Principles of Property

Valuation

Investment Method of Valuation:

Market Value of Commercial Property
 Recap
Discussed the determination of market rent for
commercial property
Retail, office and industrial warehouse
Considered the drivers of value of commercial property
Significance of determining Market Rent
Occupation (Tenant/Leaseholder)
What price (rent) should a tenant pay in return for
the right to occupy the premises?
Investment (Landlord/Freeholder)
What price should an investor pay for a building
(market value) on the promise of a future rental
flow?
 Introduction
Majority of prime commercial property owned
by Financial Institutions
Capital appreciation and income
Investment method of valuation
Values the cash flow (rent)
Considers the risk and growth potential
(yield)
What is an investment?
How do we apply the investment method
 Market Valuation

MR = Market Rent

MR MR MR MR MR MR MR

Discount Rate = All-Risks Yield (ARY) (k)

Capital Value or Market Value

 Investment

What is an investment?
sacrifice of something now for the prospect of later
benefits
How does this happen ?

Return on capital (Flow of income)

Return of capital (Increase in capital value)

 Investment Opportunities

What are the typical investment alternatives?

1. Bank deposits

2. Fixed interest securities (Government Bonds or Gilts)

3. Equities (or Ordinary Shares)

4. Property
Performance
Performance
 Investment Method of Valuation
How do we Value a Property Investment?
the conversion of a future income flow (rent) into a present value
(capital value or market value) by discounting (capitalising) at
an appropriate interest rate (yield).

Applied to both freehold and leasehold investments

With property, the income is produced in the form of:

Rent: Freehold Valuation

Landlord/Tenant Relationship
Profit Rent: Leasehold Valuation
Head Tenant/Sub-Tenant Relationship

Income can be Actual or Notional

 Assumptions
The income is
1. fixed
2. expressed in current (present day) terms
3. perpetual
4. paid annually in arrears.

Thus what we are dealing with is a perpetuity

CV = Rent (Net Income) * 1/Yield(k)

Considering two situations when valuing:

1. Rack-rented Freehold (Property Let @ MR)
2. Reversionary Freehold (Property Let below MR)
Rent
Market Rental (MR)
This is the best rent readily achievable for the property in the
market today.
Derived by comparative analysis using a common unit of
comparison
Industrial -> Gross Internal Area (GIA)
Offices -> Net Internal Area (NIA)
Retails -> Area in Terms of Zone A (ITZA)
The rent for each comparable must be converted to a rent/m2.
Capital Value
Size Location Age Rent (Gross) Condition Rent/m2 Yield
7700 Prime 15 2,160,000.00 33,232,500.00 Good 280.52 6.500%
5000 Prime New 1,600,000.00 27,825,000.00 Excellent 320.00 5.750%
9000 Prime 8 2,655,000.00 44,100,000.00 Very good 295.00 6.020%
8000 Prime 10 2,320,000.00 36,250,000.00 Good 290.00 6.400%
 Yield
Capitalisation Rate (Allrisks Yield) (k)
This is the discount rate applied to the income flow to derive
a present day capital value.
Derived from comparative analysis of investment transactions

=
()
An implicit measure of all the qualities of the investment :
1. Risk
The greater the risk in a property, the higher the yield
2. Growth Potential
The greater the growth potential of a property, the lower
the yield
Why?
All-risks Yield (k) = Risk Free Rate (Govt. Gilts) (RFR) + Risk
Premium (RP) Growth(g)
Property investment attributes
Locational: regional /local/ specific (is this a good
position for the use?)
Physical: what is the building quality?
Legal: how secure is the income/rent?

The concept of prime (best) requires an investment to

achieve high standards on all and a prime yield
would apply. Other investments will be graded
accordingly and proportionately higher yield applied.
 Understanding Yields

1,400,000

1,200,000

1,000,000

800,000
Rent

600,000

400,000

200,000

101
105
109
113
117
121
125
81
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77

85
89
93
97
5
1

Years

Rent with 2% annual growth Rent with 4% annual growth

 Understanding Yields
Rent with 2% Rent with 4% PV of 1
Time annual growth annual growth @ 8% DCF (2%) DCF (4%)
0
1 10,000 10,000 0.9259 9,259.26 9,259.26
2 10,200 10,400 0.8573 8,744.86 8,916.32
3 10,404 10,816 0.7938 8,259.03 8,586.09
4 10,612 11,249 0.7350 7,800.20 8,268.09
5 10,824 11,699 0.6806 7,366.85 7,961.86
6 11,041 12,167 0.6302 6,957.58 7,666.98
7 11,262 12,653 0.5835 6,571.05 7,383.01
8 11,487 13,159 0.5403 6,205.99 7,109.57
9 11,717 13,686 0.5002 5,861.21 6,846.25
122 109,805 1,150,891 0.0001 9.18 96.24
123 112,001 1,196,926 0.0001 8.67 92.67
124 114,241 1,244,803 0.0001 8.19 89.24
125 116,526 1,294,595 0.0001 7.73 85.93

166,535.17 247,765.72
Commercial Property Yields
 Net Income

The net income of a property investment is the total rent receivable

less any costs which must be borne by the recipient of that income.
Such costs are generally referred to under the general heading of
Outgoings.

