- When a borrower agrees terms with a lender to borrow against a property, the borrower will be required to provide a valuation for the benefit of the lender.
- The valuer will base his valuation on the instruction letter provided by the lender and their requirements
- The instruction letter provided by the lender will state the key purpose of the valuation (i.e. loan security) and the bases of valuation.
- The nature of the property and purpose of the loan will determine the bases of valuation used. For example, a simple buy-to-let mortgage will not require an estimation of Gross Development Value, whereas a residential development facility will require this.
- The valuer will then undertake a thorough internal and external inspection of the subject property (including measuring, sketching, noting current condition and defects, undertake local market research with local reputable/ established estate agents and check internal databases) and prepare the report.
- The valuer will often share his draft report with the solicitor so that the solicitor’s final report on title can be prepared. Once the report on title is finalised, this is then shared with the valuer, who then must confirm his valuation is unaffected by the report on title (often referred to as a ROT). Or alternatively, if the report is affected by the report on title, the valuer must adjust their valuation accordingly.
- The valuer must use caution and cannot over-value a property. A negligent valuation could give rise to a claim against a valuer, so if a valuer delivers a valuation below the borrower’s expectations this must generally be respected unless there is a material error on the part of the valuer.
- In the future technology could speed up the valuation process and provide greater certainty to a borrower at lower cost.
So you’ve got the property deal of a lifetime and now you’ve agreed the headline terms of your loan with your lender. The completion date is set – now what?
Once a borrower has agreed the headline terms of a loan facility with a lender there are 3 key things will generally have to take place in order to obtain the loan to buy or refinance the property or properties in question. These are:
1) The borrower has to sign the loan and facility/security documents of the lender; and
2) A loan security valuation will need to be provided in favour of the lender at or below the agreed loan to value ratio stipulated by the lender and in the case of investment loans, demonstrating the interest and/or debt service coverage ratios from the rent or rental value of the property will cover the lender’s interest payments; and
3) The borrower will need to pass the lender’s required credit, “know your client” checks and “anti-money-laundering” checks.
Almost all mainstream lenders in the UK, including alternative finance providers, will require a borrower to obtain a valuation from a valuer on the lender’s “panel”, namely a set of valuers the lender knows and trusts to be an appropriate valuer for the type of property in question and has also passed a strict due diligence process. The valuation is often referred to as a RICS Red Book valuation, which is an abbreviation for the RICS Valuation Professional Standards, most recently updated in January 2014 (web: https://www.rics.org/uk/knowledge/professional-guidance/red-book), which is a set of standards and regulations that govern the form and nature of a conforming valuation. The RICS or the Royal Institution of Chartered Surveyors is a professional body that regulates many in the property industry, including property valuers. However, not all RICS members (this author included) are permitted to carry out loan security valuations, with only registered valuers permitted and even then the type of property and location that the valuer can advise on is narrowly defined by the valuer’s experience.
The valuation is designed to ensure that the borrower is not borrowing too much money (and the lender not lending too much money) against the value of the security property. This is because in the event of a sharp market fall near the end of the loan term or a borrower default, the lender can still recoup their principal and any owed interest.
For the valuer to be instructed, 2 things must take place:
- The valuer’s fee must be paid. This is generally paid over to the lender (including VAT) and then the valuer is instructed and paid by the lender. If the valuation is not for loan security purposes, the person instructing the valuer will pay directly.
- The [lender’s] instruction letter must be issued to the valuer.
The Lender’s instruction letter or engagement letter is an essential part of the valuation process. The valuer is not permitted to commence a valuation for loan security purposes without this. An instruction letter will include the following key information:
- Details of any Conflict of Interest, of which there should be none or at worst this will be managed by way of a “Chinese wall”
- Presence of Professional Indemnity Insurance
- Details of any limits of liability and/or reliance
- The interest to be valued (i.e. the property in question)
- The purpose of the valuation
- Status of valuer (for loan security purposes this will be the valuer acting as external valuer) which will also confirm the valuer has the knowledge, skills and understanding to undertake the valuation competently
- Date of Valuation
- Basis of Valuation
- Inspection – whether the property will be inspected (if the property is not inspected it is called a “desktop valuation”)
- Measurement – whether the valuer will measure the property or whether the valuer is relying on measurements provided by the property owner
- Report Format
- Report Due Date
The most important aspects of an instruction letter for the valuer are the purpose of valuation, which when dealing with a lender as discussed previously is for loan security purposes (there are other purposes for valuation such as for company accounts or for internal purposes); and the bases of valuation.
