Property Valuation: The Five Methods [3 ed.] 9780415717670, 9780415717687, 9781315797700

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Property Valuation

Property Valuation: the five methods introduces students to the fundamental principles of property valuation theory by means of clear explanation and worked examples. An ideal text for those new to the subject, the book provides first year undergraduate students with a working knowledge and understanding of the five methods of valuation and the ways in which they are interlinked. In this fully revised edition, the new author team have: • • • •

restructured the chapters to ensure a more logical order outlined economic theory of value and the rules and constraints under which a valuer works provided detailed consideration of each of the five recognized approaches placed a larger emphasis on the Discounted Cash Flow approach.

These revisions are all written in the concise and accessible style which has made previous editions of the book so successful. The new edition of this textbook will be essential reading for undergraduates on all property, real estate, planning and built environment courses. Douglas Scarrett is now retired from his last post as Director of Estate Management at De Montfort University where he was previously Deputy Head of the School of Land and Building Studies. He was joint founding editor of the Journal of Property Management and has been an external tutor for the College of Estate Management for the past 25 years. Sylvia Osborn has worked in two leading London property consultancies and has taught valuation at the College of Estate Management, University of Reading and the University of Portsmouth. She is now Head of Academic Operations at the College of Estate Management.

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Property Valuation The five methods Third edition

Douglas Scarrett and Sylvia Osborn

First published 1991 by E & FN Spon, an imprint of Chapman & Hall Third edition 2014 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN and by Routledge 711 Third Avenue, New York, NY 10017 Routledge is an imprint of the Taylor & Francis Group, an informa business © 2014 Douglas Scarrett and Sylvia Osborn The right of Douglas Scarrett and Sylvia Osborn to be identified as authors of this work has been asserted by them in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this book may be reprinted or reproduced or utilized in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. Trademark notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data Scarrett, Douglas, 1929Property valuation : the five methods / Douglas Scarrett, Sylvia Osborn. -- 3rd Edition. pages cm Includes bibliographical references and index. 1. Real property--Valuation. I. Osborn, Sylvia. II. Title. HD1387.S28 2014 333.33’2--dc23 2013049404 ISBN: 978-0-415-71767-0 (hbk) ISBN: 978-0-415-71768-7 (pbk) ISBN: 978-1-315-79770-0 (ebk) Typeset in Goudy by Saxon Graphics Ltd, Derby

Contents

List of figures List of tables Preface Abbreviations Acknowledgements

vii ix xi xiii xv

1

The property market in context

1

2

Professional valuation practice

19

3

Valuation formulae

31

4

The comparative method

53

5

The investment method – traditional approaches

72

6

The investment method – discounted cash flow approaches

99

7

The residual method

113

8

The profits method – financial data

131

9

The profits method – valuation

144

10

Cost-based methods

158

Appendix A – Abstract from RICS Building Cost Information Service

177

Appendix B – Example of Gross External Area from RICS Code of Measuring Practice 6th edition

183

vi

Contents

Appendix C – Example of Gross Internal Area from RICS Code of Measuring Practice 6th edition

184

Appendix D – Example of Net Internal Area from RICS Code of Measuring Practice 6th edition

185

Bibliography List of statutes, regulations and Industry information List of cases Index

186 188 189 190

List of figures

1.1 1.2 1.3 3.1 3.2 3.3 3.4 4.1 4.2 5.1 5.2 5.3 5.4 5.5 6.1 7.1 7.2 7.3 7.4 7.5 8.1 8.2 8.3 8.4

Demand Supply Excess demand or excess supply Valuation formulae Relationship between the valuation formulae Typical effective yields where payment is in advance or arrear Effective rate where rents are payable quarterly in advance Floor plan of a single shop Floor plans of five shop units Profile of a rack rented investment Term and reversion profile – vertical separation Hardcore or layer profile – horizontal separation Over-rented property – profile Diagrammatic representation of a synergistic (or marriage) valuation Valuation using traditional method Residual valuation: basic approach to calculation of site value Residual valuation: basic approach to calculation of developer’s profit The main components of the development process Allocation of main development costs Interest incurred during the stages of development – shown shaded Final accounts: the trading account Final accounts: the profit and loss account Final accounts: the balance sheet The divisible balance

12 13 15 33 34 49 50 62 63 81 83 88 90 96 109 114 115 117 117 120 137 137 138 138

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List of tables

4.1 4.2 4.3 4.4 4.5 10.1

Comparison of houses in Longwood Row Zoning calculations Shops in Lowe Street Industrial units: rents and prices Industrial units: outcome of negotiations Types and features of building depreciation

59 62 64 66 66 163

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Preface

The first edition of Property Valuation: the five methods was published in 1991 with the express purpose of providing an understanding of the approach to the principal methods of valuation together with an explanation of the financial formulae employed in quantifying the value of an asset. The intention of this third edition is unchanged: to provide a reasoned introduction to and a detailed presentation of the acknowledged methods of valuation. The essentials of comparison are emphasized for it underpins, at least in part, most of the methods. A fundamental requirement is that each component is understood and combined in an attempt to construct a plausible and defensible valuation, whatever its purpose. There is greater access to information on transactions such as Land Registry records, the Internet and various commercial sites reporting sales information or indicating market trends, which is to be welcomed, although it places a greater burden on the valuer to ensure that all relevant information has been considered in reaching a conclusion. Should an investment not perform as expected, there is now a greater opportunity for clients and their advisers to explore the surrounding circumstances in an endeavour to detect whether the original report displayed any weaknesses in its preparation or delivery and in particular to examine the records of other transactions relied on, as evidence of any negligence on the part of the valuer.1 The recent recession has emphasized not only the need for the utmost care in carrying out valuations but in making contemporaneous notes as to the use and interpretation of each of the items of market information used in arriving at the reported figure to enable rebuttal of any claim of negligence. It is essential for the valuer to make contemporaneous notes of inspection details and sources of value information and the way in which they have been employed. The notes should include details of the reconciliation between the sales evidence of recent transactions. The Royal Institution of Chartered Surveyors has introduced a system of regulatory Valuer Registration;2 it is a compulsory system for United Kingdom valuers carrying out ‘Red Book’ valuations which will be extended beyond the United Kingdom at some point. The established standard is no more than a competent surveyor should follow already.

xii Preface The essentials of the other approaches to valuation including Profits, Contractor’s and Residual are set out and discussed comprehensively, supported by detailed examples. Doug Scarrett Sylvia Osborn

Notes 1 2

For example, see Webb Resolutions v. E.Surv Limited (2012) EWHC 3653 (TCC). RICS Valuer Registration – a programme to monitor the application of practices laid out in RICS Valuation Standards (the Red Book).

Abbreviations

AGM AIM BCIS CMP DCF DRC FMOP FMT FRI FRS GDV GEA GF GN GIA IASB IPD IPF IRR IRRV ITZA IVS IVSC LLP LSE Ltd NF NIA NPV plc PS PV RA

Annual General Meeting Alternative Investment Market Building Cost Information Service Code of Measuring Practice discounted cash flow depreciated replacement cost fair maintainable operating profit fair maintainable turnover full repairing and insuring financial reporting standards gross development value gross external area gross frontage guidance notes gross internal area International Accounting Standards Board Investment Property Databank Investment Property Forum internal rate of return Institute of Revenues, Rating & Valuation in terms of Zone A International Valuation Standards International Valuation Standards Council limited liability partnership London Stock Exchange private limited company net frontage net internal area net present value public limited company professional standards (RICS 2014) present value retail area

xiv Abbreviations REO RICS ROCE SDLT SF UKGN UKVS VOA VPGA VPS VS YP YP perp

reasonably efficient operator Royal Institution of Chartered Surveyors return on capital employed stamp duty land tax sinking fund UK guidance notes (RICS 2014) UK valuation standards (RICS 2014) Valuation Office Agency global valuation practice guidance (RICS 2014) global valuation practice statements (RICS 2014) valuation standards years’ purchase years’ purchase in perpetuity

Acknowledgements

The authors would like to thank the Royal Institution of Chartered Surveyors for their kind assistance and provision of abstracts from the Code of Measuring Practice 6th edition and from the Building Cost Information Service.

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1

The property market in context

Introduction The purpose of this chapter is to explore the rationale for investing in real estate, to present the context in which real estate is traded and to consider the economic basis of the market. Any consideration of the attributes of the property market must be made initially in the context of the overall investment market with its wide, sometimes bewildering, range of opportunities, the object of which is to gain a worthwhile return on the capital invested. For this reason, the broad investment market will be described briefly before passing to a more detailed consideration of the differences inherent in the property investment market. Any adviser on investment in real estate should have a broad understanding of the opportunities for investment elsewhere in the market which may be the first choice for many investors. In any free market economy decisions will be determined by the wishes of individual investors and their interaction with the market for the public good.

The overall investment market The initial motivation for saving in one form or another is to provide a safety net available should some unexpected expense arise. In addition, there is a general concern that the future is better provided for where there are savings, the return on which will be available to augment, for example, a pension or even to provide one. Where an individual has a level of income sufficient not only to provide a required standard of living there are two broad choices – increase consumption or reserve some or all of the surplus for wealth accumulation and as a foil to the uncertainties of the future. But any savings accumulated in this way should be invested effectively; otherwise, the value of the capital is reduced by the effect of inflation. Where interest rates are low and a level of inflation exists, it is possible for the total amount saved to have a lower purchasing power. Savings may be intended to act as an insurance against currently unknown future major expenditure, for a specific future expense such as school fees, to provide funds for a major purchase, to repay a mortgage or to provide or supplement retirement income.

2

The property market in context

There is almost no end to the type and range of investments available although the modest saver would wish to avoid the more volatile ones which, while capable of providing substantial gains, may put capital at undue risk. The choice is initially between consumption and investment; the latter is more likely to take place where a reasonable return on capital may be anticipated. That return may be in the form of regular interest payments, in capital gains or a combination of the two. Depending on various factors, including risk and accessibility, the return will tend to vary. There is a hierarchy of investment opportunities where, in general, a high return suggests a more than average risk. It is important that investment decisions are made after detailed enquiry and in full knowledge of the circumstances. Investors in real estate have a range of opportunities open to them. They will look for a satisfactory return reflecting the level of risk inherent in any particular choice.

The components of a sound investment Investment opportunities abound, and range from the safe guaranteed government deposit or bank saving accumulating a low rate of interest but lacking growth to schemes offering high returns in untested ventures where there is a real alternative – the chance of making a loss. Each investor determines an acceptable level of risk although the actual risk is not always readily identifiable. By its nature, risk is uncertain and its containment challenges all investors. Investments differ greatly and all have their strengths and weaknesses. There is probably no such thing as a perfect investment, although the aim is always to achieve the one most likely to serve the particular needs of the investor. A number of the important contributors to any successful investment are discussed below. Investors will determine strategy by a wide range of tests, each seen as a tradeoff between risk and return. The starting point in selecting an investment is to look at its main attributes. In the case of stocks and shares the main considerations are, briefly, that any investment: • • • • • • • • •

is easily and speedily bought and sold, with low dealing and transfer costs provides a positive income (i.e. an income at least above the rate of inflation) has the prospect of capital growth is homogenous and divisible is fully definable and documented is an investment for which there is likely to be a continuing demand requires minimal management is not affected by exchange rates is not politically sensitive.

Having made an initial selection, the investor will be guided by a range of criteria including:

The property market in context 3 • •

•

•

•

•

•

•

Security: The investor will wish to be assured either that the investment is permanent or that it will survive the length of the investment period. Risk: Investors have different levels of preference for risk. Some are risk averse; in other words they are not prepared to accept any level of risk, in which case their investments are limited to accounts where the investment is guaranteed by government or otherwise secure from default. Currently, such accounts show very low levels of interest to the extent that when inflation is taken into account, many are loss producing. Governments normally guarantee their offerings and in some other cases give limited protection to some other investments; for example, in the United Kingdom (UK) bank deposits are protected up to a maximum of £85,000. Many investors hold securities with a spread of volatility to reduce their overall level of risk in their portfolios. It is sometimes claimed that all interest rates are the same, which is a way of indicating that in each case, the pure interest element is similar, any surplus being in compensation for the perceived risk taken on. In accepting a level of risk, the professional investor is making a judgement as to the likely outcomes spread across the portfolio. Liquidity: The future is unknown and ideally the investor would wish to be able to dispose of the investment if funds are required urgently and unexpectedly. For this reason, an investor on a small scale will probably keep most assets in a fairly accessible form, the penalty for which is lower returns. Investors with larger funds will deal with this issue by balancing the portfolio to ensure that only a proportion of funds rather than the entire fund will be available at short notice if required. Income flows: The expected return should take account of all the benefits fi and disadvantages of the particular investment; regular and foreseeable payments are usually an important consideration. Growth prospects: Part of the return may be in the form of a capital gain on disposal and part may be in the increase in income over the period that an investment is held. Divisibility: The ability to sell part of an investment holding without creating problems for the remaining part of the holding is an important consideration. Ease of transfer: The complexities of acquisition or disposal tend to be reflected in the timescale. Where extensive enquiries are a prerequisite, as in real estate, the time taken will inevitably increase. Costs of transfer: Costs vary according to the type of investment. Extended transfer periods tend to be accompanied by greater formalities and higher costs; where the costs of transfer are significant there will be a tendency to hold the investment for longer periods.

Few proposed investments will meet all the criteria; the investor will judge the acceptability by any additional benefits offered by way of compensation. The overall investment package is crucial.

4

The property market in context

The investment market varies from country to country but is made up broadly of three strands: • •

•

Government issues: In the UK a variety of products are offered by, or underwritten by, the Treasury where the initial investment is guaranteed. Equities: These are commonly known as shares and there are a wide range of offers that can be acquired through a central exchange. There is an opportunity to explore the background and performance of the issuing company in order to assess the quality of the investment. Stocks and shares are traded through central exchanges; information regarding the background and performance of companies is available. There is a level of oversight by regulatory bodies although the level of risk will vary, so a careful assessment of all the known information should be collated and studied. Other investments: The main return on some investments may be in substantial gains on disposal. There is almost no end to the type and range of investments available, although the modest saver would wish to pursue those with a good track record of dividends and an element of growth. Investors will tend to avoid those capable of providing substantial gains if there is a real risk of loss of capital.

Stocks and shares may be traded through stock exchanges which exist in most developed countries. Major exchanges exist in the UK, New York and Hong Kong. There are also various subsidiary markets, mainly for smaller trades. Numerous private sector facilities offer investments but with a range of risk, requiring a degree of familiarity and investigation before committing to purchase.

Range of investments Government stock and shares of most commercial companies can be bought and sold. Information on trades and prospects is widely available in newspapers and specialist publications, and advice may be commissioned from a financial adviser. By comparison, the property market is much less transparent and will be considered later as the principal focus of this chapter. Meanwhile, some information concerning the stock market follows to enable the reader to appreciate the size and complexity of what is on offer. Government stock Numerous issues are underwritten by government and are regarded as risk free, but only in the sense that the initial investment will be returned on maturity at the end of the fixed period for which it was issued. Should the investor wish to redeem the investment before maturity, it will be sold in the market and, depending on the conditions at that time, may sell for more or less than its issue price. For example, the purchase of government stock with a nominal value of £100 and an interest rate of 3 per cent for a term of ten years will pay an annual

The property market in context 5 rate of 3 per cent and the initial capital investment will be returned at the end of the period. But should the investor wish to cash the investment after say five years, the market will dictate the price according to whether it is regarded as a good investment at that time. If, in the meantime, government stock has been issued showing a return of say 5 per cent, an investor is likely to discount any offer price for the stock. Equities Equities are normally bought and sold through financial exchanges. In the UK, stocks and shares can be traded through the London Stock Exchange (LSE) or through subsidiary or alternative markets. Most financial activities are regulated, although risk is largely a matter for the investor. Ordinary shares are issued at a price related to the notional value of the company so that each purchaser is an equity shareholder. Where a business prospers, the notional value is likely to increase, meaning that the shares may be sold at a profit. A dividend is declared each year based on the trading experience of the company; a dividend may be paid even where the company has not made a profit, although it would not be likely to happen often. Conversely, where the company is growing rapidly, it may decide to limit dividends to allow it to build up capital as a cheaper way of funding expansion. Additional equity capital may be raised through rights issues where existing shareholders are offered the opportunity to buy further shares, sometimes at a discounted price. Other ways in which a company may raise capital is through debentures or unsecured loan stock. The return on the offer will be fixed at a rate expected to attract purchasers. Debentures are a form of mortgage secured on the assets of the business and should the company default, the holders may be repaid from assets held by the company. The interest offered therefore will be less than that offered to unsecured creditors; in the event of a collapse of the business, the holders of ordinary stock would have to rely on the remaining assets of the company after repayment of amounts owing to preferred creditors. Equity investments and loan stocks are available in all areas of trading from banking and finance through engineering, industrials, professional, support services and transport among others. Few investments attract a fixed rate of interest because it is difficult to guarantee future payments from what is almost certainly variable income. Where available, the term is likely to be short and the interest rate modest. Hedge funds, capital appreciation funds, venture capital trusts and similar investment vehicles are intended to attract experienced professional investors prepared to take a risk in the expectation of success with the venture making high returns. The funds are aggressive and more risky than many investors would wish to be associated with.

6

The property market in context

Indirect investment Much indirect investment takes place through contracts of life assurance and term insurance, relying on regular payments to accrue a capital sum at the end of a fixed term. The outcomes are not guaranteed and recent performance, reflecting current very low rates of interest, often falls short of earlier projections, sometimes leaving the insured funds to repay debts (typically to redeem a mortgage) for which the policy was taken out. Other investment media Some investors prefer to invest in works of art, precious metals (especially gold), antique furniture, and so on in anticipation of an increase in capital value. In the meantime there are costs to be met in terms of insurance, storage and maintenance and in some cases a risk that the item will suffer damage or deteriorate in value due to changes in fashion.

THE PROPERTY INVESTMENT MARKET The particular features of the property investment market will now be considered.

Legal estates in land The English legal system dating from the Domesday Book of 1086 was brought up to date by the property statutes of the 1920s. There are now only two legal estates in land: freehold and leasehold. Freehold – technically the fee simple absolute in possession – is nominally held of the Crown but in practice confers ownership, meaning that the owner may do whatever he or she wishes, subject to the rights of others and the planning and other laws in force at the time. Strictly speaking, the freeholder acquires a bundle of property rights rather than the property itself but in practice the difference is not significant. Should a freeholder die intestate and without next of kin, the property reverts to the Crown. The subsoil may be reserved from any sale, allowing the transferor to exploit mineral deposits. In the UK, the Crown owns gold and silver under the land and, except in the case of small coalmines in the Forest of Dean, the right to mine for coal belongs to the State. Leasehold is a term of years absolute, granted by the landlord to the tenant by way of a lease. The lease sets out the terms of the tenancy including the duration, the rent, the responsibilities and any other matters over which the landlord wishes to exercise control. The tenant is entitled to exclusive occupation. The planning laws are likely to set out the use, and the landlord could further restrict any element of that use. Subject to any limitations in the lease, the leaseholder may create subleases but only of lengths less than the remaining term. A lease of

The property market in context 7 seven years or more must be granted by deed; otherwise, the effect will be that it is an equitable interest only. Except in very limited cases, there is no restriction on the length of a lease. There are properties that were built on land granted on lease for long terms of up to 999 years, with many being for shorter periods. Where the property is residential, there are provisions enabling the leaseholder to apply to enlarge the interest to a freehold despite any wish of the freeholder, subject to compensation computed as set out in the relevant legislation. All transactions must be recorded at the Land Registry which maintains a register of ownership and collects stamp duty land tax on any transaction. Limited information on ownership is now available on payment of a fee. Some information is publicized in statistical form. Most developed economies have some form of land registration and planning control, although the detail will vary. Where a leasehold interest is to be valued, it is essential for the valuer to obtain a copy of the lease although any matters of interpretation should be referred to a lawyer for advice.

Participants A range of participants determine the outcome of the property market. There are owners, who may also use their property as living accommodation or business premises, and tenants who agree terms with an owner to use the premises for a period subject to a number of terms contained in a contract, referred to as a lease. Many properties are acquired and altered or extended or redeveloped by developers. Developer is a wide term encompassing any person or organization that creates or converts a building for which they may provide the funds, either directly or by borrowing. There are specialists who manage these activities and they include property lawyers, valuers, building surveyors, architects and engineers. Where a landlord lets property to a tenant there is an investment, whereas a property purchased with an intention to occupy is a consumption good. Traditionally, houses have been purchased for use as living accommodation, with the additional attraction of selling at some future date and making a profit. In this way, many people have moved up the property ladder aided by some or all of the profit made on the earlier house. There is a growing practice of buying and letting residential accommodation which is within the reach of investors with modest funds. However, management of residential property tends to be fairly detailed and intensive. The long-run price elasticity of supply is quite high; supply tends to be very price inelastic. The problem arises from the relationship between stock and new buildings, and in particular the response time required to add to the stock. It is estimated that some 2 per cent of new stock is added each year. New stock will be provided only where the price of land and the cost of building is less than the price of existing stock; otherwise the provider will not make a profit.

8

The property market in context

Land Land is the basic and permanent feature whilst buildings, though durable, may be altered, added to, demolished or the use changed in response to demand. There are various reasons why a business would prefer to lease rather than buy property; in the case of retail units, the all-important feature is location within a specific area and it may be that owners of suitable premises are not prepared to sell. In many cases, business owners prefer to regard property as another cost of production and may find it cheaper to lease than to buy using a substantial loan. Leasing also gives the occupier flexibility should the business grow and require larger premises. The overall supply of land is limited, or highly inelastic, and is often referred to as ‘fixed’, although through planning permissions, redevelopment, alterations and adaptations the supply may be varied to a limited extent. Whilst land is described as one of the factors of production it may be defined as natural capital where any activity to alter it has taken place, particularly where it has been ‘improved’ in some way. It is mainly respected for its ability to enable a person to achieve a particular objective. Undeveloped land may be available where planning permission exists or may be obtained for a particular development. A purchase without first exploring the possibilities within any planning framework would be unwise unless acquired as a longer-term speculation. In many countries a planning system has provided a broad framework from which it is difficult to depart to any great extent. The availability and nature of any planning permission has a major effect on value. Authorities may intervene to achieve any particular objectives, either nationally or regionally, by offering grants, speeding up the planning process, limiting certain payments such as property tax or providing infrastructure. Most of these incentives are time limited and used to stimulate the market where it would otherwise remain dormant. Government and state interest in and control of the planning process may be extended to embrace energy efficiency, actions to lessen global climate change and creation of employment. In other circumstances, government could restrict activity by various means, including an increase in transaction taxes such as stamp duty on purchase or by imposing higher annual charges on certain classes of building or use.

The economic background to the property market There is a state of equilibrium when there is a balance of supply and demand for goods and services. It has been likened to an auction where the auctioneer accepts increasing bids as buyers continue to require goods or services. In due course the bids will find equilibrium of demand prices and supplied amounts. It also envisages the situation where a different and preferable combination occurs. Perfect competition supposes that: • •

there is an unlimited number of buyers and sellers buyers and sellers are aware of each other’s intentions

The property market in context 9 • •

factors of production are available without delay, and each unit is homogeneous.

None of these apply to the property market. Specific factors apply to land and buildings for a number of reasons: • • • • • • •

Real estate can be used for occupation (consumption) or as an investment. Land is fixed in place and quantity. There is no physical market place. Any imbalance takes time to restore. Confidence in the market is a prerequisite. Buildings are valued for their durability. High transfer purchase and costs accompany sale.

In these terms, the demand for, and value of, property is extremely difficult to forecast and/or anticipate. For example, any number of individuals may be seeking to buy or sell but on a ‘one-off’ basis, and not all of them will eventually go through with a transaction. The market, such as it is, is extremely secretive and poorly informed. Typically, when a particular demand is identified but where no suitable premises are available, satisfaction of that demand through the building process is likely to be slow whilst the various steps to meet the demand are taken. By the time the new building is finished the market may have changed. Finally, each property unit is heterogeneous and, whilst more than one of the available buildings or sites may serve the purpose, there may be problems identifying suitable buildings and locations. The market may be divided broadly into property available for sale and that which is offered on a rental basis. As outlined above, a lease is the contract through which an owner provides a property to an occupier for a period of time, although some transactions are dealt with on the basis of licences. The latter are usually for short terms and these are rarely used as the means to create investments; owners and investors tend to prefer using leases. Some specialist providers will concentrate on one sector of the market, others will be prepared to range across the spectrum which, in the case of long-term holdings, may be a useful approach to offsetting risk. The property market is not transparent, although in the UK it has become more so with the availability of transaction information through the Land Registry, together with online price comparisons and projections plus research data from the major firms of surveyors and estate agents. However, much of this information is incomplete and may require assumptions to make its use viable. It is important to remember that a valuer is responsible for the valuation submitted and there is no substitute for personal knowledge and reasoned interpolation. A well-informed valuer operating in a specific market or location may have access to formal and informal sources of intelligence and the ability to cross-check data to some extent. Any information not capable of verification should be treated with caution.

10

The property market in context

Theory of prices The economy is dynamic and reacts to events in the market. When supply exceeds demand, there will be a downward pressure on price; conversely, when demand exceeds supply, prices will rise to restore the status quo or to a state of rest. The goal is equilibrium, but that goal is elusive. By its very nature real estate has its own peculiarities, and consequences flow from that. It is heterogeneous, durable, has high transaction costs and experiences long delays in response to demand and price hikes pending resolution of shortages. Economists point to the inelasticity of supply of property brought about by the extended timescale needed to respond to a perceived increase in demand. Any decision to respond to the additional demand is an act of faith, given that any increase in the stock will be delayed by many months if not years, and apart from information on recent planning applications and decisions there is little indication as to what other investors are doing in response to the new demand. Provision is uncoordinated and fragmented and may lead to an oversupply of building stock at the expense of the developer. The planning process and its control mechanisms are not primarily concerned with matching supply and demand in individual cases, although it attempts to anticipate future needs in a locality. The laws of supply and demand are fundamental aspects of economic theory and the price of any economic good is determined by the interaction of the two components. Therefore changes in either are likely to affect price, although other factors may intrude to modify the effect. The laws of supply and demand are subject to the concept of elasticity. In the case of demand, it would be expected that a higher price would result in lower demand. This may not be the case where the indications are, for example, that the price will continue to rise. The two terms are considered below.

The law of demand The market is the central plank of the economy wherein prices are affected by demand, reflecting the total requirement for a particular commodity and ensuring that the price level will enable the sale of all the stock, in other words that demand and supply are matched. Where supply is not sufficient to meet demand, then the price will rise until equilibrium is reached. The market may have a physical presence, be remote or exist wherever there is a demand. It may be in a defined location, make use of the Internet or telephone, or exist universally wherever there is a demand. The basic law of demand is that the price of a product will inversely influence the demand for that product, other things being equal. This general law is not absolute: a household’s requirements for, say, salt are fairly fixed and a halving or doubling of price is unlikely to make any discernible difference. Where consumption falls as income rises, the goods affected are referred to as inferior goods; in general they are being displaced by other goods more to the liking of the household and which they can now afford. Demand for one good will be affected

The property market in context 11 by changes in the prices of other goods – in other words, they are substitutes. Market demand sums all the individual household demands. It ranges from repetitive purchases to the requirement for accommodation, transport, holidays, and the like. It is the sum total of demand for a product in a particular time period that requires not only a demand, but ability and willingness to pay – that is, an effective demand. The basis on which decisions are made is set by the buyers and sellers in the market. In general, state interference in real estate is limited to ensuring some order in the public interest such as planning and employment policies, which in turn may be designed to direct development or redevelopment to specific areas. In some cases development is promoted through the offer of support such as grants, road improvements, and so on. Household demand varies with the price of the good, the price of alternatives and the view as to future events, in particular changes in prices and tastes. These are referred to as determinants of demand. In the case of demand, it would be expected that a higher price would result in lower demand. This may not be the case where the indications are, for example, that the price will continue to rise. On some occasions, the demand for a product increases as the price increases, breaking the normal relationship between the two strands. This situation is referred to as perverse demand behaviour; its occurrence is most often due to speculation, where a price rise is seen as an indication that there may be further price rises to follow, so a purchase in advance makes sense. Alternatively, a price rise may be seen as an indication that the quality of the product has improved, to the extent that it is regarded as having a different market. A specific form of demand for resources is derived demand. For example, demand for a building will necessarily create demands for concrete, bricks, steel work, and so on. In a free market economy, the price of most goods is governed by demand and availability. The price of real estate is no different; whether for occupation or investment the vendor will take advice on the best price obtainable whilst the intending purchaser will seek advice on value and look into the feasibility of pursuing the purchase to completion. The prospective purchaser of a property investment will seek to compare the current and potential income with other forms of investment. A prime consideration will relate to the net return but other factors need consideration. These factors include: the size of the investment and the extent, if any, to which external funding is necessary; the burden of management; the ease of resale; the physical condition of the buildings; and future prospects of maintaining or improving cash flow, including the possibility of redevelopment. When residential accommodation is being acquired for occupation, the considerations are somewhat different, concentrating on the location and its accessibility in relation to current priorities such as schools, public transport and road networks, and closeness to work or relatives or other requirements. The house purchaser will have a price range, probably related to the level of savings available as a deposit and a sufficient income to fund loan repayments; personal requirements will vary from one purchaser to another and carry different weightings from one purchaser to another.

12

The property market in context P

Price

Price

P2

P1 D

0

Q1

Q2

Q

Quantity D P1

Demand curve Equilibrium price

Figure 1.1 Demand

Figure 1.1 demonstrates demand in graphical terms. Except where unlimited resources exist, the market distributes resources among an array of uses. Price is the basis of the market and the price is related to the scarcity and requirement for each resource. The vertical line ‘P’ represents price and the horizontal line ‘Q’ the quantity demanded. The curve reflects the direct correlation between quantity and price, reflecting the reality that the higher the price the lower the demand.

The law of supply The law of supply defines the amount of the good that will be offered for sale at a particular time and at a particular price. As the price varies, so will the supply. Where supply is greater than demand, there is downward pressure on prices; similarly, where demand is greater than supply, prices are forced upwards. Where the amount offered is similar to the amount required, the normal or equilibrium price pertains. Where supply increases, it is likely that it occurs in response to demand, where the producer identifies the possibility of increasing profits from more sales. But such a reaction will depend upon the practicality of increasing supply, including the availability of the factors of production necessary to increase activity. Should

The property market in context 13 the decision to increase supply be dependent on the acquisition of expensive machinery or the employment of experienced staff, such a decision is unlikely to be taken without some level of confidence that the increased supply has some level of permanence. The relationship is shown in diagrammatic form in Figure 1.2. The vertical line ‘P’ represents price and the horizontal line ‘Q’ quantity. The supply curve moves in an upward direction, indicating that the higher the price the greater the supply. As has been noted, where supply cannot be increased quickly, higher prices are likely to occur in the short term. It will be seen that where supply and demand are in balance the price will remain the same, but any substantial change in demand, supply or price would be likely to upset that balance. The situation may be defined as ‘a state of balance produced by the counteraction of two or more forces’, which provides an indication of the application of the term to the economic theory of supply and demand. It is the concept of determining price given the conditions of supply and demand. When the amount of any good or service is at the equilibrium price (meaning that the amount available is equal to the amount demanded) supply and demand are in balance and both parties are satisfied. The market may change following a P S P2

P1

0

Q1 Quantity S P1

Figure 1.2 Supply

Supply curve Equilibrium price

Q2

Q

14

The property market in context

substitution or restriction on the part of the consumer and/or additional facilities and marketing by the producer. This statement assumes: • • • •

that the amount supplied equals the amount demanded that demand is based on maximization of the utility based on the market price the rational approach of agents who have no incentive to change their behaviour that supply is determined by the maximization of profits.

When any of these principles is breached, there is disequilibrium. With excess supply, there is downward pressure on price, whilst a shortage of supply results in an increase in price, in both cases eventually returning to equilibrium. These relationships are particularly important in property economics, where the time lag between identifying a demand and meeting that demand is significant. For example, a company wishing to acquire a new warehouse would experience a lead time of one year or more, particularly where there were locational limitations. To add to building supply involves some detailed enquiries and action. There is the process of identification of site, negotiating its acquisition, obtaining permission for the proposed development, inviting tenders and arranging finance before the physical provision can commence. This procedure tends to take some time with a consequent delay in gaining possession. The search may be aborted at any of these stages by either party or by unfavourable information regarding the prospect of viable planning permission or the viability of the plans. The company may be able to limit any inconvenience or delay by seeking an existing building, in the expectation that it will meet its requirements without major alterations or additions that will cause delay. The supply of land is fixed, and most buildings are designed and built to last. There is some mitigation, although additions to the stock tend to be modest in relation to the existing supply. Any delay may be sufficient to have a marginal effect on prices where the premises are required urgently. There is a risk that the market may have changed by the time the new building is available and the changed circumstances affect the decision to go ahead. At the same time, there may be particular attractions attaching to a new building that cannot be offered by an existing one.

Equilibrium The general theory of equilibrium provides an explanation of pricing in a free market economy. It is that equilibrium is achieved when the price and quantity of a good responds to demand. It is assumed that producers and consumers behave rationally; it follows that the producer will do whatever is necessary to maximize profits whilst the consumer will seek out the best price. Where goods are substitutes, the rise in the price in one will produce excess demand for others.

The property market in context 15 Both statements are subject to qualification; for example, where the producer could sell more goods but only after increasing production by further investment, the initial costs of enabling that additional production may not justify the adjustment. Similarly, the consumer may devote all or part of the budget for a particular good to an alternative and therefore reduce consumption of the previous good. Their respective actions may vary between what is practicable in the short term and what is subject to a longer timescale. Where supply and demand are equal it is said that the market is in a state of equilibrium. This may be defined as a state of balance produced by the counteraction of two or more forces, which provides an indication of the application of the term to the economic theory of supply and demand. It is the concept of determining price given the conditions of supply and demand. Where supply is fixed in the short term as is the case with real estate, price would be governed by demand; any change in demand would trigger a rise in price. This imbalance is referred to as disequilibrium. P

S

Price

SE P1 DE

D

Q

0

Quantity S D P1 DE SE Q

Supply curve Demand curve Equilibrium price Excess demand Excess supply Quantity

Figure 1.3 Excess demand or excess supply

16 The property market in context The situation is shown graphically in Figure 1.3, showing the situation where supply is fixed in the short term. Then any increase in supply or demand presents a new set of circumstances where the parties will decide whether or not to proceed and, if so, on what terms.

Gearing Gearing is the effect created by borrowing some of the cost of an investment. A mortgage is the most usual form, where a purchaser arranges to acquire a property by paying part of the purchase price and raising the remainder by means of a loan from a building society or bank for the balance which is then repaid with interest, usually at regular intervals over an agreed term. The lender’s terms will specify the term of the loan and specify the rate of interest, almost certainly subject to adjustment according to the cost of money in the market. In this way, the borrower has found a way to acquire a property the value of which is greater than the resources currently available whilst the lender has identified a reasonably safe investment with regular payments of interest and capital backed up by the security of the building. Developers of commercial property may wish to borrow a large proportion of the development costs, secured on the land and the proposed development. This creates a much greater risk because the development is no more than an intention, there may be no lettings on completion, and the prospects of finding a tenant or tenants and the amount of rent to be charged are all uncertain because the conditions at some future date cannot be guaranteed. To that extent, there are significant risks in funding any development and the lender will expect to be rewarded. The reward may be in the form of a higher interest rate or, in return for favourable terms, a share of the investment on completion. Where the lender provides a long-term loan on completion of the development, the developer is committed to make agreed regular payments regardless of the income produced from the development. Should there be delay letting some of the units, the borrower will remain liable to make the payments under the agreement. It is essential that the borrower is still able to make payments in these circumstances, so the finance arrangement should be examined carefully to ensure that no undue risks are undertaken.

External intervention In a free market economy, the broad principle is that government avoids any attempt to control markets, leaving them free to act according to, and in reaction to, events. Detailed government oversight of any commercial activity is rarely productive. This general rule is tempered by the need for government to set the framework of the economy by determining the level of taxation and the way in which it is levied and then allocate that income to whatever is deemed to require expenditure or support. In the UK, apart from income and capital gains taxation, the

The property market in context 17 government oversees the collection of excise duty, value added tax, collects stamp duty and delegates some tasks to local government, in particular the collection of business rates and community charge. In a few cases, local authorities have discretion as to whether to collect a particular charge or to fix the level of charge, as is the case with community infrastructure charge. In the UK, the detailed application of planning policy is within the remit of local authorities; planning charges are levied on applications for planning permission, change of use and other aspects of planning. Charities and some other bodies do not incur tax on their fundamental work and may qualify for recovery of tax at a fixed level on donations received in money or kind from supporters. The property owner is free to own and manage the asset in whatever way is most advantageous, subject to the law of respect for the rights of others and any relevant statutory provisions. Most of the restrictions imposed by central and local government both affect and protect the property owner and it is not difficult to imagine the problems that would result if there were no central oversight. The principle, but not always the detail, of planning law is accepted as it confers benefits as well as duties. However, the investor does not expect to have restrictions unless they are necessary. Further, it could be expected that landlords and tenants are able to negotiate their own relationships.

Rent control Rent restriction on housing was introduced in the UK as a temporary measure in the First World War by the Rent and Mortgage Restriction Act 1915 but remained on the statute book, amended from time to time, for most of the remainder of the twentieth century. Rents were not permitted to increase except for changes in local rates, and the sparse returns often resulted in neglected repairs and maintenance; properties becoming empty were unlikely to be re-let. Housing to let became the province of local authorities and latterly housing associations. In the absence of the private market there was a shortage of living accommodation to let and an inevitable increase in rents once control was removed. Supply was inadequate, exacerbated by the wholesale disposal of public housing to tenants at advantageous prices from which the market has not recovered. In a bid to reduce public involvement in housing provision, ‘right to buy’ legislation was introduced, offering substantial discounts to existing tenants which were taken up widely. There was little replacement of the depleted stock. The demand for rental accommodation has in recent years been met increasingly by the private sector following the removal of rent control. Some rents are funded through the public purse as part of the benefits system.

Economic recovery In an attempt to break free from the worldwide recession originating in 2008, governments have introduced various schemes, including quantitative easing, together with assurances that the bank rate will be maintained at its current low

18

The property market in context

rate for a period of time (referred to as ‘forward guidance’). These things are intended to give confidence to a range of individuals including owners, occupiers, savers and investors. Other initiatives include ‘Help to Buy’ schemes where help is offered to secure loans at subsidized rates of interest as well as a guarantee to enable the grant of larger mortgage security for house purchase. Banks have been provided with subsidized finance to encourage lending to small and medium enterprises. These actions reflect the serious state of the economy and the efforts being made to restore confidence in the market. Any decision has consequences; the low interest rates on offer to investors as a result of various forms of financial stimuli provided to underpin the economy seriously affect the income of investors, especially where they rely on savings accounts and other safe repositories.

2

Professional valuation practice

The valuer is a pivotal figure in the smooth operation of the property market. Any proposal for development (including putting together a viable site from land in a variety of ownerships and legal interests), application for planning permission, negotiation of a loan, buying and selling of an interest, arranging a letting or settling a rent review to the best advantage is likely to involve one or more valuers, often interacting with other professionals. The ongoing management activity is no less important, ensuring that the investment performs to its full potential and any opportunities to maximize the investment are recognized and reported on. The valuer advises organizations that own or lease premises from which they operate their business activities. The range of services includes advice on managing existing assets, rental levels at review and on expiry, and recommendations about acquisitions and disposals so as to shape the holding to match corporate aspirations. The activity may be carried out by a firm of valuers and surveyors retained to look after all the company’s property interests or by various firms engaged to advise and negotiate on a particular matter as it arises. The larger companies tend to have a skilled in-house team, calling on outside firms only where particular expertise or another perspective on the problem is required.

Code of conduct and professional indemnity insurance Any firm that offers surveying services to clients and which has chartered surveyors comprising 50 per cent or more of its principals must register for regulation by the Royal Institution of Chartered Surveyors (RICS) (RICS 2013a). Once registered, a regulated firm must have adequate professional indemnity insurance. This is a requirement that is reserved in the code of conduct for firms, which states, ‘A Firm shall ensure that all previous and current professional work is covered by adequate and appropriate professional indemnity insurance cover which meets standards approved by the Regulatory Board’ (RICS 2012b, p. 5). Professional indemnity insurance in the surveying world is an insurance policy that is set up to provide recompense to any client who has suffered loss or damage

20

Professional valuation practice

as a result of receiving and acting upon negligent advice provided by a surveying professional.1 At the time of writing it is recognized that the significant risk in valuation practice is work undertaken for secured lending purposes (RICS 2013c) where banks and other lenders who have made losses in a falling property market may try to recoup their losses by recourse to claims for negligence against the valuer for the work undertaken.

