Journal of Property Investment & FinanceOffices with services or serviced offices? Exploring the valuation issuesPatrick McAllister

Article information:To cite this document:Patrick McAllister, (2001),"Offices with services or serviced offices? Exploring the valuation issues", Journalof Property Investment & Finance, Vol. 19 Iss 4 pp. 412 - 426Permanent link to this document:http://dx.doi.org/10.1108/EUM0000000005793

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Journal of Property Investment &Finance, Vol. 19 No. 4, 2001,pp. 412-426. # MCB UniversityPress, 1463-578X

PRACTICE BRIEFING

Offices with services orserviced offices? Exploring the

valuation issuesPatrick McAllister

Department of Land Management and Development, Faculty of Urbanand Regional Studies, The University of Reading, Reading, UK

Keywords Intangible assets, Property valuation, Service

Abstract This paper explores the conceptual and methodological issues relating to the valuationand appraisal of commercial properties where revenue generated by the provision of additionalservices constitutes a significant proportion of the total income flow. The paper focuses on twomain areas. First, the valuation and development of the serviced office model is discussed. Second,the implications of the growing interest of landlords in acting as access managers and suppliers totheir tenants are considered. The US debate on business enterprise value and hotel appraisal isreviewed. It is concluded serviced offices owner occupiers have two main assets ± the tangibleproperty asset and intangible business asset(s) ± which are symbiotically linked but separable. Inorder to appraise these interests valuers need to be able to value businesses and property since theincome flows derived from service provision will have different drivers and risk profiles than pureproperty-derived income flows.

IntroductionThe last decade has seen substantial evolution of the landlord and tenantrelationship in the UK. The rising market prevalence of shorter leases, servicedoffice operators and private finance initiative (PFI) models has increased thediversity of occupational solutions available to business tenants. Moreover, moreentrepreneurial landlords increasingly recognise that their tenants constitute aconveniently situated pool of potential clients with whom they have pre-existingbusiness relationships and to whom they have the capacity to market a range ofservices. This is most developed in the serviced office sector where operatorstypically supply accommodation, property services and business support servicesto their clients. This paper explores the conceptual and methodological issuesrelating to the valuation and appraisal of commercial properties where paymentsfor service provision to the `̀ landlord'' constitute a significant proportion of theincome flow. It is suggested that concepts and techniques for estimating marketvalues, worth and going concern values begin to overlap and blur when appraisalof business-property amalgams is undertaken. The valuation of the businesscomponent in particular can be problematic since a significant proportion of theassets will be intangible.

It would be myopic to believe that only the property sector is beginning toconsider the difficulties in appraising financial assets where pricing methodsbased upon replacement costs of fixed assets, such as Tobin's Q, are becoming

The research register for this journal is available athttp://www.mcbup.com/research_registers

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more and more problematic (Reid et al., 2000). The growth of the knowledgeeconomy has produced a widely reported decline in the relative importance offixed or physical assets relative to intangible assets or intellectual capital.There has been growing interest in the identification and measurement ofintangibles in corporate performance (see Reid et al., 2000). Commonly citedintangible assets are brands, client relationships, supplier networks, patents,copyrights, trained workforces, information technology (IT) systems andsoftware and research and development. Although all of the above canpotentially be generated by landlords through the ownership of tenantedcommercial property interests, the Red Book states:

The Valuer is normally concerned only with the valuation of tangible assets as the valuationof intangible and financial assets is likely to be outside his professional knowledge and skills(RICS, 1995).

This position may have to change dramatically.The remainder of the paper is organised as follows. The first part of the

paper examines growing interest in the generation of revenue streams fromservice provision to occupiers, particularly focusing on the emergence of theserviced office sector. This is followed by a discussion of the market pricingcontext for serviced offices. The third part of the paper examines UK and USappraisal guidance on the valuation of going concerns and intangibles focusingon the definition and quantification of business value. The next sectionexamines how similar problems have been addressed in the appraisal of hotelsboth in the UK and USA. Finally there is a conclusion and discussion of theissues raised.

