Valuation of extractive industry and landfill sites

Quarries are usually considered to be valuable real estate and, in most instances, this is correct. However, there are examples where quarries have failed to meet expectations, for many reasons, and mortgagees have on occasions suffered losses, indicating that quarrying is a competitive industry with high inherent risks and liabilities.

The operation of a successful quarry requires considerable expertise and a large capital outlay and there are recent instances where quarry operators have outlaid in excess of $20 million for a new crushing and screening plant.

It is of the utmost importance for all valuers to recognise and identify what is being valued. The subject of the valuation will be either:
1. the freehold operator’s interest
2. lessor’s interest, or
3. lessee’s interest.

The lessor’s interest will be the capitalised value of the rental and royalty income. The lessee’s interest should be, subject to security of tenure, similar to the interest of a freehold operator.

The timeframe over which the projected budgets and cashflows are estimated is of considerable importance, and this applies equally to freehold or leasehold interest.

In my opinion, the timeframe for the capitalisation of an EBIT should reflect the life of the quarry up to but not greater than 30 years, after taking into consideration the geological estimates of the resources, the volume of usable reserves, and all the elements of risk in meeting the budget forecasts over the term used.

The valuation of a quarry site will comprise:
? The value of the reserves to the quarry owner/operator, or
? The value of a royalty income stream to the lessor/land owner.

In Victoria, a quarry is controlled by both a planning permit issued by the local municipality, and an extractive industry work authority issued by the Department of Primary Industries. These two documents establish the working conditions relating to hours of operation, access, noise, dust and blasting.

The work authority does not have a terminating date, however it is not uncommon for a planning permit to be issued for a limited time, and in this environmentally sensitive world, it can be difficult to obtain an extension.

A large and important quarry operating in Melbourne recently applied for consent to expand within its own freehold land. The quarry has been operating for over 25 years and the application process has taken four years and cost more than $4.5 million. The quarry operators are still waiting for final consent.

Concerns for the valuer
The valuer must correctly identify the party with whom he/she is dealing, for example, a freehold owner/operator, a lessee, a lessor, a licence holder, or a government authority and Crown land.

The valuer must acknowledge all necessary consents, permits and licences. These consents may involve the land owner, the mortgagee, the government department handling Crown land, planning and environment authorities, municipal authorities and the department responsible for extractive industries.

Leases involving extractive industry sites should be registered on title.

The conditions of the extractive permits and consents are of the utmost importance and must be fully understood. Generally, the operating conditions for a quarry are usually clear and precise, and conditions pertaining to reclamation, hours of operation, restrictions on the volumes for extraction, buffer zones, lines of sight and approved work reclamation plans must be given proper and due consideration.

Development consents and planning permits are usually expected to run the full term of the life of the resource, but any possibility for early termination or the cancellation of the relevant consents must be given full weight.

A geological report is required in almost all circumstances, and a competent report will provide the valuer with not only the total volume of the reserves, but the expected volumes suitable for extraction and sale, together with estimates of overburden.

It is important to a valuer, particularly where assessments are being provided to a mortgagee, that the estimates of the resource have been carried out by competent persons and in compliance with the relevant body, which in Australia is the Australasian Institute of Mining and Metallurgy. This institute has set standards for geologists working within a particular section of the industry and I expect a professional geological report to provide me with the following:
? overburden quantities
? quality and description of reserves, and
? volume of reserves.

In the case of sand, the report
should provide:
? clay content
? estimates of coarse, medium and fine sand, and
? a fineness modulus (fm).

The total volume of reserves available for the quarry operator is an important assessment, and the valuer will often need to acknowledge that the total volume of the resource may not be able to be valued.

The life of the reserves, or term used for the purpose of a valuation, must be given weight. This timeframe is affected by the marketplace and the ability of the quarry to sell a certain volume of product, generally over a long period, and that period must reflect the inherent risks in meeting the budget estimates and volume of available reserves.

If the remaining reserves are only small, the projected life of the quarry will be considerably reduced, and will have an effect on the estimates and the risk factors used in capitalising a recurring EBIT.

