UT-2023-000116; - [2025] UKUT 00164 (TCC)

Apart from the definitions referred to at [108] above, there was some other material contained in the RICS Appraisal and Valuation Manual (5th edition, issued 2003), colloquially referred to as “the Red Book”, to which we were referred.

By way of introduction, it was explained to us that the Red Book consisted of two main elements, Practice Statements (compliance with which is mandatory for RICS members carrying out formal professional valuations) and Guidance Notes. The status of the Guidance Notes was set out in Part 1, Section 6, paragraph 6.9 of the Red Book as follows:

In addition, it was specifically recognised that “there are situations and circumstances where valuers, exercising their proper professional skill and judgment, will not necessarily follow the Guidance Notes.”

Thus a chartered surveyor would be constrained by the terms of the Red Book in carrying out a valuation, whether or not the valuation was for the purposes of a company’s accounts. He or she would be required to comply with any relevant Practice Statements in the Red Book, but would be permitted to disregard any Guidance Notes to the extent that the exercise of proper professional skill and judgment allowed.

The parties were agreed that there is no specific guidance within the Red Book on undertaking valuations in accordance with FRS 7 in the context of business acquisitions. There was however a Practice Statement PS1 addressing “Valuations for Financial Statements”. This provided (at PS1.1) as follows:

In the associated commentary, reference was made to FRS15 (and an earlier SSAP19 in relation to Investment Properties), and the equivalence of “Market Value” to the previous obsolete term “Open Market Value” as used in FRS15.

Existing Use Value was defined and commented on in PS1.3, which provided as follows:

The definition [ ], differs somewhat from the earlier RICS definition which had been imported into FRS15, though neither party argued the differences were material for present purposes.

Paragraph 5.2 of the commentary under PS 1.3 said this:

Section PS3 of the Red Book was headed “Valuation bases and applications”. PS3.1 provided as follows:

PS3.2, headed “Market Value”, provided that “Valuations based on Market Value (MV) shall adopt the definition, and the interpretive commentary, settled by the International Valuation Standards Committee.” After that definition and interpretive commentary were set out, some additional commentary was added, which included the following at paragraph 6:

Guidance Note GN1, entitled “Trade-related valuations and goodwill”, went through a number of versions over the relevant period. We were provided with versions from May 2003, September 2003, January 2006 and unknown dates in 2007 and 2008. In the 2006 version, its title was changed to “Specialized Trading Property valuations and goodwill”, and for the 2007 and 2008 versions its name was changed again to “Trade related property valuations”.

The introduction to GN1 remained largely the same throughout these versions. The following text shows the original version from 2003, with alterations made in the 2007 version (and carried through to the 2008 version) noted in italics:

There was fairly substantial revision of GN1 in its 2006 version compared to previous versions, and again in the 2007 version. The 2008 version appears unchanged from the 2007 version in all material respects. During the course of argument, we were referred by the parties to extracts from a number of the different versions for different purposes. Since the issues before us arose in relation to acquisitions which would have first been accounted for in accounts for the years ended 31 October 2004, 2005, 2006 and 2007, and since the various versions of GN1 show an evolution and development of the original guidance rather than any fundamental changes to it, we consider it appropriate to have regard to all of them. The only qualification we would add is that the concept of the “reasonably efficient operator” in valuing “Specialized Trading Properties” only became fully explicit and well-developed in the 2006 version of GN1, however we are satisfied that references in the earlier versions to “an average competent operator” were effectively intended to refer to the same underlying concept.

The introduction of the phrase “specialized trading properties” in both the title and content of the 2006 version of GN1 potentially caused confusion, which we infer was the reason for the phrase being dropped again in later versions. It will be recalled (see [108] above) that as early as 1999 (the date of adoption of FRS15), the Red Book had contained a separate definition of “specialised properties” which was adopted for the purposes of FRS15, and only covered properties far more “specialised” than care/nursing homes. As the parties clearly agreed, GN1 was intended from the outset to cover a far wider range of what later became defined as “trade related properties” (including nursing/care homes – as was made explicit in the 2007 version).

In accordance with paragraph 1.2 of its introduction (see [128] above), the purpose of GN1 was to draw attention to “the additional criteria that need to be considered by the valuer” when valuing the properties to which it related, and it was not concerned with the actual “methodology” or “method of valuation” in each case.

We were also provided with a further RICS document, apparently dating from 2011, entitled “GN2 Valuation of individual trade related properties”, whose stated purpose was to set out the principles of the “income approach” method of valuation, but without going into the detailed approach that might be relevant to any particular sort of trade related property. The purpose of this Guidance Note therefore appears to be to provide more detail of the methodology to be adopted in approaching the valuation of such properties.