BackgroundThe emergence of the serviced office sector as a high profile component of theUK commercial property market during the 1990s needs to be considered in thecontext of rapid evolution and innovation in lease structures and landlord andtenant relationships over the same period. Driven largely by the competitivepressures generated by recession, globalisation, technological change andderegulation, there have been significant shifts in business practicesthroughout the last decade. The decade has been characterised by rapid, andoften abrupt, adjustments to the organisation of production processes.Consequently, in the 1990s business commentary and practice became infusedwith the language of downsizing, delayering, demerging, flexiblespecialisation, outsourcing and core competencies. For the property sector themain repercussions have been general, if variable, increased demands tooutsource non-core activities and to occupy property on more flexible bases.

In contrast to the financial sector, a key development in the property sector inthe 1990s has been intermediation as organisations have emerged who have `̀ re-engineered'' the landlord and tenant relationship. Companies such as Mapely,Netspace, MWB and Trillium have appeared, specialising in providingaccommodation and facilities management (FM) services to occupiers. At the

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same time, landlords, notably Arlington, have been promoting the potential ofbusiness support service provision to tenants. Leasing practices in themainstream commercial property market have been transformed as tenants haveused recessionary conditions to obtain leases that are much shorter (for a detaileddiscussion see Crosby et al. (2000)). The emergence of the serviced office sectorshould be understood in the context of these cyclical and structural changes.

Although a major focus of this paper is on serviced offices per se, moremainstream property owners are becomingly increasingly conscious of theirpotential to generate additional sources of revenue from both their tenants andtheir properties. To date, this has been achieved mainly in the form of provisionof FM-related services such as cleaning, catering, maintenance, utilities etc.associated with their occupational needs. However, landlords are beginning toexplore the potential to market new products to their tenants and to act as a`̀ portal'' for other business service providers. Landlords have an asset in theirrole as `̀ gatekeeper'' to their tenants. It seems logical for landlords to exploitthis potential to act as access managers to their tenants. The value of this rolewill depend on the degree of control over access. In many instances, thelandlord's competitive advantage lies in their proximity, existing relationshipsand economies of scale in procurement rather than on exclusivity. Scale is seenas the critical variable. Large landlords, in particular, have the ability to usetheir purchasing power to achieve discounts and then to exploit potentialarbitrage opportunities in procurement. Using preferred provider models orbulk purchase, they can obtain a range of business services at discountedprices for their tenants whilst obtaining a share of the revenue generated. Thisintermediation can produce a win-win outcome for both landlord and tenant. Itis not difficult to envisage the list of services where this may be possible ±business travel, recruitment, professional services, database management,graphic design, equipment hire, financing, etc.

In the USA, legislation is currently being introduced permitting theformation of taxable REIT subsidaries (TRS) which can generate income frombusiness activities other than real estate rentals. Mueller and Anikeeff (2000)have analysed the implications of changing the balance between real estate andoperational income for portfolio risk profiles. Although their results areinconclusive, they raise interesting questions about the implications of thistrend for volatility and correlation patterns. They imply that funds and assetsmay need to be disaggregated according to the relative contribution of realestate and operational income.

Currently a great deal of interest is being generated by the issue ofcommunications infrastructure in commercial premises and its potential tocreate new sources of income and augment rental and capital values. The USA,in particular, has seen the dramatic growth of riser companies (or building-centric local exchange companies (BLECs)). As demand from the majorcorporations has matured, riser companies have been seeking to supplymedium and small sized firms concentrated in multi-let, high rise buildings andindustrial parks. Typically, these companies are going into partnership with

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landlords to install the infrastructure for high speed Internet access providingrapid data transfer, videophone and telephony. The common business model isfor the landlord to receive a percentage of the revenue stream generated inreturn for access to the tenants. The main benefits are for the landlord, whoobtains improved infrastructure, more marketable premises and an additionalincome stream. However, it also points to the limitations of the landlord's role.

