Commercial property: investment valuations

Discounting

All investment valuation is based on the concept of discounting to reflect the time value of money.
The time value of money is the concept that money in hand now is worth more than money in the
future – a concept well understood by any child offered a choice between receiving pocket money now
or in a year’s time. One way of measuring this is in terms of interest foregone.
This is effectively taking the future sum that will be received and (each year) deducting the annual
interest or investment return that could have been earned if the money was in hand in the present and
invested in a bank, another asset type or business. So the amount by which the future income is
discounted is a way of reflecting the difference in utility between having money now and receiving it in
the future. Money received now is more useful than money received in the future as you can invest it
now and receive a return on it in the future. In finance and banking theory, this lack of utility is
mathematically expressed by reducing the value of future income by the amount you could earn with it
if you had it now and invested it for the same amount of time.
If £1 could be placed on deposit for a year to earn 5% interest, then £1 receivable in a year's time has
a present value (PV) today of £1 divided by 1.05 = £0.952. This is because we could deposit the
£0.952 to earn 5%, i.e. £0.048, interest so that it would accumulate to £1 after a year. This future sum
of £1 has thus been discounted to the present by 5%, to produce a current present value of £0.952.
Capitalisation rate

This presupposes that the £1 in a year's time is certain. It might not be. If the amount of the receipt is
uncertain, the investor will not be willing to pay as much for the right to (potentially) receive it. The
investor may be willing to pay only £0.90. If so, the potential receipt of (approximately) £1 has been
'discounted' not by 5% but by 10%. So the 'discount rate' will always reflect the investor's perception of
risk. In property investment and valuation circles this discount rate is commonly known as the
capitalisation rate, 'cap rate' or yield.
In simple terms, investment valuation consists of adding up the discounted values of anticipated future
receipts.
 At a 5% discount rate, £100 receivable in one year’s time is worth £100/1.05 = £95.24
 £100 receivable in 2 years’ time is worth £100/(1.05 x 1.05) (or £100/1.052) = £90.70
 £100 receivable in 3 years’ time is worth £100/(1.05 x 1.05 x 1.05) (or £100/1.053) = £86.38
 So £100 p.a. receivable for 3 years has a present value at 5% of £95.24 + £90.70 + £86.38 =
£272.32
Years purchase

The relationship between the income (a constant income) and its capital value is traditionally known as
the years purchase (YP). So, in the above case, YP 3 years at 5% is 2.7232.
We can calculate the YP of a constant income without having to discount each receipt separately and
add them up.
We know that £100 receivable in the future is worth less than £100 now by virtue of the loss of £5 p.a.
interest. That is why £100 receivable in 3 years’ time is worth only £86.38. The difference, £100.00 -
£83.38 = £13.62, is the present value of the £5 p.a. lost interest.
If the present value of £5 p.a. for 3 years at 5% discount rate is £13.62, then the present value of £1
p.a. for 3 years at 5% discount rate is £13.62/£5 = £2.723, which is the result we obtained by
discounting each year’s receipt separately and adding them up.
So, instead of discounting each year’s receipt separately and adding them up, we can use this
formula:
YP = (1-PV) / i
where 'i' is the discount rate and 'PV' is the present value of £1 in 'n' years at 'i'%.
So, to derive YP 15 years @ 5%, there is no need to discount each of the 15 instalments individually
and add them up. Instead we can quickly calculate:
PV of £1 in 15 years @ 5% = 1/1.0515
Using a calculator with an exponent key (or a spreadsheet):
1.0515 = 2.0789, so 1/2.0879 = 0.4810
YP 15 years at 5% = (1 - 0.4810)/0.05 = 10.38
In practice, valuers do not calculate YPs from first principles. The multipliers can be obtained from
published valuation tables, calculated using spreadsheets or, most often, calculated by valuation
software packages.
Comparable evidence and the importance of judgment

Comparable evidence is the essential bedrock of any valuation.

