CBA v Jovanovic (No 4)
[2007] SADC 46
•30 November 2006
DISTRICT COURT OF SOUTH AUSTRALIA
(Civil)
CBA v JOVANOVIC & ORS (NO 4)
[2007] SADC 46
Judgment of His Honour Judge Lee
30 November 2006
MORTGAGES - MORTGAGES AND CHARGES GENERALLY - REMEDIES OF THE MORTGAGEE - SALE UNDER POWER - MODE OF EXERCISE OF POWER
MORTGAGES - MORTGAGES AND CHARGES GENERALLY - REMEDIES OF THE MORTGAGOR
Sale of hotel property by plaintiff in July 1997 for $800,000 under power of sale in mortgage - claim by plaintiff against guarantors to recover shortfall - counterclaim by guarantors and mortgagor - plaintiff's claim allowed, but Full Court held on appeal that plaintiff in breach of obligation under s420A of Corporations Act 2001 (Cth) to take all reasonable care to sell property for not less than market value - action remitted to trial judge for hearing and determination of question identified by Full Court, namely price which would have been obtained for freehold title of property in July 1997 had plaintiff taken all reasonable care in terms of section by appointing agent, conducting proper marketing campaign and putting freehold title of property to the market - action assigned to another judge after trial judge disqualified himself - two valuers who gave evidence before trial judge gave further evidence concurrently before new judge - valuers remained in agreement that correct methodology for assessing market value was to capitalise imputed rental - average nightly room rate, occupancy rate, rent to turnover rate and capitalisation rate discussed - question posed by Full Court discussed - degrees of probability of buyer of property at theoretical auction in July 1997 coming from various categories of investors and developers discussed - application by plaintiff to amend its defence discussed - answer to question posed by Full Court determined at $870,000.
Corporations Act 2001 (Cth) s420A; The Valuation of Business, Shares and Other Equity (Fourth Edition) Wayne Lonergan; Jovanovic & Ors v Commonwealth Bank of Australia (2004) 232 LSJS 339; CBA v Jovanovic & Ors (No 3) (2005) 243 LSJS 155, referred to.
Meyers v Casey (1913) 17 CLR 90; Malec v JC Hutton Pty Ltd (1990) 169 CLR 638; Sellars v Adelaide Petroleum NL (1994) 179 CLR 332, considered.
CBA v JOVANOVIC & ORS (NO 4)
[2007] SADC 46Introduction
These proceedings arise from the sale of a hotel property by a bank in purported compliance of its power of sale under a mortgage. The proceedings have a protracted history. The bank sought to recover a short-fall from guarantors. The guarantors and the mortgagor counterclaimed on the ground that the bank was in breach of its obligation under section 420A of the Corporations Act 2001 (Cth) to take all reasonable care to sell the property for not less than market value. The claim was allowed and the counterclaim was dismissed. Those orders were set aside on appeal by the Full Court of the Supreme Court. The proceedings were remitted to this Court for the hearing and determination of an issue which the Full Court identified in its reasons.
Background
The background is as follows :
1. In November 1995, the defendants (Mr and Mrs Jovanovic) arranged to purchase a property known as the Plaza Hotel in Hindley Street, Adelaide. The property is located approximately 250 metres west of the intersection of Hindley and King William Streets. The property included three ground level shops. The advertising for the sale said that the sale was to be “by informal tender”. The price paid was $750,000. The property was owned at that time by Roclin Pty Ltd (Roclin). Roclin was controlled by two male persons each named Govedarica. The business of an unlicensed budget hotel was conducted on the property. The contract excluded from the sale “All Tenant’s goods, chattels, plant and equipment and stock in trade”.
2. The transfer of the property was taken in the name of Fortson Pty Ltd (Fortson). Fortson was acquired as a shelf company by Mr and Mrs Jovanovic for that purpose.
3. The plaintiff in the action (the Bank) advanced the sum of $750,000 to Fortson to fund the purchase. The loan was secured by a mortgage over the property, a charge over the business, and a guarantee by Mr and Mrs Jovanovic.
4. At the time of the sale, Mr and Mrs Jovanovic entered into an agreement with the Govedaricas to hold two thirds of the property and the business on trust for the Govedaricas. This agreement was not disclosed to the Bank at that time.
5. By early 1997, Fortson was in serious default with repayments of the loan to the Bank, and the Bank had begun to consider the exercise of its power of sale under the mortgage.
6. In February 1997, the Bank agreed to a process of private tender between the Jovanovics and the Govedaricas.
7. On 22 May 1997, on instructions from the Bank, a Mr P.J. Burton of Knight Frank (SA) Pty Ltd inspected the property and valued it at $660,000. At page 11 of his report of that date, Mr Burton described the property and the market potential of the property in these words :
COMMENTS
Situated on the land is the Plaza Hotel, comprising 67 accommodation units and three retail tenancies to the Hindley Street frontage. At present two are occupied although one is not subject to a formal lease agreement.
The subject property is at present in a very poor state of disrepair. The retail shops fronting Hindley Street are only of a basic standard and although the vacant shop was not internally inspected, it looked to be in a very basic condition. Portion of the ground floor area located behind the leased shop was not inspected but is also in a state of disrepair according to the tenant.
Our inspection of the hotel itself revealed this to also be in a very poor state of repair. There is evidence of roof leaks in the ceilings of some of the rooms located on the top floor and some of the other rooms offer a very basic level of accommodation. It is our opinion that considerable money would have to be spent in order to upgrade the retail and hotel premises itself.