We should be wary of hyperbole in the efforts of elements of the propertysector to associate themselves with the dynamic IT and business servicessectors. Although the broadband issue highlights the landlords' asset in theirrole as `̀ gatekeeper'' to their tenants, a `̀ portal'' rather than a `̀ provider'' modelseems more realistic. Property managers are unlikely to possess the skills forthe direct provision of business services. It is debatable whether they evenshould. Parker (2000) argues that to be attractive to potential customers, thespecific service offered should be a core business in which the provider hassuperior knowledge, experience and technology with an appropriatelycapitalised business and an established management depth and stability. Onthe other hand, it could be argued that the relative newness of the businessopportunity has created an opportunity which landlords are ideally situated toexploit and in which there are few obvious competitors.

Although clearly embryonic, the emergence of such diverse forms of revenuestreams from property assets will alter risk/return profiles and has significantimplications for valuation practice. Serviced offices provide an ideal prototypeof this services/space provider-client/tenant relationship.

The serviced office sectorAlthough the serviced office concept has been established in the UK for anumber of decades, until the late 1980s the sector was characterised by acutefragmentation and diversity of ownership and nature of operation. There arevery little data available on the expansion of the sector. The first mention inthe property trade literature of serviced offices is in 1989. In a prescientarticle, Winter (1989) described the growth of the sector and the emergence ofa small number of national operators during 1986-1998, predicting that a fewmajor players would dominate the sector in the 1990s ± Regus, HQ andcitib@se. In the absence of detailed data on sector growth, a simple citationsapproach is used below to illustrate the emergence of the sector in theproperty mainstream in the mid-1990s. References in the Estates Gazette toserviced offices are presented as a (probably lagging) proxy for sectorgrowth and development (Figure 1).

The empirical evidence suggests that the supply of serviced offices is clearlysegmented into two categories. There are currently only four to five national(two or three have international capacity) providers (over ten centres) whosemain market is generally major corporations. The remainder of the sectorlargely comprises an array of relatively small-scale, niche providers who areregional in scope, generally serving local markets and firms (see Gibson andLizieri, 1999; Billingham, 1999). Recent research suggests that operators may

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be earning supernormal profits from a market failure to provide premises onflexible terms with supporting services (see Crosby et al., 1999). However, byway of caveat, normal competitive forces could be expected to eliminatesupernormal profits by an increase in supply.

Although one major operator espouses a strong preference for leaseholdarrangements, there is limited information available on general tenure patternsin the sector. In common with any property investment, the complexity of thevaluation process will be affected by both tenure and lease structures. Servicedoffice operators will own, lease their premises or, less commonly, `̀ occupy'' onthe basis of a management fee[1]. Although outright ownership is generallyimplicit in this analysis, most of the points raised apply equally to leaseholdsituations. Indeed, in leasing situations, in addition to standard 15-20 year`̀ institutional'' leases, some major serviced operators have been entering intoequity share arrangements with landlords. In this type of lease structure, theoperator typically pays a proportion of the open market rental value (50-80 percent) plus a rent linked directly to the profitability of the business centre. Thisarrangement is similar to a base plus turnover rent arrangements found in theretail sector.

The appraisal process and market structureThe anecdotal evidence of supernormal profitability in the serviced office sector isfurther supported by the rapid expansion of the sector. Naturally, the issue ofprofitability is an important factor in the value of a property to potentialoperators. It will become apparent below that a key issue is whether an individualserviced office operator will tend to bid their maximum use value for premises inorder to obtain normal profits or seek alternative opportunities to obtainsupernormal profits elsewhere. This is affected by the structure of the markets forservice provision and premises to service providers. It is argued below that ifthere were a large number of serviced office operators competing for rarelyavailable opportunities to obtain suitable premises, it is likely that the priceachieved for the premises would tend towards the net present value of future

Figure 1.Estates Gazette articlesreferring to servicedoffices 1989-1999

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super-profits allowing for a normal profit. Essentially the price that the servicedoperator could pay would become the market price with the result that the marketvalues and the use values of serviced office operators would converge. Valuationmodels that reflected the business models of service operators would providereliable indicators of market prices. In contrast, if there were a small number ofserviced operators competing for an opportunity for which there were alternativesavailable, it would be more likely that market values would diverge from the usevalues of the serviced office operators. There are strong theoretical grounds tosuggest that the divergence scenario is appropriate.

