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Chapter 5 Property Investment Valuation 5.1 Introduction Around half of all commercial and industrial properties in the UK are held as investments, where the ownership interest is separate from the occupation interest. The landlord leases the property to an occupying tenant or ten- ants.Investors in UK commercial property include large financial institutions such as pension funds and insurance companies (28%), overseas investors (15%), UK listed property companies (14%), UK private property compa- nies (15%), limited partnerships, landed estates, charities, trusts, unitised and pooled funds and private investors (23%) (IPF, 2005). The majority of commercial property investments can be placed in one of three principal sec- tors: retail (shopping centres, retail warehouses, standard shops, supermar- kets and department stores), offices (standard offices and business parks); and industrial (standard industrial estates and distribution warehousing). Investment market sub-sectors are often defined using a combination of this sector classification and their location, ‘City of London offices’ or ‘south west high street retail’, for example. There are also several smaller sectors of the property market that attract investment interest such as leisure parks, restaurants, pubs and hotels. Property that is typically held as an investment is valued with this purpose in mind; the valuer will capitalise the rental income produced by the property at an appropriate investment yield using the investment method of valuation, as we saw in Chapter 3.The underlying principle is to discount net economic benefits from an investment over its predicted life at a specified rate of return or discount rate.Chapter 2 described discounting as the process of finding the present value (PV) of expected net benefits that may be in the form of a regu- lar income, a future capital reversion or a combination of the two (Havard, 2000). The all-risks yield (ARY) technique described in Chapter 3 is based on the assumption that there is a relationship between the price paid (capi- tal value) and the annual return (net rental income). This chapter develops this notion more explicitly and describes a technique for valuing a property Wyatp05ndd 248 8182007 2:1021PM Property Investment Valuation 249 investment that involves more direct recourse to the underlying cash-flow characteristics of the investment. Before that, though, a history lesson. Up until the 1960s landlords who wished to lease commercial properties typically did so using long leases with no rent reviews. Investment in these commercial premises was regarded as low risk. Consequently the required (or target) rate of return was closely linked to similar low-risk investments such as gilts. Conventionally a premium of around 1–2% was added to the redemption yield on long-dated gilts to account for property market risk. Chapter 5 Long-dated gilts were used as a benchmark because property was regarded as a long-term investment. Valuation of property investments involved ana- lysing comparable evidence to determine the appropriate yield which was, in fact, mathematically and logically equivalent to the target rate of return (TRR) (Baum and Crosby, 1995). No adjustment was made to either the yield or the rent to reflect income or capital growth because there was none. A typical investment valuation prior to the 1960s is shown below. Market rent (MR)(£) 10000 a Years’ purchase (YP) perpetuity @ 10% 10 Valuation (£) £100000 a Investor’s target return and therefore comparable with other investments. After the 1960s, and a period of limited supply of new commercial and indus- trial property and restrictive macroeconomic policy, commercial property rents increased significantly and landlords introduced rent reviews into shortening leases so that they did not miss out on rising rents. Property became a growth investment, more like equities than fixed interest bond investments, albeit with a peculiar income pattern that goes up (usually) every 5 years (Havard, 2000). Investors were prepared to accept a lower return at the start of the investment term in expectation of higher returns later on. Property investment valuation techniques handled this change not by explicitly forecasting rental growth but by capitalising the current rent at an ARY (derived from comparable evidence) that is lower than the TRR because it implies future rental income and capital growth expectations.The gap between the two represented the expected or implied rental growth hidden in the valuation – directly analogous to the concept of a reverse yield gap between equities and bonds (Baum and Crosby, 1995). Consequently, the assumed static cash-flow is not the expected cash-flow, the yield is not the target rate and is not comparable to target or discount rates used to capitalise or value income from other investments. A typical investment valuation after the 1960s is shown below. MR (£) 10000 YP perpetuity @ 8% a 12.5 Valuation (£) £125000 Growth implicit ARY, not the target rate and therefore not comparable with other investments. From Chapter 3 we know that the ARY investment valuation technique relies on comparison to justify adjustments to initial yields obtained from Wyatp05.ndd 299 8182007 121021PM 250 PropertyValuation comparable investment transactions. These adjustments account for all factors that influence investment value except those that can be handled by altering the rent such as regular/annual management and maintenance Chapter 5 expenditure. The most important investment characteristics that need to be reflected in the ARY are income and capital risk and growth potential, but influencing these characteristics are a multitude of economic and property- specific factors including macroeconomic conditions, property market and subsectoractivity,thefinancialstandingofindividualtenants,propertydepre- ciation and changes in planning, taxation, landlord and tenant legislation. The ARY has to implicitly quantify these factors and the all-encompassing nature of the ARY means that capital value is very sensitive to small adjust- ments. In essence, a single divisor (ARY) or multiplier (YP) conceals many of the assumptions regarding choice of TRR (which includes risk) and income and capital growth expectations. Nevertheless, the ARY approach is practical and appropriate where there is a plentiful supply of comparable market transactions providing evidence of yields, rents and capital values. But there are circumstances when it is par- ticularly difficult to use the ARY technique to value a property investment. Problems arise when, first, comparable evidence is scarce, either because market activity is slow or the property is infrequently traded, and second, where there is greater variability in investments, meaning more variables must be accounted for in the ARY. Regarding this latter point, we saw in Chapter 4 how flexi-lease terms are creating greater diversity in property investment cash-flows, often with gaps in rental income. But, in addition to that, non-prime properties are generally more variable in terms of location, physical quality, condition or covenant and are therefore more risky. And problems arise where the property is more complicated than a simple rack- rented investment: the ARY technique is inappropriate for valuing property that is over-rented, let on short leases or produces varying rental income streams from multiple tenants. It can be especially difficult to quantify all of these factors in an ARY when comparable evidence is scarce. Harvard (2000) notes that increasing diversity in the property investment market has undermined the ARY valuation technique because it relies heav- ily on comparison between relatively homogeneous investment assets and simple adjustments to comparable evidence.As a result, property investment valuation techniques have emerged that focus more explicitly on the TRR that an investor requires, the expected flow of income, expenditure and capital growth that might be expected from an investment. The discounted cash-flow (DCF) technique uses an established financial modelling technique that allows comparison between property and other forms of investment. Where information is scarce, or when an unusual property is being val- ued, the DCF technique assists in the consideration of income and capital growth, depreciation, timing of income receipts and expenditure payments and the TRR. Indeed, International Valuation Standards now include guid- ance on the use of DCF analysis for valuation in GN9 – Discounted Cash Flow Analysis for Market and Non-market Based Valuations(IVSC, 2005). The guidance describes how DCF analysis involves the projection of a cash- Wyatp05.ndd 250 8/8/207 12:1021PM Property Investment Valuation 251 flow for an operational or development property. This projected cash-flow is discounted at an appropriate market-derived discount rate to establish PV. In the case of standing investment properties, the cash-flow is typically a series of periodic net rental incomes (gross income less expenditure) along with an estimate of reversion value anticipated at end of the projection period. In the case of development properties’ estimates of capital outlay, development costs and anticipated sales income produce a net cash-flow that is discounted over the projected development and marketing periods (cash-flows from property Chapter 5 development will be covered in the Chapter 6.)The guidance note discusses the structure and components of DCF models and the reporting requirements for valuations based on DCF analysis. 