Part 3: the contractor's basis of valuation
The Valuation Office Agency's (VOA) technical manual for the rating of business (non-domestic) property.
This method of valuation (originally known as the Contractor’s Test) is that employed in the case of hereditaments which are normally never let, which by their nature do not lend themselves to valuation by comparison with other classes where rental evidence does exist and which are not of the type where a valuation by reference to the accounts of the undertaking (Receipts and Expenditure Method) would be appropriate.
Contractor’s Basis can also be employed in the valuation of part of a hereditament which is otherwise valued on a rental basis but where the value of an item is not readily ascertainable by reference to rents, eg certain categories of plant and machinery.
The basic philosophy underlying the contractor’s basis is set out in the case of Dawkins (VO) v Leamington Spa Corp and Warwickshire CC (1961) 1 RVR 291:-
- The hypothetical tenant has an alternative to leasing and paying rent because he can build similar premises; the “tenant’s alternative”.
- The hypothetical tenant would not pay more in rent, and may well pay somewhat less, than interest charged or foregone on the capital sum employed in providing the “tenant’s alternative”.
The concept of the “tenant’s alternative” was confirmed in the case of Monsanto v Farris (VO) (1998) RA217, but in the Lands Tribunal Dr Hoyes said:
“However, I would reject the literal interpretation which assumes the actual building of an alternative hereditament. In operating the five stage method it is neither built nor valued, it is a total fiction and as such it should not be dressed in the clothes of supposed reality, because that produces even greater unreality …..”.
The Stage 1 costs will therefore relate to a new hereditament, but the valuation must remain firmly rooted in the actual hereditament.
1.2 Further Reading
The usefulness of the Contractor’s Basis in appropriate circumstances was approved by the Lands Tribunal in Eton College v Lane (VO) (1971 LT RA 186) and for further reading about this method of valuation the valuer should refer to the appropriate section in Ryde on Rating and the Council Tax - Division E Chapter 7.
1.3 Antecedent Valuation Date
Paragraph 2(3), Schedule 6, Local Government Finance Act 1988 provides that for the purposes of compiling a list the day by reference to which the rateable value is to be determined is either the day on which the list must be compiled or such earlier day as the Secretary of State may provide by Order.
The Rating Lists (Valuation Date) Order 1988, SI 1988/2146 specifies 1 April 1988 as the AVD for the 1990 List, and there are similar orders for subsequent Lists.
For the purposes of valuations on the Contractor’s Basis it must be assumed that a hypothetical tenant would estimate costs for the “alternative” hereditament, complete and fitted out with all rateable plant installed as at the AVD. No costs or values are to be taken at a date earlier than the AVD.
In valuing to an AVD, the “physical state” of the hereditament must be taken to be as at the date the list comes into force, or a relevant subsequent date, but other factors influencing value, including costs, must remain rooted at the AVD.
2. The Method
Although the method is now more generally referred to as the Contractor’s Basis, the original use of the word “test” was pertinent in that whilst interest on cost as a guide to rental value is the basis of the method, it is not envisaged that the hypothetical tenant should be considered as building the actual (or if appropriate a modern substitute) hereditament, but that its rental value would be “tested” by having regard to what it would cost to build and the interest that would thereby be forgone or become payable.
Whilst in the past the Contractor’s Basis has been criticised and referred to as a method of last resort, it has been refined over the years through a number of Lands Tribunal (and higher) appeals and is now an acceptable method to be employed in the valuation of certain classes of hereditament, in particular in the larger industrial field, eg oil refineries and steelworks, and also public buildings, universities, etc.
However, the underlying theory of the method is still subject to some debate. Any difficulties in this respect should be referred through the TA to CEO (Rating) for advice.
Most importantly, the valuer should not lose sight of the fact that the method is only a means to an end, ie. establishing the rental value of the hereditament under the statutory hypothesis, and whilst it is normally used in cases where other methods are not appropriate or where comparison cannot readily be made with other hereditaments, nevertheless it should not be used blindly nor in isolation and wherever possible and as far as can be ascertained the values achieved by the use of the Contractor’s Basis should be consistent with the levels obtained by other methods and applied to other hereditaments.