In a perfectly competitive market, market participants will be numerous andno single producer will have significant market power. In this situation, pricespaid for inputs will be driven by expectations of normal profit. However, it isclear from the brief discussion of the serviced office market that the industry ascurrently configured does not display these characteristics and, in thecontinuum between monopoly and perfect competition, is closer to oligopoly.Selectively drawn from Lipsey (1982), hypotheses concerning oligopolisticbehaviour are that the tendency towards joint profit maximisation is greater:

. for small numbers;

. for producers (and purchasers) of very similar products; and

. in growing industries.

It is apparent above that the serviced office sector has been characterised bylimited numbers of large producers, selling similar products in a rapidlygrowing market. When assessing bids for potential property acquisitions, thereare three main strategies available to operators:

(1) bid competitively in order to secure normal profits or force competitorsto pay `̀ high'' prices;

(2) collude (tacitly) with competitors in order to maximise joint profitability;and

(3) ignore the bidding process and seek alternative opportunities elsewhere.

Although these strategies are not mutually exclusive, it is clear that a crucialvariable is the availability of alternative substitute business opportunities.This effectively reduces the demand for any single development opportunity.

Many of these conceptual arguments were rehearsed at a planning appealhearing on 139-140 Park Lane, London. The appellant was MWB ± a majorserviced office operator. The argument concerned alternative developmentproposals and the market values of these alternatives. The central issue in theappeal was whether existing offices would revert to residential or office use ifan application for a hotel development were refused. Whilst it was agreed thatresidential conversion would create a market value in the region of £18.25million, it was argued by the developer's consultant that a serviced officeoperator would pay £20.6 million. In contrast, the council's consultant arguedthat a market value of around £16.5 million was appropriate on the assumption

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of a single standard term office letting to a service office provider (or similarbusiness tenant).

The conventional office valuations were carried out using traditionalinvestment valuation methods assuming rental values of £35 per square footand an all risks yield (ARY) of 6.75 per cent for a single letting and 7 per centfor a multi-letting. The valuation of the serviced offices to suggest a marketvalue of over £20 million was carried out using a growth implicit cash flow ofthe development and operation of serviced offices in the building at about 85per cent occupancy, the equivalent of about £150 per square foot (net internalarea) rent from occupiers, a cash flow period of five years and a discount rate of9 per cent. By taking out, in addition to all the costs of running the servicedoffices, a management fee of 15 per cent of total income from the serviced officecentre (to represent normal profit for running the serviced office business lessmanagement expenses), this left a surplus for rent/income to the real estateelement which, when discounted, produced a value of £20.6 million.

In essence, the dispute was whether £20.6 million represented the openmarket value or whether it was a calculation of worth to a business centreoperator. The latter interpretation was strongly propounded by the council'sconsultant on the grounds that:

. . . business centre operators have no need to pay more for leases or freehold buildings, thanany other business operating in the market place. . .Does a merchant bank pay more than theopen market rental value of office accommodation in the City of London, just because it canafford to?

This type of approach is consistent with the Red Book guidance on specialpurchaser which seems relevant in this context. It states that even if apurchaser can obtain marriage value, there is no certainty that it is `̀ correct toassume'' an additional bid and that, even if the special purchaser does enter themarket, they may be expected to pay `̀ one bid more'' than necessary. Theinspector's judgement on the issue was not completely conclusive. Althoughthe inspector held that he did not `̀ regard either approach as beingunreasonably based'', he felt that given the nature of the owners (a servicedoffice operator) and strength of demand for serviced office accommodation, itwas likely that it would be developed for serviced office accommodation.

Open market value, worth and going concern valueIt is not intended in this context to consider in any detail the already well-trodden ground relating to definitions of (open) market value, calculation ofworth and estimated realisation price. As we have seen, one approach toassessing the value of a serviced office building has been to calculate the netpresent value of the future revenue stream achievable by the occupier from thatbuilding. In methodological terms this is analogous to a calculation of worth.The Red Book (RICS, 1995, p.3) defines the calculation of worth as:

The provision of a written estimate of the net monetary worth at a stated date of the benefitsand costs of ownership of a specified interest in property to the instructing party reflecting thepurpose(s) specified by that party (author's italics).