5.2 A DCF valuation model The academic case for valuing property investments by capitalising a DCF at a TRR rather than capitalising an initial income estimate at an ARY derived from comparable evidence began in the late 1960s and continues to this day. Appendix 5A (see Appendix 5A at www.blackwellpublishing.com/wyatt) lists references to papers that make this case in detail, culminating in the seminal UK text book in this field by Baum and Crosby (1995). But what- ever valuation technique is employed,it must reflect the behaviour of market participants. Recourse to comparable evidence (which is generated by mar- ket transactions) whenever possible and the adoption of pricing models that are used by market participants will undoubtedly be the most reliable and consistent way of estimating market price. TheARY technique relies on analysis of prices and rents achieved on recent comparable transactions to estimate an ARY for the subject property. The growth-implicit ARY is then used to capitalise an initial estimate of the cash flow. The DCF technique capitalises or, in the language of investment math- ematics, discounts the actual or estimated cash-flow at the investor’s TRR. The DCF technique requires explicit assumptions, based on evidence, to be made regarding several factors but most importantly theTRR (which should cover the opportunity cost of investment capital plus perceived risk) and expected rental income growth. When a valuer capitalises an initial rent at an ARY of, say, 8% it is done so in the knowledge that the investor is antici- pating a return in excess of 8% over the period of ownership as the expecta- tion is that rental income and perhaps capital value will increase. Essentially, the DCF technique removes the growth element from the ARY and puts it in the cash-flow. As a result, it re-establishes the relationship between the TRR required from a property investment and those required from other invest- ments, as was the case before the 1960s when rental growth was negligible. Instead of simply capitalising the current income (actual or estimated) at an ARY, the expected cash-flow, projected over a certain period of time at a rental growth rate, is discounted at a TRR. Of course, as we shall see, the DCF technique is not a panacea and several criticisms can be levelled at it. The selection of the discount rate or TRR is Wyatp05.ndd 251 8/8/207 12:1022PM 252 PropertyValuation subjective and the Appraisal Institute (2001) argues that it is difficult to find market-supported estimates for the key variables in the cash-flow. It might be necessary to estimate current market rent (MR) and expected changes Chapter 5 over the next few years. It might also be necessary to try and predict what will happen when the tenant has an option to break or when the lease needs renewing. The variation in possible lease incentives that might be offered, length of possible voids and expenditure that might be incurred is consider- able. Moreover, because the DCF technique separates the value significant factors as distinct inputs into the cash-flow and even separates the discount rate into a TRR and an exit yield, the risk of double-counting the effect on value of these factors is high. 5.2.1 Constructing a DCF valuation model The relationship between the growth-implicit ARY and the growth-explicit DCF techniques can be represented by a simple equation: yr=g- [5.1] where y is the ARY, r is the investor’s target return and g is the annual rental growth rate. The left side of the equation represents the growth-implicit ARY technique and the right side represents a growth-explicit DCF technique. The DCF technique separates the ARY into two elements; a rental income growth rate and aTRR; in other words,theARY implies the rental growth that the inves- tor expects in order to achieve the TRR. An investor accepting a relatively low initial yield from a property investment when higher yields might be available from fixed interest investments implies an expectation of future income growth. For example, an investor with a target rate of 15% who purchases a property investment for a price that reflects an initial yield of 10% would require a 5% annual growth to achieve the target rate.This sim- ple relationship is made more complex in the UK property market because income from property investments (in the form of rent) is normally reviewed every 5 years. This means that a slightly higher annual growth rate will be required to meet the investor’s annual TRR. Provided the growth rate, target return and rent review period in the DCF approach are mathematically con- sistent with the yield adopted in the ARY approach, the valuation will be the same. The following explains why. Starting with the ARY approach, the present (capital) valu e,of an income stream from a rack-rented freehold property investment is the pv PV £1 pa or YP (see Equation 2.18 in Chapter 2) multiplied by the annual income or MR: n 1− (1 (1+Y ) ) [5.2] V = MR y where y is the growth-implicit ARY and n is the number of years for which the rent is received. If the rent is receivable in perpetuity, that is, freehold Wyatp05.ndd 222 8182007 121022PM Property Investment Valuation 253 property investment, the above formula simplifies to Equation 2.23 from Chapter 2: MR V = y In other words, the PV is equivalent to a constant annual income capital- ised at (divided by) the ARY. In the case of the DCF technique, the income