Please explain why valuers using the hardcore, or term and reversion method, after their rates to reflect “secure” tranches of income. What approaches should one adopt in an examination?
The essential difference between the “Hardcore” and “term and reversion” (T and R) methods is that the former capitalises the current rent as the “hardcore” rent in perpetuity and adds to it the additional rent on reversion capitalised in perpetuity. The latter capitalises the current rent for the unexpired term and adds to that the whole of the reversion rent capitalised in perpetuity. In both cases the appropriate deferment of income is necessary.
The concept of open market value is such that a change in method should not alter the opinion of value. If a change in method does alter the measure of value then one of the methods must be wrong.
Provided the rate percent used throughout is held at the same rate, the methods produce the same bottom line figure. On many occasions, however, valuers sense that there is more risk attaching to some part of the income stream than to another. For very many years it has been customary to reduce the term rent by 1% to reflect the view that as a contracted sum below open market rental value it is more certain than the reversionary income which remains to be negotiated in the future. It should be emphasised that it is the term rent rate that is reduced and not, as some would hold, the reversion rate that should be raised.
Throughout this theoretical analysis it should be noted that 6% represents the market capitalisation rate for this quality of property when let at open market rental value. In this respect the maximum open market value cannot exceed £333,334.
Initially a valuer might put forward this amended T and R calculation:
In practical market terms such an adjustment in value would be insignificant, and known only to the specific valuer. But is it logical to make such an adjustment? and is it necessary? are questions that need to be answered.
Applying a similar argument to the hardcore method produces a rather different picture:
Here misuse of rate adjustments now suggests that a property underlet by £5,000 for two years is worth £40,832 more than the same property let at its open market rental value. “Perhaps”, the reader is heard to comment, “you should leave the hardcore at 6% and raise the rate on the top slice income.”
Now we have valued the underlet property at £20,946 less than the same property if let at open market rental value. At a discount rate of 15%, £5,000 pa for two years is worth only just over £8,000. So this variation in rates has probably led to an undervaluation. In arithmetical terms it is possible to produce the same value as that obtained from the T & R method by calculating the rate per cent needed to discount the top-slice income given a known value for the hardcore income and given the balancing figure to be found from the T & R calculation of value. This is a tedious process which does not establish that one or other is the better method.
The question that needs to be resolved is whether there is a need to adjust the rates because part of the income is notionally more secure. Is this a rational argument to put to an investing client? In response to the institutional requirement to produce the Internal Rate of Return for each investment proposition, the investment valuer has partly provided the answer. By valuing on a same yield or equivalent yield basis one is effectively valuing by using the analysed IRR and hence no disparity between methods occurs for a normal investment. In our original example the IRR is 6% — the capitalisation rate, assuming a current rent analysis.
Other anomalies can enter into the calculation without the valuer being aware of any error. Take two properties: Shop A is let at £10,000 for five years and is worth £10,500; Shop B is let at £10,000 for 10 years and is worth £10,500.
In this example based on Phillip Bowcock’s article in the Journal of Valuation(*), one can see that the more valuable property with the earlier reversion to market rental has been valued at a lower figure than the one with 10 years to run. In practice Shop B might be one where the term per cent would be raised, not lowered, to reflect the fixed-income insecurity in real terms — so again the practice issue might not create an anomaly. But the warning is still there, namely that subjective variations in the rates per cent used can produce figures which are clearly unsupportable, and without the valuer being aware of the arithmetical consequence.
It should be recalled that much of the conventional thinking in valuation has changed very little since the time of negligible inflation. Thus in the 1950s — before the reverse yield gap emerged — it was both realistic to adopt a rate per cent for good property above the rate for gilts, and to make an adjustment for secure tranches of income. The reasoning was far sounder because the current rent used for the reversion income was at that time the best estimate of the rent on reversion. Time and growth would not vary it by any significant amount. There was then an element of security to an income below open market rental value. Now, with inflation and real growth still occurring, the capitalisation methods are full of dangers for the unsuspecting or inexperienced valuer.
Today the reversion income used is unlikely to be the real rent in the future. Under these circumstances it has been argued that the only justification for varying the term yield to produce an even lower capitalisation rate is in order to place an over-valuation on the term to compensate for a potential under-valuation of the reversion.
If the truth were known, capitalisation might only be a safe investment method when applied to rack-rented property: by chance it just works in market terms with properties with early reversions — say within five years. With great difficulty and with serious doubts as to its suitability it is used for properties with long-dated reversions.
A major worry in the mind of the expert when considering valuations produced by the subjective rate per cent adjuster is the objective criteria used for varying the rates between, say: Shop A let at £15,000 rising to £20,000 in two years’ time, Shop B let at £5,000 rising to £20,000 in 10 years’ time, Shop C let at £18,500 rising to £20,000 in four years’ time. Of equal concern is the subjective adjustment used to vary the market evidence of capitalisation rates to reflect the differences in quality of these investments when the equivalent yield or same yield method is used. Quite clearly the cash flow pattern requires the valuer to do something — but precisely what and by how much is a matter of opinion. What is clear is that in theoretical terms, given a number of assumptions, discounted cash flows can be constructed to demonstrate the potential differences in these investments, and from that point supportable different values calculated.
For the examination candidate the choice is wide open. One suspects that most examiners are looking for a supportable opinion, which means that the approach chosen must be explained. An equivalent yield or same yield approach to a varying income must be stated to be such and should only sensibly be used where the reversion is soon and is not excessive. A rate adjustment approach on term and reversion is a fairly standard approach, but the candidate must watch for a long-dated reversion where the use of any yield below gilts for the term is not really supportable.
Rate variations in the hardcore can leave the candidate looking foolish is the result does not bear comparing with the full rental value capitalised in perpetuity. Subjective adjustments to rates in the hardcore method will invariably produce an over- or under-valuation compared with a term and reversion approach, and therefore adjustment needs to be thought out very carefully.
A full DCF or real value approach is always supportable, but is safe only in the hands of the theoretically confident examinee. The theoretically confident must then take note that theoretically supportable DCF methods are not necessarily acceptable nor currently fully recognised and approved methods of market valuation. All examinees must therefore take every opportunity to demonstrate that they fully understand the principles, the practice and the technical weaknesses of whichever method they select to use.
Sadly there is no single answer to the initial questions, because most of a valuer’s approach is based on accepted custom rather than anything more profound, and few practising investment valuers are prepared to expose their reasoning to public debate. Students will unfortunately have to take on board everything and decide for themselves which elements of the dross to disregard, thus accentuating the gamble of the public examinations system when those teaching are not the same as those examining.