In my opinion, the volume of reserves used for valuation purposes will be the result of multiplying the anticipated and budgeted annual sales by the expected life, or alternatively, the projected output by the accepted life – whichever is the lesser. There is no point in attempting to value a resource of 50 million tonnes when the anticipated extraction rate is say, 60,000 tonnes per annum, which by deduction produces a need for only 1.8 million tonnes over the next 30 years.

The following example highlights the problem of valuing a site with an enormous resource, but with limited sales potential.

A life for valuation purposes of 500 years is obviously nonsense when only a small output is contemplated, and any attempt to value the total resource of 50 million tonnes will create a major valuation error.

I have seen examples of quarry valuations where a unit value per tonne in situ was applied with insufficient consideration given to the marketplace. For example, a unit value of 30 cents per tonne in situ may be justified if applied to a resource of, say, 2.5 million tonnes, that is, 25 years of life at 100,000 tonnes per annum.

However, if that resource is measured at 50 million tonnes, the unit of 30 cents per tonne in situ produces a value of $15 million. Consequently, the valuation is blown sky high, with a result as dangerous as fly rock. The valuer will have to use more stemming and less burden and certainly better consideration.

Royalties are usually established by open market negotiations, comparison with known royalty agreements, comparison with Crown royalties fixed by legislation, or by an acceptable percentage of the ex-bin selling price.

I prefer royalty agreements to be based on an ex-bin selling price with a minimum output. In today’s market, the most common royalties range between 30 cents per tonne to $1.20 per tonne.

In Victoria, Crown royalties are set by legislation and are uniform throughout the state, regardless of location, quality or resource type. Current Crown royalties are running at the rate of $1.43 per cubic metre or 87 cents per tonne, which is an interesting conversion of 1.64 tonnes per cubic metre across all product.

The best and most logical royalty agreements are those based on a percentage of the ex-bin selling price. These agreements range between 3 per cent and up to 20 per cent of the ex-bin price, but, in my experience, current agreements fall within a range of 7 per cent to 12 per cent of the ex-bin price.

Where the valuer is required to establish a royalty, consideration needs to be given to:
? the current Crown royalties – if any
? the locality in which the quarry operates
? distance from the marketplace, the cost of transport and the selling price
? quality of the stone and its ability to meet specifications, and
? the cost of production.

In a commercial royalty agreement, there should be provision for a minimum royalty or, at the very least, an annual rental. The minimum royalty protects the land owner in instances where extraction may be delayed or even ceased for reasons other than the quality of the stone. It is noted that some royalty rates are changed with the grading of various products, and it is not uncommon for a higher royalty to be paid for ‘A’ grade or Class 1 stone, and a lower royalty paid for a lesser quality. However, this differentiation in quality can lead to argument and, unfortunately, mistrust – and, in some circumstances, agreement may be difficult and expensive to achieve.

Valuation methodology
A quarry valuation can be carried out by either the capitalisation of a budgeted EBIT or by comparison with other quarries using a unit value per tonne for the available reserves. However, the latter becomes extremely subjective and almost impossible when all matters are considered, and it is unlikely that a valuer will, in fact, find two genuinely comparable quarries and an arm’s length sale that can be relied upon for comparison.

It is important to base the valuation on the capitalisation of earnings before interest and tax. This allows some comparison with other quarries, and the financial figures for an operating quarry should, at the very least, give a fair and reasonable indication of the existing market conditions.

The capitalisation of an EBIT provides a value that may be used to derive a unit value per tonne of reserves in situ. This, in turn, can be used for comparison purposes with other quarries, which quickly enables the establishment of a crude rule of thumb. However, until a value has been arrived at by capitalisation, a unit value per tonne in situ (or cubic metre) cannot be anything else but a ‘rule of thumb’.

If the capitalisation of an EBIT is accepted as a valid method, the complications of the valuation are reduced to the need to know two major estimates:
? the sustainable recurring earnings before interest and tax, and
? the anticipated or acceptable life of the quarry reserves.