Chapter 5 stream is discounted at the investor’s TRR, r, rather than the ARY. So the PV of a rack-rented freehold property investment which consists of a constant (i.e.non-growth) annual MR receivable in perpetuity annually in arrears can be expressed as follows: V = MR [5.3] r But because the DCF technique is explicit about income growth we now need to introduce rental income growth, g, into this valuation model. Let us assume rent is receivable in perpetuity and there are annual rent reviews at which the rent is increased at the estimated long-term average annual rental growth rate, g. Assuming r, g, rental growth can be incorporated as follows: V = MR [5.4] r-g But for most property investments rent does not grow each year. If non- annual rental growth is now introduced, the following equation represents a freehold property recently let at MR in perpetuity with 3 year reviews: 3 3 3 6 V = +MR +MR (1++ ) M+ (1+g ) MR (1+g ) MR (1+g)+ +R (++g) MR (1+g ) +• (1+r )( 1+r)2 1+r )3 (1+r ) (1+r ) (1+r ) (1+r)7 The above expression (which is a geometric progression) simplifies to: MR V = È 3 3 ˘ r-r Î1+g )−1 )((1+r −1 )˚ [5.5] Rearranging Equation 2.23 we can show that MR/V = y and, substituting these variables into Equation 5.5, the relationship between the ARY and DCF techniques can be shown by: Ê(1+g) -1 ˆ yr=r- Á p [5.6] Ë(1+r) -1 ¯ This is the property yield equation derived by Fraser (1993) and based on a rack-rented freehold property investment. It shows that y is determined by the investor’s TRR, r, the annual rental growth rate, g, and the number of years between each rent review (the rent review period), p. This equation is the same as Equation 5.1 except that the annual rental growth rate g has Wyatp05.nd 253 818207 12:1022PM 254 PropertyValuation been increased to compensate for the fact that rental growth is not actually received until each non-annual rent review. If the property to be valued is rack-rented and the rent and review period Chapter 5 are known, then, applying the ARY technique, the valuer only has one vari- able, ARY, to predict in order to value the property. If sufficient evidence is available this is straightforward. With the DCF technique there are two unknowns: the investor’s TRR and the growth rate. To predict the growth rate it is necessary to compare yields on recently let comparable freehold properties with an estimate of the investor’s target return for those proper- ties. Armed with this information and rearranging Equation 5.6 an average annual growth rate can be implied as follows: Ê p ˆ1 p g = (r-y (1+r ) + y -1 Ë r ¯ [5.7] Whereg is the annual rental growth expectation,y is the yield obtainable from comparable properties,p is the period between rent reviews in years andr is the estimated target return for properties of this type. The complexity of this formula is due to the rent review periods being greater than 1 year. If reviews were annual, the growth rate would be the target rate minus the initial yield on a rack-rented freehold property (g =r–y ). For example, if an investor accepts an initial yield of 8% but requires an overall return of 12%, then the income must grow by 4% over the year. But with 5-year rent reviews p 15 Ê(012 008 )(1+ 0.12 ) +0.08 )ˆ g = Á ˜ -1 Ë 012 ¯ g = 463 So an investor accepting an initial yield of 8% would require 4.63% per annum growth in the income, on average (compounded at each review) to achieve the target return. Figure 5.1 illustrates this. Rate to which the stepped rent equate to an annual growth rate of 4% per annum If price paid at this point produces an initial yield of 8% then the stepped rate of 4.63% per annum to achieveage Rent (£) a target rate of 12% per annum Growth in actual rent paid (stepped) Market rent 0 0 5 1 15 20 Time (years) Figure 5.1 Rental growth. The ﬁgure assumes rent received in perpetuity (The ﬁgure assumes rent received in perpetuity). Wyatp-05.nd 2254 818/2007 1210:23PM Property Investment Valuation 255 Equation 5.7 is often referred to as the implied rental growth rate formula. The higher the client’s target rate relative to the market-derived ARY, the better the investment must perform over the holding period to achieve the desired level of return. Comparable evidence can be used to ascertain the implied growth rate necessary to reconcile an ARY valuation with a DCF valuation (Crosby, 1990). The implied growth rate formula is constructed on assumption that property is rack-rented. g represents the market’s expec- tations of future growth and is an average growth rate. In fact it is a dis- Chapter 5 counted growth rate into perpetuity so g is influenced by expectations in the near future more than ones further away (Fraser, 1993). As an alternative it is possible to derive an explicit growth rate from direct analysis of rental growth rates prevalent in various market sectors, regions and towns. Some argue that the assumption of a stable and constant growth rate is simplistic but it can be taken to be an adequate reflection of the decision-making pro- cess of most investors.Before looking at the practical application of the DCF technique the next section will look at the input variables in more detail. 