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It is evident from this definition and from the appropriate guidance notes thatthe appraiser is being channelled towards identifying particular circumstancesof individual clients and incorporating these circumstances to calculateindividual worth. However, it could be argued that in markets where individualparticipants have similar circumstances, individual worths should, in turn, besimilar, producing concurrence between individual and market worth. Moresignificantly, the price achieved should reflect (assuming perfect competition)the market worth. In addition, it is likely that individual worth will coincidewith going concern value in the case of business-property amalgams.Rabianski (1996) stresses that a key distinction between going concern valueand market value is that the former is business and owner specific whilst thelatter is derived from market sources. Rabianski's proposed method forcalculating going concern value is akin to a calculation of worth in terms ofmethodology and information requirements. However, it seems evident in thiscase that where there is convergence between going concern value and marketvalue, the vendor will be acquiring a business that incorporates a propertyasset rather than simply a property asset. It is important to be clear about whatthe terms worth, price and value are being attached to. The variouscomponents of business-property amalgams will have their own distinctworths and prices.

The valuation of a going-concern ± UK guidanceThe serviced office space sector appears to have some of the characteristics ofproperty types that are commonly valued by reference to their trading. RICS(1995) Guidance Note 7 deals with `̀ Trading-related valuations and goodwill''and gives guidance on the valuation of property fully equipped as anoperational entity. An operational entity is defined by the Royal Institute ofChartered Surveyors (RICS) as `̀ a unit of business conducted from oneproperty''. In the UK, the most common properties valued in this way accordingto the Red Book are public houses, hotels, private healthcare facilities andnursing homes. The Red Book states that they should be properties where thereis a `̀ strictly limited use'' (RICS, 1995, PS 2.7.3). This of course is not the case forserviced office operations.

The value of an operational entity is defined as the sum of the values of landand buildings, fixtures and fittings, etc. and trading potential (excludingpersonal goodwill). The trading accounts are the recommended source ofinformation. Hence ignoring:

. . . the covenant of the particular owning company and any value attributable to goodwill,except that in the case of land and buildings valued fully equipped and trading as anoperational entity, such trading potential (i.e. that which is inseparable from the interest in theproperty) is included (RICS, 1995, PS 4.3.4).

A key issue in this area relates to the valuation of trading potential which isinseparable from the property. The Companies Act 1985 requires that fixedassets be separately identified in the company balance sheet. Whilst goodwill isdefined as an intangible, fixed asset, it is not clear whether this includes trading

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potential (formerly known as inherent goodwill and excluding personalgoodwill). RICS (1995, PS 2.7.3(b)) states that `̀ the trading potential which isattached to a property is sometimes thought of as goodwill''. Personal goodwillis generally excluded:

. . .a valuation will normally exclude any goodwill which is personal to the present owner ormanagement and which would not pass with the property on a sale with vacant possession(RICS, 1995, PS 2.7.3).

The Guidance Notes provide more detail about the nature of the value of suchtrading potential and the circumstances in which it should be incorporated:

Problems can sometimes be encountered in understanding and defining value which attachesto the building and runs with the property by virtue of circumstances such as its location,design, planning permission, license and occupation for its particular use (formerly known asinherent goodwill). A trading entity will probably have a higher value if it is currently or hasrecently been trading successfully for some time. The value may be higher still if recentaccounts can be proved. . .The Valuer, when assessing future trading potential shouldexclude any turnover and profit which is attributable to the personal skill, expertise,reputation and/or brand management, but include any additional trading potential whichmight be realised in the hands of an average competent operator taking over the business atthe date of valuation (RICS, 1995, GN 7.2.10).

An important implication is that trading potential not attached to the propertyshould be ignored in the valuation with the consequence that the valuationshould not reflect the value added by the specific brand and expertise of theoperator. This distinction was summarised by a US State court decision:

The key is whether the (income) value is appended to the property, and is thus transferablewith the property, or whether it is, in effect, independent of the property so that the (income)value stays with the property or dissipates upon sale.

