Addressing risk and uncertainty in property valuations: a viewpoint from Germany
| Published date | 01 September 2006 |
| Date | 01 September 2006 |
| Pages | 400-433 |
| DOI | https://doi.org/10.1108/14635780610691904 |
| Author | David Lorenz,Stefan Trück,Thomas Lützkendorf |
| Subject Matter | Property management & built environment |
Addressing risk and uncertainty
in property valuations:
a viewpoint from Germany
David Lorenz
School of Economics, Universita
¨t Karlsruhe (TH), Karlsruhe, Germany
Stefan Tru
¨ck
School of Economics and Finance, Queensland University of Technology,
Brisbane, Australia, and
Thomas Lu
¨tzkendorf
School of Economics, Universita
¨t Karlsruhe (TH), Karlsruhe, Germany
Abstract
Purpose – The purpose of this paper is to propose and discuss practical approaches on how to
address risk and uncertainty within valuation reports, particularly when there is only insufficient
comparable transaction evidence available.
Design/methodology/approach – A four stage approach to property valuation is proposed that can
be particularly useful if there is insufficient comparable transaction evidence available: Identifying,
measuring and expressing risk by making use of property rating approaches. Transforming risk into
risk premia for calculating the yield on a risk free basis by partially making use of models of risk and
return usually applied in finance. Simulating risk premia (since there is great deal of uncertainty
involved in determining these premia) by making use of a statistical method commonly referred to as
Monte Carlo Simulation. Using the derived yield’s probability distribution in combination with further
probability distributions for other valuation input variables (e.g. market rent) to calculate a range of
possible outcomes of Market Value as well as a number of statistical measures that can be indicative of
the valuer’s perceived uncertainty regarding the valuation assignment.
Findings – The empirical part shows that due to data limitations determining idiosyncratic risk
premia for property assets is not yet possible. This significantly hampers the development of robust
yield pricing models and reinforces the need to create databases including information on both
individual property returns and associated building characteristics.
Practical implications – The paper postulates that there are few (if any) rational reasons for valuers
not to use rating and simulation approaches as an indispensable element of the valuation process.
Originality/value – A valuation approach that allows simultaneously addressing risk and
uncertainty as well as sustainability issues within commercial property valuation practice is proposed.
Keywords Property,Risk management,Uncertainty management,Monte Carlo simulation,Investments
Paper type Viewpoint
1. Introduction
The issue of identifying and expressing risk and uncertainty within the scope of
property valuations is currently one of the key concerns in contemporary UK valuation
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1463-578X.htm
The authors thank the German Federal Office for Building and Regional Planning for supporting
the authors’ current research activities in the area of property rating systems.
JPIF
24,5
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Received February 2006
Accepted June 2006
Journal of Property Investment &
Finance
Vol. 24 No. 5, 2006
pp. 400-433
qEmerald Group Publishing Limited
1463-578X
DOI 10.1108/14635780610691904
literature. It is argued that risk and uncertainty are inherent parts of the valuation
process because the valuer is “unable to specify and price accurately all current and
future influences on the value of the asset” (Adair and Hutchison, 2005, p. 254).
The debate started in 1994 with the publication of the Mallinson Report that
outlined a number of initiatives that the Royal Institution of Chartered Surveyors
(RICS) should undertake to help improve the quality of valuations and the standing of
the valuation profession in the business world. Among other issues this report argued
that all valuations are uncertain and that a single valuation figure is an individual
valuer’s estimate of the exchange price of a certain property in the marketplace, i.e. an
expert opinion (RICS, 1994). Therefore, one recommendation of the Mallinson Report
was that common professional standards and methods should be developed for
measuring and expressing valuation uncertainty. This recommendation was
addressed by Mallinson and French (2000, p. 28) who proposed a statistical method
to account for uncertainty in valuation reports and argued that:
The solution must lie in the creation of some format description, accepted as a norm, which
conveys the essence with simplicity, but is capable of expansion and interpretation. This
would need to be presented in a prescribed professional standard, and would always be
appended to a valuation figure.
Finally, the RICS Carsberg Report (RICS, 2002, p. 3) re-addressed the issue within
recommendation Nr. 15 where it is stated that:
RICS should commission work to establish an acceptable method by which uncertainty could
be expressed in a manner which will be helpful and will not confuse users of the valuation.
Around the same time the UK Investment Property Forum (IPF, 2000, 2002) stressed
the need for more advanced and rigorous risk assessment measures within the
property investment industry and argued that:
We need a much tighter measurement framework 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 (IPF, 2000, p. 15).