5.2.2 Key variables in the DCF valuation model The key, value significant, variables in the DCF technique are the rent, rental growth rate, the TRR and the exit yield. Other variables include regular and periodicexpenses,transactionfeesandtaxes,butthesearedeterminedinrela- tion to the key variables and their estimation is relatively straightforward. The rent must be net of any regular or periodic expenditure and the esti- mation of MR is undertaken in the same way as for the ARY technique described in Chapter 3. Rental growth can be separated into two compo- nents; growth in line with inflation and real growth in excess of inflation. Depreciation is the rate at which the MR of an existing property falls away from the MR of a property that is comparable in all respects except that it is (hypothetically) permanently new. The causes of depreciation, namely deterioration and obsolescence, will be discussed in Chapter 6. So, assuming constant rental growth, an annual rate of rental growth must be net of an average annual rate of depreciation. As these two components are interact- ing growth rates their mathematical relationship with is (Fraser, 1993): gg=--md m [5.8] Where g is the average annual rental growth rate of actual property, g is m the average annual rental growth rate of permanently new property and d is the average annual rate of depreciation. As dg is usmally very small the equation can be simplified to: gg=- m d [5.9] A valuer may buy in or undertake research aimed at forecasting explicit rental growth rates and movements in capital values. Simple models might take the form of an historic time series of rents and capital values from which a moving average or exponentially smoothed set of values for future Wyatp05.ndd 255 8182007 121025PM 256 PropertyValuation years might be predicted. More complex regression-based models will pro- duce equations which identify independent variables such as GDP or other output measures, expenditure, employment, stock, vacancy, absorption and Chapter 5 development pipeline and measure their effect on a dependent variable such as rental growth or yield (Baum, 2000). The Investment Property Databank (IPD) publishes figures for rental value growth for the properties in its data- bank (which, it should be remembered, are prime institutional investments in the main). Figures are published by sector, segment and region and within these broad groupings it is possible to examine the rental growth of various sectors of the property investment market and their broad location. Using these figures it is possible to get a feel for the rental growth rates of prime investment grade property. Table 5.1 shows how badly office investments in the City of London have performed recently, especially in comparison to Mid Town and West End offices and only mid-sized office space did not pro- duce negative rental value growth in 2004. The annualised returns between 1999 and 2004 and 1994 and 2004 show that, over the longer term, things looked a little healthier but still lagged performance to the west of the City. A similar analysis of rental growth for single-let standard shop units,shop- ping centres and retail warehousing reveals significant differences in perfor- mance, as can be seen from Table 5.2. A more detailed regional and sector breakdown of rental value growth can be performed using IPD data and two examples are shown in Tables 5.3 and 5.4. This sort of market intelligence, although not at the individual property level, paints a very useful picture of rental growth performance across the main investment sectors and locations in the UK and allows an implied rental growth rate to be verified against growth rates achieved in the market.As the tables above demonstrate, a great deal of rental growth information about prime investment property can be obtained from IPD and this information can be used to derive explicit rental growth rates depending on property type and location.It must be remembered,though,that rents can be volatile in the short-term and very little is known about depreciation rates and their effect Table 5.1 Annual rental value growth (%). 2 Floor area (m ) Ofﬁce investments in 0–1000 1001–2500 2501–5000 5001–10000 10001+ City 2004 –2.0 –3.4 0.0 –2.5 –1.4 1999–2004 –0.9 –1.6 –2.2 –1.8 –3.2 1994–2004 3.5 3.2 3.2 2.7 1.8 Midtown/West End 2004 1.0 4.0 3.7 2.6 5.1 1999–2004 –0.7 0.2 0.6 0.2 1.6 1994–2004 5.0 5.3 4.8 5.2 4.3 Source: IPD. Wyatp05.nd 256 818207 12:1025PM Property Investment Valuation 257 Table 5.2 Annual rental value growth (%). 