Valuation practice in accordance with RICS Valuation Standards Since April 2011, surveyors who work as valuers in the UK operating as either independent consultants or as employees within property firms and who prepare valuations in accordance with RICS Valuation – Professional Standards (RICS 2014) have a mandatory obligation to register for regulation by the RICS. Registered valuation surveyors are required to follow the rules and guidance contained within these standards, and any significant breach of these will result in action being taken against them. The standards exist to ensure that all valuers operate to high professional standards so that those who commission and use the valuations may have confidence in the quality of the work undertaken. The standards, commonly known as ‘the Red Book’, are updated and re-issued periodically by the RICS and they set out procedural rules for surveyors to follow and so provide a framework for valuers undertaking and delivering valuations for a range of purposes. The standards set out the key principles concerned with the practice and procedures that should be adopted by practitioners in the course of preparing their valuations but they do not explain or demonstrate the valuation techniques that should be employed. Valuation methodology is the subject of textbooks such as this, whilst the RICS Valuation – Professional Standards (RICS 2014) are statements about the quality assurance protocols and procedures that relate to a valuer’s conduct in preparing valuations. All valuers must familiarize themselves with these Standards and adopt procedures that accord with them, but generally they must look to other sources for explanations and development of valuation techniques and methodology. Whilst this textbook focuses upon the various valuation techniques, it is nevertheless important briefly to outline some of the essential matters contained within the RICS Valuation – Professional Standards (RICS 2014) and other codes to set the role of the valuer in its practical context. Set out in the remainder of this chapter is an outline of the matters detailed in the RICS Standards, Codes, Guidance notes and other RICS regulatory requirements that directly influence the work of the valuers themselves. The RICS Valuation – Professional Standards (RICS 2014) is a comprehensive text outlining the required protocols relating to valuation practice. It is divided into several separate sections and valuation standards (VS) that include: Glossary, RICS Professional Standards (PS), RICS Global Valuation Practice Statements (VPS), RICS Global Valuation Practice Statements – Applications (VPGA), RICS UK Valuation Standards (UKVS), RICS UK Appendices, RICS UK Guidance notes (UKGN) and The International Valuation Standards 2013 (IVS).

Professional valuation practice 21 At the most basic level the RICS Valuation – Professional Standards require ‘all members of RICS and IRRV,2 whether practising individually or within a firm, to comply with these valuation standards if they ‘provide a written valuation’ (RICS 2014, p. 11). There are just a few exceptions to this requirement, which are the following stated exceptions to VPS1–VPS4: • • • • •

‘the valuer is performing a statutory function…3 the valuation advice is expressly in preparation for, or during the course of, negotiations or possible litigation the valuation is provided solely for internal purposes… the valuation is provided as part of agency or brokerage work in anticipation of receiving instructions to dispose of, or acquire an asset… valuation advice is provided in anticipation of giving evidence as an expert witness…’. (RICS 2014, p. 14)

In addition, a replacement cost figure for assets other than personal property is also considered ‘a written opinion of value’ (RICS 2014, p. 14). Even in these exceptional circumstances, ‘the adoption of the relevant standards is nevertheless encouraged where not precluded by the specific fi requirement or context’ (RICS 2014, p. 14). Consequently, all valuers, even those involved in the exceptional circumstances listed above, are required to adhere to the requirements of RICS Professional Standards 1 (PS 1) and 2 (PS 2). Fundamentally, PS 1 requires valuers’ compliance with ethical standards, possession of appropriate qualifications and experience, together with an expectation that valuers remain independent and objective. To this end, when a valuation is prepared for a client where it may also be relied upon by a third party, such as a shareholder, then additional declarations about the management of the working history between the client and the valuer must be provided to confirm the valuer’s independence. Also, whenever a valuer takes a client’s instructions for a valuation, then the terms of engagement and the basis upon which a valuation is to be prepared must be confirmed before any valuation report is provided. These matters are expanded upon below.

Working with clients Because the procedures and guidelines for the conduct of valuations are specified fi in the RICS Valuation – Professional Standards (RICS 2014) or Red Book, these must be complied with by surveyors undertaking valuation work for their clients. In practical terms this means that registered valuation surveyors must demonstrate best practice when confirming terms of engagement, undertaking inspections and investigations, preparing the valuation and writing the final valuation report.

22

Professional valuation practice

Terms of engagement The terms of engagement specify the fundamental basis of instruction from the client to the valuer. In accordance with RICS global valuation practice statement 1 (VPS 1) these should confirm, amongst other things, their names, the subject property, the interest to be valued and the purpose of valuation. The type of property should be specified together with the date of valuation and the basis or bases of valuation plus any special assumptions made. In total, the RICS Valuation – Professional Standards (RICS 2014) specifies 15 items that should be included in the confirmatory letter for the valuer to work effectively and efficiently with the client; only those items directly impacting upon the execution of the valuation are outlined in this chapter.

Purpose of valuation One of the key matters to be agreed between the valuer and the client is the purpose of valuation, which, as outlined above, should be stated in the terms of engagement before any work commences. Clients require valuations to be undertaken for a range of reasons which may include, but are not restricted to, the following: • • • • • •

sale or purchase of a property interest letting or leasing of a property interest development feasibility and appraisal alternative use valuations valuations for financial reporting valuation for secured lending.

The last two purposes of valuation are subject to special provisions and additional requirements in the RICS Valuation – Professional Standards global valuation practice guidance – applications 1 and 2 (VPGA 1 and VPGA 2).

Valuation basis Once the purpose of valuation is established, the valuer must determine the appropriate basis for the valuations that will be undertaken and reported to the client. RICS Valuation – Professional Standards valuation practice statement 4 (VPS 4) defines four bases of valuation: these are market value, market rent, fair value and investment value (2014). Since the 2012 edition, the RICS Standards have incorporated and adopted the bases of value definitions from the International Valuation Standards Council (IVSC) and the definitions of each are set out below.

Professional valuation practice 23 Market value Market value is defined by IVSC as: The estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion. (RICS 2014, p. 53) Market rent The IVSC definition of market rent is: the estimated amount for which an interest in real property should be leased on the valuation date between a willing lessor and a willing lessee on appropriate lease terms in an arm’s length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion. (RICS 2014, p. 54) Investment value Valuations based on investment value should adopt the IVS definition, which states that investment value is ‘the value of an asset to the owner or a prospective owner for individual investment or operational objectives’ (RICS 2014, p. 55). Fair value There are two definitions of fair value stated in the RICS Valuation – Professional Standards (2014). The IVSC definition states that it is ‘the estimated price for the transfer of an asset or liability between identified knowledgeable and willing parties that reflects the respective interests of those parties’. The definition fi from the International Accounting Standards Board (IASB) states that it is ‘the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date’ (RICS 2014, p. 55). When working with clients, valuers are likely to receive instructions that require them to undertake valuations to determine the market value of a property. Whilst this is the most common basis of valuation arising from clients’ instructions, it should be remembered that surveyors may need to use any of the bases listed above.

24

Professional valuation practice

Inspections and investigations Following confirmation of the terms of engagement, the valuer should commence investigation and inspection of the subject property in accordance with RICS global valuation statement 2 (VPS 2) in the RICS Valuation – Professional Standards (2014). However, given that the nature of valuation instructions and subject properties is infinitely varied, the Red Book does not attempt to specify in detail the requirements of any inspection or investigation. Instead the valuer is required to ensure that their investigations are sufficiently extensive to ensure that a valuation is produced that is ‘professionally adequate for its purpose’ (RICS 2014, p. 38). It is also recognized that matters which become apparent only during the course of an inspection may have an effect on the value of the property. Often inspections will involve measurement of the property and the valuer should use the appropriate methods for measuring and calculating the internal area of a property. More details about this can be found later in this chapter. Further, most investigations require the valuer to collect market evidence and other facts and so the valuer must ‘take reasonable care to verify the information provided or obtained’ (RICS 2014, p. 39). Typically, verification will extend to the valuer confirming evidence of market transactions such as rents achieved for new lettings and rent review settlements that are used to inform the valuation itself. However, the need for verification may also extend to other matters pertinent to the valuation. If the valuer is required to measure a property in order to value it, then measurements should be made in accordance with the edition of the RICS Code of Measuring Practice in effect at the time of inspection. At the time of writing, the current Code is the sixth edition published by RICS in 2007. This Code defines the core bases of measurement, and for the valuer to prepare an accurate valuation it is essential that the appropriate basis of measurement is used for the property.

Measurement of property In order to value a property or part of a property, it needs to be measured appropriately and accurately. The RICS Code of Measuring Practice (RICS 2007a) describes the various bases of measurement and provides details concerning their application in practice. It is important to note that the Code itself is a guidance note and it is likely that valuers who have applied the Code of Measuring Practice may have a partial defence if an allegation of negligence is made against them (RICS 2007a, p. 11). The Code highlights that a court will take account of any GN issued by the RICS in making a judgement as to the competence of the valuer. Nevertheless, adherence to the Code is no guarantee that a valuer will be exonerated of a charge of negligence (RICS 2007a). The valuer must also make a professional judgement as to when it is appropriate to use the Code and when it is appropriate to depart from it. The Code cautions that any departure would need to be for good reason and would need to be justified in the event of any litigation

Professional valuation practice 25 (p. 11). Accordingly, it is good practice for the valuer to record the reason for departure from the Code on the valuation file in the event that the decision is subject to challenge. Like the Red Book, the Code of Measuring Practice is not a textbook or guidance note about valuation methodology. Therefore any valuation practices such as zoning or the application of different rates of value for basements and upper floors are matters of judgement employed by the valuer, and they do not form part of the RICS Code of Measuring Practice (RICS 2007a). However, users of the Code are advised that metric units should be used as the standard system of measurement; where clients require imperial units these should be provided as supplementary information, e.g. by including them in brackets after the metric measurement (RICS 2007a, p. 4).

The bases of measurement The RICS Code of Measuring Practice, 6th edition defines three bases of measurement, as GEA (gross external area), GIA (gross internal area) and NIA (net internal area). The definition of each and its appropriate application is described below. Definition of gross external area (GEA) GEA is defined as ‘the area of a building measured externally at each floor level’ (RICS 2007a, p. 8). This effectively includes everything inside a building including, inter alia, the thickness of perimeter walls, all internal walls, stairwells, columns and piers, internal balconies, and lift and plant rooms. It excludes, inter alia, external canopies, fire escapes and open ways, and open vehicle parking areas. For residential properties in particular it excludes greenhouses, garden stores and the like (RICS 2007a). Refer to Appendix B for an example. Application of gross external area in valuation GEA is used as the basis of measurement in the calculation of site coverage and/ or plot ratio calculations for any planning application or planning approval.4 It is also used as the basis of measurement for the rating of residential property for the assessment of council tax.5 GEA is only used as the basis of measurement of building costs in the calculation of insurance reinstatement costs for residential property.6 It is not used for measuring building costs for commercial, residential or any mixed development schemes as may be required in a residual valuation. Definition of gross internal area (GIA) This method of measurement is defined as ‘the area of a building measured to the internal face of the perimeter walls at each floor level…excluding perimeter wall

26 Professional valuation practice thicknesses and external projections’ (RICS, 2007a, p. 12). Accordingly, GIA includes, inter alia, internal walls and partitions, atria and entrance halls and the voids above them, lift rooms and plant rooms, toilets and bathrooms (RICS 2007a). It excludes ‘perimeter wall thicknesses and external projections, external open sided balconies, covered ways and fire escapes’ (RICS 2007a, p. 12). Refer to Appendix C for a diagram showing GIA. Application of gross internal area in valuation In valuation terms the application7 of GIA is ‘the basis of measurement used in the marketing and valuation of industrial buildings (including ancillary offices), warehouses, department stores, variety stores, food superstores and many specialist classes’ (RICS 2007a, p. 13). It is also used as the basis of rating8 assessments in England and Wales and also for apportioning service charges9 for these same types of property. In addition, a modified form of GIA is used as the basis of measurement for the valuation and marketing of new residential properties.10 GIA is also the basis of measurement used for the calculation of building costs11 (RICS 2007a) and is the basis that should be assumed for the estimation of all building costs in a residual valuation as confirmed in the Code of Measuring Practice, 6th edition, p. 6. Chapter 7 Residual Valuation demonstrates the use of GIA for building cost estimation in valuation. Definition of net internal area (NIA) NIA is defined as ‘the usable area within a building measured to the internal face of the perimeter walls at each floor’ (RICS 2007a, p. 16). It excludes common parts, toilets, lift rooms, corridors, internal structural walls, walls enclosing excluded areas, columns, piers, chimney breasts, other projections, vertical ducts, walls separating tenancies, and space occupied by permanent air conditioning, heating or cooling apparatus – where the space it occupies is rendered substantially unusable (RICS 2007a). However, NIA does include kitchens, fitted cupboards, perimeter skirting and trunking, entrance halls and atria (measured at base level only). Some of these inclusions seem counter-intuitive, hence the importance of reference to the Code when measuring property. Appendix D provides a diagrammatic example of NIA. Application of net internal area in valuation For valuation purposes NIA is used as the basis of measurement for offices, shops, supermarkets and business uses12 that are not covered by the GIA basis of measurement outlined above. In addition, measurements for rating purposes13 and service charge allocation14 for these same types of property are also made on the basis of NIA.

Professional valuation practice 27 Special use definitions for the measurement of shops Shops are described in terms of their retail area (RA), which is the NIA. This includes all ancillary areas enclosed by non-structural partitions but excludes those enclosed by structural partitions. The RA includes various aspects of shop measurement: the main ones are gross frontage (GF), net frontage (NF), shop width (SW) and shop depth (SD) together with specific provisions relating to ancillary areas (AA) and to storage areas (StoA). Application 19 (APP 19) of the Code of Measuring Practice, 6th edition notes that RA is the ‘basis of measurement for the valuation and marketing of shops and supermarkets’ (RICS 2007a, p. 27). However, with regard to APP 19 of the Code the RICS (2007a) highlight that the practice of zoning to assess the value of a shop is ‘not a measurement technique’ (p. 27) and thus is not part of the Code, but it emphasizes that market custom shall prevail in such valuations. Accordingly, where comparable evidence shows that a zoning approach is used in valuations in a particular retail location then the valuer would normally adopt this approach if valuing something in the same place. Special use definitions for the measurement of residential property In respect of residential property the Code recommends that the ‘Residential Agency Guidelines’ (contained within the Code) ‘are followed for marketing sale or letting of property’ (RICS 2007a, p. 30–1). With regard to residential valuations it highlights that there is no single accepted practice for measurement of residential property for valuation purposes. It identifies GEA, GIA, net sales area (NSA)15 or effective floor area (EFA)16 as appropriate bases of measurement, emphasising that valuers should state which basis has been used when preparing their reports. Special use definitions for the measurement of leisure property The Code of Measuring Practice, 6th edition emphasizes that many leisure properties are valued in relation to their trading potential, recognizing that floor area is not necessarily used in such valuations. However, where floor area is considered relevant to the valuation, the Code recommends a consistent approach and the adoption of GIA.

Executing the valuation Once all inspections, measurements and market investigations have been undertaken the surveyor values the property in the appropriate way. Because the rest of this textbook is concerned with the explanation of the various methods of valuation that should be adopted for different properties, there is no elaboration of valuation methodology at this point except to highlight that one of the five methods is adopted. They are comparative, investment, residual, profits or costbased methods.

28

Professional valuation practice

Valuation reports The RICS Valuation – Professional Standards (RICS 2014) state in VPS3 that the valuation report must cover all matters included in the terms of engagement between the valuer and the client and should contain at least the minimum requirements set out below. ‘(a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k)

Identification fi and status of the valuer Identifification of the client and any other intended users Purpose of the valuation Identifification of the asset or liability to be valued Basis of value Valuation date Extent of investigation Nature and source of the information relied upon Assumptions and special assumptions Restrictions on use, distribution or publication Confifirmation that the assignment has been undertaken in accordance with the IVS (l) Valuation approach and reasoning (m) Amount of the valuation or valuations (n) Date of the valuation report.’. (RICS 2014, p. 42)

As this list reveals, the valuer must clearly state essential matters identifying the client, the property interest and how it is used, together with the purpose, basis and date of valuation. The report should confirm whether or not the valuer has had any previous involvement with the property being valued (item a). In terms of the valuation itself, a summary of the approach to valuation should be provided, including confirmation of compliance to the Standards (items k and l). In addition, when explaining the valuation, details about the currency used, investigations undertaken, any assumptions made and any information relied upon should all be explained (items g and i). The final valuation figure is stated in words and in numbers (item m), but the workings and calculations are generally not required. Finally, the valuer declares his competence to execute the valuation and signs it and rounds off the report by highlighting any restrictions on publication and any limitations of liability to third parties (item j).

Valuation record Once the report is completed and dispatched to the client, the valuer should keep a copy of the report and details of the case. The International Valuation Standards (IVSC 2013, pp. 33–4) state that:

Professional valuation practice 29 a record shall be kept of the work done during the valuation process for a reasonable period having regard to any relevant legal or regulatory requirements. Subject to any such requirements this record shall include the key inputs, all calculations, investigations and analyses relevant to the final conclusion, and a copy of any draft or final report provided to the client. Clearly this is good practice and it is in the valuer’s interest to keep a record of matters that were considered during the preparation of a valuation together with a copy of the completed valuation report. Therefore the valuer, or anyone else in the firm, can access and review the valuation case if necessary. The valuation record can be kept either in hard copy or electronic copy and it is essential that all aspects of the investigations, measurement and valuation are included before the file is archived and stored.

Summary • • • • • • •

•

•

Valuation surveyors and firms in the UK must be registered for regulation by the Royal Institution of Chartered Surveyors. Valuation surveyors and firms should have professional indemnity insurance. The RICS Valuation – Professional Standards set out the protocols and procedures for valuers to follow in undertaking valuation work. Before commencing a valuation valuers should confirm the terms of engagement with their clients. Valuers should confirm the purpose and basis of valuation to their clients. Inspections and investigations should be sufficient for the purposes of the valuation and market evidence should be verified if it is to be relied upon. Where floor area is necessary to execute a valuation, the property should be measured and the floor area calculated in accordance with the relevant RICS Code of Measuring Practice. Valuation reports for properties covered by the RICS Valuation – Professional Standards should include the minimum requirements of RICS global valuation statement (VPS 3). Valuers are advised to keep a copy of their valuation report and the associated record of their investigations and calculations for a reasonable period of time.

Notes 1 Clients may also make a claim for breach of contract – see RICS (2013b) for details. 2 Institute of Revenues, Rating and Valuation. 3 ‘This exception does not extend to the provision of a valuation for inclusion in a statutory return to a tax authority’ (RICS 2014, p. 14). 4 Application 1 (APP 1) in the Code of Measuring Practice, 6th edition (RICS 2007a). 5 Application 2 (APP 2) ibid. 6 Application 3 (APP 3) ibid. 7 Application 5 (APP 5) ibid.

30

Professional valuation practice

8 9 10 11 12 13 14 15 16

Application 6 (APP 6) ibid. Application 7 (APP 7) ibid. Application 8 (APP 8) ibid. Application 4 (APP 4) ibid. Application 9 (APP 9) ibid. Application 10 (APP 10) ibid. Application 11 (APP 11) ibid. Application 21 (APP 21) ibid. Application 22 (APP 22) ibid.

3

Valuation formulae

Introduction This chapter is devoted to exploring the role of mathematical formulae. They may be seen as tools in the hands of the valuers, which quantify and underpin the advice given, providing a numerical interpretation of that advice. Valuers’ formal education and work environment provide an understanding of the property market in all its aspects: the relevance of tenure, the suitability of buildings to perform for the purpose for which they are intended, the economic context and a range of other inputs on which the valuers will base their advice. The basic concept of valuation is the time value of money. The implication is that the investor would not part with one pound today unless there was a prospect of receiving sufficient compensation in exchange. That is to say that the exchange of capital now in return for a series of regular future payments involves the concept of discounting. The discount rate is set by the market where the nature and quality of investments are compared. A significant or unusual risk is likely to influence the discount rate, which has the effect of decreasing the exchange price. The usefulness of a set of printed calculations of compound interest and discount tables was recognized in the eighteenth century when John Smart published Tables of Simple Interest and Discount and Compound Interest Tables. An early publication specific to real estate was Inwood’s Tables for the Purchasing of Estates, Reversions, Annuities etc., first published in 1811. Having reached its thirty-third edition by 1933 it was reintroduced in an updated form by J. J. Rose in 1975. The best known publication is Parry’s Valuation and Investment Tables, originally prepared by Richard Parry in 1913 and now available in the latest (thirteenth) edition published in 2013 and produced by Alick W. Davidson. Parry’s is undoubtedly the best known and most relied on set of tables available; new formulae and extended years and rates of interest have been added as required by changes in the market. Other sets of tables published in the last 40 years (e.g. Property Valuation Tables [Bowcock 1978] and Donaldsons Investment Tables [Marshall and Donaldson and Sons 1988]) offer additional features but are less comprehensive than Parry’s. One of the limitations of any printed set of tables is that they are not, and cannot be, exhaustive; only a limited range of interest rates

32

Valuation formulae

can be included, thus requiring additional calculations by the valuer which are time consuming and potentially open to error. Electronic calculators and computers are now widely available and they can be programmed to solve any formula precisely and with complete flexibility in specifying the inputs. A further sophistication is that whilst the number of decimal places shown on the screen can be limited, any calculation takes account of the extended value of the individual component. It is also possible to account for parts of a year or include months or days in any calculation, and valuers are not restricted to the limited range of yields or interest rates offered in the printed tables. It is important that components are not rounded during the process of making an evaluation; the place for such action is at the end of the exercise when the result may be rounded to avoid the implication of any false claim regarding the degree of accuracy. Rounding is almost always applied downward. Broadly, there are nine formulae for the main purposes of evaluation; some relate to discounting and some to compounding. These are set out in Figure 3.1. It will be seen that there are three pairs of reciprocal formulae: compounding and discounting. Three further formulae acknowledge the particular aspects of years’ purchase. The reciprocal relationship between the formulae is shown in Figure 3.2. The time value of money In one way or another, the formulae reflect the time value of money. Given the option of receiving a sum of money now or, alternatively, at some future date, the rational choice is to accept it now. Not only does that choice offer certainty and freedom, but there is also a range of opportunities to spend the money in whatever way is desired. It could be used to purchase goods or invested to gain interest until the original cash sum is required for some future expenditure. Where the choice is between a sum now or a greater sum at some point in the future, the decision becomes one related to the size of the reward for delay (in terms of the level of interest offered) and the inherent risk and uncertainty in the decision. The exchange rate is that demanded by an investor in order to forgo current consumption in favour of future gains, sometimes referred to as the marginal rate of time preference. For example, the offer of £100 now or £103 in one year’s time would not be especially interesting to someone who could purchase a secure investment to gain such a sum but where the rate of inflation is 3 per cent. That is to say, the investor would wish at least to maintain the purchasing power of that capital. In general, interest rates reflect risk, and the higher the rate available the more the element of risk involved becomes a factor in the decision to purchase the investment. Capital value is influenced not only by the discount rate available but by the opportunity for the investment to grow in value. Investors are looking for a real increase in purchasing power so their expectations are influenced by growth and inflation.

Valuation formulae 33

(1+ i )

Amount of £1

Compounding tables

Annuity

Amount of £1 per annum

Present value of £1

Discounting tables

Years’ purchase

i+

n

i

(1+ i )

(1+ i )

n

n

−1

−1

i 1

(1+ i )

n

or ( + i )

⎛ 1 ⎞ 1− ⎜ ⎟ ⎝ 1+ i ⎠ i

−n

n

s Annual sinking fund

Other tables

(1+ s )

n

−1

Years’ purchase of £1: dual rate adjusted for tax

1 ⎛ s 1 ⎞ ⎟ × i +⎜ n ⎜ (1 + s ) − 1 1 − t ⎟ ⎝ ⎠

Years’ purchase of £1 in perpetuity

1 i

Years’ purchase of reversion of £1 to a perpetuity

1 i (1 + i )

n

Key: i – interest expressed as a decimal fraction n – the number of years s – sinking fund rate expressed as a decimal fraction t – tax rate expressed as a decimal fraction Notes: a The term ‘years’ purchase’ is commonly used in preference to the more descriptive ‘present value of £1 per annum’. b Periods for years and/or parts of a year can be calculated by expressing the period in years and months, weeks or days. For example, 3 years and 88 days is entered as

( 3 × 365 ) + 88 which is entered into the formula as 3.2411. 365

c

Any interest rate, whether whole or a fraction, must be shown as a decimal. For example, 7 per cent is entered as 0.07 and 8.25 per cent is entered as 0.0825, etc.

Figure 3.1 Valuation formulae

34

Valuation formulae

In each case, based on £1 COMPOUNDING

DISCOUNTING

Amount of £1

Present value of £1 1

(1+ i ) ( = A) n

(1+ i )

n

( = PV )

Annual sinking fund

Amount of £1 p.a. A −1 i

i A −1

Annuity

Present value of £1 p.a.

i 1− PV

1− PV i ALSO YP DUAL RATE adjusted for tax 1 ⎛ s ⎞ ⎛ 100 ⎞ ⎟ +⎜ i ⎜ (1 + s )n ⎟ ⎜⎝ 100 − t ⎟⎠ ⎝ ⎠ YP in perpetuity 1 i YP in perpetuity deferred n years 1 i (1 + i )

n

Figure 3.2 Relationship between the valuation formulae

Calculation accuracy In preparing advice about the value of a holding of real estate, the rent and terms of letting on which it is or could be let, surveyors and valuers base their reasoning on the use of financial formulae. These give a mathematical representation of the problem and enable the effect of a particular course of action to be expressed. Valuers use an appropriate rate of interest and period of the transaction to generate calculations that provide support for the advice offered. The evaluation of alternatives is based on estimates of the respective returns, to ensure the value of any holdings is maximized. In pursuit of accuracy, many of the results of using the formulae show a number of decimal places. Accordingly, the question of approximation is of importance,

Valuation formulae 35 especially when that result may be multiplied by sometimes very large figures, thus enlarging the discrepancy. Judgement is called for, but normally up to four decimal places is sufficient; it is important not to apply any general rounding of figures until an outcome is reached. Then a rounding decision can be taken that is compatible with the problem. Where it is accepted that valuations of property cannot be estimated within a range of 5 to 10 per cent, it is misleading to present a valuation of a property as, say £345,679, suggesting a level of accuracy that does not exist. Depending on the particular circumstances relating to the valuation, valuers tend to round off the figure at £345,000 or £345,500. Valuers are now able to obtain accurate and quick results using Excel or similar spreadsheet packages, or a bespoke computer programme; these enable precise requirements to be input and a range of results obtained that were previously not practicable. Nevertheless, it is incumbent on valuers to be aware of the assumptions implicit in any set of tables or spreadsheet and to validate the outcome of their calculations. Computers enable the refinement of any calculations to reflect periods of a quarter or month or indeed any number of days. However, this level of accuracy is only valid where the market information relied on in the assessment is similarly accurate. There are other constraints on accuracy referred to elsewhere in this book. The remainder of this chapter is devoted to an explanation of the various valuation formulae, with illustrations showing how each is used. The six basic formulae are examined in more detail and readers should note that in the following descriptions the unit of time is always in years; adjustments for shorter periods or for a period of years and months or days are shown later. The formula in each case uses ‘i’ as the decimal equivalent of the interest rate and ‘n’ to denote the number of years.

The present value of £1 This formula determines the single amount to be invested now in order to accumulate to £1 over a period of ‘n’ years at a compound interest rate of ‘i’. It is self-evident that the prospect of receiving £1 at some future date is worth less than £1 today. The precise amount of the present value is determined by the period of deferment and the rate of interest offered. Example 3.1 A legacy of £5,000 is payable in four years’ time when the recipient reaches the age of 18. Given a discounting rate of 4 per cent, calculate the present value of the sum.

36

Valuation formulae Legacy maturing in four years’ time PV of £1 in 4 years at 4% Present value

£5,000 0.85480 £4,274

Step-by-step calculation: Legacy due in 4 years’ time PV of £1 in 1 year at 4% Value in 3 years’ time PV of £1 in 1 year at 4% Value in 2 years’ time PV of £1 in 1 year at 4% Value in 1 year’s time PV of £1 in 1 year at 4% Current value

£5,000 0.9615 £4,808 0.9615 £4,623 0.9615 £4,444 0.9615 £4,274

Commentary The value of the legacy today is appreciably less than the amount receivable in four years’ time. The greater the discount rate, the lower the present value. For example, at a discount rate of 6 per cent, the current value would be £3,960. Example 3.2 An investor has a bond with a terminal value of £2,000 due for redemption in ten years’ time. The rate of interest provided is 4.5 per cent; calculate its current value. Bond value at maturity PV of £1 in 10 years at 4.5% Present value

£2,000 0.64393 £1,288

Commentary The investor may be contemplating cashing in early or using the bond as security for a loan; there will be a penalty in the form of a lower payment.

The amount of £1 The formula is designed to calculate the total amount of compound interest added to an initial single deposit of £1 for a specified time and at a declared rate of interest. It assumes that interest is added at the end of each year and that it remains in the account so that it also attracts interest in subsequent years (this is the principle of compound interest).

Valuation formulae 37 Example 3.3 A retailer has entered into a new lease which includes a commitment to spend £20,000 on internal alterations to the premises. The landlord is willing to carry out the work and defer payment for three years subject to an interest rate of 4 per cent. Calculate the amount to be repaid in three years’ time. Current cost of alterations Amount of £1 in 3 years at 4% Repayment due in three years’ time

£20,000 1.1249 £22,498

Check, showing year-by-year calculation: Loan Interest on 1 year @ 4% (i.e. × 0.04) Interest on 1 year @ 4% Interest on 1 year @ 4% Amount for repayment in 3 years

£20,000.00 £800.00 £20,800.00 £832.00 £21,632.00 £866.00 £22,498.00

Commentary It may be that the tenant is unable to find the necessary funds to carry out the work now and that he will be better able to afford the repayment when the business has been in existence for three years. Example 3.4 A building contractor has borrowed £250,000 from the bank to facilitate the early stages of a residential development and has agreed to repay the loan and accrued interest at the rate of 12 per cent per annum in two years’ time. Calculate the amount due for repayment at that time. Loan to facilitate development of building site Amount of £1 in 2 years at 12%

£250,000 1.2544 £313,600

Commentary In effect, the contractor is raising building finance, probably subject to a charge on the land to be developed. The high interest rate reflects the assessment of risk associated with the project.

38

Valuation formulae

Years’ purchase (or present value of £1 per annum) The years’ purchase or the present value of the right to receive £1 at the end of each year for ‘n’ years at ‘i’ rate of compound interest – this formula is perhaps the most widely used of all in the process of valuation. It is used to find the capital equivalent of an annual payment of rent for a particular term of years, given the capitalization rate to be used. Experiment would show that the same result is achieved by adding together the individual present values of each of the years in which a payment is due. Although accurate, this approach is very cumbersome where the term is more than a few years. Example 3.5 Your client owns a freehold office building recently let at a market rent of £30,000 per annum. The rent will be reviewed at the end of five years. You are asked to indicate the present value of the first five years’ income at a discount rate of 6.5 per cent. Rent of office building per annum Years’ purchase 5 years @ 6.5% Value of first 5 years’ rent Step-by-step calculation: Rent per annum PV £1 in 1 year @ 6.5% PV £1 in 2 years @ 6.5% PV £1 in 3 years @ 6.5% PV £1 in 4 years @ 6.5% PV £1 in 5 years @ 6.5% Value of first 5 years’ rent

£30,000 4.1557 £124,671

£30,000.00 0.93897 0.88166 0.82785 0.77732 0.72988

Capital value of first 5 years’ rent Divide by amount of £1 per annum for 5 years @ 6.5%

4.1557 £124,670.40 £124,669 5.6936 £21,896

Commentary A payment of £30,000 a year will be received at the end of each of the next five years. The capital value will depend on the discounting rate used, in this case, 6.5 per cent. The calculation will reflect the receipt of a total of £150,000 over the next five years when the first payment is deferred for one year, the next for two years and so on. A feature of compound interest is that it not only services the capital but also leaves a balance, which, if reinvested at the same rate, replaces the original capital sum at the end of the term, as demonstrated in this example.

Valuation formulae 39

Annuity purchased by £1 The formula envisages the deposit of a single amount now to provide an income for a specified period in the future. The capital and interest accruing will be returned over the life of the annuity, using up the whole fund by the end of the period. Example 3.6 Your client is taking early retirement and wishes to purchase an annuity to supplement investment income pending receipt of the work-based pension in ten years’ time. Advise on the annuity available from a capital investment of £75,000 at a discount rate of 4 per cent where drawn down is over a period of ten years. Sum available to purchase annuity for next 10 years Cost to purchase £1 for 10 years at 4% Annuity for each of next 10 years

£75,000 0.123291 £9,247

Example 3.7 Grandparents wish to provide £150,000 in eight years’ time when their granddaughter reaches the age of 25. Calculate the annual sum to be invested, assuming that an interest rate of 5.5 per cent can be achieved. Capital sum to be provided in 8 years’ time Annuity to purchase £1 in 8 years at 5.5% Annual cost of provision

£150,000 0.157864 £23,680

Commentary Examples 3.8 and 3.9 demonstrate, respectively, how provision can be made for current income from a capital sum, or, for a future capital sum produced by annual investment.

Amount of £1 per annum The formula calculates the amount to which £1 invested now and yearly thereafter would accumulate at a given rate of interest. Example 3.8 Your client pays a service charge of £3,750 per annum on business premises where the lease has 12 years unexpired. For internal accounting purposes, the client wishes to calculate the overall cost to the business for the whole of the period at an interest rate of 9 per cent, based on the company’s borrowing rate.

40

Valuation formulae Annual service charge Amount of £1 per annum for 12 years at 9% Current value of total payable

£3,750 20.1407 £75,528

Commentary Note that these calculations anticipate an annual investment and indicate the single sum if paid now that would provide the payments for the whole of the 12 years at the interest rate shown.

Annual sinking fund The formula calculates the premium to be invested at the end of each year to accumulate to £1 at a specified rate of compound interest over a period of years. Its principal use is in providing a fund to replace the capital expended in investments having a limited life – often referred to as wasting assets. It is most often used in conjunction with the remunerative rate as part of a dual rate years’ purchase. Most savings attract tax on interest receipts and, for the fund to replace the capital intended, the calculations should take account of an assumed rate of tax on that portion of the income devoted to providing a sinking fund. The topic is considered in more detail later, in the leasehold investment valuation part of Chapter 5. Example 3.9 A partner in a small estate agency business has a provision in the partnership agreement enabling the purchase of the remaining share of the business for the fixed sum of £75,000 in eight years’ time. Calculate the annual sinking fund payment to provide this amount assuming a fixed interest rate of 5 per cent. Cost of business share Annual sinking fund to provide £1 in 8 years at 5% Annual provision to accumulate purchase sum

£75,000 0.1047218 £7,854

Commentary This is another example of the way in which annual savings accumulate to provide a capital sum at the end of the period. Example 3.10 The tenant of a small flat has agreed to purchase it in five years’ time when a deposit of £25,000 will be required. Calculate the amount to be invested each year if a rate of interest of 3.5 per cent can be obtained from a five-year fixed interest bond.

Valuation formulae 41 Deposit required in five years’ time Annual sinking fund for 5 years at 3.5% Annual provision to accumulate deposit

£25,000 0.1865 £4,663

Commentary It can be seen from inspection that, with interest, the annual amount will be less than one fifth of the total amount required. The calculation reflects the precise annual amount, taking account of the rate of interest payable.

Years’ purchase in perpetuity (present value of £1 per annum in perpetuity) If it can be assumed that income will be received indefinitely on a yearly in arrear basis, the formula is of the simplest form. The years’ purchase is found by dividing the decimal equivalent of the appropriate yield into unity (1/(i/100)). The basic method of valuation capitalizes the current income without taking any future increases into account. The valuation is based on current income (where the rent payable is the current market rental value). In these cases, the expectation of rental growth is reflected implicitly in the all-risks yield shown by the analysis of recent sales of similar types of property. Where the current rent is below market rental value, there is a two-stage process that is described in the next section. Other valuation approaches using estimated future rental values are explained in Chapter 6. Example 3.11 Calculate the capital value of the right to receive a net income of £25,000 per annum in perpetuity where the appropriate return by reference to market intelligence shows sales of similar type of investment is 8 per cent. Current net rent Years’ purchase in perpetuity at 8% Capital value

£25,000 12.5 £312,500

Commentary It will be seen that, unlike the return on investment in limited period interests, the return on capital is as specified in the question. Wasting assets (i.e. leasehold interests) do not conform to this relationship.

42

Valuation formulae

Years’ purchase in perpetuity – term and reversion Example 3.12 Small office premises were let three years ago at a rent of £15,000 per annum on lease for a term of 20 years, with rent reviews at the end of each five- year period. The current market rental value is £17,000 per annum. Calculate the present capital value of the investment where the appropriate all-risks yield is 7.5 per cent. Method 1 Term Rent per annum for next two years Years’ purchase 2 years at 7.5% Reversion to market rental value Years’ purchase perpetuity deferred 2 years at 7.5% Value of freehold interest

£15,000 1.7956

£26,934

£17,000 11.5378

£196,143 £223,077

Commentary The basic method of valuation is a two-stage process. In the term section the valuer capitalizes the current income without taking any future increases into account. The valuation is based on current income (where the rent payable is the current rental value). The expectation of rental growth is reflected implicitly in the all-risks yield shown by the analysis of recent sales of similar types of property. In this case, the market rental value is above the rent being paid by the occupier. Therefore the valuer should take the future rental increase into account (but at today’s level of rental value). This is done in the reversion element of the calculation where, in two years’ time at rent review, the rent will return (or revert) to market rental value. Because this estimate of future rental value is being undertaken at today’s date, the reversionary element of the valuation presents the current estimate of market rental value. Example 3.13 Your client wishes to purchase shop premises with a net rental value of £60,000 per annum to show a yield of 6 per cent. The property is occupied by a trader who also owns the property. Your client has agreed that the business can continue for the next three years before possession is given but without any payment of rent. Calculate the capital value of this investment purchase.

Valuation formulae 43 (a) Method 1 Net rental value per annum Years’ purchase perpetuity at 6% Deduct years’ purchase 3 years at 6% Capital value (b) Method 2 Net rental value per annum Years’ purchase perpetuity at 6% Present value of £1 in 3 years at 6% Capital value

£60,000 16.6667 2.6730

13.9937 £839,622 £60,000

16.6667 0.83962

13.9937 £839,622

Commentary Both methods shown in Examples 3.12 and 3.13 give a capital value of the income, assuming that the cash flow does not begin until year four. Example 3.12 shows a term and reversion valuation where the term income is capitalized by the years’ purchase for the remaining two years until rent review. The reversionary element assumes that the rent will revert to the market rent in two years’ time at rent review and this element is capitalized by the combined result of the years’ purchase in perpetuity multiplied by the present value of £1 for the waiting period of two years. As the present value for a period is always less than one, multiplication will have the effect of reducing the figure for years’ purchase in perpetuity. Note that present rents and present market rental values are used; there is no projection of the current rental value to an estimated higher rent at that time, even though it may be expected. The absence of any overt anticipation of higher future rents (as opposed to rental values) is reflected in the level of yield. In Method 1, the years’ purchase for the number of years before the first rent payment is received is deducted from the years’ purchase in perpetuity. Method 2 acknowledges the delay of three years in receiving the first rent by multiplyingg the years’ purchase in perpetuity by the present value for three years at the same rate as the years’ purchase in perpetuity. As the present value for a period is always less than one, multiplication will have the effect of reducing the figure for years’ purchase in perpetuity multiplier.