A property that is let will generate a contractual rent. On expiry of the lease (or at rent review if there is
one), the income may change (increase or reduce) to the market rent – often called (in the UK)
the rack rent. The market rent can be determined from observation of the rents agreed in open market
lettings of similar properties, although lease renewals, rent reviews and expert determinations may
also be useful indications of market rent.
Similarly, the appropriate capitalisation rate to arrive at an estimate of market value can be determined
by analysing the relationship between the incomes and observed market prices/transaction prices of
comparable investments. The valuation methods described here need to be used in analysing
the comparable transactions in order to deduce the appropriate capitalisation rate/yield with which to
value the property.
No two properties are the same, so valuers need to apply judgment in interpreting evidence and
adjusting it to reflect differences between the property being valued and the comparables. Sometimes
very little comparable market evidence will be available and that judgment and experience will play a
significant role.

All-risks yield

An office building let at its market rent of £10,000 p.a. might command a market price of £200,000.
The capitalisation rate is therefore 5.0%, as is the initial yield. The capital value is 20 times – or 20
years purchase – the current income. This YP means that it will take 20 years for the income derived
from the property to equal/replace the market value/capital value/price paid for the property.
However, in the absence of significant cyclical swings, the rent would be expected to rise (at rent
review or on re-letting) to keep pace with inflation. After a while the rental value will start to be affected
by obsolescence as the building gets older – and becomes, worn out or outdated. When the current
lease expires, the property may become vacant, or void, for a time before a new tenant can be found.
During that period there will be outgoings (such as insurance premiums and business rates on empty
space) to meet. There will also be marketing costs and letting fees to pay, and perhaps also capital
expenditure on upgrading, renovating or refurbishing the space.
If we simply apply a 5% capitalisation rate or input yield to the £10,000 p.a. income to arrive at a
capital value of £200,000, all of the above factors are implicitly wrapped up in the 5% capitalisation
rate which, for this reason, is known as an all-risks yield and valuation methods employing an all-
risks yield are known as implicit methods.

Reversionary investments
Term and reversion method

Since market rents tend to rise and fall, the contractual rent under the existing lease may differ from
the current market rent. If the current passing rent is less than the market rent, the investment is said
to be 'reversionary'. This varying income can be valued using the all-risks yield as a capitalisation rate.
How do we value a property let at £10,000 p.a. that is expected to revert to a market rent of £15,000
p.a. in 3 years’ time?
Having established that the present value at 5% of £100 p.a. for 3 years is £272.32 and that the value
of £100 receivable in 3 years’ time is £86.38, we can now calculate:
Passing rent (p.a.) £10,000

YP 3 yrs at 5% 2.7232

Value of 3 yrs’ income £27,232

Market rent (p.a.) £15,000

YP in perpetuity at 5% 20.00

Capital value at yr 3 £300,000

Present value of £1 in 3 yrs at 5% 0.8638

£259,151

Total value £286,383

The initial yield is (10,000/286,383) x 100 = 3.49%.
The reversionary yield is (15,000/286,383) x 100 = 5.24%.
Note: This simplified example assumes that a reversionary investment is valued using the same cap
rate as applicable to a rack-rented investment. In practice a higher cap rate will usually be appropriate,
for reasons explained below.
Note that one input yield has been applied, and equivalent yield, at 5%. However, the input yield that
determines the output yield does not have to be an equivalent yield. This could just as well be a net
initial yield derived from transactional evidence. In the 'term and reversion method' and the 'hardcore
method' two different input yields are often applied to determine the output yields.
For instance, the example above used the 5% yield to value both the passing rent and the future
market rent on reversion (at the end of the current lease). In some cases a valuer might apply a lower
or higher yield to the market rent to reflect that valuer's perception of the risks relating to achieving the
reversionary rent.
The above approach is known as the 'term and reversion method'. The cash flow is said to be 'sliced
vertically'.
Hardcore method

An alternative approach, which generates the same result, is the 'hardcore method' in which the cash
flow is 'sliced horizontally' thus:
Passing rent ('hardcore income') p.a. £10,000

YP in perpetuity at 5% 20.00 £200,000

Increase at yr 3 (p.a.) £5,000

YP in perpetuity at 5% 20.00

Capital value at yr 3 £100,000

Present value of £1 in 3 yrs at 5 0.8638 £86,383

Total value £286,383

Note: 5% is not the investor’s overall rate of return (an equivalent yield). The 5% all-risks yield implies
rental growth that will increase the income during the holding period and also produce a capital gain
on resale.