2004 1994–2004 1999–2004 2 Single-let standard shops by ﬂoor area (m ) 0–250 2.0 2.2 3.1 251–500 2.6 1.9 3.1 501–1000 3.4 2.4 3.4 1001–2000 3.0 2.5 3.8 Chapter 5 2001+ 2.3 2.7 5.2 All single-let standard shops 2.9 2.4 3.6 Shopping centres by ﬂoor area (m )2 0–7000 3.3 3.4 3.6 7001–14,000 2.5 3.0 2.7 14,001–25,000 2.9 3.7 3.8 25,001–50,000 3.6 3.1 4.2 50,001+ 4.7 3.4 6.0 All shopping centres 3.7 3.3 4.2 Retail warehouses by ﬂoor area (m ) 0–2500 4.0 4.3 4.7 2501–5000 4.3 4.1 4.4 5001–10000 5.4 5.3 5.7 10 001–15 000 6.4 6.6 7.4 1001+ 7.9 7.2 8.3 All retail warehouses 6.0 5.8 6.3 Source: IPD. on rental growth prospects in the long-term. As an alternative, therefore, a long-term average expected‘market’ rental growth rate can be implied from the relationship between the ARY derived from comparable evidence and the target rate on rack-rented freehold property investments. The way that this implicit growth rate can be calculated was shown in Section 5.2.1. The growth rate should be indicative of rental growth on properties regardless of whether they are rack-rented or reversionary freeholds or leaseholds (but with due care exercised in the case of geared profit rents).Also, if attempting to derive an implied growth rate from a reversionary comparable transac- tion it is important to bear in mind what Brown and Matysiak (2000) say in Section 5.2.3 below. The TRR (also referred to as the equated yield or discount rate because it is the rate at which cash-flows are discounted to PV) should adequately compensate an investor for the opportunity cost of capital plus the risk that the investor expects to be exposed to. It is therefore a function of a risk-free rate of return and a risk premium: a higher risk premium (and thus higher target rate) would be used to discount the future cash-flow of a more risky property investment and cause its PV to reduce accordingly. It is difficult to obtain evidence of the target rate from the market but the base-line is the return from a risk-free investment. The closest available proxy for the risk- free rate is the gross redemption yield on long-dated fixed interest gilts; the Wyatp05.dd 257 8182007 121025PM 258 PropertyValuation Wales Scotland Chapter 5 East North Humber Yorks & West North Midlands West Midlands East Eastern West South East South London Rest of London Fringe C. London West End Town City/Mid- Annual rental value growth (%). : IPD. ces Outer Table 5.3 Reta2s149199t4–20ard1ret4l7l.0a.ehO4f6es.5..76.4 30.02.76.34L4n.5.n6.123.23.2.6.542..2.6.3.2..2.6.4.2..3.6.3..2.2.7.43.65 Wyatp05.nd 258 818207 12:1026PM Property Investment Valuation 259 Table 5.4 Annual rental value growth (%). 2004 5 years 10 years Standard shops 2.4 2.4 3.5 Centralondon 0.0 2.6 6.3 Rest of London 2.2 3.1 3.8 South East and Eastern 2.8 2.3 2.6 Chapter 5 Rest of UK 3.4 2.3 3.0 Shopping centres 3.7 3.3 4.2 In-town 3.5 3.3 3.9 Out-of-town 4.5 3.4 — Retail warehouses 6.0 5.8 6.3 Retail arks 6.5 6.1 6.7 Fashionparks 6.9 8.6 — Other retail warehouses 4.6 4.3 4.8 Dept/variety stores 3.5 4.0 4.0 Supermarkets 3.6 2.7 2.6 Other retail 1.6 2.3 3.1 Standard ofﬁces 0.6 –0.4 2.5 Centralondon 1.3 –0.9 3.6 Rest of London –1.9 –0.6 2.3 Inner South Eastern –2.3 –2.4 1.5 Outer South Eastern 1.8 1.3 1.4 Rest of UK 1.7 2.4 1.3 Ofﬁce parks –1.9 –0.7 2.4 London and South Eastern –2.6 –1.4 2.7 Rest of UK –0.3 1.0 1.8 Standard industrials 1.1 2.4 2.7 London 1.6 3.4 4.1 Inner South Eastern 0.9 2.2 3.2 Outer South Eastern 1.1 2.5 2.5 Rest of UK 0.9 2.0 1.8 Distribution warehouses 1.1 1.5 1.9 Other property 1.1 1.2 2.7 Leisure 0.5 0.9 1.9 Source: IPD. cash-flow is certain, the investment is liquid and it is cheap to manage. It thus provides a good indication of the opportunity cost of long-term invest- ment capital – an investment time-frame or holding period comparable to property investment (Fraser, 1993). However, with an increasing prevalence of shorter leases, it might be appropriate to look to medium-dated gilts and SWAP rates as benchmark evidence for a risk-free rate of return. A risk pre- mium is then added to this risk-free rate which should cover (Baum and Crosby, 1995): ▯ Tenant risk; risk of default on lease terms, particularly payment of rent but also repair and other obligations, risk of tenant exercising a break Wyatp05.dd 259 818207 1210:6 PM 260 PropertyValuation option or not renewing lease (higher risk if the lease is short). The level of tenant risk will depend to an extent on the type of tenant; a public sec- tor organisation may be considered less likely to default than a fledgling Chapter 5 private sector company. ▯ Physical property risk; management costs (e.g. rent collection, rent reviews and lease renewal) and depreciation. This type of risk is less acute in the case of prime retail premises because land value is a high proportion of total value, but the reverse is true for, say, small industrial units.A certain amount of physical property risk can be passed on to the tenant via lease terms. ▯ Property market risk; illiquidity caused by high transaction costs, com- plexity of arranging finance and accentuated by the large lot size of prop- erty investments. ▯ Macroeconomic risk; fluctuating interest rate, inflation, GDP, and so on, all affect occupier and investment markets in terms of rental and capital values and potential for letting voids. ▯ Planning risk; in the main,this