Introduction
This paper discusses the similarities and differences of Hypothetical Development Method of Valuation (HDMV) and Residual Method of Analysis (RMA) to strategically found the borderline with regards to their functionality, methodology and other features. In effect, this can mitigate the overlapping perception of laymen regarding their uses and the usage of the appropriate term for any effort regarding asset valuation and analysis. The structure of the paper is as follows: introduction, literature review, relevant cases and conclusion. The literature review illustrates the demarcation between HDMV and RMA explicitly through professionally-quoted definitions, some historical background, comparative evaluation against other methodologies and empirical researches. Two court cases are derived in the Australian Courts with primary disputes arising from Pointe Gourde and San Sebastian principles respectively. The case analysis concentrates on HDMV and RMA implications from/ to the cases. Lastly, conclusion is attached for summary of learning and clarification of the paper objective with regards to the belief of the writer.
Literature Review
Hypothetical Development Method
Valuation methods developed as early as 1900s primarily to guide litigation, and lately, as basis for professional practice standards especially for public accountants and other licensed valuators ( 2006). The latter admonition is what Australian Property Institute is applying to its members to streamline valuation techniques. The assessment of value oftentimes leads to determination of the market value in which negotiation between the willing buyer and willing seller is the fundamental premise ( 2006). Within this voluntary arbitration, a common assumption exists wherein the market value of a certain property should be based on its highest and best use. However, there are properties such as land that have been yet to be consume to its maximum potential making the establishment of the land’s value in question, if not, in dispute. In these cases, hypothetical development method of valuation (HDMV) is proved to be valuable.
HDMV involves scenario planning by which a particular development proposal is applied to the value of the property initially to resolve “highest and best use” issues. The market value is derived by deducting the selling, development cost and associated risk of the “pre-supposed” future property from its original sale price without the proposal ( 2006). In this way, HDMV is useful in assessing feasibility of a certain project, rational decision between development alternatives and the determination of market value for the proposed developments not merely the property itself. For example, an owner is deciding whether to sell or improve (put investment) his property. By applying HDMV, he can determine the most profitable decision alternative. If after HDMV it is found that the market value of property development is greater than the sale price of the unimproved land, the owner can likely opt to sell the land to avoid investment risk.
As observed in the table below, HDMV is distinguishable with other property valuation methods because it departs from the central goal of property valuation per se and has the ability to reflect alternative development options applicable to such property. Perhaps, discounted cash flow analysis float side-by-side to this HDMV unique feature as it also deviate from the property in question to the propensity of an asset to generate income. However, unlike HDMV, cash flow analysis does not aid in valuing the highest and best use of the property when applied with improvements rather the quality of income stream. This can also be in the case of capitalization method as it involves the inclusion of rent income in the valuation. The remaining methods have the central similarity of basing valuation with similar transactions which would ultimately undermine or overestimate the market value of property in question due to variances in size, location, views and quality of accommodation. This procedure is subjective to the valuer that is imposed with infinite factors to consider and analyze as well as personal biases and self-vested interests. On the other hand, HDMV can control these factors and biases by imposing limitations to valuation through development costs alone. The limitation, however, also arises to this strength because HDVM does not have the ability to measure the value of property rather the property developments in the future.
Table 1: Comparison of Valuation Methods against HDMV
Method
Primary Activities
Unique Feature
Practical Use
Direct Comparison
- comparison of the property with similar transactions
- can be straight or analytical comparison
- most frequent used method especially in residential property and vacant land
Summation
- comparison of vacant and developed sites
- the added value of improvements is added to the result of the primary activity
- helpful in rating and taxation valuation
Capitalization
- net passing rental is capitalized or multiplied in perpetuity
- uses a certain percentage called yield that has a formula of net rent/ sale price
- used in commercial, investment and hospitality premises whose operations are on a going concern
Hypothetical Development
- pre-supposes a development proposal on a certain property
- scenario planning for future property improvements
- applied in assessing the feasibility of a project, development option and value of the proposed development
Depreciated Replacement Cost
- methodology of summation with regards to depreciated replacement cost
- uses cost estimates and allowances for depreciation to account for property and improvement obsolesce
- evaluation of specialized assets for financial reporting purposes
Discounted Cash Flow Analysis
- use the stream of future cash flows of the property
- necessitate computation of net present value (NPV)
- use to value substantial commercial premises subject to long-term lease agreements, and also, valuing subdivisions
Residual Method of Analysis
One of the uses of residual method of analysis (RMA) is to assess the socio-economic value instead of mere profitability of redevelopment and rehabilitation plans on a certain property such as land ( 2006). The tenet of not improving a land, that is, when the sale price of a completed development is less than the cost of development, gives rise to abruptly selling the land without investment on it. This is what HDVM reflect and imply whenever the market value of the land is expressed. However, the financial focus of HDVM makes it non-conducive as analytical tool especially when the decision criteria go beyond profit maximization for the parties involved.
