Valuation & Investment Appraisal - Assignment Example

 VALUATION & INVESTMENT APPRAISAL Critical Analysis Assignment Brief VALUATION & INVESTMENT APPRAISAL Critical Analysis Assignment Brief ________________________________________________________________________ 1. TASK You act as a property investment adviser to a small Property Fund located in North West England. The Fund have built up a commercial property portfolio over the last few years and the table below summarises the returns generated over the last five years from the six properties currently held in it. The Fund are now considering their options for further property investment in the region and have asked you to prepare a brief report covering the following matters: 1. Calculations showing the return/risk characteristics of each property individually, and of the portfolio as a whole, based on the historic data provided. (470 words – 20 marks) This is the way in which the rate of return is going to be calculated on these various properties. “[Using the income method, the] most basic approach for a potential buyer is to calculate the rate of return by dividing the net annual income (gross earnings, less expenses) by the purchase price of the property, added to any improvements that might be needed to keep it in service” (Jannen, 2010, pgh. 5). Here is the formula which would normally be utilized in calculating the return/risk on the properties individually and then comparing them side by side: “[(earnings - expenses) / (price + repairs) = annual rate of return on investment]” (Jannen, 2010, pgh. 5). However, for all practical purposes, what will be done here is to use the income return. What will be done is to take all the income return percentages for each property, and then divide the total of each property’s complete amount of income return percentages by the number of percentages added up. This is how the returns were calculated. Then, each property was organized, highest to lowest, by returns in the following table: Title of Property Calculation Avg. Income Return 1. Liverpool Office 76.32% / 5 15.3% 2. Warrington Park 50.18% / 5 10.04% 3. Manchester Retail 45.26% / 5 9.05% 4. Warrington Office 42.68% / 5 8.54% 5. Manchester Office 31.83% / 5 6.37% 6. Liverpool Retail 22.57% / 5 4.51% As can be seen, the Liverpool Office ranks with the highest income return. Next comes the Warrington Park property. In third place is Manchester Retail. Fourth is the Warrington Office. Fifth is the Manchester Office, and sixth is the Liverpool retail. With income return, one of its pitfalls is that it does not take into account depreciation over a long period of time—in this case, five years. A lot could happen to a property in a five-year time period. There could be problems associated with the upkeep of the property, and so on and so forth. For example, if the property is an office, the office will periodically need to be checked for structural damage, damage and/or clogging in the office’s gutters, and wear and tear on the property due to inclement weather such as snowstorms and thunderstorms. Other problems that can happen when dealing with property upkeep include having to pay property taxes, real estate taxes, and other local, state, and federal taxes and/or fees which may be assessed on the property. Additional problems may include having to hire someone to maintain the property’s upkeep, such as a vendor who offers services like horticultural lawn care. If a property’s owner wants to keep the property clean, the owner will most likely have to outsource cleaning to a cleaning service that can properly clean the property’s interior on a daily or weekly basis. 2. Property market research into the likely performance of the various geographical locations and sectors in which the properties are situated. From this an estimate should be made of the capital value and net rental income (and hence the income return, capital return and total return) that each property might be expected to deliver over the next two years. It will suffice for estimates to be made directly from the market research undertaken without the need to ascribe probabilities, but the estimates should be accompanied by a brief discussion explaining the rationale for them. (880 words – 40 marks) I. Capital Value. (270 words) Capital value, or valuation, of a property, is mapped out in the graph above. Basically, it looks like the two highest-valued properties are Manchester Retail and Manchester Office. This, obviously, says something about Manchester as an area. It is probably more high-class, has a lower crime rate, and may have more gated communities living there. Property valuation depends largely on how well the property is kept up, as well as what type of people are inhabiting the property grounds, who utilises the facilities, and so forth. Valuation is largely determined by the type of neighborhood in which the facility or property is located. Therefore, if the neighborhood has deteriorated, this does not bode well for the capital value of the property. It is essential that a property be maintained well in order to command a high property value. As such, it only makes sense that the owner of a property should see it in his or her best interest in order to properly maintain the quality of the property in question. As can be seen from the graph, the Warrington Park and the Liverpool Office are at the