Covid-19: Uncertain property valuations

Uncertainty of Property Valuations

Valuations carried out in the UK are ordinarily performed based on the Royal Institution of Chartered Surveyors (RICS) Red Book guidelines. These valuations generally comply with the requirements of IFRS and UK GAAP as a fair value measurement. However, RICS has recently issued a statement advising members that they may need to insert the following ‘uncertainty clause’ into Red Book valuations undertaken for their clients:

… As at the valuation date, we consider that we can attach less weight to previous market evidence for comparison purposes, to inform opinions of value. Indeed, the current response to Covid-19 means that we are faced with an unprecedented set of circumstances on which to base a judgement.

Our valuation(s) is/are therefore reported on the basis of ‘material valuation uncertainty’ as per VPS 3 and VPGA 10 of the RICS Red Book Global. Consequently, less certainty – and a higher degree of caution – should be attached to our valuation than would normally be the case. Given the unknown future impact that Covid-19 might have on the real estate market, we recommend that you keep the valuation of [this property] under frequent review.

The Challenges

This situation provides challenges to both companies in the preparation of financial statements, and their auditors, where the company in question accounts for properties at fair value. The issue is most acute for property investment companies whose property assets are typically accounted for at fair value (mandatorily for all but the smallest companies under UK GAAP and as an accounting policy choice under IFRS). However, investment property companies are not the only ones affected. For example, some companies:

• have surplus property assets that meet the definition of investment property that is accounted for at fair value, albeit property investment is not be their primary activity;
• own the freehold of properties that they use in their business operations, applying a policy of revaluation to such owner-occupied properties;
• invest surplus funds into unit trusts, which have direct property investments. A number of these funds have suspended redemptions by unitholders on the basis that a reliable value cannot be determined. Under IFRS, such investments are required to be measured at fair value and ordinarily would be measured at fair value under UK GAAP. Although cost is a permitted basis of measurement under UK GAAP where fair value cannot be reliably estimated, issues arise where they previously have been accounted for at fair value, i.e. in times where it was considered the fair value could be measured reliably; or
• sponsor defined benefit pensions, with scheme assets invested directly in property.  All scheme assets are required under both UK GAAP and IFRS to be measured at fair value of scheme assets for the purposes of accounting for those pension arrangements.

In light of the RICS statement, where a property valuer deems it necessary to qualify its valuation, this may not be sufficient to comply with IFRS or UK GAAP fair value requirements. 

UK GAAP

Under UK GAAP, where a reliable measure of fair value is no longer available for an asset measured at fair value, its carrying amount at the last date the asset was reliably measurable becomes its new cost. The company is then required to measure the asset at this cost amount less impairment, if any, until a reliable measure of fair value becomes available.

IFRS

However, looking to IFRS, the situation where observable inputs are not available is addressed. In such circumstances, the company would be required to develop unobservable (Level 3) inputs using the best information available in the circumstances, which may be internal data. Whilst this may result in a change in valuation technique, this is permissible in circumstances where a change in valuation technique or its application results in a fair value measurement that is equally or more representative of fair value under the circumstances. Changes in market conditions is an example of such a change.

However, where an adjustment applied to the valuation technique (calibrated to the last unqualified market value) may be possible for certain properties (e.g. tenanted investment properties), it may not be possible in all circumstances to collate sufficient internal data to reliably value all properties on that basis.

It is, however, clear in IFRS that if an investment property has been previously measured at fair value, it shall continue to be measured at fair value.

This may leave some companies reporting under IFRS in a difficult position, as depending on materiality, auditors are likely to draw attention to the valuation uncertainty identified by valuation expert though inclusion of an “emphasis of matter” paragraph in their audit report.

Given, the challenges in this area companies with properties carried at valuation should have early discussions with their advisers.