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Real Valuations of Christchurch Real Estate

12 August 2011

Property valuation is a difficult business in an economy recovering from disaster

Financial Reporting and Valuation Uncertainty Post Christchurch Earthquakes

Accountants and Valuers are grappling with the impact on real estate values used in financial reporting post the September 2010 and February 2011 earthquakes. This article discusses the valuation framework, the impact of the earthquake on property values, valuation uncertainty, the need for greater clarity from valuers on the key assumptions used and how this impacts financial reporting and auditing.

Valuation Framework

For valuers the valuation of real estate assets in New Zealand for financial reporting must comply with International Valuation Standards and specific New Zealand Guidance Notes as detailed in the Australian and New Zealand Valuation and Property Standards. Principal authority is found in:

IVS 1 Market Value Basis of Value

IVS 3 Valuation Reporting

IVA 1 Valuation for Financial Reporting

NZVGN 1 Valuation for Use in New Zealand Financial Reporting

The vast majority of valuations for financial reporting are required by either NZIAS 16 Property Plant and Equipment/FRS-3 Accounting for Property, Plant and Equipment or NZIAS 40 Investment Property/SSAP-17 Accounting for Investment Properties and properties intended for sale. Broadly these accounting standards require real estate assets to be recorded at Fair Value which is largely synonymous with the valuation concept of Market Value.

Valuation Uncertainty

A valuation is not a fact; it is an estimate of the most probable of a range of possible outcomes based on assumptions made in the valuation process. Market valuations are estimates of the most probable price that would be paid in a transaction on the valuation date.

In some cases the degree of uncertainty is negligible; however in Christchurch, post-earthquakes, the uncertainty, due to a range of factors, is very significant. From this arises a situation where the degree of uncertainty falls outside any range that might normally be expected and accepted. It is this abnormal uncertainty that must be recognised by valuers and properly communicated to valuation users.

Valuation uncertainty should not be confused with market risk. In the context of market value, valuation uncertainty relates to the probability that the valuation estimate would differ from the price in an actual transaction on the same terms on the valuation date.

Valuation uncertainty normally increases due to a lack of market activity, a lack of liquidity or a combination of both. In Christchurch the principal sources of uncertainty include the fact that valuers are required to rely extensively on judgement, market uncertainty, and the lack of market observables.

Major Valuation Issues - The Unanswered Questions

Establishing market values in Christchurch post-earthquakes presents unique challenges to the valuer. In certain locations and property sectors there are few, if any, market transactions. In other areas and property types there has been some activity but providing quite conflicting outcomes in terms of rental levels and investment returns - do the new leasings represent a fair sustainable market level or do they simply reflect a short term "spike" due to a supply and demand imbalance?

Valuers are grappling with establishing values for buildings that have been damaged but can be repaired. At valuation date the repair cost may be unknown - should they make an allowance for risk/profit?

How do valuers establish the value of a property where the building has been damaged beyond repair? The insurance pay out may or may not cover the cost of demolition and removal of debris, however the challenge is calculating the land value when valuers have no certainty that the land has retained its bearing capacity. How is land value assessed when it is not known the form or functions that will be permitted in the specific location? Increased building costs due to increased building codes may impact significantly on land values.

With investment property located in the "red zone" tenants cannot access their premises. Will they return once the buildings are repaired and access is available? Can tenants be forced to continue to pay rent for premises they cannot occupy or when do the premises become untenantable? These issues impact on the short and long term risk profile of the property and must be reflected in market values.

We are already seeing significant increases in insurance premiums on renewal. Can the tenant or owner occupier absorb these costs? If the new premium costs cannot be passed on to the tenant, the net cashflow from the property will reduce, and this will flow through to the value of the assets.

Increased insurance excesses may impact on loan value ratios and liquidity. This must be considered when establishing values - current market value represents the present day expectation of all future benefits from ownership. If there is greater uncertainty, the specific property risk increases and impacts on today's market value.

Disclosure and Dialogue

There is no easy, simple solution to the significant issues faced. In an ideal world a valuation methodology would be developed that would provide certainty and clarity to valuers and accountants. Unfortunately every property has its own individual set of challenges that require specific consideration. There is no easy "fix".

What is required from valuers is greater clarity and commentary on the key assumptions supporting the valuation conclusions. The valuer must make specific reference to the matrix of issues associated with each individual property and explain the treatment in the valuation process. Open and transparent dialogue is required to give the users of the valuation an explanation on the impact of assumptions and the basis of valuation.

This may not give the degree of certainty that applied pre earthquake; however it will assist accountants and auditors when considering the level of reliance that can be placed on the reported values.

Financial Reporting

This clarity and communication must extend to financial reporting via the values used and the disclosures made in financial statements by accountants. Accounting standards have required greater disclosures in recent years and it is arguable whether in some cases this extra disclosure has provided useful information and more importantly is even understood by the users of those financial statements. In the current situation post earthquakes we must revert to the objectives of financial reporting.

Accountants must disclose information that will provide relevant information to the users of those financial statements, one of the key objectives of financial reporting. The disclosure must be in plain English and easy to understand. Accountants need to think beyond a check box in their disclosure checklist and meeting minimum disclosure requirements. Consider the stand back test: Have the financial statements achieved a fair presentation?

Impact on Auditors

The level of uncertainty post earthquakes will also clearly impact on the audit. Auditors can no longer flick to the page in the valuation report where the valuer has disclosed the valuation and tie the amount into the financial statements. They have to read the valuation report. Auditors must work alongside the client and valuer, they must talk to them and discuss the key assumptions that they have used. The auditor must make an assessment as to whether they agree with those key assumptions and ultimately ensure that values and the disclosures made in the financial statements present a true and fair view. As the auditor goes through this process they will also be considering the impact on their audit report.

Conclusion

Valuers are being put in a difficult situation having to ascribe values to real estate in the current economic environment in Christchurch. Financial reporting is the mechanism through which these values and how they have been calculated including the key assumptions used are articulated to the wider business community. We must avoid a tick the box approach to disclosure checklists and stand back and consider the values used and disclosures made. Accountants and auditors, like valuers, are going to have a difficult time and will have to perform extra work and will need to make additional disclosures in their respective reports and financial statements. The earthquakes though will give accountants a chance to strengthen their ties with valuers and their clients so that together they can provide the financial information needed by the wider business community.

By Chris Stanley & Mark Leadbetter CA

This monthly paper reflects the views of the writer and may not represent the views of all TelferYoung staff.