Some recent developments in valuation practice and law

Transcription

1 Some recent developments in valuation practice and law Introduction 1. Most properties are assessed on the comparable basis. But some can only be valued by indirect methods; the R and E method and the CB method. The relevant principles are to be found mainly in case law going back to the nineteenth century. In the last 20 years or so there has been a good deal of litigation to tackle the problem of adapting old principles to modern economic conditions. I will focus on the R and E method, partly because some of the cases have involved some important legal principles of wider importance. The Joint Rating Forum Guidance Note on the R and E method 2. The JRF Note produced in 1997 is one of the best starting points. It sets out the key principles and gives guidance for each stage of the method. 3. The initial stages are concerned with choosing appropriate sets of accounts relative to (a) the AVD and (b) the list date (for the rebus sic stantibus factors set out in para.2(7) of schedule 6 to the LGFA 1988 eg state of the hereditament, mode or category of occupation, etc.) then adjusting these accounts to the rating hypothesis, so as to arrive at the divisible balance, or the profit to be divided between the HL and HT ie. taking into account only those revenues and expenses referable to the occupation of the hereditament. 4. The established case law says that the tenant s share has to be sufficient to induce him to take a tenancy of the property and to provide a proper reward - to achieve profit - an allowance for risk - a return upon tenant s capital (see JRF para.5.46). These elements can be assessed individually or taken together globally. 1

2 5. The tenant s share is a first charge on the DB, leaving a residue as the rent payable to the HL (or rateable value). That may sometimes result in the HL receiving a small rent, or even a nil rent (the Southern Railway case). That will depend upon the inherent profitability of the property. 6. The most difficult part of the R and E method is the distribution of the DB. It calls for skilful judgment on the part of the valuer. The JRF suggests four methods:- (1) percentage on HT s capital (2) percentage of gross receipts (3) percentage of the DB (4) a spot figure, appropriate to the size of the gross receipts, the HT s capital and the DB. 7. Methods (3) and (4) can be highly judgmental eg. giving 60% of the DB to the HT and treating the rest as rent. It may be necessary to find support in previous assessments and valuations for the same type of property. Similarly a method using a percentage of gross receipts is often based on comparators. 8. Much of the recent litigation has focussed on the first method, applying a percentage return to the HT s capital. To do this it is necessary to divide all the assets employed in the business between those which are rateable (the hereditament) and those which are not. The rateable assets (RA) are treated as belonging to the HL and the non-rateable assets (NRA) belong to the HT. As a matter of law, the valuer must assume that the successful bidder for the letting of the RA will also be able to purchase the NRA at market value (Railway Assessment Authority v. Southern Railway Company [1936] A.C. 266), so that the HT will be able to use all of the assets and operate the business. 9. So the HT s capital will comprise the market value of the NRA plus working capital. It is not always easy to determine that market value. There may well be no market evidence to rely upon. The assets may be unusual or even unique. The figures in the ratepayer s books may be no more than accounting 2

3 figures. The JRF suggests that where no better evidence is available, the valuer should estimate the depreciated replacement cost ( DRC ) for the HT s assets. 10. What then should be allowed as a percentage return on the HT s capital, so as to arrive at the HT s share of the DB, leaving the HL s rent as a residue (the rateable value)? 11. The JRF tells us that the percentage return on capital may be derived from a discount rate used in DCF appraisals, a ROCE from published accounts, or the target ROCE for a company (para.5.52). 12. The other rate of return suggested is the Weighted Average Cost of Capital (WACC). The WACC is an economic or corporate finance tool which combines two key components for the cost of financing a company s business, its cost of debt and its cost of equity, weighted according to the company s leverage (the proportions of its debt and its equity). 13. Following the 1994 decision of the Hong Kong Lands Tribunal in China Light & Power v. Commissioner of Rating and Valuation [1996] RA 475 valuers in the UK have been using WACC. The WACC approach was first applied by the Central Valuation Officer when valuing BT s hereditament in England and Wales and approved by the Central Valuation Tribunal ([1998] RVR 86). 14. Since then there has been a tendency to treat WACC as something like the philosopher s stone (or the valuer s stone), which because of its supposed objectivity can avoid criticism of a valuer for using judgment or being subjective. But the JRF did warn against treating the WACC approach as being definitive and the dangers of spurious accuracy (para.5.54). They turned out to be right. The first CLP case 15. In Hong Kong there are two electricity utilities. HEC covers Hong Kong Island. CLP covers Kowloon and the New Territories. They are each assessed on the R and E method. 3