Years’ purchase, dual rate, adjusted for tax on sinking fund element It was stated above that the years’ purchase formula has a built-in sinking fund. However, it would be unrealistic to assume that a sinking fund could be invested at the same rate as the accumulative rate bearing in mind the requirement for a safe, ‘riskless’ investment to replace the original purchase price. This formula therefore provides for the remunerative rate on the investment – the return on capital – and a lower secure rate for reinvestment in a sinking fund – the return of capital. A further complication is that the sinking fund will be provided out of taxed income in most cases, requiring the formula to recognize that the sum saved

44

Valuation formulae

each year is a net amount after tax has been deducted and which is sufficient to accumulate to the original purchase price over the life of the investment. For the reasons given, fewer valuers now use dual rate tables in valuations of leasehold premises. The following example demonstrates its use. The alternative is to reflect the relative inadequacies of leaseholds by an adjustment of the yield. Example 3.14 A client wishes to purchase a leasehold interest that has an unexpired term of 35 years and a current rent of £16,000 per annum. The head rent is fixed at £1,000 per annum. Market indications are that a yield of 10 per cent would be expected and that a sinking fund could be taken out to show a return of 3 per cent. Assume a tax rate of 25 per cent on the sinking fund element. Prepare a valuation of the leasehold interest. Annual income from leasehold interest Deduct head rent Profit rent Years’ purchase 35 years at 10% with sinking fund at 3% and a tax rate of 25% Capital value of leasehold

£16,000 £1,000 £15,000 8.1932 £122,898

Commentary There is no information regarding the lease terms but as no reviews are noted and the yield is relatively high, it is assumed that the rent does not change over the life of the investment. The way in which the total income is applied to provide a return to the investor and at the same time a sinking fund to replace the original capital at the end of the leasehold term is also shown. The remaining lease term of 35 years is regarded as a wasting asset requiring replacement of the original capital at the end of the term. The years’ purchase formula is modified to include a sinking fund taken out at a safe and therefore low rate of interest to provide for the original capital to be replaced. As the premiums for the sinking fund will be payable from taxed income, the effect on tax must  also  be provided for. Selection of the tax rate creates some difficulty but should reflect the rate paid by companies or individuals likely to engage in such activities. It should be noted that some investors, such as charities, enjoy certain tax benefits and would be able to consider the provision of a sinking fund from gross income. There is no evidence that investors do take out a sinking fund, but its inclusion in the years’ purchase table enables a comparison with freehold market yields.

Valuation formulae 45 Example 3.15a Estimate the value of the leasehold interest in shop premises held on long lease with six years remaining at a rent of £20,000 per annum where the current rental value is £50,000. A sinking fund can be taken out to show a return of 2.5 per cent net of tax. The yield required is 11 per cent. Current rental value Deduct current rent Profit rent Years’ purchase 6 years at 11% with sinking fund at 2.5%, subject to income tax at 30% Capital value of leasehold

£50,000 £20,000 £30,000 2.9972 £89,916

Commentary This is an example of a short leasehold interest. It is widely accepted that few investors take out a sinking fund, a situation which is examined in Chapter 5. To illustrate the effect of ignoring provision of a sinking fund, Example 3.15(b) shows the capital value where it is accepted that the income is limited to a term of six years. Example 3.15b Current rental value Deduct current rent Profit rent Years’ purchase 6 years at 11% Capital value of leasehold on single rate basis

£50,000 £20,000 £30,000 4.2305 £126,919

Commentary Without making provision for a sinking fund, the capital value would be considerably higher, as indicated in Example 3.15(b)

Years’ purchase for life or lives Life interests are indeterminate terms in freehold or leasehold property. The person with the benefit of a life interest is referred to as the life tenant or tenant for life. There may be a single life tenant, joint life tenants or a tenancy for the longer of two or more lives. Such interests are now rare, surviving from an earlier time when many landed estates were settled to maintain them in family ownership. When the head of the family predeceased his wife, it was a common arrangement to leave the estate to her for the duration of her life with the remainder to the heir or heirs. The tenant for life of a freehold interest is empowered to sell the freehold interest although the proceeds of the sale must be dealt with in specified ways in

46 Valuation formulae order to protect the interests of the reversioner. There are no restrictions on a sale by the life tenant of the life interest, the benefit of which will cease on the death of that tenant. A tenancy for life would be void for uncertainty, but a person holding a life interest may grant a lease for a term of years, terminable by the tenant for life or his heirs on the death of a named person. The process of valuation is complicated and precarious, the more so because of uncertainty about the length of the interest, depending as it does on a person’s life expectancy. English Life tables, compiled by government statisticians from census information and recorded mortality of a sample of 100,000 people, enable probability factors to be calculated. They are widely used by actuaries in insurance matters. The probability factors are then incorporated into a years’ purchase figure to reflect the uncertainty. Any individual may of course live a longer or shorter life than the tables predict and any valuation is therefore highly speculative. The interest belongs to the class referred to as wasting assets. It is likely that the majority of valuers will complete their professional lives without ever being called on to complete the valuation of a life interest. For that reason, no examples of such valuation approaches are included.

True yields The traditional valuation formulae were based on the assumption that rent was payable annually in arrear. Increasingly over the years and particularly since the 1960s, rents of commercial premises at least have been payable quarterly in advance. There is some discussion regarding the fact that many valuers continue to value on an annual in arrear basis. When valuers relied on printed tables there was no ready alternative to the use of tables constructed on a yearly in arrear basis. However, with the advent of financial calculators, computers and bespoke programs there is no reason why the precise terms of payment should not be reflected in any valuation. This comment is subject to the reservation that any evidence of rents or yields deconstructed from information on past transactions should compare like with like. This perhaps leads to the conclusion that the default position for commercial valuation is the quarterly in advance basis. Where provisions as to payment differ between the comparables and the interest to be valued, any necessary adjustments should be made to ensure that the information used is appropriate.

Effective and nominal yields The formula on which the yearly in arrear years’ purchase is based employs a nominal yield reflecting the total income received during the year but with no addition for interest for the reason that if the rent is paid at the end of the year there has been no reinvestment during that period. By contrast, where rent is paid quarterly in advance, it is assumed that as each payment is received it is reinvested and the formula should reflect that change.

Valuation formulae 47 Income received in arrear can be described in terms of the effective yield by the following adaptation of the basic years’ purchase in perpetuity formula 1/i as follows: Yield (e) is (1 + i/p)p –1 see figures and formulae (7 Figure 3.25) where ‘p’ is the number of times the income is received and reinvested during the year It will be seen that where the rent is received annually in arrear, the basic formula shows the effective yield. Where the income is received quarterly in advance, the nominal and effective yields may be found from: Nominal yield

i = 4[1 – (1–(1+ r)–1/4]

⎡ 1 − 1 ⎤⎥ e=⎢ 4 ⎢⎛ i⎞ ⎥ ⎢ ⎜1 − ⎟ ⎥ ⎢⎣ ⎝ 4 ⎠ ⎥⎦

Effective yield

The following specific formulae apply to years’ purchase: Years’ purchase in perpetuity – quarterly in advance 1 −1/ 4 ⎡ 4 1 − (1 = r ) ⎤ ⎣ ⎦ Years’ purchase for a term: single rate, quarterly in advance 1 − (1 + e )

−n

4 ⎡1 − (1 + e ) ⎣

−1/ 4

⎤ ⎦

And Years’ purchase for a term: dual rate, quarterly in advance 1 4 ⎡1 − (1 + r ) ⎣

−1/ 4

⎡ 4 ⎡1 − (1 + s )−1/ 4 ⎤ ⎤ ⎦⎥T ⎤+⎢ ⎣ ⎦ ⎢ (1 + s ) n − 1 ⎥ G ⎢⎣ ⎥⎦

where ‘r’ = effective rate and ‘s’ = sinking fund and TG = tax rate on sinking fund

48

Valuation formulae

Should the valuer continue to use published tables it should be clear that the three main ones differ in their treatment of the reinvestment of income. Parry’s tables assume that rents received during the year are re-invested at the time of their receipt and at the same annual rate of interest. Bowcock’s tables allow for the credit of interest twice yearly; the intention is to make the overall return more closely comparable to that received on other forms of investment such as stock and shares. Rose’s tables are based on an assumption that interest is added yearly. In the values produced in this publication, it is stated that the risk rate is determined to reflect the fact that the investor can invest the payments as they are received at such a rate of interest that the total accumulated interest received during the year will provide the risk rate required. Perhaps reflecting the uncertainties, the Investment Property Forum (IPF) has produced a set of conversion tables. It will be seen that there is no unanimity of approach, requiring the valuer to conclude the most likely reflection of the investment market. In any negotiations, valuers should establish the basis of all calculations. Greater detail is not within the scope of this introductory text but a simple valuation of a rack rented property, ignoring costs of purchase, is shown in Example 3.16 to compare the use of formulae. Example 3.16 Freehold retail premises have been let recently on lease on full repairing and insuring terms at a rent of £100,000 per annum, payable quarterly in advance. There is provision for upward only rent reviews at intervals of five years. Prepare a valuation to show a yield of 7 per cent. Traditional approach: £100,000 × YP perpetuity yearly in arrear (14.2857) = £1,428,570 Parry’s QIA table: £100,000 × 14.9054 = £1,490,540 Bowcock’s table: £100,000 × 14.6596 = £1,465,960 Rose’s QIA table: £100,000 × 14.5547 = £1,455,470

Commentary These results demonstrate the differences in approach and assumptions. They also underline the need to determine the basis on which any quarterly in advance valuation is constructed.

Valuation formulae 49 IN ARREAR Yield %

Yearly

Quarterly

IN ADVANCE Yearly

Quarterly

4

25

25.373

26

25.6219

5

20

20.3716

21

20.6212

6

16.67

17.0381

17.67

17.2871

7

14.28

14.6559

15.28

14.9054

8

12.5

12.8694

13.5

13.1190

9

11.11

11.4795

12.11

11.7294

Figure 3.3 Typical effective yields where payment is in advance or arrear

True equivalent yields The additional space required to offer more frequent intervals meant that only some of the more used rates are shown in this way. So even with the information available, some valuers would continue to use the tables based on yearly rests and suggest that the difference was insufficient to justify a change in approach. With electronic devices now readily available, the only justification for not adopting the true payment interval regime is the issue of comparability. When sales information is found, it is not necessarily complete and some details may be the subject of a confidentiality agreement with the result that there is no conclusive evidence of the basis of the sales history divulged. This is an important consideration when relying on comparison. Most major commercial transactions are now analysed in this way and analysis on this basis could be supported. The statistical and other analyses provided by major research groups such as IPD and a number of the large national and international professional concerns together offer more insight into the market than ever before. The major firms and some others adopt quarterly in advance in their valuations as the default position. Until relatively recently, valuations were made on the basis that rents were receivable yearly in arrear – whether or not that was the case – largely due to the inability of any set of valuation tables of reasonable size being able to offer other payment profiles over the same range of yields. It may be argued that valuation by reference to market evidence where that evidence is analysed on the basis of receipts annually in arrear gives an appropriate result. Whilst this is so, where the analysis of comparables and the valuation are both treated on the same basis, it is uncomfortable to accept that the very basis of the comparison may be seen as flawed in that it does not accord to the actual circumstances of the transaction. With the availability of current technology the valuer is no longer restricted to sets of printed tables. Wherever possible, analyses and subsequent valuations should be made on the actual basis of the transaction. It is important that information from transactions and use in valuations are on the same basis, that is, either annually in arrear or another basis reflecting the actual payment provisions.

50

Valuation formulae

An example of the calculations required to reflect payment of rent at intervals on other than the traditional basis of yearly in arrear is as follows: Given the nominal (annual) rate of interest per annum, the effective rate where rents are payable quarterly in advance is given by the following formula: ⎛ 1+ i ⎞ e =⎜ ⎟ ⎝ m ⎠

m −1

where e is the effective rate i is the annual (nominal) rate of interest and m is the number of payments in one year. Figure 3.4 Effective rate where rents are payable quarterly in advance

Example 3.17 What is the effective rate of interest on a rent payable quarterly where the annual nominal rate is 8 per cent? 4

i⎞ ⎛ The effective rate is ⎜ 1 + ⎟ − 1 4 ⎝ ⎠ which is (1+0.02)4 – 1 = 1.0824 – 1 = 0.0824 which is 8.24% with a years’ purchase in perpetuity of 13.1190 (nominal [yearly] rate is 12.5)

Therefore, where rent is received quarterly in advance the years’ purchase in perpetuity at 8 per cent is 13.11901 whereas the nominal rate is 12.5 years’ purchase. For completeness, where payments are made yearly in advance the formula is (1 + i)/i. (The relationship to the annual in arrear result is that yearly in advance will always be greater by one [unity] since the first payment is received immediately the lease commences.) The following formulas enable income flows to be valued on the actual basis of receipt:

Valuation formulae 51 Years’ purchase in perpetuity – annually in arrear 1/i Years’ purchase in perpetuity – annually in advance (1 + i)/i Years’ purchase in perpetuity – quarterly in advance ((1 + r )-n)/4 [1 – (1 + r) –1/4] Years’ purchase for term – annually in arrear (1 – (1/(1 + i)n )/i Years’ purchase for term – quarterly in arrear 1/4[4/1 + i – 1] Traditionally, calculations in Parry’s and other valuation tables were based on the assumption that rents were received yearly in arrear although later editions contain some results based on receipts quarterly in advance. Today, commercial lettings are invariably granted on leases providing for payment of rent to be quarterly in advance. The printed valuation tables now provide some information on this basis although the demands on space limit the extent and range of those provided. Where the valuation is made on a yearly in arrear basis whilst the actual letting terms are different, the rent or interest is referred to as a nominal yield, whilst calculations reflecting the actual letting terms show the effective yield. The earlier and more frequent payment of rent enables earlier reinvestment and potentially a greater accumulation of interest. It is likely that an experienced investor would be surprised to find that the yield on which the investment was acquired did not reflect the true position. At least, the valuer should be in a position to advise as to the effective yield if asked. The standard response of the average valuer would be that there was no error because the valuation was based on the analysis of sales of similar investments where the same assumption was used. Whilst there is some merit in the argument, it must surely be preferable to prepare any valuation on the actual basis of the letting. The market is not wholly transparent, although much more information is now publicly available than was once the case. But whichever approach is used, the valuer must value in the same way that the transactions were analysed. In the absence of full information regarding the comparables used to determine the yield, it may be that the analysis assuming the payment of annual rent in arrear must prevail. The major parts of any printed valuation tables use one year as the interval between the receipt of one payment and the next. Even when quarterly payments and particularly those quarterly payments in advance became more common, not all valuers responded by changing the basis of the years’ purchase calculation. Such a change would be reliant on analysis of sale transactions being deconstructed in the same way which is only possible if all the relevant information is available. The additional space required to offer more frequent intervals meant that only some of the more commonly used rates are shown in this way. So even with the information available, some valuers would continue to use the tables based on yearly rests and suggest that the difference was insuffi ficient to justify a change in approach.

52

Valuation formulae

The only justification for not adopting the true payment interval regime is the issue of comparability; the precise letting terms of some comparables may well not be known. This is an important consideration when relying on comparison. Some elements may be subject to a confidentiality agreement although the basic information can be found in public records. The statistical and other analyses provided by major research groups such as IPD and a number of the large national and international professional concerns together offer more insight into the market than ever before. It is the case that most major commercial transactions are now analysed on the basis of the effective yield. Most major professional firms and, increasingly, others adopt quarterly in advance in their valuations as the default position. Where payments are due quarterly in advance or at any intervals departing from the assumption of yearly in arrear, the formulae should be adjusted to reflect the position. There is one caveat embraced in the edict: that ‘as you analyse, so should you value’. This is an important rule as otherwise, like is not being compared with like. Formulae may be adjusted where required. It may be that a particular format will be followed simply because insufficient details of the analysed transactions are available to refine the detail.

Contemporary approaches An alternative approach to the long-standing one based on using an all-risks yield as outlined above is to use discounted cash flow (DCF) involving the forecasting of future rental trends with the presumption of a sale at the end of a specified holding period. This route is explored in detail in Chapter 6.

Note 1

From Parry’s tables

4

The comparative method

Introduction Comparison is the basis of one of the five principal methods of, or approaches to, valuation. It is likely to play a part in most valuations, sometimes alone but often in conjunction with other tests and techniques. It may be described as the basic approach to the valuation of property, the valuer being required to review the available evidence of recent transactions, to analyse it as far as possible and then to relate any results to the property being valued, making allowances for differences identified. It may be used as a method on its own or to provide some guidance in combination with other valuation methods. The guiding principles of comparison were well set out by Forbes J. in the case of GREA Real Property Investments Limited v. Williams (1979) when in the course of his judgement he said: It is a fundamental aspect of valuation that it proceeds by analogy. The valuer isolates those characteristics of the object to be valued which in his view affect the value and then seeks another object of known, or ascertainable, value possessing some or all of those characteristics with which he may compare the object he is valuing. Where no directly comparable object exists the valuer must make allowances of one kind or another, interpolating and extrapolating from his given data. The less closely analogous the object chosen for comparison, the greater the allowances which have to be made and the greater the likelihood of error. The only comment to be made is that the valuer seeks as many comparisons as possible in attempting a fair reflection of the market rather than the single object referred to in this extract from the judgement. Following that insightful account, it is worth exploring the process in some depth. Dictionary definitions include: •

compare: to examine so as to perceive similarity or dissimilarity (the noun being made up of the Latin com (for together) and par (meaning equal)

54

The comparative method

• •

comparative: almost but not quite; estimated by comparison comparison: that which in its relation to something else serves as an example or illustration.

Comparison implies the need for critical examination to divine the level of similarity or dissimilarity of each separate object so as to discover the extent to which there is comparability. It is pursued by: • • •

analysis: the resolution of a compound into its parts or elements interpretation: to give the meaning of; explain; to construe; decipher; elucidate; define; embody ideas or facts application: relating and applying the information gained to the property under examination.

With regard to real estate, the valuation process involves taking the conclusions of the examination of other transactions and then weighing the components to the extent that they appear to affect any element in the build up to market value. Having isolated and further analysed all aspects of the earlier transactions where some comparisons may be possible, the valuer must proceed to interpret the information in a way that is relevant to the valuation in hand. A prospective purchaser often has a broad specification of what would be a suitable property for purchase whilst remaining open to the range of properties available, any one of which may be able to meet the criteria. The extent to which the information is significant depends to some extent on the method and purpose of valuation; the reaction of the market is almost always a feature of value. Such an approach is a normal activity for anyone wishing to make a purchase. A motorist seeking a new car or a household deciding to replace a bedroom suite will search the market and make a decision based on price, utility, convenience and personal preference, and all these aspects will play a part in the eventual decision with the caveat that the selection is much smaller in the case of property where the choice will be based on what is available and on the market for sale at that time. Should there be nothing meeting the purchaser’s particular specification the next best option may be chosen or the search delayed pending other property becoming available on the market. Suffice to say that each difference will offer a different perspective and may lead to an adjustment of the price bracket and compromise within which the particular purchaser would be prepared to proceed. To a greater or lesser extent, the principle of comparison has a bearing on and contributes to each method of valuation and is therefore fundamental to any consideration of value in respect of most property interests. The exceptions tend to be where there is no commercial transaction involving transfer of property, such as the assessment of rebuilding and associated costs for insurance purposes. The question of comparison where property is involved is less straightforward than comparing stocks and shares. In regard to the latter, each has the same characteristics and rewards, whereas every property is unique and the investment profile will relate not only to the buildings on the site and the use to which they

The comparative method 55 are put but also to the tenure, background of any lettings, the status of the current tenant, the precise way in which the premises are used and the prospects, if any, for enhancement. The examination will identify whether, and if so to what extent, the similarities and differences may be taken into account in using recent transactions as a guide to the value of a property. When considering real estate, whether for investment or occupation, only limited information will be available; each property is unique. In particular, prospective purchasers of residential accommodation for occupation will react differently to the various features in ways that may not be rational. Details of recent transactions are now much more accessible through the Internet, the Land Registry and public records generally, although it is some time before information is recorded and available. Often, the level of detail is limited. Recent market information should be preferred. In normal circumstances, the older it is, the more questionable will be its current relevance. Where the market is relatively inactive, any evidence should be examined carefully. Some types of property are valued by direct capital comparison, that is to say by looking at a range of sale prices for similar properties obtained over the recent past, relating the features to those of the comparables and determining a capital value from the information available. Principal among them are residential properties where the valuer normally refers to capital values. In other cases, the capital value will be arrived at by finding rental values from lettings of similar properties and then applying a yield derived from analysing sales where rental information and lease contents are available. The profits and residual methods use some elements of comparison although they are of less prominence, whilst the contractor’s method is more related to cost so that building cost indices provide the main input. The first task therefore is to find similar investments that have been sold in the open market in recent times and to make detailed comparisons. The valuer then isolates those parts or elements which bear comparison and examines them to assess the extent to which that information may be relevant. In other words, the evidence must be examined and tested to the point where it can be classified fi as comparable. Some information will be discarded as not sufficiently persuasive. In each case, it is necessary to record the calculations and relevance of each piece of evidence relied upon in the construction of the new valuation so as to establish a confidence level; then before finally affirming the output, the degree of confidence in each may be revisited before signing off the valuation. All comparables considered should be listed to show why some information has not been relevant or not sufficiently persuasive to rely on in producing the current valuation. There will be divergence for a number of reasons: the valuer may estimate the current rental value at a different figure from another valuer; the effect of the terms of the lease may be interpreted differently and a property regarded by one valuer as a reasonable comparable may be discounted by another valuer for various reasons – it may be considered to be in a different area for comparing rents; there may be differences in layout or age of the property which are regarded

56

The comparative method

differently, or the longer-term benefits may be seen in a different light. But although in a valuation of a normal investment there may well be components where differences show themselves, it would be expected that the overall capital values would be within a range of 5 to 10 per cent of each other. A prospective buyer who has a particular reason to purchase not possessed by others in the market (sometimes referred to as a ‘special buyer’) can normally outbid the ordinary buyer. For example, the owner of an adjoining property who saw elements of added value by combining the properties, or at least their sites, would be prepared to pay a premium to secure the premises although this would need to be only one bid above the next highest bidder. This is not part of the value of the property because the adjoining owner may not have any intention to purchase the site or may not be in a position to do so; the additional value can only be justified by the owner of the adjoining property taking into account the marriage value of the transaction. When there is enough information to determine current rental value and yield, the valuation is completed by use of the investment method, various aspects of which are described in Chapters 5 and 6. In each case, it is necessary to record the calculations and relevance of each piece of evidence relied upon in the construction of the new valuation. All comparables considered should be listed to show that some information has not been relevant or not sufficiently persuasive to rely on in producing the current valuation. Valuations of investment properties for commercial use are based on comparison of rental values and current yields. Some of this information will be available from comparison of recent transactions; yield will also be influenced by wider factors. The results of analysing recent transactions can never be wholly conclusive and should be treated with some reserve. Part of the valuer’s task is to show the relevance of the information derived from other transactions and that it has been applied appropriately. To arrive at a comparison, the valuer will select similar properties sold in recent times, analyse the sales information and then interpret the information collected in a way in which it can be applied to the subject property. This is the most difficult of the three stages because interpretation is a matter of opinion. It will be appreciated that valuation is not a precise pursuit; there is considerable scope for genuine differences of interpretation between valuers, the importance and relevance of individual aspects being rated differently. It is unlikely that the valuer will have first-hand knowledge of all the transactions referred to and a level of judgement or informed speculation is often involved. An unexpected high or low outcome should not be taken at face value without further enquiry; there may have been extensive structural work necessary or a need to sell before a particular deadline, either of which could have a depressive effect on value. There are differences between comparing transactions in the residential area  and those in the investment area significant enough for them to be described separately.

The comparative method 57

Residential property for owner occupation The purchase of residential property for owner occupation is an example of the comparison being made almost exclusively by reference to capital values. Houses acquired to be let as investments and various types of commercial investment properties are valued by the investment method, usually by finding rental values and current yields from inspecting the records of recent transactions, using that information in an investment valuation. A recent tendency is to refer to capital value per unit of floor space in London and other high-value locations. Whilst there are many distinctive one-off residential properties, much of the housing stock built during and since the Victorian era has followed one of several basic designs. Some builders are prepared to incorporate variations during construction but more often an estate comprises groups of houses based on typical plans. Many are subsequently altered to suit the requirements of the occupier, which may or may not have an effect on value. Common changes include combining two reception rooms to achieve a larger single room, providing an additional bathroom, extending the kitchen, adding a conservatory or converting the garage to additional living accommodation. Together with aspect and location, these changes are likely to result in a range of capital values and offer a challenge to the valuer as to whether additional value is created. Location and accessibility Occupiers have different priorities according to their commitments, needs and preferences. A family with young children may prioritize easy access to schools and shopping facilities whilst retired couples may opt for village living, thereby forgoing the convenience of everyday facilities on the doorstep. Older people may eventually consider purpose built units, so called granny flats or a care home. Even within the main groups, there will be differences of choice. The sum total of these requirements will determine demand. Aspect Both the immediate outlook and the siting of the building will influence enjoyment of the space; to be in a cul-de-sac offers limited traffic and some seclusion, although occupying a house at the end of the cul-de-sac may result in unwanted vehicles turning with the associated activity and noise. On the other hand, a busy road is accompanied not only by traffic but difficulties of entering the road at peak times and possibly restrictions on roadside parking. Site conditions and surrounding influences fl A steep site or one overshadowed by natural features or buildings will have its drawbacks. The valuation does not include a structural survey but the valuer should have a basic knowledge of construction and enough local knowledge to be

58

The comparative method

aware of flood plains and other areas susceptible to heavy rain, to made-up ground and to areas where the subsoil has shown indications of movement or slide in the past. Tenure Information on the tenure of any property should be provided in instructions to the valuer; the majority of residential property is of freehold tenure. Where it is not provided, any assumption should be stated to avoid uncertainty. Some freeholds are subject to rent charges. The value of leasehold properties is sensitive to the unexpired term of the lease, the annual payment made to the landlord and the conditions imposed by the lease including any terminal responsibilities. In interpreting these liabilities, the valuer may rely on terms contained in the lease and any report should be presented on the basis that certain assumptions have been made and that they should be the subject of legal advice. Property specific The age, method of construction and current condition will all influence a prospective purchaser. There may well be physical defects or elements of design or construction which are not very satisfactory but which could be remedied, although any necessary expenditure is likely to be reflected in offers made. In the extreme case, the property may be so far outdated in terms of design or use that the only viable approach is redevelopment. It would normally be wise at least to make initial enquiries of the planning authority as to what would be acceptable on the site as any restrictions are likely to be reflected in the eventual sale price. Where purchases are for owner occupation the emphasis is on capital value. The average prospective purchaser probably has a preferred area and some knowledge of recent transactions in that area. The area may be one of several possible locations under consideration or there may be a strong desire for a house in a very precise area. The valuer will be aware of the general demand and also of any particular reasons for elements of that demand, although not all demands will convert directly into a higher price; for example, additional space at the side of the house for the erection of a second garage may have only a modest effect on value whereas a unique open view of a distinctive range of hills may be greatly appreciated. Example 4.1 You have been instructed to inspect number 27 Longwood Row and give advice on the strategy for a sale in the near future. There are some 36 houses in the culde-sac, all but two being similar semi-detached units built about ten years ago with three bedrooms and two reception rooms; some have had structural alterations. Table 4.1 lists six recent transactions with details of any major changes to the original plan.

The comparative method 59 The street runs east to west. The even numbers face south and have gardens backing onto a strip of woodland with agricultural land beyond. The odd numbers have slightly wider frontages. Number 6 is the only detached house for which sales information is available. Table 4.1 Comparison of houses in Longwood Row House House type no. 27 6 14 21 22 26 33

Semi-detached Detached Semi-detached Semi-detached Semi-detached Semi-detached Semi-detached

Bedrooms Reception 3 3 4 3 3 4 3

2 2 2 1 2 1 2

Garage

Sale price

double single double (through) space double (through) single (& cons.) single

to advise £345,000 £360,000 £315,000 £340,000 £335,000 £310,000

Months ago 6 4 7 2 5 4

Commentary The sale price of number 6, the detached house, is not the highest price in the schedule. The value of a detached house is somewhat limited where most of the properties in the close are semi-detached. Neither does a second or double garage appear to make a marked difference; the results for numbers 14 and 26 would suggest that a fourth bedroom is in demand. The even numbers probably sell more readily because of the outlook at the rear; the results suggest slightly higher prices on this side.

Residential units purchased for letting purposes For the major part of the twentieth century, rents of dwellings were controlled and the landlord was subject to other restrictions with the result that few properties were purchased for letting, whilst landlords would tend to dispose of any property once it became vacant. There is now a relatively free market for letting residential units and the sector is flourishing. It appeals to those of relatively modest means wishing to invest in real estate. The main attractions of any investment are the financial return and the ease of management. Quite often houses purchased for letting require repairs and improvements to make them suitable as investments and ongoing maintenance will in general fall on the landlord; the cost of any initial work should be investigated thoroughly and the time element forecast as nearly as possible, bearing in mind that no income will be received until the work has been completed and a tenant found. The task of management should not be underestimated; quite often tenancies last for only a fairly short period and each new letting incurs fees and costs of advertising, added to which the property may be vacant for some weeks or months and may need refurbishment. Although ongoing professional management is expensive because of the detailed attention

60

The comparative method

required, the landlord is relieved of direct involvement; a sound agent will carry out the duties diligently. Should the property remain empty for six months, council tax may become payable. Where purchases have been financed by loans, it is essential that funds are available to make mortgage payments even though rent payments have ceased for the time being. Most landlords or their agents take a deposit against damages or unpaid rent; it is important for the deposit to be held in an approved tenancy deposit scheme under the provisions of the Housing Act 2004.

Commercial investment properties The remainder of this chapter is devoted to the various types of commercial property likely to be valued by the investment method based on aspects of comparison. In the case of retail units, valuers may compare rental values by using a system of zoning which will be explained.

Retail units A trader will evaluate any retail shop premises on the basis of how well the location will support the proposed business. An estimation of turnover will enable the trader to explore whether the resulting gross profit after payment of rent will be sufficient to meet all the expenses of purchasing stock, staffing and overheads and leave a satisfactory net profit. Retail shop rents reflect the retailer’s assessment of the trading potential of the location. The fundamental benefit of shop premises is that they provide a visual statement to the potential customer of what the trader offers. Location is all important as is the relationship between frontage and depth. The frontage is essential; the depth required varies with different traders but at some stage each trader will have sufficient space; further space is then unlikely to show an economic return. The nature and quality of adjoining and nearby retail units are likely to influence rental values. The would-be tenant of a retail unit is seeking a prominent position in a collection of shopping units providing a critical mass to attract would-be customers; the shopkeeper may be a baker, a newsagent, a jeweller, a fashion retailer or any other trade found on the main street. Some are visited on a daily basis, some at regular intervals and others irregularly and often at long intervals. Some purchases are on a whim which may be the result of being attracted by a window display. Some shops act as a magnet and other shopkeepers will wish to open next or near to them, which is likely to have the effect of raising the rent level. The best, now historical, example was the Woolworth’s store, which was regarded as the beacon of the street in which it was located; the rents of adjoining shop units peaked, trailing off as the distance from the main shop increased. The traditional high street location has been displaced to some extent by alternative provision: retail parks, covered shopping centres, out of town and regional shopping centres. In the worst cases, the traditional main street has vacancies,

The comparative method 61 short-term lettings with frequent changeovers and a profusion of charity shops. Meanwhile, online selling has developed where a wider range of goods may be sold at lower prices and delivered. The retail market is in a state of flux, even with suggestions that some rows of shops may be converted (or changed back) to living accommodation. The basis of any rent used in analysis should be investigated. In the case of newly built premises, it is usual to offer a shell for the tenant to complete at his expense, although where the shop has been occupied previously, much of that work will have been done. The tenant may have been given an extended rent free period as an incentive to take a lease. The rent review pattern may vary; a long interval between reviews may have influenced the original negotiations. The approach of the valuer is to taper the unit value as the depth increases. A system of zoning was developed in the 1930s. At the time, a standard shop unit had a frontage of 20 feet and an overall depth of 60 feet: the metric equivalent is taken as six metres and 18 metres. In that case, each zone would have a depth of six metres. (The Valuation Office Agency uses a slightly more accurate conversion of 6.1 metres). Other depths are established as the norm in some localities. The first zone (that space immediately behind the frontage) is referred to as Zone A, followed by zones B and C and possibly D according to total depth and to what appears appropriate in the particular location. The space is then assessed in terms of Zone A (ITZA), with each unit in each successive zone being worth half of a unit in the preceding zone. Zoning is widely used in the assessment of rental values in the open market; it is also applied by the Valuation Office Agency in making comparisons of lettings for the purpose of determining business rates assessments. Example 4.2 Figure 4.1 shows the outline floor plan of a shop having a frontage of eight metres and a depth of 21 metres. The following analysis in Table 4.2 is shown on the basis of three six-metre depths and a remainder of three metres. The premises were let recently on full repairing and insuring terms (FRI) at a rent of £37,500 per annum. An alternative analysis shows the use of four depths, where the remainder (Zone D) has a depth of only three metres. Zoning is applied to the ground floor retail trading area or to what could reasonably be regarded as the retail area. The specification of the property at the time of letting and the extent of the demise should be checked to confirm the area to be measured. Any retail trading space on upper or lower floors would normally be included at a reduced unit rate (usually related to but less than the Zone A rate). Any provision by which the floors can be reached more easily, for example, a ramp or a moving staircase, may influence the rental value on subsidiary floors. It is not always appropriate to apply zoning in the valuation of retail space. For example, a small unit such as a kiosk typically has a very limited depth and uses requiring

62

The comparative method

3m

D or remainder

6m

C

Zones

21m 6m

B

6m

A

8m Frontage Figure 4.1 Floor plan of a single shop Table 4.2 Zoning calculations Using three zones Zone A B C

Dimensions

8m × 6m 8m × 6m 8m × 9m Totals Zone A unit rate of £416.67 Using four zones A 8m × 6m B 8m × 6m C 8m × 6m D 8m × 3m Totals A Zone A unit rate of £431.03

Area: sq.m.

ITZA

Rent per sq.m ITZA

48 48 72 168

48 24 18 90

£20,000 £10,000 £7,500 £37,500

48 48 48 24 168

48 24 12 3 87

£20,689 £10,345 £5,172 £1,294 £37,500

Note: The number and depth of zones would be dependent on local practice

The comparative method 63 very little storage space (for example, use for the sale of newspapers and magazines or drinks to take away) must be assessed on its merits. The confined space, probably all likely to fall within Zone A, would be likely to be undervalued if assessed on the basis of the Zone A values of the adjoining properties. Where the shop unit has a frontage to two streets, the zoning principle may have to be adapted. With a standard sized unit and both streets of equal retail importance, it could be argued that the whole of the space could be classified as Zone A. On the other hand, not every trader needs or can use that amount of display area. Where a unit is deeper than would be of economic use to the average tenant it is unlikely to enhance the rental value. Indeed, the additional costs of maintenance, insurance and other outgoings may have an adverse effect. The use of Zone A rates found from the analysis of a series of small shops would be unlikely to be appropriate when valuing a larger nearby shop. On the other hand, it is possible that it may indicate that the unit would produce a higher income if divided to provide smaller units. Example 4.3 Figure 4.2 shows the outline plan of five shop units in a thriving shopping area of a substantial town. Units 1 and 3 are recent lettings whilst units 2 and 4 were let three and two years ago respectively. Table 4.3 sets out the available information.

D

18m

20m

18m

25m

20m

B

Unit 1

Unit 2

Unit 3

Unit 4

Unit 5

6m

7m

7m

Zones

C

A

Frontage to street Figure 4.2 Floor plans of five shop units

8m

6.5m

64

The comparative method

Table 4.3 Shops in Lowe Street Unit dimensions ITZA* Date of letting

Rent

ITZA

Lease terms

1 6 × 18 63 Last month £25,000 £396.83 15 years (5-year reviews) 2 7 × 20 77 3 years ago £29,000 £376.62 10 years (5-year reviews) 3 7 × 18 73.5 Recent £30,000 £408.16 7 years (No review) £34,550 £352.55 9 years (3-year reviews) 4 8 × 25 98 2 years ago 5 6.5 × 20 71.5 To let Advise Purchased for £425,000 Unit 5 is available to let; advise the purchaser on the rental value of this unit. *on basis of 3 zones and a remainder

Commentary Rents have increased over the years and recent lettings confirm that growth is continuing. There is no information as to the reasons for the letting of unit 3 for seven years without review or the three-year review pattern agreed for unit 4. The absence of a review provision in the lease of unit 3 appears to have been achieved without any initial adjustment of rent and is of advantage to the tenant in an area where rents appear to be increasing by 4 or 5 per cent a year. On the basis of the information available, it is suggested that a rent of £29,000 per annum on a FRI lease for 10 or 15 years with upward-only reviews at five-year intervals should be achievable. On that basis, the investor has acquired unit 5 to show a return of approximately 6.75 per cent, justified by evident demand and the record of rental growth. Retailing has been affected by development over the last 25 years. The establishment of supermarkets in or near existing shopping centres has affected some sole traders, butchers, bakers and greengrocers. Shopping centres with good parking, often free, attract shoppers from a wide area, competing with town centre retailing. Purchases over the Internet are often cheaper, offer delivery and widen the choice available. Larger retail chains such as John Lewis in the UK operate in both sections of the market.

Criticisms of zoning methodology Zoning provides one way of comparing space in an attempt to examine achieved rental values. However, there are several criticisms of the process. The main ones are set out below. Artificial process Some critics consider that the zoning process is artificial. It should be seen as an analytical tool of comparison for the valuer, not a decision making tool for the prospective occupier. It is widely used by valuers and depends on the use of actual rental values. There is no compulsion to use the approach. There are other ways of determining rental value.

The comparative method 65 Expected profit determines rental bid Some consider zoning an irrelevance because retailers estimate levels of profit when determining their rental bids which are based on their experience of trading in other locations. By contrast, the valuer is trying to determine the value for a particular unit based on rent levels in the locality. Any subsequent agreement would reflect the nature of the business and so the maximum figure offered would vary to some extent between traders. Where the landlord owns other units nearby, a spread of complementary rather than competing traders will tend to maximize rents. Zoning is sufficiently well established as a tool of analysis for it to be regarded as a useful indicator. Zones are arbitrary The zone depths are arbitrary and the rental value of each zone is not supported by transactional evidence. The zone depths adopted are those considered appropriate to the location and as such they provide a common basis for comparison between retail units. Natural zoning In the case of a parade of identical shops, without other information there would be no point in examining the zoning approach. Whether or not all retailers paid the same rent would be to some extent controlled by the occupants and their trade. For example, a jeweller selling high-value, high-margin goods is likely to be able to outbid a specialist baker, whilst a bookmaker with the benefit of a gambling licence could afford rather more based on some level of monopoly conferred by the licence. Granting a lease to a take-away food shop could maximize the rent but may also limit the number and types of retailers willing to trade in the vicinity. Whether similar positions would suit all the traders suggested is unlikely; shopkeepers in general have a sensitivity about the nature of their trading neighbours. A group of shops may be owned by one company, by individual investors or by individual occupiers. In their different ways they will all have a common interest in a balanced mix of activities which will make for a more vibrant centre.

Industrial Industrial units cover a wide range of buildings. They are compared by investigating the quality of the space offered and its flexibility, which will be reflected in the rental value. Older buildings are increasingly unsuitable for modern activities and require either major modifications or demolition and rebuilding. Transactions should be analysed to determine the market yield acceptable to the investor. Many operations are highly mechanized, with operations computer controlled. A visit to a large bakery or a vehicle manufacturer would confirm the

66

The comparative method

interdependence of the process and the enclosure around it. In most cases, negotiations between the owner and the occupier for necessary alterations to accommodate a change in manufacturing processes would delay progress and be unsatisfactory to both parties. Most occupiers will require some office space although the ratio varies depending on the type of work undertaken. Part of the main building may be used to accommodate the office space, with the height of the main building sufficient to allow two-storey office space (demountable where required). An alternative is to provide the space outside the main building. Example 4.4 A recently developed small industrial estate is in popular demand. Each building has a steel portal frame with steel cladding. Units are available on standard lease terms of 15-year duration with five-year upward-only rent reviews on a FRI basis. Recent sales show a return in the region of eight per cent. Table 4.4 Industrial units: rents and prices Unit

Area

Rent quoted

Rent per square metre

A B C D

465 465 480 480

£25,000 £27,000 £26,500 £26,500

£53.75 £58.00 £55.21 £55.21

Asking price (to yield 8%) £312,500 £337,500* £331,250 £331,250

*includes overhead gantry crane

Table 4.5 Industrial units: outcome of negotiations Unit

Area

A B C D

465 465 480 480

Rent achieved Rent/m2 £23,500 Available Sold £25,000

Sale price

£50.54

let

£52.00

£275,000 £305,000

Return

Sold Approx. 9% Let and sold Approx. 8.20%

Commentary The landlord has been flexible when offers have been received. Unit A is let at a rent slightly under the target. Unit C has been sold at below the investor’s required yield; on the other hand, it has released capital. Unit D has been let and sold; presumably another investor has been satisfied with the development – the yield on this sale is 8.25 per cent; it should be noted that the asking rent was reduced during negotiations. The continuing availability of Unit B suggests that the inclusion of additional specialist features should be avoided.

