Real Estate Valuation and Appraisal - Research Paper Example

REAL ESTATE VALUATION AND APPRAISAL Monsoon Accessories Price per square metre 305 pounds Tenants Present Interest Term 1 $ $ Market rent 203130 Less rent paid -428500 $ (225,370.00) YP 10% 5 years 1.53625 -346225 Term 2 Overpriced MR -225370 YP 10% 5 years 3.79078 PV 10% 3 years 0.75131 -988095 -1334320 Tenants Proposed Interest Profit Rent (-203130-Y) YP 10% 5 YEARS 3.79078 (-770021.1414-3.7078Y) Tenants present interest= Tenants Proposed Interest (-1334320) = (-770021.1414-3.7078y) Y equals 152192.36 Landlords Present Interest Term 1 Net Passing rent 428500 YP 5% for 3.25 years 2.9327 1256663 Term 2 Reversion to current price 428500 YP 5% for 5 years 3.79079 PV of one pound 3.25 Years 5% 0.73362 1191664 Reversion Reversion to market rent 203130 YP at 5% 20 PV of 1 pound 5% at 15 years 0.3186 1294470 3742797 Land lord proposed Interest Term 1 Term passing rent X YP at 5% in 15 years 7.6061 7.6061X Reversion Reversion to market rate 203130 YP at 5% 20 PV of 1 pound in 5 years at 5% 0.7835 3183153 3183153.404 + 7.6061X Landlords present Interest equals Landlord proposed interest 3742796.71 equal 3183153.404 + 7.6061X X equals 73571.55 57 is overpriced. The tenant’s present interest is much higher than the landlord’s present interest. The tenant’s present interest is 152192.36 pounds and the Landlord’s present interest is 73571.55 pounds. The Landlord will charge the tenant a fee of 152192.36, however this rent is overpriced and the landlord will be making excess profits. A discounting rate of 5% was used this is the expected long run discounting rate for houses in the UK. The tenant’s interest rate was set higher at 10% yield. The tenant will naturally have a higher interest rate than the landlord. The current average price of per square metre of retail property is 305 pounds on Buchannan Glasgow. This figure was used to calculate the current market price for the property. Unit 6 North Point Land lords presents Interest $ $ Net Market Rent 17160 YP perp. 5% 20 343200 Market Value 343200 Land lord proposed interest Term Net passing rent 14805 YP 5% 3 years 10.37966 153670.84 Reversion Net market rent 17160 YP perp. 5% 20 PV 1 pound in 5years 0.48102 165085.068 318755.908 Landlord proposed premium 24444.09 Tenant proposed premium profit rent 2355 YP 7% 9.1079 21449.1045 The landlord may agree on the tenant’s terms. The maximum price of 21449.1 that the tenant is willing to pay is not far off from the landlords desired price of 24444.09 . By the landlord accepting the tenant’s price he would avoid huge costs incurred while waiting for a new tenant. Market value refers to the estimated amount at which a property would be sold to a knowledgeable buyer and the purchase has been transacted at arm’s length. 193/199 Bath street Glasgow Straight line approach 11094*(5-0.75)/(5-0.25)= 9926.210526 Discounted Approach Headline rent 11094 YP at 6.75% 3.5912 PV of headline 39840.78168 1/YP 6.75 for 4.75 years 0.253047 Net Effective Rent 10081.59028 Hardcore approach Tenant Present interest Term1 Market Rent 11111.2 Less rent paid 9890 Profit rent 1221.2 YP at 6.75% 1 year 0.936768 1143.9813 Term 2 Market rent 11111.2 YP at 6.75% 5 year 4.12779 PV 0.721374 33085.60961 34229.59061 Tenant Proposed interest Profit rent 11111.2-Y YP at 6.75% 5year 4.12779 45864.70025-4.12779Y Tenant present interest equals tenants proposed interest 34229.59 equals 45864.7003 - 4.12779Y Y = 2818.726 There are various methods used to value property. The property method of valuation. This method has the following steps: Step 1. An assessment is made of the FMT that could be generated at the property by an REO. Step 2: An assessment is made of the potential gross profit from the FMT. Step 3: An assessment is made of the FMOP Step 4: The FMOP is capitalized at an appropriate rate reflecting the risks and rewards of the property and its trading potential. Comparable market transactions can be used. Costs of alterations made by new buyer in improving the facility and delay in FMT should be factored. The rent payable on a rent review or the reasonableness of a passing rent should reflect should reflect a return on the tenants capital invested in the operational entity. Certain extended or more detailed forms of profits valuation may be appropriate, particularly for some larger or more complex trade related properties. Consideration of different income streams, and/or use of a discounted cash flow model may be appropriate. CODAGON STREET GLASGOW Tenant present interest Term 1 Market Rent 218739 Rent Paid 214450 Profit rent 4289 YP 10% 0.465374 1995.9895 1995.9895 tenant proposed Interest Profit rent (218739-Y) YP 10% for 5 years 3.79078 (829192.9072-3.79078Y) Tenant present equals Tenant proposed 1995.99 equals 829192.9072- 3.79078Y Y= 218212.8527 218212.8527/1594 = 136.896 2121*136.896 = 290357 Proposed = 290357.2525 Rental valuation. The following items are carefully considered when undertaking a rental valuation. Extent of the demise: Is it a ground rent, a shell rent, a fully fitted rent or something in between? Lease or hypothetical lease term: There has been a move in recent years towards shorter leases in the general commercial property sector. However, licensed property operators, particularly those leasing properties finished to builder’s shell condition, usually