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
Business or management risk
Influence on return:
Rate to the decisions affecting the development, operation, refinancing or timing of the sale of the property
Degree of importance and control
- more controllable compared to economic risks
- inadequate business decisions can have a long term effect
Financial risks
Influence on return:
- arise from the degree of leverage selected by the owner
- affected by the mortgage terms
- greater leverage - greater volatility of cash flow given a change in rents, vacancy or expenses
Degree of controllable decision for an investor
- more controllable decision for an investor
Liquidity risk
Ability to convert the asset to cash quickly while preserving returns
Transaction costs are high
- no real control, unless willing to accept low price
Political risks
Influence on returns:
Regulatory risks - local, national, international
Political changes - uncertainty
Significant risks
No control over it for the investor
Indirect property investment - real estate investment trusts
A type of security traded on major exchange
Company is primarily engraved in property investments
No corporation tax or capital gain on profits made from real estate investment
Dividends from REITS are taxed
Pay out 90% of its property income to shareholders
Can be purchased through a stockbroker or share trading platform
Indirect - authorised property unit trusts
Collective investment scheme that invested in property
Unit’s value is directly related to the value of the assets held by the trust
Open-ended vehicles
Price of each unit depends on the NAV
Returns from funds directly derived from investments
Two common options for payment - income and accumulation - wrap up distributions and reinvest to increase the capital value
Property unit trusts part 2
Prone to property specific risks
Trusts are exempt from capital gains tax
Pays corporation tax at a special rate
Sales of units by investors is subject to capital gains tax
Tax on the distribution has the same basis as dividends
Can be purchased through a financial adviser, or directly from the provider in some cases
Other undirected routes
Secondary funds market: allows institutional investors to buy positions in existing funds
Debt funds: retail investors can invest in real estate debts via non listed debt investment vehicles or via crowdfunding
Property futures and other derivatives: limited access to this market for retail investors
Listed
Shares are liquid
A degree of price uncertainty
Performance of the vehicle is influenced by movements in equity markets
