The pitfalls of property valuations
Part 2 of 3: Factors affecting valuations
While it’s not impossible to obtain a valuation for a partly completed property development, there are a number of important considerations that need to be made.
Property development in an SMSF encompasses many activities that range from the renovation and re-lease of existing buildings to the purchase of vacant land for development.
It’s not impossible to obtain a valuation for a partly completed property development, as the SMSF may have had a recent valuation undertaken for the following reasons:
- Acquisitions, mergers and sales of businesses or parts of businesses
- Loan security
- Financial reporting
Where a formal valuation isn’t available, an SMSF auditor will look at the purchase price of the property and the current costs to date, then review any factors that may impact the value stated in the financial reports.
Whether the fund is a going concern will always impact the acceptance of any valuation. One exception is where there’s evidence of an abnormal risk of default by a contracted party at the valuation date.
Is there a risk in accepting partly developed property valuations?
SMSF auditors are aware that valuations for these types of property include special assumptions about the condition of the building/s when complete.
There may be a risk in accepting these assumptions at audit, but it is both impractical and potentially impossible for the valuation to include verification of every feature of the property that may impact future development of the site.
Other risks that can have a material impact on the valuation include:
- dispute or insolvency of one of the parties
- increased construction costs
- changes in supply and demand of materials
- significant property market movements
At any stage of the development, a valuation will involve considering the value that a market participant would give the actual development on completion.
Factors affecting development land valuations
Most development land valuations will reflect the value of that interest in the property at the end of the development period. These types of valuations are typically affected by the following:
- legal permissions or zoning, including any conditions or constraints
- limitations or conditions imposed on the relevant interest by private contract
- rights of access to public highways or other public areas
- geotechnical conditions, including the potential for existing contamination
- the availability of necessary services such as water, drainage, sewerage and power
- the requirement for any off-site infrastructure improvements and the associated rights required to undertake the work
- any archaeological constraints or the need for archaeological investigations
- the availability and cost of funding
Where a valuation uses the discounted cash flow method, an SMSF auditor may exercise caution as the value can be very sensitive to changes in assumptions and costs which may be unknown on the valuation date.
Specialised development properties
“User-specific” and “investor-specific” properties simply mean they are built to suit the specific requirements of one organisation and then purchased by another investment organisation before the development commences.
Developments of this type are very specialised due to their size and purpose and can be difficult to value, such as medical centres.
Problems can arise where the original user, or the original investment owner, change their mind about the property. In these cases, there may be few alternative users or investors available, which can have an adverse impact on the current valuation.
An SMSF auditor may consider whether there are likely to be other potential tenants. Otherwise, the property may have limited value to anyone other than the original user and investor.
The importance of property title searches
An SMSF auditor is obliged to obtain sufficient evidence on which to base their opinion and ensure compliance with s109 SIS.
The purchase contract can initially verify beneficial ownership of the property by the SMSF. The contract should be in the name of the trustee as trustee for the fund.
Where the contract isn’t available, or the fund’s name doesn't appear on the contract, a declaration of trust can establish that the trustee has purchased the property on behalf of the fund.
Note that in some states, such as NSW, the declaration of trust should be signed at the time of purchase. Otherwise, additional stamp duty may be payable. Care should be taken to avoid unnecessary costs and professional advice should be sought, but the trustees may be able to sign an acknowledgement of trust as post-purchase audit evidence.
Depending on which state the property resides in, the title search will typically show the trustees name only. It’s extremely important to determine whether the fund is the beneficial owner or not, especially when the fund has a corporate trustee that acts in other capacities.
Without confirmation, there’s no guarantee that the proceeds of the sale of the property (or indeed any insurance proceeds) will make their way back to the fund.
Another reason for conducting an annual property title search is that some trustees may view the SMSF as a “cash cow” and use the property for off-balance sheet financing during times of economic and financial hardship.
In part 3 of our series, we discuss how to verify borrowings, leases and rent.
Written by Shelley Banton, executive general manager, technical services, ASF Audits