refers to planning policy and development control. For example, Sunday trading, presumption against out-of-town retailing, promotion of mixed-use, city centre developments on previ- ously developed land. Baum and Crosby (1995) point out that, for valuation, it is not feasible to quantify all of these components of risk as this would need to be done for each comparable – this sort of thing is more appropriate in property invest- ment appraisal (see Chapter 7). Instead, the valuer subjectively chooses and adjusts a target rate not at the individual property level but by grouping various property investments and examining the risk characteristics of each. By far the most frequently encountered investment type is a rack-rented free- hold. Regular rent reviews mean that this is an equity-type investment that benefits from income and capital growth just as equities do, albeit with less frequent income growth participation. Whereas the return from an invest- ment in company shares relies on the continued existence and profitability of that company, a property investment will remain even if the occupying company fails. Unlike share dividends, rent is a contractual obligation paid quarterly in advance and is a priority payment in the event of bankruptcy. After a likely rent void the premises can be re-let and perhaps used for a different purpose, subject to location, design and planning considerations. This reduces the reliance of the investment on a single business occupier, helps underpin the value of the investment and reduces risk. A freehold let on fixed ground rent has a risk profile similar to undated gilts as it generates a fixed income from a head-tenant who is very unlikely to default on what will probably be a significant profit rent. Consequently this type of property investment is very secure and risk will derive from changes in the level of long-term interest rate and inflation rather than property or tenant-specific factors (Fraser, 1993). Some of the more general ‘market’ risks, such as illiquidity, tenant cov- enant and yield movement are best incorporated by adjusting the TRR. Wyatp05.ndd 260 8182007 121027 PM Property Investment Valuation 261 Other, property-specific, risks such as regular deductions from gross rent, a depreciation rate slowing rental growth, voids and management costs can be reflected in adjustments to the cash-flow. In this way properties of the same type can be grouped together to help estimate a risk premium for a particu- lar sector or sub-sector of the market such as high street shops or secondary industrials on the basis that properties within each sector have similar tenant risks and lease structures. Chapter 5 The selection of a risk premium for an individual property is therefore rather subjective but Baum and Crosby (1995) argue that a risk premium of around 2% is an appropriate rule of thumb 2% is based on historical relationship between prime property yields and gilt yields prior to reverse yield gap, although the size of the premium will vary over time and differ depending on sector. The Appraisal Institute (2001) suggests that investors should be inter- viewed to obtain their views on target rates of return. If a target rate is used with an ARY to imply an average annual rental growth rate the valuation is insensitive to the level of target rate (within realistic bounds); a higher target rate implies a higher growth rate, ceteris paribus. Figure 5.2 illustrates the sensitivity of the capital value of a rack-rented freehold property investment to changes in the ARY and changes in the target rate. It can be seen that, particularly between 1% and 10% value is much less sensitive to changes in the target rate regardless of the growth rate and exit yield assumptions. A property is a durable, long-term investment asset and in order to avoid trying to estimate cash-flows far off into the future, a holding period of between 5 and 15 years is normally specified, after which a notional sale is assumed. The length of the holding period can be influenced by lease terms, such as the length of the lease or incidence of break clauses, or by the physical nature of the property, perhaps timed to coincide with a redevel- opment towards the end of the period, but the longer the period the more 2,000,000 1,800,000 ARY value Target rate value (1) 1,600,000 Target rate value (2) 1,400,000 Target rate value (3) 1,200,000 1,000,000 Value (£)000 600,000 400,000 200,000 0 1 2 3 4 5 6 7 8 9 1011121314151617181920 Percentage Figure 5.2 Capital value sensitivity to ARY and TRR. Capital value of £17 500 pa rental income using a range of ARYs and a range of TRR assuming a (1) rental growth at 5% pa and an exit yield after 25 years of 10%; (2) growth 5% exit yield 8% and (3) growth 3% and exit yield 8%. Wyatp-05ndd 2211 818/207 1121027 PM 262 PropertyValuation chance of estimation error when selecting variables. The notional sale value or exit value is usually calculated by capitalising the estimated rent at the end of the holding period at an