Why, when valuing reversionary and fully let freeholds by the investment method of valuation, is it customary to ignore future growth in the full rental value?
This is a question which raises some fundamental issues about the nature and use of valuation techniques, and a full answer requires some examination of the historical background to the development of valuation models. Before considering this, however, it is important to clarify, in precise terms, what is meant by the “investment method” of valuation in this context.
It is assumed that the questioner is referring to what might best be described as the “conventional” approach to investment valuation which, in broad terms, requires the capitalisation of future incomes by an appropriate discount rate, usually referred to as the “all-risks” yield.
The conventional approach
The “conventional” approach to investment valuation usually assumes a static income profile which, for a simple reversionary freehold, where the current income is less than the full rental value, might be illustrated as follows:
The main feature of this model is the assumption that once the full rental value, ie the maximum rent at the time of valuation is achieved — in this case at the next rent review — all future income flows are assumed to remain at this level.
There are, of course, a number of different “conventional” solutions to the valuation problem: term and reversion, using variable capitalisation rates; the hardcore or layer method, utilising different rates of interest for the top and bottom slices of income; and the equivalent yield method which adopts the same yield for both term and reversion. Whichever method is adopted, however, each is based on the same static income assumption, combined with some form of all-risks yield. For the sake of simplicity, it is assumed that the majority of valuers would now normally use the equivalent yield approach when valuing a reversionary freehold interest by conventional means, adopting the same yield for both term and reversion. This can be illustrated by reference to a simple example:
Example 1
What is the capital value of a freehold shop let on a full repairing and insuring lease with reviews every five years? The last review took place two years ago when the rent was fixed at £8,000. The current full rental value is £10,000.
Using the conventional valuation model, the income profile would appear as follows:
Given the knowledge that similar reversionary freeholds have been selling at yields of around 6%, it is possible to carry out the following valuation:
The first question that most logically minded students ask when confronted with this model is that surely the rent will be higher than £10,000 by the time the next review comes around. The standard response would be “yes”, it probably will, but we do not know by how much, so any potential for future rental growth will be reflected in the use of the all-risks yield. As this will be drawn from market evidence, it is a fair reflection of the expectations of investors and should, therefore, be capable of producing an accurate valuation. This, of course, explains why an investor would be content with an initial return of 6% from this shop investment when the same £161,284 invested in a building society would be capable of producing a return, in terms of interest payments, of up to 10% each year (at current rates of interest) with very little risk at all.
In cases where market evidence is plentiful the method should produce an accurate result, although, it could be argued, that when used in this fashion the valuer is actually carrying out a valuation by the comparison method rather than the investment approach.
However, even in circumstances where sufficient market evidence is available, this magical all-risks yield has a good deal of work to do. Unless the yield can be derived from identical investments, the valuer will need to use considerable skill in assessing how the evidence should be adjusted.
The “all-risks” yield
The yield is the measure of all the qualities of the investment. So, apart from reflecting all the physical characteristics of the property itself, its location, the tenant and the nature of the lease, possible future changes in planning, taxation and other legislation, it is also the measure of future upward changes in full rental value due to growth and inflation as well as possible falls in value because of depreciation.
Each of the factors influencing the yield is in itself complex. Change in future income, for example, is not simply a question of change in the purchasing power of that income as a result of inflation. If this were the case, the assumption of a static real income profile would be broadly logical. However, in addition to maintaining real value, most property investments can also be expected to exhibit real growth in excess of inflation. This level of growth has probably arisen in general terms because of the relationship between a relatively fixed and inelastic supply of property, set against a broadly rising demand in terms of a growing and increasingly wealthy population. In addition, growth in specific cases might arise as a result of planning betterment or the arrival on the scene of a special purchaser or tenant. However, there is little evidence to suggest that valuers undertake quite this degree of analysis before deducing an all-risks yield. This is to say nothing of depreciation, an increasingly important element in a world where technological advancements can render certain types of property relatively obsolete within a comparatively short space of time. So, in reality, we are dealing with not just one but a number of complex variables to arrive at the appropriate yield.
Apart from the obvious difficulties faced by the valuer in determining the correct yield, the fundamental problem is that the “conventional” investment model does not fairly reflect the reality of rising rents and, in a sense, adjusting the yield rate to take this into account makes the method doubly illogical. A case of two wrongs trying to make a right!
Furthermore, even if the valuer has been able to select a yield which properly reflects all the risks of the investment, the conventional method, as applied above, contains one fundamental flaw. The yield of 6% reflects, among other things, rental growth, but in the term period the rent will not change. It is three years to the next review, and during this time the investor is receiving an inflation-prone income rather than the inflation-proofed income implied by the application of a low all-risks yield. As a result, the term will tend to be overvalued.