Freehold: Rent - Outgoings = Net Income

Leasehold: Rent - (Outgoings + Rent Paid) = Net
Income (Profit Rent)
 Outgoings

Outgoings are any costs incurred in keeping the building in a

condition fit to receive rent.
There are generally three types of lease agreement regarding
the liability of outgoings
FRI: Full Repairing and Insuring Terms
Tenant is responsible for all outgoings
IRI: Internal Repairing and Insuring
Tenant is responsible only for internal repairs and
insurance
IRO: Internal Repairing Only
Tenant is responsible only for internal repairs; Landlord
is responsible for all other outgoings.
 Outgoings
The main outgoings are:
1.Repair
2.Insurance
3.Management
4.Rates
5.Landlords Services
Where a building is let in multiple occupation it may be convenient
for the landlord to provide certain services. The landlord may
recover costs by:
1. including an amount in rent
2. by levying a separate service charge.
In valuation the service charge is ignored because it is assumed to
be non-profitable.
 Transaction Costs
Capital Values are normally reported net of costs
When providing investment valuation advice it is normal practice to include
in the total purchase price an allowance to cover purchasing costs;
1. stamp duty,
2. solicitors fees and
3. any other expenses to the purchaser brought about by the transaction.

This in total currently amounts to 3 7% of the purchase price (depending

on the value of the transaction).
For the purposes of this module will assume costs at 5%.

CV (gross) = CV (net) + 5% of CV (net)

CV (gross) = CV (net) * 1.05

generally CV (gross) = CV (net) * (1+TC)

where TC = % Transaction Costs (i.e. 5%)
 Rack-Rented Freeholds

Property Let at Market Rental Value

MR MR MR MR MR MR MR

Discount Rate = All-Risks Yield (ARY) (k)

Capital Value or Market Value

 Valuation Layout

MR
less Outgoings
Net Income
times YP (PV of 1 p.a. @ 1/()
ARY(k%))

equals Capital Value (Gross)

less Transactions costs
(TC) (approx. 5%) ()
equals Capital Value (Net) (1 + )
 Example
You have been asked to value an industrial unit which is to be sold as an
investment. The property measures 300m2 GIA situated within a modern
industrial estate. The property has just been let on an FRI lease for 15 years
with 5 yearly rent reviews. The rent agreed was 20/m2.

You have searched office records and found a similar size property recently
let at 5000 p.a. and sold for 60000 (net of costs). This represented an All-
Risks yield of 8% assuming purchase costs of 5%.

Inputs
Market Rent = 300m2 x 20/m2 = 6000

=
()

5000
= = 0.08 (8%)
60000 (1.05)
 Valuation
1 1
As before = = 6000
0.08

Market Rent 6,000.00

1
PV of 1 p.a. in Perpetuity @ 8% 12.5000
0.05
Capital Value (Gross) 75,000.00 6000 12.5
75000
Capital Value (Net) 71,428.57
1.05
SAY 71,400.00
 Example
You have been instructed to determine the market value of this retail unit.

10m

High Street
15m
 Details

The shop is in a good trading location and has width of 15m and a depth of 10m.

Your research has revealed the following comparable evidence:

SHOP A:
Shop width 10m, shop depth 15m. Recently let at 8,250 p.a. on a modern FRI lease.
SHOP B:
Area 150 sq.m. ITZA (In terms of Zone A). Recently let at 12,300 p.a. on modern FRI
lease. This property sold soon after the letting to an investor for 260,000 (net of costs)
SHOP C:
GF sales area 98 sq.m. (all Zone A) including a WC 6 sq.m. Recently let at 7,000 p.a.
on FRI terms and recently sold to an investor for 107,000 (net of costs).