RMA considers offsetting of cultural and financial value when deciding on land improvements (2006). For example, an investor plans to rehabilitate a land location with cultural heritage value that requires relocation of illegal squatters as well as demolition. There are cases that the improved environment of the land can lure tourist that can infuse the probability of making the investment catalyst for economic transactions to flourish. This can ultimately lead to the rise of the market value of the rehabilitated land from its original acquisition and development costs. However, in cases that the value of rehabilitated land is less than the associated costs, the cultural value can replace the lacking of the financial value of the investment which can mitigate economic costs from investors. RMA allows social financial analysis to be available to specific properties which the government and public organizations can utilize to have optimal obtainment of their goals and responsibilities.
For its part, HDMV redeem its importance as it is the initial step to be undertaken when conducting an RMA. The basic equation of residual method of valuation is in accordance to what HDVM reflects to value properties, such that, C = A – B, where A stands for the sale price of the completed development, B stands for the cost of development works including profits and C stands for the maximum purchasing cost of land to carry out the development and to protect future income streams (2006). On the contrary, RMA goes beyond numbers and allows non-monetary rather social benefits to mitigate economic costs.
Properties such as licenses caused widespread debate in the US and its Federal Communication Commission (FCC) on how to treat the value of intangible media assets (2005). In this case, the FCC license itself derived the most attention from the media industry and authorities. For this purpose, there are several methods of valuation analysis to consider (see table below). Unlike HDMV, RMA together with cost approach is the simplest forms of valuation analysis. The bottleneck, however, arise from the fact that RMA as well as cost approach do not account for full value of the property. This is in accordance to what some of Securities and Exchange Commission (SEC) staffs have argued. They added that direct-value methods are more accurate measure of the license’s cost. In the contrary, they are taunted as subjective which is pointed as source of their weakness. RMA polish this shortcoming by simply subtracting the fair-market value of the business to the amount of its total assets. The residual amount or the difference will stand as the license value. In this case, the license value is one of the most crucial properties that a media company should possess because it is the core requirement to be able to operate in the industry. As such, it is very important and strategic for industry actors to measure its value. Through licenses, the government can derive levies, business entities can operate and undergo licensing schemes and the community can possess the key to reflect their voices from government lobbying.
Table 2: Comparison of Techniques in Valuation Analysis against RMA
Method
Core Task
Strengths
Weaknesses
Residual
- uses a series of subtraction wherein the left over value of the purchase price (the market value of the entity/ business) that is deducted with its assets will be the license amount
- simple and the allocation of the residual to the license value reflects the start-up importance of licenses
- it does not account to the full value of the property unlike direct-value methods
Income approach
- the income that can be derived from license issuance is related to the cost of the license
- fits to direct-value method
- multiple scenario thinking leads to plenty of subjectivity and hypothetical analysis
Market comparison
- the value of the license is based on similar properties
- fits to direct-value method
- Difficult to find similar transaction data
Cost approach
- the investor will only pay the replacement or reproduction cost of the property
- fits to direct-value method
- This approach does not mirror the full economic value of the license or franchise
Later, the argument of SEC staffs won a SEC policy prohibiting entities to use residual method when performing annual impairment test (2005). The test is carried-out to determine if the carrying amount of an asset exceeds its fair value ( 2006). However, residual method tackles this issue very lightly, primarily due to its simplicity of execution, which in turn undermine the proper approach to intangible assets particularly the goodwill. As a result, the nature of the goodwill, which is not saleable by itself and cannot produce its own cash flows ( 2006), valuation turned out to be problematic and inaccurate. In effect, the prohibition was implemented. In the case of Emmis Communications, an Indianapolis-based media firm, the change of accounting regulation resulted to a non-cash charge of approximately 0M (net of tax) (2005). This situation gives rise to an argument that residual method tends to undermine the intangible asset of an entity in favor of those financial and tangible ones.