We were unable to obtain any trading details from the hotel operator. He suggested that at present the hotel had an occupancy rate of between 50%-55%, of which 90% represents permanent occupants.
It has become evident over the last few years that Hindley Street has deteriorated in terms of value and as a source of entertainment. In the past it was acknowledged as the centre for night time entertainment in Adelaide. Rundle Street now holds this mantle to the detriment of Hindley Street which has and continues to be the source of much negative publicity.
Despite the opening of the University of South Australia campus further along Hindley Street, there appears to be little increase in activity in Hindley Street east of Morphett Street. The lack of activity is evident in the fact that the hotel located on the corner of Hindley and Morphett Streets is vacant. Furthermore, building owners along Hindley Street have not upgraded their premises and this creates a negative perception of the street as old and in disrepair.
All of these factors lessen the chances of a purchaser being found for the Plaza Hotel. However a positive aspect is the fact that there are a number of investors who own properties along Hindley Street. They may seeks to expand their holdings further and it is to these investors that the Plaza Hotel may appeal.
MARKET POTENTIAL
Given the state of disrepair of the premises, the lack of trading details available from the Plaza Hotel operation and the fact that there are vacancies on the ground floor, we consider that the subject property would have very limited appeal in the current market place. The lack of trading details for the Plaza Hotel raises questions concerning the profitability of the business, especially given the disrepair of the premises. At present an investor would be faced with a substantial cost to upgrade the premises, with only minimal rental income provided. The Game Quest tenancy, which is the only formally leased portion of the premises, is due to expire on the 4th September 1997. While we do not know whether the tenant will vacate, it does raise the question and therefore lower the marketability of the premises.
Any property investor would be very wary of the income producing potential of the hotel and the fact that Hindley Street as an entertainment venue has deteriorated in recent years. Consequently the purchaser would be faced with an initial capital expenditure with the prospect of vacancies in the short term and what may be an enviable (doubtless the word intended was unviable) hotel operation. We do not consider that this scenario would appeal to many investors in the market place and consequently an extended selling period of in excess of six months may well be required in order to dispose of the property.
8. On 14 July 1997, the Bank accepted an offer from the Govedaricas to purchase the freehold of the property through Roclin for $800,000. The Bank financed the purchase with a loan to Roclin of $620,000. The loan was guaranteed by the Govedaricas. Two of the shops were occupied. The contract excluded from the sale “all goods, chattels, plant equipment and machinery and moveable items not in the nature of permanent improvements in or about the Land”. Settlement was on 17 August 1997.
9. On 11 February 1998, the Bank commenced the action in this Court against Mr and Mrs Jovanovic under their guarantee. The amount sought was $39,615.09. Fortson entered the proceedings as plaintiff to a counterclaim against the Bank.
10. On 13 June 2003, the primary judge entered judgment for the Bank against Mr and Mrs Jovanovic for $77,643.93. Fortson’s counterclaim was dismissed.
11. On 3 March 2004, the Full Court, in Jovanovic & Ors v CommonwealthBank of Australia (2004) 232 LSJS 339, set aside the primary judge’s orders as having been based upon the wrong test. The Full Court decided that the Bank’s sale of the property by a private tender process was in breach of s 420A of the Corporations Act. Section 420A(1) provides :
In exercising a power of sale in respect of property of a corporation, a controller must take all reasonable care to sell the property for:
(a) if, when it is sold, it has a market value – not less than market value;
or
(b) otherwise – the best price that is reasonably obtainable, having regard to the circumstances existing when the property is sold.
Besanko J, with whom Mullighan J agreed, said (at paragraph 117 of the reasons) :
The question remains as to the price which would have been obtained for the freehold title of the property had the Bank taken all reasonable care in terms of the section. In the circumstances of this case that involved appointing an agent, conducting a proper marketing campaign and putting the freehold title of the property to the market. The difference between the price which would have been obtained had that been done and the price the Bank in fact obtained, together with appropriate adjustments in relation to the expenses of the sale, is the measure of the loss for the breach of the duty in s 420A. Unfortunately, this court is not in a position to determine that figure. It involves an assessment of the valuation evidence including an assessment of the extent to which that precise issue has been addressed by the valuers, and a determination as to the valuation evidence which should be preferred. It may be noted that the market value as defined by one or more of the valuers who gave evidence is not necessarily the same as the sale price that would have been achieved had the Bank appointed an agent, conducted a proper marketing campaign and put the freehold title of the property to the market.
The Full Court remitted the action to the primary judge for the hearing and determination of the issue identified by Besanko J, namely: What price would have been obtained for the freehold title of the property in July 1997 had the Bank appointed an agent, conducted a proper marketing campaign and put the freehold title of the property to the market?
12. On 6 September 2004, the primary judge disqualified himself on the ground of perceived bias. The action was assigned to me. I then heard an application by the Jovanovics and Fortson for leave to call further evidence.
13. On 22 December 2005, in CBA v Jovanovic & Ors (No 3), (2005) 243 LSJS 155, I decided to allow the parties to recall the valuers who had previously given evidence before the primary judge. The valuers were Mr P.J. Burton of Knight Frank, called by counsel for the Bank, and Mr R. Williamson of F.P.D. Savills and Mr R. Taylor of Richardson and Wrench, called by counsel for Fortson and the Jovanovics. I directed that the valuers should first confer under the supervision of Master Norman.