3. The Valuation Stages
As the Contractor’s Basis was refined, an approach based on five stages of valuation evolved and this was followed by the Lands Tribunal in Gilmore (VO) v Baker Carr (No 2) (1964 LT 4 RVR 7).
The creation of more than five stages is also possible; indeed the Lands Tribunal commented on this aspect in Imperial College of Science and Technology v Ebdon (VO) and Westminster City Council (1984 LT RA 213) and departed from the established approach by adding a sixth stage headed “the negotiations”. However, it is considered that all relevant factors can be accommodated within one of the following five stages:-
Stage 1 Estimation of the Replacement Cost (ERC).
(See paragraph 4 below).
Stage 2 Estimation of the Adjusted Replacement Cost (ARC).
(See paragraph 5 below).
Stage 3 Estimation of the site value.
(See paragraph 6 below).
Stage 4 Application of the statutory decapitalisation rate.
(See paragraph 7 below).
Stage 5 Consideration of the results of Stage 4 to see whether it represents the correct answer on the statutory hypothesis.
See paragraph 8 below).
Whilst the foregoing breaks the process of valuation down into five component stages it is essential to remember that it is the hereditament as a whole that is being valued and whilst the precise number of stages is not necessarily significant, it is important for the valuer to be clear as to what needs to be considered at each stage. Subsequent paragraphs expand on each stage in turn.
4. Estimated Replacement Cost (Stage 1)
The first stage of the Contractor’s Basis is to establish what it would cost to construct all the buildings within the hereditament (including site works and all rateable plant and machinery) on a cleared site.
The valuer may have actual costs available or may be required to estimate the cost of either replacing the actual building(s) or, in appropriate circumstances, replacing them by a modern substitute.
4.2 Direct Cost Information
It is usually necessary to estimate the replacement cost but actual costs may be utilised providing they have been adjusted to ensure they are consistent with the hypothesis that the whole hereditament has been costed assuming a single contract.
Adjustments to the actual cost may be needed to reflect various factors including:
the actual cost of an extension or a single building may differ from what it would cost if it formed part of a larger contract
items which would be inconsistent with the basis of the whole hereditament being constructed under a single contract, eg. costs incurred in maintaining access to parts remaining in use during the work; costs incurred because of difficulty of working in and around existing structures, etc.
non-rateable plant and machinery
the costs being incurred at a date other than the date of valuation (ie. the AVD);
Caution should be exercised where a single cost appears out of line with the Rating Cost Guide (RCG) in much the same way as consideration of a single rent which may appear out of line with a rental “tone”. That cost should be compared to other available cost evidence to see if that level of cost is to be preferred to the RCG.
If a body of cost evidence appears out of line with RCG, NABS should be contacted to confirm analysis of the cost evidence and, if necessary, amend the RCG.
Reference should be made to the VOA Rating Cost Guide for guidance as to the appropriate indices to be adopted where actual costs are to be considered but which have been incurred either before or after the date of valuation.
It should be noted that the cost required is that which would be incurred for the hereditament as at the AVD and the figures reproduced in the VOA Rating Cost Guide accord with this requirement. When actual costs are being considered, it is important for the valuer to be aware of the period and the basis of the contract, ie fixed or variable price, so that the appropriate dates can be adopted for the purposes of indexation.
Some confusion has arisen in the past as to the date which is relevant for levels of costs to be established in particular by taking a date prior to date of valuation to allow for the period required for construction of the “alternative hereditament”. However, this is considered to be incorrect. The appropriate cost level is that relevant at the AVD irrespective of the size and complexity of the hereditament involved and the likely construction period.
It should be noted that locational adjustment of actual costs may be necessary at the appropriate date mentioned above. This is because actual costs should always be adjusted to location factor 1.00 before indexation, and then, after indexation, brought to the appropriate locational level for AVD by application of the RCG location factor. Adjustment to location factor 1.00 should be made by applying the a factor pertinent to the appropriate date, and these factors may differ from those published in the RCG; advice should be sought from NABS.
