residential, retail, industrial or commercial property should be based on discounting the current and future cash-flows distributed by that property at an appropriate discount rate. Predicting with confidence the likelihood of the future cash-flows requires objective knowledge and experience. The choice of discount rate is often thought of as being a reflection of risk tolerance however if the assessment of cash-flows is realistic and therefore in itself contemplates risk then the adopted discount rate need only reflect a rate that satisfactorily compensates the investor after taking into consideration inflation and the possibility of future interest rate rises. For straight out investments I require a minimum 10% whereas for development projects my discount rate is much higher. Note this is not a return on total cost or margin, it is effectively the annual rate of return required on the investment.

What we see today in most commercial type property valuations is simply the capitalisation of net income where the capitalisation rate is determined by market evidence and the result is then compared to recent sales evidence. In other words two different methods in forming an opinion on market price not worth.

Residential valuations are determined purely by sales evidence, again market price not worth.

Are Property Valuers Too Conservative?

One of the most common complaints about valuations is that the valuation is less than the replacement cost. Whether you believe a property valuation is (i) an opinion on market price or (ii) an estimate of worth, replacement cost is irrelevant.

As explained above, an opinion on market price is about what the property will sell for in a given market. Just as one man's trash can be another's treasure, the opposite can also be true.

If the property is a residential home then worth may relative to what we want in a home. If the property is an investment then the only consideration is the net income the property generates.

Value is the difference between an asset's intrinsic worth and its market price.

This article first appeared in Australian Broker Magazine - April 2012


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