The comparative method 67

Retail parks Many larger companies have found it impracticable to locate in the traditional retail location for a number of reasons, including cost. Their requirement for display and storage makes such space expensive and not convenient where large goods are stocked, either for delivery or collection. Many companies have grasped the opportunity to locate in larger space away from the traditional shopping area, in premises that are little more than substantial ‘sheds’. In the UK, operators such as B&Q, Dunelm and Argos together with many well-known supermarkets have been attracted to well serviced sites away from congested central retailing districts. In such locations there tend to be fewer restrictions, longer trading hours, adequate free car parking and easy access. In the UK some of the early planning permissions granted approved the building without limiting the maximum sales area created; the overall size of each building was intended to avoid domination by one trader. However, without any specific restriction, some traders have created upper storey space, affecting the intended balance of the site. In the process, the trader has been able to increase the capital value of the unit.

Offices Office accommodation can vary greatly. It may be provided above retail premises, in a converted house or a purpose built modern office block and either let in suites or occupied wholly by one company. There are various types of office property: city centre office properties may be let as a whole or in separate parts, whilst small office suites within a building may be designed to be let to a series of individual occupiers. Different methods of measurement apply to office blocks in single occupation and those let in suites as set out in the RICS Code of Measuring Practice. Some city centre office accommodation is located in premises originally intended for other purposes but which have been converted to office use because the demand for offices exceeds that of dwellings in that situation or that the area is no longer a pleasant place in which to live. Especially in smaller conurbations, the demand for office space can be satisfied in an area convenient to the commercial centre where supporting facilities exist without the need for new construction. Well converted space can be very attractive, but by reason of the original design it is often not possible to let it on a full repairing basis, therefore requiring the provision of maintenance, repair, insurance and possibly cleaning to remain the responsibility of the investor. Such an arrangement is best funded by a service charge, with quarterly payments in advance on account, any shortfall being collected on the presentation of accounts at the end of the year. Some tenants prefer purpose built premises on the fringe of the centre or edge of town where onsite parking is available and there is ready access to and from major roads and the public transport system.

68

The comparative method

Unit rents of multi-storey buildings tend to be highest on the ground flfloor although the difference may be mitigated by the provision of adequate lift facilities. Private car parking provision for staff and clients is an important consideration. A distinction should be made between purpose built and converted offices. The purpose built office will be equipped with up to date facilities such as lifts, staff and visitors’ wash rooms and the accommodation of modern technology. Some occupiers are drawn to fully occupy the complete office block if its design, specification and location add to the prestige of the occupier’s business. Conversions of architecturally attractive houses for office purposes may appeal to tenants such as architects, solicitors and accountants. In the UK, buildings of this nature may be listed, carrying limitations such as a restriction on external advertising and a more detailed planning procedure prior to any alterations to the building sometimes leading to delay. The costs of maintenance and upkeep are likely to be higher than those of a modern property. Example 4.5 Office premises You have been instructed to value Onyx Court, a well-designed office block having a floor area of 1,250 square metres completed three years ago and let to a major public company for a term of 20 years on a FRI lease at a rent of £210,000 per annum. There is provision for an upward-only rent review every fifive years. You are aware of the letting of Corian Court, a recently completed nearby office block, having a floor area of 1,500 square metres. It has been let on FRI terms to a major bank for the processing of credit card operations. The lease is for a term of 15 years with upward-only rent reviews at five-year intervals. The agreed rent is £310,000 per annum. The freehold interest was subsequently sold for £5,150,000. First, analyse the letting and sale of Corian Court – 1,500 square metres. Assume that space has been measured in accordance with Code of Measuring Practice. Rent £310,000 equivalent to rate per square metre of £207. Sale price of £5,150,000 equivalent to approximately 6 per cent all risks yield. Valuation of Onyx Court – 1,250 square metres. The rent of £168 per square metre is below the current rental value of £207 per square metre shown by Corian Court. Next review in two years’ time. Valuation next two years – Current rent £210,000 Years’ purchase 2 years at 6% 1.8334 Reversion to – Rental value at £207 per square metre £258,750 Years’ purchase perpetuity at 6.5% deferred two years 13.5640 capital value

£385,014

£3,509,685 £3,894,699 Say £3,900,000

The comparative method 69 An inspection might well confirm that Onyx Court is superior and would justify a slightly higher unit rent. Apart from size, the two properties are very similar and would sell readily to major investors. The term and reversion valuation for Onyx Court is on the basis of equivalent yield; there seems little justification for applying a lower yield on the term element of the valuation.

Science parks Science parks have emerged in more recent times and typically comprise a site on or beyond the edge of a town or city and developed with a variety of buildings suitable for high-end research and experimental work where there may be a link with the local university and often an element of interaction between the firms based there. It may take some time before the site is fully developed to reflect the importance of achieving a level of synergy among the occupiers. Some of the best examples of this category have an emphasis on light airy working conditions and a low-density landscaped site.

Business parks Groupings of modern office buildings, often single storey or low rise, provided with ample parking and pleasant landscaping have been developed to cater for commercial office tenants. Rents are often below city centre levels, reflecting the much lower land costs incurred in this type of development.

Warehousing Warehouses were originally built by manufacturers as a storage space for goods produced and awaiting sale or by retailers for back-up supplies. In either case they offered advantages of stock control and efficient delivery of items required. Most were sound but basic structures. Some companies had larger premises; tobacco and wine importers use what are known as ‘bonded warehouses’, enabling them to store stock pending the final stages of preparation for sale, the great advantage being that excise duty is not payable prior to the stock being removed from the warehouse. This concession represents a valuable saving for the tenant in terms of working capital. In more recent times, some aspects of warehousing have taken on a much greater sophistication aided by the widespread use of containers delivered from portside or rail depots for onward transmission to distribution hubs strategically placed in various parts of the country. Another recent development is the provision of service warehouses where the business provides a comprehensive logistics service to include transportation, warehousing, cross docking, inventory management, packing and freight forwarding packaging and delivery of goods at short notice to a range of businesses or end users. The widespread purchase of goods over the Internet has greatly increased demand for these services.

70

The comparative method

Specialist properties Beyond the main parts of the commercial sector there are other, more specialized uses such as hotels, public houses, care and nursing homes, petrol filling stations, cinemas and similar where the emphasis is on the ability of the site and the business carried on to produce a profit to which the capital value is related. This class of business is usually without evidence of similar transactions and the valuer resorts to a consideration of the accounts in a profits method approach which is described in Chapter 9. A further category comprises properties such as redundant churches, town halls, schools, gas works, hotels, petrol filling stations, cattle markets and similar holdings which do not normally come onto the market; when they do it is probably because they have become superfluous in their original use. Any sale therefore tends to be on the basis of the value for some other use following adaptation of the buildings or for redevelopment with suitable planning permission obtained for the site.

Land Single plots of land probably in or near largely built up areas and for residential or commercial development can probably be valued by comparison with recent sales transactions, which in turn may enable the valuer to determine a price per square metre. In such a case, it should be possible to make a fairly straightforward comparison between the cost of purchasing a completed building and of developing a site to achieve the same objective. Areas of land away from cities with no obvious alternative use and without planning permission for redevelopment are difficult to value on a unit price basis. A starting point is to consider agricultural value. Where this is not applicable, it may be possible to assess a site value using a cost-based method as described in Chapter 9. The method involves identification of a possible use, the capital value of the completed development from which the total costs and developer’s profit are deducted, leaving a balance which is the highest price payable for the site if the predicted costs are to be covered.

Automated valuation modelling Automated valuation modelling relies on records of residential market transactions. The values are generated by reference to valuation reports, Land Registry and other public records, and statistically updated historical records, fused with mathematical modelling and computer logic to produce a result reflecting market trends. It is useful as a generalized first indicator but does not reflect the information available from an inspection and so makes assumptions as to comparability and condition. Despite the limitations, the information enables a first impression to be formed as a prelude to detailed inspection and investigations.

The comparative method 71 The current main use is initial assessments of suitability for loans; it saves time and may save fees for a prospective purchaser where the indication is that a loan of the required amount would not be forthcoming.

Market information The commercial market is tracked and analysed by a number of organizations and the data and analyses provide useful background data indicating trends in the market. Different organizations monitor various aspects of the property market; some may focus on rental or investment trends whilst others provide in-depth analysis and overview of the market. The valuer may find it helpful to review the available reports in order to gain a sense of the wider market. A great deal of information can now be gathered from Internet sources whilst more detailed and specific information can be obtained on subscription. All these sources provide a useful starting point for the valuer, although the information required to prepare a particular valuation should be identified and validated as far as possible.

5

The investment method – traditional approaches

Introduction Real estate is one of many avenues offering investment opportunities. Unlike stocks and shares, direct investment in property requires substantial sums of money even where part of the purchase price is funded by a lender. Alternatively, indirect investment by acquiring shares in property companies, insurance companies and similar businesses reduces the need for such large capital sums. Decisions on investment in property should normally be regarded as long term because transfers are slow and expensive, and most property units are indivisible. The principal property investors and companies set standards for their holdings and when the particular property no longer meets those standards it is likely to be sold or redeveloped.

The property investment market Where the client acquires real estate for investment purposes, there will be a call on the valuer to advise on suitability, potential, value and sources of finance. The same surveyor may also be asked to take on the task of long-term management of the property. The surveyor as property manager must be conversant with estates and interests; the content of leases and statutory provisions such as planning and development control; and landlord and tenant legislation, consulting with appropriate experts and specialists when necessary. Where the surveyor undertakes ongoing management duties, they are likely to be limited either expressly or by implication; in particular when acting as agent, the surveyor should not assume powers that have not been delegated.

The components of a sound investment Before discussing the detailed approach to the valuation process later in this chapter, it is necessary to consider some background information relating to investment in real estate in general. Every investment has strengths and weaknesses. The investor will decide, on a case by case basis, the trade-off between return and risk and will have regard to

Traditional approaches 73 some fundamental matters in determining which types of investment to pursue whist considering the limitations each presents. The main attributes sought in an investment, which should be considered by valuers in formulating their advice to investor clients, are summarized as follows: • • • • • • • • •

easily and speedily acquired and disposed of, without restrictions on access and with low dealing and transfer costs a positive income flow after taking account of the effect of inflation homogenous and divisible fully defined and documented in demand from other investors minimal management no responsibility for maintenance or insurance costs not politically sensitive potential for an increase in capital value.

The above attributes are not necessarily best found in investment in real estate; the negative effects such as high dealing costs, indivisibility, delay in liquidating an investment and the requirement for management advice all militate against the view of an ideal investment. On the other hand, each property is unique and may offer opportunities for value enhancement beyond the normal receipt of rent; it is satisfying to view one’s investment and there is an element of prestige in property ownership. The absence of some of the qualities for an ideal investment will not necessarily exclude a property from selection, but they offer a good initial guide. The positive attributes set out above are preferred by most investors although each has biases and may specialize in particular ways, thereby pitting their judgement against certain identified risks. For example, an investor might decide to acquire an investment requiring a high level of management, either initially or as an ongoing prospect, but will expect a benefit from that level of involvement and should recognize that there are risks in pursuing such a strategy which may in the end prove unsuccessful. Valuation is a formal process, using whatever market information is available to arrive at an investment valuation of what is a unique holding. Some of the considerations are set out below.

Direct comparison Where sufficient information is available, direct capital comparison of any recent transaction involving a similar property may be possible; this is an approach adopted in valuing residential property for owner occupation where there is usually a wealth of information on sales. With most commercial properties, the similarities are often less apparent. In this event, it becomes more reliable to determine rental values from recent lettings and to derive information on yield ranges from an analysis of recent sales.

74

Traditional approaches

Comparison and analysis Identification of the components required to perform a valuation will vary according to the nature and purpose of the particular valuation. Comparison plays a part in most valuations and is an important aspect of the valuation of investment properties.

Rental value Where the valuation relates to a recent letting, it is essential to confirm the terms of the lease and to consider whether the rent agreed is appropriate. A letting substantially above or below the market level should be noted. Where the property has been let for some time, the rent should be estimated by reference to current market evidence. In the same way, evidence of sales may be analysed to find the yield at which a particular property changed hands. In some cases, direct capital comparison is used, although a check valuation may be carried out using the components of rent and yield. For example, in valuing a farm a valuer will have a value per hectare in mind as a broad guide, but will consider the holding in detail to assess the quality of the farm house and farm buildings to determine its value. The key considerations would be the type of letting if it is occupied by a tenant, the nature of farm activities undertaken, the total area, the quality of the land, the convenience of the holding and its proximity to markets. Farms are usually valued by specialized agricultural valuers and whilst the basis of comparison is set out here this specialized area of practice is not pursued in further detail in this book. Residential properties are usually valued on a direct capital value basis, although there is a recent tendency in large cities and particularly in London to give a floor area and a price per unit. Retail premises are often valued by treating the property as being divided into zones, where each zone away from the front of the shop is assigned a lower unit value (as described in Chapter 4). Investment properties rely for their value on rent, rental value, yield and prospects. Other approaches are examined and explained in more detail in the appropriate chapter. In the case of investments and purchases for owner occupation, the defining principle is that of demand and supply.

Yield The total yield is made up of a risk-free return and a risk premium. The former reflects the yield on those forms of investment that may be regarded as the universal reference point of safe investment. In the United Kingdom that point was once represented by the return on government stock but that is no longer the choice as, in times of significant inflation, the return on such stock, though extremely safe, does not compensate sufficiently for inflationary loss. The risk premium attempts to measure the market response to exposure to a particular level of risk, a measure not easily quantified, especially over an extended period.

Traditional approaches 75 The yield reflects not only annual receipts or interest payments but also any capital growth anticipated on the eventual sale or maturation of the investment.

Return The incidence of receipt of interest payments or rent is important. The interval between payments is important as is the question of whether they are made in arrear or in advance. Earlier payment allows for reinvestment, and true equivalent yields are discussed in Chapter 3. Most investors arrange their holdings by selecting a spread of types of investment where in general the cash flow and the capital accumulation are balanced to suit their particular needs.

Risk and security The ordinary meaning of risk may be defined as the extent to which the outcome diverges from the expectation. The outcome may be greater than expected, which may be an indication of a carefully sourced investment. A relative risk is that the anticipated income is achieved but it has a lower purchasing power than calculated. In addition to being secure, the income should justify the decision to forgo instant access to and use of cash in favour of the longer-term result. One way of limiting risk in property investments is to specify a holding period at the end of which the investment is sold.

Liquidity and divisibility Some investments are more easily and readily tradable than others. To take two extremes, stocks and shares can be bought and sold easily in a day or two at a recognizable price and the account settled within two weeks at a relatively low cost. By contrast, interests in real estate may take some months to find a buyer and some time after that to complete the legal transfer, prior to which time there is no guarantee that the transaction will complete. Until a purchaser has been identified, the outcome of any potential sale of property is in the balance. Similarly, the difficulty of offering investments in appropriate lots in terms of size and attractiveness is more easily achieved with shares than with property, not least because of the limitations of indivisibility on real estate. The further problem with delay is that the market may alter for the worse during the waiting interval, representing an additional risk for the investor. Moreover, meeting an urgent need to raise funds is not readily achieved where holdings are in property that must be sold to generate the necessary cash. Therefore it is advisable for some assets to be held in cash or short-term holdings where there is no penalty for early redemption. Unlike shares, there is not usually the potential to sell a portion of a property, and even where this is possible there remains significant delay before the cash is finally received for the asset. Furthermore, only relatively small

76 Traditional approaches amounts may be borrowed from a bank against the security of property assets although the amount will be further curtailed where a loan already exists. The investor wishing to invest in property but having neither the necessary substantial funds nor the willingness to accept the delays has the opportunity to acquire shares in property companies, many of which specialize in particular sectors of the market. In summary, property is most suitable for long-term investment; constant dealing will erode profits because sale and purchase costs and fees are likely to be substantial.

Management All investments require an element of management. Specialist investments such as property are often entrusted to professional managers unless the investor has the knowledge and capacity to undertake the task. In either case, it is a timeconsuming and expensive undertaking. Property investments can be unpredictable, and unexpected issues may arise from time to time that require prompt and close attention. Accordingly, property management tends to be relatively expensive. At the same time, opportunities for renegotiating leases, acquiring adjoining property, selling land to an owner of adjoining property or changing the use of some premises are all examples of the opportunities where unexpected additional levels of income or capital are found.

Dealing costs When investing in or disposing of assets, the investor should be properly and fully advised. The degree of advice and service varies from one type of investment to another but this cost, whilst discretionary, is usually necessary to ensure a satisfactory transaction; however, expenses such as stamp duty and land tax are unavoidable.

Outgoings Wherever possible, a landlord endeavours to let premises on a full repairing and insuring (FRI) lease. For well-maintained property with a foreseeable future it should be possible to agree such terms with a tenant. In the case of old or neglected premises, the landlord may have to accept that the tenant will try to minimize any expenditure and that the property is therefore likely to deteriorate further. Any provision to require a higher standard of maintenance and repair is likely to have an impact on the rent a tenant is prepared to pay. Premises where the fabric is old and the site is nearing redevelopment are usually let without specific requirements except for basic repairs. In all other cases, it is usually in the interests of both parties to ensure that the premises are maintained. From a management perspective, a full repairing lease where the tenant is responsible for all maintenance is the preferred form. Where

Traditional approaches 77 the landlord remains liable for some maintenance work, it should be borne in mind that the costs are met out of a rent that is fixed for a period, with the potential for reducing the net rent over the term. In some cases the responsibility for repairs and maintenance is split between landlord and tenant, most usually with the landlord being responsible for the structure and the exterior and the tenant for internal work. Where the landlord has responsibility for any outgoings, any valuation should reflect the probable costs year by year. From experience, the valuer is able to make a judgement as to the provision to be made. The following figures give some guidance: • • • • •

External repairs and maintenance: 5 per cent of rental value Internal repairs: 5 per cent of rental value Insurance: 1 per cent of rental value Management: where let on full repairing and insuring terms from 2.5 per cent of rental value Management: where let on internal repairing and insuring terms from 5 per cent of rental value.

Any expenditure by the landlord will be based on current levels but financed from rents fixed for a period. Where buildings are in multi-occupation or where the services are in common use, the landlord may utilize a service charge arrangement, whereby all work is undertaken by the landlord in the first instance and then charged out to each tenant in proportions previously agreed.

Government intervention Any investment may be affected by changes in government policy. Real estate is particularly vulnerable as it is fixed in location, and ownership is registered. Specifically in relation to property, the government may introduce a higher rate of local tax for certain types of property, adding to the costs of occupation and/or ownership. A release of significant amounts of government owned land for development would have knock-on effects on any private land holdings intended for early development. Furthermore, government intervention in property occupation arrangements through new legislation also has a significant effect on property investment because investors gain their return on capital through receipt of rent from occupiers. In the United Kingdom, the possibility of outlawing upward-only rent reviews has been urged and hinted at by the government in recent years. Upwardonly rent reviews are a valuable underpinning for the landlord, particularly for landlords that are pension funds and insurance companies where a level of guaranteed income is desirable in these businesses. It is nevertheless worth noting that both Ireland and Australia have introduced legislation making any such provision null and void. Recent trends in commercial lettings have seen a

78

Traditional approaches

reduction in the length of lease, making this issue less of a consideration. Nevertheless, there is still a fair case to be made for banning the upward-only rent review arrangement whereby the tenant is required to meet any increases in rental value whilst being denied the benefit of a reduction in rent where market rental values have decreased. In England and Wales, discussions between landlords, tenants, solicitors and estate managers have resulted in the production of a voluntary code promoting more balanced lease terms between landlords and tenants. It is entitled The Code for Leasing Business Premises in England and Wales 2007 (Joint Working Group on Commercial Leases) but to date it appears to have had only limited application.

The role of the valuer The role of the valuer is to advise on market value. In respect of its members, the Royal Institution of Chartered Surveyors (RICS) sets out the procedure when instructions are received. Information on the preliminary steps is set out in Chapter 2. Whether or not the valuer is a member of the RICS, the procedure is worthy of adoption, as it is intended to set out clearly the duties of the valuer and the relationship between the parties. The scope and limitations of the instructions are then clear. In most cases, the primary purpose of the valuation is an assessment of the market value of the premises as an investment. Whilst the valuer has regard to the quality and condition, the valuation does not extend to a structural survey and the client must decide whether to commission a separate inspection for that purpose. In some cases the valuation report makes a recommendation to that effect and where a lender is involved, a structural survey may be a prerequisite to any offer of a loan. Once the client has decided to proceed with a purchase, the valuer may be instructed to negotiate the terms and possibly provide a management service in the future. The preparation of a valuation will require the valuer to inspect the property, make any enquiries arising out of that inspection and search out any recent transactions of comparable properties so as to establish the market value. If not already received, details of tenure will be required and where leasehold a copy of the lease or a ‘resume’ of the relevant parts will be required and would normally be supplied by the client’s solicitor. Where the tenure is freehold, any provisions of an unusual nature likely to affect the enjoyment of the property should be made available to the valuer. The valuer is unlikely to have any knowledge of any restrictions contained in any lease or conveyance; such information will come from the client’s solicitor and where interpretation is required, the solicitor usually provides advice. The valuer may also request further information regarding, say, shared access, possible rights of light, boundaries and restrictive covenants. The surveyor is dependent on others to provide information that is not publicly available. In addition, planning enquiries are usually made to confirm the current use and any developments proposed in the vicinity.

Traditional approaches 79 There may be other questions raised by the surveyor following inspection and for which reference to the owner or the owner’s agents is necessary. Where applicable, details of current leases should be obtained, including information concerning rents and other sums payable. The basis of the valuation should be stated and in particular whether the property is being sold with vacant possession or subject to any tenancies. It is also advisable for the valuer to make further enquiries where the lease is silent or ambivalent on any particular aspect; where clear answers are not available, the valuer should state the problem and then value, either on alternative bases depending on the resolution of the enquiries or subject to a particular outcome being confirmed.

The valuation approach A strong core of practising valuers continues to value investment properties using the all-risks yield approach, notwithstanding that the yields used cannot be readily compared to returns available in the wider investment market. However, in terms of property values, there is unlikely to be a better base for valuation than the sale prices of similar properties sold recently. The all-risks yield may be defined as one that reflects implicitly all future benefits and disadvantages of the investment. Specifically, the all-risks yield takes no explicit account of future rental growth, with only current rents and current rental values being used in the valuation. On the other hand, it may be said that the yield has regard to the expectations of the market. Where it is anticipated that rental values will increase over time and where the lease makes provision for rent reviews at regular intervals, there will be an inherent expectation of growth. This is reflected in a lower yield and the level of the yield reduction is dependent on the buoyancy of the market and expectations for the future. In times of recession and over provision of particular types of space the possibility of increases in rents should be viewed realistically. The trends in the property investment market depend on so many events over which the investor has little or no control. For example, the market now accepts inflation as a feature of modern life but there was once a time when landlords were willing to let commercial premises on long terms (21 years and sometimes more) at a fixed rent negotiated at the commencement of the tenancy. Over time the growth in business performance and the consequent requirement for business accommodation fuelled the demand for various types of commercial property. As business and market confidence increased and parts of the property market overheated there was a brief time when upward-only reviews were set at threeyear intervals; more recently there has been a return to five-year reviews and shorter leases. Tenants no longer set the same store in the security of continuing at the same address for long periods. At the time of writing the rate of inflation has averaged an annual rate of about 3 per cent for the last ten years; real growth for the investor would be an annualized increase in excess of the level of inflation, currently a doubtful event.

80

Traditional approaches

The all-risks yield can be derived from any recent sale where the rent paid is the full rental value and the purchase price is known. Where an investor commits say £1,000 to secure an annual return of £60, the clear inference is that the investor considers 6 per cent a fair return on that investment. The initial valuation process is as straightforward as that and cannot be improved where a rack rented investment is involved, that is, one where the rent paid is at market rental level. Nevertheless, the valuer may have some justified reservations where an isolated comparable provides the only all-risks yield information. Where there is more than one comparable and they offer fairly consistent information on yield and rental levels, the valuer has far better evidence of the investor’s market view. The detail of the valuation format will differ according to whether the property is let or available to let and also whether it is let at the market rental value or at a more historic rental level. In the latter case it is expected that the current rent will be below the current market rental value and where that is so, the valuation will take account of the opportunity to increase the rent at some point in the future. But it should be noted that there is no projection of the rental value in the valuation; the rental value that is assumed to take effect from the next review (or the end of lease) is limited to the current market rental value at the date of valuation. The approach to valuation is demonstrated below according to whether the investment is let at full market value or at less than market value.

Freehold investments let at market rental value The valuation of interests for investment purposes is based on analysis of recent market activity. The property market is heterogeneous; it is highly unlikely that any two properties are identical and the site is unique. However, the valuer is able to discern activity and movement in the investment market from continuous observation and investigation. The information is rarely complete and whilst the main details of property transactions are now publicly available through the Land Registry, full information is not provided, or may not be timely, and so certain assumptions may have to be made. For example, the precise terms of a lease – including the frequency of payment; review interval; responsibilities for repairs and insurance; special arrangements such as rent free periods and any onerous provisions – may not be disclosed. For this reason, any additional information available through contacts or other sources assists in ensuring that as much information as possible is reflected in the analysis of the transaction to enable the valuer to be as precise as possible. However, the quality of information acquired in this way does vary and anything that is doubtful should be disregarded. It should be emphasized that as many comparables as possible should be gathered to provide as strong a supporting base of information as possible. In addition, the valuer uses their knowledge and experience to review the evidence and prepare the valuation. The simplest analysis of evidence occurs where a property that is recently let is sold in the open market. In other words, the property can be assumed to have

Traditional approaches 81 been newly let for the highest rent obtainable. After making deductions for the landlord’s outgoings, the initial yield can be calculated quite simply by dividing the net income by the price; the years’ purchase in perpetuity (YP perp) can be found by dividing 1 by the yield. Accordingly, if an initial yield of 8 per cent is calculated then the corresponding years’ purchase in perpetuity may be calculated thus: 1/0.08, giving a YP perp of 12.50. When dealing with property transactions where there is a sale of a property let at market rental value then the years’ purchase in perpetuity is the inverse of the yield. Thus, if an investment has a yield of 7 per cent, the corresponding YP perp is 14.2857 which is 1/0.07; a yield of 6 per cent has a corresponding YP perp of 16.6667 or 1/0.06; and a yield of 5 per cent has a YP perp of 20.0000 or 1/0.05, and so on. The yield at which the premises changed hands is an indicator of the investor’s view of its future prospects. For example, should the rent be fixed at the initial figure for the first ten years when the normal practice is to have five-year rent reviews? This would tend to have a negative effect on the initial yield. Other aspects such as the age and condition of the building, the strength of the investment and the reliability of the tenant, the future possibilities for obtaining permission for a better and higher use are all considerations. In particular, the relationship between rental growth and inflation should be distinguished. In general, rents should move at least in line with the overall cost of living, whilst the hope is that rents will outpace inflation and so show real growth. However, it is important to retain perspective; future possibilities or intentions can often be affected or undone by economic phenomena or by changes to an area and to its land use planning or development control regulations. There are also future changes that cannot be known at the time an investment is purchased, which might give rise to an increase in value. For example, a neighbouring owner wishing to assemble a site for redevelopment may be in a position to offer above the market value for an adjoining or nearby property but may not make the reasons known. In such instances, the neighbour’s need to purchase a particular property or site because of its importance to his proposals may cause a substantial bid to be made for its purchase. £

Market rental value Time

Figure 5.1 Profile of a rack rented investment

∞

82

Traditional approaches

For the remainder of this chapter the process of valuation on the basis of the all- risks yield is demonstrated through a series of examples. The first two show a building either just let or about to be let – by inference at market rental value. See Figure 5.1 for an illustration of this. Example 5.1 A modern freehold office block has recently been let on a FRI lease for a term of 15 years at a rent of £150,000 per annum. The lease contains provision to review the rent at five-year intervals. The premises will be occupied by a branch of a national insurance company. The investment market is fairly active and investments of this type would be expected to show a return of 7.5 per cent. It is anticipated that there should be no difficulty in finding a purchaser. Calculate the market value of the investment. The property is modern and has been let to a tenant with a good covenant; the rent is net with the exception of the landlord’s management charges. The property is of a type likely to appeal to a variety of investors. Net rack rent per annum Years’ purchase @ 7.5% in perpetuity Capital value

£150,000 13.3333 £1,999,995

Commentary The tenant is well established and a national organization. The market is said to be fairly active, yet there is so far no certainty that the premises will find an occupier immediately or soon or that the tenant’s covenant will be of the same quality. There is no indication as to the type of tenant in other similar properties where transactions have taken place and provided information on yield. Should most of the relevant transactions have involved lettings to local businesses then there could be a case for accepting a slightly lower yield. Was the asking rent reduced, even marginally, to secure the letting to the insurance company? These considerations are all relevant to the final valuation and raise questions on which the local valuer should have views. Management expenses have not been deducted from the net rent; valuers ignore the cost of management on premises let on FRI terms. The valuation would be rounded off to a figure of £2,000,000. Rounding should be done, if at all, at the end of any set of calculations. Rounding during the course of a set of calculations risks the requirement for accuracy; a number rounded and multiplied by another in the course of a valuation exercise may lead to unintended results. Example 5.2 A small office block is to be let on completion on internal repairing and insuring terms. There is an active market for such accommodation by local businesses and

Traditional approaches 83 it is expected that the asking rent of £30,000 per annum will be achieved. Provide a valuation to enable your client to raise a loan for the acquisition of further property investments. Rack rent per annum on internal repairing terms Deduct insurance, external repairs, management, say 10% Net rent Years purchase @ 8.5% Capital value

£30,000 £3,000 £27,000 11.7647 £317,647

Commentary In this example, the landlord retains some responsibilities for maintenance per annum, which makes the property a slightly less attractive investment compared with Example 5.1. It is anticipated that it will be let to a local company and therefore with a satisfactory covenant rather than an outstanding one. There is as yet, no firm letting. Nevertheless, the local market is described as active. The valuation reflects these differences in this investment compared with that in Example 5.1 and so an expected yield of 8.5 per cent is used in this valuation. The higher yield here represents the higher risk that is perceived in this investment.

Freehold term and reversion valuations In many transactions, the lease was entered into some time before the sale took place. Most modern leases provide for regular rent reviews to ensure that there is an opportunity to reset the rent to market level and thus maintain the value of the investment. Such circumstances require an approach where the valuation is made in two tranches. The more common method is by vertical separation (see Figure 5.2) but a horizontal separation (see Figure 5.3 on page 88) also has its advocates and both will be described. Term and reversion profile – vertical separation of income £

Market rental Current value rent Time

Figure 5.2 Term and reversion profile – vertical separation

∞

84

Traditional approaches

Figure 5.2 shows the profile where the income is valued in two stages – the initial rent is capitalized for the period to the next review date or the end of the lease. The remainder (based on an estimate of the current rental value) is then capitalized and deferred for the period before which the new rent may be charged. The same yield may be used for both tranches, although some valuers use a slightly lower yield for the initial tranche on the basis that the rent is that payable rather than being an estimate and that it is safer because it is below market rent. Example 5.3 Retail shop premises in a main shopping street were let three years ago at £29,000 per annum on FRI terms on a 15-year lease with rent reviews at the end of every fifth year. The current rental value is £33,000 per annum. There is evidence of sales to support a yield of 7 per cent. Term Current rent per annum net Years’ purchase 2 years @ 6.5% Reversion Current rental value Years’ purchase perpetuity @ 7% PV £1 in 2 years @ 7% Capital value

£29,000 1.8206

52,797

£33,000 14.2857 0.87344

12.4777

411,764 464,561

Commentary The valuation consists of two parts: the first two years are valued to show the present value of those payments; the remainder is valued using the current market rental value in perpetuity, deferred for two years to allow for the two years of income already valued in the first part of the calculation. In this implicit approach, no expectation of future rental growth is expressed, although the yield adopted expects rental growth to continue. On the assumption that the investment performs as anticipated, the actual yield will be in excess of the all-risks yield applied. The exercise to calculate the actual yield requires a discounted cash flow (DCF) approach, which is described in Chapter 6. Slightly different yields have been used in the two parts of the calculation; it is well-established practice to use a slightly lower yield for the initial rent on the basis that it is well secured. In this example, the yields vary by one half of 1 per cent. The underlying reason for this approach is that because the current rent is less than the market rent it is considered to be more secure. The problem is that the investment is one entity – it cannot be separated. A further concern is that whereas the yield for the reversion is evidenced from analysis of transactions, there is no support for the arbitrary lowering of the yield for the term, instead simply recognition that the marginally greater security should be acknowledged.

Traditional approaches 85 The following example reworks the earlier calculation on the basis of one yield, which is the yield found from an analysis of recent transactions. Example 5.4 Term Current rent per annum net Years’ purchase 2 years @ 7% Reversion Current rental value Years’ purchase perpetuity @ 7% PV £1 in 2 years @ 7% Capital value

£29,000 1.8080

52,432

£33,000 14.2857 0.87344

12.4777

411,764 464,196

Commentary The market-derived yield of 7 per cent has been used in this example. It should be noted that the difference in capital value is small and well within any margin of error which has been established through court decisions as being in the region of 5 per cent in straightforward cases. The difference between the two results is infinitesimal. Any adjustment to the market yield for use in the term part of the valuation will vary according to difference in rental levels and number of years to reversion, information not used in determining the lower rate. There is no rational explanation of the practice and the single rate approach is to be preferred in most cases. An exception could be made where the term income is for more than a normal review interval of, say, five years. Investors do not expect rents to be increased each year and accept five-year intervals as a pattern integral to valuation in real estate. Should the interval be in excess of five years, the income then begins to appear ‘inflation prone’ in which case it would be appropriate to reflect the fixed nature of the initial income in application of a higher yield for the term part of the valuation. The following example illustrates the point. Example 5.5 A modern freehold office block is let on a FRI lease for a term of 15 years granted four years ago at a rent of £50,000 per annum. The lease contains provision to review the rent at the end of the seventh year of the lease. The premises are occupied by a government department. Current rental value on the lease with five-year reviews would be £60,000. The investment market is fairly active; recent sales have taken place to show a yield of 8 per cent. Calculate the market value of the investment.

86

Traditional approaches Term Current net rent per annum Years’ purchase 3 years @ 7.5% Reversion Reversion to Years’ purchase perpetuity @ 8% PV £1 in 3 years @ 8% Capital value

50,000 3.3493 £167,465 £60,000 12.5 0.79383 9.922875 £595,373 £762,838

Commentary The terms of the lease are uncommon and it can only be presumed that at the time of marketing the premises, the present tenants offered the best covenant and that the landlord was anxious to conclude a letting. There are no direct comparables and the valuer must reflect any disadvantage associated with their being only one review in the lease. The lack of regular reviews would limit the degree of interest in this investment property. Example 5.6 A similar office block to the one described in Example 5.5 was let four years ago to a local business at a rent of £50,000 on FRI terms for a term of 15 years with five-yearly rent reviews. In investment terms, the covenant of the tenant is not as good as that of the government department. The property is now offered for sale as an investment. Provide some preliminary advice to the investor about the value of the property. Term Modern office block let at net rent of Years’ purchase 1 year @ 9% Reversion Reversion to Years’ purchase perpetuity at 9.5% PV £1 in 1 year @ 9.5% Capital value

£50,000 0.9174

45,870

£60,000 10.5263 0.9132

9.6126

576,757 622,627

Commentary In this example an equivalent building to that in Example 5.5 is let to a tenant with a relatively weak covenant. The investor’s valuer reflects the higher risk this presents by adopting a higher all-risks yield. The valuer has selected a yield of 9.5 per cent on the reversion to indicate the market expectation of return at the market rent of £60,000 given this tenant’s relatively weaker covenant strength. The yield adopted in the term element is a half per cent lower, again to reflect the relative security of the current income.

Traditional approaches 87 Term and reversion – equivalent yield The case for a reduced yield for the term income is that the current rent has been agreed and that there is uncertainty regarding the rent to be paid on review until negotiations have taken place. It overlooks the fact that the investment is one transaction. As the parts cannot be separated it is argued that the same yield should be used in both parts of the calculation to reflect the true risk of the investment; there is support for this view in the observation that the valuer is unable to analyse the market to find two yields; the difference between the two is no more than a personal view unsupported by evidence but simply reflecting an instinct that a lower income must be more secure and should therefore be reflected in the calculations. An alternative is to use the equivalent yield approach to valuation, in which both term and reversion are valued using the same yield. In this way, the use of information gained from market analysis is less arbitrary and the origin of the yield can be identified. It is a useful approach for analysing freehold sales transactions, where a trial and error valuation approach can be used to reveal the equivalent yield. This is demonstrated in Example 5.7. Example 5.7 A freehold warehouse sold recently for £236,000. The property was let two years ago on a 15-year lease with five-yearly rent reviews at a rent of £16,000 per annum. The current rental value is now £22,000 per annum. Calculate the equivalent yield associated with this transaction. Term Current rent per annum net Years’ purchase 3 years @ 9.00% Reversion Current net market rental value Years’ purchase in perp at 9.00% 11.1111 PV £1 in 3 years @ 9.00% 0.7722 Capital value Term Current rent per annum net Years’ purchase 3 years @ 8.50% Reversion Current net market rental value Years’ purchase in perp at 8.50% 11.7647 PV £1 in 3 years @ 8.50% 0.7829 Capital value

£16,000 2.5313

£40,501

£22,000 8.5798 £188,756 £229,257

£16,000 2.5540

£40,864

£22,000 9.2107 £202,635 £243,499

88

Traditional approaches

Commentary A trial and error valuation approach is used to find the equivalent yield. To do this the known rental information is put into a term and reversion valuation and then the appropriate years’ purchase multipliers are applied using the same estimated yield for both parts of the valuation. In the first valuation a yield of 9 per cent is estimated and this returned a capital value of £229,257, which is below the sale price reported. Therefore a second valuation was performed using a lower yield, which gives a higher years’ purchase multiplier and thus a higher capital value. The second valuation used a trial yield of 8.5 per cent and this returned a capital value of £243,499, which is higher than the sale price. Clearly the equivalent yield attaching to the market transaction is between 9 per cent and 8.5 per cent. If the valuation was run for a third time using a yield of 8.75 per cent it would return a capital value of £236,173, which is close to the equivalent yield of the investment. The resulting equivalent yield is directly based on the market evidence and it will now assist the valuer in undertaking a valuation of a similar subject property in the locality.

The hardcore or layer model (horizontal separation) An alternative way of treating the two tranches of income is by the hardcore or horizontal separation model as shown in Figure 5.3. The layer or hardcore model treats the rental income in a different way. This variation adopts an arbitrary position whereby the current (core) income is assumed to continue into perpetuity (or for the length of the leasehold interest where the interest is not perpetual) with the remaining, so-called marginal or top slice income, commencing at some date in the future, capitalized at a higher rate. There are various suggestions as to the way in which the yields should be calculated but they all involve using the selected all-risks yield and then relating the two. The approach was devised in the 1950s with a specific purpose in mind – that of dealing with a particular effect of tax. The model has gained a certain status despite warnings against its use, particularly in its shortened form. It is claimed that the layer method is much used in practice, with the emphasis on current income which is carried into £

Market rental Current value rent

Marginal rent Core rent Time

Figure 5.3 Hardcore or layer profile – horizontal separation

∞

Traditional approaches 89 perpetuity. Any anticipated increase is treated as less secure and therefore valued applying a higher yield determined by formula rather than by reference to the market. It seems an unnecessarily complicated approach that does not easily connect with evidence gathered from the market. The principal weakness of this method is that the whole of the anticipated increase is valued at a higher rate, even though the rental figure used is based on current values and not projected to the time when it will be implemented. Use of the equivalent yield approach would seem to be preferable. The final point is that where a hardcore model formed part of a submission to be decided by arbitration or subject to forensic examination in a legal framework, the valuer could be subject to a range of questions, the answers to which would be difficult to convince anyone conducting a dispassionate inquiry. Example 5.8 A freehold office block is held on lease for a term of 20 years of which 13 remain. The lease provides for rent reviews at five-year intervals. The current rent, on FRI terms, is £25,000 per annum and the market rental value £35,000 on the same terms. Comparable investments have sold to return a yield of 7 per cent. Hardcore or layer valuation Core rent Years’ purchase in perpetuity @ 6.5% Marginal rent Years’ purchase in perpetuity @ 7% PV £1 in 3 years at 7% Capital value

£25,000 15.3846

384,615

£10,000 14.2857 0.8163

116,614 £501,229

Compare with a traditional term and reversion valuation Term Current rent per annum net Years’ purchase 3 years @ 6.5% Reversion Market rental value Years’ purchase perpetuity @ 7% PV £1 in 3 years @ 7% Capital value

£25,000 2.6485

66,213

£35,000 14.2857 0.8163

11.6614

408,150 474,362

Commentary The years’ purchase applied to the reversion reflects the market yield because the marginal rent ‘tops up’ the current rent to market rental value. However, the marginal rent is uncertain and the yield is intended to reflect this. The core rent,

90

Traditional approaches

however, is much more secure and so has been valued at a yield that is below the market yield. Again this differential between the yields applied to each tranche of the valuation is not anchored in the evidence on yields derived from market transactions; rather, they are an interpretation of them.