bottom of the totem pole in valuation. However, Liverpool Retail is almost comparable to Warrington Office. This signals that Warrington and Liverpool might be lower-class than Manchester, but their valuations are about equal in terms of having one property with a medium valuation and one property with a small valuation apiece. Having said that, it might behoove the owners of the Liverpool and Warrington properties to be especially vigilant as it pertains to the upkeep of their respective properties. This is key. II. Net Rental Income. (179 words) The net rental income for the Manchester properties both increased slightly. In the meantime, the Warrington properties’ net rental income stayed about the same. Meanwhile, the Liverpool properties’ net rental income slightly upticked before returning close to its original figures posted. This could have to do with several factors. The net rental income of Manchester properties would probably go up, especially if the neighborhood, over the years, continued to be a safe environment in which to own a business and so forth. The Manchester properties’ net rental income increase demonstrates that these properties are very valuable and that they should be kept up with care. The net rental income of the Warrington properties indicates that the neighborhood is still in good condition. The fluctuating net rental income of the Liverpool properties indicate that rent prices are based on how the neighborhood is doing financially. Liverpool is a particularly famous city in the U.K., due to the fact that the Beatles originally started out there. Thus, fluctuating net rental income may have to do with shifting prices in the economy. III. Income Return. (175 words) Speaking very generally, most of the income returns (not all, however) tended to fluctuate, usually forming peaks, over the course of five years. What these peaks say about the properties, overall, means that the income returns are not steady, which signals a serious problem in the economy when looking at the big picture. Fluctuating income returns signal internal difficulties which have to do with the property itself and/or the surrounding environs. Most likely, the properties themselves will have to bear the weight of scrutiny by investors who are looking for good deals on real estate. In addition to the condition of the property, investors also look at the surrounding neighborhood and also make incriminating judgments that way, which can sway potential buyers to buy or not buy in a neighborhood—thus affecting the value of properties depending on how “good” the neighborhood is. Many times such evaluations are subjective, but nonetheless this is an inevitable thing that people tend to do in order to objectively try to assess a property’s extrinsic worth. These numbers are crucial. IV. Capital Return. (117 words) The capital return of the properties in question beg the question how the property value has changed over the course of time—in this case, five years. Property values can change over time due to a number of factors—the way the neighborhood is gerrymandered; the amount of residents that live in a neighborhood, town, or city; the demographics of the people moving into the neighborhood’s properties; and other factors that deal with the property values of land, which can fluctuate over time. The fluctuation in property values has a lot to do with how the properties are perceived in the marketplace. If properties’ values are not properly assessed, it is entirely possible this could affect sales. V. Total Return. (177 words) Total returns of all the properties are going into the negative. This should concern the property owners, because this takes into account capital appreciation and income received. Capital appreciation is the amount that the values of certain properties becomes more valuable. Appreciation of properties happens over time, just like with several other financial factors to consider. However, appreciation depends largely on the upkeep of a property and its surrounding environs. If a property is not maintained to its level of maximum efficiency, problems could develop. Income received was generally higher in areas like Manchester and Warrington, although Liverpool had its own shares of profits. Generally, a good rule of thumb is that your properties’ value appreciate in direct proportion to the length of time the demographics of the neighborhood remain rather homogenous. Once homogeneity is destroyed, then the community starts breaking down because people cannot get along well because they do not share common goals, ideas, and beliefs. Total returns, therefore, can be affected by these problems and as such should be taken seriously. This is key. 3. A critical analysis of your findings in Parts (1) & (2) above, together with your reasoned advice to the Fund on future investment decisions consistent with their long-term objectives of creating a substantial, medium risk, high growth, property portfolio in the North West region. (880 words – 40 marks) There are a variety of problems one can face. These properties all have their particular brand of staying power. The Manchester properties look the most promising, obviously because they have the highest valuation out of any of the properties listed. When one is buying properties, one wants to know that the valuation of the properties is going to be profitable in the