Serviced office valuations raise tempers

Copyright: David Lawson– Property Week Jan 2000

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The UK property industry has a  remarkable talent for shooting itself in the foot. No sooner does it find a sector to raise the pulse of investors, than it descends into doubt and anxiety about how to handle it.

  The paint is barely dry on the sign which hived off serviced offices from the rest of the market yet valuers are  coming under fire for stifling the sector's growth. 'We have had dozens of schemes stopped in their tracks because buildings are still rated at vacant possession value,' complains  Ian Read of Citibase, one of a clutch of smaller operators aiming to build national chains.

  He is not alone. Tempers are becoming equally  frayed at the other end of the spectrum, where  Regus and HQ pulled out of stock market floats as squabbles developed  behind the scenes over asset valuations. Such big players are are not shy about using their financial muscle to lean on nervous lenders but they often rely on venture capitalists and  grumble to anyone who will listen about  the pessimism that valuers splash across their accounts.

  This is nothing new, of course. Retail warehousing and leisure parks are still struggling to escape valuations geared to 'mainstream' uses rather than acceptance in their own right. But Read sees a wider significance in the troubles faces by his market.

 'Everyone accepts there is a sea change in the way occupiers will look for accommodation in future,' he says. 'Shorter tenure will become more common. But where will it come from.'

  Occupiers are  struggling to cast off surplus space as they rationalise to core activities but a new generation of landlords keen to take on the space for serviced offices is being held back.

  Research by the Department of Land Management at Reading University has confirmed that this is not the cry of some small, frustrated player. As with any new property format, fault lies in the tortoise-and-hare structure of the industry. Pioneers rush forward  with some amazing product which fills a market gap but valuers plod behind, hobbled by old conventions.

   Almost inevitably, the academics reached similar conclusions as in the past: the real villains are the banks, which refuse to consider valuations other than on a pure bricks-and-mortar basis. The logic is that a serviced office operation may fail, so no extra value should be attached to the use. Buildings must be rated only according to vacant possession value.

   That sends even the most enthusiastic landlords rushing back into their shells, says Citibase, which co-sponsored the research with consultants DTZ. 'An owner may be keen to offload empty space but once advised it will add no extra value, will often withdraw,' says Read.

 Even if that hurdle is straddled, freeholders can present another barrier. 'We were ready to go with one central London office block but the owner's advisers said it would damage the value of the building to have a serviced office use. It is still empty three years later, draining the leaseholder's cash flow' he says.

 Those two final words are crucial to finding a way out of this tangle. Cash flow is crucial says the Reading University report.'For bank lending purposes, the underlying property asset is not the only factor to consider. Lending policy should be based on the potential profitability of the business as well as the property asset.'

  Banks are 'misreading' this sector if they stick to vacant possession values while valuers using traditional techniques 'may fail to assess the value accurately', it adds.

 Cash flow valuations are not revolutionary. In fact, they are enshrined in the RICS Red Book and commonly used for hotels and leisure operations. So why are there still so many problems?

 This is partly because big operators are grabbing headlines as they grow, giving the impression that all is well. But  they often buy freeholds and  rely on their reputation to influence banks. That does not mean they are entirely happy.

 MWB chief executive Richard Balfour-Lynn points out that DLJ recently paid 25m pounds for a 20% stake in his business centre operation, which in theory made the assets worth 125m pounds.  In practice, however, the fully diluted NAV stands at 10m pounds in the firm's accounts.

 'We may not have problems borrowing but we do have one putting forward an accurate picture as a public company,' he says.

 Smaller operators  hit the buffers because they offer a service rather than buy their own property. Citibase accumulated its 11 centres at a time when forced sales put prices close to vacant possession value but now faces a tougher time.

 Read blames  valuation firms which  are slow to adopt non-traditional techniques. 'We sponsored the research to get a debate going and persuade them to move,' he says.

  Valuers bridle at being made villains in this saga, however, pointing out that they are the servants of banks. Robert Peto, a director of DTZ,   agrees with the academics  that banks are 'looking at things from the wrong end of a telescope' by not asking for figures which take some account of the business being run from a building. That means they end up with a 'worst-case scenario', he says.

 He has more than co-sponsor's interest in the research, however. As a member of the RICS Appraisal and Valuation Standards Board, he helps shape amendments to the Red Book. He is also trying to clarify the concept of  investment worth  in a think-tank set up with the Investment Property Forum.

 So are there  changes in the pipeline to satisfy the likes of Read and Balfour-Lynn? 'There is nothing on the agenda about amending the Red Book,' he says. But, as the research makes clear, that may not be necessary when approved techniques already exist for cash flow appraisals.

 'I suggest serviced office operators should go to a different part of each bank,' says Peto. 'Try the business lending desk rather than the property desk.'

  That will demand some introspection by the operators themselves. Most believe they are property companies offering flexible space, according to the Reading University study. Perhaps they should take note of the major names, which see themselves as 'systems integrators'.

 'That they own the buildings or lease them on a long-run basis is secondary to the operation,' it says.

  Either way,  serviced offices still carry a stigma which carries valuation penalties and antipathy from landlords and institutions. This is still a new market and many are still waiting to see how it performs in a downturn. Peto also points out that until one operator buys another, there will be no benchmark for investment values.

 In the meantime, the report calls for more use of cash flow analysis. Not surprisingly, this is not a new idea. The academics recollect that the 1994 Mallinson Report called for the need to 'know the client' and their business to give proper advice. Potential borrowers could help themselves here as well.

 'Secrecy surrounding the level of income, expenditure and returns within individual business sectors is a barrier to the ability of valuers to value accurately,' says the study.

  Perhaps time, and a maturing market, will solve that, as well as lifting the stigma. Meanwhile bankers - and their valuers - will probably be tarred as villains. But they should be used to that by now.