A basis of valuation defines how the property is to be valued. The most important basis of valuation that a customer will observe are as follows:
- Market Value
- Market Rent
- Existing Use Value
- Gross Development Value or
- Market Value Assuming 90 Day Restricted Sale
- Market Value Assuming 180 Day Restricted Sale
- There are other bases of valuation which can be found in the link to the Red Book on the RICS website above
It is not uncommon for a valuation report to contain two or more “Bases”, i.e. two or more valuation figures.
Market Value: is the single most important basis of valuation.
It is defined by the RICS Red Book as:” the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion.”
In short, it is what the property is worth for sale as it stands on the date of valuation, making no special assumptions.
Market Rent is defined as: “the estimated amount for which a property would be leased on the valuation date between a wiling lessor and a willing lessee on appropriate lease terms in an arm’s length transaction wherein the parties had each acted knowledgeably, prudently and without compulsion”
Effectively, Market Rent it is what the property is worth for rent as it stands on the date of valuation, making no special assumptions. Its importance is to establish what the property could be let for and this is often particularly relevant if the property is vacant but also if it is let at a rent that is considerably higher than the Market Rent (i.e. over-rented) or below the Market Rent (i.e. underented). Particularly where a commercial lease is short on a property, it confirms to the buyer and lender that when re-let or when the lease may be renewed there would be enough rent to cover the interest payments and meet ICR and DSCR tests.
Existing Use Value is defined as: “the estimated amount for which an asset should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction after proper marketing and where the parties had acted knowledgably, prudently and without compulsion, assuming that the buyer is granted vacant possession all parts of the asset required by the business and disregarding potential alternative uses and any other characteristics of the asset that would cause its market value to differ from that needed to replace the remaining service potential at least cost.”
EUV is therefore what the property is worth, vacant and in its existing use. So if a property is an industrial building in a mainly residential area for example, EUV disregards any development potential the property has, even if it has planning. It offers a lender an idea of its “worst case” position if the property’s Market Value is considerably higher than EUV due to considerable development potential and the development land market falls away or some implied “hope value” of obtaining planning does not materialise during the term of the loan.
Gross Development Value (“GDV”): we would define this as ”the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion on the special assumption that the proposed development has been completed to a reasonable standard, in accordance with current regulations and in accordance with the planning permission as of today’s date.”
The purpose of a GDV valuation is to help a development property buyer/owner evaluate how much their development will be worth and thus, establish if the development project is viable. By the same token it enables us as a lender know whether the amount borrowed is a reasonable proportion of the realisable assets once the development is completed. A GDV valuation would not be required for a regular investment asset such as a buy to let flat or a commercial investment unless either had particularly strong development potential.
Market Value assuming 90 and 180 day sale periods: These valuation bases are precisely the same as Market Value, with the special assumptions that there is a restricted marketing period. This is particularly useful for property traders or buyers of below market value property as it helps them establish what the property would be worth if they have to sell the properties quickly, for instance in an auction. It is particularly relevant for assets for which there might be a limited number of purchasers (i.e. luxury homes) where the sales periods are much longer than usual. For wider market housing such as flats or low-mid priced family homes there is often no difference between the 90,180 and regular Market Value valuation bases. For lenders it is also a helpful tool because should the worst case happen, the lender knows that if the properties have to be sold quickly, this would be a likely amount that could be applied to repay their loans.