Analyse the comparable information using zones of 6m and advise on the Market Rental
Value and Market Value of the subject property. (Remember to assume costs of 5%)
 Analysis and Notes
Rent/m2 Lease Sale Value (Net
Area ITZA Total Rent ITZA Terms Location Condition of costs) ARY (%)
Subject Property FRI Good Good
Shop A 8,250.00 FRI Similar Good
Shop B 150 12,300.00 FRI Similar Good 260,000.00
Shop C 92 7,000.00 FRI Poorer Good 107,000.00

1. Determine the area of the subject property and Shop A in terms of Zone A.
2. Determine the rent/m2 for Shop A, B & C
3. Determine the market rent from the comparable evidence.
4. Determine the ARY from the comparable evidence (Shops B & C) (k=Net
Income/Capital Value (Gross))
5. Determine the market value (capital value) using the ARY and Market Rent. You
should value this as a rack-rented freehold (property let at market rent) using the
appropriate layout
 Valuation

Market Rent
PV of 1 p.a. in perp @
ARY%

Capital Value (Gross)

Capital Value (Net)
 Investment comparables 5.08%

6.31%
7.9%

6.2%
How do these
compare with
7 Walker
Street?
8.1%
 Future or Reversionary Freeholds
Used where the current rent passing is below Market Rent (MR). i.e.
part way through a term where the rent was fixed for 5 years. The
valuation is considered in two stages.
Term and Reversion
1. Term:
The period for which the current income is fixed.
2. Reversion:
The period following the expiry of the current rent.

Market Rent

Rent Passing

Term Reversion

Capital Value or Market Value Discount Rate = All-Risks Yield (ARY) (k)
 Valuation Layout: Term and Reversion

Term
Rent Passing
less Outgoings
equals Net Income
times PV of 1p.a. @ k% for X years (Years
Purchase)
equals Term Value
Reversion
MR
less Outgoings
equals Net Income
times PV of 1 p.a. in perpetuity @ k% (YP perp)
times PV of 1 @ k% for X years
equals Reversionary Value
Capital Value Term Value + Reversionary Value
 Reversionary Freehold

You have been asked to value a city centre office building which
was let on a 15 year FRI lease with 5 year upwardly only rent
reviews 2 years ago. The current rent passing is 23,000 p.a. and
your records suggest that the property would let today for 28,000
p.a. Your records also suggest that an appropriate ARY
(equivalent yield) to apply to this investment opportunity, would be
5%
 Stepped Annuity

1 1+ 1 1
= 1 + 2 (1 + )1

3
1 1 + 0.05 1
= 23000 + 28000 (1 + 0.05)3
0.05 0.05

=
 Valuation
Term 1 (1.05)3
Rent Passing 23,000.00 0.05
PV of 1 p.a. for 3 years @ 5% 2.7232 23000 2.7232
62,634.70
Reversion
1
Market Rent 28,000.00
PV of 1 p.a. in Perpetuity @ 5% 20 0.05
PV of 1 for 3 years @ 5% 0.8638 (1.05)3
483,749.06
28000 20 0.8638
Capital Value (Gross) 546,383.76 62634 + 483749

Capital Value (Net) 520,365.49 546749 1.05

Say 520,000.00
 Example

You have been asked to value a retail warehouse park, comprising six units
currently occupied by Scottish Power, B&Q, Comet, Currys, JJB Sports and
Mothercare. The total investment is currently let at 300,000 p.a. The
individual leases will all expire in 3 years and there are no rent reviews
scheduled within this period. Your current estimate of market rental value for
the entire site is 400,000 p.a. You are aware of a similar retail park
transaction, that achieved an equivalent yield to the investor of 6%.

Your client has asked you to advise her on the capital value of the retail
warehouse park, using the traditional term and reversion equivalent yield
approach.

Remember: Treat this as a stepped annuity but using a valuation layout

 Valuation

Term
Rent Passing
PV of 1 p.a. for 3 years @ 6%

Reversion
Market Rent
PV of 1 p.a. in perp @ 6%
PV of 1 for 3 years @ 6%

Capital Value (Gross)

Capital Value (Net)
 Note

1. The valuation derives the Capital Value of the property by

capitalising the Net Income into perpetuity

2. Yet the property is only being let for 5 - 10 years.

3. The valuation automatically assumes that the property will be

re let at the end of the term. It will then be re let again and
again in perpetuity.

4. Thus as growth in rentals at every re letting (and rent review)

is already implied in the yield, the valuation is simply YP in
perpetuity.
 Summary
Property is one form of investment asset with its own unique
characteristics

Must value from the perspective of an investor

Growth in income
Risk

Investment method of valuation

Discounting the current rent (net income) at an appropriate
yield (k)
Unrealistic assumptions of fixed perpetual rent
Yield adjusted to reflect real world