4.4 VOA Rating Cost Guide
In most cases it will be necessary to estimate the replacement costs and, as uniformity is important, estimates should wherever possible accord with the RCG, or Rating Manual Vol 5 Practice Notes.
In cases where items cannot be identified within the Rating Cost Guide and cost guidance cannot be otherwise readily ascertained advice should be obtained from NABS (for buildings and siteworks) or the Plant and Machinery Valuer, or in other cases of difficulty, Professional Services Directorate.
It should be noted that the cost under Stage 1 should include fees.
4.6 Substitute Building Approach
Where a building is such that perhaps because of age, design or type of construction it would not be realistic to envisage rebuilding it in its present form, as an alternative to estimating the cost of replacing the actual building, the valuer may estimate the cost of a modern substitute building. For example, the subject hereditament might have excessively high ceilings by modern standards or considerable ornamentation and embellishment which would not be replicated in a new building.
Where a substitute building approach is adopted, costs should be estimated on the basis that the substitute building is of a quality and specification, and has such services as would be required, to enable the use carried on in the actual building to be carried out satisfactorily in all respects.
In cases where this approach is adopted because the actual building is, for example, over-ornate, the substitute building should be of a similar floor area to the actual, but where the reason is that the actual building is over-large, perhaps due to changes in demand or technology, then any differences, (both advantages, but more likely disadvantages), between the substitute and the actual building may be reflected at Stage 1 by costing a suitably sized alternative building or at Stage 2 by making an allowance. Care should be taken to avoid “double counting” of this type of allowance.
The starting point for considering a substitute building approach is to identify a deficiency in the actual building. In Shell UK Exploration and Production Ltd v Assessor for Grampian Valuation Joint Board (LTS 2000) the Tribunal said :
“An appropriate allowance should, admittedly, be made in valuing subjects under the contractor’s basis in order to reflect identifiable deficiencies, and this assessment could be assisted by reference to modern substitute costs. However the starting point was to identify a relevant deficiency. That had not been done in the present case.”
If no deficiency can be identified in the actual building, then a modern substitute approach is not appropriate.
If the hereditament in question is of a commercial nature the substitute issue will also involve the consideration of the qualities of the competing hereditaments. If all or most of the competing hereditaments also reflect many of the disadvantages of the appeal hereditament and few if any have the qualities of the ‘substitute’ then there is little or no ‘real’ disadvantage in the market place.
5. Adjusted Replacement Cost (Stage 2)
The Estimated Replacement Cost established at Stage 1 is converted to Adjusted Replacement Costs by making adjustments or allowances that take into account any deficiencies in the actual building from an occupational point of view which are not reflected in the ERC.
Whilst it might be anticipated that a building actually completed at or just prior to the date of valuation should not normally justify any adjustment, each case must be considered on its merits. It may be that there have been technological or user requirement changes since the building was designed or the building was over specified possibly to allow for future expansion.
It is important for the valuer to be fully aware of the reasons for any allowance which is proposed to be made. Age related scales of allowances are not always capable of reflecting all relevant considerations.
5.2 Physical and Functional Obsolescence
As a generality over the broad spectrum of buildings and rateable plant and machinery there is a tendency with increased age for there to be depreciation in value of the item due to a loss of occupational usefulness of a building, or of efficiency of plant, in comparison with modern counterparts. However the extent of the depreciation will depend on the use and type of the item in question.
In order to provide a degree of uniformity the VOA Rating Cost Guide 2010 contains guidance on appropriate allowances in the form of age related scales which, together with the accompanying notes, should be referred to before any adjustment is made to either buildings or plant and machinery under Stage 2.
For R2017 the age related scales to adopt for a particular property class will be detailed in the Practice Note for the class. In all cases where there is no specific class guidance, the age related scales together with the accompanying notes contained in the Contractor’s Basis 2017 Practice Note attached to this section of the RM should be used as guidance.