Once the valuer is instructed, he or she will visit the property, noting the weather conditions at the time, take numerous photographs and take detailed notes in relation to the property, including the condition of the property. The valuer will do a detailed evaluation of the immediate area and the surrounding areas also. It may also be appropriate for them to visit comparable properties in the area and compare. For example, for retail warehousing (e.g B&Q, DFS, PC World etc), the comparable properties in a town may located at disparate locations and it may be necessary to note the position, prominence, access, transport links, neighbouring tenants and the presence of anchor retailers (e.g. proximity to a supermarket or IKEA) which might act as a draw or deterrent for shoppers and thus be worth paying more (or less) for as a tenant to rent such a property.
Once back in the office the valuer will then commence preparation of the report. The preparation of the report can vary depending on the size and complexity of the property in question. A single flat in an apartment block will take less time than a shopping centre with 120 tenants. A valuation report will typically contain the following sections:
- Executive Summary (i.e. a summary of the contents of the report, including the valuation figures)
- Location, providing a commentary on the local area including:
- Situation; and
- Communication (transport links, road network etc)
- Site: including access arrangements and environmental matters
- Description of the property, including floor areas and condition
- Building defects – although most valuers are not building surveyors, they are able to establish whether there is any disrepair at the property as this will have a negative bearing on the valuation
- Tenure – whether freehold or leasehold, including head lease terms if leasehold
- Taxation – for example business rates or council tax
- Planning – details of any planning consents or refusals at the property and details of the local planning authority
- Macroeconomic overview – a snapshot of the local, national and international economic picture prevailing at the time of the valuation and details of any economic trends that are emerging that might be influential in deriving demand for property.
- Local Market Overview – a snapshot of the local property market and details of any relevant comparable transactions
- Principal Valuation Considerations – a summary of the key issues taken into consideration by the valuer in determining their opinion of value:
- Location – i.e. is the property well located relative to its use and whether there is ample supply of competing properties (or not)
- Building condition – is the building in good condition relative to its competition/comparables and of a modern specification (or not)
- Issues relating to the site – i.e. problems with the title. Usually the valuer will liaise with a lender or buyer’s solicitor and request their draft report on title to identify any title matters that might affect demand for the property or impact on the saleability
- Income security – i.e. the quality of the tenant (if let) and the length of the lease remaining
- Saleability – how easily would the property sell in the open market if made available
- Asset Management Opportunities – could the property be redeveloped or could the value be enhanced in any way
- Comparable evidence – details of transactions relating to similar properties in the local area. For certain properties the geographical spread for comparables could be quite wide (such as the Thames Valley office market) whereas for some the spread could be very narrow (e.g. New Bond Street shops).
- Valuation Methodology and Conclusions: This details the assumptions and method used to establish the basis of value. It will typically also involve a degree of rationalisation so the reader can understand why the valuer came to their conclusions.
- Maps & Plans
- Valuation Calculations: basic residential valuations may not contain calculations as the method of valuation (the comparable method, see below) will have been used to calculate value and as such
- Terms of Engagement
Deriving an Opinion of Value/Methods of Valuation (i.e. how they do it):
There are 5 main methods of value and the valuer when deriving value must follow the following hierarchy (highest to lowest) as far as possible (note comments in c)):
- Comparable Method: this is a method of value where the valuer assesses the subject property and compares it to a similar property in the area that has recently sold and makes an appropriate adjustment for size, quality of finish, position and other factors that might be relevant. This method is generally used most often with residential properties that are offered for sale with vacant possession or for rental valuations.
- Investment Method: where a property is let, the investment method (effectively) involves assessing the annual rental income and capitalising this income based on an appropriate multiplier (or yield) to establish a fair opinion of value. This method is most commonly used on let commercial and residential property. Well let properties with secure income that is likely to grow over the years will have a high rental multiplier (or low yield) whereas properties that have income that is insecure and likely to fall over the following years would have a low multiplier (or high yield).