ARY. When an ARY is used to estimate an Chapter 5 exit value it is called an exit yield and is usually higher than initial yields on comparable but new and recently let property investments because it must reflect the reduction in remaining economic life of the property and the higher risk of estimating cash-flow at the end of the holding period.The exit yield may reflect land values if demolition is anticipated. Prime yields tend to be fairly stable but care should be taken when choosing an exit yield, if the holding period is less than 20 years as it can have a significant impact on the valuation figure. Where an allowance has been made for refurbish- ment in the cash-flow during the holding period the exit yield should reflect the anticipated state of the property. The extent of depreciation also needs to be considered: for example, if the subject property is 10 years old and the appropriate market capitalisation rate is 7%, given an expectation of stable yields, the best estimate of the resale capitalisation rate after a 10-year holding period is the current yield on similar but 20-year old buildings. The effect of depreciation also needs to be considered when estimating projected rental values. 5.2.3 Applying the DCF valuation model 5.2.3.1 Rack-rented freehold property investments A freehold property investment was let recently at £10 000 per annum (receivable annually in arrears) on a 15-year FRI lease with 5-year rent reviews. Assuming an initial yield of 8% (from comparable evidence), a tar- get return of 12% (risk-free rate 9%, market risk 2%, property risk 1%), an implied annual growth rate (calculated in Section 5.2.1) of 4.63% and a holding period of 10 years after which a sale is assumed at an exit yield equivalent to today’s ARY, the valuation of this property is shown below: Period Growth @ Projected PV £1 YP in perpetuity (years) Rent (£) 4.63% pa rent (£) @ 12% @ 8% PV (£) 1 10 000 1.0000 10 000 0.8929 8 930 2 10 000 1.0000 10 000 0.7972 7 970 3 10 000 1.0000 10 000 0.7118 7 120 4 10 000 1.0000 10 000 0.6355 6 360 5 10 000 1.0000 10 000 0.5674 5 670 6 10 000 1.2539 12 539 0.5066 6 357 7 10 000 1.2539 12 539 0.4523 5 668 8 10 000 1.2539 12 539 0.4039 5 066 9 10 000 1.2539 12 539 0.3606 4 527 10 10 000 1.2539 12 539 0.3220 4 038 10+ 10 000 1.5724 15 724 0.3220 12.5000 63 289 Valuation 124986 Wyatp05ndd 222 8/8/007 121027PM Property Investment Valuation 263 The net income in each period is discounted at the TRR to a PV and these are totalled to obtain a total PV or valuation of the subject property.Because no growth is implied in the target rate the rental income must be inflated at the appropriate times (rent reviews) over the term of the investment to account for growth. At the end of the holding period a notional sale is assumed so the projected rent of £15 724 is capitalised at an exit yield based on the current initial yield of 8% (a YP of 12.5). Checking this answer against anARY valuation,because the rental growth Chapter 5 rate has been implied from the relationship between the target rate and the ARY, the answers will be the same. MR (£) 10000 YP in perpetuity @ 8% 12.5000 Valuation (£) 125 000 A rack-rented freehold is least prone to inaccurate valuation using the ARY technique. The advantage of the DCF technique is that more informa- tion is presented, use of a target rate enables cross-investment comparisons and specific cash-flow problems such as voids and refurbishment expendi- ture can be incorporated. DCF valuations are frequently used for complex investment properties where there may be many tenants, all with different covenant strengths, rents, lease terms and rent review dates. Comparable evidence will therefore be scarce and the number of input variables high. 5.2.3.2 Reversionary freehold property investments As we know from Chapter 3 a reversionary property is one where the rent passing is below the MR.The valuation of a freehold reversionary interest in a retail property let at £10000 per annum on a lease with 3 years until the next rent review and a 5-year rent review pattern is shown below.A compa- rable property recently let on a similar review pattern at £15000 per annum sold for a price that generated an initial yield of 6%. It is assumed that the investor’s TRR is 13% and the holding period is until the second rent review in 13 years’ time. ARY term and reversion valuation: Term (contract rent) (£) 10000 YP 3 years @ 5% 2.7232 27232 Reversion to MR (£) 15000 YP in perpetuity @ 6% 16.6667 PV £1 in 3 years @ 6% 0.8396 209900 Valuation (£) 237132 DCF valuation: Using the implied growth rate formula (Equation 5.7), the annual growth rate implied from a target rate of 13% and an initial yield of 6% assuming 5-year rent reviews is 7.76% per annum. Wyatp05.dd 263 818/007 121028PM 264 PropertyValuation Rent Growth Projected PV £1 YP in perpetuity Years (£) @ 7.76% rent (£) @ 13% @ 6% PV (£) Chapter 5 1 10 000 1.0000 10 000 0.8850 8 850 2 10 000 1.0000 10 000 0.7831

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