On the other hand, Media General, a Southwestern American media firm, was affected relatively more unfavorably than other industry participants as they are on the top spot of the industry (2005). This is because its intangible asset is relatively greater than competitors that can be reflected by its reputation, innovation abilities and human resources (2003). The emergence of SEC Topic D-108 or the “Use of Residual Method to Value Acquired Assets Other Than Goodwill” also initially charged the company with at least 0M (the same as ) ( 2005). The Residual Method is the commonly used method of valuation analysis from 1997 to 2000 until the adoption of the policy in 2001. The predicament arises because former users of the method will have to accept direct method in which the valuation of FCC licenses prohibits the association of the station’s value. As residual method merely accepts the value of the license from the residual of its business value from its total assets, the previously higher licensing levies by licensor to its clients will be slashed by the amount of goodwill the former is carrying. No wonder that top media firms and stations will be the ones who will be seriously affected by the legal restriction.
The Nature and Studies of/ on Property Valuation and Analysis
The International Valuation Standards Committee (IVSC) states that competent, objective and professionally developed valuations are required for effective business transactions ( 2006). Asset valuation has its roots in classical and contemporary economics wherein the techniques are formally established during 1940s. Due to the shortages of historical costing, current valuation proves to have growing recognition in financial reporting. In its attempt to organize and streamline the process of property valuation, Australia produced Australian Property Institute (API) that invites all property valuators to be a member ( 2006). The organization is highly-respected which leads to some Australian companies requiring its mortgage valuators to be a member of API.
Real asset valuation is typically estimated with an error as there are several factors a valuator should consider but time constraint and personal biases hamper the process to achieve objectivity (2002). For a simple real (illiquid) asset, variance factors are unique locational, physical and contractual-relational characteristics that cannot be replicated by comparable assets. In addition, when the asset will not be traded or sold for the mere purpose of (say) taxation, estimation persists. Moreover, this difficulty tripled for commercial real estate due to the presence of revenue flows in valuation analysis. Lastly, there is the tendency for the error to be carried over time making that valuation to be driven away from accuracy like “a drunk tends to wander further and further from his starting point”. This means that the initially wrong valuation tends to be increasingly aggravated and problematic as time and transaction pass by (2002).
The research of (2002) found a methodology to resolve this problem. They propose that the optimal value estimate for a real asset is shown by three time-weighted terms; namely, a deterministic forward value, a comparison of observed values with previously determined time-filtered values and a convexity correction for incomplete information. This conclusion stemmed to there assumption that there are true asset values that are unobservable. The heart of the methodology integrates the observable and unobservable values of the asset through the use of autocorrelation and variances to calculate an efficient unbiased estimate of the true asset value. This research has useful implications in the land valuation specifically.
There are cases by which RMA is on the upper hand against the strict valuation features of HDMV possibly by the former ability to analyze the situation and other factors beyond financial matters. For example, the US Department of Interior (DOI) previously have strong assumption in favor of market price and appraisal methodologies in measuring damages committed by a guilty organization to compensate for environmental injury (1991). However, the District Court of Appeals placed DOI in error from persistently using this method. In the case of hazardous spills, natural resources and ecosystems have underlying values that are not fully captured by financial conversions. As such, valuation methods are not standalone techniques when reflecting the entire, causal effects and perpetual damages of oil spills and other corporate mismanagements.
The critique of contingent valuation (CV) and travel cost methods (TCM) in the realm of natural resources and ecosystems may also stand as an eye-opener for deeper thoughts about RMA and HDMV (1991). CV requires a valuation method that relies on individual responses to establish exchange value while TCM places valuation weighs on the travel costs of certain recreational sites from the destination of travelers to the site itself. The absence of price for non-market goods and determining its value is the challenge CV and TCM ought to pursue. However, the methodology of these two valuation techniques is tarnished. CV uses a questionnaire format to aid non-market goods but the open-ended question of this instrument adversely affects its reliability and validity. On the other hand, TCM looses its accuracy due to its valuation assumptions on how to deal with travel time, timing of visitors and number of visits that is obvious from travel contingencies and excessive uncertainty of traveling from the perspective of travelers. As implied, subjectivity and ambiguous assumptions deflect the objectivity of property valuation.
