1. Property investment valuation

2. Valuing property investments
Property ownership and occupation are often separate interests and the capital amount paid for the freehold is a function of the income-producing potential
Even when occupiers buy property for their own occupation they usually consider the opportunity cost of the capital and the financial return the asset may produce
With such properties valuation is the estimation of the future financial benefits derived from the ownership expressed in terms of their present value
The valuer needs to be able to estimate future net benefits and discount them at a suitable rate to calculate present value

3. all risks yield methods
Property Investment Valuation
all risks yield methods

4. Property investments
For around half of business premises in UK, there is a separation between occupation and ownership
Tenants pay rent to occupy premises
Landlords receive rent as a return on their investment
But how much should a landlord (investor) pay for a rental income?
Easy option is to look at market transactions
What rents are being paid by tenants
What prices are being paid by investors
There is a relationship between the price paid (capital value) and the rent paid (rental value)

5. Market valuation Valuation = income / yield
A property is let at £50,000 per annum
Market initial yield is 7%
What’s the value of the property investment?
Remember, a valuation is an estimate of price
Valuation = income / yield
= 50,000 / 0.07
= 714, 286
Yield:
describes ratio of income to capital value
used to compare investments
derived from comparable properties that have already let and sold
often constant for similar types of property in a locality

6. Relationship between income and capital value
Another way of writing that equation is
Valuation = 50,000 x 1/0.07
= 50,000 x
=  714,286
1/YIELD in the formula is known as the YEAR’S PURCHASE (YP)
YP is a multiplier and is the inverse of the yield, it is the PRESENT VALUE OF £1 per annum

7. Bit of history

8. application

9. Rack-rented freeholds
What is the capital value of a shop recently let at a market rent of £20,000 per annum? Investment sales of similar properties show an initial yield of 7%. Present (capital) value = MR x 1/y = £20,000 x 1/0.07 = £285,700 Remember, this relationship is used to derive initial yields from comparable evidence where MR and price paid (P) are known: y = MR/P

10. Reversionary freeholds
Not all investment properties for sale are let at market rent at the time of the sale – these are called ‘reversionary’ freehold property investments
Conventional valuation methods for reversionary freeholds:
1. Term and reversion
2. Hardcore and top-slice
3. Equivalent Yield (overall, growth implicit, ARY applied to term and reversionary income streams to calculate same value as using term and reversion method)
Example: A factory is let for £25,000 pa on a lease with 3 years unexpired. The FRV is £30,000 pa and initial yield from comparable evidence is 9%

11. 1. Term & reversion Term rent 25,000 YP 3 yrs @ 8% 2.5771 64,428
Reversion to MR 30,000
YP 9%
PV 3 9% x ,400
Valuation ,823
Term yield implies growth where there is none – over-values term
Reversion MR is at today’s values rather than in three year’s time – under-values the reversion
Both errors roughly cancel each other out

12. 2. Core & top-slice Core rent 25,000 YP perpetuity @ 9% x 11.1111
277,778
Top-slice ,000
YP 10%
PV 3 10% x ,565
Valuation ,343
Again, the core is over-valued and the top-slice under-valued
Growth-implicit ARY for hardcore rent which contains no growth
Top layer is highly geared and contains all growth – yield choice?

13. 3. Equivalent yield (T&R)
Term rent ,000
YP 3 8.5%
63,850
Reversion to MRV 30,000
YP 8.5%
PV 3 8.5% ,318
Valuation ,168
Differences between comps and subject must be reflected in ARY and therefore is only as good as the evidence

14. ARY methods - summary Method used for property that is let
Income is net of outgoings (repairs, insurance, services, rates, head rents and other rent charges)
If the property is empty then evidence of rents obtained on comparable properties must be obtained
Need a good supply of comparable evidence for rents and capital values
Yield assumed to account for all factors that affect investment value so CV is very yield sensitive
Comparison rather than investment valuation method (ARY is the unit of comparison)

15. Property Investment Valuation
DCF method

16. Constructing a DCF valuation model 1
In real estate the present value of a future (estimated) rental income stream is calculated in two ways:
By discounting current estimate of rent at an ARY
By discounting projected estimated of future rent at a target rate
The relationship between the (growth implicit) ARY method and the (growth explicit) DCF method is
Target rate (r) = ARY (y) + rental growth rate (g)
We can get an idea of y from comps and we can obtain typical r from investors; that leaves g…
Provided r, g and review period are compatible with y adopted in the ARY model, the valuation will be the same

17. Constructing a DCF valuation model 2
The PV of an expected future income is discounted at a rate, r, which reflects the quality (in terms of risk, liquidity, expenses, etc.) of the investment
PV £1 pa (YP) =
(1+r) (1+r)2 (1+r)3
PV of a property with annual rent (MR) receivable in arrears
  = MR + MR + MR
(1+r) (1+r)2 (1+r)3

18. Constructing a DCF valuation model 3
PV of a property with annual rent (MR) and annual growth (g) in arrears = MR + MR(1+g) + MR(1+g) (1+r) (1+r)2 (1+r)3 PV of a property with annual rent (MR), annual growth (g) and 3 yr rent reviews

19. Constructing a DCF valuation model 4
This equation simplifies to: Rearranging, we can show that and substituting these variables for y; where p = period between reviews in years This is the same as y = r - g except the growth element has been reduced by the effect of the rent review periods delaying the receipt of higher income.
NB. This constant growth annuity is perpetual
NB. So if growth was annual the PV of constant growth annuity of £1 would be = 1 / r-g

20. Constructing a DCF valuation model 5
Rearranging the equation we can calculate the growth rate:
Complexity of this formula is due to the review periods being > 1 yr.
If reviews were annual the growth rate would be the target yield minus initial yield on a rack rented freehold (g = r - y).
Qu. Assume an ARY yield of 8%, 5 yr rent reviews and a target return of 12%, what is the implied growth rate?

