Comparison of German and Anglo Saxon Real Estate

Comparison of German and Anglo Saxon Real Estate Appraisal Methods Steffen Sebastian, Tobias Schnaidt

Legal Sources and Transparency of Information Legal Sources Transparency of Information § § Solicitors are obliged to transmit to the valuation committees a copy of the contract for each property transaction § The Committee constructs a database from the information gathered § Price development indices and other key figures are made accessible to the public § Transaction information remains strictly confidential § § Slide 2 The Construction Code (Baugesetzbuch) contains the central elements regarding the creation of local committees of valuation experts and the general definition of market value The principles of formulation for the market value are stated in the Valuation Decree (Wertverordnung vom 06. 12. 1988 / Wert. V 98) Even though the decree is not mandatory for non-public transactions, German property valuations are based solely on this legal framework ERES 2010

Definition of Value Definition of Market Value Criteria of Market Value § § Legislation interprets this definition by establishing that the market value is the price which would "probably" be achieved under normal conditions § “Price” - Presumption of a previous transaction § "Probable Value" - A value that lies around the average value of potential values The market value if defined in § 194 Construction Code: ". . . the price which may be achieved under regular trading conditions depending on the legal circumstances and characteristics, depending on the general nature and the site of the land [. . . ] without regard to any exceptional or personal circumstances ". Slide 3 ERES 2010

Differentiation to other Value Definitions Mortgage Value (Beleihungswert) British Market Value Definition § § 12 § "The value which is assumed for the loan security must not be greater than the market value determined by a cautious formulation. In determining this value, only the durable characteristics of the property [. . . ] may be taken into account“ “The estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s length transaction after proper marketing wherein the parties have acted knowledgeably, prudently and without compulsion” RICS Red Book 2003 § Definition was adopted to the fit the definition of the IVSC § § Slide 4 Definition according to of mortgage bank act In practice, the mortgage value is based on the market value reduced by certain allowances against the net revenue Allowance of 10 - 40% ERES 2010 .

Valuation Methods Determination of Market Value § The Valuation Decree specifies formulation techniques for the following valuation methods § Cost Replacement Method § Price Comparison Method, which includes: - the “By Comparison” Method - the "By Revenue" Method § No provision for financial mathematical methods in the German Valuation Decree (Included in the Immo. Wert. V 2010) Valuation Methods Slide 5 ERES 2010 “By Comparison” Method § “By Revenue” Method Cost Replacement Method The market value is determined by the most significant result of the three valuation methods

Cost Replacement Method Calculation Method § Based on the concept of "natural value", i. e. the sum of all the manuacturing costs § Different possibilities of use, and in particular future revenue are not taken into account § Only used when no income stream can be determined (owner-occupied) and no comparable transaction exists Market Value = Actual Costs of Reproduction - Deductions depending on the level of wear and tear Slide 6 ERES 2010

Comparison Methods Comparison Problems § The comparison method has its roots in the concept of efficiency in the financial markets § Theory: Prices reflect the amount that an average of all participants in the market were prepared to pay at a specific time § Problem: properties are far more heterogeneous than securities because the individual factors such as age, site, physical condition and current occupation are of great importance § Problem: Property markets have infrequent trades, are intransparent and not capable of managing all the information Property markets are the opposite of an efficient market Slide 7 ERES 2010

„By Comparison“ Method Segmentation § § Seperate segments are formed for properties which are distinguished by qualitative value factors § Distinguishing quantitative factors within a segment are considered with adjustments in market value § § Slide 8 The whole market is segmented into different heterogeneous categories depending on the factors which determine the value § 3 to 5 of the Valuation Decree itemises the qualitative (type of use, site) and quantitative (age, area, etc. ) value factors Transaction data is used to determine a representative price for each segment ERES 2010 Example: An office block in Berlin is not compared with a hotel in Frankfurt. A residential property is compared with older/younger residential properties in the same city

„By Comparison“ Method Conversion Coefficient Land Price Valuation § § § The committee of valuation experts establishes reference prices for land for the whole region they manage The technique consists of attributing a reference value for a fictituous type of land regarding its main characteristics, in particular COS Land value differences which are the result of different COS are considered with adjustments according to a conversion coefficient COS (COS) 0. 8 0. 93 1. 4 1. 16 1. 00 1. 6 1. 25 1. 2 1. 08 1. 34 Example: The value of the land type in Cologne is calculated at 200 €/m 2, the COStype = 0. 8. If we now look for the value of a similar plot of land with a COS = 1. 2, the ground value VS is calculated as follows : VS = 200 € / m 2 x coefficient C = F(COS) / F(COStype) = 1. 08 / 0. 93 = 1. 61 VS = 200 € / m² x 1. 61 = 232 € / m² Slide 9 ERES 2010

„By Revenue“ Method Calculation § Valuations of buildings intended for investment are essentially done using the by revenue method The formula for the market value is composed as follows: § All the factors which have not already been included in the net revenue factor and remaining lifespan are implicitly taken into consideration in the rate of capitalisation. The potential of future plus values is expressed in the rate of capitalisation in particular. § Slide 10 The empirical formulation technique for the rate of capitalisation derives from the “by comparison” method ERES 2010 V = (RN – TC x VS) x M + VS V = Market Value VS = Ground Value RN = Net Revenue TC = Rate of Capitalisation M = Multiplier