6. Value of Land (Stage 3)
The consideration of the land element comprises two stages. The first is to establish the capital value of the site of the hereditament. The second is to make such adjustments as may be appropriate in the circumstances of the case having regard to the fact that the site has been developed with the actual building(s), etc, standing upon it.
The value adopted for the land should be on the basis that the site is cleared of all buildings with such services as existed at the relevant date available for connection and with planning permission for development for the buildings comprising the hereditament having regard to their existing use and reflecting all advantages and disadvantages of the site and its location.
Where the subject land is unstable or presents other development difficulties it should normally be valued on the basis of a stable site, (abnormal construction costs should be avoided wherever possible). Where actual costs of abnormal works are available or unstable land value evidence exists and reference to these actual figures is considered desirable, guidance from the RBS should be sought in accordance with the Rating Cost Guide.
The valuer should have in mind at this stage that various site works will inevitably be required to the bare land, eg roads, drainage, lighting, and if these have not been reflected at Stage 1 in the cost of the buildings and plant and machinery, an appropriate amount should be reflected in the land value.
6.2 Scope of Evidence
Evidence as to the value of the land may be obtained from market transactions in sites for use within the same mode or category. Any price actually paid for the land may require adjustment to conform to the date of valuation, to exclude any value attributable to development not yet realised (eg. for future extensions) and, if appropriate, to reflect any expenditure on works outside the curtilage but which enhances the value of the site and the hereditament in question.
Difficulties may be experienced in establishing the appropriate land value when the hereditament is in a class of its own, and where there is normally no market in land for the particular use. Whilst it would not be correct to value the site as if it were available for some other use, the valuer is not precluded from considering the evidence relating to land used or to be used for other purposes in the vicinity.
Thus, although the required value is limited to the value for a development restricted to the actual use, in the absence of more suitable evidence, the value of land for the adjacent use or the adjacent prevailing use can be brought into the consideration but only if, and to the extent that, it would be regarded as relevant by the negotiating parties. It is for the valuer to decide the extent to which (if at all) that evidence should be adjusted to fit the circumstances affecting the land in question (see Dawkins (VO) v Royal Leamington Spa Borough Council and Warwickshire County Council (1961) 1 RVR 291).
6.3 High Alternative Land Values
Particular care needs to be exercised when the adjacent prevailing use value is patently at a much higher level than might reasonably be expected for land restricted to a development for the actual use. This may well arise when for historical reasons rather than current need the hereditament is sited in its present location and could without detriment be located in an area of lower land value. In these circumstances in establishing the appropriate value of the actual site the valuer may consider the value of an appropriate alternative (or substitute) site or location, making such adjustments as may be necessary to reflect the advantages or disadvantages of the actual site.
6.4 Value of Surplus Land/Land with Development Potential
Whilst the value of the land should reflect all inherent advantages and disadvantages it should not include any development potential over and above that required for the buildings within the hereditament. Thus surplus land within the hereditament which is reserved for future expansion should be valued rebus sic stantibus (but adjusted as appropriate when the expansion takes place). However the valuer needs to exercise care in distinguishing surplus land from that which whilst undeveloped with buildings, forms part of the overall development as open areas of amenity land or safety buffer zones.
It may be that the site of the subject hereditament is of extensive acreage and that the only evidence of value arises from the sales of comparatively small parcels. In adjusting evidence from such a source, an allowance for scale would be appropriate but the quantum must be a matter for local knowledge and judgement and harmonisation within and between other classes and co-ordination groups. With larger sites there may be a range of differing uses within the curtilage of a hereditament, eg amenity land, safety zones, open storage and intensive industrial development. Whilst it is preferable for the value of the land to be built up having regard to the various uses to which it is put, an overall price for the entire site may be adopted, but care should be taken to ensure that those user elements of lesser value are duly reflected in the overall price. Care should also be taken to avoid duplication of user and quantity allowances.
Having established the value of the cleared site it is then necessary as part of this stage to consider whether that value requires to be adjusted to reflect the assumption that the site is to be viewed as one encumbered by the building(s) standing upon it. Thus the valuer needs to refer back to Stage 2 and consider whether the adjustments made to the buildings reflect factors which would have an adverse effect on the level of value adopted for the land.