21. Constructing a DCF valuation model 7
= 4.63%
Investor accepting an initial yield of 8% would require 4.63% growth in income pa on average (compounded at each review) to achieve target return of 12%
More frequent the reviews and/or the closer the reversion, greater the growth potential

22. Key variables
Rent and rental growth
Target rate of return
Exit yield

23. Applying the DCF valuation model: rack-rented freeholds
Value a rack-rented FH investment let recently at £10,000 pa on 5 yearly rent reviews assuming an initial yield of 8% (from comparable evidence), a target return of 12%* and an implied annual growth rate (calculated above) of 4.63%. Assume a holding period of 20 years, rent received annually in arrears and the investment is sold at end of lease at exit yield equivalent to today’s ARY
*risk free rate of 8%, market risk of 2% and a property risk of 2%
ARY method:
Full rental value 10,000
YP 8%
Valuation £125,000

24. Applying the DCF valuation model: rack-rented freeholds
FH let at market rent is least prone to inaccurate valuation by ARY method
Advantage of DCF is that;
more information is provided for future analysis
target rate concept enables cross-investment comparisons
specific cash-flow problems can be incorporated

25. Rent (£)
YP 11%
PV £ %
31,840
perpetuity
PV £ %
YP 5 16%
24,947
PV £ %
YP 5 16%
19,547
PV £1 5 16%
YP 5 16%
15,315
YP 5 16%
12,000 5 10 15 20
Time (yrs)

26. Applying the DCF valuation model: reversionary freeholds
A FH with a MR of £1,000,000 pa is let on a 10-year FRI lease two years ago with a current rent £750,000 pa. There is a rent review in year 5, the ARY is estimated to be 8% and the target rate (equated yield) of the investor is 10.75%. Rental growth rate is 3.20% pa.
ARY method (equivalent yield):
Term rent ,000
YP 3 8%
1,932,825
MR 1,000,000
YP 8%
PV 3 8%
9,922,500
Valuation 11,855,325

27. Applying the DCF valuation model: reversionary freeholds
Short-cut DCF approach:
Term rent (£) ,000
YP %
1,840,785
MRV in 3 yrs (£) 1,099,016
YP 8%
PV %
10,113,066
Valuation (£) ,953,850

28. Applying the DCF valuation model: leaseholds
A LH shop is held on a head-lease with 12 years unexpired at a fixed rent of £10,000 pa with no further rent reviews. The property is sublet for the remainder of the head-lease term at a current rent of £30,000 pa with 5 yr rent reviews (MR is £35,000). Rack-rented FH shops sell for an ARY of 6%.
ARY method (single rate):
Term profit rent (£) 20,000
YP 2 yrs 8%
Term value (£) ,666
Reversion profit rent (£) 25,000
YP 10 yrs 8%
PV 2 yrs 8%
Reversion value (£) 143,814
Valuation (£) ,480

29. Applying the DCF valuation model: leaseholds
ARY method (dual rate):
Term profit rent (£) 20,000
YP 2 yrs 8% and 4%
Term value (£) ,076
Reversion profit rent (£) 25,000
YP 10 yrs 8% and 4%
PV 2 yrs 8%
Reversion value (£) ,253
Valuation (£) ,329

30. Applying the DCF valuation model: leaseholds
DCF method:
Assuming a target rate of 10% for FH property, the ARY of 6% implies rental growth of %pa. The target rate must be adjusted to reflect the added risk of a LH investment, say 15%.

31. ARY or DCF method?
Choice of method is a matter of availability of evidence:
when plentiful ARY method is often easy & accurate
when scarce or when an unusual property is being valued TRR method helps focus attention on investor fundamentals: growth, depreciation, holding period, timing of income & expenditure & target rate of return
ARY method is a simplified DCF. Where the cash flow does not vary the YP (PV £1pa) can be used. But many property investments have net cash flows that vary so ARY approach is unsuitable for many investment problems, e.g.
Investments with a ground lease and an occupational lease granted at different times, rents and review periods.
Leaseholds where head-lease has infrequent reviews and the sublease does not.

32. ARY or DCF?
ARY method:
Implies risk, rental growth, etc. in yield choice
Allowances for security, liquidity, management, etc. are also implied in the ARY
Is unsuitable for some investment problems and
Does not permit comparison with other investments such as gilts, equities and stock

33. ARY or DCF?
DCF method:
capitalises income at the investor’s target rate (as pre 1960’s)
is explicit about growth by applying a ‘growth rate’ to the income flow
requires assumptions for target rate of return (cost of capital and risk), growth rate, holding period and exit yield
Depreciation, say 2.25%
Defaults, say 0.75%
Illiquidity premium 0.50%
Property risk premium 3.50%
Gov bond yield 3.70%
TRR estimate 7.20%
Office yields, say 5.10%
Implied rental growth 2.10%
allows comparison