Lecture 9&10 - Property Flashcards
Size and structure of the property investment market
Uk property market is estimated to be worth £6,800bn
Commercial property £883bn with 486bnbe investable
Residential property: £5,915bn, 63% owner-occupied
Sector performance drivers
Sector performance drivers
Offices: business demand, workplace availability, new supply, functional obsolescence
Industrial/distribution: distribution network, proximity to customers, accessibility to skilled labour
Retail: catchment, competition, retail mix, impact of ecommerce
Alternatives: income is not fixed, returns not highly correlated with other sectors
Sources of real estate
Cash flow Rental income - expenses Equity gains from price appreciation Inflation Changes that go beyond inflation
Income return
Rents: tenants commitments under the terms of the lease
Commercial lease length: avg 7 years in the UK, with 5 yearly upward only review
Residential lease length: much shorter
Commercial lease: FRI - business tenants is responsible for insuring and repairing
Residential lease: landlord’s maintenance and management costs is higher
Residential income tends to be more predictable over the longer term, the length and size of the tenant voids tends to be smaller
Rent reviews
Rent tends to be set to the market level if new level is higher or equal to the previous rent
If market rent is below the current rent, rent will remain unchanged
Other mainstream provisions:
1) fixed uplift rents: rents are uplifted are a pre-established period by a set value or %
2) index-linked rents: linked to an index such as the RPI
3) turnover-related rent: rent is set as a % of the tenant’s business turnover
Covenant strength
Investment value of two identical buildings occupied by tenants paying the same rent will differ if there is a perceived difference in ‘covenant strength” between the tenants
This difference is reflected in yield or cap rate
Unique features of a property as an asset
Tangible asset that requires management Heterogeneity and valuation-based Liquidity Transaction costs Risks
Tangible asset
Land: generally retains value- limited supply and subject to the restrictions of land-use planning system.
Property: wear and tear - needs “active” management - refurbishment and redevelopment, renegotiation of leases etc.
There is a cost involved in property management - depending on the terms of the lease
Effective management is needed to maintain income flow and attract occupiers
Costs of managing multi-let assets tend to be larger than single let assets
Heterogeneity and valuation-based
Advantage: a large range of opportunities exists - prospect for diversification, even with a small number of assets
Drawbacks: asset pricing is challenging - qualified surveyors need to follow standards to estimate value for properties
- for transaction purposes
- financing for borrowing or capital raising purposes
- performance benchmarking
- unit pricing for funds
- for annual accounts
Pricing of real estate assets
Overall level of value is determined by the balance between supply and demand
In valuation context, the specific value of property is determined by the perception on the level and riskiness of the CF that property can generate
Heterogeneity - difficult to compare price/value directly
Concept: property value per £ of current net rent or income
Capitalisation rate or All Risks Yield = rent/price
Property values can be represented as earnings divided by cap rate/ARY
All risks yield or cap rate
The remunerative rate of interest used in the valuation of freehold and leasehold interests, reflecting all the prospects and risks attached to the particular investment, such as the likelihood of future rental and capital growth
Determinants of cap rate/ARY
Opportunity cost of capital
Growth expectations
Risk
ARY = RF + RP - (G–D)
Liquidity
Transactions take longer
Physical and legal perspective
Higher liquidity/transaction risk than financial assets traded on Central exchanges
Consideration for investors in a fund holding direct properties - redemptions may be delayed
Transaction costs
Direct property transaction costs are higher than other financial assets
Higher tax rate
Costs of lawyers, chartered environmental surveys and the land registry -1.5-2%
Economic risks
Influence on returns:
- factors that influence the expected demand or supply
- currency risks could be related to economic risk
Degree of importance and control
- expectations are built into a pro-forms financial statement
- deviations from expectations are often economic in nature
- no control over econ risks
