Understanding the mainstream types of property valuation and being conversant with the theory behind these

Question 1

What can a property valuation provide?

Answer 1

Used to arrive at an estimate of the price at which a property might be sold as at a particular valuation date

Question 2

What is the Calculation of Worth / Investment Value?

Answer 2

Can be used to reflect a particular party’s assessment of the property’s value based on their own assumptions about the asset, rather than market assumptions

Question 3

What is the Market Value / Capital Value of a property?

Answer 3

Effectively the price that will be agreed by the seller and the buyer based on market assumptions (rather than the particular assumptions a specific buyer / seller)

Question 4

Why does the Market Value differ from Investment Value?

Answer 4

A market participant’s opinion of worth/investment value will almost always differ from the Market Value because each market participant has different income requirements, expectations, attitudes to risk, tax position, etc.

Question 5

What is the key RICS guidance for valuation?

Answer 5

RICS Valuation - Global Standards (Red Book)

RICS does not prescribe or regulate valuationmethods.

The methods described here are those commonly used.

Question 6

What are the TWO investment valuation approaches?

Answer 6

IMPLICIT

EXPLICIT

Question 7

What is the IMPLICIT investment valuation approach?

Answer 7

A method that uses a capitalisation rate/yield and current Market Rent derived from comparable evidence

AKA ‘traditional method’ or ‘direct capitalisation method’

Question 8

What is the EXPLICIT investment valuation approach?

Answer 8

A valuation method that identifies the expected cash flows and discounts them at a target rate of return (or IRR)

AKA ‘DCF method’

Question 9

How does the IMPLICIT investment valuation method work?

Answer 9

Primarily used in the UK market

Comparable evidence = essential bedrock, but note that no 2 properties are the same, so care needed.

Capitalisation rate / yield then determined by analysing relationship between incomes and observed market prices/transaction prices of comparable transactions

On expiry of a rental lease / review, the income may change (increase or reduce) to the MR, AKA the rack rent

Question 10

What is the Market Rent?

Answer 10

Rents agreed in open market lettings of similar properties

AKA rack rent

Question 11

What is the All-Risks Yield (ARY)?

Answer 11

Let’s say we have a capitalisation rate as 5% = initial yield from a comparable

BUT rents rise and fall, rental can be affected by obsolescence, risk of vacancy = period of outgoings, marketing costs and letting fees to pay, potential
renovation expenditure etc

If we apply a 5% cap rate / initial yield to our income, the above risks = implicitly incorporated in the 5% cap rate. Therefore = ARY and valuation methods employing ARY = IMPLICIT methods

Question 12

What are the FOUR key IMPLICIT valuation methods?

Answer 12

Initial yield method

Equivalent yield method

Term and reversion method

Layer and hardcore method

Question 13

How does the Initial Yield Method work?

Answer 13

Similar logic as EY, valuers often value using IY as the input yield/cap rate that determines the equivalent and reversionary output yields

The IY is applied to the current passing rent only and typically does not involve any discounting to get to the MV

IY is still a type of implicit ARY = reflects all the risk and reward factors

IY (implicit) hence reflects a potential market participant’s view of risk in a property

If the property is currently vacant / subject to a high amount of vacancy it will probably not be appropriate to value it off IY and instead use EY

Question 14

How does the Equivalent Yield Method work?

Answer 14

Simpler approach = apply one cap rate/input yield to all components of the calculation = EY

Valuers often apply EY they think is appropriate (derived from market evidence and market sentiment) to entire income stream to determine value, rather than applying two different input yields to income stream

E.G. if, in the hardcore method, 5% is applied to capitalise the hardcore income and 6% applied to the reversionary increase, the result would be £269,968. The EY that would generate the same result is 5.29%.

Question 15

How does the Term and Reversion Method work?

Answer 15

Cashflow said to be sliced ‘vertically’
Since MR tends to rise and fall, the PR under existing lease may differ from the current MR

If PR

Question 16

How does the Layer and Hardcore Method work?

Answer 16

Cashflow said to be sliced ‘horizontally’ and generates same result as Term and Reversion

o Passing rent ‘hardcore income’ = £10k
o YP (perp) @ 5% = 20, therefore £200k
o Increase at year 3 = £5k (to get to MR of £15k)
o YP (perp) @ 5% = 20, therefore £100k @ year 3
o But PV of £100,000 in 3 years = 0.8638 x £100k = £86,383
o Therefore total value of investment = £286,383

Question 17

What is ‘Reversionary Risk’?

