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ANDREW E. BAUM is Professor of Practice at the Saïd Business School, University of Oxford, where he leads the Future of Real Estate Initiative. He is also Senior Research Fellow at Green Templeton College and Emeritus Professor at the University of Reading. He is Chairman of Newcore Capital Management and advisor to several property organisations. He has held senior positions with Nuveen, CBRE Global Investors, Grosvenor and other investors and fund managers.
NEIL CROSBY is Professor of Real Estate in the Department of Real Estate and Planning at the University of Reading. He is a Fellow of the Academy of Social Sciences, has been awarded life membership of the Investment Property Forum and a fellowship of the Society of Property Researchers, and is a member of the RICS Valuation Standards Board. He originally qualified and practised as a Chartered Valuation Surveyor in the UK before holding academic positions at Nottingham Trent and Oxford Brookes Universities.
STEVEN DEVANEY is an Associate Professor at the Henley Business School, University of Reading, where he teaches both investment appraisal and market valuation methods. He was previously a Lecturer in Real Estate at the University of Aberdeen and worked as an analyst at Investment Property Databank.
Preface xi
1 Property Investment Appraisal in its Context 1
1.1 What is Appraisal? 1
1.2 The Appraisal Process 4
1.3 What Makes a Good Appraisal? 5
1.3.1 Accuracy, Bias, Smoothing, and Lagging of Valuations 6
1.3.2 Client Influence on Valuations 11
1.4 Conventional and Discounted-Cash-Flow Approaches to Appraisal 12
2 Principles of Investment Analysis 15
2.1 Introduction 15
2.2 Types of Investments 16
2.2.1 Cash Deposits 16
2.2.2 Fixed-Interest Securities 17
2.2.3 Index-Linked Securities 19
2.2.4 Ordinary Shares (Equities) 20
2.2.5 Property 22
2.2.6 Summary of Investment Types 24
2.3 Qualities of Investments 25
2.3.1 Income and Capital Growth 27
2.3.2 Operating Expenses 28
2.3.3 Liquidity, Marketability, and Transfer Costs 28
2.3.4 Real Options 29
2.3.5 Leverage 30
2.3.6 Tax Efficiency 31
2.4 Sources of Risk 31
2.4.1 Business and Financial Risk 32
2.4.2 Nominal and Real Risk 33
2.4.3 Systematic and Specific Risk 34
2.4.3.1 Systematic Risks 35
2.4.3.2 Specific Risks 35
2.4.3.3 International Investment Risks 37
2.4.4 Diversifying Risk 37
2.5 Comparing Investments: NPV and IRR 41
2.6 Initial Yield Analysis and Construction 46
2.7 Summary 48
3 The DCF Appraisal Model 51
3.1 The Cash Flow Model 51
3.2 The Inputs 51
3.2.1 The Holding Period 53
3.2.2 The Lease and Lease Events 54
3.2.3 Depreciation, Refurbishment and Redevelopment 55
3.2.4 Forecasting Rental Growth 57
3.2.5 The Resale Price 58
3.2.6 Exit Capitalisation Rate 58
3.2.7 Expenses 59
3.2.8 Void (Vacancy) Allowances 60
3.2.9 Transaction Costs 60
3.2.10 Taxes 61
3.2.11 Debt Finance 61
3.3 The Discount Rate 62
3.3.1 The Risk-Free Rate 63
3.3.2 The Risk Premium 64
3.4 Examples 66
3.5 Summary 82
4 The Evolution of Freehold Market Valuation Models 83
4.1 Introduction 83
4.2 The Evolution of Conventional Techniques 84
4.2.1 The Changing Perception of Investors 84
4.2.2 Historical Application of the Basic Valuation Model 88
4.3 Rationale of the Pre-1960 Appraisal Approach 90
4.4 The Post-1960 Conventional Market Valuation Model 94
4.4.1 The Fully Let Freehold 95
4.4.2 The Reversionary Freehold 95
4.4.3 Over-Rented Properties 102
4.5 Conclusions 107
5 Contemporary Freehold Market Valuations 109
5.1 Introduction 109
5.2 Analysing Transactions 111
5.2.1 Implied Rental Growth Rate Analysis 111
5.2.2 Calculation of the Implied Rental Growth Rate 111
5.2.3 Implied Target Rate Analysis 113
5.3 Full Explicit and Short-cut DCF Valuation Models 114
5.3.1 Introduction 114
5.3.2 An Explicit Cash-Flow Model Including Short Cut DCF 114
5.3.3 DCF by Formula 117
5.4 Alternatives to DCF 118
5.4.1 Introduction 118
5.4.2 Real Value 119
5.4.3 Arbitrage Model 124
5.5 Reversionary Freehold Valuations 127
5.5.1 Analysis of Transactions 127
5.5.2 Short Cut DCF 128
5.5.3 Real Value 128
5.5.4 Arbitrage 129
5.6 Over-rented Contemporary Model Valuations 130
5.6.1 Analysis of Transactions 130
5.6.2 Short Cut DCF 131
5.6.3 Real Value 131
5.6.4 Arbitrage 132
5.7 Summary 133
6 Freehold Market Valuations - Applications 135
6.1 Introduction 135
6.2 Analysis of Transactions 136
6.3 Rack Rented or Vacant Property Investments 139
6.3.1 Conventional Model 139
6.3.2 DCF by Formula 140
6.3.3 Explicit DCF (Assuming a Nine-Year Holding Period) 140
6.3.4 Arbitrage/Real Value 141
6.4 Two-Stage Reversionary Freeholds 142
6.4.1 Basic Two-Stage Reversionary Freeholds 142
