Introduction to commercial property valuation b w (1)

WELCOME TO COMMERCIAL PROPERTY VALUATION IN THE UK

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Topics covered

• Rationale, role of valuations and required competencies for valuation

• The simple Net Initial Yield (the jargon starts here!) approach to commercial property valuation

• The valuation of reversionary commercial real estate assets

• The term and reversion approach• The layer (or hardcore or slicing) approach• Putting the techniques into practice

1. Rationale, role of valuations and required competencies for valuation

What is the point of this stuff?• Well, if you’re not going to practice in the UK, this has limited value. If you are, then you need to know

this stuff.• I’m not sure what I’ll be doing in the future,• In that case, you’re probably best to ignore it. It’s full of jargon that you won’t remember, quite

specific to the UK market and has some quirky features. • You’re not selling it to me.• I’m not trying to sell you anything. • I’ve got an exam in it.• Unless, of course, you’re going to be examined on it. Then, unfortunately for you, you are a forced

buyer. However, it’s worth bearing in mind that these methods are embedded in the UK real estate market and widely used for estimating Market Value of shops, shopping centres, retail parks, offices and industrial properties.

• Why?• Investors use estimates of Market Value when

– Doing deals (setting asking prices, working out what the ’going rate’ is for a property)

– Measuring investment performance (capital, income and total returns)

– Borrowing against the properties (banks always want to know the value of the collateral)

– Financial reporting (balance sheet, company accounts)

Do I need to know anything first?

• Yes - I’m afraid so• You need to know about basic financial maths

– About basic discounting – About capitalising income streams

• Look at Topic 1 (again?) – if in doubt. The last part of Introduction to Financial Maths for Real Estate Appraisal really covered the main approach to commercial property valuation.

• You need to know some basic real estate terms - about leases, rents etc. This is tricky since it’s difficult for me to know what needs to be explained and what doesn’t. Will try to do it as I go along.

What do I need to be good at?

• Commercial property valuation needs you to have competency (how to do it) and knowledge (about markets, standards, rules) in a few areas

• Oh,oh• They are– Technique – how to apply the different methods– Market knowledge about inputs – essentially rents and

yields (often called cap rates)– Regulation – professional guidance e.g. International

Valuation Standards– And, er, lots and lots of jargon (er, technical terms)

2. The Simple Net Initial Yield Approach to Commercial Property Valuation

OK. Where do we start?• Let’s pick up where we left off when describing how to capitalise income streams in Introduction to

Financial Maths for Real Estate Appraisal.• I must admit I was a bit hazy there.• We basically said that you only need two pieces of information to get a value of an income stream that you

have the right to receive in perpetuity (forever)• You mentioned two…

• Yes – the value was the current income divided by the cap rate. For racked rented properties that is essentially how it is always done.

• Rack rented?• When the tenant is paying what the property is worth, then a property can be said to be rack rented?• Why wouldn’t they be paying what it’s worth.• Well, in the UK and Republic of Ireland, in many leases the rent paid stays fixed for five years and, if the

lease is longer than five years, it is then reviewed to the market level. After the review, it stays fixed until the next rent review.

• So?• The Market Rent tends to change over time and between rent reviews or before the end of the lease,

tenants can find themselves paying more than it is worth (if rents in the market fell) or less than it is worth (if rents in the market rose)

• Ok, I see

The Simple Net Initial Yield Approach

• Sounds complicated.• It’s really simple. You basically need to obtain and process two pieces

of information to get the value of a commercial property

• The current rent paid• The Net Initial Yield (this is a capitalisation rate)• The first is a fact. It is the contractually agreed rent. • The second is an estimate. It is obtained from analysing deals

involving comparable (very important word) properties • An example would be good.• An example is nearly always good – albeit it may not always be a good

example.• That’s really deep. A good example would be good.

Indeed• OK. Let’s say that you have been instructed to estimate the Market Value of a shop on

Oxford Street let three years ago to Samsung on a 15 year lease with upwardly only

rent reviews every five years at a rent of £130,000 per annum. The Market Rent is now £175,000 per annum.

• So rents have risen since the property was let three years ago?• Yep…and well done for grasping the timing• …and the rent can’t change for another two years• Nope. Well, I’ve just told you the current rent paid is £130,000. You only need now to

know the (net initial) yield (I repeat that this is a capitalisation rate).• How would I find that out?

• You need to look for deals involving similar properties. Yields come from deals.

• You’re not just saying that because it rhymes?• That’s just a coincidence.