These two estimates reduce the problems of valuation to a very simple question – how much profit can the quarry make, and how long will it last?

To complete the valuation, it will be necessary to make assumptions and to provide the following estimates and budgets:
? total volume of reserves
? life of the reserves (both a physical life and an acceptable budget period)
? annual sales volumes
? average selling price
? cost of production
? EBIT, and
? a rate for return on capital, and a reinvestment rate or sinking fund.

The value of the reserves is arrived at by the use of the Present Value formula for projected earnings over a terminal period. This is a typical ‘dual rate’ and, in my opinion, the sinking fund component should provide for an allowance for income tax paid on the interest earned by the sinking fund or amortisation allowance.

The life of a quarry is acceptable up to a period of 25 to 30 years, but seldom is it necessary to extend that period. It is usual to divide the available reserves by the projected sales to arrive at the life of the quarry, however periods longer than 30 years have only a marginal affect on the final value. There will be instances where the period for capitalisation purposes is reduced below the physical life of the quarry for the purpose of reflecting the market’s perceived opinion of the operation, and to reflect the risk in achieving the projected EBIT.

The following example could be representative of several quarries servicing the Melbourne metropolitan areas, and I see no reason why the same methodology would not apply to quarries throughout Australia and New Zealand.

The value of plant and machinery will be added to the value of the land and reserves. If the fixed plant is valued at $8 million and the mobile plant at $1.8 million, the total value for the quarry as a going concern is $26.3 million, representing a return in perpetuity to the quarry operator of 14.14 per cent per annum.

The cost of production must include a proper allowance for the depreciation of plant and machinery, the value of which can be added to the value of reserves to attain the total value of the quarry operation.

Valuers are familiar with typical dual rate assessments, but there can often be a misunderstanding of the procedure. I cannot agree to the use of high capitalisation rates while maintaining the same high rate for the replacement of a depreciating asset. The following break-up, or proof of the capitalisation procedure, assists in the understanding of the workings of the dual rate.

There are differing opinions as to the use of the sinking fund rate or amortisation allowance, and also the allowance for income tax. I prefer to use the above scenario, but agree that other sets of figures may be considered, provided that the same method is always used to allow proper comparisons between quarry operations.

The above example results in the valuation of 15 million tonnes of stone at a unit rate of $1.10 per tonne in situ. This, in my opinion, is far more satisfactory than attempting to analyse other sales information to arrive at a unit figure per tonne. At the same time, it is admitted that a unit value of $1.10 per tonne in situ is high when it is considered this quarry is effectively paying for 25 years of stock in advance.

Errors and mistakes
There are many mistakes to be made in the valuation of extractive sites, but it may only be financial difficulties resulting in a sale that allows the valuation to be tested in the marketplace. A list of common errors include:
? The valuer attempts to assess the whole of the known reserves when this volume is excessive.
? The use of a low capitalisation rate is a common error, with no attempt to use a dual rate reflecting a risk-free replacement of a depreciating asset.
? The estimated life of the quarry can often be too long. Consideration for a shorter capitalisation period should be given to isolated quarries, which may have only a small market share, a low selling price, and be subject to severe competition, including quarries owned by local municipalities.
? The use of a profit figure higher than market indicators requires careful consideration. A proper allowance for depreciation of plant and machinery, and all outgoings including reclamation, must be provided.
? The expiration date of leases and agreements are important, particularly where there may be the opportunity for a lessor to refuse an extension of a lease.
? The difference between the value of freehold and leasehold reserves is often only minor, provided there is security
of tenure. It may be incorrect to severely reduce the value of the reserves held under lease as compared with
freehold reserves.
? Residual values must be treated with extreme caution. It is unlikely that an alternative use will be found by the quarry operator during the extractive life, and most attempts to project the future value over a long period will later prove to be inaccurate.
? Buffer areas rarely add value to the quarry operation. Unless there is surplus land that can be sold without adverse affect to the operation, it is seldom a quarry will dispose of the buffer areas, even if they are considerably larger than required by legislation.
? The value of the hole for a future landfill can be important, but extreme caution must be exercised when projecting a future value, and high risk rates for discounting purposes should be used. Personally, I am reluctant to provide a value for a future landfill unless the closing of the quarry is imminent, and there is a sound basis for assuming the necessary permits and consents for landfill will be issued.
? It is not uncommon for owners to incorrectly assume the value of the quarry is related to, or even equal to, the value of the gross income for example reserves of one million cubic metres and a selling price of $10 per cubic metre equals $10 million. This is obviously incorrect, but I have seen valuation reports prepared by consulting engineers stating the value of a particular quarry based on this assumption. The same mistake is also made when a profit figure is used over the total volume of reserves without discounting to present values.