6.4.2 Long Reversions 143
6.4.3 Over-rented Properties 146
6.5 More Complex Reversionary Freeholds 153
6.5.1 Lease Events and the Valuation of Multi-let Property 153
6.5.2 Alternative Review Forms: Indexation and Fixed Increases 162
6.5.3 Summary 166
6.6 Comparing Conventional and Contemporary Techniques 167
6.6.1 Defending Conventional Techniques 167
6.6.2 Target-Rate Choice 167
6.6.3 Fully Let Freeholds: Contemporary Versus Conventional Valuations 168
6.6.4 Reversionary Freeholds: Contemporary Versus Conventional Valuations 169
6.7 Taxation and Market Valuation 178
6.8 Conclusions 182
7 Leasehold Valuations 185
7.1 Introduction 185
7.2 The Evolution of Conventional Leasehold Valuations 185
7.3 Contemporary Leasehold Valuations 194
7.3.1 Fixed Leasehold Profit Rents 195
7.3.2 Geared Leasehold Profit Rents Reviewable Rent Received, Fixed Rent Paid 196
7.3.3 Synchronised Reviews in Head- and Sub-leases 200
7.3.4 Reversionary Leaseholds Reviewable Rent Received, Fixed Rent Paid 200
7.3.5 Reviewable Rent Received, Unsynchronised Reviewable Rent Paid 202
7.3.6 Over-rented Leaseholds 204
7.4 Conventional Versus Contemporary Techniques 206
7.5 The Limitations of the Contemporary Models for Leaseholds 209
7.5.1 Analysis and Valuation Using Leasehold Comparables 209
7.5.2 Analysis and Valuation Using Freehold Comparables 212
7.6 Taxation and the Market Valuation of Leaseholds 215
7.7 Conclusions 216
8 Measurement and Pricing of Risk in Appraisals 217
8.1 Introduction 217
8.2 Nature and Sources of Risk 218
8.3 Measuring Risk 220
8.3.1 Risk-Adjusted Discount Rate 222
8.3.2 Sensitivity Analysis 224
8.3.3 Scenarios 228
8.3.4 Simulations 229
8.4 Risk Pricing 232
8.4.1 Assessing the Risk Premium 233
8.4.2 Certainty-Equivalent Cash Flows 234
8.4.3 The Sliced-Income Approach 235
8.5 Summary 238
9 Development Appraisal 241
9.1 Introduction 241
9.2 Valuation Methods 242
9.2.1 Basic Residual Method 242
9.2.2 Discounted Cash Flow Residual Method 243
9.3 Developer's Profit 250
9.4 Changes in Costs and Values and Phasing of Developments 253
9.5 Finance 253
9.6 Conclusion 254
10 Bank Lending Appraisals 259
10.1 Introduction 259
10.2 The Bank Lending Valuation Problem 260
10.3 Market Value 261
10.4 Mortgage Lending Value 261
10.5 Basel III Definition of Long-term Value 263
10.6 Investment Value 264
10.7 Illustration of the Three Established Approaches 264
10.7.1 Market Value (Equivalent Yield 6.5%) 265
10.7.2 Mortgage Lending Value 266
10.7.3 Investment Value 267
10.8 Performance of the Three Valuation Bases over the Last Two Property Market Downturns in the UK 268
10.9 Summary and Conclusions 271
11 Conclusions 273
Bibliography 277
Index 291
The subject of this book is the appraisal of property, or real estate, investments. In choosing the term 'appraisal', we have two distinct applications in mind.
The first of these is market valuation; this means to fix a price for an asset, or to predict the most likely selling price of an asset.
The second is investment appraisal. This means to estimate the worth or value of an asset.
The book is concerned with the difference between these two terms. While a market valuation will tell us what a property asset is likely to sell for, an investment appraisal will tell us what the asset is worth to us. In a scenario where we wish to acquire a property, comparison of these appraisals can help us answer the following question: should we pay the market price - or not?
There is now widespread acceptance of the international definition of Market Value set out in the valuation standards of the International Valuation Standards Council (IVSC), which is commonly known as 'the White Book'. This definition is
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.
(IVSC 2019)
Many nations feel the need to have their own valuation standards, not least the UK, whose standards (maintained by the Royal Institution of Chartered Surveyors [RICS]) have been through a number of editions of what is commonly referred to as 'the Red Book'. The latest edition (RICS 2020a) adopts the aforementioned international definition of Market Value. There are also some regional standards such as the European 'Blue Book' published by TEGOVA, The European Group of Valuers Associations. This has in the past created some tension and rivalry between international, regional, and national bodies, particularly in Europe. Yet there is now very little disagreement, if any, on the general wording of the Market Value definition, even if there are some differences in interpretation. Hopefully, these differences will continue to diminish as the property investment market becomes more and more international.