14. My reasons of 22 December 2005 include a table which compares the figures which the valuers adopted before the primary judge for the purposes of arriving at their valuations. The table was in the following form :
Burton
Williamson
Taylor
hotel rental
70,000
75,000
70,000
shop rental
38,750
45,000
45,164
108,750
120,000
115,164
deduction for land tax
5,825
-
-
102,925
120,000
115,164
capitalisation rate
13.5%
11%
11.5%
762,407
1,100,000
1,000,000
deductions for · repairs 50,000 - - · letting up allowance
55,000
-
-
add back rental surplus
866
-
-
capital value $660,000 $1,100,000 $1,000,000
15. As appears from the table, the valuers were not all that far apart in their projections of rental income for the hotel and the shops. The differences between them at that time were with respect to the capitalisation rate, and with respect to deductions that Mr Burton made for land tax, repairs and letting up allowance.
16. Mr Burton and Mr Williamson were also in agreement before the primary judge that rental income can be imputed by multiplying $30 (estimated average nightly room rate) by 67 (number of rooms in the hotel) by 365 (to produce an annual result) by 50% (occupancy rate) by 20% (rent to turnover rate). The result of that arithmetic is $73,365. I have used the expression “rent to turnover rate” to describe a rate which reflects industry experience of what rental can be sustained in the market from a given level of turnover.
17. None of the valuers was asked to take into account evidence that a Mr Stefanovic gave before the primary judge. In my reasons of 22 December 2005, I said (at paragraph 22) :
I go back to the projections that the witnesses made with respect to hotel rental. Messrs Burton and Williamson assumed that the occupancy rate of the hotel at the time was in the order of 50%. Mr Taylor assumed that the rate was between 35% and 40%. It appears, however, that none of the witnesses was asked to take into account the evidence of Mr Stefanovic. He was the night manager of the hotel between March 1992 and May or June 1998. He was the only first hand source of information about the actual occupancy rate of the hotel. He said that, of the 67 rooms that were available for letting, 40 to 45 rooms were occupied by permanent residents, and about 15 rooms on average were occupied by casual guests. He said that an average of one or two rooms would have been in an unfit state to let at any one time. 53 rooms as a percentage of 67 rooms is 79%. As for room rates, the following is a summary of Mr Stefanovic’s evidence on that topic:
permanent residents
standard room $91 per week
room with ensuite $130 to $140 per week
casual guests
one person
standard room $25 per night
room with ensuite $35 per night
two persons
standard room $35 to $40 per night per room
room with ensuite $45 to $50 per night per room
three persons
standard room $50 per night per room
room with ensuite $75 per night per room
18. The conference under the supervision of Master Norman took place on 15 February 2006. The participants were Mr Burton and Mr Williamson. Fortson and the Jovanovics elected not to recall Mr Taylor. The Master’s report of that conference shows that Mr Burton stood firm on each of his figures in the table and on his ultimate figure of $660,000. Mr Williamson increased his hotel rental from $75,000 to $115,000 and his occupancy rate from 50% to 75%. A recalculation to reflect those changes produced an ultimate figure of $1,460,000. The valuers agreed that capitalisation of imputed hotel rental was the correct methodology. The only other agreement they could reach was that the figures which they gave previously for shop rental were within an acceptable range.
19. The hearing resumed before me between 29 May and 1 June 2006. Mr Burton and Mr Williamson were called by the parties. They gave their evidence concurrently. My purpose in directing that course was to facilitate a free flow and exchange of information and opinion between the valuers themselves and between the valuers and the court.
Issues for consideration
Having heard the evidence of Mr Burton and Mr Williamson, it is apparent that they are now even further apart than they were before the primary judge and at the conference.
Mr Burton maintained his position that the successful bidder would have been an investor. He said that hotel rental should be imputed at $70,000, that the capitalisation rate should be assessed at 13.5%, and that $660,000 was the capital value.
Mr Burton found support in his report for his figure for hotel rental from the rate per room of West’s Private Hotel at 108-112 Hindley Street. That hotel had been leased at a rental effective in January 1995 of the equivalent of $1,760 per room. West’s Private Hotel comprised 33 rooms, and was located close to the Plaza Hotel and with a similar basic level of accommodation. Mr Burton said that he adopted a lower rate of $1,000 or $67,000 ($1,000 multiplied by 67 rooms) because the Plaza Hotel had twice the number of rooms.
Mr Williamson maintained his position that the successful bidder would have been a developer. He spoke of an average rate per room of between $25 and $30, an occupancy rate of 79%, and a rent to turnover rate of between 20% and 25%, producing a hotel rental in the range of $95,000 to $140,000. He finally settled on $120,000 as “the middle ground”. He added shop rental of $45,000, and capitalised the resultant figure of $165,000 at 11% to reach a capital value of $1,500,000.
Mr Williamson’s view was that Mr Burton’s rate per room approach was highly unreliable but that, in any event, a rate per room of $1,760 times 67 rooms produced a figure of $117,920, which was close to his ultimate figure of $120,000.
It is apparent from the above that each of the variables in the formula for capitalisation of hotel rental – average nightly room rate, occupancy rate, rent to turnover rate and capitalisation rate – will need to be examined before I come finally to the question posed by the Full Court.
Average nightly room rate
Although, as I will explain in a moment, Mr Stefanovic’s evidence is unclear on how many rooms of the hotel overall were occupied in and about July 1997, a number of propositions can be extracted from his evidence.