Amortising reserves
The amortisation of reserves can be a matter of company policy. There are taxation implications, and company law may require the amortisation of a depreciating asset unless valid reasons are provided. I believe there is good argument not to amortise quarry reserves if these reserves have a life longer than, say, 20 years, and where future valuations are likely to maintain current values as a minimum.

The accounting procedures carried out at many quarries can be doubtful, and often improper, and this occurs particularly with small quarry operations where the full accounting of all outgoings is either not provided or overstated. The cost of final reclamation can involve considerable funds, and it is noted that in Australia reclamation may be defined by the Australian Taxation Office as capital expenditure, and not an operating cost.

Company policy will decide whether there is a value for those reserves held under lease. The value of leasehold reserves is open to interpretation and varies between companies and, inx particular, the major operators. In my opinion, the value of secure leasehold reserves is similar to that of secure freehold reserves, albeit there may be an adjustment to the earnings for the royalty payment.

As an example, I ask the question: ‘If all the Boral quarries were held under lease, and all the Hanson quarries were held freehold, would this mean that Hanson has assets in its balance sheet and Boral has no equivalent assets?’

It is often difficult to obtain accurate costs of production, and accounting procedures will differ from operation to operation. Like all businesses, there will be a break-even point and a valuer must be aware that a unit profit per tonne for a quarry with a high output will not be accurate if used to value another quarry with a smaller output.

Plant and machinery is an important part of the success of any quarry, and the correct choice of plant has serious repercussions on the cost of production.

The value of machinery is subject to age, obsolescence, maintenance programs and capacity. In my experience, a good rule of thumb for the valuation of fixed plant is to assume the primary items such as crushers, screens and conveyors represent between 35 per cent and 40 per cent of the replacement cost new (RCN) of the total plant.

This assumption provides a ready method of establishing the RCN of the total plant, and judgment needs only to be made on a percentage for depreciation and obsolescence. It is generally easier to obtain new prices for individual items of plant than to establish values for used items which also requires a judgment on the value of civil works, installation and electrics.

Valuation of royalty incomes
A royalty income can be capitalised in a similar manner as described for an EBIT. The lessor’s interest requires assumptions on the projected rates of extraction and the perceived risks involved over time for the royalty stream to remain stable, or to increase or decrease.

If the lessor’s interest is offered for sale, the minimum royalty will become an important figure in the mind of a purchaser. Unless the purchaser is familiar with the quarrying industry, a vendor may find it difficult to convince purchasers of the expectation of a higher royalty income stream than the Crown minimum, and that risk will be reflected in the capitalisation rates.

There are many instances where the capitalisation of a royalty should also reflect a risk-free sinking fund for the replacement of capital, similar to the valuation of the reserves as a depreciating asset.

Capitalisation rates for royalties are likely to have a range between 12 per cent to 17.5 per cent per annum.

Be aware
These notes are not intended to be all embracing and definitive. Provided the valuer is aware of the traps and pitfalls in assessing the value of an extractive site, together with the misinformation often provided by over enthusiastic clients, the valuer should be in a position to make logical judgments on the estimates and budgets required.

Robin Hocking is a director of CJ Ham and Murray and has considerable experience in the valuation of quarries and landfills, having valued more than 300 throughout Australia over the past 15 years.

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