require longer terms, typically 15 to 25 years, in order amortise the initial fit out costs. Valuers need to be conversant with the requirements of the particular submarket in which the subject property sits. Lease criteria for fully fitted public houses trading as community locals are very different to those for a large club or branded restaurant. User provisions: Does the lease specifically prohibit change of use within the prevailing submarkets? Tenant obligations: Examples are repairing and decorating requirements, and terms of occupation. Alienation provisions: Is the lease assignable? Can the tenant sublet? Rent review provisions: Such provisions are basis of rental assessment, hypothetical term and disregards, e.g. occupation, goodwill and improvements. Trading matters: This includes hours of operation and licence conditions. Wholesale supply ties provisions. The value of the property will always be affected by economic factors of supply and demand and the taste and preference of the tenant. The following matters should be considered: • attractiveness and style of property; • availability of finance; • economic and regulatory matters; • length of lease and lease terms; • location; • provision of domestic accommodation; • quantum of profit; • supply of similar properties; • surplus or obsolescent accommodation/ amenities; • terms of, and restrictions on, trading; • trading potential and risk; and • type of operation. (RICS Practice standards UK, 2010) Bank head Medway Edinburgh Summary Market rent 157320 Rent review 5 resale Point 15 years Current all risks yield 8.50% Exit yield 9% Target rate of return 11% Likelihood of implied growth rate use growth explicit DCF to value this investment. g 11.7647-3.9406 7.8241 11.7647*0.6650 7.82405 1.000006391 1.000006ˆ0.2-1 = 0.000001278 g=0.0001278% Year Current Amount pound 0.0001278% YP perp. 5years PV of 11% Present Value 0-5 157320 1 3.695897 1 581438.516 6-10.0 157320 1.00063916 3.695897 0.59345 345275.2325 11-15.0 157320 1.001278735 3.695897 0.35218 205032.8644 16-20 157320 1.001918716 3.695897 0.209 121753.8135 21-25 157320 1.002559106 3.695897 0.124034 72302.70288 26-30 157320 1.0031999 3.695897 0.0736081 42935.53562 Value of the business 1368738.665 Baum and Crosby (2007) advocate the use of discounted cash flow techniques because these techniques are flexible and can explicitly take account of their impacts on the risk and income growth attached to a property investment. For example, they are able to deal with short leaseholds or properties that are over-rented. The main arguments in support of the contemporary techniques are: Traditional techniques breakdown in the absence of good comparables so that they often include subjective manipulation of information by the valuation surveyor. Traditional techniques have in the past produced price inefficiencies (for example, in the short leasehold market) and some practices result in errors (for example, the Bowcock problem). DCF based techniques take a more rational approach to the valuation of the income flow. Discounting cash flows is a more flexible technique which can easily deal with short leaseholds and unusual costs and receipts. The main complaints refer to the difficulties associated with accurately forecasting future cash flows and the subjective nature of selecting an appropriate equated yield. Advocators of the traditional methods argue that these methods are more objective because the estimation of market values relies purely on comparable transactions. The purpose of a valuation is to predict price. If the market is using irrational methods, so should the valuation surveyor. However, even the most ardent supporter of the traditional techniques accepts the need to use DCF derived techniques where there are no good comparables The implied rental rate of growth and its relevance A full discounted cash flow model should contain estimates of all future income streams. These estimates for a real estate investment should contain expected rental income flows which allow for changes in future rental values. This is fundamentally different from the traditional valuation methods. They rest on the use of the initial yield which builds in the implied expectation of rental growth in its calculation. In the UK, investors have for certain types of property been prepared to accept a lower initial yield than the return attached to risk free government bonds. This is due to the fact that the income from bonds cannot rise - it is fixed. However, rental income can rise. Therefore, investors may be prepared to accept a lower yield than the risk free level because they expect rents to grow. This is termed the implied rate of rental growth. The implied growth rate is merely the implied long term average growth rate derived from evidence of pricing currently in the market place. Yet, cyclical movements in the market may result in different short term growth rates. The actual growth rate can be calculated as: (1+g) =n√(1+r1)(1+r2)....