In Dawkins (VO) v Royal Leamington Spa Borough Council and Warwickshire County Council (1961) 1 RVR 291 the Lands Tribunal commented:-
“…. when in time a school becomes obsolescent it is an encumbrance of the land and the value of both is depreciated. But so long as there is no obsolescence and provided there has been no extravagance in the building, it seems to us that the value of the land as the site of a school to the owners of that school is no more and no less than what they paid for it”.
This aspect was considered in the Imperial College case it being contended by the ratepayer that the same allowance as given on the buildings should be given on the land. Having referred to the Leamington case the Lands Tribunal concluded:
“The starting point on the building is “cost” and on the land is “value”. The value of the site may reflect advantages or disadvantages not accounted for in the estimated replacement cost of the substitute buildings but properly to be reflected in the adjusted cost thereof. For these reasons the amount of the deduction to be made to the buildings may be different from that on the land. The facts have to be considered in each case”.
Thus whilst each case should be considered on its merits, it will probably be appropriate in most cases for the value of a site to be discounted by the same amount as the aggregate allowance for deficiencies (made at Stage 2) on the building(s) erected upon it. However this will not necessarily be the case where the site includes additional land (either of the same or different use) in excess of that required for the building.
6.6 Land Value as a percentage of development costs
The use of a percentage addition for land value is prevalent in schemes of valuation based on the contractors test, mainly where there is a large class of complex hereditament such as hospitals or universities. The use of a percentage addition can only be justified where the following circumstances are present
- a) The valuation is part of a valuation scheme to which all parties have agreed
- b) The percentages have been derived by means of a thorough analysis based upon evidence particular to the valuation scheme.
Such an analysis may be based upon one of two methods.
The percentage is derived from a large number of sales of land for construction of buildings within the class, related to the cost of construction of the actual hereditaments built upon it.
The percentage is derived from the likely build cost of hereditaments, related to the amount of land required, by the plot ratio, and the cost of suitable land for an alternative use in the vicinity, subject to a “Dawkins” discount because of the restricted mode or category of use of the class of hereditament.
In both methods the percentage is derived from consideration of evidence of land values, the land values are not derived from the percentage of development cost
It follows that it would be wrong to import such percentages into any other class because many of the factors (Costs, Contract size adjustments, plot ratio etc) will be different and any land values so produced will not be soundly based. For example it would be incorrect to use a percentage from a scheme of valuation for fire stations to value the land element for a library
Even in circumstances where there is an agreed valuation scheme and the process of deriving land values has been carried out rigorously, the value of the land element cannot be defended by means of a percentage approach in valuation tribunal or Lands Tribunal where the value of the land is in dispute. In such circumstances full consideration must be given to the value of the land upon which the hereditament stands. (In fact the same is true of any element of a valuation scheme).
In respect of schemes of valuation the Lands Tribunal made the following comment in Dawkins v Leamington Spa Corporation and Warwickshire CC the Lands Tribunal said (of the formula used for assessing schools at the time) “ From time to time during the hearing we were asked to comment upon various aspects of the formula. It is, as we remarked earlier, no more than a convenient short-cut: an assessment arrived at by applying the formula, if it needs to be tested, must be tested on the contractors basis.”
7. Decapitalisation (Stage 4)
Although this stage is headed Decapitalisation, it in fact encompasses the addition by the valuer of the figures produced at Stages 2 and 3, to provide what has, on occasion, been referred to as Effective Capital Value and the application thereto of the appropriate decapitalisation rate to give an annual equivalent.
7.2 Problems with the Decapitalisation Rate
Prior to the rates being statutorily imposed, the determination of the appropriate rate percent for application to the capital value had become perhaps the most contentious stage in the Contractor’s Basis of valuation. Small differences in the rate percent had a significant effect on the resulting assessment and the route to the appropriate decapitalisation rate became increasingly the subject of litigation.