Dealing first with GN1 in its various iterations, the first issue addressed was “identifying the operational entity”. This was concerned with ensuring that only the appropriate assets were included in any valuation (so excluding consumables, stock in trade, leased assets, etc).

The core of GN1 was then concerned with distinguishing between trading and nontrading properties for valuation purposes. The “correct” valuation basis for a trading property was given as “market value as a fully-equipped operational entity, having regard to trading potential”, whereas for a non-trading property the “correct” basis was given as “market value of the empty property having regard to trading potential”. By way of commentary on the latter basis, the versions up to 2006 said this: The closure of a business, and the removal of some, or all, of the trade equipment, may have a significant effect on the value of the property. It will, therefore, often be appropriate to express the value on the basis of one or more Special Assumptions, as well as on a basis reflecting the status quo. This is often a requirement when advising a lender as to the value of trade-related property for loan security purposes.

In the 2007 and 2008 versions of GN1, the text was significantly revised, but wording to the same effect was included, with the addition of the following: It does not follow that the difference between this special assumption and the value reflecting the status quo represents the value of transferable goodwill, and valuers should not indicate any such apportionment. For example, the differences could reflect the cost and time involved in removing the fixtures and purchasing new equipment.

GN1 then went on to consider in more detail the application of the “market value” concept to trade-related properties, with some analysis of how two aspects of goodwill – the first referred to as “inherent” or “transferable” goodwill and the second as “personal” goodwill – played into the market value of such properties. The 2007 version of GN1 reflected, as one might expect, a refinement and slight evolution of the earlier versions, without material change to the underlying principles. Most of the 2007 version of GN1 is included at Appendix 4 to this decision.

Turning to GN2, it was not explained to us why there was no version earlier than 2011 in the documents before us, nor indeed whether an earlier version even existed. GN2 does appear to cover much of the same ground as GN1, whilst additionally going into detail on valuation methodology; it also makes reference at one point to a separate document “GN1, Valuation certainty”, and since none of the versions of GN1 before us made any reference to “valuation certainty”, we infer that there had been some redrafting and re-numbering of the Guidance Notes such that GN2 now encompassed all the material previously included in GN1, which had itself been replaced by a new document which addressed entirely different issues. In short, GN2 represented an expanded version of GN1 which addressed in a single document both the relevant content from the earlier GN1 and more detail on valuation methodology.

The introduction to GN2 started as follows:

GN2 then went into great detail on the steps involved in a “profits method of valuation”. This involved first making an assessment of the fair maintainable turnover (“FMT”) that could be generated at the property by a reasonably efficient operator (“REO”). An assessment should then be made of the potential gross profit arising from the FMT, which should then be adjusted to arrive at a fair maintainable operating profit (“FMOP”). A market value could then be arrived at for the property by capitalising the FMOP “at an appropriate rate of return reflecting the risk and rewards of the property and its trading potential.” In doing so, “evidence of relevant comparable market transactions should be analysed and applied”.

Under the heading “5. Valuation approach for a fully equipped operational entity”, it was stated that such a valuation “necessarily assumes that the transaction will be either the letting or the sale of the property, together with the trade inventory, licences, etc., required to continue trading.” This might in turn require further assumptions to be made as to the continued availability of (for example) leased assets, licences, consents, permits etc.

The end result of a valuation using this approach would be reported as “Market Value as a fully equipped operational entity having regard to trading potential subject to any agreed or special assumptions…” (the same wording as paragraph 3.2 in the previous GN1, see Appendix 4).

Under the heading “6. Valuation approach for a non-trading property” the following text appeared:

The end result of a valuation using this approach would be reported as “Market Value of the empty property having regard to trading potential subject to the following special assumptions…” (the same wording as paragraph 3.5 in the previous GN1, see Appendix 4).

GN2 also contained definitions of “Personal goodwill (of the current operator)” and “Trading potential”, as follows:

Finally, we were also supplied with a further RICS document dating from January 2014 and headed “VPGA 4 Valuation of individual trade related properties”. This appears to replace GN2, and apart from some small renumbering, entirely echoes the earlier document.

Introduction

The commentary to PS3.2 indicates that special consideration must be given to the application of Market Value to certain categories of property that are normally bought and sold on the basis of their trading potential. Examples of this type of property include hotels, bars, restaurants, movie theatres or cinemas, gasoline or petrol stations. The essential characteristics of properties that are normally sold on the basis of their trading potential is that they are designed, or adapted, for a specific use and that ownership of the property normally passes with the sale of the business as an operational entity.

This Guidance Note considers the additional criteria that need to be considered by the valuer in these cases. It does not concern itself with methodology, which will vary depending upon the trading property to be valued.