Of the total number of rooms that were occupied, most were occupied by permanent residents at rates of $13 per night ($91 per week) in the case of standard rooms and $18 to $20 per night ($130 to $140 per week) in the case of rooms with ensuites. Mr Stefanovic gave his evidence in 2003. He said that “about a dozen” rooms were with ensuite bathrooms. Mr Burton’s inspection of the hotel in May 1997 disclosed that the actual number of rooms with ensuites was 14.
The relatively small number of rooms that were occupied by casual guests were let at rates of $25 per night (one person) to $35 to $40 per night (two persons) in the case of standard rooms and $35 per night (one person) to $45 to $50 per night (two persons) in the case of rooms with ensuites (I will assume that the use of a room by three persons was uncommon).
When these propositions are used to find an average room rate for all rooms that were occupied on any one night, the likely range in my view is between $15 and $20. If I am right about that, it must follow that the estimate of $30 adopted by both Mr Burton and Mr Williamson before the primary judge, and Mr Williamson’s range of $25 to $30 before me, were too high.
Occupancy rate
Mr Burton said at page 11 of his report that he was unable to obtain any trading details from the “hotel operator”, but that the “hotel operator” suggested that the hotel had an occupancy rate of between 50% and 55%, of which 90% represented permanent occupants. The contact person provided by the Bank to Mr Burton was Mr Jovanovic, so Mr Burton assumed that Mr Jovanovic was his source of information. Since, however, the “hotel operators” were the Govedaricas, it may be that one or other of the Govedaricas was the source. Counsel for the Jovanovics made the point that the Govedaricas had an interest in minimising the occupancy rate, because they were potential purchasers of the hotel at that time.
Mr Burton also wrote that an occupancy rate of 50% is supported by “industry parameters”.
Mr Williamson referred, in his report, to a report of JLW Transact of February 1997 which detailed the level of occupancy rates of hotels in the upper segment of the market between 1995 and 1997. For the full year of 1995, the rate was 65.8%. Mr Williamson said that that figure could be related to the lower segment of the market as well. Mr Williamson said that, aside from Mr Stefanovic’s evidence with respect to the Plaza Hotel, the occupancy rate in 1997 for hotels like the Plaza Hotel would have been, on average, between 50% and 65%.
Mr Burton disagreed that the figure of 65.8% in the JLW Transact report could be related to the lower segment of the market.
A further point about occupancy rates is the evidence of Mr Williamson, which seems logical, that a high permanent population residing in a hotel would often reflect itself in a higher occupancy rate overall.
Mr Burton was not prepared to adopt any higher occupancy rate than 50%. When I put to him that Mr Stefanovic’s evidence would suggest an occupancy rate of 79%, Mr Burton said :
I’m not discounting it, I suppose, is the thing, but the basic standard or basic premise for doing a valuation of a property such as this would be to try and get three years financials, so you can determine a sustainable level of trade, a sustainable level of occupancy and things such as that, because there are various situations where hiccups might occur. You might have occupancy go from a base 50% up to 75% in one year because 20 football clubs or whatever visit and they stay in Hindley Street, but the, the year after, it reverts back to the 50%, which is the benchmark, if you like, that that business can sustain. If those figures were available and those financials were available for, say, a three-year period, you can go, okay, the occupancy is sustained at 75%, the revenues are sustained, based upon that, at a certain level and therefore, you can go ‘The normal test of rental would be 20% of that sustainable revenue and therein lies your rental’, and that may result in a higher rental, but you’ve also got to give consideration to the fact that we did all this analysis and the 50% occupancy was what was considered market at the time. If you had that financial information in front of you, you may well come to the conclusion that a higher level of occupancy, therefore, a higher level of turnover and, potentially, a higher level of rental is sustainable and come to that conclusion, but you have to have that information available, rather than a once‑off ‘These are the turnovers and these are the rentals’. Well, that’s what I would do to determine that, because, ultimately, when you are using a capitalisation approach, you are trying to determine a rental that is sustainable, if you like, for the longer term and takes into consideration what levels of turnovers and things such as that are sustainable for the longer term.
Having reread and reconsidered Mr Stefanovic’s evidence, I have reached the conclusion that 79% is not an estimate which I should accept to the exclusion of all others. Mr Stefanovic, who, as I have said, gave his evidence in 2003, was not asked to express the occupancy rate in percentage terms. 79% was my extrapolation. I quote the relevant part of his evidence :
QYou had some permanent residents.
AActually, most of the rooms were occupied by permanent residents.
QRoughly how many.
AI would say about 40 to 45 rooms.
QThis is permanent residents.
AYes.
QWhat do you mean by permanent residents.
APeople that actually paid weekly, a weekly amount and actually lived in the hotel.
QWere they on a weekly rate.
AYes, they were.
QHow much did they pay at that time, that is about August 1997, per week for a single standard room.
AAs far as I remember, about $91 a room.
QAnd for a room with an ensuite.
A$130 to $140 a week.
QUsually, around about August 1997, around about that time, usually what was the general occupancy of the hotel, in other words, roughly how many rooms on average were let out at any one time. Did that include permanent residents as well as non-permanent residents.
AIn percentage or -?
QIf you are able to given an approximate room number.
ALet’s say out of the 67 you said the hotel had probably about 15 rooms on an average.
Although Mr Stefanovic’s reference to 15 rooms in his last answer may have been a reference to casual guests or “non-permanent residents”, and was probably not responsive to the question “roughly how many rooms on average were let out at any one time”, at no point was he asked to express the occupancy rate in terms of a percentage.