4 16. In the 1994 decision the Tribunal relied upon evidence from economists to establish the WACC of CLP. It arrived at a figure of 27% (what is often overlooked is that the Tribunal then stood back and looked at the evidence overall and adjusted that figure down to 25% - [1996] RA at p. 508). 17. The key point to note about the 1994 decision is that the utilities were regulated then, and now, by a Scheme of Control agreed with the HK Government. That capped the return which could be earned by CLP and HEC to 15% on their regulated assets (valued by their net book value) (see [1996] RA 505). So at that stage CLP s cost of capital, and the rate of return allowed to the HT, was higher than the return which the company (or any hypothetical tenant) was able to earn in reality. But that was understandable, given the funding costs which would be borne by someone taking over the venture at that point in time. 18. Since then, of course, risk rates around the world have fallen dramatically. By 2004/5 the WACC for CLP and HEC were 10% and 8.31% respectively and yet the actual return they were earning was 15% (or close to that figure). The cost of capital had become cheaper than the actual rate of return being achieved. 19. The Commissioner insisted that the WACC approach should still be followed, so that a WACC of say 8.31% would be applied to the NBV of the HT s assets and all the residue of the DB would pass to the landlord as rent. Obviously, this produced a return for the HL on his rateable assets far higher than 15%. 20. In Hong Kong a fresh valuation list is prepared annually. As the cost of capital declined so the HL s proportion of the DB rose to 80% or even 90%. CLP s rateable value moved up from $2 or $3 bn. to about $14 bn. 21. Both utility companies appealed the assessments over a number of years and then two long trials took place to determine the RV s for 2004/5. HEC was the first to go. 4

5 Hong Kong Electric v. Commissioner of Rating and Valuation [2010] RA The Tribunal decided that the DB should be split in proportion to the respective assets of the HL and HT (using NBV s). The effect was to give to the HT the same rate of return on the NRA as HEC actually earned on all its regulated assets in the real world. The Tribunal said that the HT would look to earn what the actual operator was able to earn. It is the HT who bears the responsibility for running the business of generating electricity and supplying consumers so as to meet their requirements (paras ). 23. An important part of the Tribunals reasoning concerned the relative bargaining power of the hypothetical parties. The CRV had argued that it was only the landlord s rateable assets to which any monopoly of place attached (eg. because of their locational advantages) and so the HT s rate of return should be driven down to its cost of capital. The Tribunal disagreed. It decided that the HT s assets were functionally just as important as the HL s (they included boilers, turbines, transformers and switchgear). Both sets of assets were essential to achieving the profits of the business (paras ). 24. So the HEC decision, reinforced by the Tribunal s subsequent decision in CLP s case (LDGA 241/2004; LDRA 365-9/2004), has exploded the myth that WACC always provides a sufficient return for the HT in any R and E valuation. The HEC case in the Court of Final Appeal 25. The CRV successfully appealed to the Court of Appeal, overturning the Tribunal s judgment, so that the WACC method was temporarily reinstated. But HEC then appealed to the Court of Final Appeal, who overturned the CA judgment and restored the Tribunal s decision ([2011] RA , ; (2011) 14 HKCFAR 579). The main judgment on the R and E method was given by Lord Millett NPJ. It is just as important as the decision in Southern Railway. 5

6 Back to reality 26. In the 1994 CLP appeal Godfrey JA had said this in the Court of Appeal The world of rating appears to one unfamiliar with the arcane, to be cloud cuckoo land, a world of virtual unreality from which real cuckoos are excluded although it seems that permission to land will be granted to a cuckoo flying in from the real world if it can demonstrate that its presence in cloud cuckoo land is essential, not merely accidental: see Dawkins (VO) v. Ash Brothers & Heaton Ltd). But the CFA s decision in 2011 marks a firm return to reality. It reflected the reality principle laid down by the English Court of Appeal in Hoare v. National Trust [1998] RA 391, namely that the valuation should not depart from the circumstances of the real world, except in so far as the rating hypothesis otherwise requires (ie. as laid down in legislation and by case law). And so Bokhary PJ stated (para.5):- Throughout my life in the law, I have always regarded reality as a touchstone. If there truly is a separate rating world, then I am a mere visitor to it. And as such, I was initially somewhat bemused by the statements made in some of the cases to the effect that rating operates in a world of unreality or worse. As it seems to me upon closer inspection, however, there is no unreality in rating beyond that which is forced upon it by the requirement that the rateable value of a tenement be ascertained in terms of the hypothetical year-to-year tenancy laid down by s.7(2) of the Rating Ordinance. Likewise you will be glad to know that Litton NPJ and Millett NPJ stated that rating valuers should not operate in cloud-cuckoo land (paras. 104 and 190). 27. What sometimes bedevils rating cases are attempts to apply precedents or principles too literally or strictly, without considering whether that makes sense. 28. I suspect that many of you have often seen in rating appeals this passage cited from Lord Asquith in East End Dwellings Ltd v. Finsbury Borough Council [1952] AC 109, 132: 6