Furthermore discussions relating to the contemporaneous revaluations in Scotland and England/Wales suggested that harmonisation was unlikely to be achieved on this potentially contentious issue without the imposition of a statutory rate.
7.3 The Statutory Rates
Appropriate decapitalisation rates to be adopted in Contractor’s Basis valuations either of the hereditament as a whole or of any part that is derived from a cost based approach (eg. plant and machinery) are prescribed in the relevant regulations.
8. Overall Consideration (Stage 5)
8.1 “Stand back and look”
This stage has been referred to as “the stand back and look” stage but it is important to recall that a number of adjustments and allowances may already have been made at earlier stages. Thus the valuer must be careful to ensure that adjustments at this stage are only made for matters which have not already been allowed for in considering the buildings and land separately at Stages 2 and 3.
However the valuer should now review the four stages that have preceded and make such further adjustments to them which, on reflection, are necessary, leaving those which cannot properly be made at the previous stages to be considered at Stage 5.
Under the traditional 5 stage approach the adjustments made at Stages 2 and 3 reflect particular deficiencies in the buildings and plant and machinery that have been costed, whilst adjustments at Stage 5 are to reflect factors which affect the value of the hereditament as a whole.
8.2 The Effect of Financial Aid
Following the decision of the Land Tribunal (now Lands Chamber of the Upper Tribunal) in Allen (VO) v English Sports Council/Sports Council Trust Company no allowance should be made within a Contractor’s Basis valuation either specifically for grant funding, or for limited affordability on the part of the hypothetical tenant, even in instances where the means of the only identifiable likely tenant are slender.
In some instances it may be appropriate to consider whether the availability of grant has resulted in a hereditament which is more costly, either because of size or level of specification, than would be actually required by the likely hypothetical tenant at the AVD. If this is so then a simpler and/or smaller substitute should be costed at Stage 1. On the other hand if it is judged that the actual hereditament is exactly the design which the hypothetical tenant would have wanted at the AVD, then no such adjustment should be made.
For further details of the Tribunal’s reasoning behind the decision and its ramifications in terms of contractors basis valuations see RM 4 Section 7 Appendix 2
8.3 Allowances appropriate for “state of the industry”
As already indicated, this method of valuation is adopted for hereditaments which by their nature do not lend themselves to valuation by comparison with other classes and it may be that the buildings and/or plant will be of a specialised nature suitable only for the particular use or process for which they have been designed.
This will be of particular relevance in the case of industrial hereditaments but the valuer should nevertheless still be mindful of the principles involved in considering whether any allowance is appropriate when valuing other classes.
Specialised buildings and/or plant will be costly to provide but if there is no actual nor foreseeable demand for the product which they are designed to produce (and no alternative use for the premises within the rebus rule) then it must be accepted that the hypothetical tenant is unlikely to be prepared to make any bid for the hereditament.
Whilst this is the extreme situation, it does underline the need for the valuer to keep in mind that cost does not necessarily equate with value and to be aware of the state of the particular industry concerned so that, if necessary and as appropriate, adjustments can be made at Stage 5 to reflect the relative bargaining strengths of the landlord and tenant in this respect.
In this connection the valuer should not necessarily rely on the fact that the hereditament has been recently completed. The construction of a specialised industrial plant may take several years from planning to completion, and during that time changes in demand and/or technology could have an adverse effect on the viability of the hereditament.
8.4 New Venture Allowance
The expression “state of the industry” tends to suggest reference to the economic health and well-being of an already established (but perhaps now contracting) industry, but it may also be relevant at Stage 5 to consider whether the hereditament is in a class which, at the AVD, comprises a new venture where demand has yet to be established and where an allowance may be appropriate to reflect the uncertainties facing the hypothetical tenant.
It is at Stage 5 that the valuer has to conclude as to whether the outcome of the application of the contractor’s basis represents the rental value of the hereditament on the statutory basis.
The aim is to establish an assessment the level of which fits within the general framework or pattern of values in the area, but which nevertheless fairly reflects the demand for the class of property involved.