Given that 79% (or any higher percentage for that matter since counsel for Fortson argued a range of between 82% and 89%) is an extrapolation that was never put to Mr Stefanovic to test his response, I do not think that I should ignore entirely the other evidence on the topic. As I have said, Mr Burton obtained an occupancy rate of 50% to 55% from “the hotel operator”, and said in his oral evidence that his rate of 50% was within “industry parameters”. The rates which Mr Williamson and Mr Taylor adopted before the primary judge were 35% to 40% (Mr Taylor) and 50% (Mr Williamson).
Later when I come to the question posed by the Full Court, I will make a further point that perceptions of the occupancy rate in the minds of potential bidders might have differed from the reality.
I accept Mr Burton’s view that, when imputing rental income to the hotel business, it is important to consider the sustainability of that income.
Rent to turnover rate
I have said that this rate reflects the costs which must be deducted from turnover to arrive at a rental to be imputed to the property. Those costs would include cleaning, light and power, laundry, telephone, repairs and maintenance, and fixed costs such as advertising, insurance, interest, and accounting and licence fees.
Obviously enough, the rent to turnover rate will vary from hotel to hotel. A hotel with a high ratio of permanent to casual residents will attract, generally speaking, a higher rate than a hotel with a low ratio of permanent to casual residents. Mr Stefanovic’s evidence was that the permanent rooms were made up by a maid once a week. The valuers agreed that the industry standard was 20% to 25%. Mr Williamson observed, however, that this standard related to hotels which charge a nightly or casual rate. He said :
Yes, where it is of a permanent nature, eg $91 at 52 weeks, as opposed to the $30 at 365. You can, in fact, use a mixture of rates and come up with a cocktail of rental, but you can’t just simply apply a rate of 20 to 25% when that is the sort of accepted rate at the time, I think the valuers all agree, for the assessment of a hotel, where you have deduced what the income is based on an occupancy on a nightly rate. The reason for that is simply this: if somebody is staying on a weekly rate, they probably clean their own room and, therefore, the cleaning cost to the hotel doesn’t exist – that is not uncommon – and there are other expenses that would not be levied where someone is living as a permanent and, therefore, your rental return can obviously afford to be higher as a percentage of turnover because your on-costs don’t exist to the same degree.
Later, Mr Williamson said :
I guess it’s the same as the application of 20-25%. I think it’s an accepted practice to consider that if you’ve got permanent occupancy, the costs are lower, and therefore the discount rate to arrive at a rental is higher. There were certainly hotels around Hindley Street at that time – I think there still are – I don’t know the level of permanency, but there are high occupancies there. Now it may be, presumably, because of that. I’ve not analysed them, but I know that there are hotels, like the one in Bank Street and the Paringa which are higher; they are in the 30-40% rent to turnover bracket.
Mr Burton was reluctant to move from his previous rate of 20%. He did agree, however, that the higher the percentage of permanent residents the lower the cost per room.
Mr Williamson made the further point, with which Mr Burton agreed, that a high rent to turnover rate may result from the charging of unduly high tariffs or it may demonstrate the unviability of the business.
Capitalisation rate (cap rate)
As I have already said, all three valuers were in agreement that the appropriate approach was to capitalise imputed rental income. In their evidence before me, Mr Burton and Mr Williamson did not take issue with the extract which I quoted from The Valuation of Business, Shares and Other Equity (Fourth Edition) by Wayne Lonergan in my reasons of 22 December 2005 (paragraph 17), namely :
Income producing properties are generally valued by capitalising the (pre tax) net rental income the property produces at a capitalisation rate (often referred to as a running yield) based on the yield reflected in contemporaneous sales of comparable income producing properties.
For example, if an office building generated net rental income (before tax) of $8m per annum and the prevailing capitalisation rate was 8 per cent, then the building would have a value of $100m ($8m net rent divided by 8 per cent equals $100m capital value). This valuation method assumes a continuation of current rental income, and that the potential for rental and capital growth risks associated with investing in the property and any tax deductions available to an owner of the building are all reflected in the yield.
This method is relatively easy and inexpensive to apply. It is also favoured by many property valuers.
I am satisfied from the evidence that the capitalisation rate is important to an investor. It represents the income yield he hopes or expects to achieve from his capital outlay. To a developer, on the other hand, the cap rate is less important. A developer is concerned to add value to the property for the purpose of ultimate wealth creation. Immediate rental income is not a primary consideration. If rental income covers holding costs, however, that would be an added attraction.
In the case of the Plaza Hotel, the options for a buyer in July 1997 would have included renovating and upgrading the property to increase the return as a hotel, converting to permanent accommodation, and converting to student accommodation.
Other considerations to bear upon the price that a prospective purchaser would pay would be the cost of funds to be borrowed, the absence or unreliability of management and trading information about the hotel, the extent to which existing leases would restrict vacant possession, and whether tax advantages could be achieved by negative gearing. A fifth consideration, which I have already mentioned, is the sustainability of income to be imputed to the hotel. It should be said, however, that the second, fourth and fifth of these considerations would probably weigh more with an investor than with a developer.
In their evidence before me, as I have said, Mr Burton and Mr Williamson maintained the positions that each took at the conference. Mr Burton’s cap rate of 13.5% reflected his view, purportedly based upon comparable sales, that a traditional investor would have been the likely buyer of the hotel, whereas Mr Williamson’s cap rate of 11% reflected his view, also purportedly based upon comparable sales, that developers would have been dominant in the market for the hotel.
