The reporting of risk in real estate appraisal property risk scoring
Alastair Adair
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 beencriticised for inconsistencies and failures to reflect risk and uncertainty in certain valuationassignments such as 英國dissertation網the pricing of urban regeneration land. Also the Investment Property
Forum/Investment Property Databank specifically concluded that a new approach is needed whichcombines conventional analysis of returns uncertainty with a more comprehensive survey of businessrisks. 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 analysiswithin investment decision making and the property industry, drawing on the findings of the mostrecent literature that assesses the utilisation of risk management approaches.Findings – Financial risk management is examined and the workings of the D&B credit rating modelillustrated. 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
1. Introduction
Risk and uncertainty are inherent parts of the valuation process as often the valuer isunable to specify and price accurately all current and future influences on the value ofthe asset. While the final single point estimate of value may become a statement of factin the minds of the users of the valuation it nevertheless remains the opinion of anexpert. Indeed the large number of academic and practice based studies into valuationvariance confirm the subjective nature of property asset pricing (Adair et al., 1996). Inthose circumstances where risk and uncertainty are reported according to the RICSAppraisal and Valuation Manual (RICS, 1996) or Red Book the valuer can claim, withsome justification, that best practice has been satisfied. However, despite suchprescribed standards the profession has been criticised for inconsistencies and failuresThe Emerald Research Register for this journal is available at The current issue and full text archive of this journal is available atwww.emeraldinsight.com/researchregister to reflect risk and uncertainty in certain valuation assignments such as the pricing ofurban regeneration land (Syms, 1996). In addition the Investment Property#p#分頁標題#e#
Forum/Investment Property Databank (2000) highlighted the need for more rigorousrisk assessment measures within the property profession. More specifically theyconcluded that a new approach is needed which combines conventional analysis ofreturns 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 expressinguncertainty, particularly when pricing in thin markets where information is deficient.
To this end recommendation 15 of the report exhorts that professional bodiesrepresenting both valuers and end users should agree an acceptable methodology forreporting uncertainty within the valuation, which can be readily communicated tothird parties. It is stressed that the methodology adopted must enhance thedecision-making process and not confuse end users. Interestingly the term risk doesnot appear in recommendation 15 however an understanding of the difference betweenrisk 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 riskbased 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 investmentdecision-making and the property industry drawing on the findings of the most recentliterature which assesses the utilisation of risk management approaches. Financial riskmanagement is outlined as applied through the D&B credit rating model and a similartechnique is applied to real estate through the development of a property risk score.The paper explains the decision-making framework within which the property riskscore is applied and examples are advanced across each of the principal commercialsectors.
2. Risk and uncertainty in property pricing
Investment decision-making is concerned with choosing optimal levels of both returnand risk; the risk return trade off. Consequently the principal source of uncertainty istime as the forecasting of future events is difficult and becomes more unreliable as timeelapses. Uncertainty arises therefore from a lack of knowledge and information and onthis premise Hargitay and Yu (1993) construct a spectrum of uncertainty. Thespectrum ranges from certainty (full knowledge) at one end to total uncertainty (lack ofknowledge) at the other. In between there are two further points namely, risk andpartial 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#p#分頁標題#e#
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#p#分頁標題#e#
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
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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#p#分頁標題#e#
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#p#分頁標題#e#
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#p#分頁標題#e#
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
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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#p#分頁標題#e#
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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. 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,
Source Type, use and approximate volume of data
Electoral roll Director address verification
Bank data Verification of information supplied
Telephone numbers Verification of information supplied
D&B call centre 6,000 business interviews per day
Customer files Data matches and new records
Royal Mail 4,000 postcode changes p.a.
London and Edinburgh Gazettes and
other official sources
Liquidations, receiverships, administrations,
bankruptcies, petitions, detrimental notices,
(estimated at 35,000 p.a.)
County Courts 350,000 judgments p.a.
News and Media 12,000 newsworthy events p.a.
Payment experiences 3.9 m references p.a.
24,000 debts placed for recovery p.a.
Companies House 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
Source: D&B (2002)
Table I.
Examples of D&B main
data sources
Band Financial strength based on tangible net worth
5A £35 million þ
4A £15 million to £34 million
3A £7 million to £15 million
2A £1.5 million to £7 million
1A £700,000 to £ 1.5 million
A £350,000 to £700,000
B £200,000 to £350,000
C £100,000 to £200,000
D £70,000 to £100,000
E £35,000 to £70,000
F £20,000 to £35,000
G £8,000 to £20,000
H £0 to £8,000
N Intangible net worth
O No net worth
NB New business
NQ Not quoted – ceased trading#p#分頁標題#e#
Table II.
Financial strength bands
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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).
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 1
51 to 85 2
16 to 50 3
1 to 15 4
Table III.
Failure score conversion
chart
Company D&B rating Explanation
Specsavers Optical Superstores Ltd 3A1 A financial strength of £7-£15 million and an overall
condition which is strong (minimal risk)
Carphone Warehouse Ltd 5A3 A financial strength of £35 þ million and an overall
condition which is fair (slightly greater than average
risk)
Starbucks Coffee Holdings (UK) Ltd N3 A financial strength which is negative and an overall
condition which is fair (slightly greater than average
risk)
Dixons Group Holdings Ltd 5A2 A financial strength of £35 þ million and an overall#p#分頁標題#e#
condition which is good (low risk)
Source: D&B (2002)
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
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perpetuity in the conventional approach to valuation. The intention here is to make the
risk components explicit.#p#分頁標題#e#
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#p#分頁標題#e#
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;#p#分頁標題#e#
. location (prime, secondary etc.);
. sector bias;
. liquidity issues;
. management issues;
. overall economic context;
. national market factors;
. local market factors;
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. 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
http://www.ttc-switch.com/dissertation_writing/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#p#分頁標題#e#
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#p#分頁標題#e#
Office Retail Industrial
Wear and tear of building fabric Wear and tear of building fabric Wear and tear of building fabric
Declining neighbourhood Declining neighbourhood Declining neighbourhood
Environmental factors Environmental factors Environmental factors
Contamination Contamination Contamination
Obsolete plant Obsolete plant Obsolete plant
Air-conditioning Air-conditioning Air-conditioning
Changed layout Changed layout Changed layout
e-wiring Changed location Eaves height
Changed location Changed location
Outsourcing Outsourcing
Downsizing Downsizing
Restructuring Restructuring
Business process re-engineering Business process re-engineering
Hot desking
Home working
Team working
Table V.
Depreciation and
obsolescence risk
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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#p#分頁標題#e#
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.
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