Answer 17

A reversionary investment (PR< MR) may be riskier than a rack-rented investment (let at current MR) because greater proportion of the value may rely on the
future MR, which is uncertain

Extra risk = scale of the reversion and unexpired duration of the existing lease

Additional risk = requiring a higher return, i.e. applying a higher cap rate to discount the income

Question 18

What is an Over-Rented Investment?

Answer 18

An investment where the PR>MR

If the income will revert to lower MR on lease expiry, the investment can be valued using the term and reversion method, employing either an EY / different cap rates for the two components

Difficult if in depressed market conditions, there may be no market evidence of effective MR and a lack of sales of rack-rented investments to provide evidence of the hardcore cap rate

Question 19

How does the EXPLICIT investment valuation method work?

Answer 19

More often used in markets outside the UK

Requires valuer to articulate all cash flow assumptions and attitudes to risk, hence EXPLICIT

Most common method = DCF

More suitable for complex investments

The value of an asset is the PV of future expected cash flows after discounting them at a target rate of return or a minimum required IRR

Cash flow assumptions are typically more meticulous, but can also be more subjective (personal) over implicit techniques

Question 20

How does DCF work?

Answer 20

Projected cash flows = explicitly estimated over a finite period - commonly 5, 10 or 15 years = holding period / investment horizon

Cash flows discounted back to PV, not at the ARY, but at discount rate reflecting purchaser’s overall target rate of return / IRR

The final year’s net income stream is also capitalised at an ARY / cap rate, AKA exit yield; exit cap rate; or terminal cap rate

Exit value, which assumes sale of the property at end of the DCF holding period = discounted by discount rate and added to the discounted sums of cash flow

These sums = NPV = Market Value of property / amount an investor could bid for property on assumption they are achieving their minimum IRR

Question 21

What features can be modelled in the DCF?

Answer 21

Income changes resulting from anticipated variations in MR

Effects of obsolescence on rental growth and/or on required capital outlays

Income voids

Void costs (property outgoings and taxes on vacancies that may arise)

Re-letting costs (marketing, agents and legal fees)

Refurbishments and upgrades

Exit value at the end of the cash flow period, to reflect both anticipated market conditions and anticipated condition of investment at the end of holding period

Question 22

What is an advantage of the DCF?

Answer 22

Every investor’s expectations and required rate of return will differ

DCF can derive an opinion of worth / investment value to a specific investor

Helps to analyse returns

Can compare investment options

Can conduct scenario testing/sensitivity analysis

Question 23

What are some risk factors that may affect the discount rate / target rate of return?

Answer 23

Illiquidity upon sale (e.g. lot size, transaction times, availability of finance)

Failure to meet MR expectations (forecast rental growth)

Risk of locational, economic, physical and functional depreciation through structural change

Risks associated with legislative change (e.g. planning/privity of contract, MEES);

Risk of exercise of lease breaks

Risk of failure to re-let (void risks)

*NEED TO TAKE CARE THAT YOU ARE NOT DOUBLE COUNTING RISKS

Question 24

What are Effective Rental Values?

Answer 24

Upon new lease, often rent-free period for tenant to fit out the unit

In weak market conditions, rent-free period may be extended = incentive for new tenant

Rather than negotiating a lower rent, tenant is effectively borrowing from landlord in return for paying higher rent later = also suits landlords with higher headline rent

The rent determined by lease at review = estimated
rental value (ERV), which may differ from the MR

Question 25

What issues arise when using Effective Rental Values?

Answer 25

The eventually higher headline rent does not represent the true MR

In the market where incentives apply, no market evidence of net effective rents exists

Valuers (and arbitrators) therefore need a basis for converting headline rents into net effective rents

Question 26

How is Taxation considered in an investment valuation?

Answer 26

Typically, only taxes relating to property asset being valued = taken into consideration

Vast majority of purchasers will have to pay SDLT and hence is reflected as a purchaser’s cost in valuation

Company related taxes = not reflected in valuations as these vary greatly depending on type of legal entity that owns the property

E.G. corporate tax regime relating to a charity = different to a pension fund / a limited liability company

Question 27

How is Gearing / Leverage considered in an investment valuation?