Of the comparable sales referred to by the valuers, both before the primary judge and again before me, the following appeared to attract the most attention :
9-11 Hindley Street, Adelaide (retail and commercial) 12.61%
110-112 Franklin Street, Adelaide (backpacker style accommodation) 14.65%
125-127 Pirie Street, Adelaide (restaurant) 13.15%
88-90 Hindley Street, Adelaide (former Greater Union Complex) no cap rate
12-16 Hindley Street, Adelaide (the old Miller Anderson store) 7.3%
Mr Burton described the sales of income producing properties at 9‑11 Hindley Street and 110-112 Franklin Street as “major benchmarks”. He regarded 12-16 Hindley Street as a development site, and he used the sale of that property primarily to cross check his valuation of the hotel by reference to the basic plot ratios of each site. He said that the appropriate cap rate for the Plaza Hotel would have been between 12.5% and 14.5%.
Mr Williamson thought that the sale of the old Miller Anderson store in March 1996 was the most comparable. As I said in paragraph 21 of my reasons of 22 December 2005, a cap rate of 7.3% was based upon the holding income from ground-level shops as a percentage of the sale price. There were, however, three levels of vacant space above ground level, and it is at least arguable that some rental income, albeit with the expenditure of money to upgrade, should have been imputed to that space. Perhaps the more important point is that the cap rate was probably not central to the purchaser’s decision to buy the old Miller Anderson store. He would have been focussing mainly upon the development potential of the property. It should also be observed that Mr Burton and Mr Williamson were in agreement that the Miller Anderson store was in a superior location.
Mr Williamson’s evidence to the primary judge, based mainly upon the Miller Anderson sale, was that the cap rate for the Plaza Hotel would have been in the range of 10% to 12%. Hence his ultimate figure of 11%.
Mr Williamson told me that the likely buyer would have come from the second or third of the following four categories :
1. Traditional investors who are risk averse and looking for a higher yield of between, say, 12 to 13% to 13.5%.
2. Investors with development experience who are prepared to take a risk to obtain a yield of between 11 and 12%.
3. Developers and/or entrepreneurs and/or builders, generally of some wealth and ability, who would be satisfied with a yield of 10 to 11%, with holding income a bonus.
4. Premium paying purchasers with ‘blue sky visions’ for property, who would see more potential than most buyers and who would be content with a yield of 9%.
Mr Williamson said he had had dealings with persons in each of the four categories. His marketing campaign prior to any auction of the Plaza Hotel would have targeted persons in all four categories, but especially categories 2 and 3. He mentioned a number of names and the properties that they owned in Hindley Street and nearby.
The attention of both valuers was drawn to the question which has been remitted to me from the Full Court, namely, ‘What price would have been obtained for the freehold title of the property in July 1997 had the bank appointed an agent, conducted a proper marketing campaign and put the freehold title of the property to the market?’.
Mr Williamson said that, whilst the full range within which the property would have been sold is 1.23 million to 1.77 million, buyers in categories 2 and 3 would have shown enough interest to pay :
Category 2 1.33 – 1.43 million (assuming a 75% occupancy rate)
1.375 – 1.5 million (assuming a 79% occupancy rate)Category 3 1.45 – 1.6 million (assuming 75%)
1.5 – 1.65 million (assuming 79%)As I have said, Mr Williamson’s final position was an imputed hotel rental of $120,000, an imputed shop rental of $45,000, and a cap rate of 11%. On those figures, the capital value is $1.5 million.
Mr Burton said that the likely purchaser would have come from category 1, but that, in any event, given a properly conducted sale, neither a traditional investor nor a buyer from any other category would have paid more than $660,000.
It is true that the Plaza Hotel was passed in at an auction in March 1992. However, the five year gap to July 1997, not knowing the reserve, and the absence of any other information about the auction, make that evidence of doubtful relevance and weight, and so I put it out of my mind.
Although it is also true that there is no evidence that a person in category 2 or 3 was interested in buying the property at the time of the sale in July 1997, there is no evidence either that persons of that kind were directly approached or specifically targeted as potential buyers.
The sale of the property “by informal tender” in November 1995 for $750,000 is of doubtful relevance, given that it was not an arms-length transaction, and given also that developers of the kind identified by Mr Williamson may not have been specifically and actively targeted.
Deductions
Unlike the developer, the traditional investor would need to factor into his bidding intentions the cost of repairs to make the hotel tenantable and the time that it would take to obtain tenants to occupy the vacant shops. Mr Burton’s letting up allowance of $55,000 assumed a time-frame of twelve months, whereas Mr Williamson suggested six months. Unlike the developer, the traditional investor would also need to take account of his liability for land tax.
An application by the Bank to amend its defence
Counsel for the Bank submitted, subject to an application to amend its defence, that the Jovanovics and Fortson should be barred from equitable relief under the defence and counterclaim by reason of the primary judge’s findings that they were guilty of deceitful and fraudulent conduct in relation to the sale in November 1995. Counsel cited, amongst others, the authority of Meyers v Casey (1913) 17 CLR 90, and the following passage from the reasons of Isaac J at page 123 :
It is not laying down any principle to say that his ill conduct disables him from having any relief in this Court. If this can be founded on any principle, it must be, that a man must come into a Court of equity with clean hands; but when this is said, it does not mean a general depravity; it must have an immediate and necessary relation to the equity sued for; it must be a depravity in a legal as well in a moral sense.