Over-rented property An over-rented property is one where the current rent is significantly higher than the current rental value. Such a situation is not common but, when present, raises relevant valuation concerns. Reasons will vary: possibly the tenant was badly advised when taking the lease; on the other hand, the rent agreed may have been a fair one when the lease was entered into but is now above the current rental value as it is in an area which, for whatever reason, is less popular than it was previously. There are many possible reasons why this should be so: for example, a new road bypassing a row of shops, the imposition of on-street parking restrictions, or the availability of superior premises nearby at competitive rents could all be reasons why a rental value has gone down. The profile of an over-rented property is shown in Figure 5.4. The effect is that the income is less secure than is normally the case. It is possible that the deterioration will continue or that the market will improve until, at some time in the future, the rental value will equal and then exceed the current rent level. The security of any rent in excess of the market value is difficult to judge, and depends to some extent on the quality of the tenant’s covenant. An independent trader might well be unable to maintain the business if subject to higher overheads than competitors. Should the premises be vacated, the owner will have to accept the current rent level on a re-letting if a new tenant is to be found soon. The period during which the high rent is paid is a risky one, and any misgivings would be reflected in a valuation using a high yield to compensate for the disadvantages. Many investors would judge the property to be unsatisfactory as an investment and not consider it suitable to add to their portfolio. Where there is a reversion or a rent review due within a reasonable time and the location is inherently sound, the problem may resolve itself by negotiation to a lower market rent. Where the tenant is of good standing and there is the £

Market rental value

Current rent

Time

Figure 5.4 Over-rented property – profile

∞

Traditional approaches 91 possibility that the premises will be vacated, consideration should be given to offering to release the tenant from the current lease in favour of a new one at a lower rent, or negotiating a capital payment for accepting a surrender where feasible, although neither party is in a strong negotiating position. An overrented property will appeal to a very limited investment market. There is no model to suggest how to deal with a valuation but, as indicated, it is a situation that the landlord should seek to resolve if possible and one that, if successful, is likely to prove to the advantage of both parties. The next example sets out the traditional treatment; however, one of the contemporary approaches using a DCF approach would probably be more relevant. Example 5.9 Shop premises were let to a local trader, nine years ago on FRI terms at a rent of £17,500 per annum on a 15-year lease with upward-only rent reviews at five-year intervals. Since that time, two supermarkets have been established and the main retailing district has moved significantly. The tenant has produced his audited accounts that show poor results; his offer to pay £9,500 per annum from the next review appears to be a genuine assessment of his ability to pay. It is unlikely that another tenant would be found easily or that a higher rent could be obtained. Advise on the capital value of the premises. Hardcore or layer valuation Core rent Years’ purchase in perpetuity @ 9% Marginal rent Years’ purchase 1 year @ 9.5% Capital value

£9,500 11.1111 £105,555 £8,000 0.9132 7,306 £112,861

Compare with a traditional term and reversion valuation Term Current rent per annum net £17,500 Years’ purchase 1 year @ 9% 0.9174 £16,055 Reversion Market rental value £9,500 Years’ purchase perpetuity @ 9.5% 10.5263 PV one year @ 9.5% 0.9132 £91,320 Capital value 107,374.36

92

Traditional approaches

Commentary The landlord will be reluctant to reduce the rent but alternatives such as taking possession and seeking another tenant look unnecessarily risky. The nature of the investment has changed and the investor should be focused on ensuring that the value does not reduce further. The continued payment of rent is dependent on the tenant being able to maintain the current level of business; it is in the interests of the landlord to support this endeavour. On the basis that a fair rent is established by the representations on behalf of the tenant, a valuation based on the offer and capitalized at a fairly high yield is as much as can be expected. The future does not look encouraging, although at the lower rent there may be a greater chance of longer-term lettings. Both the hardcore and term and reversion methods of valuation return poor capital values, and the final valuation figure must weigh up the likelihood of maintaining the rent of £9,500, which is best represented by the hardcore method of valuation. Example 5.10 A retail warehouse was let to a national chain store on a 25-year lease 18 years ago. The current rent is £40,000 per annum on FRI terms and with five-year upward-only rent reviews. The site is an isolated one and since the building was erected a retail park has been established nearby and is the direct cause of the business being closed as uneconomic two years ago. The current value as a site for redevelopment for another purpose is in the region of £90,000. Prepare a valuation of the property. Term Current rent per annum net Years’ purchase 7 years @ 11% Reversion Capital value of the site PV 7 years @ 11% Capital value

£40,000 4.7122 £90,000 0.4817

£188,488

£43,353 £231,841.00

Commentary The instructions reveal a difficult position for both parties following changes in trading prospects for the area. Using a market yield the property has a theoretical capital value of just over £230,000, although it is unlikely that a purchaser could be found at this level. It has little to commend it as an investment. The continued payment of rent relies entirely on the covenant of the tenant. The landlord would be well advised to open discussions with the tenant with a view to accepting a surrender of the lease subject to a negotiated payment. Redevelopment could then take place.

Traditional approaches 93

Leasehold interests So far, the valuation approach described has been limited to freehold investments. However, there are leasehold interests where the profit rent – the difference between what the leaseholder pays to the superior landlord and what is obtained from the subleaseholder – is of sufficient size and duration as to be a suitable form of investment. Where the rent of a leasehold interest is less than the rental value, the difference between the two is referred to as a ‘profit rent’ in the hands of the leaseholder. The profit rent may be enjoyed for the whole of the remainder of the term, or only intermittently if there is no coincidence between the head and subleases; it may retain a constant relationship where such provision is made by the lease, or the financial relationship may vary primarily due to the lack of coincidence between head and subleases. Such complicated relationships increase the difficulty of analysis and valuation. The terminable interest in leasehold properties raises problems of valuation not present in valuations of freehold interests. By definition, all leasehold interests are of a finite duration. The length of the unexpired term is critical and will influence the valuation approach. Leases may be granted for very long periods such as 999 years, although most are for much shorter periods. For the purposes of valuation, leaseholds are referred to as short, medium and long. There is no precise definition, the main differentiation being between those interests with an unexpired term sufficient to ignore the limitation in valuation terms, and shorter terms where the interest is regarded as a wasting asset. Where interests have 60 years or more to run, the practice has been to treat the income as received in perpetuity, as the capital value of any reversion after that time is likely to be a relatively insignificant part of the total capital value. Where the interest is for a shorter term, the convention is to assume the creation of a notional sinking fund to ensure replacement of the original capital. It is argued that it is then possible to derive the yield from similar, freehold investments where there is much more information. But the investment remains a leasehold investment and the freehold yield is therefore used only as a base, typically being increased by one or two points. To offset the disadvantage of a wasting asset, a notional sinking fund is provided to replace the original purchase price at the end of the term, thus perpetuating the income and again seeking to justify the comparison with a freehold interest. It is assumed that the amount reserved for the notional sinking fund will be taken from the rental income, and provision must be made for a sufficient sum to be available after tax. The yield on the sinking fund is taken at a low, safe rate to ensure that there is no risk of default, ensuring that the capital is replaced. The requirement not only for a safe investment but also for a guaranteed level of interest on sinking fund payments over a long term would attract relatively low rates. Net rates of 3–4 per cent are in common use. Investments with a short life would use the major part of the income in providing a sinking fund.

94

Traditional approaches

Although there is no evidence that sinking funds are taken out and used to  replace capital, their provision in the valuation framework provides a theoretical base for comparison with freehold. The formula for years’ purchase takes on a special form and calculates the years’ purchase at the remunerative rate with provision for a sinking fund at the (lower) accumulative rate and adjusted for tax. Where there are changes in the profit rent over the period of the investment, the valuation will proceed by stages, each with its own years’ purchase multiplier and each providing a sinking fund. There is the prospect of two or more notional sinking funds based on replacement at the end of the respective periods; when one stage finishes and the next begins, the previous fund closes but is not called on because at that stage the investment continues to provide an income. The accumulation of interest on the closed fund ensures that there is a total overprovision of sinking funds. Some techniques of adjusting this overprovision are available. The better alternative appears to be a DCF investigation; however, there is little information about what rate of return is acceptable in return for a complete loss of the original investment. Much will depend on the size of the profit rent, the period for which it is to be enjoyed and the attitude of the particular investor to risk. Example 5.11 An office building is held on lease for an unexpired term of 15 years without review at a rent of £25,000 per annum. The current rental value is £37,500 on the same terms. The appropriate freehold yield on typical letting terms would be 6.5 per cent. Interest rates on safe long-term investments are in the region of 2.5  per cent, and the appropriate tax rate is 20 per cent. Value the leasehold interest. Rental value per annum net Less fixed rent Profit rent Years’ purchase 15 years at 8% with sinking fund at 2.5%, tax 20%

£37,500 £25,000 12,500 6.6797

£83,496

or, on the assumption that a sinking fund would not be taken out: Profit rent £12,500 Years’ purchase 15 years at 8 % 8.5595 £106,994

Commentary The traditional approach to the solution of this more involved leasehold interest does not deal adequately with future increases in rental value, and a DCF calculation would directly reflect the future rent reviews.

Traditional approaches 95 Leasehold valuations are often undertaken on behalf of tenants wishing to assign their lease or surrender the lease in exchange for a lease for a longer term  and possibly with changes to other terms. These negotiations often take place against a background of a transfer of the business and the sale of goodwill. It is likely that valuers will be appointed to act for each party. Following the changes to business tenancies introduced by the 2004 Order (Regulatory Reform (Business Tenancies) Order 2003 (SI 2003/3096), which took effect in 2004), valuations will vary according to whether the tenant has the protection of sections 24–28 of the Landlord and Tenant Act 1954 as amended. Without that protection, the value of any assignment would be likely to be seriously affected as the goodwill of the business would not be protected beyond the end of the current lease. Relatively short leasehold interests may have a special appeal for non-taxpayers, for whom the benefit of the income is further enhanced. Any investor in leaseholds, particularly shorter leaseholds, will appreciate the complications but may still be attracted to a greater return for a limited period. A short leasehold interest is an unusual form of investment and one that the investor needs to consider carefully. The decision will be more than usually interwoven with the investor’s personal situation and wishes. There is a possibility that some investors are attracted by the relative lack of competition and see the opportunity of appreciably higher returns. For example, a retired investor might see the benefits of a high return for a period of five or ten years, accepting the eventual loss of any income. A modest holding may sometimes be the key to a larger transaction, and the prospect of a third party being delayed by the intervening interest could result in an offer to buy out the interest out of scale with the real value of the holding. For example, take the case of the lease of a small workshop expiring in five years’ time where the freeholder of the estate of which the workshop is a small part has had an offer to purchase the whole site for residential development. Where the workshop lease is the only thing standing between the freeholder and a substantial windfall profit, the leaseholder would be in a very comfortable position. It is not suggested that such a situation would present itself as part of acquiring a lease, but there is a possibility that the lease would have a value for the reasons suggested. Many investors would not consider purchasing a short leasehold interest unless  there is a capital or business advantage in doing so. Example 5.12 illustrates such a situation where there is both a capital and a business advantage to the freehold investor and a capital advantage to the leasehold occupier. The  leasehold valuation here features as just one part of the valuation of the wider scenario and these types of situation may be resolved through the use of synergistic or marriage valuations where a similar approach to that shown below is adopted by the valuer. A diagram of a synergistic value scenario is shown in Figure 5.5.

96

Traditional approaches

unencumbered by a lease

LH value

Freehold (FH) value

Capital value in £

Marriage value

FH value subject to a lease

Key FH – freehold LH – leasehold Figure 5.5 Diagrammatic representation of a synergistic (or marriage) valuation

Example 5.12 Your client owns the freehold interest in converted office premises let on lease for a term of 35 years at a fixed rent of £12,500 per annum, having five years to run. The short leasehold is available and your client is negotiating to purchase the leasehold interest to enable him to occupy the premises for his business. The market rental value is £65,000 per annum and recent sales of freeholds let on modern leases show a return of 7.5 per cent. Prepare a set of valuations to support a decision as to the sum to be offered to the leaseholder. Synergistic or marriage valuation Freehold interest subject to the lease Term Current rent on lease Years’ purchase 5 years @ 7% Reversion Market rental value of Years’ purchase in perpetuity @ 8% PV 5 years @ 8% Value of freehold subject to the lease

£12,500 3.8897

£48,621

£65,000 8.50729

£552,974 £601,595

Traditional approaches 97 Leasehold interest Market rental value Rent under lease Profit rent YP 5 years at 9.5%, SF 2.5%, tax at 25% Value of leasehold interest Freehold unencumbered by lease Market rental value Years’ purchase in perpetuity @ 7.5% Market value of freehold unencumbered by lease

£65,000 12,500 £52,500 2.8681 £150,575

£65,000 13.3333 £866,665

Calculation of the synergistic (or marriage) value Value of freehold unencumbered £601,595 Value of freehold subject to the lease Value of the leasehold interest £150,575 Value of all interests Synergisitc value unlocked by the merger of interests Calculation of the offer to the leaseholder Value of the leasehold interest Plus say 50% of synergistic value

£866,665

£752,170 £114,494

£150,575 £57,247 £207,822

Commentary Acquisition of the leasehold interest by the freeholder would enable the full rental value to be enjoyed five years earlier than envisaged under the existing lease. A purchase of the leasehold on the basis of the valuations shown would increase the value of the freehold interest by some £265,000 for an outlay of approximately £208,000.

Rent payments in advance It is seen from Chapter 3 that the basic formulae are based on yearly rents, which does not necessarily reflect the true basis of rental receipts. In leases of commercial premises it is common practice for rents to be payable quarterly in advance and the default position should therefore be to perform the analysis of all transactions and all valuations in this sector to reflect market practice. An investor receiving rent quarterly in advance or in any other way should be able to have a correct interpretation of the value of the income flow. It is also possible to calculate more accurately as regards time. The number of days, weeks or months can be input where, as is often the case, the unexpired term is not a whole number of years.

98

Traditional approaches

The following example explains the difference between nominal and effective yields; it is emphasized that any valuation using either yield should have found the comparisons on the same basis. Example 5.13 A warehouse let at £9,500 on a FRI lease at a rent of £9,500 per annum has been valued to show a return of 9 per cent on the basis that the rent is paid annually in arrear. The purchaser has asked for the valuation to reflect the lease term requiring rents to be paid quarterly in advance at the same yield. (a) On the basis that the rent is paid annually in arrear Net rent payable £9,500 Years’ purchase in perpetuity @ 9% 11.1111 Capital value (b) On the basis of quarterly in advance £9,500 11.7294 Years’ purchase in perpetuity @ 9% A difference of or approximately 5.27%

£105,556 £111,429 £5,874

Commentary It is shown that the provision to pay rents quarterly in advance makes a difference in capital value of over 5 per cent. It is essential to examine the source of the original yield of 9 per cent to confirm that it was derived from comparables where the rent was paid annually in arrear.

Summary • • • •

• • • •

The normal valuation process involves an interpretation of market activity. Each property is unique, so valuers will tend to reach different conclusions when applying market intelligence to specific valuation problems. The valuation is the value at a point in time. The valuer should be alert to what developments or changes are proposed in the area and the extent to which they are likely to have an effect on the property being valued. Some valuers choose to value using direct market yields as evidence, carrying with them implications about future expected growth. Other valuers prefer the DCF approach, where growth is projected and forms the basis of the valuation, and this is explored further in the next chapter. Any valuation must have regard to any contractual provisions, especially those that cannot be renegotiated. There is acceptance that valuation is not a precise process and requires valuers to use their professional judgement and subjective interpretation of the evidence presented.

6

The investment method – discounted cash flow approaches

Introduction Low initial all-risks yields are acceptable to investors in property only because there is an expectation of rental growth. Traditional valuations do not quantify the growth; they simply reflect what, on analysis of recent transactions, the market has accepted as appropriate given past experience of market growth. That experience is likely to inform, at least in part, the level of expectation of future growth. There will be a market yield for investments in general, adjusted for particular sectors and for individual investments within each sector. Once that market yield is known, the implications for growth can be exposed. At one time, investment in good quality modern property occupied by major commercial or industrial concerns was considered to be almost as default-free as is investment in government stock, particularly as there was the opportunity to renegotiate the investment return at regular intervals via upward-only review provisions that are unique to property investment and an extremely valuable attribute. At the time of writing, property investments are not viewed with the same level of optimism due to the effects of the global financial crisis, the ensuing recession and trends towards more flexible working patterns. The prevailing poor economic conditions have caused some major businesses to fail and for others they have had a significant impact on growth and prosperity. The knock-on effect of this is that companies are downsizing and shedding staff in order to survive, which in turn reduces their business space requirements. Moreover, many companies that remain viable are not necessarily increasing their occupation of commercial property. Instead, many companies are moving increasingly towards technology enabled flexible, home or mobile working solutions to keep down the cost of their property overheads in order to remain solvent. Therefore, for property investors, if the occupying tenant fails there is likely to be a loss of income for quite some time until another tenant is found. In similar circumstances, for shareholders in that same company, a catastrophic failure resulting in the liquidation of the company would leave them with no more than a share of whatever the liquidator was able to salvage from the remains of the

100

Discounted cash flow approaches

company after paying all its other debts. Accordingly, property investment valuation models using discounted cash flow (DCF) techniques should allow for void periods where there is no rental income from the property, but where there is likely to be capital expenditure on marketing costs and also, possibly, refurbishment works.

All-risks yields and equated yields Implied income growth can be calculated given the all-risks and equated yields. On a yearly basis, the calculation is simple. Where the market yield is, say, 10 per cent and the return on the investment is 6 per cent, the income growth is the difference between the two, namely 4 per cent. But as investments in property do not usually afford an opportunity to make annual adjustments, rental growth must be related to the length of the review interval. The cumulative effect of the delay in revising the rent will be to require a higher rate of growth than if an annual adjustment could be made. The calculations necessary to identify and quantify growth will be used in the answer to Example 6.1, using the formula set out below. K = E – (ASF × P) where P = (1 + g)n –1 K = the all-risks yield (decimal) E = the equated yield (decimal) P = the rental growth over the interval ASF = the sinking fund to replace £1 at ‘E’ for period ‘t’ g = annual growth (as a decimal) n = rent review period Example 6.1 An investor has purchased retail shop premises in the main thoroughfare of a town for £1,000,000. The unit has just been let to a national multiple on FRI lease terms for 20 years with reviews at intervals of five years, at a rent of £50,000 per annum. The market rate is generally agreed to be 10 per cent. Calculate the implied income growth. Analysis of purchase

price rent p.a. ARY years’ purchase

£1,000,000 £ 50,000 5% 20

Implied rental growth where market rate is 10 per cent can be calculated as follows.

Discounted cash flow approaches 101 1 + gt =

20 − 3.7908 YP perp @ K less YP ‘t’ @ E 16.2090 = = = 1.305241 YP perp @ K × PV ‘t’ @ E 20 × 0.620913 12.4184

1 + g^5 = 1+g= g=

1.305241 1.054722 0.05472

Growth over five years (%) which is

30.5241

5.47% per annum

Commentary The expectation is that the rental value of the shop premises will increase each year by 5.47 per cent, and that this will be reflected in substantial increases at each review. The annual growth is found from the formula as set out in the example. It is sobering to reflect on the implication of the recent purchase, which is that the annual rental value will increase by an average of 5.5 per cent into the future.

Discounted cash flow Many investors and financial and academic commentators have expressed impatience and frustration with the continuing use of the implicit ‘non-growth’ approach to valuation. It is claimed that not only does it misrepresent the property market and make it difficult to know the effect of any yield adjustment, but also, and perhaps more importantly, it isolates property investment from other forms of investment in that the calculated yields from each are not directly comparable. It does seem unsatisfactory to assume the continuation into perpetuity of rent at a level that would be unacceptable capitalized at a yield that grossly understates the level of return expected. That the fictions may compensate each other to determine the ‘correct’ value is considered less than satisfactory by many professional investors who are keenly interested in the rate at which rents are expected to rise and in the current and projected return on capital invested.

Use of discounted cash flow and net present value in business decision making The DCF technique is a tool that has long been used by accountants and business analysts. In this context, a DCF approach may be applied to cash flow estimates generated for a proposed project or projects. These cash flows are then discounted at an appropriate rate of interest in order to derive a present day value for the future income from the project(s). The discount rate applied may relate to bank lending rates if the project is to be debt financed. In this case the rate selected by the bank will reflect the interest margin above base to reflect the risk attached to the investment company seeking the loan and/or to the investment itself. By contrast, if the project is being evaluated to reflect estimated returns from alternative investment opportunities, then a rate would be selected that would reflect the opportunity cost of the investment project, e.g. this could be by

102

Discounted cash flow approaches

reference to British Treasury bond rates if a secure and relatively risk-free investment is required as a comparator. Once the discount rate is selected, it is then input in decimal form into the present value (PV) formula and the PV multiplier is then calculated for the desired time period over which the cash flow would be received. The PV multiplier is then applied to the cash flow to adjust the future cash flow into present day terms. Reference to Example 6.2 shows the use of a simple DCF as a decision making tool. Example 6.2 A business decision needs to be made about two projects A and B to determine which one is best to undertake. The estimated cash flows of each project are set out below. End of year 1 2 3 4 5 Total

Cashflow estimate Project A –£2,000.00 £1,000.00 £3,000.00 £5,000.00 £10,500.00 £17,500.00

Cashflow estimate Project B –£1,500.00 £500.00 £5,000.00 £6,500.00 £7,000.00 £17,500.00

The rate of return on alternative investment opportunities is estimated at 5 per cent. Calculate the net present value (NPV) to determine which project is expected to be the most profitable. a End of year 1 2 3 4 5 Total

b Cashflow estimate Project A –£2,000.00 £1,000.00 £3,000.00 £5,000.00 £10,500.00 £17,500.00

c PV @ 5.00%

d Project A DCF

0.9524 0.9070 0.8638 0.8227 0.7835

–£1,904.76 £907.03 £2,591.51 £4,113.51 £8,227.02

NPV

£13,934.32

e Cashflow estimate Project B –£1,500.00 £500.00 £5,000.00 £6,500.00 £7,000.00 £17,500.00

f PV @ 5.00%

g Project B DCF

0.9524 –£1,428.57 0.9070 £453.51 0.8638 £4,319.19 0.8227 £5,347.57 0.7835 £5,484.68 NPV

£14,176.38

The DCF figure is derived by calculating the appropriate PV multiplier for each period and then multiplying it by the estimated cash flow for the corresponding period.

Discounted cash flow approaches 103 Accordingly, as the expenditure or income for each year occurs at the end of the year the PV multiplier for each year is calculated to correspond with the year number (or waiting time) shown in column a for each period of the project. The year 1 and year 2 PV multipliers are calculated as follows. 1

(1 + i )

n

=

n

=

1

(1 + i )

1

(1 + 0.05)

1

1

(1 + 0.05)

2

= 0.952381 = 0.907029

Example 6.3 If the income and expenditure occurred at the beginning of each year then the DCF calculation would need to be revised as set out in the example below. Where the expenditure in year one is made now, which in a DCF calculation is represented by the number 1.0000, in other words no discount is made when this figure is multiplied by the initial expenditure. The cash flow in year 2 then occurs at the beginning of that period so the PV multiplier is calculated using a discounting period of one year, which is the total waiting time represented by the previous period which has just ended. a Start of year 1 2 3 4 5 Total

b Cashflow estimate Project A –£2,000.00 £1,000.00 £3,000.00 £5,000.00 £10,500.00 £17,500.00

c PV @ 5.00%

d Project A DCF

1.0000 0.9524 0.9070 0.8638 0.8227

–£2,000.00 £952.38 £2,721.09 £4,319.19 £8,638.38

NPV

£14,631.03

e Cashflow estimate Project B –£1,500.00 £500.00 £5,000.00 £6,500.00 £7,000.00 £17,500.00

f PV @ 5.00%

g Project B DCF

1.0000 -£1,500.00 0.9524 £476.19 0.9070 £4,535.15 0.8638 £5,614.94 0.8227 £5,758.92 NPV

£14,885.20

As these examples show, discounting annual cash flows over a period of five years is useful to ascertain values of short-term projects but it is not particularly helpful when analysing investment income and costs over a much longer period of say 15 to 20 years. Accordingly, the DCF technique requires adaptation for use in property investment valuation and analysis in order to accommodate longer time scales, whereas the business use of the method as shown here is normally for a relatively short ‘pay-back’ period only, which could be as little as five or six years, and often with the terminal value relatively low (scrap value or nil).

104

Discounted cash flow approaches

Discounted cash flow as a tool for analysing property investments First, the income flow is adapted to reflect a period of income which corresponds to the time elapsed between rent reviews, and the estimate and attribution of growth to the initial rent is achieved by the application of the compounding (or amount of £1) formula. Once growth is applied, the inflated income stream is capitalized by the application of the years’ purchase, for a short finite term (or present value of £1 per annum) formula and then discounted back using the present value of £1 formula to reflect the time elapsed before the rental uplift of the period in question. Finally, once all these operations have been applied to the rental income, the result is the DCF for one period between rent reviews. Repeating this same process for each period between rent reviews will result in a series of DCFs being produced, which, when summed together, give the net present value (NPV) of the investment. Effectively the NPV represents the investment value, or value of worth for an investor at a given rate of return. Example 6.4 shows how a DCF may be structured to represent income flows, growth and rent review periods in a property investment valuation. Example 6.4 An investor wishes to obtain a valuation of worth for a recently let property. The rent passing is £40,000 per annum and the rent review pattern is five yearly. At the date of valuation the rate of growth is estimated as 2.5 per cent. The all-risks yield on the property is estimated at 6 per cent in its present condition, however it is expected that this would move up to 7% after 25 years to reflect fl the age and condition of the building. The investor requires a return of at least 8 per cent, and he intends to hold the property for 26 years at the end of which the property will be sold. Set out in Example 6.4 is a DCF calculation that could be used to calculate a valuation of worth. It is assumed there will be no income voids in this example. a b c Period (years) (£) Rent From To from previous period 1 5 40,000 6 10 40,000 11 15 45,256 16 20 51,203 21 25 57,932 26 perp 65,545

d Growth amt £1 @ 2.50% 1.0000 1.1314 1.1314 1.1314 1.1314 1.1314

e (£)Rent review (rent × growth) 40,000 45,256 51,203 57,932 65,545 74,158 NPV

f YP 5 years @ 8.00%

g PV of £1 @ 8.00%

h (£) DCF

Note

3.9927 3.9927 3.9927 3.9927 3.9927 14.2857

1.0000 0.6806 0.4632 0.3152 0.2145 0.1460

159,708 122,978 94,695 72,917 56,147 154,691 661,137

q r s t u v w

Discounted cash flow approaches 105

Notes a–w a,b These columns show the running time period that the investment is held. Column a shows the start of the time period following rent review or new letting (row q) and column b shows the end of the time period which culminates in the start of the rent review process. c Column c shows the rent received from the previous period before the rent review was completed. d Column d shows the growth multiplier, which is the compound interest formula (amount of £1) for the period of five years at 2.5 per cent. Note that in years one–five the rent has been fixed at the point of letting so no uplift is applied. Instead, 1.0000 appears in this column. e Column e shows the estimated reviewed rent for the period and it is calculated by multiplying the rent from the previous period by the compounding formula, i.e. (c × d for each row in the table). f Column f is the years’ purchase (YP), five years at 8 per cent, which is applied to each annual tranche of rental income (shown in column e) to convert this annual income into five years of capitalized income. This lump sum is discounted and shown in column h. g In column g, a present value (PV) multiplier is applied to each five-year fi tranche of capitalized income to reflect fl the waiting time until this income is received. Accordingly, in the first period of years, 1–5, shown in row q, no PV is applied as the first-year income is received at the present time – hence 1.0000 is entered. (By contrast, PV values are always less than 1.) Thereafter, the PV is applied in each row to reflect the time elapsed in the preceding period before the reviewed income can be received. Accordingly, for the second tranche of income in years 5–10 (row r) the PV of £1 at 8 per cent for five years is applied, refl flecting the waiting time of the preceding cash flow (row q). The income in row s has a PV of £1 at 8 per cent for ten years, applied to reflect the period elapsed before the reviewed income from year 11 onwards could be received. h/q Column h, rows q–u shows the value of the discounted cash flow for each tranche of capitalized rental income. h/v Column h, row v, shows the discounted cash flow value of the final sale price of the property assuming it is to be sold in the 26th year of ownership. Note that the YP in perpetuity is applied (column f, row v) to the rent on review in order to calculate the future capital value of the property before the discount factor is applied (column g). The all-risks yield applied is 7 per cent. h/w In column h, row w, the net present value (NPV) is calculated by adding up the DCF values in column h. As presented, the NPV is effectively the valuation of worth for the investor at a given rate of return, which in this case is 8 per cent. Information is needed about the rent payable, the current rental value, the probable rental growth, the review intervals and the discounting rate of interest. Valuers wedded to conventional approaches criticize the attempt to predict rental values and argue that the current rental value is as far as the valuer should go in providing information for a valuation. At the same time, they see no

106 Discounted cash flow approaches problem in using an all-risks yield derived from property transactions, even though it bears no direct relationship to other non-property yields; they are content to adjust that yield up or down to compensate for perceived differences in age, quality and earning capacity despite their inability to gauge the precise effect of any adjustment on actual return. One of the advantages of the DCF technique is the discipline of quantifying the anticipated rate of rental growth, which may cause the valuer to think more deeply about the qualities of the investment. The selection of an appropriate yield should cause less difficulty since a direct comparison may be made with other investment media. The surrogate for yield comparison has been the gilt-edged market. Long-term or undated gilts were regarded as the perfect risk-free investments, any other form of investment being inferior and with a level of risk, the difference being reflected in an addition to the rate of return. The definition of risk has widened considerably in recent years to include, in particular, the problem of maintaining the purchasing power of income. Gilts today are more properly described as ‘default-free’. In the case of high-quality investment properties let to blue-chip tenants on modern leases with upwardonly rent reviews, it could be argued that there is no default risk and that the overall risk is significantly less than that in most investments in equities. However, there is risk in holding any long-term investments when compared with short-term Treasury bills or similar investments, risk for which an investor will expect to be compensated by way of an increased yield. However, real returns are likely to remain fairly low given the continuing level of inflation and the number of funds seeking good quality investments. Whereas the NPV assesses an investment relative to a selected yield, the IRR determines the return produced by a particular income profit, reported as a yield, not an amount. The latter approach is therefore useful in non-market appraisals making use of the investor’s required target rate or opportunity cost, as well as enabling an investor to compare two prospective investments.

Application of DCF techniques to determine level of return Example 6.3 shows how DCF can be used to calculate the net present value (NPV). However, the DCF technique may also be used to calculate the internal rate of return (IRR). As the example shows, the DCF technique enables all the cash flflows (incoming and outgoing) to be discounted at a selected rate of interest, which represents the investor’s target rate of return (or an approximation thereof). When all the cash flows are summed (having regard to their signs) the result will be the net present value (NPV). If the target rate of return has been achieved, the NPV will be zero; if it has been exceeded, the NPV will give a positive balance; and if the NPV is negative, then the target rate or return has not been achieved. The conventional valuation performed using an all-risks yield is a discounting exercise, summing the value of the right to receive successive incomes for a stated period. The convention is to use a low yield to compensate for the expectation

Discounted cash flow approaches 107 that income will rise, linked to the use of the current rental value with no attempt to extrapolate the anticipated growth. The discounted cash flow approach may be used in this way, but its distinguishing feature is that it is more often used to reflect capital value using a market yield (derived from the overall investment market but possibly adjusted to reflect the peculiarities of property) combined with income in which anticipated growth is quantified. The following calculations show the two approaches. Example 6.5 Your client owns the freehold interest in well-situated shop premises recently let on an institutional type lease at a rent of £25 000 per annum for a term of 25 years with five-yearly reviews. The all-risks yield is found to be 6 per cent. Analysis of recent sales of comparable properties and rents on newly let properties indicate that income growth has remained steady at 4 per cent over the last few years. The equated yield required is to be taken as 10 per cent. The property income stream is to be analysed to determine whether the investment property meets the investor’s required return of 10 per cent. Accordingly, trial rates of 9 per cent and 11 per cent are used to determine the IRR associated with the investment. Because the calculation allows for growth the resulting IRR is the equated yield. As the valuation set out in Examples 6.5a–c demonstrates, this investment does not achieve the investor’s required rate of return of 10 per cent but the valuer’s job is done. It is for the investor to determine whether a return of 9.66 per cent falls within his acceptable range of return for commitment to the investment. DCF with growth and equated yield carrying forward rent with growth with amt £1 held constant All risks yield Rent review Period (years) From To

1 6 11 16 21 26

5 10 15 20 25 perp

(£) Rent from previous period 25,000 25,000 30,416 37,006 45,024 54,778

Growth amt £1 @ 4% 1.0000 1.2167 1.2167 1.2167 1.2167 1.2167

(£)Rent review (rent × growth) 25,000 30,416 37,006 45,024 54,778 66,646

YP 5 years @ 9.00%

6.00% 5 yrs PV of £1 @ 9.00%

3.8897 1.0000 3.8897 0.6499 3.8897 0.4224 3.8897 0.2745 3.8897 0.1784 16.6667 0.1160 Sum of all cashflows Less purchase price NPV

(£) DCF

97,241 76,893 60,802 48,079 38,018 128,813 449,846 416,667 33,179

108

Discounted cash flow approaches

Period (years) From To

1 6 11 16 21 26

5 10 15 20 25 perp

(£) Rent from previous period 25,000 25,000 30,416 37,006 45,024 54,778

Growth amt £1 @ 4% 1.0000 1.2167 1.2167 1.2167 1.2167 1.2167

(£)Rent review (rent × growth) 25,000 30,416 37,006 45,024 54,778 66,646

YP 5 years @ 11.00%

PV of £1 @ 11.00%

3.6959 1.0000 3.6959 0.5935 3.6959 0.3522 3.6959 0.2090 3.6959 0.1240 16.6667 0.0736 Sum of all cashflows Less purchase price NPV

(£) DCF

92,397 66,713 48,169 34,779 25,111 81,761 348,930 416,667 –67,736

Equated yield = 9.66% Equated yield is calculated thus: R1 +[(R2 - R1) *( NPV R1/( NPV R2 + NPV–R1))] Where R1 = R2 = NPV R1 = NPV R2 =

lower target rate of return higher target rate of return NPV at the lower rate NPV at the higher rate

Note The NPV figures entered must be absolute values − i.e. the negative signs are ignored

Commentary The valuation is straightforward: the shop is rack rented and there is market evidence of the all-risks yield. Furthermore, an estimate of income growth has been derived from the market, possibly by reference to research report data such as that distributed by the larger property consultancies. Finally, the investor has indicated the required return rate, which is a matter of investment choice by the individual and not a matter for the market. The capitalized amount is deferred at the equated yield rate of return. Where rental growth is known the equated yield can be found by taking two trial rates. The values are then calculated for both rates, one of which should give a positive result and the other a negative one. In that event, the true yield is captured between the two yields and may be determined more precisely by formula or by selecting two more yields and repeating the calculation until the ‘correct’ yield is found when the sum of the discounted incomes is equal to ‘0’.

Discounted cash flow approaches 109 Example 6.6 A property with a market rental value of £20,000 per annum and let on FRI terms for 20 years with 5 yearly rent reviews, has been sold to show an all-risks yield of 5 per cent. Calculate the IRR given an expected rate of rental growth of 3 per cent per annum and an exit yield of 6 per cent. Market rent YP perp @ 6% Capital value All risks yield Rent review

£20,000 16.6667 £333,333 6% 5 yrs

Figure 6.6 Valuation using traditional method Period (year) From To

(£) Rent from previous period

Growth amt £1 @ 3.00%

(£)Rent review (rent × growth)

YP 5 years @ 8.50%

1 6 11 16 21

20,000 20,000 23,185 26,878 31,159

1.0000 1.1593 1.1593 1.1593 1.1593

20,000 23,185 26,878 31,159 36,122

3.9406 1.0000 3.9406 0.6650 3.9406 0.4423 3.9406 0.2941 16.6667 0.1956 Sum of all cashflows Less purchase price NPV

(£) Rent from previous period 20,000 20,000 23,185 26,878 31,159

Growth amt £1 @ 3.00% 1.0000 1.1593 1.1593 1.1593 1.1593

(£)Rent review (rent × growth) 20,000 23,185 26,878 31,159 36,122

YP 5 years @ 9.50%

5 10 15 20 perp

Period (year) From To

1 6 11 16 21

5 10 15 20 perp

PV of £1@ 8.50%

PV of £1@ 9.50%

3.8397 1.0000 3.8397 0.6352 3.8397 0.4035 3.8397 0.2563 16.6667 0.1628 Sum of all cashflows Less purchase price NPV

Equated yield = 8.69% Equated yield is calculated thus: R1 +[(R2 – R1) *( NPV R1/(NPV R2 + NPV R1))]

(£) DCF

78,813 60,762 46,846 36,117 117,768 340,306 333,333 6,973 (£) DCF

76,794 56,551 41,645 30,667 98,026 303,683 333,333 –29,650

110

Discounted cash flow approaches Where R1 = R2 = NPV R1 = NPV R2 =

lower target rate of return higher target rate of return NPV at the lower rate NPV at the higher rate

Note The NPV figures entered must be absolute values − i.e. the negative signs are ignored

Commentary As stated, the sale shows a return on an all-risks yield basis of 6 per cent. When the expectation of growth is taken into account, it is clear that an overall yield of 8.69 per cent would be achieved if the forecast rental growth was confirmed by events.

Short-form discounted cash flow With continuing concerns expressed about the traditional term and reversion approach, the short-form DCF option has been proposed as an alternative. The difference is that in the short form, the term income is discounted at the equated yield, as is the deferment of the reversion. In general terms and where rental growth is significant, the short form shows a higher capital value; in other words, it suggests that a term and reversion valuation based on the all-risks yield undervalues the investment. The longer the reversion, the more this approach seems to be at odds with market evidence; investors purchase property to share in income growth, and the longer the period for which the rent is fixed, the less like a property investment it appears to be. There may be an implication that investors purchase on the basis of rental growth but they are more confident where the benefits are not too long delayed. The implied rental growth is calculated from knowledge of the all-risks yield, the market or equated yield and the interval between rent reviews. It is then used to discount successive tranches of projected income at the equated yield rate. At the end of the period, the remainder of the capital value is calculated by treating it as a reversion and discounting using a growth-implicit yield. Two aspects need further investigation. First, the holding period may be for any length of time but is usually set at between 15 and 30 years. A 15-year period would certainly seem the shortest period over which to reflect anticipated rental growth; a 30-year period, over which substantial growth is part of the attraction of the investment, is questionable. Changing needs may put the design and layout and possibly the location of the property at a disadvantage. Second, the all-risks yield used at the end of the holding period is unlikely to be the same as that derived from market sources at the time of the original valuation.

