Are you in a spin over rotation?
The long-awaited update of the RICS Red Book UK Supplement was published on 19 October. The changes that will surely attract most attention are the new rotation and authorisation requirements for Regulated Purpose Valuations (“RPVs”) in UK VPS3. These changes stem from recommendations in the Independent Review of Real Estate Investment Valuations issued by Peter Pereira-Gray in December 2021. While these changes reflect how best practice has evolved in the target market of the review, RICS valuers need to be careful not to unnecessarily trigger these requirements in other situations.
One of the Pereira-Gray recommendations was that RICS should develop a time-specific, mandatory procurement and rotation process for valuers. Since 2003 the Red Book has required firms that provide repeated valuations of the same asset and which may be relied on by parties other than the client to have and disclose a rotation policy for the valuer responsible. This is followed by a statement that RICS considers it good practice, but not mandatory, to rotate valuers at a maximum of seven yearly intervals. Although this remains in PS2 5.4 of the current Global Red Book, in the UK, where the term RPV is used, this is to be replaced from May 2024 by mandatory rotation requirements. In a nutshell UK VPS3 3.3 now states:
The valuer responsible cannot value the same asset or assets for a continuous period of more than five years, and there must be a break of at least three years before they resume responsibility for the same valuation.
The valuation firm must not agree a contract for more than five years to value the same asset for the same purpose and can only accept a further contract if they have not valued the same asset for the same purpose for a continuous period of more than ten years without a break of at least three years.
There are transitional arrangements where existing contracts are in place that apply for two years from 1 May 2024.
Pereira-Gray also made recommendations around how such valuations should be authorised by clients. These have been implemented by RICS in the new UK VPS3 3.4. These require the valuer to ask the client in writing whether the instruction or draft instruction has been made with the approval of a non-executive director, an independent chair of the audit committee, a corporate compliance officer or another person of equivalent “power or authority”. The client’s response must be included in the final terms of engagement and referred to in the report or any published reference to it. However, it is silent on what the valuer should do if the client declines to respond.
As is clear from the title of the Pereira-Gray review, it was concerned with valuations of investment property. Furthermore, it is apparent from reading the report that its focus was the recurring valuations, typically quarterly or monthly, required by funds investing in real estate. Few would argue that the need to ensure independence and minimise threats to objectivity mean both limits on the length of time that the same valuer or firm continuously values the same asset and effective oversight of the process for appointing new valuers are reasonable measures. I therefore welcome the proposals as they relate to valuations for regulated funds, REITs and other real estate investment vehicles.
I do, however, have concerns that problems could have been created for both RICS members and their clients by including ANY valuation for financial reporting for a private sector entity in its list of what constitutes an RPV. The only exception from the new provisions in UK VPS3 3.3 and 3.4 is if the client is a micro entity, a small or medium company as defined in the Companies Act. This overlooks very important distinctions between how investment property is treated in financial statements compared with other types of property, plant and equipment.
In financial reporting investment property is unique as it is the only non-financial asset class for which the fair value on the reporting date must be disclosed, either as the carrying amount on the balance sheet or in the notes to the accounts. In contrast, other fixed assets such as operational property, plant and equipment can be carried either at initial cost less depreciation or at fair value. In my experience, most entities adopt the first option. Where an entity’s main activity is not investing in real estate the value of its operational property, plant and equipment is rarely a material consideration in the financial performance of the entity and this is why accounting standard setters have never mandated the disclosure of the fair value of such assets in financial statements.
Notwithstanding the preference for carrying most assets other than investment property at cost less depreciation, it not uncommon for a valuer to be asked for an estimate of fair value of such assets to assist an entity in the preparation of its financial statements. Such valuations can be used to help the entity determine both the depreciable amount and the amount of depreciation to apply to an asset but are not going to be disclosed to investors. Encouraging access to appropriate expertise to assist in this process is surely in the interests of the entity and its shareholders. Putting unnecessary obstacles in this process is unhelpful.
The need to rotate valuers who may have provided valuation advice that has never been, nor will be, relied on by a party other than the client and the requirement for the valuer to enquire whether an appropriate person has authorised their appointment are unnecessary complications. It is difficult to imagine the finance director of a listed engineering company responding well to a request from a valuer for confirmation that a non-executive director has authorised their appointment when all they want is the fair value of operational property and an apportionment to its component parts to help them determine what depreciation charges they should make in their accounts.
A further practical issue is that when providing a valuation of operational property, plant or equipment the valuer, or indeed their client, may not know whether the valuation will be disclosed or relied on in the final financial statements. That will be a decision for the client after they have received the advice, not the valuer.
This problem could have been avoided if the definition of an RPV in UK VPS3 had been made consistent with PS2 5.1 in the Global standards by applying only to valuations to appear in published financial statements rather than valuations for any financial reporting purpose. Alternatively, it could simply have stated that only valuations of investment property for financial reporting fell within the RPV definition. It is to be hoped that one or the other changes will be made in future editions of the UK Supplement.
In the meantime, RICS firms will need to act carefully if approached to provide valuation advice for assets other than investment property which their client requires to assist with its financial reporting. I suggest the following need to be considered with particular care when preparing the terms of engagement for such an instruction*:
The identity of the legal entity that is the client. Bear in mind that the directors of a company are a separate legal entity from the company and its members.
The valuation purpose should be to advise the directors and management only in connection with their selection of appropriate accounting policies.
Ensuring that the valuation is for the named client’s use only and that it may not be published or referenced in the entity’s published financial statements or disclosed to any third party without the valuer’s consent in writing.
Advising the client that if it wishes to refer to or otherwise disclose the valuation provided in the published accounts, RICS standards require specific procedures to be followed which will require a supplementary instruction and terms to be agreed.
The values provided should of course be consistent with the relevant accounting standard but citing the required basis or other provisions does not automatically mean that they can be used for financial reporting by the client, just that they are suitable for such use.
These measures should ensure that the initial advice will fall outside the provisions of UK VPS3 unless and until the client decides that it wishes to disclose or refer to the valuations provided. If this happens then it will be necessary to agree supplemental terms based on the conditions and disclosures in UK VPS3, and also to comply with other existing provisions for financial reporting valuations, such as a draft publication statement as required by VPS 3 2.2(j) in the current Global Red Book.
© Valuology 2023
*These recommendations reflect the interpretation of the author of the contrasting provisions in the RICS Red Book Global and new UK Supplement and are not endorsed by RICS. Firms are advised to obtain specific legal advice on the terms that are appropriate for the type of work they commonly undertake.