For the purposes of the preceding study, HDMV can be inserted with some weaknesses with regards to accuracy. This is especially significant if the development proposal to the land is not readily supported by a sufficient investment. There should be a guarantor to finance the improvement to be able for HDMV achieve accuracy as property valuation method. In the contrary, HDMV does not measure the value of land rather the value of the project. For this purpose, this idea is applicable to other valuation methods. On the other hand, the weakness of RMA is identified in its simplicity. The study can be useful for direct-value methods by which there are several factors to consider that questionnaire would be a possible improving tool for better valuation analysis. This is because valuators may face subjective answers when surveying the property and determining the relevant factors to consider.
Relevant Cases
Waters v Welsh Development Agency
This case highlighted the inability of HDMV to aid in deriving sound judgment for the purpose of determining the value of land alone. Although the use of HDMV concerns with valuing improvements which is the distress arising from the natural reserve qualities of the subject land, the case shows the far more important aspect of initially identifying if the improvements intended in the subject land is conclusive in its valuation ( 2006). However, HDMV would have helped when the natural reserve qualities of the subject land is included in the valuation attributable to the claimants. The valuation method would have provided the total sum of compensation the claimants should receive from the respondents. In the contrary, the process is not been tapped as it was initially admitted that the value of the subject land was exclusive with the improvements the acquirer can provide after the purchase and after the development (2006)
The preceding statement can be partially answered by RMA because of its ability to measure the socio-economic qualities of the subject land. Impliedly, it may have been used when the possible increase in value of the claimant’s land after acquisition by the respondents is terminated in arriving at the compulsory acquisition compensation (2006). RMA has the capacity to strip back the value of the land without the pre-supposed improvements. The Court admonished that the increase in compensation primarily due to the improvements of the land from the acquirer’s developmental efforts is invalid (2006). RMA is a more active tool than HDMV because the value of the subject land is required less with the value of improvements. Another, RMA is an analytical technique where the bounds of HDMV are very limited. However, RMA socio-economic indicator is undermined because the acquisition features of the subject land of providing habitation for national birds from the primary work of constructing a barrage is not injected in the computation (2006).
The case noted several learning on determining property value. First, the seller should expect that a buyer would realize an enhanced value for the subject land as it would appear to be non-saleable if positive characteristics are not eminent. This is in conjunction with the “value to the owner” principle in which the claimant should establish his own share to increase the value of the subject land (2006). In effect, no other value attributable to the subject land should arise if the need and purpose of the acquirer is already triggered. In the latter case, the supposedly increased in value would be passed on to the buyer. This provision convinced that HDMV is useful for the buyer alone to establish the level of development in the acquired land. On the other hand, RMA can be useful in the perspective of the Court to explain fully the reduction in the value complaint of the claimants. The claimants can use HDMV to compare the probable increase in the purchase price to the cost of litigation to assess their risks, that is, there should be a positive net gain between them.
Secondly, the “special and pressing want” of the acquirer-authority should be disregarded in imposing the fair compensation value for the claimants and the subject land (2006). There is no reason that the increase in motivation and interest of the buyer can amplify the land’s value. The Court implied that the seller cannot use such to push his self-vested concentration that ultimately bends the real value of the property. This is learning for HDMV and RMA to exclude potentiality assessment beyond ones that can be realized in the strict open market. Here, the buyer are seen as homogenous and should be approached in determining the value of the subject land accordingly. Third and last, when assessing property value, the Pointe Gourde or “no scheme” principle applies (2006). This means that there should be no increase in the value of land due to the implementation of a certain project. This is helpful in rationalizing the improvement-based limitation of HDMV. Its unique feature to evaluate the benefits of land or property development takes away its ability to evaluate the land or property instead. In the contrary, RMA mitigates this shortcoming by readily reducing the land value with developments to arrive with the value without the development.