event that one should buy the Manchester properties and then sell them. The properties in question which don’t seem to be as profitable in the long-term scale of things will definitely have to be Liverpool first, and Warrington second. Liverpool is definitely not going to be an area in which people will want to invest if the property values and other indicators keep fluctuating. However, the one saving grace about Liverpool is its name. Liverpool is a very famous city and it is world-renowned, and thus it is very possible that the city could use that factor to its advantage to bolster property prices. Variation between future prices are at risk when the neighborhood goes downhill. Some types of risks undertaken are inherent to the nature of enterprise’s activity, buying speculative properties. Other risks are deemed as natural to certain type of businesses like this one. Similarly, other categories of risks not wanted can be prevented without undertaking the process of hedging bets. For example, a business man operating a shop would prepare for natural risks like poor products and stiff competition among others. However, risk of fire on the stock of shop owner could be minimized by taking an insurance contract. Some types of hedges are not financial instruments. For example, an individual who bets that the neighborhood will not go downhill would minimize and/or hedge the currency risk by making expenses payments using the currency desired. Financial institutions and banks may use the hedging strategy to regulate their mismatches of liability and assets. Such matches could include the mismatch between short-term deposits and long-term loans which attract a rate of interest which is fixed. In lending industry, hedge loan is a particular financial product which is used to moderate the risk fluctuating of prices in a given stock portfolio. Thus the hedge loan serves as security debt loan stock which is structured with no recourse. There different types of hedges which investors can uses to minimize the risks. One example of hedges is natural hedges. Various hedges can be used without necessarily being derivatives or financial instruments. Natural hedge represents investments which minimize the unwanted risk by harmonizing cash flows. That is expense and revenues. For instance, a business man exporting goods to the United States faces business risk associated with variation in United States dollar value. Such an exporter could start a facility for production to match the organizational costs structure with the expected sales. Similarly, a firm which starts a branch and/ or a subsidiary in another economy and finances its business with local currency debt financing though the home interest rate may be low. Through matching expected revenues and debt payments of local currency, foreign currency exposure is minimized by the parent organization. One of the methods of hedging risk within property values is buying insurance to secure compensation in the event of financial loss which might occur due to fire and damage of property among other factors. Portfolios are usually influenced by macroeconomic variables which affects market. The major determinant of portfolio risk is the degree and/or extent of variance of returns either in the opposite or same direction. Risk depends on association between different securities return in the portfolio. Asset performance in a given portfolio usually have a tendency to move in a given market direction. If there growth or recession assets follow the same direction a phenomenon referred to as correlation. Assets performance within a portfolio has a tendency of following market trend. This explains the importance of holding a portfolio with various assets so as the combination can effectively handle different phases of economy. Association between the assets movement and market trend is measured by correlation coefficient and covariance. Calculation of covariance is similar to variance calculation. However, difference between actual values of the asset calculation is substituted by the degree in which various assets offset each other. Additionally risk-based pricing could be employed to minimize risks. This is carried out by charging higher rate of interest to borrowers who have high tendency of defaulting. Lender put into consideration such factors as credit spread, credit rating, loan purpose and loan-loan ration when estimating their returns. Similarly, a company could employ stringent credit policy to minimize the rates of defaults. A stringent policy of credit allows a given lender to advance loans to individuals who have capacity and character to pay for the obligations. Credit character and capacity is carried out through credit assessment of the borrower. Assessment could be carried out by examining their financial statements and even bank accounts to determine their ability to pay. Moreover, a given company could reduce the debtor’s collection period. Debtor’s collection period denotes the average amount of time a company undertakes to recover its debt from the borrowers. Debts which take long time to be repaid usually turn to be uncollectible. This is how risk is analyzed in the acquisition of property. BIBLIOGRAPHY Jannen, B.J. 2010. Accepted methods of property assessment. [Online Article]. Available: http://www.ehow.com/list_6064605_accepted-methods-property-assessment.html Read More