If it is accepted that “it should be the aim of an appraisal to achieve accuracy by means of rational techniques”(1), the conventional model can hardly be said to pass the test. Why, then, is it so widely used? True, there are alternative approaches available, but the vast majority of valuers in practice still stick with the traditional methods or variations on it.
Historical perspective
The use of the method can be traced back to the end of the last century when the first valuation text books recommended the use of the standard investment formula for the valuation of fully let freeholds, reversionary freeholds, and leaseholds:
Net income x Years purchase = Capital value
By 1943, when the first edition of Modern Methods appeared, little had changed and, although by 1962 the 5th edition introduced the layer method as an alternative, the basic model remained the same.
Baum and Crosby argue that, up until about 1960, this was perfectly logical in the light of investors’ perceptions during that period. Inflation was comparatively low, running at an average of fractionally over 3% between 1910 and 1960. Yields on Government Securities, regarded as the benchmark for all other investment yields, tended to be stable. Average growth in rents was just over 3% and, although the annual rate was variable, with rents actually declining during the periods of war and the depression but rising sharply in the intervening period (rents doubled between 1918 and 1930), any upward trend in rents was not well appreciated.
One only has to look at standard lease terms — often 42 years without a review — to appreciate that this was the case. In fact rent reviews did not become commonplace before the 1960s and until then “the security of income offered by good covenant tenants was perceived to outweigh any opportunity of participating in rental growth”(2).
Against this background the conventional model appears quite rational. In reality, the income under a lease would have been fixed for between 21 and 42 years. There was little perception of future growth by investors, and yields would be closely related to the yields from undated government stock, with some allowance for the differences between stock and property investment. In such circumstances the initial yield would, in effect, amount to the internal rate of return of the investment and it seemed perfectly sensible practice to apply this yield to the capitalisation of the income.
The reverse yield gap
However, the economy, or at least investors’ perceptions of it, did change significantly during the 1960s and the reverse yield gap between gilts and equities confirms the change in institutional thinking and the importance then attached to the real value of the returns.
The reverse yield gap has been defined as:
The difference between the yield from equities and the yield on gilt-edged or fixed-income securities, where the yield from equities is exceeded by that of the yield on gilt-edged or fixed-interest securities.(3)
In times of low inflation, growth in income is less important, so there is little distinction in the mind of an investor between a fixed-interest security and a property investment. In fact, with long leases without review, property was, in effect, a fixed-interest investment. However, once inflation is accepted as endemic to the economy, the need to maintain the real return from an investment becomes essential. As rent reviews were introduced, property investments at least had the potential to maintain the real value of the income from the investment and thus became inflation proof — and in this respect more akin to equities than government stock.
Fixed-income yields had in fact begun to rise in the 1950s, and this trend continued through the 1960s:
By 1970 the gap had grown as gilt yields moved up towards 9%. At the same time, yields on inflation-prone ground-rent investments also rose, from around 5% to 12%, while yields on inflation-proof property investments tended to remain fairly static.
Against this background the conventional valuation approach seems to lose credibility. Incomes are no longer static. Real value will tend to fall between the review dates, while rental growth is likely to occur at each review. The shortening of the rent review period is testament to this. No longer will the capitalisation rate be the internal rate of return. The true rate of return will, in fact, be dependent on future growth, as well as inflation. The response of the valuer, rather than abandon the tried and trusted method, was to adapt it by adjusting the yield downwards to reflect these factors, as demonstrated in the example.
Post-1960, the true income profile of a property investment is very different. Returning to the original example, allowing for rental growth and falls in real value, the income profile would appear as follows:
At each review date, the rent will be determined by the rate of rental growth, requiring the valuer to make some explicit assumption of future events. Between review dates, however, the real value of the net income will actually decline as it is inflation prone.
The difficulty with conventional methods is that “the derivation of the all risks yield and also the adjustments which are made thereto are usually intuitive, imprecise and subjective. But, above all else, they are implicit.”(4)
Growth explicit methods
What is required then, is an explicit model, which will more accurately reflect this income profile. The real value/equated yield method is one such approach and this was considered in detail in this column on August 13 1986. Broadly speaking the method requires the following inputs:
The equivalent yield, e
The growth rate, g
The review period, t
The inflation risk free yield, i
The complexity of these inputs has led some commentators to suggest that any such method would not gain acceptance in the profession as a whole. This is surely unacceptable. With the development of computer software and the ability to carry out the calculations quickly and accurately, there is no reason why the average investment valuer should not be capable of such explicit approaches. In terms of understanding, it is submitted that the method is no more difficult than the “conventional” approach.
Although real value methods derive from full discounted cash flows (as indeed does the conventional approach), it is possible to apply the variables using a recognisable valuation format and this type of application will be considered in a later article.
References
1 Baum and Crosby, Property Investment Appraisal Routlege, 1988
2 Ibid
3 Jones Lang Wootton Glossary of Property Terms
4 Trott A, Property Valuation Methods RICS/South Bank Polytechnic, 1986