I do not agree with the submission. I do not consider that the Bank’s breach of s 420A arose from or was related to the conduct of the Jovanovics and Fortson in any relevant sense. The Bank’s decision to sell by process of private tender was taken independently of any deceit or fraud. The Jovanovics and Fortson are seeking relief against the consequences of a breach of statutory duty by the Bank. Their conduct does not have, to use Isaac J’s words, “an immediate and necessary relation to the equity sued for”.
In the result, I need not deal with the application to amend, nor with the remaining submissions that counsel for Fortson made with respect to the application.
General remarks about the reliability of the evidence of Mr Burton and Mr Williamson
Although Mr Burton was a licensed valuer who had practised in that field and Mr Williamson was and is a sales consultant with considerable experience in the tourism and hospitality industry (I have described Mr Williamson in these reasons as a valuer merely for convenience), those differences in background alone do not provide a satisfactory basis for preferring the views of one over the views of the other. Both seemed to have an equally clear understanding of the issues and the competence to address them.
Mr Burton had the advantage of inspecting the hotel and the location in May 1997, but the weight of his evidence before me was diminished by his professed inability to reconsider his earlier views. An illustration of this emerges from his response to a question about Mr Stefanovic’s evidence :
What I’m saying is that I would consider it, or I would have considered it, if it was available. I’m not in a position to now go back and say ‘This is the figure on the property’: one, I’m no longer a valuer; two, I haven’t been doing valuations in Adelaide, I’ve been living in Sydney for seven years. It’s not something you can do from a valuation perspective and come up with a different figure in isolation. I’ve said ‘it may have an impact on value’, but you can’t just go through from a valuation perspective and come up with a different figure. As I’ve said to the judge, if that information was available and everything of that nature, it may have impacted upon the valuation. To quantify the degree to which it would have an effect or may have had an impact requires that the whole process is re-assessed.
Later Mr Burton demonstrated an unwillingness to reconsider his original valuation in these words :
In my current profession, I’m not a valuer. I read valuation reports and of that ilk, but I am now out of the market, so I’m not in a position, nor do I think it would be professional of me, to go arbitrarily ‘Yes, that’s the turnover, yes, that’s the occupancy, yes, that’s the rental, and, on that basis, you flow it through and it comes up with a figure’.
In the case of Mr Williamson, I have already expressed the opinion that his average nightly room rate and his occupancy rate were too high, and his rent to turnover rate was too low.
As for the capitalisation rate and the relevance of Mr Williamson’s four categories of potential buyers, I am unable to resolve the differences between the valuers by the expedient of accepting one view and rejecting the other. The views of both are open to argument and must be taken into account.
In the end, I will draw my own conclusions about the issues in dispute, but I will do so by giving such weight to the views of the valuers as I see fit.
My answer to the question posed by the Full Court
The answer to the Full Court’s question must arise from hypothesis rather than historical fact. I am required to make the theoretical and false assumption that the Bank had put the freehold title of the property to the market after appointing an agent and conducting a proper marketing campaign.
In Malec v JC Hutton Pty Ltd (1990) 169 CLR 638, the High Court was concerned in a personal injury damages case to determine the earning capacity which the plaintiff would have enjoyed had he not been injured.
Brennan and Dawson JJ said (at pages 639 to 640) :
The fact that the plaintiff did not work is a matter of history, and facts of that kind are ascertained for the purposes of civil litigation on the balance of probabilities: if the court attains the required degree of satisfaction as to the occurrence of an historical fact, that fact is accepted as having occurred. By contrast, earning capacity can be assessed only upon the hypothesis that the plaintiff had not been tortiously injured: what would he have been able to earn if he had not been tortiously injured? To answer that question, the court must speculate to some extent. As the hypothesis is false - for the plaintiff has been injured - the ascertainment of earning capacity involves an evaluation of possibilities, not establishing a fact as a matter of history. Hypothetical situations of the past are analogous to future possibilities: in one case the court must form an estimate of the likelihood that the hypothetical situation would have occurred, in the other the court must form an estimate of the likelihood that the possibility will occur. Both are to be distinguished from events which are alleged to have actually occurred in the past. Lord Diplock said in Mallett v. McMonagle (1970) AC 166, at p 176:
‘The role of the court in making an assessment of damages which depends upon its view as to what will be and what would have been is to be contrasted with its ordinary function in civil actions of determining what was. In determining what did happen in the past a court decides on the balance of probabilities. Anything that is more probable than not it treats as certain. But in assessing damages which depend upon its view as to what will happen in the future or would have happened in the future if something had not happened in the past, the court must make an estimate as to what are the chances that a particular thing will or would have happened and reflect those chances, whether they are more or less than even, in the amount of damages which it awards.’
Deane, Gaudron and McHue JJ said (at page 643) :
If the law is to take account of future or hypothetical events in assessing damages, it can only do so in terms of the degree of probability of those events occurring. … But unless the chance is so low as to be regarded as speculative – say less than 1 per cent – or so high as to be practically certain – say over 99 per cent – the court will take that chance into account in assessing the damages. Where proof is necessarily unattainable, it would be unfair to treat as certain a prediction which has a 51 per cent probability of occurring, but to ignore altogether a prediction which has a 49 per cent probability of occurring. Thus, the court assesses the degree of probability that an event would have occurred, or might occur, and adjusts its award of damages to reflect the degree of probability.