Spot the jargon

Let’s keep it simple• Fine by me

• Textbooks (Yuk!) tend to say something like…”A similar shop nearby recently

sold for £3,653,000. It was let to The Gap two years and three months ago on a 15

year lease with upwardly only rent reviews every five years at a rent of £146,100 per annum. The Market Rent is now estimated to be £200,000 per annum.”

• I’m assuming that they’re different shops in terms of size etc. and I can’t just say that the other shop must be worth £3,653,000 also. That would be too easy.

• You’re right. We need to work out what the Net Initial Yield was from the comparable and use it to value the property that we’re trying to value.

• Huh?• The property that sold for £3,653,000. Deals come from yields – remember?• Oh yeah, so they do. I thought that it was the other way around• Works both ways. Once we’ve worked it out then we apply it (the Net Initial Yield) to

get the value. It’s not as straightforward as you’d think working out the Net Initial Yield

Any chance of a picture?

• Nope. Sorry. The Net Initial Yield is an expression of the relationship between the amount invested and the rental income.

• So – it’s the current rent as a percentage of the price paid.

• No – it’s the current rent as a percentage of the total amount invested.• Aren’t they the same thing?• No – the total amount invested is price paid plus buying costs such as Stamp Duty (4% of price paid for

commercial properties over £500,000), agents’ (Yuk!) commission (1% ish), legal fees (0.5% ish), surveys, VAT on above. They work out (as I write) at about 5.8% of price paid in total – in the UK!

• Ah – so getting out my mobile...the total invested in the comparable – impressed? – was £3,653,000 plus 5.8% of £3,653,000.

• Just multiply £3,653,000 by 1.058 – that should do it.• Oh yeah, that’s £3,864,645• …and the Net Initial Yield was• £146,100 divided by £3,864,645 – that’s pretty much bang on 3.78%• Most people in the market would probably be aware that shops in Oxford Street sold at Net Initial Yields of

circa 3.75% - but it is the comparable that proves it.• So it’s just a matter of applying the 3.78% to the property that we’re valuing.• Yes• Beginning to see why it is called a SIMPLE Net Initial Yield approach.

OK then – you value the property• Right then, you told me that the value was just the rent paid divided by the net initial yield. So £130,000

divided by 3.78% (gets out calculator) is £3,439,153. Right?• Right but it needs another step. You need to take off costs of buying the asset• What? The 5.8% transaction costs• Yes-• Ok. 5.8% of £3.439 million is-• No – the transaction costs aren’t 5.8% of £3.439 million• You said that they were 5.8% of the price paid• Yes – and £3.439 million is not the estimated price that would be paid for this asset. • I’m confused.• Well, when working out the NIY, we add 5.8% of the price paid to get the total invested. The £3,439,153

represents the estimated total investment for the shop in Oxford Street. We need to work out what number plus 5.8% of that number gives us £3,439,153. That should give us the Market Value

• Ah…so the Market Value plus 5.8% of the Market Value is £3.439 million.• Yes – the easiest way to get to the Market Value is just to divide £3.439 million by 1.058. That’s just over

£3.25 million• I’ll just check…£3.25m plus (gets out calculator) £188,500 costs of buying is…….(more calculations) £3.435

million. I suppose we were rounding a bit?• Yes. All you need to remember is that when working out yields, it is normal to add on costs to the price

paid and when doing a valuation it is standard to take off transaction costs. You do that by dividing the valuation gross of transaction costs by 1+transaction costs.

• Not sure if I can remember all that• You just need to do a few and it is really straightforward

Actually…

• It would all be much simpler and make no difference if we ignored transaction costs altogether. Let’s say we work out the yield from the comparable by dividing £146,100 by £3,653,000. That’s 4%.

• Then we divide the rent in the property being valued at 4% - that’s £3,250,000

• That’s much easier• I know but that’s not how they do it in the UK. The

convention is to add on the transaction costs to work out the yield and then to adjust the valuation for transaction costs. Nothing that I can do about it.

You can value any property like that?

• Basically, yes, you can value a lot of UK commercial properties on typical leases like that….a textbook would have something like…

Rent passing £130,000

Years Purchase in perpetuity @ 3.78% 26.4550

Valuation (gross of costs) £3,493,153

Valuation (net of costs) £3,250,000

Not sure where this phrase comes from. Someone told me sometime ago that it was an old accounting phrase that accountants don’t use anymore. Basically it seems to come from the fact that it would take 26.45 years of the assets current income to recoup the purchase price plus purchase costs.