Investment appraisal, or the estimation of worth or value, is not necessarily market-based. Between the second and third editions of this book, this concept was both developed and institutionalised, having entered UK valuation standards in the 1990s as the 'calculation of worth'. It was subsequently defined in International Valuation Standards under the term 'Investment Value'. Up until 2013, this was defined as:
the value of property to a particular investor or class of investors, for identified investment objectives. This subjective concept relates specific property to a specific investor, group of investors, or entity with identifiable investment objectives and/or criteria.
(IVSC 2007)
This definition blurred a major issue, specifically whether worth or value is to an individual investor or to a group of investors. This question has significant implications about how value might be assessed in practice, as the value to an individual and the value to a group may not be the same. However, in the 2013 edition, the IVSC changed the definition and came down heavily on the side of Investment Value representing worth to the individual investor rather than to a group or the market. The latest definition is:
the value of an asset to a particular owner or prospective owner for individual investment or operational objectives.
Individual investors are influenced by a set of criteria through which the value of an asset might be assessed. For example, their tax situation, the rate at which they can borrow, how much equity capital they have, what adjoining assets they own, and the strengths and weaknesses of their existing investment portfolio are all factors that may lead them to perceive value in a particular property.
Hence, while all investors may agree upon such important variables as the size of the asset being appraised and the cash flow implications of the lease, individual investors will often be subject to different motivations (see Chapter 2). As will be shown later in this book, the distinction between the estimated price (Market Value) and worth (Investment Value) can be important.
Further, it is possible that a group of investors will share the same characteristics and use similar criteria, the result being that they attach a similar value to a particular property asset. Ascertaining the possible buyer group is very relevant to appraisal and the appraisal process includes identifying objectively measured market variables and the prospective owner's (or group of owners') subjective estimates of other relevant factors. Hence, we believe that there are three basic concepts of value attached to appraisal: first, Market Value or exchange price; second, worth to a group or the market place; and, third, worth to the individual. Investment Value was in previous definitions used to cover both the second and third concepts, but worth to the individual is now the sole basis of Investment Value. We believe that this leaves a definitional hole. Assets can be valued differently to exchange price not just because a specific investor has particular characteristics relating to tax, debt, or other reasons; there are plenty of examples of where the market as a whole did not recognise certain characteristics concerning the asset causing them to under- or over-price properties as a consequence.
The term 'appraisal' covers all three processes. We use the term market valuation for the process of estimating Market Value (the prediction of the most likely selling price) and we continue to use Investment Value for both worth to the market and the individual, and will be specific about which is which in the text. We hope this will not cause confusion. It is a shame that the possibility of confusion exists, largely because the development of property terminology has been influenced by the isolation of the property world from other financial markets. There is no doubt regarding the meaning of valuation in the securities markets: it means the estimation of worth. Market valuation (or pricing) is a function that is carried out by buyers, sellers, and market makers. The price of a particular company in the stock market is publicly quoted, and large numbers of identical shares in that company can be bought and sold at that price. There is no need to employ a valuer to estimate the Market Value (or most likely selling) price of a publicly listed share - that price is available on a screen in real time.
In property, however, prices are not available, because each property is unique, the market is private, and there are no market makers. The price at which a transaction will take place will be influenced by an expert opinion - a 'valuation' - because there is insufficient market evidence and insufficient homogeneity of product for traders to be able to fix prices. While there may be some consensus regarding the most likely selling price or Market Value, it is to be expected that, at any one time, different views of worth will be held by different individuals and groups. These differences will fuel market turnover: those who believe that the Market Value is higher than the worth of the asset to them will sell; those who believe that the worth to them is higher than Market Value will buy.
Two other concepts of value need to be considered. First, International Financial Reporting Standards (IFRS) contain a definition of value for use in financial reporting that is termed Fair Value. The definition is
The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date.
(IASB, 2020)
This definition is expanded upon in IFRS 13. However, it can be seen that there are strong similarities with Market Value given the focus on exchange price in the context of an assumed transaction at the date of measurement. In fact, the RICS (2020a) suggests that the definitions of Fair Value and Market Value are consistent for most practical purposes. Given this, it was confusing that International Valuation Standards contained a definition of Fair Value that differed from both Market Value and the IFRS definition. The IVS definition also focused on exchange price, but dropped some of the requirements of Market Value by allowing specific circumstances affecting the parties involved to be taken into account. This concept has since been renamed Equitable Value and we do not consider it any further.
Another concept and definition of value that is not included in International Valuation Standards is Sustainable or Long Term Value. This cannot be ignored in the wake of the Global Financial Crisis (GFC) and the part that both residential and commercial real estate played in that crisis. The term 'sustainable' is used in the sense that it can be sustained through time and it is the basis for Mortgage Lending Value, a concept used by some European banks as a risk-management tool for their commercial loan books. Mortgage Lending Value is part of the Basel accords, along with Market Value, and is used in the determination of...
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