However, this division may not be straightforward since it can be difficult todistinguish whether an asset is attached to the property. In terms ofintangibles assets we can identify three types of intangible assets (orgoodwill) that are normally:

(1) incapable of being separated from the property upon transfer ofownership;

(2) capable of being attached to or detached from the property upon transferof ownership; or

(3) incapable of being attached to the property upon transfer of ownership.

Although the majority of intangible assets will tend to be associated with thebusiness, certain types of intangible asset can be difficult to categorise.Valuable elements of the business such as supplier contracts, software systems,workforce or customer lists may or may not be transferred with the building.At the same time, an individual building may have acquired a profile as aserviced office location and will usually contain a number of clients in situwhich cannot be separated from the building. However, a major serviced officeoperator will have acquired a reputation and client base which are related to the

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quality of their business model rather than property-specific. The value addedby expertise, knowledge and abilities of the existing owners will normally beincapable of transfer.

In addition, the distinction between income generated by tangible assets (theproperty) and intangible assets (the business) may be difficult to allocate. Thereis in certain respects a symbiotic relationship between the two. Whilst it is clearthat property owners will not be able to generate service income without atenant base, it is also likely that tenants will be prepared to pay a premium tolocate in premises with access to business services and infrastructure.Moreover, it is not difficult to envisage circumstances where there will be atrade-off between rent and business services, with the level of rental beinglinked to the purchase of business services[2]. It is possible to identify twopotential effects on rental incomes. First, there may be substitution effects. Itwill often be rational for landlords to adjust rental pricing to reflect theadditional services that may also be supplied to tenants. Other things beingequal, tenants who take services will tend to be more attractive. Second, theremay be enhancement effects. It is possible to envisage situations in which rentlevels are affected by the quality of services available in a given building. Fromthe USA there is anecdotal evidence to suggest that certain buildings canachieve a rental premium which have access to high bandwidth infrastructure.Consequently, problems may emerge in isolating the effect of service provisionon rental values.

The valuation of going concerns ± the US debateThe 1990s have seen a debate in the USA concerning the possible existence ofbusiness value associated with but separate from underlying real estate assets.The source of the debate originated in attempts to argue for a reduction intaxation liabilities for real estate investors since local taxes were payable onreal estate value but not tangible and intangible assets. It is most commonlyassociated with the leisure sector where business value is identified as thevalue of `̀ an established operation in an established location with anestablished staff, having an established reputation'' (Fisher and Lentz, 1990, p.169). Many of the arguments made are relevant in the context of serviced officesuites as many of the same issues emerge. The central tenets of the variousarguments and analyses are presented below.

In the US literature terms such as `̀ business value'', `̀ business enterprisevalue'' and `̀ going concern value'' are often used interchangeably and/orinconsistently. Martin and Nafe (1996, p.2) define going concern value as:

. . . the value of a proven property operation. It includes the incremental value associated withthe business concern, which is distinct from the value of the real estate only. Going concernvalue includes an intangible enhancement of the value of an operating business enterprisewhich is produced by the assemblage of the land, building, labor, equipment, and marketingoperation. This process leads to an economically viable business that is expected to continue.

It is generally taken to be the value the real estate plus tangible and intangibleassets. The Uniform Standards of Professional Appraisal Practice states that

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the appraiser must `̀ identify and consider the effect on value of any personalproperty, trade fixtures or intangible items that are not real property but areincluded in the appraisal'' (Appraisal Standards Board, 1993, p.10). Tangibleassets generally include plant and machinery, fixtures and fittings, furniture,inventory, working capital. The definition of business enterprise value has alsobeen the subject of some ambiguity.

A common understanding is that it reflects going concern value minus themarket value of real estate and other tangible assets. However, a morerestrictive definition found in the empirical research is that it is the capitalvalue of the rent received minus market rent. In this paper the former approachis taken (see Owens, 1998).

