Times of change

Bearing in mind that some modern valuation methods may now be outdated, what methods are suitable to deal with real-life situations? Further to the 13 May and 10 June Mainly for Students valuation features, here we consider the valuation methods suitable for situations encountered in practice. Rack-rented investments Where a property is let at market rental value, and is a “rack-rented” investment, the “all risks yield” or “market yield” can be used to capitalise the “market rent” or “open market rental value” (OMRV), such as £80,000 x YP perp. at 8% (12.5) = £1m (on the annually in arrears basis). The 8% all risks yield implicitly reflects future uncertainty, including risks relating to macro-economic conditions, property market and sub-sector fortunes, the financial standing of individual tenants, depreciation/obsolescence and changes in planning, taxation, landlord and tenant and any other legislation. The key determinants of the yield are security of income and the prospect of rental growth. The lower the yield, the better those qualities. This is why prime City of London institutional grade investments may be securing, say, 6% against 9% commanded for good-quality, but still secondary, provincial investments. The yield adopted by the valuer will reflect yields achieved on comparable rack-rented transactions. If there is good-quality evidence available, any rack-rented property can be valued accurately by the straightforward use of the all risks yield. Reversionary investments A “reversionary” investment is where a property has a “term” of “rent passing” pending the “reversion” to a market rent or “estimated rental value” (ERV). A traditional “term and reversion” valuation on the in arrears basis could be as follows. Term Rent passing £50,000 YP 3 years 7% 2.624 £131,200 Reversion Market rent/ERV £80,000 YP perp. 8% 12.5 PV 3 years 8% 0.794 9.925 £794,000 Capital value £925,200 say £925,000 The term is valued at, say, 1% below the market/all risks yield owing to the greater security of income deriving from a rent below market value (providing “profit rent to the tenant”), with any reletting being expected at the higher market rent in the event of default. The “layer” or “hardcore” method is a “conventional” valuation approach based on traditional methodology. Whereas the term and reversion approach valued the periods of rent passing and market rent/ERV individually, the layer/hardcore method allows both the hardcore rent passing and the additional reversionary layer, or “top-slice”, to be valued into perpetuity. For the same rent passing of £50,000, and market rent of £80,000, as above: Hardcore Rent passing £50,000 YP perp at 7% 14.286 £ 714,300 Layer/top-slice Market rent/ERV £30,000 YP perp 8% 12.5 PV 3 years 8% 0.794 9.925 £ 297,750 Capital value £1,012,050 say £1m The principal difference with the term and reversion approach lies in the ability to apply a yield exclusively to the top-slice element, and account more accurately for the risk of today’s market rent not being realised at the reversion. The difference of £75,000 with the term and reversion valuation of £925,000 is due to a greater proportion of the income being valued at 7% than at 8% – demonstrating the sensitivity that methodology and yield selection can have on valuation accuracy. Where the reversion is to rent review, the tenant remains contractually committed to paying a market rent, but there may still be uncertainty as to the level of rent that could be determined. At lease expiry, the tenant could depart, or the statutory provisions of lease renewal could create unfavourable terms. To reflect these risks, investors may apply a yield to a reversionary top-slice element beyond lease expiry or break which is higher than the all risks/market yield of 8% (which reflects a contractual entitlement to receive a market rent). The term and reversion approach would constrain such a yield adjustment because the uplifted yield has also to apply to the core rent passing as well as to the more uncertain top slice element; the core rent passing typically commands a yield lower than the all risks/market yield. The bull market factor In strong market conditions, investors may be bullish about the prospects for rental growth at the reversion, and the relatively lower level of rent passing during the term may be of less attraction, notwithstanding its greater security against tenant default. It may be priced by investors as a fixed income, and may therefore be attributed a yield above the all risks yield applied to the reversionary income. A term of one to three years to reversion may warrant a relatively small upwards yield adjustment because the fixed nature of the term is not particularly onerous, noting that even a rack rent may have to wait five years for further growth to be realised. When the term is of 5-10 years or more, its fixed nature, and its erosion by inflation and rental growth, may warrant a yield which relates to alternative fixed income investments, such as gilts. Many factors will affect the respective attractions of rack-rented against reversionary investments. In the case of some secondary sectors, for example, the attractiveness of reversionary investments will be limited by the need for investors requiring finance to cover interest repayments with the initial rent passing. The “equivalent yield” approach is another conventional technique based on traditional methodology. The same yield is used to capitalise the rent passing and market rent/ERV. This may be appropriate where the income for each period is equally as secure, owing