Discounted cash flow approaches 111 The following example takes a 20-year holding period as the longest over which a forecast of sustained rental growth is appropriate; it has been assumed that similar properties to the one being valued, but 20 years older, can be identified fi to give an appropriate all-risks exit yield. Example 6.7 Value the freehold interest in modern office premises let on FRI terms with ten years unexpired, the current rent being £15,000 per annum without further review. The current market rental value is £21,000 per annum, assuming five-year reviews. Recent sales confirm an all-risks market yield of 6.5 per cent, while the market rate is 11 per cent. Compare a valuation by the traditional term and reversion approach with an assessment using the short-cut DCF model. Traditional valuation Term Current rent per annum YP 10 years @ 6.5% Reversion to Rental value YP perpetuity @ 6.5% deferred 10 years

£15,000 7.1888

£ 107,852

£21,000 8.1958 Total

£172,112 £279,944

With an equated yield of 11%, the anticipated rental growth is 5.07% Rent in 10 years’ time will be £21 000 × 1.6400, which is £34 435 Short form Term Current rent per annum YP 10 years @ 6.5% Reversion to Rent in 10 years’ time YP perpetuity @ 6.5% PV £1 in 10 years @ 11%

£15,000 7.1888 £34,435 15.3846 £529,769 0.3522

£107 832

£186 585 £294 417

Commentary Both approaches value the current rent for the next ten years (although at different discount rates). The current rental value is £21,000 per annum, which is the figure assumed in the valuation of the reversionary part of the interest on the traditional basis. It should be assumed that, at that point, the rent negotiated would be on modern lease terms and in particular with a five-year review pattern. Note particularly that no attempt is made to project rental growth to find a possible rental value in ten years’ time. The short form valuation assumes that the rental value will continue to grow and on this basis calculates what it is likely to be in ten years’ time. The valuation then proceeds to value the first tranche at the equated yield rate of 11 per cent and the remainder in perpetuity without further explicit reflection

112

Discounted cash flow approaches

of rental growth, at the all-risks yield rate. Note that the value of the reversion is deferred at the equated yield rate.

Summary • • • • • •

DCF is a technique that enables projected cash inflows and outflows to be evaluated at present-day values. DCF valuations can be used to calculate NPV or IRR. Income growth can be explicitly calculated in DCF valuations. DCF valuations enable two projects to be compared on the basis of their NPV and IRR. The IRR that allows for growth is the equated yield and this can be calculated using a DCF valuation. DCF valuations can be adapted for use in a range of property valuation situations which may include, but are not restricted to, phased property development schemes, leisure properties, investment property valuations, property refurbishment and re-letting schemes, investments with income voids periods.

7

The residual method

Where market evidence is available, the investment or comparable methods of valuation are appropriate. This caveat applies to land as well as to buildings but unless the land comprises a relatively small, single site for which there might be some evidence of sales, differences in the size, shape and potential suggest that it is unlikely that a comparable transaction would be forthcoming. Where it is required to provide a valuation of undeveloped land or value land with obsolescent buildings incapable of producing an economic rent but which are suitable for redevelopment, the residual method may be used. The current rent, where the existing property is let, is unlikely to be a guide to value; similarly, it is equally unlikely that a similar site or group of buildings have been sold recently that would provide even a rough indication of what the land and buildings are worth. In these circumstances, the valuer tends to mimic the market; that is, the possibilities of developing or redeveloping the site are explored to determine whether a viable use can be found for the site which would offer a means to value it. Generally, the approach would be to calculate the difference between the final value of the redeveloped site and the cost of carrying out the development work, sufficient to give the developer a satisfactory return that takes account of the risks inherent in such an undertaking. Determining whether land has a redevelopment or development value is related to whether a satisfactory planning consent can be obtained for the proposed scheme. Essential to the considerations is the understanding that not only must planning requirements be met, but the scheme must also generate interest and demand for it to sell either as an investment or for owner occupation upon completion. Apart from any novel ideas regarding what might be suitable and profitable, there will be general views as to the type of development suitable for the site and the immediate area. One of the considerations is that a sizeable site may be developed in many different ways and for different uses, subject always to planning consent. Where the site is large enough to allow for internal access roads and some mixed use, a tentative layout is central to the investigations necessary to make a bid for the site.

114

The residual method

Factors affecting value As indicated above, many factors could influence any proposals for development and consequently the value of the land. These include: • • • •

• •

•

the area, shape and contours of the site the existing road frontage and ease of access, including any apparent problems the location of the site and its suitability and accessibility for the use or uses proposed the proportion of the site that may be developed in relation to the total site area. Any proposals would have to take into account service ducts, main sewers, easements, overhead power cables and physical features such as slopes, flood plains and the nature of the subsoil the geology and soil and its effect on additional costs of foundations and substructures any planning considerations such as the likelihood of restrictions on hours of business, height of buildings, community infrastructure levy, highway improvements, building materials to be used and similar considerations statutory and other protection of the existing buildings. In England and Wales buildings may be listed as being of architectural or historic importance or they may be susceptible to listing. Any such designation may affect the layout and external appearance of any new buildings.

This list is illustrative, not exhaustive, but it indicates the types of problem and the probable delays associated with each item. It also indicates the requirement for painstaking enquiries and preparation to avoid likely problems.

The basic approach In essence, the method is a cost-based approach which is then related to a final value to test the viability of any development proposal. The procedure for determining site value is illustrated in Figure 7.1; alternatively, where the cost of the land is known, the procedure is shown in Figure 7.2. VALUE ON COMPLETION OF DEVELOPMENT less COSTS AND DEVELOPER’S PROFIT leaves SURPLUS FOR SITE PURCHASE Figure 7.1 Residual valuation: basic approach to calculation of site value

The residual method 115 VALUE ON COMPLETION less CONSTRUCTION COSTS AND SITE PURCHASE COSTS leaves BALANCE FOR DEVELOPER’S PROFIT

Figure 7.2 Residual valuation: basic approach to calculation of developer’s profit

Criticisms The approach is not without its critics. It is claimed that the inputs can be manipulated to such an extent that any result can be achieved. This is an overreaction, particularly when the purpose is to acquire land and/or buildings for development or redevelopment in the light of competition from other parties similarly interested. Too low an offer on the part of the potential purchaser is likely to fail when other bids are received, whilst an owner with an inflated view of value is likely to experience a dearth of interest and a failure to find a buyer. For a developer to be interested, there must be a reasonable prospect of a profit on completion and compensation for taking on specific risks, particularly that of attempting to assess the future market. Where the criticism may be justified is where the assessment of value is a theoretical exercise to establish a value for acquisition where there is one buyer and the value will not be tested in the market.

The bidding market for development land In the normal situation, the property development market is composed of builders, developers, investors, speculators and others wishing to purchase land for the purposes of redevelopment. They normally arrive at the value of the site by a deductive process and their principal concern is to decide whether the value of the completed project justifies all the costs of completing the development. The difference between the value of the completed development and the costs of carrying out the scheme represents the maximum bid the developer can afford to make on the basis of the inputs used. Different developers may arrive at higher or lower bids reflecting levels of efficiency, costs of overheads, the firm’s cost of borrowing, or the desire to purchase a particular piece of land. Thus the residual method has the attributes of a ‘calculation of worth’ rather than of market value, because the inputs into the valuation are often highly specific to a particular developer or bidder. The matter of worth versus market value is important. When developers are considering a bid, they need two points of reference: worth, which

116 The residual method is a calculation showing what they can afford to pay, and market value, which is what they will have to pay to secure the site from other competing bidders. The unique calculations made by each interested party will result in a range of possible bids. The greater a developer’s efficiency the higher the residue, or resulting value, although not all of the efficiency savings will necessarily be used to purchase the site. A developer should be able to make the winning bid without sacrificing the whole of the increment attributable to the company’s greater efficiency and will consider the likely bids of competitor others together with the benefits of purchasing the site. Except in auction situations, it is possible to make an initial offer to establish interest and possibly obtain feedback from the vendor before negotiations begin. For example, a developer may have calculated a residual value of, say, £1 million for an office development site but would be ill-advised to make an offer until the market price was known. If the site was then placed on the market at £850,000 the developer would be in an advantageous bidding position and may also obtain it for less through the negotiating process. Conversely, had the asking price been fixed at £1.1 million, a purchase at this price would eat into the developer’s profits based on the calculations made. Worth and value therefore set the parameters within which to bid, and where worth is lower than market value the developer may decide to withdraw from the transaction altogether. If the deal is abandoned it would be wrong to conclude that time had been wasted. On the contrary, the exercise has indicated to the prospective developer that the particular site should be avoided unless there is a realistic prospect of either reducing costs or intensifying development to increase the value of the completed project. If negotiations remain open with the vendor then the developer may eventually secure the site at the higher price but with a more profitable scheme in the end. This is an example of the way in which development proposals are shaped and refined.

The process of valuation Having collected as much information as possible about the site, locality and costs, the valuer will make use of it in determining the residual value of the site. However, it should be highlighted that the available information may be used to produce results other than site value. For example, the land may already be in the ownership of the developer or its price may already be fixed, in which case the developer may wish to determine the available spend for construction works or may calculate the minimum value of the completed development to justify the payment of a certain land price. The main constituents of the development process are shown in Figure 7.3, whilst a typical allocation of costs is illustrated in Figure 7.4.

The residual method 117 Preliminaries

Construction

Post-construction

Appoint professional team

Define building programme

Finalize lettings (access to tenants for fitting out)

Site preparation Construction work

Organize sale OR Take up long-term finance

Advertise press and onsite

Make all payments due in respect of development

Finalize plans Invite tenders Arrange finance (long/short term) OR Find buyer

Figure 7.3 The main components of the development process

Fees 11% Land purchase   after costs)   (balance 26% 

Finance 11%

Letting  fees  and   marketing  expenses 11%

Building   Costs 26%

Risk and profit     15%

Figure 7.4 Allocation of main development costs

Value on completion The first step is to estimate the gross development value (GDV), which is the capital value of the completed development. If the development involves a commercial property then the floor area of the proposed building is calculated and multiplied by the rent per square metre to find the total rental value. This in turn is multiplied by the years’ purchase in perpetuity at an all-risks yield that has been identified through the analysis of the market. This part of the assessment involves the investment method and is normally straightforward, involving a

118

The residual method

market rent (or rack rent) capitalized in perpetuity for a freehold valuation or, if leasehold, for the length of the ground lease available (or more typically 125 years). Where the interest is leasehold, the frequency and nature of rent reviews, if any, of the head leasehold interest will be relevant to the yield, as will the effect of any unusual provisions in the lease that fetter the developer’s ability to manage and operate the development in the best way. This is because it is assumed that the development will be sold on completion and, accordingly, the estimated costs of transfer are deducted from the final valuation. If the proposed scheme involves residential development then the value on completion is calculated by estimating the sale price of each house or apartment. The estimated sale prices will vary depending on the range of accommodation proposed. Typically one would expect different sale prices for houses with four, three or two bedrooms and similarly distinct prices for apartments of different sizes. In addition, the estimated sale prices should also reflect other distinctive features such as the size of any garage or the number of car parking spaces provided with each property. Analysis of the residential market in the locality should provide sufficient comparable evidence for the valuer to make a reasonable estimate of the property values upon completion. Once this data is collected then the GDV for a residential scheme is calculated by adding together all the estimated sale prices of each residential unit. In the United Kingdom it is usually assumed that the majority of properties in a private development scheme would be sold to separate owner-occupiers with, sometimes, a small proportion allocated for sale to a not-for-profit housing association or equivalent. Mixed scheme developments may involve a combination of different types of commercial property or may involve a combination of commercial and residential property. In the case of the latter, the GDV is calculated using a combination of the investment method and the comparative methods outlined above.

Development costs When estimating development costs, the initial exercise is likely to consist of a broad estimation of the main costs and a view as to whether the completed value of the development is likely to be sufficient to justify further investigation. The main constituents of development costs are discussed below. Building costs The valuer should allow a sufficient sum for building costs and contingencies, especially since these have a ‘knock-on’ effect on other costs (for example, fees and finance). Too generous an allowance, on the other hand, may make the residual amount uncompetitive and result in failure to purchase the site. At this stage a good deal of information, expertise and experience is called for. Details of building costs will eventually be determined when a contract is signed with the appointed contractor. Meanwhile, information will be gathered from a range of available sources. The developer might provide figures based on

The residual method 119 its own cost experience. Price books such as Spon’s or Laxton’s give a wide range of price information; the Building Cost Information Service (BCIS) provides a price subscription service under the auspices of the Royal Institution of Chartered Surveyors (RICS). An edited extract from RICS Building Cost Information Service is given in Appendix A. The proposed development will be measured, typically off plan, to reflect fl the total letting space. It is important for the measurements to conform to the standards laid down in the RICS Code of Measuring Practice (CMP) (2007a). The calculations should also include associated items such as demolition, site clearance and preparation where relevant. With an ever-growing emphasis on environment, costs may include the remediation of ground contamination as a prerequisite of planning permission. The valuer may be able to obtain the advice of a quantity surveyor; alternatively, the development team may have sufficient expertise to advise at this stage. Professional fees and charges Professional fees charged by architects, quantity surveyors and engineers might account for 12–15 per cent of the construction cost depending on the complexity of the building. Charges are levied by the local authority for planning applications and building regulation approval. Site acquisition, the development itself and any sale of the completed scheme will involve fees, charges and expenses. The developer may agree to make a contribution to the professional fees of other parties (for example, as an incentive for prospective tenants) and will be responsible for any arrangement fee in respect of short-term finance. Stamp duty land tax (SDLT) will be payable. Where the developer is registered for VAT the amount paid can be ignored, as it will be recoverable. Charities and certain other groups are in a different position with regard to VAT, and it may be necessary to provide for all or some of the charges. Contingencies An allowance in the region of 5 per cent of the combined building costs and fees is made to cover the cost of unexpected items. The allowance may be higher where significant areas of cost have not been resolved in the early stages. Short-term finance Short-term finance is required to provide working capital to acquire the site, pay for professional services and meet interim and final certificates issued by the architect. The money is borrowed and interest paid for the period of the loan. Three distinct elements require finance: the land acquisition, the construction (the building costs, professional fees and incidental expenses) and the void period (the period following completion of construction until the development is sold or refinanced).

120

The residual method

Total loan followed by sale or refinancing

Interest payable

£

Interest on land throughout development and void period Preliminary

Building work

Void pending letting

Figure 7.5 Interest incurred during the stages of development – shown shaded

Land acquisition Borrowing for the land purchase will be a constant part of the total finance package to cover the site purchase, fees and associated preliminary costs. This is shown diagrammatically in Figure 7.5. Where there is a void period, the land element together with the construction costs need to be financed for an uncertain period beyond physical completion of the works. Construction Borrowing for the construction phase requires progressive access to the total loan negotiated to enable payments to be made as costs are incurred. Where it is possible to predict the rate and timing of expenditure, a more sophisticated cash flow approach can be adopted. Otherwise, an accepted ‘rule of thumb’ is to calculate the total interest on the build costs and to assume that, on average, half that amount will be borrowed over the period. This allows for the fact that not all of the loan will be drawn down at once but at intervals. This approximation provides a quick estimate of interest payments where the detailed construction and project plan are not available. Void period In the case of a commercial property development, once it is completed the premises are available for occupation. However, there is no certainty that a tenant or tenants will have been found by this stage so it is prudent to allow a void period by the end of which the building will be occupied. Many commercial developments are speculative, built in the belief that tenants can be found for the space created. Where possible, the developer will agree sale terms with an institution or other investor to take effect once the development is complete and fully let.

The residual method 121 Marketing the development will take place before construction is completed, but it is unlikely that all the space will be let by the time that it is ready for occupation. Until this point is reached, short-term finance will continue to be required to cover all the costs of land purchase, construction fees and other charges. Where short-term finance is required it is usually arranged through a bank or similar lender to meet the developer’s need to borrow funds. The perception of property development is that of a higher-risk activity. However, the interest rate negotiated may also reflect the size of the loan, the proportion it bears to the total development cost, the existence of a pre-letting or forward sale, and indeed the track record and financial reliability of the developer concerned. In assessing a developer’s best bid for the land, finance costs should be included in the residual valuation even if a developer is acquiring the land and financing construction out of its own funds. This ensures that the opportunity cost of that money is reflected in the valuation and avoids the calculation of a bid price where the developer is effectively paying twice for the land and thus bidding away potential profit. In the event that there is strong competition for a site that the developer is particularly anxious to secure and develop, the firm may choose to forgo some or all of the expected return on internal funding by adjusting the amount included for this item. Where an investment fund is sufficiently interested in acquiring the completed development, it may be the institution that also provides the short-term finance. Advertising and marketing Advertising and marketing are crucial to the development. Publicity costs can be high and not entirely predictable; where lettings are not taking place as anticipated, it may be necessary to re-launch the marketing campaign and increase the budget by a significant amount. Expenditure may include advertisements in newspapers and magazines, radio and television advertising, site boards, show buildings or suites, on-site negotiators, printing of brochures and other publicity material, press releases and general launch costs. The Internet also provides a flexible and effective advertising medium offering extensive cover, and a budget should be allocated for the monitoring of, and response to, online queries and expressions of interest. The allowance is best estimated by costing the proposed campaign and adding a margin; it is inappropriate to calculate the cost as a percentage of the capital or rental value unless the developer has had considerable experience with the particular type of development. Agency fees In the case of a commercial property agency fees are incurred in the letting of units in the completed development and the investment sale of the tenanted entity. Where joint agents are appointed, the total costs are likely to be higher. Agency fees also arise upon the sale of residential properties to owner-occupiers

122

The residual method

or investors. The sale of a residential property to an investor does not normally carry the expectation that the agent will find a tenant for the purchaser ahead of sale. Fees will usually be expressed as a percentage of the estimated rental value used in the GDV. Investment sale fees represent the purchaser’s prospective costs of acquisition, to include an agent, solicitor and stamp duty, with investment sale fees amounting to some 6 per cent of the sale price. The purchaser deducts the sale fees from the GDV to arrive at the net price to be paid. Other costs Other costs may be incurred in compensating outgoing tenants or in winning the consent of occupiers of adjoining property (for example, infringements of rights of light or allowing a crane to traverse the air space). In England and Wales all letting and sales transactions will be liable to SDLT. Developer’s profit The developer’s profit and risk will be shown as a cost of the development process. The amount charged may be a percentage of the net capital value of the completed development or a percentage of the total costs involved, the allowance typically ranging from 10–25 per cent. The level of profit and risk will be judged on the complexity of the proposal, the volatility of the outcome, the prestige of association with the particular development and the extent to which the profitability may be assured (possibly in part by a prearranged sale to a fund or investor).

Land value The gross amount available for land purchase is found by deducting the gross development costs from the net development value. The remaining figure, the surplus, includes not only the cost of the site, but also fees, SDLT and finance charges in acquiring the site and holding it until the development is fully let and income-producing and thus capable of disposal in the investment market. The net amount after deduction of costs is not a value in the strict sense, merely an indication of the maximum bid the particular developer can afford to offer for the site if the required returns are to be achieved on the basis of the information available. The following example demonstrates the whole process in relation to a proposed office development. The accompanying commentary gives a step-bystep explanation of the valuation.

The residual method 123 Example 7.1 A developer wishes to acquire a site in a provincial city where outline planning permission has been granted for the erection of an office block with a gross internal floor area (GIA) of 1,500 square metres. The accommodation will be arranged over three floors served by two passenger lifts and surface parking will be provided for 20 vehicles. There is a steady demand for office suites at rents in the region of £150 per square metre. Short-term finance is available at a cost of 9 per cent and the completed development should show a yield of 6 per cent. Construction costs are estimated at £1,000 per square metre with a building period of 12 months. It is expected that the whole of the space should be let within three months of completion of building works. Advise the company as to the maximum price it can afford to pay for the land, allowing for profit of 15 per cent of the development value. Estimation of site value £ £180,000 16.6667

Estimated rental value 1,200 sq.m @ £150 per sq.m Years’ purchase in perpetuity @ 6% Gross development value Deduct costs of sale @ 5% Net proceeds of sale Gross development costs Gross area 1,500 sq.m @ £1,000 per sq.m £1,500,000 Surface car parking £100,000 Contingencies @ 5% £80,000 Professional fees @ 15% £252,000 Short-term finance @ 9% for 1 year On construction costs (average 50%) On fees (average 75%) On total cost + finance over void period (3 months) Agency fees Fees @ 10% of rents Marketing campaign Total costs of development Developer’s risk and profit 15% of GDV after costs Surplus available for land purchase Present value £1 for 1.25 years @ 9% Gross site value Deduct site acquisition costs @ 6% Maximum available for site purchase − net

£

Note a b £3,000,006 c £150,000 d £2,850,006 e

} £1,680,000 £252,000 £1,932,000

g h i

£75,600 £17,010

j k

£44,092

£18,000 £20,000

f

£136,702

l m

£38,000 £2,106,702

n o

£427,501

£2,534,203

p

£315,803 0.8979 £283,552 £16,050 £267,502

q r s t v

124

The residual method

Commentary The following notes refer to the reference letters in the example, providing additional information where necessary. Notes a–v a

b

c

d

e f

The rent is arrived at from a consideration of current market comparables but will not be determined until the scheme is complete, so is referred to as an estimated rental value. As offices are measured for letting purposes on a net internal area (NIA) basis in accordance with the RICS Code of Measuring Practice (2007a), the given GIA of 1,500 sq m has been reduced, in this case by 20 per cent, to 1,200 square metres. This gives a net to gross ratio of 80 per cent, which is a reasonable estimation for a modern construction. Too much of a reduction from the GIA could suggest that there is an element of waste or poor design and that the plans should be revisited. The yield is determined by reference to recent sales of similar new or modern office buildings in comparable locations. The site is assumed to be freehold and so it is valued in perpetuity unless the development is subject to a long lease. The GDV is the best estimate of capital value of the completed development. It is calculated by multiplying the total estimated rent by the years’ purchase in perpetuity. There is an element of risk in the assessment since the building is not yet available to let and the market for office accommodation is liable to change. A pre-let would greatly reduce that risk although at the expense of possible increases in rental value during the build period. Risk is reflected in the yield adopted for the years’ purchase multiplier. No projection of rental values is used; the valuation is on the basis of current market rental information. Sale costs (agents’ and legal fees and disbursements) are deducted from the capital value of the completed scheme, or GDV, on the assumption that the investment will be sold on completion or once all the suites are let. This is calculated as £3,000.006 × 0.05 = £150,000. The capital value out of which all costs and profit must be met. Building costs are assessed as accurately as possible on the basis of the GIA using the information available at the time of valuation. Initial costs may be assessed on the basis of current cost, and useful sources of building cost information are Spon’s Architects’ and Builders’ Price Book and the BCIS cost index published by the RICS. However, the valuer of a large scheme will probably take advice from a quantity surveyor who will be in a position to refine the cost estimates as the design progresses. It is unlikely that all the details will have been settled at the time when a bid for the land is being prepared, which suggests that a margin should be allowed for contingencies; once the bid has been made and accepted, any additional costs will reduce the level of developer’s profit.

The residual method 125 g

h

It is usual to allow a sum for contingencies as a normal part of the building process, taking account of the uncertainties attaching to any building venture. The allowance depends on the uncertainties in any particular development but typically would be 3–5 per cent on the sum of construction costs. An estimate of professional fees should be included to allow for input from a range of professionals involved in the development process. The professionals involved include the architect, quantity surveyor, mechanical and electrical engineer and others as required. The fee estimate tends to be a composite figure usually in the range of 12–15 per cent of the total building costs. A complex scheme, say one involving demolition and redevelopment behind a retained façade, might require the input of other professionals such as structural or civil engineers and the fee estimate in such circumstances might be higher still. This example assumes a straightforward scheme and so fees are calculated as 0.15 × £1,680,000 = £252,000.

i

j

This is the sub-total of the major cost items. It is the figure upon which developers will assess their profit margin if they choose not to base it on the value of the completed development scheme. The developer will incur interest charges for building finance, which is estimated based on experience as an average amount of one half of the building costs for the whole of the building period. As development is a risky undertaking, the level of interest charged is likely to reflect this. Where internal funds are used, there will be an opportunity cost as they will not be available for other activities of the developer. The lending terms should be established and the total interest will be compounded and paid at the end from the proceeds of sale. In this example, interest on building cost is calculated as: ((1.09)1 – 1) × (£1,680,000 × 0.5) 0.09 × £840,000 = £75,600.

k

A substantial part of the professional fees are earned before construction commences and the interest cost is calculated to reflect this; it is usual to calculate the interest on professional fees on the basis of 75 per cent. Accordingly this figure is calculated as: ((1.09)1 – 1) × (£252,000 × 0.75) 0.09 × 189,000 = £17,010.

l

Where it is anticipated that the building will not be fully let immediately after completion, finance will be required for a further period (in this case estimated at three months). The cost of finance at this stage becomes the whole of the amount outstanding which includes the sum of the major cost items i, together with the compound interest on building costs j and professional fees k. This element is calculated as follows:

126 The residual method ((1.09)0.25 – 1) × (£1,932,000 + £75,600 + £17,010) 0.0218 × £2,024,610 = £44,092.

m n

o p

Note that the compound interest is calculated for 0.25 years, which is the decimal representation of the three-month void period. However, interest on the land element is dealt with separately (see note r below). The sub-total aggregates all the finance costs. Ideally, an agent should be engaged early in the development process and a fee structure and marketing budget established. The building must be let to tenants in order to create a saleable investment. The services of a commercial property agent will incur a fee, usually based on a percentage of the first year’s rent together with the payment of disbursements for advertising and the production of particulars or brochures. Commission at a rate of 10 per cent has been allowed for in this example together with a marketing budget of £20,000. The total estimated costs of the development are shown. The developer’s reward for assuming the risk of development is often assessed as a proportion of the GDV or of the total costs involved. The provision will vary according to the complexity of the development and the developer’s desire to be associated with it. In this example the developer’s profit has been calculated at 15 per cent of the net proceeds of sale (i.e. GDV minus costs): £2,850,006 × 0.15 = £427,501

q

r

s

t

v

The total development costs are deducted from the net proceeds of sale to show the surplus available for site purchase including fees, costs and interest payments. The interest incurred in acquiring the site and holding it until the investment is sold must be deducted, leaving the amount available for site purchase and costs. This is done by applying the present value (PV) @ 9 per cent for the total development period, which includes both the construction and the void periods. Accordingly, the PV applied here is the PV @ 9 per cent for 1.25 years, i.e. 1/ (1.09)1.25 = 0.8979. This is the sum available for site purchase and site acquisition costs. It is found by multiplying the surplus for land purchase by the PV multiplier (i.e. q × r). Site acquisition costs of 6 per cent of the site bid. To calculate this v must be deducted from the gross site value. To calculate this figure, find the net site bid v and deduct it from the gross site value to find the acquisition costs. See paragraph v to see how to do this. The net sum available for site purchase must not include site acquisition costs; these costs must be deducted from this same net sum. To solve this conundrum the valuer must find the inverse multiplier to apply to the gross site value to find the net site value. Accordingly, the simple formula 1/1 + 0.06 calculates the inverse multiplier, where 1 + 0.06 represents the site value (1) plus the estimated percentage sale costs (0.06). When the inverse

The residual method 127 of 1.06 is found (by dividing 1.06 into 1) then the resulting multiplier will reduce the gross site value s to a net site value v that excludes costs at 6 per cent. The calculation is performed as follows: 1/1.06 = 0.9434 0.9434 × £283,552 = £267,502. The result (the ‘residual value’) is the maximum available for site purchase after payment of all site acquisition costs. It should be emphasized that the amount is the maximum available and not necessarily the value. It may be seen as a calculation of worth to the particular developer; other interested parties may have different views as to the precise form of the development, the costs and the eventual market value. At this stage, this result indicates a basis for negotiation, enabling a first bid to be made to gauge the reaction of the vendor.

Where land is already owned There are occasions where the land and buildings are already in the ownership of the developer, either through a recent acquisition or because they are part of the holdings of an investor who now wishes to redevelop. The book value or the recent purchase price will be available as part of the exercise to test whether a redevelopment is viable. All costs, including stamp duty and interest, can then be included in the calculations, in which case the surplus, if any, will represent the developer’s profit. At this point, the developer will be in a position to decide whether the profit is sufficient to justify proceeding. Example 7.2 The facts are as given in Example 7.1 except that the land is available at the asking price of £255,000. The developer wishes to know whether the proposal would show a profit. The previous calculations in Example 7.1 are adjusted to take account of this additional information. Gross development value on completion of scheme Estimated rental value 1,200 sq.m @ £150 per sq.m Years’ purchase in perpetuity @ 6% Gross development value Deduct costs of sale @ 5% Net proceeds of sale Gross development costs Gross area 1,500 sq.m @ £1,000 per sq.m £1,500,000 Surface car parking £100,000 Contingencies @ 5% £80,000 Professional fees @ 15% £252,000

£ £180,000 16.6667

£

Note a b £3,000,006 c £150,000 d £2,850,006 e

} £1,680,000 £252,000 £1,932,000

f g h i

128

The residual method Short-term finance @ 9% for 1 year On construction costs (average 50%) On fees (average 75%) On total cost + finance over void

£75,600 £17,010

period (3 months)

j k

£44,092 £136,702

Agency fees Fees @ 10% of rents Marketing campaign Total costs of development Add price required for site Acquisition costs @ 6%

£18,000 £20,000

£38,000 £2,106,702

£255,000 £15,300

Add short-term interest 1.25 yrs @ 9% Profit available on basis of fixed price for site Profit as a percentage of GDV after costs

£270,300 £30,743

l m

n o i ii iii £2,407,745 £442,260 15.52%

Commentary The calculations have been adjusted, in particular to take account of the information given regarding the price of the land. The key difference in Example 7.2 is that the developer’s profit figure has been omitted and in its place the land cost and associated expenses are included. By so doing the bottom line is no longer the residual land value but instead it is the amount available to reimburse the developer for risk and profit. Notes i–iii i ii

Here the known net land cost of £255,000 is included in the calculation. The acquisition costs of 6 per cent are calculated on the net land cost, thus: £255,000 × 0.06 = £15,300. iii The interest charges on the loan to cover the cost of the land plus the acquisition fees are calculated over the whole of the 15-month development and letting period. Measured as a percentage of GDV it is 15.52 per cent, only slightly more than specified by the developer in Example 7.1. On paper, the developer will make an additional £14,759 profit. Both examples may be criticized for the assumptions necessarily made. The residuals both assume that most borrowings are evenly spread throughout the build period and that costs are incurred from day one, neither of which is true in practice.

The residual method 129 A cash flow approach would enable the valuer to be more precise in the timing of cash flows that may have a significant effect on viability, especially where short-term interest rates are high or development periods long.

Discounted cash flow The following example uses discounted cash flow in an attempt to add precision to the exercise, in that there is an opportunity to show inputs and outputs more nearly to where they are incurred. It cannot, of course, take account of those unexpected items that add to the cost once the land has been purchased and the development process has commenced. Example 7.3 A developer has identified a site suitable for the erection of four small office blocks that will appeal to local professional firms wishing to have occupation of the whole space in one of the buildings. Provide an estimate of the maximum site value on the basis of the following information: Costs by quarters Year 1

Year 2

Quarter 1

–£135,000

Quarter 1

–£150,000

Quarter 2

–£130,000

Quarter 2

–£164,000

Quarter 3

–£145,000

Quarter 3

–£170,000

Quarter 4

–£160,000

Quarter 4

–£190,000

Lettings will commence at the beginning of the second year and the rent roll will be as follows: Lettings by quarters in Year 2 Quarter 1 (one unit)

£15,000

Quarter 2 (three units)

£45,000

Quarter 3 (four units)

£60,000

Quarter 4 (four units)

£60,000

Building costs are expected to rise by 1 per cent per quarter. The buildings will be let or sold on completion according to occupiers’ wishes. No allowance has been made for any increase in rental values, which would be fixed for a period in the case of a lease; any increase in capital value is likely to be marginal and not sufficiently certain as to include in the calculations. The development is expected to show a yield of 7.5 per cent on sale.

130

The residual method

Finance is available at 2.5 per cent per quarter, compounded up to the end of the development period in two years’ time. The developer requires a return on expenditure of 15 per cent of capital value. SOLUTION Period Development Inflation fl (quarter) costs @ 1% 1 2 3 4 5 6 7 8

–£135,000 –£130,000 –£145,000 –£160,000 –£150,000 –£164,000 –£170,000 –£190,000

1.0100 1.0201 1.0303 1.0406 1.0510 1.0615 1.0721 1.0829

Current Rental cost with payments inflation received –£136,350 –£132,613 £0 –£149,394 £0 –£166,497 £0 –£157,652 £15,000 –£174,089 £45,000 –£182,263 £60,000 –£205,743 £60,000

Sale of all units Total rents p.a. YP perp, 7.5%

£240,000 13.33333

Deduct developer’s profit at 15% NPV

£479,998

Net cash flow –£136,350 –£132,613 –£149,394 –£166,497 –£142,652 –£129,089 –£122,263 –£145,743

Quarter interest @ 2.5% 0.9756 0.9518 0.9286 0.9060 0.8839 0.8623 0.8413 0.8207

NPV

–£133,024 –£126,223 –£138,727 –£150,838 –£126,083 –£111,313 –£102,856 –£119,618

£3,199,992 PV @ 2.5%

0.8207

£393,956 £2,806,036

Summary • • • •

•

• • •

The residual method is used where there is potential for development, redevelopment or refurbishment. It enables a site value to be found without direct market evidence of value. The method simulates the approach taken by developers bidding for sites on the open market. Development is a complex activity, dependent on a wide range of variables, thus making the comparison method a much less suitable framework for valuation. The rationale of the method is that the investment value of the completed development less total construction and associated costs leaves a surplus with which the developer can finance the purchase of the land including fees and other costs. The input variables need to be carefully researched and considered to avoid any knock-on effect throughout the calculations. The residual is highly flexible and can be used to determine the developer’s maximum land bid or the profitability of a given scheme. The method can be criticized as being too simplistic in its approach to timing of costs including finance charges – these matters may be alleviated by use of a discounted cash flow model.

8

The profits method – financial data

Introduction This method of valuation is used in situations where reference to the relative success or profitability of a trading business is used as the means to determine the value of the property within which that business is located – in other words, where, for reasons of monopoly, uniqueness or nature of the business concerned, the value of the property or land is bound up within the business itself. Therefore, given that this method of valuation requires review and consideration of the report and accounts of a trading business before any valuation is undertaken, these two aspects of the valuation process are dealt with in separate chapters in this book. This chapter gives an overview of business accounts and outlines how they may be used to provide insight into the business. The next chapter explains the profit valuation method. Businesses such as racecourses, theme parks, marinas, ski slopes (with hotels, restaurants and ski lifts) and casinos are sufficiently unusual to limit the scope for valuation by comparison; the value is therefore likely to be directly related to the business takings. In some activities such as horse racing and skiing, the weather will also play a part in the level of activity. Also, although not monopolies in the strict sense of the word, public houses, petrol filling stations, restaurants, leisure facilities and similar types of use are notoriously difficult to value by comparison and so the profits method is often used by specialist valuers to value these types of properties.

Gathering accounts information It is advisable to extend review beyond the most recent set of trading accounts and a well-established practice is to examine the accounts for the three most recent trading years. A series of accounts should give a more balanced indication of the general health of the business than could be obtained from a set of accounts for one financial year alone. The valuer is better able to judge the performance of a business by reviewing several sets of accounts to establish the most recent financial trends in the business history because reference to only the most recent accounts may not be sufficiently representative of the general trading situation.

132

The profits method – financial data

This is highlighted in Valuation Information Paper no. 6, which is concerned with hotel valuation; it states: ‘… assessment and analysis of historic performance is generally from the viewpoint of a likely purchaser or operator of the business. In this context, it is important to note that current and past performance is no guarantee as to future potential. The task of the valuer is therefore to assess future trade on the basis of such a competent operator (unless the valuer assumes otherwise, in which case the Assumption should be clearly stated in the Report), rather than an existing operator. Current performance may either overstate or understate the market’s assessment of trade’. (RICS 2004, p. 3) Valuers should be cautious if for any reason the business cannot produce accounts for the most recent trading year, or, if their presentation appears to be subject to unreasonable delay, then further enquiries are essential. As an alternative, it may be possible to gain some insight into the business from the content of the uncompleted accounts from the trader’s accountant (but only with the trader’s co-operation). However, there is no substitute for the audited and certified accounts if the valuer is to make an informed judgement about the value of the business.

Overview of company structures Broadly there are two main types of business structures: • •

businesses that are personally owned limited liability companies.

Small businesses may be private limited companies, partnerships or sole traders. Companies are dealt with below. Sole traders are operated by the sole owner, and partnerships are operated by two or more (normally not exceeding 20) owners trading as a partnership. Each and every partner is responsible for the debts of the firm. Finance is raised from the owners of the firm and from banks and private loans, often secured on some or all of the business assets and sometimes personally guaranteed by one or more of the owners. Larger organizations tend to trade as limited liability partnerships (LLP) or public limited companies (plc). The extent of the liability of shareholders in a company is limited to the amount invested or promised to be invested; they have no further liability or call on other assets they may own. Public and private limited companies are regulated by the Companies Acts. There is no bar to the small individual trader committing a cash payment and forming a company. The cash payment confers upon the owner a number of shares in the company, thereby creating the company as a separate entity distinct from the owner. The company may then limit its liability as described above

The profits method – financial data 133 without further recourse to the owner’s assets. As companies develop and grow an advantage of trading as a limited company is that financial needs that extend beyond the initial capital from the original owner may be raised by the further issue of shares or, in the case of larger companies, debt instruments such as debentures. The shares of public companies are traded on the Stock Exchange or, in the case of smaller limited companies, on the AIM (formerly known as the Alternative Investment Market). Share ownership There are different classes of share: preference shares carrying a fixed rate dividend and, the main class, ordinary shares. Committing capital to a business by buying ordinary shares effectively means that the individual has a part ownership of the business and ordinary shareholders will receive a variable dividend based on the profitability of the company, depending on how the board of directors choose to distribute company profit at the end of a trading year. As part owners of the business, the ordinary shareholders have rights to vote at the business Annual General Meeting (AGM). Preference shareholders’ dividends are issued ahead of those for ordinary shareholders, and in the event of a trading year with low profits it is possible that preference shareholders receive dividends when ordinary shareholders do not. The report and accounts of public limited companies show, at the bottom of the balance sheet, the value of money invested in the business through shares issue.

Overview of company accounts Before a final set of accounts can be prepared, the company accountants calculate a trial balance from the financial records of the company. The purpose is to confirm the arithmetical accuracy of the double-entry system of bookkeeping which records in the various books of account money received into the business and sums that it has paid out. A normal accounting period is one year so users of financial accounts should note in particular the year end date when all financial transactions are brought together. The result is a set of accounts that show the relative trading success of the business, together with its capital assets and liabilities. A set of published report and accounts usually includes three key financial statements, which are the balance sheet, the profit and loss account or income statement, and the cash flow statement.

Profit and loss account The profit and loss account records the result of the year’s trading and it is prepared by extracting from the trial balance the balances of the books of account concerned with income or expenses. A profit and loss account has two parts:

134 1 2

The profits method – financial data Trading section: This reveals the gross profit by offsetting the primary costs of manufacturing against the sales receipts for goods sold. Profit fi and loss section: This offsets business expenditure on overheads against the gross profit to reveal net profit or loss.

If the business is engaged in manufacturing, the trading account and the profit fi and loss account are usually prepared and presented separately. This is because it is essential that the manufacturer carefully matches the sales revenue against the cost of making those goods, in order to calculate the gross profit. For a manufacturing organization the gross profit in the trading account would then be transferred into the profit and loss account so that overheads and expenses may be deducted in order to reveal the net profit (or loss) for the business. Because a manufacturing business makes the products it sells, the cost of raw materials used in making the products actually sold is calculated. Stocks of unconverted raw materials are excluded from the calculation because they do not match to the sales actually achieved. In addition, the value of the work undertaken to convert raw materials into components or products is included because this directly matches the goods produced and this direct labour is a cost that attaches to the sales of the goods in the trading period. Where this manufacturing labour has made products that are still incomplete, the value of the incomplete goods or work in progress is included in the calculation for gross profit because they represent a cost to the business for the trading period in partly used raw materials and labour. Any finished goods awaiting sale are excluded from the gross profit calculation because they are unconnected to the cost of the products actually sold. Instead, the value of these finished goods awaiting sale are an asset to the business and a potential source of revenue. Thus their value is a ledger balance that is represented on the balance sheet. In contrast to a manufacturing company, businesses supplying professional services will prepare only profit and loss accounts, deducting all business expenses (overheads) from the income. Examples of such businesses are a solicitor’s practice, an accountancy firm or a travel agency.