All that is really going on here is that we are using the deal to find out how many times the rent, properties are selling for –in this case 26.455. We’re using that to value similar properties and multiplying their rents by 26.455. It’s also the same as dividing the rent paid by 3.78%

Initially, for a total investment of £3.493 million, this shops would yield 4% of the total investment.

It’s not my fault but I feel guilty for the amount of jargon involved in valuation

Let’s say that we are trying to value an office (Office A) where a rent review has just been agreed at an annual rent of £100,000. The rent review indicates that it is rack rented - since the purpose of a rent review is (usually) to reset to Market Rent

A similar (but larger) office (Office B) nearby let at £120,000 has just been sold for £2,400,000. It’s also rack rented. Two ways could be used to use the information from Office B to get the capital value of Office A

• Comparable analysis to obtain Net Initial Yield

• Rent divided by amount invested• £120,000/(2,400,000 * 1.058)• NIY = 4.7259%• The valuation is • Market Rent £100,000• YP in perp at 4.7259% 21.16• Valuation (gross of costs)

£2,116,000

• Market Value £2,116,000/1.058

• Market Value £2,000,000

• A more simple but less commonly used way to get the Market Value is to ignore transaction costs in analysing the comparable and capitalising the rent.

• Comparable analysis to obtain Gross Initial Yield • Rent divided by price paid• £120,000/(2,400,000) = 5%• The valuation is • Market Rent £100,000• YP in perp at 5% 20• Market Value

£2,000,000

3. The Valuation of Reversionary Commercial Real Estate Assets

So, are there other methods?

• Yes, although this is the only method for valuing rack-rented properties. There are other methods for valuing reversionary properties.

• Reversionary?• Properties where the tenant is paying less than it’s worth. It is expected that the rent will

revert (Geddit?) to a higher level at the next rent review or at the end of the lease – whichever comes first. You may have noticed that both of the properties on Oxford Street were reversionary.

• There’s another method? • Yes, it’s to value the rent paid and the uplift separately. There are two basic approaches.• First, get the value of the rent paid until rent review, get the value of the right to receive the

rent after rent review, then add them together• Second, get the value of the right to receive the rent paid forever and add the value of the

right to get uplift (above the rent paid) forever. • Let’s say that another shop on Oxford Street has a 10 year lease with three years until the

first rent review. The rent passing is £100,000 and the Market Rent is £125,000. • Time for some pictures, I think.• Hooray

4. The term and reversion approach

Rent

Years

Rent review

Rent paid – £100,000

Market Rent - £125,000

3

This is meant to represent the value of the right to get £100,000 for three years.

This is typically called the term

This is meant to represent the value of the right to get £125,000 in perpetuity but it doesn’t start for three years

This is typically called the reversion

The value of the property is the values of the term and the reversion added together

Trying to show that it’s a perpetuity

5. The layer (or hardcore or slicing) approach

Rent

Years

Rent review



3

This is meant to represent the right to get £100,000 forever.

This is typically called the bottom slice or core

This is meant to represent the right to get £25,000 in perpetuity but it doesn’t start for three years

This is typically called the top slice

The value of the property is the values of the core and the ‘top slice’ added together

Another way of doing this is to split up the rental incomes differently so…

More jargon – I don’t think there’s a conspiracy to confuse. I think that it’s more likely that specialist functions like real estate appraisal generate their own specialist terminology.

5. Putting the techniques into practice

Rent

Years

Rent review



3

So now we have the four pieces of information1. The rent passing - £100,0002. The Market Rent - £125,0003. The Term – 3 years4. The Yield – 5%

The fourth variable is the yield. Although I really don’t like to do this - we’ll assume the yield for the moment – we’ll go with 5%.

Let’s try to put a value on this asset. You need four pieces of information to value a reversionary property – if you’re not using a simple NIY approach

Let’s set it out like a textbook example

Step One – value the term


YP 3 yrs @ 5% 2.7232

1−(1+0 .05)− 3

0.05

£272,320 2.7232*£100,000

Step Two – value the reversion

Market Rent £125,000

YP in perp @ 5% 20

PV 3 yrs @ 5% 0.8638 ¿ (1+0.05)− 3

£2,159,594 £125,000*20*0.8638

Valuation (gross of costs) £2,431,914 £273,320 + £2,159,914

Market Value £2,298,595 £2,431,914/1.058

Let’s value it using the slicing or layer or hardcore method – (jarg…)

Step One – value the core


£2,000,000

Step Two – value the top slice


YP in perp @ 5% 20

PV 3 yrs @ 5% 0.8638

£431,900


Market Value £2,298,582

YP in perp @ 5% 20

It’s the same value as before.