However, to date the decision if and how risk and uncertainty are expressed and
reported within property valuations is left to the judgement and experience of the
individual valuer alone. More precisely, the latest edition of the RICS Red Book (RICS,
2003) does not provide guidance on how to report risk and uncertainty in a
comprehensible and appropriate manner. As a consequence, “individual valuers must
take the issue into their own hands and offer the client what they feel is their best price
estimate” (Joslin, 2005, p. 270).
The situation is pinpointed by the following – admittedly very extreme but real –
example.
In 1973 a Germanbank issued a closed-end propertyfund consisting of one mixed-use
property asset with more than 20,000 square metres of rentable floor area located in the
city centre of a majortown in the northern part of the country.In August 2004 the rental
contract with the majortenant (occupying more than 60 per cent of available floorspace)
expired. Since a new tenant has not been found until today the fund is facing serious
financial difficulties. However, a sale of the property is not a feasible option for the
investors because the expected selling price is below outstanding loans. A particularity
of this closed-end fund was that the property asset’s market value was estimated by a
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group of German valuation experts on an annual basis (this procedure is usually
required for Germanopen-end property funds). At 31October 2003 the valuation experts
estimated the property’s market value at e17.6 million (DGA, 2004). One year later,
however, the valuation experts’ estimate was e6.3 million only, which is a correction of
the previous year’s figure by considerable 64 per cent (DGA, 2005). The valuation
experts argued that this correction was due in order to reflect increased expenses
necessary for the revitalisation of the property asset (since it no longer complied with
today’s office userrequirements) as well as a longer time span requiredfor finding a new
tenant. However, the circumstance that the major tenant would not renew the rental
contract was already well-known at the date of the 2003 valuation. Sadly, this is not the
end of the story; today the fund management expects that a “realistic” selling price
ranges between e2ande3 million which would represent a correction of the 2004
valuation by another 60 per cent. In total, this amounts up to a deviation from the 2003
valuation figure by more than 80 per cent within slightly more than two years only
(DGA, 2005; Loipfinger, 2006). That the group (!) of valuers was not able (or wiling) to
detect and account for this risk of obsolescence as well as for associated uncertainties
with regard to finding a new tenant gives cause for serious concern.
Unfortunately,this is not the only recent example for considerable “over-valuation” of
property assets in Germany. At the end of 2005 German “HypoVereinsbank” (HVB) –
now owned by the Italian ‘Unicredit’ – had to buy a portfolio consisting of 20 properties
from their related property fund company (“iii-investments”) because the fund company
was facing financial difficulties due to the circumstance that the properties’ market
values could not havebeen realised in the open market; the selling price wason the order
of e500 millionbut immediately after the transactionHVB revalued the portfolio fortheir
balance sheet at approximately e290 million (FTD, 2005; Su
¨ddeutsche Zeitung, 2005;
Jumpertz, 2005). Also, “Deutsche Bank” has refused to re-buy shares of their open-end
property fund (“Fonds-Grundbesitz-Invest”) in December 2005 because all 130 fund
properties needed to be revalued (Reichel, 2005); and German “Deka-Immobilien” is
facing pressureto revalue their fund’s (“Deka-Immobilienfonds”) propertyassets as well:
at the end of 2004 the auditors of Deloitte & Touche (mandated by the fund company
themselves) and KPMG (mandated by the German financial supervisory authority,
BaFin) detected a difference of e700 million between the market values estimated by the
group of valuers responsible for valuing the fund’sassets and the auditors’ own estimate
(Ho
¨nighaus, 2004; Bo
¨rsen-Zeitung, 2005); in November 2005 the fund company’s CEO
stated that within the next four years downward-adjustments in market value of the
fund’s assets are likely to be on the order of e1.1 billion (Haimann, 2005).
As a consequence, the German open-end fund industry is criticised heavily for the
quality of valuation reports issued by the group of “sworn” valuation experts which are
syndicated within the association of property-investment-experts (“Bundesverband der
Immobilien-Investment-Sachversta
¨ndigen”, BIIS) and which are usually mandated to
value the open-end funds’ property assets. This has lead to an intense debate among
German valuation experts about the usefulness of particular valuation methodologies
and practices.The debate is difficult to understandfor all those who are not familiarwith
German valuation guidelines and applied practice in detail. In essence, it is a debate on
the superiority of valuation approaches between those who stick to traditional German
valuation practice (i.e. a practice that distinguishes between a land element and an
element for the building when estimating market value and thereforeexhibits a range of
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