Balance sheet The balance sheet shows all the remaining balances from the double entry book after those for the trading profit and loss account have been stated. In other words, the balance sheet shows all the balances that remain on the books of account at the end of the trading year and these are either asset accounts or liability accounts. In accounting terms fixed assets are items which have intrinsic worth and which have an expected lifetime exceeding one year, the standard accounting period. They include both tangible and intangible assets and investments. Tangible assets include land and buildings, plant and machinery, fixtures, fittings, tools and equipment; intangible assets represent the company’s view of the value of its goodwill, patents, licences, trademarks and similar rights and assets. There

The profits method – financial data 135 is no current uniform practice in relation to goodwill, but there should be no objection to its inclusion where there is some evidence that a value exists or where it has been purchased from a previous owner. Current assets are also items that have intrinsic worth, but which have an anticipated lifetime of one year or less. Typically these include cash in the bank and debtors (i.e. those owing money to the business). The value of fixed and current assets is shown on the balance sheet. The other main groupings of capital on the balance sheet are liabilities or debts. These are also classified by reference to their term or lifetime: long-term liabilities or loans are those which have a term exceeding one year, whilst current liabilities are loans repayable within one year. An example of a long-term loan would be a mortgage or business loan, whilst current liabilities would include creditors (i.e. those to whom the business owes money) such as suppliers of raw materials who have not yet been paid. The net current assets are represented by stock, debtors and cash less the total amount owed by the firm to short-term creditors, such as trade creditors, any overdrafts from the bank and outstanding tax owed to the Inland Revenue. The net current assets calculation indicates the state of working capital within the business, i.e. how effectively short-term money circulates within the business, enabling it to keep running. Effective working capital management would be maximizing the number of cash receipts for goods sold, requiring debtors to pay their invoices promptly whilst extending the business’s credit terms and payment period to creditors who have supplied raw materials or services. If the double entry bookkeeping system has been followed properly and the arithmetic balances are correct then this equation is true: Capital + Liabilities = Assets i.e. Capital = Assets – Liabilities In summary, the broad purpose of the balance sheet is to record where all the company’s capital came from and where it was spent. It also shows: • • •

the long-term value to be realized from fixed assets the short-term value to be realized from current assets the expected costs of long- and short-term liabilities.

The balance sheet displays all the assets of the business including any profit not distributed from previous accounting periods. The total amount shown is the theoretical value of the business – the amount available should the assets be sold. A business in sound heart would be expected to realize more than is shown, for several reasons. First, there is a tendency to write down assets for depreciation (and tax) purposes, regardless of their true value in the business or the market. After some time, many of the more durable assets of a business will have a nil book value although remaining in operational use. Second, purchasers would

136 The profits method – financial data consider making a payment for goodwill, which may be described as the opportunity to continue trading with the company’s current customers and acquiring new customers attracted by the firm’s name, trademarks and reputation.

Cash flow statement The cash flow statement is included in the report and accounts to show where cash has come from and where it has been spent. Whilst the balance sheet will show the opening and closing cash and bank balances at either end of the trading year it does not reveal the movements of cash between these two points. Equally the profit and loss account may show a healthy profit but offers little information about the liquidity of the company. For example, one element of the cash flow statement is concerned with recording increases or decreases in cash movements within its operating activities. Thus, increases or decreases in the balances of debtors, creditors, stock, accruals,1 prepayments,2 bad debts, etc. are calculated to determine whether there is a cash inflow or outflow from business’s operating activities. In addition, the statement records the decreases or increases in cash flow arising from investment activity and taxation. The relative cash movements are balanced against changes in the financing activities of the business, e.g. through the issue of share capital or debentures to finally reveal the net increase, or decrease, in cash to the business.

The use of company accounts A review of the set of accounts for the last complete financial year will give some indication of the health of the business. Individual components can be used to measure various aspects of the profitability of the business, and various recognized ratio or performance indicators assist in this process. A more thorough picture of the business will be gained by analysing the accounts for the previous three financial years and observing trends in the key financial statements and in the performance indicators. Simplified final accounts for an imaginary business are shown below to illustrate the trading account (Figure 8.1), the profit and loss account (Figure 8.2) and the balance sheet (Figure 8.3). In addition, an illustration of how these main statements of account are used to derive the divisible balance for the profits method of valuation is set out in Figure 8.4. In this simplified example the accounts presented are for an imaginary business Aquasport, which is a small water sports club specializing in providing club facilities and training courses for rowing, sailing and canoeing crews. The club has a bar and small function room, boathouse, moorings, and a small gym plus a modest retail facility selling specialized sports kit and equipment. The club owns one large towing vehicle, three boat trailers (one large, two small) and three outboard engines and a range of boats and canoes.

The profits method – financial data 137 Figure 8.1 Final accounts: the trading account Final accounts for Aquasport for the year ended 31 December 2013 Trading account £ Sales

£ 343,045

1

Less

Returns

10,500

Discounts given

15,454 25,954 317,091

Cost of sales

2

Opening stock at 1 January 2012 Purchases Discounts received Closing stock at 31 December 2013

35,670 123,052 –1,485 –44,500 112,737

Gross profit fi

204,354

1 Sales include club subscriptions, training courses, function room hire and kit/equipment sales 2 Cost of sales arise for the retail outlet and bar/function room

Figure 8.2 Final accounts: the profit and loss account Profit and loss account £ Gross profit fi

£ 204,354

Interest received

4,750 209,104

Less expenses Management and administration costs

20,100

Heat, light, power, security and mooring costs

72,526

Bank charges and interest

3,124 95,750

Net profit fi

113,354

138

The profits method – financial data

Figure 8.3 Final accounts: the balance sheet Balance sheet Fixed assets Fixtures and fittings Training equipment Marine sports equipment

£ Cost

£ Depreciation

16,500 35,000 62,500 114,000

1,500 4,250 12,500 18,250

Current assets Stock Debtors and prepayments2 Cash at bank and in hand Current liabilities Trade creditors and accruals1 Other liabilities Net current assets Net assets Capital accounts Hi Lo

£ Net book value 15,000 30,750 50,000 95,750

44,500 15,250 17,255 77,005 43,725 13,252 56,977 20,028 115,778 68,970 33,393 102,363

Current accounts Hi Lo

7,700 5,715 13,415 115,778

Figure 8.4 The divisible balance To find divisible balance: Net profit Return on capital employed say Divisible balance Shared 60% to trader 40% to freeholder

£ 113,354 9,262 104,092 62,455 41,637 104,092

The profits method – financial data 139

Analysing the accounts The final accounts for the year show the gross and net profit together with the asset values, and give a general impression of the health of the business. Further information can be gleaned by looking at the strengths and weaknesses of the business. The final accounts can be analysed in a number of ways, and where more than one year’s accounts are available, trends can be established. There are various standard ratios and measures that can be applied to business accounts to assess the underlying position of the business and these may be broadly grouped as follows: • • • •

Profi fitability ratios show if the company is operating profitably in order to reinvest and grow. Liquidity ratios are calculated to determine the company’s ability to pay short-term debts. Solvency ratios indicate whether the company has sufficient owners’ capital to pay long-term debts. Effi ficiency ratios indicate how effectively capital has been employed within the company.

Set out below is a summary of the more common ratios that can be applied to a set of company accounts.

Profitability ratios Return on Capital Employed (ROCE) In its most simple form the ROCE ratio is expressed as Profit × 100 = x% Capital

There are various ways of interpreting and then calculating this ratio but a common formula is: Profit before interest and taxation (PBIT) ×100 Shareholders’ funds + Long-term loans

where PBIT = operating profit plus interest received minus interest paid on longterm loans The profits of a business are related to the capital employed by the owner. The level of return would be expected to exceed that obtainable by depositing the capital in a relatively safe investment such as a building society account. The owner would expect a significantly higher return for the uncertainty and additional risk assumed in employing the capital in a business.

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The profits method – financial data

Gross profit ratio Gross Profit × 100 = x% Total sales revenue

There is likely to be an industry norm against which to compare but as a general principle overstocking and subsequent sales may erode this margin. The gross profit needs to be sufficient to cover all the expenses of running the business. It follows that a high turnover may offer the opportunity to lower unit prices or to offer discounts to some customers. Net profit ratio Net Profit before taxation × 100 = x% Total sales revenue

This ratio is only useful for making internal comparisons in the business because every business has different financing and operating arrangements. Therefore, if using this ratio to compare businesses, then allowance has to be made for any differences between them. Accordingly, this ratio is most useful for establishing a pattern and trend for the particular business under scrutiny and it is less useful for cross-sector business comparisons.

Liquidity ratios Liquidity ratios indicate the extent to which short-term business assets can be converted into cash quickly in order to cover any short-term debt or other liability. Such a requirement could arise within one trading year, an example of which could be the repayment of a bank overdraft. Current ratio Current assets or Current assets : Curren nt liabilities Current liabilities

This is the direct ratio between current assets and current liabilities, where the term current indicates that the items under consideration have a lifespan of one year or less and so are regarded as relatively liquid. Some textbooks indicate that a ratio of 2:1 is desirable. However, as Dyson (1994) suggests, there is no evidence to suggest this is necessary, highlighting that the nature of trading for the individual business must be taken into account. For instance, a business with a high turnover dominated by cash payments, rather than payment on credit terms does not necessarily need to satisfy the 2:1 ratio in order to remain solvent.

The profits method – financial data 141 Liquid ratio or acid test ratio current assets minus stock or Current asssets minus stock : Current liabilities current liabilities

This is sometimes referred to as the quick ratio, and it differs from the current ratio because stock is excluded as it is the most illiquid of the assets. In other words stock, because it will take time to sell for cash, is not easy to liquidate quickly. Thus the acid test, revealed by this ratio, is the extent to which a company could call upon cash or near cash assets to settle any sudden demand to meet current liabilities such as a bank overdraft repayment. It effectively indicates the company’s ability to meet debt payments from its bank account and debtor payments. Many texts cite that a desirable ratio balance is an approximate equivalence of 1:1 between liquid assets and current liabilities. However, Dyson (1994, p. 191) argues that there is ‘no evidence to support this view’. Nevertheless, it is fair to say that if the current liabilities exceed the current assets by a significant amount, then the firm might be in difficulty if put under pressure to settle a large shortterm debt. Stock turnover ratio Stock × 365 Cost of sales

The result of this ratio calculation is expressed as a number and it gives an indication of the average length of time that stock is held before it is sold. The result will depend on the type of business and the stock held and should be considered against industry norms. A low number such as 2 will indicate that stock is held for six months of trading whilst a high number such as 26 will indicate that stock is held for approximately two weeks. Where stock has a short shelf-life, the result will be a much higher number indicating that shelf-life may be only a matter of days. Days debtors trade debtors × 365 turnover

This ratio reveals the average time taken for trade debtors (those who have purchased goods or services but not paid for them) to pay the business for their purchases. A retail shop will have few, if any, such customers, whereas a builders’ merchant catering for the trade will transact most of its business in this way.

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The profits method – financial data

Ideally the business should work to minimize this period of time; therefore a high number of days may indicate a potential working capital shortage (available cash) for the business. Days creditors Trade creditors × 365 Cost of sales

This ratio shows how quickly the business pays its accounts to suppliers of goods and services. A delay in making payments can be a cheap source of temporary finance for the business, but constant abuse of the credit facility will be noticed by suppliers and may result in the business receiving different treatment such as a shortening of credit terms or barring from advantageous prices deals. As a general principle effective management of a company’s working capital would be to ensure that the day’s debtors period is shorter than the day’s creditor period, thus ensuring the cash is collected in by the business before it pays its short-term debts.

Using accounts to prepare for profits method valuation When given an instruction to value a building (and/or a business) where the profits method is required, the valuer will need to gain insight into the business operation through the report and accounts. Therefore, before attempting any valuation, the valuer should not only make reference to the main financial statements but also to the company report along with other third-party information resources to arrive at a fair overview of the trading business. Having obtained the business accounts, a review of the written report is essential and the valuer should pay particular attention to any proposed changes to the existing business such as a move into a new market or different country or any activities, past or proposed, that would lead to unusual income inflow or cost outflows for the business. Then a simple year-on-year comparison of the balance sheets, profit and loss accounts and cash flow statements will give some insight into the business operation. During this process any significant differences from year to year are likely to become apparent, and valuers should be aware of any extraordinary expenditure on goods or services and any extraordinary income or capital changes such as fixed assets sales in any one year. Usually such activities have a significant effect on the profit and loss account or balance sheet. Following the initial comparison of the main financial statements of account, the valuer could then calculate financial ratios to gain further insight into the business operation. With three years of accounts available it is possible to calculate ratios for each trading year to establish patterns of activity across the time period. This analysis will then inform the selection of values input into the valuation as it will influence the valuer’s perception of the level of maintainable income and the likely costs associated with this.

The profits method – financial data 143 Finally, it should be remembered that this area of practice is one that is dominated by focused experts, many of whom specialize in the valuation of properties and businesses, in particular business sectors. As a result, they will have access to data about the industry sector, which may not be as readily accessible to all valuation practitioners. Accordingly, whilst this textbook explains the basic principles relating to the five methods of valuation, it should be recognized that property valuations requiring profits method are highly specialized fields of practice. Such buildings are usually valued by specialists who have a good understanding of accounting and business sector norms to underpin their valuation practice. Nevertheless, it is important that the principles of the method are recognized and understood by students and practitioners. Therefore, now that the background to the method has been summarized, the valuation methodology is outlined and explained in the next chapter.

Summary • • • • • •

For reasons of monopoly or uniqueness, the value of some types of properties is bound up with the business associated with them. These types of property may be valued by reference to the trading success of the business with which they are associated. The profits method is a valuation methodology that examines trading reports and accounts as a means to value property. Properties with leisure uses are commonly valued by reference to the profits method of valuation. Valuers should review and analyse the last three years of trading accounts for the business concerned to estimate the appropriate inputs into the valuation. This is a highly specialized area of valuation performed by specialists with a comprehensive knowledge of the sector and a good understanding of financial accounting.

Notes 1 2

Sums owed by the company at the end of the trading period in respect of services it received. Sums owed to the company at the end of the trading period in respect of services paid for in advance.

9

The profits method – valuation

Introduction Thus far in this book the methods of valuation reflect the situation that relates to many shops and offices, and such properties tend to be located in towns and cities where there are a variety of similar properties in the locality. In the case of shops, these usually trade side by side in shopping streets and the valuer will, in normal circumstances, judge rental levels by analysing the rents of occupied premises in the vicinity and applying the results to the shop unit to be valued. Allowances will be made for size, relative location within the trading area and lease variations, and also for any advantages and disadvantages the subject property may have compared with the comparable evidence available. By contrast, the profits method is used primarily to establish a way in which businesses that exhibit some element of monopoly or uniqueness may be valued, or may have their property assets valued. This is done by reference to the profits fi the business generates, and this approach is used when there is an acceptance that they cannot be valued directly by the comparison or investment methods because there are either no similar premises or businesses with which they may be directly compared or comparable transaction data is simply not available in the wider market. The outcome should be a fairly close appreciation of the appropriate rental value, reflecting the opportunity for the tenant company to make a profit from its operations and for the landlord to receive a market rent. In other words, the market rental value is estimated by use of the comparative method described earlier in this book. This might then be converted into a capital value using one of the investment methods of valuation described earlier in the previous chapters of this book. In these circumstances it is possible to see the very clear separation between the rental payment required by the owner, as distinct from the trading profit generated by the business occupier. The valuer, who is primarily associated with the valuation of the interests in the land and building, can easily identify the rental revenue which relates to the building which will be used in generating a valuation for either the owner or the occupier. However, certain types of businesses have a monopoly element that will have a strong influence on the trading results. It may be the building, the use to which it is put, the location or

The profits method – valuation 145 some combination of these features. Such buildings are usually bought and sold on the basis of their trading potential and so are valued using the profits method of valuation. The RICS Valuation – Professional Standards in VPGA 4 state that individual trade related properties have these essential characteristics: • • • •

designed for specific use lack flexibility the property interest is intrinsically linked to returns that can be generated from the business value reflects trading potential. (RICS 2014, p. 84)

Features of the profits method of valuation Using accounts Valuers dealing with business transfers (whether the business is offered with or without the freehold or leasehold interest of the premises) will need to have access to financial accounts but they should remember that they are not accountants and should not work beyond their competence. It is always prudent to seek information or advice from the client’s accountant or another conversant with the type of business carried on. This would particularly be the case where the business is complex or has a large turnover. Business potential A prospective purchaser may hold the view that current profits could be improved substantially by better management, improved financial controls, or the incorporation of other sales lines or improvements to the business. To the extent that any business potential would also be recognized by other prospective purchasers, the ability to create additional profits will be taken into account in any offers made by interested purchasers. Such aspects should be reflected as an intrinsic part of the value of the business, although the eventual purchaser would expect some benefit for the effort and cost of harnessing the potential. In fact, there may be a perfectly good reason why the vendor has not implemented the change (or perhaps did so in the past and found it unsuccessful). The purchaser will be taking the risk of failure associated with any change or new idea. The business operator An important part of the value of some types of business to which the profits principle may be applied is the personality of the owner or operator. It is well known that a business fronted by a celebrity or character is likely to experience an increase in custom. For example, a famous chef will be of immense value to the reputation of a restaurant. Ex-boxers are often very successful public house landlords. The same may apply to experts; a car tuning station run by a former

146 The profits method – valuation racing driver or a sports centre supervised by an Olympic athlete are likely to attract additional business by association with the well-known name. That element of value is unique and cannot be transferred. Equally, another wellknown person could attract his or her own following, but it would be wrong to pay a price based either on the reputation of the vendor or on the expectations of the drawing power of a particular new owner. Conversely, it is sometimes found that a business has been neglected by an owner who is financially restricted, ill, lazy or incompetent. Such a business may be judged capable of substantial improvement given competent and unfettered management. To the extent that it can be judged, some allowance may be made for such a prospect, although again the prospective purchaser would expect to negotiate a price that acknowledged the effort, time and risk associated with any such enhancement.

Situations where the profits method may be used The profits principle is used in a range of cases where any of the other approaches are unlikely to be satisfactory. It is used by valuers specializing in, and with wide experience of, the particular type of business activity under consideration. Not only is there a need for an intimate knowledge of the type of business, but the valuer should be aware of the statutory provisions where the valuation is for rating or compulsory purchase purposes. Examples of properties that are valued by reference to their trading potential include hotels, restaurants and night clubs (RICS 2014).

Valuation approach Instructions relating to trade related property will normally require a valuer to provide a market value or a market rent figure. Both types of valuation will require the valuer to refer to the profit generated by the business and to make an assessment as to the net profit that could be achieved by a ‘reasonably efficient operator’ (REO) (RICS, 2014).

Reasonably efficient operators At the most fundamental level businesses exist by selling products and services to customers to generate revenue, or turnover, that exceeds business costs, or overheads, in order to create a business surplus or profit. For valuers reviewing the accounts of a trading entity their starting point is to judge whether the turnover reported reflects the level of revenue generation that could be achieved by a reasonably efficient operator (REO) (RICS 2014). Experienced valuers, familiar with the business sector, will know whether the amount of sales generated (turnover), fully reflects what is possible for a particular business entity in a particular location. Where valuers judge the turnover to be either excessive or constrained, they will adjust the turnover downwards or

The profits method – valuation 147 upwards, respectively, to reflect this fact and this will be deemed to be the ‘fair maintainable turnover’ (FMT) (RICS 2014, p. 85).

Net profit, adjusted net profit and EBITDA When all business costs are deducted from turnover the result is a profit, or loss for the business. Therefore, in general terms, net profit is the positive sum left in the accounts once all business costs have been deducted from total sales (turnover) and a simple example is provided in Figures 8.1 and 8.2 in Chapter 8. A valuer assessing this business will review these accounts and make adjustments for ‘any abnormal and non-recurring expenditure, finance costs and depreciation relating to the property itself, as well as rent where appropriate’ (RICS 2014, p. 85). The adjustments made by the valuer might involve increasing or decreasing the cost of these items resulting in, respectively, a reduced or increased adjusted net profit compared with the reported net profit in the accounts. Very simple businesses, such as privately owned family enterprises, may report net profit in their annual report and accounts. More complex businesses and typically publicly quoted businesses tend not to state net profit fi but instead state earnings before interest, taxes, depreciation and amortisation (EBITDA) which is the nearest equivalent item in their report and accounts. In either case valuers must review the ‘profit’ outturn, and where appropriate, make any adjustments to it, mindful of the level of turnover and the nature and location of the business. The result is their assessment of the fair maintainable operating profit (FMOP) for the business entity concerned given their knowledge and understanding of the particular market sector.

Fair Maintainable Operating Profit Having made adjustments to the fair maintainable turnover to reflect what would be achieved by a reasonably efficient operator (REO), the result is the fair maintainable operating profit (FMOP). From the FMOP the valuer will determine the market value or with some further adjustment make an assessment of market rent for the property. Discounted cash flow is another alternative method for the valuation of leisure property. However, as this chapter in this book is concerned with an explanation of the profits method it will not pursue DCF further and readers are directed back to the chapter about discounted cash flow to consider how it can be adapted to capture the various income streams and costs associated with a leisure property in order to value it.

Sale of a business as a going concern When a business is for sale in the open market as a going concern there may be a goodwill element. In these circumstances the price will then reflect not only the intrinsic value of the physical premises but also the benefit of acquiring an

148

The profits method – valuation

established business with its clients or customers who may be expected to continue to patronize the business after sale to the new owner. Whilst this is commonly the case with many leisure properties it may be appropriate to apply a variation of the profits principle to other types of premises where, although not a monopoly, the business may be unique to the immediate area. An example would be a general store in a small community in a remote or rural area. Typically, this might be the only business of its type in the locality and it may also incorporate living accommodation. In these circumstances one approach would be to value the business in two parts. First, either the market rental value is capitalized to derive a capital value for the building, or the valuer’s knowledge and experience of the market is used to go direct to determining a capital value based on the residential market in the vicinity whilst also making an allowance for the profits from the retail element. Depending on the nature of the general store and the country in which it is located it could be that such a business, with living accommodation combined, located in a small community would attract considerable interest given its local business monopoly. The opportunity to live and work from home with a relatively stable income and profit may offer an attractive business enterprise where there is no obvious competition nearby or within easy commuting distance. However, retail and business trading patterns change over time and the valuer must take this into account in preparing the valuation. In England, many small village general stores have disappeared entirely in the face of overwhelming competition from nearby supermarkets, and from Internet retailers who deliver goods direct to the customer’s home. In other countries, however, this is not necessarily the case and a general store in a small rural community may still have good trading potential for the foreseeable future. More commonly, the profits method of valuation is used for valuing various types of leisure property such as hotels, cinemas, sports centres and marinas for which there are no obvious direct comparators. Such properties are unique not only by virtue of their location but also in respect of the business clientele, reputation, bespoke products or services, etc. Hence, even two hotels in a particular location will not only have slightly different built specifications and facilities but are also likely to have different profiles in terms of business reputation and customer loyalty. These factors will affect the net profit of the business which, when adjusted in the profits method of valuation, will also affect the value of the building and the value of the business as a going concern when they are valued using the profits method.

Approach to assessing market value To arrive at a market value, the valuer should capitalize the fair maintainable operating profit (FMOP) at an appropriate rate of return to arrive at a capital value (RICS 2014). The expectation is that the valuer would have knowledge and experience of the sector and access to comparable evidence to enable this assessment to be made. Further valuers would also reflect in their valuation any

The profits method – valuation 149 costs involved in alterations or repairs required to enable the fair maintainable turnover (FMT) to be achieved by the reasonably efficient operator (RICS 2014). Example 9.1 The Courtyard is a café that occupies a prominent site in the centre of a prosperous town; the property is owned freehold by the business owner/operator. The café sells coffee, snacks, cakes, and meals and it is licensed to sell alcoholic beverages with meals. The café is open during the day but not in the evening. The accounts have shown a steady increase in turnover and profit over the last three years and the latest accounts show receipts of £260,000 and the net profit of the business is £67,150. The café and business are being offered for sale and the profits valuation is made on the basis that the reasonably efficient operator will continue to operate the café and generate this level of turnover and profit, which in turn are used to provide an indication of the value of the business. The Courtyard Profit and Loss Account (operator is an owner occupier) Turnover judged as being FMT

£260,000

Cost of sales (purchases) Gross profit

£98,800 £161,200

Less business expenses Staff Electricity and gas Business rates Repairs and maintenance Total

£80,000 £10,000 £2,250 £1,800 Net profit judged to be FMOP Capitalized at 7% Market value

£94,050 £67,150 14.2857 £959,286

Commentary This simple valuation example shows where the valuer is required to make a judgement about the profitability of the business and to consider whether the operator is a reasonably efficient operator (REO). In this case the valuer considers that the turnover that was achieved in the last year of trading is the fair maintainable turnover (FMT) and the business costs are reasonable thus giving rise to a fair maintainable operating profit (FMOP). Comparables known to the valuer indicate that the appropriate rate of return (YP perp) is 7% which, when applied to the FMOP, returns a market value of £959,286.

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The profits method – valuation

Approach to assessing market rent In common with other commercial properties, leisure properties also have two types of occupier, one type, as outlined in Example 9.1 above, is an owner occupier who also operates the business; the other type is a tenant operator who does not own the property but who pays a rent for occupation in order to run his business from the property. In the second scenario a landlord owns the property, receives a rent but takes no role in operating the business. Periodically an appropriate market rent must be agreed between the landlord and the tenant under the terms of the lease. To determine a market rent, again the final audited accounts must be used and, as before, the valuer must make a judgement as to the fair maintainable operating profit (FMOP). From this figure allowances are then made for interest on the tenant’s capital invested in the business. The remaining amount after these adjustments have been deducted is referred to as the divisible balance. This sum is then assumed to be available for an equitable division between the business trader and the property owner. In academic examples this balance is often apportioned equally between the two parties but there is no requirement for this to be done in practice. The objective is to reflect the contribution of a party to the success of the enterprise and in the case of the property owner’s position it indicates the level of rent that could be paid by a tenant for the right to occupy. The reason for adjusting accounts in this way and then dividing the divisible balance between the parties is to provide an adequate reward to the tenant for running the business, while properly reflecting the contribution of the landlord in providing the premises. Specialist valuers engaged in this type of work will know the business sector very well and so will have a sound knowledge of typical patterns of return, and this will enable them to make appropriate adjustments to the accounts and also make fair allocation of the divisible balance between the two parties. Example 9.2 The earlier ‘Courtyard’ café used to demonstrate the approach to market valuation is revisited here to show the approach to calculating the divisible balance and the revised market rent if the property was occupied by a trader tenant rather than an owner trader. The Courtyard Profit and Loss Account (operator occupies the property under a lease) Turnover judged as being FMT

£260,000

Cost of sales (purchases) Gross profit

£98,800 £161,200

Less business expenses Staff salaries Electricity and gas

£80,000 £10,000

The profits method – valuation 151 Current rent payable Business rates Repairs and maintenance Total

£12,000 £2,250 £1,800 £106,050 £55,150

Net profit Add back Current rent payable Adjusted net profit judged to be FMOP

£12,000 £67,150

Allowances for tenant’s investment in the business Trade fixtures and fittings £20,000 Stock £2,500 Cash and working capital £500 Total of tenant’s investment in business £23,000 Return on capital @ 5% Divisible balance Tenant’s share Landlord’s share – Market rent

£1,150 £66,000

50% 50%

£33,000 £33,000

Commentary In this example the accounts up to gross profit are identical to those shown in Example 9.1. The main difference is that here under business expenses the current rent passing is deducted. As the instruction is to determine the market rent the valuer must exclude the rent currently payable by adding it back into the business accounts and thus show an adjusted net profit which in turn is assumed to be the fair maintainable operating profit (FMOP). This accords with the RICS Valuation – Professional Standards which state that FMOP is ‘the level of profit, stated prior to depreciation and finance costs relating to the asset itself (and rent if leasehold), that the reasonably efficient operator (REO) would expect to derive from the fair maintainable turnover (FMT)’ (RICS 2014, p. 85). The valuer then makes a further allowance to the FMOP to take account of the tenant’s investment in the business. This also accords with the requirements of the Red Book which states ‘to assess the market rent for a new letting … an allowance should be made from the FMOP to reflect a return on the tenant’s capital invested in the operational entity – for example, the cost of trade inventory, stock and working capital. The resultant sum is referred to as the divisible balance. This is apportioned between the landlord and tenant having regard to the respective risks and rewards, with the landlord’s proportion representing the annual rent’ (RICS 2014, p. 87). In this case the tenant’s capital investment in the business totals £23,000 and a 5 per cent rate of return on this capital is deducted from the FMOP to arrive at the divisible balance. In this example the divisible balance is shared equally

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The profits method – valuation

between the two parties and so the proportion representing the landlord’s share is considered to be the market rent for the property, in this case it is £33,000.

Approach to valuation for investment purposes In common with other types of commercial property a market exists in the ownership and sale of leisure properties between investors in the leisure property market. In these circumstances the investors are not the trade operators growing or running the leisure business, they are speculators on the capital value and rental growth of properties in the leisure sector. As such they purchase properties and lease them to leisure business operators for which they receive a rent in return. Valuing such properties for investment purposes is undertaken by reference to the market rent and the terms of the lease on the property. The valuation for investment purposes is calculated by applying a capitalization rate to the market rent as the example below shows. Generally, the capitalization rate for an investment property differs from that applied to vacant possession valuations (RICS, 2014) or sales of leisure businesses between leisure business owner-operators. The latter case involves a transfer of the whole business to a new purchaser together with the vacant trading property. The appropriate capitalization rate for valuing a leisure property investment is selected by the valuer by reference to, and analysis of, comparable transactions in the market. Example 9.3 a.

Valuation of the building: With reference to the example accounts in Figures 8.1–8.4, the market rent of the asset is already calculated in Figure 8.4. The 40 per cent share of the divisible balance accruing to the freeholder is the market rent for the property. The valuation of the property as an investment is shown below. Value of the building Market rent YP in perpetuity at 7% Capital value of property

£41,637 14.2857 £594,814

Commentary In this example the market rent is calculated as £41,637 and the valuer has used his knowledge and evidence of comparables in the market to capitalize the rent at 7 per cent all risks yield to return a value of £594,814.

The profits method – valuation 153 Example 9.4 Returning to the ‘Courtyard’ café valuation shown above in Example 9.2 the valuation for investment purposes is shown below. Market rent £33,000 YP in perpetuity at 9% 11.1111 Market value of property for investment purposes

£366,667

Some businesses have several income streams that contribute to turnover. A good example of this is a hotel property where income is generated through sales of rooms as well as sales of food and drink, and shop sales – souvenirs, postcards, tobacco, etc. Set out below is a simple example of such a valuation which is followed by corresponding explanatory notes. Example 9.5 Set out below is a simplified example of a hotel valuation where several sources of income contribute to the overall turnover of the business. Note Income from rooms £500,000 Income from meals £400,000 Income from drinks £200,000 Shop sales £25,000 Gross income (considered FMT)

£1,125,000

Purchases (Cost of sales) @ 40.00% Gross trading profit Business expenses Staff costs Cleaners, reception, concierge Restaurant and kitchen £120,000 Owners’ salaries £60,000 Overheads Electricity and gas £10,000 Business rates £12,000 Laundry £7,500 Insurance £4,000 Repairs land and blgs £9,500 Stationery £700 Telephone £4,250 Total overheads Net Operating Profit considered FMOP

£250,000

a

£875,000 b c £250,000

d

£477,950 £397,050

e

154

The profits method – valuation Capital invested in business Fixtures and fittings £110,000 Stock £6,500 Cash £4,000 Total capital invested £120,500 Return on capital @ 6.00% Divisible balance Landlord’s share or Market Rent @ 50.00% Tenant’s share @ 50.00% Investment valuation Market rent YP perp @ 9.00% Investment value

£7,230

f

£389,820

g

£194,910

£194,910

i j

£194,910 11.11

i k £2,165,667

Notes to Example 9.5 a

b c d

e f

Purchases are only calculated on the income items for which stock has been bought in and then sold on, either with a mark-up, eg. shop goods and drinks, or bought in as raw materials, converted into a product and then sold, eg. food ingredients for meals. However, there are a fixed number of rooms and there is no stock purchase required in order to sell them. Accordingly, purchases are calculated based only on the income streams where stock purchase was necessary in order to make a sale. In this example, purchase cost is estimated in line with industry norms – possibly because the accounts showed an exceptional or unusual figure. However, in some cases actual purchase costs may be used directly from the accounts where they accord to industry norms. As the title suggests, this section includes all costs associated with running the business as a whole. Staff costs – these may be separated out particularly where these vary depending upon the volume of trade. Overheads are unavoidable costs that need to be paid in order to make the business function, and they may be fixed or variable depending on the volume of trade. Business rates and telephone line charges, for example, will need to be paid regardless of the level of trade, whereas costs of laundry and stationery will vary according to trade volume. Net operating profit is the sum remaining once business costs and overheads have been deducted from gross profit. Here it is considered to be FMOP. Return on capital – this reflects the value of the return that could have been received by purchasing alternative investments instead of investing capital in the business. It is reasonable to assume that the owner will have expectations of receiving at least the going rate for such investment and so this is calculated by estimating a per annum return on the value of the

The profits method – valuation 155 tenant’s business assets. This return rate would be estimated by reference to prevailing market finance rates. g The divisible balance is calculated by deducting the return on capital from the net operating profit. The remaining divisible balance is the sum that will be apportioned between the building owner and the trading occupier. i and j Here the divisible balance is divided equally between i, the building owner as market rent and j, a reward to the trading occupier for their business acumen and success. k In the investment valuation the market rent is capitalized by a multiplier reflecting similar transactions in the market.

A brief note about turnover rents It is worth noting briefly that another approach to providing an appropriate rent for an income-producing property where the rental value is difficult to determine is to base the rent on the turnover of the business. In theory, the rent for the types of unusual properties discussed in this chapter, where there is little or no comparable evidence, could be set in this way. However, there is little evidence of such arrangements, although undoubtedly they exist. Where this practice has become established is in the settlement of rents in large modern shopping centres where there is little or no direct comparable evidence, particularly where the developer identifies a substantial budget for promotions and other initiatives to launch the new centre and to enable it to become established quickly. The approach is a logical one because rent is one of the expenses to be paid out of total takings: the landlord cannot expect too great a share of the profit if the tenant is to continue in business, while the tenant will have the comfort of knowing that, in the early stages at least, there is some understanding of the time taken to develop the potential of the business. In many new shopping centres there are computerized tills that return all sales data from the retail units to the landlord’s management team. This means that both parties are fully informed as to the actual level of trade and thus they have the data to set the rental level as a direct proportion of the business takings. If applied effectively this approach enables a rent to be set that shares the risks and returns between landlord and tenant depending on the trading conditions. However, this is not the practice in many shopping centres and some centres adopt an alternative approach which is to charge retail tenants a fixed base rent and then require a proportion of the turnover to be paid as a top-up rent, thus reflecting trading conditions whilst maintaining core investment income for the owners. Whilst this enables both parties to share in risks and return from the retail sector, if the base rent is set high then in persistently difficult trading conditions retail occupiers may be forced into either administration or liquidation whereupon their rental commitments may be extinguished and the landlord receives no further rental income until the unit is re-let.

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The profits method – valuation

Accounting standards and valuation standards The valuation of property occupied and used in the course of business is strictly prescribed by financial reporting standards (FRS) issued by the Financial Reporting Council (FRC). The committee sets out the general principles to be observed in the preparation of asset valuations. It also makes recommendations and gives guidance, both of which are of crucial importance where the results will be publicly available. To conclude this chapter it is necessary to mention again the importance of reference to valuation codes of practice and guidelines contained in the RICS Valuation – Professional Standards, or Red Book as it is more commonly known. Whilst the focus of this textbook is primarily to provide an explanation of valuation methodology, it is important to highlight that valuers must, where necessary, prepare valuations in accordance with the RICS Valuation – Professional Standards (2014) or its subsequent updates. The context in which valuations are provided and used is of prime importance in the case of asset valuation, and the valuation of fixed assets for financial statements is subject to the rules, practice statements and guidance contained in these Standards. The main purpose of these rules is to ensure that any valuation is clear and unambiguous. They are designed to prevent the inclusion of values that are inappropriate and misleading, intentionally or otherwise. Historically, at least in part, they were intended to deter the practice of asset stripping where a business was acquired on the basis of its going concern value but then closed down and the land ownership broken up and developed or sold for its best use. Effectively, this practice deprived owners or shareholders of part of the intrinsic value of the business.

Summary It is clear that within the full spectrum of commercial properties some are unusual in style, nature or location. Many properties involved in leisure businesses operate in monopolistic or unique circumstances where there are few direct comparisons available. Thus, another valuation approach is necessary, and usually the profits method is adopted in these circumstances. The essential element attaching to the use of many commercial properties is the occupation of a building in order to run a business and make a profit. This is considered paramount in the case of many leisure businesses, and so the profits method is deployed for the purpose of valuation where the methodology requires examination of the actual trading results together with the potential trading prospects. Any trading surplus, commonly termed net profit, is carefully considered and adjusted to exclude exceptional items and also to reflect the practice of a reasonably efficient operator (REO). The result should be the fair maintainable operating profit (FMOP). The fair maintainable operating profit (FMOP) is a key variable in the valuation of a leisure property. If the business is to be sold as a going concern,

The profits method – valuation 157 then the FMOP is capitalized at the appropriate market rate to give a market value for the business as a whole which includes the building. However, if the building is owned by an investor and leased to a trading occupier, the FMOP is adjusted to reflect the tenant’s capital investment in the business. The resulting figure is the divisible balance which is then divided appropriately between the investor and the trading occupier. The share of the divisible balance that accrues to the investor is considered to be the market rent and this in turn is capitalized at the appropriate market rate to give a market value for investment purposes. As highlighted towards the end of this chapter, particular care must be taken in the use of this method for the purposes of producing a valuation for reporting purposes, and it is essential that any valuation is prepared in strict adherence to the RICS Valuation – Professional Standards. It is advisable therefore that any valuation using this or any other method is ‘triangulated’ or cross-checked by reference to comparable evidence where possible and in addition is supported by a valuation calculated using another method of valuation. In the case of a leisure property, the DCF approach would be a desirable alternative to employ to provide such a check valuation.

10 Cost-based methods

Introduction As the previous chapters have shown, the valuation of a particular interest in land is normally made by reference to its tenure, its use and its income-producing capacity. The valuer collects all factual information about recent sales or lettings of similar types of property, analyses them and then prepares a valuation to calculate the market value. However, not all valuations relate to market transactions; there are many instances where an opinion about the value of a property interest is required even though no market activity has taken place. For example, a company may need a valuation of its property assets for inclusion in the company’s final accounts, or an annual value may be required as the basis of a rating assessment. Such requirements do not normally present a problem when, say, valuing shops or retail warehouses because the valuer can draw on market information relating to sales and lettings of similar types of property in order to estimate the market value. A difficulty arises when there is a requirement to value certain types of buildings and uses where such interests rarely change hands. For example, buildings such as schools, hospitals, libraries, chemical plants, oil refineries, gas works, sewage treatment works, airports, docks, power stations, shipyards and steelworks are all specialized buildings which are seldom bought or sold. Consequently, there is no likelihood that a capital or rental value could be assigned to such buildings through the analysis of comparable market transactions. Accordingly, because there is no body of market information available, an investment methodology cannot be applied so an alternative approach must be adopted. Occasionally, specialized buildings are sold. However, the sale price will not necessarily assist in assigning a value to similar buildings in use as the most likely reason for sale is that the property no longer fulfils the purpose for which it was intended. It may have become redundant due to advances in technology or changes in a process or through the streamlining of activities. For example, a school building may be offered for sale because it is too small to meet current demand from children in the locality so it has been replaced by a larger building on a bigger site, better designed to cope with a higher numbers of pupils. The school owner, which could be a public or private organization, has no further

Cost-based methods 159 operational use for the school. In this situation the owner will first consider whether the building could be used for some other related activity such as storage, but if no such use is identified, then the owner will sell the building for the best price possible. It may be that an alternative use for the school is obvious and it is one for which permission to redevelop the property would be readily forthcoming. If that is the case, the owner would be advised to obtain the appropriate permission and then market the building with the benefit of the new use and the right to develop. However, if the future use is uncertain, the building would be placed on the open market to attract the best offer. Thus, the prospective purchaser of the school must consider the viability of any proposed future use, the likelihood of obtaining permission to redevelop the building and the number of other competitors bidding for the building. These uncertainties tend to reduce the value of any offers made to the owner.

