The Valuation of Property Investments

Nigel Enever, David Isaac, Mark Daley

• Publisher: Estates Gazette
• Year: 2014
• ISBN:
  9781135334536
• Edition: 7
• Topic: Betriebswirtschaft
• Subtopic: Immobilien

The credit crunch has highlighted the fact that fully understanding property appraisal and valuation is more critical than ever. With a long and reliable history, this new seventh edition covers all the major aspects of valuing various types of investment property. Fully updated and revised, this edition tackles the problems of inflation and growth, the equated rent principle and the special problems of short leaseholds, reversionary investments and taxation implications. Separate sections are devoted to investment appraisal, risk, investment strategy and computer and statistical aids.

Part 1
The Economic and Legal Framework

1
Investment

Investment in any form involves the acquisition of an asset by way of a capital sum in return for future income flows and in many cases, such as property and shares, the expectation of the capital growth of the asset. This book examines financial investment in existing property to the exclusion of assets created by property development.

Property investment is only one of several opportunities open to investors and since all investment markets rise and fall in value at different times throughout the economic cycle, it is necessary to consider the comparison of property investments, not only one with another, but also with other forms of investment.

Investment Markets

Different types of investment have different characteristics and may appeal to different types of investor and investor preference may change with varying economic conditions. For example, in uncertain foreign exchange markets, investors may look to commodities, such as gold, which are considered to be a “safe haven” at such times.

Investments in property can be subdivided according to type and size, such as small houses at one extreme, and multi-million pound office investments at the other. It can be subdivided according to location: a small industrialist may limit his demand for factory space to a particular area, for example, whereas a pension fund acquiring industrial property for its investment portfolio may be relatively indifferent to the part of the country or region in which the property is located. A particular property may, according to its type, attract demand at a local, a national or even an international level.

Types of Investment

The commonest form of investments include: stocks and shares, which are bought and sold on the Stock Exchange; loans to companies (debentures) government securities; insurance policies; unit trusts; property; works of art; durable articles bought for use; commodities and so on. The term “property”, as used in the book, concerns freehold and leasehold interests in land and buildings, or landed property as it is sometimes known. The significant increase in commercial and residential property prices in the early part of the 21st century until 2008, when the market fell dramatically, also attracted many small property investors. These investors acquired portfolios of residential and tertiary commercial property for letting, often as a substitute for investment in more traditional funds, given the good prospects for capital growth through this period. The rising interest in property investment from smaller investors had increased since the mid/late 1990s, as many saw opportunities to diversify and also participate in the rapid growth in asset values.

However, by the end of 2008 it was apparent that many investors had suffered significant losses, as did many property companies, developers and property fund managers. The downturn of 2008 occurred after many years of rising values and falling yields. Finance was widely available from banks both from the UK and overseas looking for exposure into the buoyant UK property market. The reasons for the downturn that followed are outside the scope of this book but, in brief, stemmed from problems in the wholesale money markets that affected banks’ ability to lend to one another and to their customers. The recession that followed appears, at the time of writing, to be deep and may be prolonged. However, it is perhaps the case that some correction in values was inevitable, given the cyclical nature of the property market. The risks involved in investment in the property market are linked to this cycle and wider economic conditions but such risks can be mitigated, to some extent, by diversifying the property investment portfolio.

The property sector can be broken down into various segments, in which different classes of purchaser will be interested. These segments could be geographic or based on a property type. Demand for office, retail or industrial investments may fluctuate with the market and within a given market segment. For example, if an investor is looking to build a portfolio of offices, it could be prudent to spread the portfolio over various regions of the UK rather than simply concentrate on London. This would assist with spreading the risk should adverse local conditions affect a specific locality.

Methods of Investing in Property

Acquisition of property is normally termed “direct” investment, as against various means of “indirect” investment considered below. Property may be acquired by auction, by tender, by private treaty, or by takeover bid. Further variations of “direct” investment are through property development and “sale and leaseback”.

In many instances, major investors have undertaken development themselves and sought to let the property thereafter. Depending upon the size of the transaction, the company may finance through mortgage or through the issue of bonds but often may enter into partnership with another firm often with the latter taking an equity stake in the venture.

A sale and leaseback transaction takes place when a company, currently an owner-occupier, sells the freehold or long leasehold to a third party and in return takes a lease, paying a market rent. Such arrangements have been popular in recent years because companies do not necessarily wish to continue with ownership of property, but require occupation of the building in question to fulfil their business objectives. There can also be portfolio advantages of selling certain types of building in certain locations where a company may be over-represented in a certain area or market sector. The obvious advantages of raising capital for reinvestment in the business may perhaps be tempered by the future prospect of long-term rental growth but for “blue-chip” companies the price achieved may be a more attractive proposition than raising the money through conventional sources. This is because the tenant will be seen as low risk, attracting a low yield in the market, and as a result the rent agreed between the investor and the selling company will be able to generate substantial capital sums.

An alternative means for an owner-occupier or potential owner-occupier to raise capital is to mortgage the property. This would create an indirect property investment for the mortgagee by way of a loan secured on the property. Two further indirect methods of investing in property, but where an equity-type investment is created, are through property bonds, and through shares in property companies.

A property bond is a life assurance scheme similar to unit trust life assurance, but with the premiums and dividends linked to property instead of stocks and shares. As regards shares in property companies, these may be acquired by direct purchase of shares in individual companies on the Stock Exchange or by purchase of unit trusts that hold property company shares, generally along with non-property shares in a broad portfolio. Property shares will reflect the growth in the value of the underlying property portfolio but may react also to the general movement of the stock market as a whole.