(1+r n) Or (1+g) = n√(Rental value end of period/Rental value beginning of period) How to measure the implied rate of rental growth Given that you know the initial yield associated with a particular investment from comparable transactions, then it should be possible to calculate the level of growth necessary to achieve a specific return as long as you know the investor’s target rate of return. How to evaluate an investor’s target return You know what the minimum acceptable level will be. This is the level of return available from risk free investments. The risk free rate of return is usually measured as the gross redemption yield on long dated Treasury bonds. This is because property is a long term asset with income streams that are less volatile than short term interest rates. By choosing long-dated, you are attempting to mirror the characteristics of holding property. However, as holding patterns have decrease to an average of 9-12 years there is an argument for selecting gilts with redemption of say 10+ years2. Yet, other investments are not risk free. For property, rent may not be received due to voids or tenant default. For shares, dividends may not be paid due to low profitability or bankruptcy (Fraser, 1993). Hence, investors require an extra return for the risks attached to specific investments. The most commonly cited risk premium for prime property is 2%, which is added to the current yield on long dated gilts. Hence, if long dated bond yields are at 10%, you can estimate that investors will have a target rate of return in the region of 12%. For non-prime property the premium will depend on the property type, its location, the quality and specific lease and physical characteristics. Properties with less attractive features must be more risky and less marketable than prime so a higher target rate of return is necessary. The greater the risk attached to the investment then the higher the risk premium required by the investor. The basic equation for calculating the implied rate of rental growth for an investment with annual rent reviews is: g= (1+e)/(1+k)-1 where e is the equated yield/ required rate of return and k equals the current all risks yield4. e is the equated yield which can be calculated as the sum of the gross redemption yield on gilts plus a suitable risk premium for the subject property. If e increases, the implied growth rate (g) will also increase assuming k remains constant. The situation is slightly more complicated if there is non-annual rent reviews. For example in the UK, three and five yearly rent reviews are commonplace. Greater growth is required to compensate for the fixed income in the period between rent reviews. The simplest formula is: (1+g)n= (YP perp@k% - YP perp@e% for n years)/( YP perp@k% -PV perp@e% for n years) where: g = implied rate of rental growth n = rent review period k = capitalisation rate/yield e = target rate of return/equated yield Growth explicit discounted cash flow method Given that property is a durable asset, even annual cash flow valuations would be cumbersome if cash flow projections are valued in perpetuity. Yet, investors do not typically hold property in perpetuity. Baum and Crosby (2007) point out that investors tend to resale property assets at reversion or rent reviews so they argue that it is valid to build the assumption that the property is sold at such a point into the valuation. This would permit the cash flow projections to be terminated at an appropriate point in time with future cash flows beyond that point in time being replaced by the resale price. So, if the investor assumes a holding period for his/her investment then the DCF can be shortened by assuming a resale at the capitalisation rate. Baum and Crosby also advocate making explicit allowance for rental growth expectations through the holding period. This would be handled in the calculation by allowing the rental flow to be increased at each rent review date by the implied rental growth rate. The cash flows should then be discounted at the equated yield and the resale value at the end of the holding period should be calculated as the future rental value capitalised in perpetuity at a suitable capitalisation yield. A suitable capitalisation yield would be the all risks yield estimated at the end of the holding period. This is occasionally referred to as the exit yield, and need not be the same as the current all risks yield. Reference Baum, A and Crosby, N (2007) Property Investment Appraisal, 3rd Edition, Thomson Business Press. Crosby, N (1983b) The investment method of valuation: a real value approach, Journal of Valuation, 2, 48-59. Fraser, W D (1993) Principles of Property Investment and Pricing, 2nd Edition, MacMillan, London. Fraser, WD (2004) Cash-flow Appraisals for Property Investment, Palgrave Macmillian. Isaac, D and Steele, RICS Practice Standards, UK (2010) The capital and rental valuation of public houses, bars, restaurants and nightclubs in England and Wales. 1st Edition guidance notes. Ryden (2011) 69th Scottish property review. Valuation Office Agency (2011) property Market report. The annual guide to the property market across England Wales and Scotland.Crown Copyright. Doty (2007) Using AVMs with first mortgages – factors for success. Presentation at the Predictive Methods Conference,June 2007. AIC (2008) Canadian Uniform Standards of Professional Appraisal Practice, 2008. Appraisal Institute of Canada Clark, L (2008) AVMS need a standard too. Paper delivered at the RICS Automated Valuation Conference, London. CML (2007a) FSA Guidance on the use of automated valuation models (AVMs) in the context of Basel. Council of Mortgage Lenders. Mark Creamer(2013).The gloablisation of valuation. EMEA ViewPoint. Read More