Reversionary risk

A reversionary investment (a property having a passing rent below market rent) may be riskier than a
rack-rented investment (i.e. one let at the current market rent) because a greater proportion of the
value may rely on the future market rental value, which is uncertain. (Note: most leases in the UK have
upward-only rent review provisions.) A smaller proportion of overall value may derive from the
contractual passing rent, secured on the covenant of the existing tenant.
The degree of extra risk will vary according to the scale of the reversion and the unexpired duration of
the existing lease. Additional risk needs to be accounted for by requiring a higher return, i.e. applying
a higher capitalisation rate to discount the income. (The higher cap rate is the same as a smaller
multiplier (YP), resulting in a reduced capital value.) This can be done in a number of ways:
 In the term and reversion method, a higher cap rate can be applied to the reversionary income.
 In the hardcore method, a higher cap rate can be applied to the reversionary increase.
However, neither of these is entirely logical since:
 In the term and reversion approach, the secure contractual income may continue beyond the rent
review to market rent (if the tenant renews the lease at expiry or re-gears the lease at the
prevailing market rent.)
 In the hardcore approach, the secure contractual income will not continue in perpetuity.
Equivalent yield

A simpler approach is to apply one cap rate/input yield to all components of the calculation. This is
known as applying an 'equivalent yield'.
The term 'equivalent yield' (rather than 'constant yield') derives from the traditional use of the methods
referred to above. For example, if, in the hardcore method, 5% is applied to capitalise the hardcore
income and 6% cap rate applied to the reversionary increase, the result would be £269,968. The
uniform equivalent yield that would generate the same result is 5.29%.
Valuers in practice will often simply apply the equivalent yield they think is appropriate (derived from
market evidence and market sentiment) to the entire income stream to determine value, rather than
trying to justify applying two different input yields to the income stream (especially when a risk
premium applied to the reversionary income stream is very difficult to justify from evidence from
transactions in the market).

Initial yield

Following the same logic, valuers will often value using the initial yield as the input yield/capitalisation
rate that determines the equivalent and reversionary output yields. The initial yield is applied to the
current passing rent only and typically does not involve any discounting to get to the market value. But
this input yield is still a type of implicit 'all risks yield', which reflects all the risk and reward factors
contained in the income stream going forward. This initial yield, as an implicit input yield, hence
reflects a potential market participant’s view of risk concretised in a bid level for the property. As such,
it expresses the valuer’s view of how much a knowledgeable and prudent investment purchaser would
be likely to bid for the property if it were offered for sale at the valuation date.
If the property is currently vacant or subject to a high amount of vacancy it will probably not be
appropriate to value it off an initial yield. In such cases, the valuer would value off an equivalent yield.

Running yield

In the example used earlier:

The initial yield was (10,000/286,383) x 100 = 3.49% p.a. for 3 years.
The reversionary yield was (15,000/286,383) x 100 = 5.24% p.a.
These rising/falling annual yields are known as the running yield.
Note: where major costs are anticipated it may be appropriate to treat these as capital value
deductions rather than deductions from revenue.
An investment that is highly reversionary (or wholly/partially vacant) will show an unusually low initial
yield. This will cause difficulty for investors who finance their purchase with debt since there may be
insufficient income to cover the interest charges in the initial years. It may also present a problem for
institutions that need to maintain a certain level of income yield. By discouraging purchasers, this may
provide a further reason why market evidence will often reveal that equivalent yields for reversionary
investments will be higher than those for similar investments let at market rent.
Sometimes this problem is overcome by the vendor agreeing to 'top up' the income in the initial years
or provide rental guarantees for a set period of time on vacant space.