Although, as I have said, Malec was concerned with the assessment of damages for personal injury, the principle recognised in that case is not confined to cases of any particular kind : Sellars v Adelaide Petroleum NL (1994) 179 CLR 332 at 355.
It will be convenient at this point to repeat the observations that I made in paragraph 8 of my reasons of 22 December 2005 on s 420A(1) of the Corporations Act 2001, and also to quote the evidence that Mr Williamson gave when asked to comment on that paragraph :
Paragraph 8
When it comes to the measure of any loss, there is a difference between asking “What is the market value of the property?”, and asking “What price would be achieved by taking all reasonable care to sell the property for not less than market value?”. The second question, unlike the first, does not focus exclusively upon market value. Assets are often sold under or over their market value. Sometimes a buyer with a special interest in acquiring an asset will pay a premium on market value. So the second question would permit consideration of information that a buyer was prepared at the relevant time to pay more than market value.
Mr Williamson
I think, as I understand it, 8 is really just trying to look at the operation of the market. It is fairly common for a market price by valuation, or market value by valuation, to occur at one level, and it is not uncommon for a party to buy a property above what it’s been valued for in practice. The purpose of creating a chart of the different categories of buyer by identifying what sort of a property it might be and who would be interested, is a profiling exercise to look at what might be a reasonable buyer group to buy a property and what might they pay and how are they going to evaluate it. As I say, there are many examples of a property being valued for one sum and going for a higher sum. There are occasionally examples the other way, too, but often the market price, or the new market price that comes from an auction or a tender or sale, provides the fodder for the next valuation of, perhaps, a similar property by the valuation community, and that’s how I’ve seen it operating in practice for as long as I can remember.
The question posed by the Full Court is not to be answered merely by adopting and applying what we now know about actual room rates and occupancy levels of the hotel in 1997. It is the perception of the hotel business in the market place rather than the reality of that business which should guide the answer to the Full Court’s question. One would ordinarily expect the perception to match the reality, especially after “a proper marketing campaign”, but that might not have been so in this case, given the absence or unreliability of management and trading information at the relevant time.
To put the point another way in connection with the occupancy rate, potential bidders at the auction may not have been any better informed about the occupancy rate than were the valuers. It will be recalled that the valuers thought that the rate was 35% to 40% in the case of Mr Taylor and 50% in the case of Mr Burton and Mr Williamson. It will also be recalled that the “hotel operator” was suggesting that the rate was between 50% and 55%. Again it should be remembered that the various components of the equation would have been more important to investors than to developers.
Although the poor condition of the hotel, the depressed state of Hindley Street at the time, and the absence or unreliability of management and trading information about the hotel are considerations which could have been in the minds of potential bidders at the auction, those considerations are already reflected in the average nightly room rate and the occupancy rate. The extent to which the shop tenancies and arrangements with the operators of the hotel would have hindered vacant possession is a further consideration which will need to be weighed in the scales.
To reflect the hypothetical nature of the enquiry, I will assign a range to each of the components in issue.
As for imputed hotel rental, I estimate the average nightly room rate at between $15 and $20, I select an occupancy rate of between 55% and 65%, and I select a rent to turnover rate of between 25% and 30%. I will multiply the average room rate by 65, being 67 rooms less (say) 2 which would have been uninhabitable at any one time, and by 365 to arrive at an annual result. So the figures at the bottom and top of the range are :
$15 x 65 x 365 x 55% x 25% = $48,933
$20 x 65 x 365 x 65% x 30% = $92,527
The figure in the middle of that range is $70,730. After adding $45,000 for shop rental, the total for imputed income becomes $115,730.
I have reached the conclusion that the buyer of the hotel at the auction would have come from one of Mr Williamson’s categories 1, 2 and 3, and that as between those categories the degrees of probability of that event occurring were as follows :
category 1 50%
category 2 35%
category 3 15%
As for the capitalisation rate for each category, I select 13.5% to represent category 1, bearing in mind that Mr Burton’s range of 12.5% to 14.5% seemed to be reasonably based upon the sales of the income producing properties mentioned earlier in these reasons. I select 11.5% to represent category 2 and 10.5% to represent category 3. I conclude that, as an investor, a buyer from category 1 would have made the deductions deposed to by Mr Burton.
On that approach, the arithmetic for each of the categories is as follows :
category 1
$115,730 (hotel and shop rental) - $5825 (land tax) = $109,905
¸ 13.5% (cap rate) = $814,111 - $104, 134 (repairs and letting up allowance less rental surplus) = $709,977 (capital value)category 2
$115,730 (hotel and shop rental) ¸ 11.5% (cap rate) = $1,006,348 (capital value)
category 3
$115,730 (hotel and shop rental) ¸ 10.5% (cap rate) = $1,102,190 (capital value)
Having established capital values for the categories, I now multiply each by the chance that the eventual buyer would have come from that category.
Category 1 - $709,977 x 50% = $354,988
Category 2 - $1,006,348 x 35% = $352,222
Category 3 - $1,102,190 x 15% = $165,328
$872,538The final figure needs to be rounded off to avoid contributing even further to the undesirable but unavoidable appearance of mathematical precision.
In the result, the answer that I give to the question posed by the Full Court is $870,000. It will be recalled that the price for which the property was actually sold in July 1997 by the plaintiff was $800,000.
I invite counsel to address me on the orders which should now be made to finally dispose of the claim and counter-claim in the proceedings.
0
3
1