Using a food metaphor, we’ve just sliced up the pizza differently. The pizza doesn’t change in size.

We’ve applied 5% to the same rents in both valuations.

Also remember that all rents are in current terms. Expectations about rental growth are implied in the yield.

Slight rounding difference

Rent

Years

Rent review



3

This is the value of the core

The top slice

Just to be clear….

£431,900

£2,000,000

Rent

Years

Rent review



3

For the term and reversion…

£272,320 £2,159,594

This is the value of the term This the value of the reversion

So, where does the 5% come from?

Can’t you guess? Deals’n’yields? Yields’n’deals?

Ah! From the comparables?

Remember? A similar shop nearby recently sold for £3,653,000. It was let to Gap two years and three months ago on a 15 year lease with upwardly only rent reviews every five years at a rent of £146,100 per annum. The Market Rent is now estimated to be £200,000 per annum.”

Well, we basically need to work out the single yield (termed the equivalent yield) applied to both the term and the reversion produces a value of £3,653,000. Like the IRR, you have to use iteration (trial and error). The answer is 5% (equivalent yield analysis is for another presentation)


YP 2.75 yrs @ 5% 2.5112

Value of term £366,890


YP in perp @ 5% 20.0000

PV 2.75 yrs @ 5% 0.87444

Value of reversion £3,497,755


Market Value £3,652,784 Close enough to £3,653,000

What about the first shop that you mentioned in Oxford Street?

The one that had £130,000 rent passing and a Market Rent of £175,000?

Yes

Same processRent passing £130,000


YP in perp @ 5% 20.0000

YP 2 yrs @ 5% 1.8594

Value of term £241,723

PV 2 yrs @ 5% 0.90703

Value of reversion £3,174,603


Market Value £3,229,042

That’s not quite the same as the NIY valuation! But it is very close.

No. It isn’t exactly the same. They’re analysing the comps in different ways. The NIY is pretty simple. It is saying that the comparable property has sold for 26.45 times its rent passing - so should nearby properties

The weakness is that the properties aren’t totally comparable. The properties have different reversionary potential and the uplift in rent is only two years away in this property compared to 2.75 years away in the comparable. That makes it better. The equivalent yield approach takes this into account more accurately.

There’s about a 0.5% difference between the two different methods of valuation – pretty small given lots of other uncertainties in the valuation

I’ve heard that some valuers apply different yields to cores and terms etc .

• Yes – I must admit that this type of thing does irritate me a bit.• Why’s that?• Well, there are lots of apparently plausible arguments for doing this but, to me, it’s a bit like bald men

fighting over a comb. There’s rarely anything like the perfect comparable – they’re always different in terms of things like tenant/location/lease/building quality, reversionary potential, etc. Also they’ve usually happened ages ago. The seemingly plausible arguments for making adjustments to yields don’t really hold up.

• So – I assume that they’re trying to do as best they can. • To me, it seems weird to be tweaking yields a bit here but not there when there are lots of other factors to adjust for as

well. The yield is a signal of the price of rents that has varying levels of reliability. More pompous chartered surveyors tend to say that something like that it is then down to the valuer’s art or judgement but guess what?

• What?• Different valuers tend to make different judgements. • Do you have any better ideas?• Er, not really. We’re relying on the market to provide us with the perfect price signal and it rarely does. We just need

to make sure that we’re not applying archaic practices unthinkingly. Use the information provided by the deal or deals most efficiently and we need to accept that there is intrinsic uncertainty in the price signals that are produced by a limited number of deals that involve unique circumstances, involve unique properties and that took place in the past. It’s just not easy to control for all these problems in a rigorous way in a valuation. Ideally valuers would like lots of recent deals involving identical properties i.e. similar leases, tenants etc. to obtain reliable, timely and repeated signals of pricing levels. That doesn’t happen and won’t any time soon.

THAT’S ENOUGH. YOU SEE HOW I GET POMPOUS MYSELF SOMETIMES?

WE’VE COVERED A LOT OF GROUND. I’M PRETTY SURE THAT THE MAJORITY OF TENANTED COMMERCIAL PROPERTIES

(RETAIL, OFFICE, INDUSTRIAL) IN THE UK ARE VALUED IN THIS WAY.

THERE’S SOME THINGS THAT WE HAVEN’T COVERED.

ANALYSING TRANSACTIONS FOR YIELDS, OVER-RENTED PROPERTIES, ‘SHORT-CUT’ DCF METHODS OF COMMERCIAL

PROPERTY VALUATION

FOR ANOTHER OCCASION?

Business

Introduction to commercial property valuation b w (1)