Major Differences Ertragswertverfahren Investment method § § Slide 11 the separation of the land the capital value ERES 2010 net income will be received into perpetuity

Forecast Immowert. V 2010 § Valid from 1 st July 2010 § Further development of the Wert. V 98 § Includes changes to fit the European Valuation Standards better • simplified by revenue method • DCF method (for special issues) § Base is now the common market rent • Misinterpretations expected • Government clarifies that common market rents are sustainable gained and that there shouldn’t be a change in the valuation practice Slide 12 ERES 2010

Criticism German Valuation § Static (sustainable rent as base) § Not in line with the market German Verkehrswert is an average price of normal business dealings and the British market value as the price of best use. (Mansfield and Lorenz 2004) § Anglo Saxon = International = DCF Morgan and Harrop (1991) argue that in some countries the net present value methods have replaced the Ertragswertverfahren. § Empirical findings for lagging and smoothing (Glaesner 2010) § Valuations in the UK are far more objective and conceptually correct (Crosby 2005/07) § Very often criticism in the daily press Slide 13 ERES 2010

Criticism Contradiction § The personal circumstances disqualify the DCF method as a method of finding the market value. (Engel 2002) § The DCF can’t replace the Ertragswertverfahren and the Ertragswertverfahren isn’t as static as often claimed. It is basically comparable to the investment method of the RICS. The expected developments on the real estate markets find reflection in the rate of capitalization and any possible variations that can already be identified by the valuer can be considered in the market value. (Simon 2000) § There is no international convention that pretends any method that isn’t used in Germany. § There aren't any international valuation methods that are contrary to the ones used in Germany § DCF method can’t be seen as the international leading method for the market value valuation (Kleiber 2004) Slide 14 ERES 2010

Conclusion German Property Valuation § well structured and conceived system of property valuation § basis in the Federal legislation and the additional published guidelines § Ertragswertverfahren that can be supported by the other valuation methods is highly oriented to sustainability § Germany has very good data for the land values however the transparency despite the Gutachterausschuss and Statisitische Bundesamt is quite low § (Downie et al. 1996) Slide 15 ERES 2010

Conclusion § Empirical findings for smoothing and lagging (Glaesner , et al. 2010) • Interest of German fund managers to stabilize and smooth value changes § Moral hazard GOEF Valuators (Crosby 2005/2007) Majority of the business can be based on fees from only one client if the valuer counts two funds of the same stable as two entities § Interest of UK fund managers to strive down mark to market in times of bearish markets (Crosby 2009) § No consistent evidence that the German methods are the reason for eventual over- or undervaluation Slide 16 ERES 2010

Thank you for your attention! § Questions § Discussion • Arguments for criticism of the German methods? • Further research is mandatory ! Slide 17 ERES 2010

Bibliography § Crosby, Neil (2005/07), German Open Ended Funds: Was there a Valuation Problem? In: Working Papers in Real Estate & Planning 05/07 § Crosby, N. , C. Lizieri and P. Mc Allister (2009), Means, Motive and Opportunity? Disentangling Client Influence on Performance Measurement Appraisals, Paper presented at the European Real Estate Society conference, Stockholm, Sweden, 2009 § Downie, M. L. , Schulte, K. -W. , Thomas, M. (1996), Germany, . In Adair, A. , ML. Downie, S. Mc. Greal ang G. Vos (Ed), European Valuation Practice, London: E & FN Spon, 1996 § Engel, Ralf (2002): Das Aus für die DCF-Methode? , in: Grundstücksmarkt und Grundstückswert 13. Jg. , Nr. 6/2002 § Glaesner, S. M. , Thomas, M. , Schiereck, D. (2010), Lack of German Real Estate Fund Volatility – is the Market or the Valuer to Blame? In: Glaesner Return Patterns of German Open-End Real Etstate Funds, Frankfurt a. M. : Peter Lang, 2010 Slide 18 ERES 2010

Bibliography § Kleiber W. (2004), Was sind eigentlich die sog. Internationalen Bewertungsverfahren? , in: Grundstücksmarkt und Grundstückswert 14. Jg. . , Nr. 4/2004 S. 193 -204 § Mansfield, John R. / Lorenz, David P. (2004): Shaping the future: The impacts of evolving international accounting standards on calculation practice in the UK and Germany, in: Property Management Vol. 22 No. 4/2004 S. 289 -303 § Morgan, John F. W. / Harrop, Martyn J. (1991): Neue Ansätze der Bewertung und Beurteilung von Anlageobjekten, in: Grundstücksmarkt und Grundstückswert 2. Jg. . , Nr. 3/1991, S. 128132 § Simon, Jürgen (2000): Europäische Standards für die Immobilienbewertung, in: Grundstücksmarkt und Grundstückswert, 11. Jg. , Nr. 3/2000, S. 134 – 141 § Simon, Jürgen (2006), Internationale Bewertungsstandards in: Grundstücksmarkt und Grundstückswert 17. Jg. . , Nr. 5/2006, S. 270 -281 Slide 19 ERES 2010