Much of the debate in the USA has focused on the appraisal of hotels andretail malls and the term `̀ operational entrepreneurship'' has been coined todescribe its origin. For retail malls, business value is identified as stemmingfrom a number of sources:

. management expertise producing an optimal tenant mix;

. effective tenants' association;

. good promotion and marketing;

. brand name value associated with the tenant covenants;

. the detailed terms of the leases and occupational agreements,particularly with magnet stores;

. other income from car parking charges and license agreements; and

. management/service charges and related income.

Evidence cited for the presence of such business value is the existence ofpercentage rents and the payment of higher than market rents at lease renewal.Based on the premise that a proportion of rental income is paid for theentrepreneurship of the landlord, Fisher and Lentz (1990) provide empiricalanalysis to illustrate that lease renewals tend to produce higher rents than newlettings in retail malls. However, this work has been criticised on bothmethodological and conceptual grounds. In methodological terms, there hasbeen criticism of the assumption that higher rents at lease renewal imply theexistence of business value. It has been pointed out that there are importantincentives to existing tenants to pay higher than `̀ market'' rents when balancedagainst the costs of lease termination and relocation (Miller et al., 1995).Moreover, Miller et al. (1995) argue that in a competitive, dynamic market,`̀ entrepreneurial value'' (super-profits) will not persist due to market entry orthat income related to `̀ excess productivity'' eventually becomes attached to theproperty rather than the business. Moreover, of direct relevance in thisresearch, they argue that:

. . . the argument for separating out business value obviously exists when an appraisal includesa going-concern value as part of the total appraisal, but such going-concern value should bebased on the net expected profitability of the business entity given that a competitive rent is

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already paid. There is no reason to expect any component would be passed on to the owner of thereal estate, beyond the competitive rent that is paid (Miller et al., 1995, p. 206).

The lessons of hotel appraisalsHotels provide a useful analogy to the serviced office market. Methods ofvaluation are also comparable since discounted cash flow methods are oftenused for the valuation of hotels. Routinely the net present value of the netincome flow is taken to represent the open market value of the hotel. Indeed it isaccepted in the UK that for hotels the going concern value represents the openmarket value of a hotel. This situation often represents a convergence ofmarket worth, going concern value and open market value. This is to beexpected in the hotel market where the market structure forces the hoteloperator to bid close to their use value to obtain the property. However, caselaw and practice within the UK have distinguished between the value of thegoing concern and the value of the property. The judge in Corisand InvestmentLtd v. Druce & Co. (1978) clearly defined going concern value in terms of theamount that an operator might pay for the right to generate the income flows:

The purchaser would calculate what he could expect to earn in the hotel as it stands, or as hecould make it operate, and what price it is sensible to pay for the right and opportunity toearn that income. The valuer tries to make the same calculation.

However, a distinction was drawn between the going concern value and a `̀bricksand mortar'' value. The latter was defined as going concern value less goodwilland contents and assuming `̀ that the new operator will have to generate profits''(Borner, 1994, p.298). This is essentially a valuation assuming that the concern isnot going and that the operator will enter a `̀ shell and core''. The task is toestimate the price that an operator would pay for rights to (re)start a hoteloperation as opposed to taking on a business that is ongoing. It is analogous to USmethodologies to separate business and real estate values in hotels.

Aswehaveseen, the local taxregime in theUSAhasresulted inamorerigorousapproach to deconstructing values. Kinnard and Worzala (1999) examine theproperty value and business value elements of a hotel property and reinforce the`̀ nearlyunanimousagreementamongscholars,authorsandpractitionersthatthereisadiscernible,separateandmeasurablebusinessvaluecomponentinanoperatinghotel'' (Kinnard and Worzala, 1999, p. 8). They dissect the operating income andexpenses of the hotel and suggest that around 70 per cent of going concern value isattributabletothepropertyasset,whiletheremaining30percentrelatestothevalueof the intangibleassetsandthe furniture, fixturesandfittings. In thehotel context,the intangible assets identified are:

. working capital;

. assembled, trained and skilled workforce;

. brand;

. advanced reservations; and

. past customer lists.

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Other profit centres are also included which will possess similar intangible assetsand which are inextricably linked to the hotel ± restaurants, bars, valet/laundryservices, gym/health club, conferences, telephone systems, car parking etc.