Influences on the Investment Markets

There are numerous influences on the investment markets, the major ones being the development of specialist institutions to convert prospective purchasers into actual purchasers, and the means by which the government exerts its influence. The special institutions referred to include the building societies that enable individuals to convert income into capital for house purchase.

In many ways, the markets for occupation and investment are interlinked. Business occupiers are more likely to acquire freehold or long leasehold property for owner occupation rather than decide to rent if there is a significant supply of finance for purchase available in the market and optimism that values may continue to increase in strong markets. Many businesses occupiers also saw an opportunity with SIPPs (a UK scheme based on self-assessed pension polices), which offer advantages to ownership over renting in many cases, given the tax relief available.

Since the early part of 2007, the development of a UK REIT market has increased the number of indirect property investment products that are available with several major property investment companies converting to REIT status. In the strong property market in the early years of the 21st century, many private individuals also invested in property unit trusts and some funds produced spectacular results for several years.

Returns on Investment

The income generated or the capital gain achieved from an investment can be measured by converting it to a percentage of the capital outlay. This percentage is normally calculated on an annual basis and is referred to as the rate of interest or discount rate. A capital gain can be described in terms of an annual discount rate by calculating the rate of compound interest required to achieve a certain capital gain over a given period of time.

In the case of property investment, if the property is purchased for letting, the returns will be in the form of rental income and/or capital appreciation. If it is purchased for occupation, the return will be in the form of savings in rental outgoing as well as the prospect of capital appreciation.

The initial yield on an investment is the current net income expressed as a percentage of the capital value. This initial yield is sometimes known as the flat yield, straight yield, or running yield. The current income is normally known or can be estimated, and therefore capital value of the investment depends upon the yield that investors are prepared to accept.

Investors seek the highest rate of return on their capital. This is not to say that they seek the highest initial yield. They may accept a low initial yield because of the long-term prospects of the investment, in terms of rental growth. For example, an investment in a property occupied by a blue-chip company may attract a lower initial yield than a similar building occupied by a less established or more volatile business, where the risks of tenant default are higher. The yield reflects the investors’ perception of the future risks attached to the investment and it follows that the higher the yield, the higher the risks and the greater likelihood of problems associated with an investment. These risks could involve tenant default as mentioned above, risks with obsolescence, market sector risks and so on.

Initial yields may also be called the “all risks yield”, meaning it tries to take these risks associated with ownership of the investment into account.

The rate of return on a particular investment is determined by the forces of supply and demand within the market, and is evaluated by investors and their advisers by comparing returns from various investments. There are, however, certain underlying economic influences on the rate of return, and these are considered briefly below.

Even in times of zero inflation, an investor will require a return, however small, for foregoing consumption and to compensate for the risks inherent in any investment. In times of inflation, however, he will hope also to be compensated for any erosion of his capital and income. The rate of return required from the investment will also be affected by the incidence of taxation as it differentiates between types of investment, classes of investor, and between the types of return, eg, income or capital gain.

In addition to these all-pervading influences—inflation and taxation—there are more specific risks and problems that affect the rates of return on various investments. The risks may be categorised as follows:

• (i) The possibility of actual loss of capital as, for example, through bankruptcy or a crash on the investment market.
• (ii) The possibility of loss of income. This is very closely associated with (i).
• (iii) The risk of irregularity of income, eg, because a company is unable to declare a dividend regularly through unprofitability.

Other influences on the rate of return, which are not strictly speaking risks, but are more in the nature of problems that have to be overcome by work, time or expenditure in relation to the investment concerned, include the following:

• (i) The liquidity of the investment, ie, the ease with which it can be converted into cash.
• (ii) The costs of transfer (sale and purchase).
• (iii) The cost and trouble of management, including maintenance and compliance with legislation.

Fixed-Interest Securities

Having considered in broad outline how various factors affect the returns on investments, it is now appropriate to consider which factors are particularly relevant to various types of investment and how these factors combine together to determine yields in each case.

Securities is the Stock Exchange term for stocks and shares in general. The largest single issuer of securities is the government. Gilts represent money borrowed by the government on which it pays a fixed rate of interest—that is, the amount payable each year during the life of the stock is always the same, whatever happens to market interest rates during that time. Similar securities are issued by Local Authorities, Public Boards and by Companies, such as stocks, bonds, loans and debentures.

Gilts or gilt-edged securities are issued at a nominal or face value of £100. When selling at a price of £100 they are selling at par (or face) value; over £100 they are selling above par; at less than £100, they are selling below par. Each stock, when issued, will bear a specific fixed interest rate expressed as a percentage of nominal value. This is the stock’s coupon rate.

Any purchaser of stock can expect to receive the very next interest payment until the stock goes ex-dividend. This means that the interest (dividend) payment is imminent and will be paid to those registered stockholders on a specified date. Therefore, the new purchaser cannot receive a dividend payment until the subsequent date. Interest on most stocks is paid every six months. Prices can be calculated either on this basis or on a cum dividend basis (ie, including forthcoming dividend).

Gilt-edged securities are basically of two types; those where the governmen...

Table of contents

• Cover Page
• Half Title page
• Series page
• Title Page
• Copyright Page
• Contents
• Preface to the Seventh Edition
• Dedication
• Table of Cases
• Part 1 The Economic and Legal Framework
• Part 2 Investment Valuation
• Part 3 Investment Appraisal
• Index