The most common mistakes in valuing properties

Mistakes and too much subjectivity can lead to over-valuation and heightened risk.

Property valuation is far from a scientific process. The tendency for subjectivity to intrude creates the potential for bias and over-valuation. That, in turn, leads to heightened risk and disappointment when market forces expose the absence of scientific methodology.

This is not unique to property valuation. The entire accounting profession has been engaged in a decades-long debate on what constitutes fair value for assets. Fair value is what a willing buyer and willing seller agree is a fair price under current market conditions. This is easily established when a transaction is about to take place, but what if the asset – or, more specifically, property – is not up for sale and there is no horse trading between buyer and seller resulting in a price being agreed?

Companies must confront this problem every day. Let’s break this down to understand some of the more common mistakes that are made in property valuation.

• Bias and Conflict of Interest: Research published in the Journal of African Real Estate Research shows bias enters the valuation process when random or systematic errors are allowed to occur. Valuers may face pressure to provide favourable valuations to clients, leading to potential conflicts of interest and biased assessments. Different valuers will often arrive at different valuations, showing the lack of scientific rigour that has historically muddied the field of property valuation. This can be mitigated by placing greater reliance on decision-support systems that are relatively immune to the problem of human bias.
• Data Availability and Quality: Data quality can be limited, particularly in emerging markets or rural areas, and is often unavailable in some markets. For example, a shopping centre in a rural town where there is no comparable property against which to establish a benchmark. In this case, historical valuations may be useless. The depreciated cost of the building may be rendered meaningless by a change in demographics or a declining economy. To arrive at a more meaningful valuation requires a detailed study of not just other properties in the town, but the population and demographic shifts and the impact this has had on the local economy. Data availability and its quality are more trustworthy in larger economic centres, provided it is reliable and up-to-date.
• Market Volatility: Rapid changes in market conditions, such as fluctuations in demand, interest rates, or economic conditions, can make it challenging to predict property values accurately. We saw this in the immediate aftermath of Covid lockdowns when demand for commercial office space hit a low due to falling demand and remote working. Vacancies in A+, A and B grade offices dropped to nearly 19% in 2023 from the long-term average of about 10%. In parts of Johannesburg, office vacancy rates surged to 25% in some areas in 2023. Hence, it is crucial to keep a close eye on market trends and events – such as elections, Covid and economic downturns – that could impact property values.
• Subjectivity in Valuation Methods: There are many different methods of valuing properties, such as sales comparison with other recently sold properties in the area, the income approach (using the income the property generates to estimate fair value), or the cost-based approach (measuring the price of purchasing a property against the cost to build an equivalent building). Each method has its uses, depending on the circumst5ances, and this is where a professional valuer is required. Each valuation method may yield vastly different results, leading to subjective interpretations of property value.
• Inadequate Regulatory Oversight: Weak regulation and enforcement of valuation standards can result in inconsistencies and inaccuracies in property valuations. This is particularly true in emerging economies where regulation is weak, or weakly enforced, data is sparse and the opportunity for corruption is rife. The UK courts have adopted a tolerable margin of error between valuations of 10-20%. Outside of this, negligence is assumed to have occurred. A study of sub-Saharan Africa found valuation variances were high compared to international benchmarks. To the extent that regulation is weak and valuation methods are poorly understood or ignored, valuations are prone to human manipulation.
• Lack of Transparency: Limited transparency in the valuation process, including undisclosed assumptions or adjustments, can undermine the credibility of property valuations. A low level of transparency of real estate markets remains a problem for most countries, affecting the level of real estate investment. This can be a concern where undisclosed assumptions are made to arrive at a valuation, wrong or irrelevant data sets are inserted into the valuation model or building defects are hidden from a potential buyer. Another transparency issue that could affect valuations is imminent changes to by-laws or zoning permissions.
• Non-Standardised Practices: Variations in valuation practices across regions or among valuation firms can lead to inconsistencies in property valuations. There is a danger that valuation professionals will lean towards different valuation methods that may not be appropriate in a specific circumstance (for example, attaching a higher weighting to the cost-based rather than the sales comparison approach).
• Limited Professional Competence: Insufficient training and expertise among valuers may result in errors or inaccuracies in property valuations. This has been and remains a problem in SA where many poorly trained valuers have found employment in the field.
• Ethical Concerns: Ethical issues such as misrepresentation of property characteristics or misleading reporting can compromise the integrity of valuation reports. We see this with some real estate agents motivated by commissions on property sales. The incentive is to hide potential downsides to the property investment, while talking up the positives. The job of the professional valuer is to arrive at a fair and transparent valuation.
• External Factors Impacting Property Values: Factors such as environmental risks, political instability, or social unrest may not be adequately considered in property valuations, leading to undervaluation or overvaluation of assets. South Africa is replete with such examples, where municipal water or electricity supply has all but ceased to exist. This would require the property owner to make alternative plans and to account for the costs of going “off grid”. There are many examples of small town businesses in Mpumalanga and North West, to name just two, having to relocate to areas where municipal services were more reliable.

Any professional valuation requires a detailed analysis of these external factors and their likely impact on valuations.

This is by no means an exhaustive list, but it does address some of the key concerns any professional valuer must consider.

Feel free to contact RSM South Africa for any queries.