Discussion and conclusionThe serviced office sector epitomises how the business of providing space canbe amalgamated with the business of providing services to form a goingconcern with a substantial property component. It seems evident from thisdiscussion that, like hotel operators, serviced offices owner occupiers have twomain assets ± the tangible property asset and the intangible business asset(s) ±which are symbiotically linked but separable. Both types of operator cangenerate income streams in the property from a diverse range of sources. Thevalue of a serviced office operation as a going concern can be split between thebusiness and the property. However, an important point is that each asset willhave its own market price and worth.

A key consideration is that serviced office operators need only pay marketprices for premises. In common with other businesses, the market price forpremises will often diverge from their use value or worth to the serviced officeoperator. Given the relatively large availability of suitable premises and therelative immaturity of the sector, it appears that in the current market asignificant proportion of the value generated by a serviced office can beallocated to the business. However, it may be inappropriate to assume thatcurrent profit margins are sustainable. In a mature market, it is unlikely thatsuper-normal profitability or excess productivity will persist. `̀ Excess''business value will be eroded by price competition in two main ways. First, theprice competition from new entrants will erode super-normal profitability fromservice provision. In this case a fall in the value of the business component willresult in a decrease in the going concern value. Second, the profitability of thesector will attract new entrants who will be prepared to bid closer to their usevalues in order to acquire properties. In this case, value will shift from thebusiness to the property component of the going concern value. Wherever thevalue, there will still be intangible assets separable from the property sincesuch businesses will generate a diverse range of income streams from theprovision of services and other office infrastructure.

Further, it is apparent that a significant element of the leased commercialproperty stock has the potential to be transformed into going concerns. Thehorizons of property owners in terms of leasing arrangements and serviceprovision are being broadened. For a landlord who receives part of the rentalincome related to profits, they have an equity-property hybrid in terms ofinvestment characteristics. The emergence of new revenue streams and profitcentres will have general implications for the valuation of commercial property.In order to appraise these interests valuers need to be able to value businessesand property. The income flows derived from service provision will havedifferent drivers and risk profiles than pure property-derived income flows.

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This raises a number of questions. Are property valuers capable of valuingbusinesses? How can we separate property, tangible and intangible assets?How useful is capital market pricing of FM and business services companies?

It is possible to point to a number of potential pitfalls. There is a danger ofvaluing properties `̀ in isolation''. Many of the incomes and liabilities will belinked to companies rather than buildings. How will the benefits of crossmarketing and cross purchasing be allocated? Further, it should be borne inmind that in business entities characterised by blurred boundaries andsymbiotic relationships, allocating value becomes increasingly problematic.Service provision activities can either substitute and/or enhance rental income.Inevitably, marketability of service provision contracts and revenue vis-aÁ -visthe premises will be an important variable.

Whatever the pitfalls for valuers, it is likely that the diversity ofoccupational patterns within the UK property market will continue to expand.The main drivers of the demand for occupational flexibility and outsourcingremain robust and should continue to generate demand for space-serviceblends. Diversity undermines traditional valuation models which arefundamentally based upon market transactions involving comparableproperties. By increasing the heterogeneity of the property market, theemergence of business-property amalgams will further exacerbate thedifficulties of valuation posing new challenges to both practitioners andeducators of property professionals.

Notes

1. Although outside the scope of this paper, in the case of ownership there are also problemsrelating to the OMVEU definition and assumptions about vacant possession.

2. The corporate property manager of a major clearing bank has outlined a scenario in whichspace is `̀ free'' with the landloed income generated by services (Morrison, 2000).

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This article has been cited by:

1. Patrick McAllister, Pavlos Loizou. 2009. The appraisal of data centres: deconstructing the cash flow.Journal of Property Investment & Finance 27:1, 65-80. [Abstract] [Full Text] [PDF]

2. Jan Bröchner, Henrik Olsson, Davor Sinik. 2004. Serviced offices: owner capabilities for FM coordination.Facilities 22:3/4, 74-78. [Abstract] [Full Text] [PDF]

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