General principles It is clear that an alternative approach is necessary in order to value specialized properties and a cost-based approach has developed to address this problem. The methodology links the value of the building to the value of the site and cost of construction. In other words, the rationale of a cost-based methodology is that: Value of the building = value of the site + cost of construction

The cost-based methods There are two cost-based valuation methods: the contractor’s method (or contractor’s test), which is used for ratingg purposes in Great Britain, and the depreciated replacement cost (DRC) method which is used for accounting purposes and accords with the requirements of international accounting standards. In essence these valuation methods are broadly similar but there are some differences in the rationale for their use and the detail of their application. These differences are examined later in this chapter.

Depreciated replacement cost valuations Rationale Because cost-based valuation methods use cost, or adjusted cost, as a proxy for value, with very limited reference to market evidence, construction cost is a key consideration for the valuer. However, as highlighted in the RICS Valuation – Professional Standards, UK guidance note 2. ‘It is fundamental that DRC is recognised as a valuation to which the valuation standards apply, and not a cost estimation exercise. Each valuation

160

Cost-based methods to which the standards apply must be prepared by or under the supervision of an appropriately qualified valuer’. (RICS 2014, p. 258)

The paper goes on to specify the particular areas of specialized knowledge that are required of a valuer undertaking a DRC valuation, which are: • •

• •

‘an understanding of the asset, its function, and its environment; knowledge of the specification that would be required for an equivalent asset in the current market, and the cost of acquiring or procuring that asset; sufficient knowledge of the asset and its market place to determine the remaining physical and economic lives of the asset; and sufficient knowledge of the sector in question to assess functional, technical or economic obsolescence’. (RICS 2014, p. 258)

The RICS (2014) further highlights that the skills of more than one valuer may be required in order to produce a valuation that meets Red Book requirements. Therefore, it is clear that DRC valuation practice is the domain of specialists. Nevertheless, the key considerations relating to each aspect of the valuation are summarized below in order to provide an introductory guide to their preparation. Approach to estimating building costs The general principle adopted in the calculation of construction costs is to assume that a ‘modern equivalent asset’ would be built to replace the one that is subject to the valuation (RICS 2014, p. 259). However, some buildings simply provide a shelter for extensive or specialized plant without which no building would exist. In these cases the valuer must first categorize which assets constitute plant and which are classified as buildings in order to provide the appropriate valuation (RICS 2014). As this is an introductory textbook it focuses upon the valuation of specialized buildings rather than plant and machinery, but readers should be alert to the wider aspects of DRC method valuation. Replacement building Conceptually, the notion of a modern equivalent replacement for the specialized property asset is a straightforward one and encompasses both the replacement of the land and the replacement of the building. To estimate building costs the valuer must estimate the size of the hypothetical building that would provide an equivalent replacement for the subject property. The hypothetical building may be smaller in size if it is envisaged to offer better planned space. ‘For example a modern building will often be able to offer more efficient space, as it can provide open plan or clear span areas that have a greater capacity than an older building

Cost-based methods 161 with fragmented accommodation and a poor net to gross floor area’ (RICS 2014, p. 263). Specification of the replacement building Once the size of the hypothetical replacement building has been established, the valuer must then determine its specification. This again may differ from the subject property, particularly if the building is old, because building techniques or technology will have advanced during the lifetime of the building. Unnecessary elements and embellishment should be avoided. However, any features of the building that are essential to its use should be included. For example, an airport may require a wide strip of land and a high fence around its perimeter for reasons of security. Cost of the replacement building Once the size of the replacement building has been established then the valuer can gain a good idea of construction cost by applying a unit price (normally cost per square metre) to the area of the hypothetical building. There are several published sources of building cost information that could be used for this purpose and in some cases these may be sufficient for the requirements of the valuation, but the valuer must make that judgement. The average price index for quarter 4 in 2013 in Appendix A is an extract from the RICS Building Cost Information Service (BCIS) database (2013), which shows aggregated costs per square metre for all elements of construction for different types of property. Another commonly used source of cost data is Spon’s Architects’ and Builders’ Price Book (Davis Langdon 2013). In addition, lump sums or further cost estimates must be added for any necessary ancillary structures, landscaping, site works, external works and car parking. Finally, building finance and professional fees are added to the total costs. Detailed cost estimates Where a valuation requires more detailed cost estimates to be provided then the valuer will make reference to the separate elements comprised within the building. For each component of the structure the material and labour costs are totalled to derive an overall cost. This approach requires a more detailed knowledge of construction costing and collation of this data is likely to be timeconsuming and may involve input from cost specialists and quantity surveyors. Approach to estimating site value As highlighted above, the DRC method requires that the valuation has two aspects: the land and the building constructed upon it. Therefore a cost for the site must be estimated in addition to the cost of constructing a modern replacement

162

Cost-based methods

building. The size of the site is likely to be similar to that occupied by the property being valued although, if the hypothetical modern replacement building provides more efficient space within the building envelope, less land may be required. When calculating site cost the valuer must be aware that: ‘… if the actual site is clearly one that a prudent buyer would no longer consider appropriate because it would be commercially wasteful or an inappropriate use of resources, the modern equivalent site is assumed to have the appropriate characteristics. The fundamental principle is that the hypothetical buyer for a modern equivalent asset would purchase the least expensive site that would be suitable and appropriate for its proposed operations’. (RICS 2014, p. 260) Therefore the buyer would not compete with more valuable alternative uses, nor would it buy a site that was larger than required to accommodate a modern equivalent development. The RICS Valuation – Professional Standards (2014) gives a great deal more detail about the locational and market factors that a valuer should take into account when calculating site cost. In summary, valuers may consider site costs based on a more appropriate suburban location and may also reference site value to the most equivalent use to that being valued. For example, industrial land cost may be the most appropriate site cost reference for an oil refinery or other specialized industrial use. In collecting and reviewing evidence for site cost ‘the overriding objective is for the valuer to establish the lowest amount that a prudent purchaser would pay to acquire a site for an equivalent development in a relevant location at the valuation date’ (RICS 2014, p. 262). DRC method and historic buildings The notion of an equivalent replacement asset also applies to historic buildings, however, ‘… only where the historic nature of the building itself creates an intrinsic part of the benefit or service potential of the asset would it be correct to reflect the cost of reproducing the actual asset in the cost of the modern equivalent’. (RICS 2014, p. 263) The argument for reproducing the asset is rare but would include historic buildings of vital importance to the community, such as a parliament building or an art gallery housed in a historic building of significance in its own right (RICS 2014). The cost would be based on a modern equivalent building constructed to replicate the original asset, and so costs are likely to be higher because they would replicate design elements and features.

Cost-based methods 163 Depreciation Depreciation may be defined as the measure of wearing out, consumption or some other reduction in the useful economic life of a fixed asset. This could arise from use, effluxion of time or obsolescence due to technological or market changes. This notion is core to the DRC method, so once the building cost estimate is complete, an adjustment is required to reflect the age and obsolescence of the building being valued. This adjustment is a cost reduction to reflect the depreciation inherent in the building being valued. UK guidance note 2 in the RICS Valuation – Professional Standards (2014) describes three types of depreciation, these are: physical deterioration, functional obsolescence and external obsolescence (RICS 2014, p. 265). The nature of these forms of depreciation is summarized in Table 10.1. Table 10.1 Types and features of building depreciation Type of depreciation

Features

Examples

Physical deterioration

Partial: wear and tear normally associated with age; lack of maintenance and repair

Partial: damage to building fabric and finishes; poor decorative condition; damage from water ingress

Total: cost of repair and refurbishment exceeds cost of new building

Total: derelict building

Partial: inadequacy of the design or specification for the current use; specified for a process no longer carried out

Partial: unnecessarily high ceilings; redundant corridors; poor layout; under-utilized space for equipment installed

Functional obsolescence

Total: space is too small for Total: a new technology eliminates the need for the purpose asset (even if it is only a few years old); building configuration cannot accommodate a new production process External obsolescence

Partial: overcapacity in a Partial: prevalence of vacant market reducing demand for buildings; oversupply of a the asset building type Total: market for the asset has disappeared entirely

Total: vacant and possibly derelict property

164 Cost-based methods Life of the building In order to reflect depreciation within the valuation, the remaining life of the built asset must be assessed assuming regular repair and maintenance, but any refitting or refurbishment that would extend the life of the asset should be disregarded. An allowance for depreciation is then made. There are three different ways that depreciation can be calculated and applied to an asset: straight line, S-curve or reducing balance. These approaches are commonly used in accountancy to depreciate a wide range of fixed assets, including vehicles, furniture, office equipment as well as plant and machinery. Whilst the depreciation approach is intended to reflect what happens to the market place, some fixed assets have active resale markets with extensive data that establishes the pattern of depreciation over the lifetime of the asset, and others do not. There is no depreciation approach that is particularly suited to a building. However, the straight line approach is commonly used in DRC valuations because it is clear and easily understood. In this chapter it is this approach that is used in the worked examples, and the reader is directed to UK guidance note 2 in the RICS Valuation – Professional Standards (2014) for further detail about the strengths and weaknesses of S-curve and reducing balance approaches. Land It is important to emphasize that depreciation is applied to the building only, and normally not to the site cost. The RICS (2014) emphasizes that ‘it is not normally appropriate to make any deduction for depreciation from the cost of acquiring a modern equivalent site in the market because freehold land rarely depreciates’ (p. 269). Application of DRC methods Where a DRC valuation is applied to a property in the private sector the RICS Valuation – Professional Standards (2014) highlight that in the valuation report the valuation should be ‘accompanied by a statement that it is subject to the adequate profitability of the business, paying due regard to the value of the total assets employed’ (p. 139). This is because accounting standards require that all businesses conduct an ‘impairment review’ of all assets before entry of any valuation into the balance sheet. For valuers working in the UK, the UKVS1 1.16.1 further requires that the value reported should be the higher of either the ‘value in use’2 of the property ‘or its fair value less costs to sell’ (RICS 2014, p. 140). Effectively this means that the value reported is the higher of either the ‘current value of the future benefits that will be derived by the entity from the continued use of the asset, or the proceeds the entity would gain from the asset’s immediate retirement and disposal’ (RICS 2014, p. 140). Logically therefore, a private sector company must continue to derive benefit from the property in its current use as part of its overall business to justify the adoption of the DRC method of valuation for the purposes of financial reporting. Where the value in

Cost-based methods 165 use is lower than the market value that could be realized upon cessation of the business, it may be necessary to ‘write the reported market value down to the value in use in an impairment review’ (RICS 2014, p. 140). In the public sector, however, assets are used for delivery of services rather than the generation of profit. Nevertheless, public sector accounting also requires consideration of impairment. Therefore, as emphasized by the RICS, the ‘validity of a valuation derived using the DRC method depends upon a continuing requirement to use the asset for the provision of the service in question’ (2014, p. 140). The valuation must be combined with a statement that ‘emphasises to users that the valuation cannot be relied upon as an indication of the amount that could be recovered if the service was discontinued and the asset retired’ (p. 140). The RICS Valuation – Professional Standards UKVS 1.16.3 (2014) further highlights that when DRC valuations are reported to clients the valuer should also state that ‘the value of the site for a potential alternative use may be significantly higher’ or, if appropriate, ‘the value of the asset would be materially lower if it ceases to be part of the going concern’ (p. 141). Therefore, for the purposes of this chapter it has been assumed that the examples set out below to demonstrate the DRC method are for properties that have value in use for the private business concerned. Example 10.1 The market value of a small bottling plant is to be calculated using the DRC approach. The estimated cost of a replacement building is £5,000,000. The site comprises 3 hectares, and industrial land in this location is £160,000 per hectare. The appropriate allowance for obsolescence is 75 per cent because the building is 30 years old and it has a life expectancy of 40 years. Fees for the replacement building are estimated at 12 per cent and the rebuilding period would be expected to be two years at a finance rate of 8 per cent to fund construction and land purchase. Estimated building cost

£5,000,000

Plus fees @ 12%

£600,000 £5,600,000 £465,920 £6,065,920

Plus finance @ 8% for 2 years Gross Replacement Cost Less Allowance for obsolescence @ 75% Depreciated replacement cost of building Land Land value 3 hect @ £160,000 Plus finance @ 8% for 2 years Depreciated replacement cost of land and buildings

a b c

£4,549,440 £1,516,480 £480,000 £79,872

d e f g

£559,872 £2,076,352

h

166 Cost-based methods Notes a b

c d

e f g

h

Fees are calculated as a percentage of estimated building costs. Finance cost is applied to half the sum of building cost plus fees, £5,600,000/2 = £2,800,000. Finance cost is calculated using the formula (1 + i)n – 1 which is (1.08)2 – 1 = 0.1664. Total cost of finance = £2,800,000 × 0.1664 = £465,920. Gross replacement cost = sum of estimated building cost plus fees plus finance cost. Depreciation in this simple example is calculated as a percentage, thus (age of building/estimated life of building) × 100 = (30/40) × 100 = 75 per cent. This is then applied to the gross replacement cost to calculate the amount of depreciation inherent in the building (i.e. the amount by which the building has worn out) thus £6,065,920 × 0.75 = £4,549,440. The DRC of the building is calculated by subtracting depreciation from the gross replacement cost, i.e. £6,065,920 – £4,549,440 = £1,516,480. Land value is calculated by multiplying the price per hectare by the number of hectares, i.e. £160,000 × 3 = £480,000. Finance cost is applied to the whole land value. As above, finance cost is calculated using the formula (1 + i)n – 1 which is (1.08)2 – 1 = 0.1664. Total cost of finance = £480,000 × 0.1664 = £79,872. Total DRC is the sum of the DRC of the building plus the land value plus finance cost.

Example 10.2 A DRC valuation is to be undertaken for a food processing plant. The plant comprises a series of buildings spread over a site of 4.5 hectares. The buildings are 20 years old but their layout within the plant is now inefficient as a result of technological advances in the business sector. The estimated cost of a modern replacement building is £18,000,000 and land values in this location are estimated at £220,000 per hectare. The notional rebuilding period is estimated at two years with fees estimated at 10 per cent and a finance rate of 9 per cent to fund rebuilding and land purchase. The obsolescence allowance in the valuation is to be calculated by reference to the plant’s age of 20 years with a life expectancy of 50 years. In addition, it is expected that a further allowance of 5 per cent will be applied to the depreciation cost to allow for the outdated layout of the plant. Estimated building cost Plus fees @10% Plus finance @ 9% for 2 years Gross Replacement Cost Less Allowance for obsolescence @ 45%

£18,000,000 £1,800,000 £19,800,000 £1,862,190 £21,662,190 £9,747,986

Cost-based methods 167 Depreciated replacement cost of building Land Land value 4.5 hect. @ Plus finance @ 9% for 2 years

£11,914,205 £220,000

Depreciated replacement cost of land and buildings

£990,000 £186,219 £1,176,219 £13,090,424

Contractor’s method (or contractor’s test) The development of the method The contractor’s method (or contractor’s test) grew out of case law associated with rating appeals judged by the Lands Tribunal;3 this makes it quite different from the development of other valuation methods which are rooted in the financial principles associated with the compounding and discounting of income. The challenge for the Lands Tribunal at the time was to consider and judge what constituted a reasonable and appropriate approach to the rating of properties where such buildings and installations were sold infrequently, if ever. The uncertainty in the valuation profession and the lack of agreement between the different parties in certain cases led to intervention by the Lands Tribunal and the courts. It was then for the judiciary to pass judgements on the cases presented. To be credible the ‘test’ had to produce an equitable result in the assessment of a net annual value for rating revenue purposes or for compensation payable where land was acquired under compulsory powers. Accordingly, development of the ‘test’ resulted from a concern with finding an annual or capital sum without the availability of market evidence. Over time, case law precedents determined it was to be achieved by estimating the construction cost of the building and the value of the land, making allowances for obsolescence and disabilities where appropriate. Both the Lands Tribunal and the courts have expressed considerable reservations about the test, which gave full rein to the valuer’s judgement without offering any market-related evidence in support. Thus, greater emphasis was placed on the standing and experience of the valuer and this highlighted the need for integrity and independence in assembling the various components and reaching a conclusion. Now, the main use for the contractor’s test is to determine annual values in the hypothetical world of rating assessment. However, it is also used in assessing capital values in relevant cases of compulsory purchase. The seminal case that defined the contractor’s test was Gilmore (VO) v. BakerCarr (1963) where in its judgement the Lands Tribunal enunciated a set of rules presented as five stages in the valuation process, which found general favour. The rules were as follows: • •

Estimate the cost of construction of the building. Distinguish between value and cost and make deductions from the cost of construction to allow for age, obsolescence and any other factors necessary to arrive at the effective capital value.

168 • • •

Cost-based methods Establish the cost of the land. Apply the market rates to decapitalize the capital value arrived at. Take account of any items not already considered.

A sixth stage was added by tribunal member Mr C. R. Mallett in the case Imperial College of Science and Technology v. Ebdon (VO) and Westminster City Council (1984). He stated: ‘I hesitate to add another stage to the saga of the contractor’s test but I think it is logical and necessary first to determine the annual equivalent of the likely capital cost to the hypothetical tenant on the assumption that he sought to provide his own premises, then to consider if the figure is likely to be pushed up or down in the negotiations between a hypothetical landlord and a hypothetical tenant having regard to the relative bargaining strengths of the parties’. Decapitalization Historically, in the case of rating assessments, once the capital value had been assessed, the need for an annual value had to be considered. Where an annual value was required, the valuer would determine what appeared to be the decapitalization rate in the circumstances, recognizing that the rate would tend to differ according to whether the use could be described as commercial or not (the latter encompassing utilities, schools and the like). The Lands Tribunal and the courts had developed what might be termed the decapitalization doctrine by defining the way in which a capital value arrived at by use of the test would be represented in annual terms. Although the legislation now makes provision for the rates at which capital sums are to be decapitalized, there is still some merit in following the underlying reasoning in approaching the question. Since 1990 the percentage rates have been prescribed by statutory instrument. Overview of the contractor’s method The contractor’s method of valuation as applied in a rating assessment involves these steps: 1

2 3

Estimated replacement cost (ERC) is calculated by reference to the Valuation Office Agency (VOA) building cost tables for the 2010 revaluation, assuming a substitute building. The cost of fees is also added to these costs. Adjustments for age and obsolescence made to the ERC in accordance with the VOA guidelines set out in the relevant rating cost guide. Land value is estimated by reference to those in the locality and a reduction of up to 20 per cent reduction may be applied to reflect the mode and category of use of the subject property.

Cost-based methods 169 4

Adjusted replacement cost (ARC) is calculated as follows: ARC = ERC – allowance for age and obsolescence + land value.

5 6

Decapitalization rate – to find an annual equivalent for rating purposes, the ARC is decapitalized at the prescribed rate. End adjustments are applied at the last stage of the valuation to reflect fl any particular advantage or disadvantage of the property not accounted for elsewhere.

A brief outline of the practical application of the contractor’s method is set out in Example 10.3. This generic example is provided followed by a short summary of the main inputs into the valuation. Example 10.3 An electricity supply company owns a high voltage sub-station erected some 60 years ago in an enclosed hill farm and adjoining moorland, the site extending to about 2 hectares. It is approached over a lengthy, unmade right of way. A valuation is required for internal financial purposes only; it is anticipated that the facility will continue in use for the foreseeable future. Estimated cost of construction Value of land – current use Total Deduct for age and disadvantages, 70% Value on contractor’s basis

£4,500,000 £20,000 £4,520,000 £3,164,000 £1,356,000

Valuation rationale It is assumed that the equipment has been maintained to current standards. The installation is performing the task for which it was established. However, the site was developed some 60 years ago, is in a remote location and has sub-standard access (it is assumed that the company has no power to widen or otherwise improve the track without permission from the owner or owners). The combination of factors justifies a substantial deduction for age and obsolescence. There is little likelihood that a vacated site could be put to alternative economic use. The costs of integrating the site with the surrounding agricultural uses could not be justified financially. The valuation shows a discount of 70 per cent: even so, the figure is considerably greater than would be likely to be achieved should the site be decommissioned and offered for sale. Cost of site It is accepted that the cost of the land is fixed broadly with reference to the value of adjoining land. The reason is that it would not be possible to negotiate the

170

Cost-based methods

purchase of a suitable site at a price less than could be achieved by selling it for whatever alternative use would be likely to be approved by the planners. In some cases, the alternative use would be obvious, while in others it could be unclear without some guidance. In Example 10.3, the alternative use seems to be associated with rural land management. Without powers of compulsory purchase, the price would be subject to negotiation based on a figure somewhat above moorland value, with the vendor free to discontinue the negotiations, even where a good price was proposed. Where compulsory powers exist, there is less scope. But in either case, the owner could expect a price reflecting an increment over the current use value of the land, with possible additions where its loss would create special problems for the vendor or affect the value of the land retained. Approach to estimating and adjusting building cost The approach to estimating building costs for contractor’s method valuations is broadly the same as that outlined for the DRC valuation explained earlier in this chapter. The adjustment of the building costs should also take account of depreciation and obsolescence as outlined above. However, rating assessments are undertaken only periodically and the valuations are prepared on the basis of an antecedent valuation date to ensure that all properties subject to rating assessments are valued to the same reference point. At the time of writing, the rating list for non-domestic property is dated 2010 and the antecedent valuation date assumed is 1 April 2008 (VOA, n.d.). For properties requiring valuation by the contractor’s method, the VOA prepare a Rating Cost Guide which ‘provides levels of costs at the valuation date of 1 April 2008 and is intended to be used to assess the Estimated Replacement Cost (ERC) … at Stage 1 of the contractor’s basis of valuation’ (VOA n.d.). The Guide also provides information and guidance about adjustments to reflect age and obsolescence in order to assess the ARC (VOA n.d.). Therefore, whilst the approach to assessing building costs for the contractor’s method is the same as that used for the DRC valuation, the date of the cost data is likely to differ in most cases. DRC valuations involve the use of current building costs at the date of valuation, whereas contractor’s method valuations are used for rating purposes and referenced to an antecedent date requiring reference to historic cost data. Land value Land value is assessed: having regard to values prevailing in the locality ‘… a reduction of up to 20 per cent from the prevailing land use value may be appropriate to reflect fl the mode and category of use, but this need not be made where there is evidence of land being acquired at the full value for the prevailing use in the area’. (VOA 2010)

Cost-based methods 171 Property disadvantages Any disadvantages not covered in the above categories should be reflected in an end adjustment. Examples based on Lands Tribunal cases Set out below are a few examples of contractor’s method valuations based on real cases. A brief account of the circumstances of each case is provided and then followed by a summary of the valuation. The subsequent commentary draws attention to significant aspects of the decision or result. Example 10.4 A small regional airport (Based on Coppin (VO) v. East Midlands Airport Joint Committee (1971)) The airport is conveniently near the M1. At the time of the appeal the airport had new, purpose-built terminal buildings and a single main concrete runway. The expenditure on the latter had been greater than was necessary for handling the volume of air traffic at the time and was undertaken with future expansion in mind. The airport was run by a joint committee of local authorities in the region and they accepted that there would be an annual deficit on the cost of running the airport. For this reason, the valuation was not made using the profits basis: the tribunal member stated: ‘there was no profit motive and no profit and therefore the profits basis was clearly inappropriate’. Both valuers pursued the contractor’s basis but produced widely differing results (valuation officer, £37,000; valuer for respondent ratepayers, £11,400). The main differences were the decapitalization rate (5 per cent as opposed to 3.25 per cent) and the deduction for disabilities (15 per cent and 40 per cent, respectively). The decision of the tribunal member (Mr J. H. Emlyn Jones) reconciled the views of the two valuers. He also accepted that some recognition should be given to what the valuation officer first termed ‘under user’ but later amended to ‘new  venture allowance’, which he then incorporated into the allowance for disabilities. While observing that he would normally accept 5 per cent as the proper rate of return, he preferred to acknowledge the ‘new venture’ aspect by adjusting the rate of interest to 3.75 per cent rather than include it as an end allowance under the heading of disabilities. Total capital cost Less Cost of excess runway Proportion of cost of let portion Relevant capital cost Less Sum to reflect date of valuation 12.5%

£1,239,000 £103,070 £145,000

£248,070 £990,930 £123,866 £867,064

172

Cost-based methods Less Sum for disadvantages (including new venture allowance), say

£67,064 £800,000

Effective annual value at 3.75%

£30,000

Commentary The case rehearsed the arguments for and against the use of the profits method and concluded that it was inappropriate in this instance. In adopting the contractor’s method, there were allowances in respect of excess capacity and the ‘new venture’ status of the undertaking (the latter resulting in a 25 per cent reduction in the effective annual value). The acceptance that there was no profit motive suggests that the member was looking at an actual occupier as opposed to the hypothetical occupier required by rating law. Some difficulty seems to lie in the possibility of a similar regional airport operated by a commercial company for profit – would the assessment be dealt with differently? The valuation on which the annual value was based appears to have been generous towards the ratepayer. It may have been reasonable on the part of the tribunal member to acknowledge the innate problems of a new venture, but he then went on to reduce what he referred to as the proper decapitalization rate of 5 per cent by 25 per cent, which suggests some element of double counting. The current system prescribes the decapitalization rates, ensuring a uniform and fairer approach in such cases. Example 10.5 A public school (Based on Governors of Shrewsbury School v. Hudd (VO) (1966)) In an appeal against the gross value placed on the school, the ratepayers’ valuer built up the valuation by taking a unit price per ‘equivalent boarder’ (2.5 day boys being equivalent to one boarder); extra amounts were then added to the previous total for amenities not likely to be present in all public schools. The valuation officer preferred to proceed by formulating a valuation using the contractor’s basis. The valuer found an effective capital value as follows. Cost of modern substituted buildings Less Average deduction of 60.5% Add Site works Professional fees Land Effective capital value

£1,205,955 £730,526 £475,429 £47,543 £41,838 £48,980

£138,361 £613,790

Cost-based methods 173 The tribunal increased the allowance for obsolescence to 70 per cent and determined a gross value of £15,750, based on a decapitalization rate of 3.5 per cent. The tribunal (Mr Erskine Sims and Mr H. P. Hobbs) felt that the valuation officer’s starting figure was too high, and that in arriving at his deduction he relied too much upon ‘guidelines produced and too little upon his own judgement’. The decision was based on increasing the allowance to 70 per cent, taking 3.5 per cent to show a gross value of £15,750 for the school buildings included in the assessment. The tribunal went on to make other adjustments that are not relevant to this account. Commentary The tribunal did not accept the unit price per boarder approach, presumably because there was no adequate comparison on which to form a view about the value of a place. The buildings were old and unsuited and the cost of building was therefore estimated on the basis of modern substituted buildings. The deduction for obsolescence varied with the age and the state of individual buildings, but overall averaged just over 60 per cent. It should be noted that site works, professional fees and land were calculated separately and not subject to the allowance made on the buildings. The tribunal observed that the valuation officer’s starting figure was too high. Surprisingly, given this statement, the members did not reduce the starting figure but increased the allowance for obsolescence to 70 per cent. Example 10.6 A school within the University of London (Based on Imperial College of Science and Technology v. Ebdon (VO) and Westminster City Council (1984)) The valuation officer and the valuers for the other two parties all gave evidence. There was agreement that the contractor’s basis was the most appropriate approach in ascertaining the assessment. There was only one difference of opinion about the estimated replacement cost of the 15 buildings involved, disagreement centring on the amount of the disability allowance. The parties ranged in their opinions from 0–54 per cent. The member of the Lands Tribunal (Mr C. R. Mallett) summarized the evidence given about the appropriate allowances and then proceeded to use his discretion based on the evidence to determine the gross value for rating purposes. The tribunal discussed its decision through the five stages suggested in Gilmore (VO) v. Baker-Carr (1963) and added a sixth stage aimed at enabling the figures produced by the process to be reviewed at the end of the exercise. The member said:

174

Cost-based methods ‘I think it is necessary and logical first to determine the annual equivalent of the likely capital cost to the hypothetical tenant on the assumption that he sought to provide his own premises, then to consider if this figure is likely to be pushed up or down in the negotiations between a hypothetical landlord and a hypothetical tenant having regard to the relative bargaining strengths of the parties’.

In the event the final figure of £767,205 was rounded to £767,000. The Lands Tribunal decision was upheld by the Court of Appeal; leave to appeal to the House of Lords was refused. The decision of the tribunal Estimated replacement cost (agreed by the parties) Add Capital value of land, 15.725 acres @ £400,000 Deduct For obsolescence, 11% Deduct End allowance for disadvantages, 7.5%

£20,340,438 £6,290,000 £26,630,438 £2,929,348 £23,701,090 £1,777,582 £21,923,508

Commentary Although the parties agreed that the contractor’s basis was the correct approach to the valuation of the buildings, there was a wide divergence of views about the amount of the disability allowance, if any.

Summary • • •

• • •

Both DRC and contractor’s method require construction cost estimates as part of the valuation. Although the terms DRC and contractor’s method are often used interchangeably, their rationale, use and methodologies differ. DRC is used for asset valuation purposes where the property has value in use for a private business, or where the property is required for the continued provision of a service. Contractor’s method is used in the rating assessment of non-domestic properties. The building cost data for DRC and contractor’s method are drawn from different sources. Both DRC and contractor’s method adjust the building costs to reflect age and obsolescence and the VOA issue guidelines for these adjustments for contractor’s method valuations.

Cost-based methods 175

Notes 1 2 3

UK Valuation Standards (UKVS) ‘are national association valuation standards that have mandatory status in the UK’ (RICS 2014, p. 121). Defined by the International Accounting Standards Board (IASB) (see RICS 2014, p. 55). The Lands Tribunal has now been succeeded by the Upper Tribunal (Lands Chamber) with the passing of The Transfer of Tribunal Functions (Lands Tribunal and Miscellaneous Amendments) Order 2009.

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New build Car wash buildings (25) Port and harbour buildings (20) Boat control buildings (20) Air transport terminals (15) Air traffic control buildings (30) Aircraft storage/repair buildings (20) Radio buildings (30) Recording studios (30) Television buildings (30)

Building function (Maximum age of projects)

Maximum age of results: Default period

1,387 2,430 1,921 1,861 6,560 825 1,683 1,693 1,854

Mean

875 1,022 1,304 671 1,880 89 819 699 979

Lowest

– – 1,247 – 1,530 – – – – –

Lower quartiles

– 1,483 1,962 1,840 – 814 1,630 – 2,183

Median

£/m2 gross internal floor area

Last updated: 05-Oct-2013 12:19 At 4Q 2013 prices (based on a Tender Price Index of 236) and UK mean location (Location Index 100).

Description: Rate per m2 gross internal floor area for the building cost including prelims.

£/m2 study

– 1,939 – 2,064 – – – – –

Upper quartiles

1,899 6,457 2,497 3,250 11,240 1,580 2,653 2,686 2,400

Highest

Appendix A – Abstract from RICS Building Cost Information Service

2 5 3 6 2 4 4 2 3

Sample

Television studios (30) Closed circuit television control buildings (20) Telephone exchanges (30) Telephone engineering centres, TSCVs (30) Transmitting/receiving stations (30) Post Offices (35) Sorting Offices (15) Generator houses, power stations, etc (30) Sub-stations (electricity transmission) (30) Battery buildings (electricity storage) (20) Water supply, treatment, storage and distribution buildings (30) Refuse depots (15) Incinerators (30) Mortuaries, morgues (15) Bulk goods storage facilities (35) Fish farms, fisheries (30) Nurseries (horticulture), greenhouses, etc (30) Livestock buildings – farms (pig pens, milking parlours, etc) (30) Stud farms, stables and the like (25) Agricultural storage buildings (35) Agricultural storage with non thrust resistant walls (35) Food/drink/tobacco factories (15) Breweries (20) Factories for chemical and allied industries (15) Factories for metals (20) Factories for mechanical engineering (20)

Building function (Maximum age of projects) 2,183 2,400 1,897 834 2,982 1,009 1,027 1,095 1,759 1,801 1,307 968 1,739 3,145 2,501 853 284 261 1,023 489 387 1,091 527 1,285 891 866

Mean – – – 713 1,382 – 340 994 1,058 – 864 306 – 2,764 – – – 176 716 175 – 410 488 303 365 416

Lowest – – – – 1,415 – 981 – 1,268 – – 527 – – – – – – – – – 786 – 462 – –

Lower quartiles – – – 869 3,074 – 994 1,111 1,310 – – 632 – 3,173 – – – – 900 493 – 1,345 – 862 899 886

Median

£/m2 gross internal floor area

– – – – 3,141 – 1,191 – 1,360 – – 1,039 – – – – – – – – – 1,374 – 2,037 – –

Upper quartiles – – – 922 5,896 – 1,975 1,165 3,798 – 1,749 2,572 – 3,470 – – – 346 1,575 793 – 1,404 565 2,761 1,410 1,296

Highest 1 1 1 3 5 1 9 4 5 1 2 6 1 4 1 1 1 2 4 4 1 8 2 5 3 3

Sample

Factories for instrument engineering (35) Factories for electrical engineering (25) Factories for electronics, computers, or the like (20) Factories for vehicles (25) Factories for textiles (25) Factories for leather, leather goods and fur (25) Factories for clothes, footwear (30) Factories for bricks, pottery, glass, cement (30) Factories for timber, furniture (30) Factories for paper, printing and publishing (20) Builders’ yards, Local Authority maintenance depots (15) Factories Generally (20) Up to 500m2 GFA (20) 500 to 2000m2 GFA (20) Over 2000m2 GFA (20) Advance factories Generally (15) Up to 500m2 GFA (15) 500 to 2000m2 GFA (15) Over 2000m2 GFA (15) Advance factories/offices – mixed facilities (class B1) Generally (15) Up to 500m2 GFA (20) 500 to 2000m2 GFA (15)

Building function (Maximum age of projects) Lowest – 689 298 470 681 398 – – 320 230 462

163 314 163 230 301 543 301 303 307 1,096 307

Mean 1,043 805 933 653 712 442 1,129 320 444 648 867

713 919 693 646 566 757 551 439 924 1,432 881

529 – 668

402 618 405 347

443 641 443 407

– – 781 – – – – – – 448 729

Lower quartiles

935 1,557 906

534 721 501 404

601 771 594 523

– – 862 – – – – – – 517 897

Median

£/m2 gross internal floor area

1,123 – 1,088

689 867 664 516

862 1,172 825 829

– – 1,184 – – – – – – 731 1,076

Upper quartiles

1,642 1,642 1,442

1,112 1,112 1,073 697

2,761 1,993 2,761 1,621

– 920 1,538 835 744 486 – – 568 1,395 1,139

Highest

23 3 11

48 10 26 12

189 31 88 70

1 2 5 2 2 2 1 1 2 6 6

Sample

Over 2000m2 GFA (15) Purpose built factories Generally (25) Up to 500m2 GFA (25) 500 to 2000m2 GFA (25) Over 2000m2 GFA (25) Purpose built factories/offices – mixed facilities (15) Warehouses/stores Generally (15) Up to 500m2 GFA (15) 500 to 2000m2 GFA (15) Over 2000m2 GFA (15) Advance warehouses/stores (15) Purpose built warehouses/stores Generally (15) Up to 500m2 GFA (15) 500 to 2000m2 GFA (15) Over 2000m2 GFA (15) Cold stores/refrigerated stores (20) General hospitals, GP hospitals, cottage hospitals Generally (25) Up to 1000m2 (25) 1000 to 7000m2 GFA (25) 7000 to 15000m2 (25) Over 15000m2 GFA (25) Canteens, refectories (15)

Building function (Maximum age of projects) 346 163 585 163 230 293 141 496 294 141 141 181 496 294 181 472 629 629 894 950 1,110 927

769 962 751 759 761 570 1,065 595 469 443 602 1,108 570 489 863 1,763 1,878 1,702 1,606 1,881 2,134

Lowest

808

Mean

1,443 1,422 1,447 1,336 1,534 1,727

371 642 369 363 649

365 700 379 360 339

465 637 469 430 425

517

Lower quartiles

1,665 1,699 1,646 1,661 1,800 1,820

496 824 426 488 773

484 797 465 408 399

677 841 603 731 694

684

Median

£/m2 gross internal floor area

1,954 2,151 1,905 1,882 2,048 2,337

628 1,049 717 545 1,106

641 944 803 537 505

920 1,313 827 951 1,014

1,083

Upper quartiles

4,664 4,664 3,241 2,045 3,092 4,609

3,056 3,056 1,103 978 1,338

3,056 3,056 1,103 978 857

2,761 1,410 2,761 2,368 1,682

1,621

Highest

250 78 141 15 16 15

47 7 12 28 6

65 8 14 43 16

109 7 40 62 17

9

Sample

Restaurants (20) Cafes, snack bars, coffee bars, milk bars (25) Motorway services buildings – mixed facilities (15) Public houses, licensed premises Generally (20) Up to 500m2 GFA (20) 500 to 2000m2 GFA (20) Function rooms, banqueting rooms, meeting rooms, etc (15) Dance halls, ballrooms, discotheques (15) Concert halls (30) Opera houses (30) Theatres (15) Drama ancillary buildings (25) Cinemas (30) Community centres Generally (15) Up to 500m2 GFA Generally (15) Steel framed (15) Concrete framed (35) Brick construction (15) Timber framed (15) 500 to 2000m2 GFA Generally (15) Steel framed (15) Concrete framed (30)

Building function (Maximum age of projects) 1,340 995 – 953 1,353 953 2,531 – – – 1,480 279 995 647 647 1,094 – 647 1,562 807 916 –

1,559 1,575 1,555 3,245 4,381 4,087 3,117 2,075 994 1,332 1,504 1,690 2,031 904 1,120 2,011 1,396 1,396 1,193

Lowest

1,854 1,783 1,872

Mean

1,195 1,243 –

1,117 1,476 – 938 –

1,163

1,361 – 1,366 – – – – 1,686 – 1,027

1,358 – –

Lower quartiles

1,394 1,411 –

1,490 1,548 – 1,076 2,029

1,425

1,563 1,610 1,526 3,213 – – – 1,865 – 1,137

1,645 1,515 –

Median

£/m2 gross internal floor area

1,578 1,516 –

1,886 2,412 – 1,257 –

1,632

1,765 – 1,805 – – – – 2,475 – 1,480

1,896 – –

Upper quartiles

2,204 2,005 –

4,404 4,404 – 1,803 2,424

4,404

2,126 1,762 2,126 4,024 – – – 3,061 1,710 2,020

3,029 3,108 –

Highest

48 32 1

30 14 1 11 4

82

14 3 11 4 1 1 1 10 2 5

5 4 1

Sample

Brick construction (15) Timber framed (15) Over 2000m2 GFA Generally (15) Steel framed (25) Concrete framed (35) Brick construction (40) Timber framed (5) General purpose halls Generally (15) Up to 500m2 GFA (15) 500 to 2000m2 GFA (15) Over 2000m2 GFA (35)

Building function (Maximum age of projects) 807 1,205 1,153 898 – – – 862 862 1,013 –

1,413 1,371 936 773 1,404 1,488 1,513 1,359 1,554

Lowest

1,342 1,554

Mean

1,257 1,260 1,125 –

– – – – –

1,158 –

Lower quartiles

1,463 1,482 1,259 –

1,406 1,450 – – –

1,296 1,589

Median

£/m2 gross internal floor area

1,730 1,751 1,377 –

– – – – –

1,578 –

Upper quartiles

2,382 2,382 2,240 –

1,687 1,687 – – –

2,204 1,833

Highest

48 40 8 1

4 4 1 1 1

12 4

Sample

Appendix B – Example of Gross External Area from RICS Code of Measuring Practice 6th edition Area of outbuilding included in GEA (1 .10)

Chimney breasts included (1 .3)

Ground floor

Stairwells included (1.3)

First floor

Area of open balcony excluded from GEA (1.16)

Appendix C – Example of Gross Internal Area from RICS Code of Measuring Practice 6th edition

Mezzanine floor (2.8)

Mezzanine floor (2.8)

Areas beneath stairs below1.5m included in GIA (2.14)

Area of internal projections not deducted from GIA (2.2)

Area of internal walls included in GIA (2.1)

Ground Floor

Area of stairwell included in GIA (2.12)

First Floor

Appendix D – Example of Net Internal Area from RICS Code of Measuring Practice 6th edition

Columns excluded (3.17)

Ful heigrt glazi'g measurements (NIA4)

Toilet, stajrs and landing lobby exclud9C (3.12 and 3.14)

Kitchen included (3.4)

Male

CupbOard occupying usat>e space included (3.5) Female

Door recess excluded (3.15b)

Notional lift lobby included (3.3)

Lift

Lift

Meter cupboard excluded (3.16)

Unusable space excluded (3.20) Stajrwell excluded (3.14)

Columns excluded (3.17)