particularly to the strength of a tenant’s covenant. The equivalent yield approach would therefore commonly apply to well-let prime investments, but may be suitable for any property benefiting from good-quality tenants. It may also be appropriate where the difference between the rent passing and the market rent is small – although whereas institutional grade properties may warrant a term and reversion approach, investors, and therefore valuers, of many secondary properties may often merely capitalise the rent passing. The equivalent yield is also a means by which other transactions are analysed, and is often the basis by which deals of institutional-grade investments are reported in the property press. Accounting for growth In the above approaches, the longer the term and/or the greater the difference between the level of rent passing and market rental value, valuation methodology and yield selection have a more sensitive effect on the capital value determined. Whereas there may be ample evidence of yields in rack-rented situations, term and reversion investment profiles tend to be too divergent for straightforward yield comparisons to be made. Furthermore, the value of the reversion is reliant on today’s rental values, which may change during the period to the reversion – three years in the above example. The potential for rental growth is accounted for implicitly in the all risks yield. This reflects the potential for rental growth into perpetuity, yet is used to value rental growth over only three years. Economic turbulence, property market crashes of the mid-1970s and early 1990s (which could be repeated), and high-profile negligence claims against valuers highlighted the shortcomings of traditional methodology. Nowadays, valuers have to deal with quickly changing economic and property market conditions, more sensitive variations in interest rates and finance costs, falling as well as rising rental values, overrenting and the like. Leases are shorter and terms generally more flexible and diverse. Seemingly gone, however, is high inflation. Markets in paper assets such as equities and bonds produce immediate reactions in prices and yields, but property lacks such liquidity and divisibility, especially with large lot sizes. The market can dry up, leaving little or no market evidence upon which valuations can be based. And when rental growth stalls and/or rental values fall, the traditional method’s implicit accounting of rental growth prospects through the all risks yield becomes inadequate. These factors have helped to bring modern valuation methods to prominence, although traditional methodology remains widely used. Most lower-value/lower-quality properties will adopt the traditional method, with its straightforward approach dealing suitably with the way investors formulate their bids (and determine market value), and the way valuation ranges can be relatively wide. Increasing sophistication As the quality of investment property improves, investors become more sophisticated in their techniques, and valuers must do likewise. For the same property, some investors may apply traditional approaches, while others work to modern methods and some, as well as valuers, do both. Even for prime institutional interests, traditional methods will have their place, albeit alongside increasingly advanced appraisal methods. Quarterly in advance methodology will also be applied. The final part of this article will be continued next week, beginning with DCF. Practitioners, academics and students will then be invited to contribute to further features, addressing some of the issues raised. The two parts are based on a lecture given by David James of the University of Central England as part of the RICS West Midlands Branch CPD programme. Valuation practice Coping with change and contention The aim of valuation is, of course, to mirror the process of investors who determine market values by their acquisitions. Although the valuation process is increasingly influenced by computer packages, these are not a substitute for market knowledge and the intuitive judgments that are made by valuers. Care needs to be taken that the precise science afforded to valuation and investment appraisal in some quarters of the profession is not unduly disproportionate to the many forces at work within the economy and property market. Valuation should reflect market trends, and not investors’ internal accountability requirements. DCF may be suitable for calculations of worth/investment appraisal, but traditional term and reversion and equivalent yield methodology may often suffice for valuation purposes. Indeed, in the case of a rack-rented freehold investment, the DCF capitalises the rent at the market/all-risks yield, and produces the same value as the traditional method, with the all-risks yield remaining the key to the valuation. Valuation practice will always generate contention. Even a leading property conference provider’s recent “Latest and best practice in property appraisals” valuation day-course adopted 10% gilt yields within valuations when they have been around 5% in the financial markets for several years. Equity markets are often referred to as being under- or over-valued. Could the same apply to property, and to what extent might appraisal and valuation practice be responsible? Inappropriate practice may not be bailed out by rising values in today’s relatively low inflationary climate – especially if downward pressure on rentals is brought about by changes to the economy and to property markets, resulting particularly from new technologies.