In a recent “Mainly for Students” feature you referred to the “real value” approach. Could you please explain what this is all about?
“Real value” approaches are investment valuation techniques, and are considered as alternatives to the most widely accepted modern approach, equated yield valuation. The approach was first developed by Ernest Wood in 1972 and a hybrid has since been developed which has a foot in both real value and equated yield camps.
Wood derived his model from first principles based on the capitalisation of an inflation-proof income (an income which can rise at each rent payment date to match the devaluing effects of inflation). The yield used to capitalise the income is an inflation-proofed return which he calls the “inflation risk free yield” (IRFY). This represents the real return of the investment.
This type of income flow has a static real value profile, in that in real terms the income remains constant. A typical property income is usually fixed for a certain time between reviews and is therefore prone to inflation until each review. Between reviews the income has a declining real value profile. Figure 1 indicates the static real value profile (SRVP) and the declining profile of a 5-yearly reviewable rent, showing a reinstatement of the real value (or purchasing power) of the rent at review. This assumes that rent increases and inflation match each other.
In Wood’s model the valuation of an inflation-prone income is based on the assessment of a yield which is derived from the inflation-proofed yield amended for the decline in the purchasing power by the rate of inflation.
The valuation of a proofed income receivable in 1 year’s time is therefore:
The fixed or inflation-prone income declines in value over the year (in real terms)
This reduced rent can then be discounted at the same yield as the proofed rent:
The inflation-prone yield is therefore a combination of the real return, and the inflation rate is determined by
inflation-prone yield = (1+i)(1+d) – 1
The equated yield approach starts from the choice of an inflation-prone target yield (e = equated yield). The real value approach starts with the target yield based on the inflation proofed yield, and herein lies the major and most relevant difference.
The hybrid model also uses the declining profile of a fixed income (Figure 1) but suggests that the decline is by the amount of rental growth (g) that a totally reviewable income can participate in. When inflation and growth are the same, no difference in d or g exists, but this change in approach becomes more than semantic when normal conditions of real gain and real loss are considered. The real value hybrid assesses a fixed income yield as (1 + i) (1 + g) – 1. As the equated yield model also assesses changes in income as rental growth (g) the hybrid can also base its target yield on a direct comparison with fixed income yields and so the real return can be assessed by suggesting that a fixed income can either be valued as:
The equation can be altered to suggest that the real return can be assessed from the fixed income return and the growth rate, ie,
Both real value and the hybrid produce formula for the valuation of partially proofed income flows (income flows rising on a regular basis due to rent reviews) based on the income profile illustrated in Figure 1. The hybrid model is shown below:
Example 1 (a) — Valuation of a rack rented freehold let at the ERV of £10,000 pa on 5-year reviews to show a real return of 4% and assuming rental growth 8.7% p.a.
As equated yield (inflation prone yield) is equal to the real return adjusted for inflation’s effects, then the equated yield is:
e = (1+i)(1+g) – 1
e = (1.04)(1.087) – 1 = 0.1305 say 13%
The inputs required for the equated yield model are the equated yield and the growth rate, so the real value hybrid could be undertaken from these same inputs by assessing the real return from the inflation-prone yield and the growth rate. Due to the current popularity of using fixed-interest inflation-prone yields for comparison between property and other yields, this approach is more probable.
Example 1 (b) — Valuation of a rack rented freehold let at its ERV of £10,000 pa on 5-year reviews to show an equated yield of 13% and a rental growth of 8.75% pa.
i = (1+e)/(1+g) – 1
i = (1.13/1.087) – 1
i = 0.0395 say 4% (as before)
The valuation of the first 5 years is an inflation-prone rent so it will be valued at the equated yield (or the real return adjusted for growth).
The rent is then reviewed, but in the real value profile it is returned to £10,000 pa. The rent is inflation prone for the next 5 years (and is therefore capitalised at e%) but is deferred at the real return (i). The reason for this is that the rent of £10,000 is not the expected rent in 5 years’ time in money terms, but does represent the purchasing power of the rent in 5 years’ time. Increases in rent over the 5 years have been ignored, as these increases are only necessary to be able to purchase the same goods as 5 years previously. The rent is inflation proofed and is deferred at the inflation-proofed yield. The valuation becomes:
The third block of income is based on another reinstatement of rent to £10,000 pa
The progression continues, and can be summated into a formula based on three YP formulas
In order to assess the value of Example 1 the YP formula is multiplied by the rental value. The whole term is assumed to be perpetual.
An all-risk yield of 5% found from market comparison therefore implies a growth rate of 8.7% pa to achieve an equated yield of 13% when the rent is reviewed every 5 years. The real return is 4%.
The hybrid model relies on comparisons of transactions, from which an implied rental growth rate is assessed. The real return can then be assessed from the equated yield and growth rate. There are many implied growth rate formulae, the one used here is the formula developed in conjunction with the hybrid.
It is to be hoped that real value approaches receive more recognition in the future. The use of index-linked returns to compare property with other investments may promote the use of real value, but even if this does not happen real value should be part of every valuer’s repertoire of expertise. The comparison of models leads to an understanding of models, and students in the centres of education who study real value are better equipped to understand all techniques as they are introduced to the full range of inflation-prone and inflation-proof yields. Contemporary investment valuation models such as equated yield and real value are as much, if not more, about yield levels and implications as about the models themselves.
Readers who question the need for these more complex approaches should test their own subjective approaches to the three properties given. Technically, on the assumptions given and implied, the figures of £325,000, £235,000 and £320,000 are supportable opinions of value. In this form the growth of and the timing of future value changes is explicit. However, many other factors remain implicit and the models can be developed to be more explicit about some of these factors.
Example 2 — In order to illustrate the application of the model an example of three similar shops in a parade is taken where the capitalisation rate/all-risks yield is 6% and the equated yield is assumed to be 12%.
Shop A — is let at £15,000 pa with 3 years unexpired
Shop B — is let at £5,000 pa with 10 years unexpired.
Shop C — is let at £18,500 pa with 4 years unexpired.
Each shop has an estimated rental value of £20,000 pa and it is assumed that the normal review pattern of both rental value and yield comparisons is 5 years.
Step 1 — assess the implied growth rate necessary to increase 6% initial yield up to 12% if rents are reviewed every 5 years.
