RICS Draft Guidance Note: Sustainability and ESG in commercial property valuation and strategic advice, 3rd edition

Sustainability and ESG in commercial property valuation and strategic advice 3rd ed

9 Valuation methods and considerations

Red Book Global Standards VPS 5 paragraph 5 emphasises that:

'the valuer is ultimately responsible for selection of the approach(es) and method(s) to be used in individual valuation assignments, unless statute or other mandatory authority imposes a particular requirement.'

Accordingly, this guidance does not set out good practice recommendations on the valuation approach or method, but does look at models commonly adopted and their interaction with sustainability and ESG factors.

9.1 Income approach: discounted cash flow (DCF) model

Under the DCF model, the forecasted cash flow is discounted back to the valuation date, resulting in a present value of the asset (see IVS 105, 50.2). Investment values are commonly calculated using explicit DCF techniques and are normally prepared for investors who are seeking to judge not just current performance but also future. DCF may also be used to calculate, for example, fair value or market value. A DCF will normally require valuers to prepare detailed explicit income and cost predictions relating to the subject property taking a specific time frame and calculating an exit value.

DCF has the advantage of clearly depicting the cash flow cost and income assumptions and is therefore suited to taking account of ESG and sustainability factors, as these can be modelled in detail within the valuation. These could even be factors that are not yet clearly evidenced in market transactions.

9.2 Income approach: capitalisation model

The capitalisation model applies a yield to expected net income over a single or limited number of periods and therefore implicitly considers growth and risks. It is most appropriate when the asset is operating at a stabilised level of growth and profits at the valuation date (see IVS 105 50.10). Where the capitalisation model is used, the issue of analysing comparable transactions from which market yields, income and costs are derived is always a matter of valuer judgement. The implicit nature of the model makes it more difficult to identify sustainability and ESG elements within the evidence and attribute these to the valuation.

9.3 Valuation considerations using the income approach

The valuation techniques set out above allow the valuer to consider the factors set out below, relevant to sustainability and ESG, implicitly (capitalisation) or explicitly (DCF). The DCF method is beneficial in many cases as the explicit reference to these relevant valuation factors helps understand their importance to the valuation. The techniques do not need to be used in isolation, for example, the capitalisation model can be used to cross check a DCF and vice versa.

9.3.1 Rental growth

Various sustainability and ESG factors can form a part of rental bids. These may be based on environmental considerations such as energy efficiency but also economic sustainability and wellbeing factors. Changes in consumer and occupier behaviour over time can lead to structural change in markets. It is important for the valuer to be aware of such changes and their impact on both the immediate rental bid and the resilience of income over time.

9.3.2 Obsolescence and depreciation

Many sustainability factors can impact the rate of obsolescence and consequent value depreciation. Valuers should consider whether the subject property is below market and regulatory standards appropriate to its location and class, and the extent to which this is resolvable. Where retrofitting and capital expenditure (further details in section 10.2) can bring the property to a reasonable and appropriate level of sustainability, this can be factored in by the discounted net cost of retrofitting. However, in some cases this may not be possible at an economic cost and the property's life could be compromised.

9.3.3 Risk premiums

Properties that do not meet the sustainability characteristics required in their market may suffer from decreasing occupier and investor demand. They may then represent a higher investment risk, and the risk premium attached to the discount rate in a valuation may need adjustment, either throughout the cash flow period or from the point where value erosion is thought likely to take place. Sensitivity analyses or other explicit risk modelling may be needed to measure the potential impact on value. Where a discount rate based on a risk-adjusted rate is used, it is recommended that an explicit explanation is provided to the client. It is also important that the main sources of risk are identified. Finally, in considering risk it is important not to double-count. Risks to the actual cash flow should be placed within the annual anticipated income/expenditure estimates within the cash flow. Only those risks that do not relate to rent or direct outgoings should be applied to the discount rate.

9.3.4 Exit yield

A DCF calculation is undertaken for a fixed period. The degree to which differentials reflecting sustainability are observable in market transactions is likely to vary and may be difficult to separate from other characteristics - in some cases it may not be observable at all. Valuers are therefore advised to consider the likely impact of sustainability on the residual value at the end of the explicit cash flow period, reflecting on the need for adjustments to either exit yield or site value reversion assumptions.

9.3.5 Duration to sell or let

Valuers will need to consider whether income is likely to suffer interruption at the end of a lease term or in the event that a tenant operates a break clause, if the property is less sustainable than others on the market. While the impact is likely to relate to the prevailing economic and local markets conditions, the security of income is a critical consideration for investors. Therefore, valuers should consider the extent to which sustainability and ESG characteristics are likely to be determining factors in the length of time taken to either let or sell a property and any impact on incentives, discussed in 9.3.6.

9.3.6 Incentives

There may be greater market expectations for rent-free periods and higher risk of void periods where property does not meet market or regulatory sustainability and ESG requirements. There may also be an expectation that property owners make capital contributions to meet sustainability and ESG requirements.

9.4 Market approach: direct comparison

The market approach provides an indication of value by comparing the subject asset with identical or similar assets for which price information is available. Elements of the market approach may also be required to generate the inputs for the income methods above. The issue of capturing relevant ESG and sustainability factors is challenging where using the market approach as assets are generally heterogenous. It is also difficult to distinguish from transaction evidence what the motivations of the parties are in respect of sustainability and ESG. Where using the market approach, valuers should analyse and set out the extent to which comparable evidence is relevant, including in specific relation to ESG and sustainability.