- Residual method: For development sites the residual method is often the best method of value. This valuation method involves establishing the gross development value of a property, deducting the costs of building and selling the development (plus any other associated costs) to derive the land value, at the same time making an adjustment for developer’s profit ((usually 10% -20% for smaller schemes of all costs and 20% – 30% for larger developments, including bank interest). In simple terms GDV – costs – developers profit = residual value. Whilst the hierarchy would dictate the comparable and investment methods to be preferred methods of valuation for a valuer, the valuer is obliged to derive the highest and best use for a site, so if the property has development potential, despite being well let properties for example, the valuer must take development potential into consideration and thus use the residual method to establish if the residual method would give a higher value than either comparable or investment methods.
- Profits method: for properties on which a trade takes place, or are effectively going concern businesses, such as public houses or hotels for instance, the above methods may not be the best methods for deriving value. Note that many pubs in London have been lost because alternative uses such as residential have been more appropriate and these assets may have been more appropriate to value using the residual method. The basic premise for the profits method is to establish a reasonable EBITDA for the pub or hotel and then apply an appropriate multiplier to establish the capital value of the property. Many property interests in the hospitality trade are held leasehold with terms of less than 25 years, yet unlike many other commercial uses (e.g. office occupational leases), licensed premises leases can be very valuable in the right locations.
- Depreciated Replacement Cost: in the rare circumstances where none of the above methods can be applied, the method used does the following:
- Take the physical buildings, plant and machinery on site and estimate the cost of replacing them, then make an appropriate deduction for age, wear and tear.
- Take the land the property sits on and apply an appropriate land value, using the comparable method
- Merge a) and b) to derive the valuation
Figure and Review
Once the valuation is completed it is then delivered to the lender, assuming the lender instructed the valuation or whoever instructed the valuation. The lender will normally always share the valuation with the borrower for them to review and challenge any assumptions made by the valuer.
However, it is important to note that the valuer’s role is to establish a property’s highest and best value, particularly in deriving market value, despite many opinions to the contrary perceived in the wider property market. The valuation market is also highly competitive and valuers do not want to have a reputation of being too negative. Notwithstanding, valuers owe a duty of care to the party their valuations are addressed to. A negligent valuation can cost lenders in some cases millions of pounds and the lender or affected party will have the right to pursue the valuer for a professional negligence claim if the valuer over-values a property by more than 10% of its true value as at the valuation date.
Therefore, whilst a valuation figure that does not meet a borrower’s expectations can be disappointing, it does not generally make that valuation less right.
Technology Will Transform Valuation
In the very near future the valuation profession could become highly automated. Technologies such as Blockchain, Virtual Walkthrough, drones, Machine Learning and AI to name but a few will change the face of the valuation and property industry beyond recognition. This will be hugely significant for property purchasers because not only will this speed up the transaction process but also provide a great deal of certainty around property values for the banks or lenders lending to the purchaser. Gone will be the days of waiting weeks for the bank’s valuer to turn around their valuation report, only for the property to be “downvalued”.
For example, in residential property, such as a flat in a new-build block, all the details of the property can be stored on Blockchain, including title, internal imagery in 3D, floorplans, local searches and most importantly a valuation register for the unit. Even in the face of a material refurbishment, this unit can be revalued in a matter of hours as a small drone can recapture the imagery of the unit in 3D (within as little as an hour) to establish finish and condition. Then an AI driven bot can then derive a fresh valuation analysing all the units in the vicinity, comparing their finishes and specification and applying an appropriate adjustment for market trends. The final valuation report can then be approved by a “human” valuer, applying the RICS maxim of “stand back and look”, to ensure that the valuation makes sense.
The hope then will be that the technologizing of the property and valuation industry will speed up the transactional process for all property buyers and reduce the transactional costs. By providing certainty around valuations quickly, this will result in fewer abortive transactions. All good news for the consumer.
About Avamore Capital:
Avamore Capital is a special situations lender that provides loans to property traders, property developers, property investors, and other property entrepreneurs. Loan sizes are between £0.5m and £5m with larger loans possible in conjunction with its partners. Avamore Capital provides a flexible approach, quick feedback and very fast drawdown, subject to due diligence.