Bowers v Council of the Shire of Pine Rivers
This case reflects the attributes of HDMV. Although it was not made implicit how the Court arrive in the exact amount of valuation from the disagreement of the claimant (.8M) and respondent (.4M) on the value of the land with pre-supposed development (2006). The hypothetical improvement is arisen from the 2003 intention of the respondent to resume the part of the 1978 land that included that of the claimant (2006). In the offing, the hypothetical amounts arrived by the two parties are applied with HDMV. However, the Court dug further from the arguments of the two parties in establishing the prospects of the subject land. For their purpose, RMA is minimally, if not actually, used. This is because HDMV and other valuation methods are the main tools that were utilized to determine the “best guess” on the per hectare rate of the resumption (2006). The main issue is to identify the highest and best use for the subject land wherein the claimant arrive on its land valuation figure by acknowledging that the land is possible to undergo a Residential A development while the respondent argued that it can only serve six rural residential allotments (2006).
Just like the first case, the second case provided several learning about property value. Initially, HDMV requires the development presumption to be framed and rationalize within the legal and operational restrictions that can impede and dissolve intended improvements (thus, additional value/ cost) for the subject land. This is what the “San Sebastian” principle is aimed at (2006). According to the research of the Court, Residential A prospect was viewed non-operational because there is no water and sewerage system at the time and before the resumption deal (2006). Further, rural allotments are too minimum for the highest and best use of the land. Rather, the Court awarded a probable improvement of the land as small park lots (2006). This brought to the open that the Court tried to rule in the middle of the claimant and respondent’s respective arguments. Due to this, it can be said that the execution of HDMV has shares of property analysis, development factor research and the intention of the Court for mitigation not merely arrival at an accurate valuation.
Then, RMA does not embody all the necessary tools to resolve property issues. Its optimal benefits are achievable if the property in question has already been applied with improvements. For the purpose of the Court, this situation is not useful because the property has yet been imposed with development. In fact, the core dispute of the two parties is the cost of the prospective development on the property (2006). As such, RMA obtain its own weakness. It does not have the concrete function to resolve valuation issues unlike HDMV primarily because the former is a technique for analysis. And in analysis, the premises and results should be available to be able for scrutiny to take place. Due to this, the case proves that HDMV is a prerequisite for RMA at times when development values are conflicting between the two parties in litigation.
Conclusion
From the presentation, it is found that HDMV and RMA have their strengths and weaknesses primarily because they belong to different methodologies; namely, valuation and analysis. As observed, RMA is used for the obtainment of HDMV since the arrival of a more accurate value estimate for a property requires analysis of the factors to be included in the valuation. On the other hand, HDMV serve as the benchmark for RMA to be able for parties to have valuation comparison and arousal of litigation goals if deviations are too excessive. This ultimately creates a vicious cycle wherein the methodologies of RMA and HDMV overlap that makes distinguishing their function difficult. Seemingly, one cannot be fully used if the other is not in similar operation or there is an error in using the complementary methodology. In effect, the process of valuation as well as deciding in litigation turn-out to be two-times exposed to error, that is, error in valuation and error in analysis.
In addition, the role of a valuator to his client exist because the task of valuating a property is knowledge-based and only expert advise can survive the industry standards and expectations. Due to this, it is inevitable for valuators to transform HDMV and RMA as complementary techniques to arrive at a professional level of valuation methodology. The use of such is what clients want and what Court needs. In the event that HDMV and RMA are separated, problems that ultimately lead to litigation arise. The absence of HDMV in RMA pursuits can be argued with result that has a lack in valuating the property entirely including future improvements to arrive at the highest and best use. Conversely, the absence of RMA in HDMV efforts can lead to financially-focused property value without regard to the implicit but important issues to consider like life and environment.
With this admonition, it is no wonder that HDMV and RMA are often misunderstood and interchanged. The undertaking to value a property is not done by laymen rather professionals while questions arising from the professional valuation is resolved by Courts. This situate people to have limited knowledge on the properties that embodies HDMV and RMA and (to our finding) their necessary combination in carrying valuation and litigation issues. It is like saying that laymen are undergone the potentials of technological era but do not know how the life improvements are made, or at best, laymen do not know how to use the full potential of new technologies. This is because they are not technical and legal professionals. They are mostly aware on how to consume the technology rather to improve it and are not motivated to fix it rather to call a technician to prevent additional cost of imprudence. If only laymen (buyers/ sellers, landowners/ interested or “with stake” parties) are aware of the how of the obscure technology (property valuation), fixing (HDMV) and improving (RMA) the technology can be done without technicians (valuators) and manufacturers (Courts).
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