7 If you are bidden to treat an imaginary state of affairs as real, you must surely, unless prohibited from doing so, also imagine as real the consequences and incidents which, if the putative state of affairs had in fact existed, must inevitably have flowed from or accompanied it...the statute says that you must imagine a certain state of affairs; it does not say that having done so, you must cause or permit your imagination to boggle when it comes to the inevitable corollaries of that state of affairs. That reference to inevitable corollaries has led countless valuers and advocates to pile one artificial assumption upon another. The powerful analysis of Lord Walker NPJ in Best Origin Ltd v. CRV [2013] RA at pp (based upon English case law) should cause that practice to stop. He pointed out that the modern trend is to come back to the simple question what are the purposes of the statutory fiction. Those purposes should be used to define how far it is permissible to depart from reality. 29. In rating the fundamental object is to assess the occupation value of a property in annual terms on a uniform basis for all ratepayers. See what happened in the HEC case. The vacant and to let principle 30. In the well known case of Fir Mill Ltd v. Roydon UDC (1960) 7 RRC 171, 185 the Lands Tribunal decided that the hereditament must be valued on the assumption that it is vacant, that the existing process machinery (ie. NRA) has been removed, and the existing business has ceased. The CRV, ignoring the reference to cessation of the business, argued that although the incoming tenant would take over at market value the existing non-rateable assets, it must be assumed that at the very moment when the letting takes place and the valuation is carried out the NRA have been removed from the property for a scintilla in time and then immediately reinstated so that the business could carry on. In effect, all the lifts in Hong Kong would be without power for a split second. The effect, of course, would be to depress considerably the value of the HT s assets. 7

8 31. But the CRV did not really ask herself what purpose did that artificial assumption serve? Did it comply with the object of a rating valuation? The CFA held that it did not. An R and E valuation is carried out on a going concern basis in order to capture annual occupation value. The existing business, essential to the profit earning capacity of the hereditament, carries on without interruption. The HT s assets are not to be treated as removed and then reinstalled at the moment when the valuation is being carried out. The NRA are valued in situ. That does not give the actual occupier (or the HT) a sitting tenant advantage, because the NRA are available to all potential bidders in the market at their true market value, based upon the economic contribution they make (see eg. paras. 181, 187 and 190-9). 32. Lord Millett pointed out that the context of Fir Mill was very different. There the Tribunal had decided that an empty cotton mill should be valued as if it were available for any factory purpose (its mode or category of occupation) and not restricted to use as a cotton mill. Hence, the presence of process machinery for a cotton mill, which was an incumbrance to valuing the premises as a factory, had to be disregarded, in order to fulfil the statutory purpose of the rating hypothesis (para.196). The use of hindsight in a valuation 33. The 1994 CLP decision is often cited as authority for using post valuation date evidence, applying the Bwllfa principle ([1903] AC 428; see [1996] RA at pp.494-5). This subject has been revisited in an important decision by the HK Lands Tribunal in its Review Judgment in the CLP case (given on 3 January 2014). 34. As Lord Steyn said in R v. Home Secretary ex parte Daly [2001] 2 AC 532:- In law context is everything. In Bwllfa it was perfectly obvious that post valuation date material should be used. The case concerned a claim for compensation for loss of profits, a continuing loss. Plainly, regard should be had to the profits actually lost, 8

9 taking into account any actual mitigation of the loss. That could only be done with the benefit of hindsight. 35. The 1988 Act requires the rebus factors (paragraph 2(7) of schedule 6 to the 1988 Act) to be taken as they were on the list date, not on the valuation date. That is a statutory fiction, and not really hindsight. Beyond that, the object is to find the rent at which the premises would have let on the valuation date. 36. In the recent CLP case the valuation date was 1 st October 2003 and CLP s accounting year ended on 31 December. The issue was whether, as the CRV contended, the 2004 accounts should be used rather than the 2003 accounts. David Holgate QC Landmark Chambers 31 st March 2014 This seminar paper is made available for educational purposes only. The views expressed in it are those of the author. The contents of this paper do not constitute legal advice and should not be relied on as such advice. The author and Landmark Chambers accept no responsibility for the continuing accuracy of the contents. 9