Answer 27

Property often acquired with benefit of debt finance

Use of debt increases an investor’s return on equity /
increases their IRR

In some markets (such as UK), debt does not pass to purchaser on a property sale, so properties are valued on an ungeared/unleveraged basis, i.e. ignoring the debt

In other regimes (such as US), debt usually passes with property, so valuations apply an equity cap rate / discount rate to the equity income to arrive at a MV for the equity.

Question 28

How could you pitch your forecast to your company for an investment opportunity?

Answer 28

Produce a profitability study = demonstrate the project will be financially beneficial to the company

A project = profitable if sum of its cash flows = positive (i.e. cashflow surplus)

To gain approval for project, need to persuade investment committee that your forecasts are
realistic and objective

Forecast should include uncertainties in order to reduce unpredictability as much as possible

Investment budget = limited; need to identify projects which are most profitable

Can assess risks of the projects by analysing different scenarios

Not just financial criteria but suitability for company’s strategy, project’s social and environmental impact, image. CSR etc.

Question 29

How might you define and present profitability of an investment in terms of CASH FLOW?

Answer 29

Assess investment expenditure and forecast savings, expressing as cash flows

Need to present main cashflows:

• Investment cash flow (ICF) (normally negative value)
• Operating cash flow (OCF)
• Sum of these two within one year = Free cash flow (FCF); ICF + OCF = FCF

Project only profitable if savings generated > initial cost

Cash flow diagram can help to visualise this over time

Question 30

What is Investment Cash Flow (ICF)?

Answer 30

What the project actually costs

The purchase / sale of a fixed asset like property, plant, equipment, vehicles = investing activity

Intangible purchases (licenses, patents, development costs) = investing activity

Proceeds from sale of a division / cash from a merger / acquisition = investing activity

Other expenses such as studies, recruitment, training costs, advertising for launch = investing activity

Question 31

What is Operating Cash Flow (OCF)?

Answer 31

Measures amount of cash generated by a company’s normal business operations, such as manufacturing and selling goods or providing a service to customers

Corresponds to income from ‘every day’ sales

OCF is calculated once taxes are deducted, where tax = part of expenses

Question 32

What is the notion of time value of money?

Answer 32

For projects longer than 3 years, important to assess notion of time value

PV; £100 received today is worth more than £100 received in 1 years’ time

If money can be invested at interest rate of 4% then 100x1.04 = worth £104 in 1 years’ time

Question 33

What is the notion of discounting?

Answer 33

Investor may be willing to pay only £90 for promise / possibility of receiving £100 in 1 year’s time. If so, the potential receipt of £100 has been ‘discounted’ by circa 10%

Discounting = calculating current value of future cash flow; PV = FV / (1+R)^n;

Question 34

What is the discount rate?

Answer 34

Discount rate will always reflect the investor’s perception of risk

Represents investors’ expected rate of return on project

More risky project = higher discount rate = higher expected rate of return

Different risks so may have different discount rates (e.g. may have 3 rates; high, medium and low-risk projects)

E.g. higher risk = investing in business area with political instability / diversifying in business area that doesn’t exist

Lower risk = renewing investments in one of your existing
products

Discount rate = set by finance dept.

Question 35

What are some key profitability measures?

Answer 35

Payback Period

NPV

IRR

Profitability Index (PI)

Question 36

What is the payback period?

Answer 36

Most commonly used indicator of profitability = time required to recover initial investment made

Generally occurs where cashflow switches from -ve to +ve cashflow

If 2 projects competing for same investment, one with shortest payback period and highest NPV = most favourable

Ensure that payback period is shorter than project lifespan

Question 37

What is the NPV?

Answer 37

NPV = key decision-making criteria and is beneficial if +ve or = 0

If NPV = 0 = financially beneficial as profitability meets expected rate of return

If 2 projects competing for same investment, one with shortest payback period and highest NPV = most favourable

Question 38

What is the IRR?

Answer 38

The discount rate which gives a NPV = 0

If NPV = 0 = financially beneficial as profitability meets expected rate of return

Project = financially beneficial if IRR is at least equal to discount rate (represents investors’ expected rate of return)

If project IRR = 15% and expected return = 10% = financially beneficial to company

If two projects compete, highest IRR doesn’t necessarily generate most wealth, particularly if different scale projects

If NPV>0 then IRR>project’s expected rate of return

Question 39

What is the Profitability Index (PI)?

Answer 39

If 2 projects have same NPV but different initial ICF, you can calculate PI = NPV / ICF

Highest PI = most profitable

PI helps to ensure investment budget used effectively as possible