Changing Commercial Valuation Methodology – A Case for Green Building

Green Building in South Africa is fast-becoming the norm of the New Build Commercial Property Development with all kinds of tax incentives and presumably lowered operating expenditure for the owner / landlord. The case for approaching a Property Valuation of this kind (in the case for a Green Certified Building) is argued by many to follow the traditional Income Capitalisation Method of Valuation, with the effects of Green Building being absorbed either by achievable rental (in the instance where the value add effects the Indoor Environment Quality for the occupants, and they will presumably pay a slight premium on the space, within market parameters), or the value add may be absorbed in the lower Operating Expenditure Ratio output of the building; this thought, strengthens the notion that no change in Valuation Methodology is necessary.

Consider though, the fact that a Green Building is normally comprised of an intricate set of specialised Plant & Machinery, which have various impacts on the building performance and environment at large. The valuer would be wise to therefore give some thought on the effective lifespan of the Plant & Machinery components. We know that currently, the valuation of Plant & Machinery, is currently not recognized by the South African Council of the Property Valuation Profession (SACPVP); it is a long-accepted norm that the valuer ignores the effect of Plant & Machinery in the standardized Income Capitalisation Method of Valuation (especially in the case of the Commercial Property).

The case for Green Building however, has the added complication that the Green Building Features and Initiatives (GBFIs – as the term was coined at the University of Cape Town) are normally made up of highly specialised Plant and items of machinery which contribute in their existence to the output of the Green Building. The question therefore surfaces: Can the valuer continue to disregard Plant & Machinery in the valuation approach?

From the earlier argument by some, that the effects of Green Building can either be absorbed in rental achievable or by lowering the operating expenditure, is mathematically incorrect. The reason for this is simple: The Income Capitalisation Method of Valuation assumes a 50 Year cashflow / perpetual annuity. It is therefore assumed that both the Gross and Net Income are kept at a standard stream, with a consistent Expense Ratio over the 50 Year Scenario. However, in the case for Green Building, it is incorrect to assume that specialised Plant and Machinery can achieve this same 50 Year lifespan. In practice, we know that these are moving parts, which need interval maintenance and service plans which purport to a strong degree of variability in the holding period and effective lifespan of these assets. In other words, during the assumed 50 Year effective lifespan, there will be considerable fluctuation in the Expense Ratio of the Green Building.

To expand on the point further, the valuation report of a Green Building should perhaps look something like a 50 Year Discounted Cashflow where the Valuer has modelled a strong degree of research into the Plant & Machinery component to model the expected variability of the Expense Ratio in conjunction with the market-related rental achievable on the Gross Lettable Area of the building itself. Further to this, the valuer would be able to map out, by means of the Net Present Value and Internal Rate of Return calculation, different scenarios of the Holding Period (in intervals of say 5, 10 or 15 years). In graphing the change of the Net Present Value, the valuer will then be able to report on the Optimum Holding Period and the subsequent Holding Period Returns.

In the case for Mortgage Lending, this approach allows for the Financial Institution to minimize their risk of the client defaulting by tailoring the loan term to fall within parameters of favourable return. Why should a bank sign a client up for a 10 Year loan, if Year 9 (by investigation) purports to a complete replacement of the specialised plant installed, minimizing Net Profit for the Landlord, adding to the risk of default in meeting the mortgage payments. Instead, the bank now has the ability to have informed, calculated decisions on the optimum term of the loan.

Some argue however, that the Discounted Cashflow method brings with it a large degree of assumptions in the calculation inputs, but the opposite can also be argued; the lack of assumptions in the Income Capitalisation Method of Valuation and how this disproportionately distorts expected cashflows. An assumption is not something the valuer should shy away from, as a good amount of market research will enforce the calculated assumption to apply in any event. This is necessary where the underlying asset is built up from components which have differing expected lifespans, which cannot be standardized.

Therefore, the valuer will play an integral role in the future of Green Building Valuation and the subsequent valuation of Plant & Machinery installed in these buildings. This also means that regulatory bodies such as the SACPVP will need to inform themselves on the relevance of Plant & Machinery Valuations and provide an accreditation in this regard to ensure that the same high standard of Immovable Property Valuation is adopted for this new channel in the industry.

In valuation circles, the joke is often to say that the best way to conduct a Plant & Machinery Valuation is to not do it in the first place. However, the valuation of such types of Asset Classes are integral and useful in a changing industry. More on this topic to follow in my next edition.

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Nathan Theron