Identifying the operational entity

The operational entity will usually comprise:

Consumables and stock in trade are normally excluded.

The valuation of an operational entity necessarily assumes that the transaction will be of the property interest, together with all the equipment required to continue operating the business (it is assumed to be ‘fully equipped’). In this context equipment includes Plant & Machinery, fixtures, fittings and furnishings. However, care must be taken because this Assumption does not necessarily mean that all such equipment is to be included in the valuation. For example, in the case of a valuation in connection with a proposed transaction, or for security purposes, some equipment may be owned by third parties and will therefore not form part of the interest being valued. When valuing for Financial Statements the valuer must be clear whether equipment is classified as fixed assets or as consumables. In order to avoid misunderstanding the valuer should always establish what is to be included in the valuation when settling the Terms of Engagement, and make this clear in the Report.

Where assets that are essential to the running of the entity are either owned separately from the land and buildings, or are subject to separate finance leases or charges, an Assumption may need to be made that the owners or beneficiaries of any charge would consent to the transfer of the asset as part of a sale of the operational entity. If it is not certain that such an Assumption could be made, the valuer must consider carefully, and comment in the Report on, the potential impact on the valuation that would be caused by the lack of availability of those assets to anyone purchasing the operation.

Application of Market Value

The valuer should distinguish between the Market Value of an operational entity, and the value to the particular operator (its Worth to that operator). The operator will derive Worth from the current and potential net profits from the business operating in the chosen format. While the present operator will be one potential bidder in the market, to come to an opinion of value the valuer will need to understand the requirements and the achievable profits of all other potential bidders, and the dynamics of the open market.

It is necessary to qualify Market Value in order to make clear what is included in the valuation, and the Assumptions that have been made as to the property’s trading status.

Where the property is trading the correct basis would be:

However, if the property is vacant following a cessation of trade, or if it is a new property with no existing trade to transfer, other variations may be required to describe this. For example, a vacant property is likely to have been stripped of all or much of its trade equipment, but could still be valued having regard to its trading potential. The correct basis here would be:

The closure of a business, and the removal of some, or all, of the trade equipment, may have a significant effect on the value of the property. It will, therefore, often be appropriate to express the value on the basis of one or more Special Assumptions, as well as on a basis reflecting the status quo. This is often a requirement when advising a lender as to the value of trade-related property for loan security purposes. Examples of Special Assumptions are given in Appendix 2.3.

Trade-related potential and goodwill

The trading potential that is attached to a property is sometimes referred to as ‘goodwill’. However, a valuation on the basis of Market Value should exclude any personal goodwill to the present owner or operator which would not be passed to a purchaser of the property.

The task of the valuer is to assess the fair maintainable level of trade and future profitability that could be achieved by an operator of the business upon which a potential purchaser would be likely to base an offer. When assessing future trading potential the valuer should exclude any turnover and profit that is attributable solely to the personal skill, expertise, reputation and/or brand name of the existing owner or management. However, in contrast, the valuer should include any additional trading potential which might be realized under the management of an average competent operator taking over the existing business at the date of valuation.

Problems can sometimes be encountered in understanding and defining the goodwill attached to the land and buildings of a property by virtue of its circumstances, such as its location, design, planning rights, licence and occupation. This ‘inherent goodwill’ should be carefully differentiated from personal goodwill.

It is particularly important to be able to identify the type of person or entity that constitutes a potential purchaser of such a property (excluding a ‘special purchaser’). Generalizations can be dangerous and misleading. Consequently, it is essential for the valuer to have detailed knowledge of purchasers’ requirements in the relevant market and to have an in-depth appreciation of the market.

When valuing properties by reference to trading potential, the valuer will need to compare trading profitability with similar types and styles of operation. Therefore a proper understanding of the profit potential of those property types, and how they compare to one another, is essential.

The valuer should endeavour to establish the accuracy and reliability of trading information provided for the purpose of the valuation. If any doubt of its accuracy exists, or of the underlying Assumptions supplied, the valuer should recommend verification.

A secondary basis of comparison may be by reference to physical factors, for example, when comparing one hotel with another using a value per bedroom approach. However, when using such a method it is essential that the basis used for comparison is truly relevant, as regards style, location, trading circumstances, and so on.

New competition can have a dramatic effect on profitability, and hence value. The valuer should be aware of the impact of current, and expected future, levels of competition and, if a significant change from existing levels is anticipated, should clearly identify this in the Report and comment on the general impact it might have on profitability and value.

Outside influences, such as the construction of a new road or changes in relevant legislation, can also result in a very substantial effect on the value of property valued by reference to trading potential.

Particular care must be taken, where the valuation is for the purposes of Financial Statements, to ensure that other items in the Financial Statements are not already included in the valuation.