Over-rented investments

An investment where the passing rent is in excess of the market rent is said to be over-rented. If the
income will revert to the lower market rent on the imminent expiry of the lease, the investment can be
valued using the term and reversion method, employing either an equivalent yield or different cap
rates for the two components.
The situation becomes more difficult where, as in the UK, leases are often longer and subject to
upward-only rent reviews. Suppose a property with a market rental value of £10,000 p.a. is let for
another 15 years at a passing rent of £20,000 p.a. (subject to 5-yearly upward-only rent reviews).
Market evidence is that similar rack-rented investments sell at 20 YP or a 5% cap rate. But implicit in
this cap rate is an assumption that, over the long term, market rents will grow, at least to keep pace
with inflation. In fact, if such over-renting has arisen, it will probably be the result of a severe cyclical
fall in market rents and the likelihood is that rents will at some point recover, growing significantly
faster than the rate of inflation.
Valuing such investments on an all-risks yield (implicit) basis presents considerable difficulties. A
common approach is to value the market rent as a ‘hardcore’ income and then add a risk premium to
the yield used to value the over-rented tranche of income, often referred to as the 'froth'.
The problem here is that in depressed market conditions, there may be no market evidence of
effective market rents and a lack of sales of rack-rented investments to provide evidence of the
hardcore cap rate.

Discounted cash flow

Implicit methods of valuation employ all-risks yields as input yields with most real-life complications
wrapped up into/implied in the input yield/s chosen. An alternative approach is to make all the cash
flow assumptions explicit. This requires the investor and/or valuer to articulate all cash flow
assumptions and attitudes to risk. Such an approach tends to be more applicable to complex
investments and/or to markets in which sophisticated investors operate.
This methodology is usually referred to as a discounted cash flow (DCF) method. This is something
of a misnomer since the discounting of cash flows is the basis of all investment valuation methods
including the all-risks yield approach.
In the DCF method, the projected cash flows are explicitly estimated over a finite period – commonly
5, 10 or 15 years – the investor’s holding period for the asset or investment horizon, reflecting such
matters as:
 income changes resulting from anticipated variations in market rents;
 effects of obsolescence on rental growth and/or on required capital outlays;
 income voids;
 void costs (property outgoings and taxes);
 re-letting costs (marketing, agents and legal fees);
 refurbishments and upgrades;
 an exit value at the end of the cash flow period, to reflect both anticipated market conditions and
the anticipated condition of the investment at the end of the cash flow/holding period.
The cash flows are then discounted back to the present, not at the all-risks yield, but at a discount rate
reflecting the investor’s overall target rate of return/hurdle rate of return or hurdle IRR.
The final year's net income stream is also capitalised at an all-risks-yield or cap rate, known by many
names including:
 the exit yield;
 exit cap rate; or
 terminal cap rate.
This terminal value or exit value, which assumes a sale of the property at the end of the DCF holding
period, is also discounted by the discount rate and added to the discounted sums of each year's cash
flow in the present.
These sums create a net present value (NPV), which, in the case of a valuation, is the market value of
the property, or the amount that a third party investor could afford to bid for the property on the
assumption that they are achieving their minimum hurdle rate of return (the discount rate).
Because every investor's expectations and required rate of return will differ, the DCF method is often
used to derive an opinion of worth or investment value to a specific investor, for analysing potential
investment returns, comparing investment options for assets or for scenario testing/sensitivity analysis
. However, DCFs are very versatile and can be used to analyse open market transactions by adopting
a set of assumptions that the valuer considers to be typical of investors in the market place and which,
in combination, will equate to the observed market price. Those assumptions can then be used to
assess the market value of another property.

DCF example

The task is to calculate the investment value, or worth, of an office building as at December 2009.
There are 3 tenancies:
 The 3,000 sq. ft ground floor is let at £35,000 p.a. on a lease expiring in June 2011, following
which there is expected to be a 12-month void. Outgoings will be incurred during the void period
at the rate of £6psf plus, after 3 months, property tax of £9psf. It is estimated that £50psf will
need to be spent on refurbishment, before achieving a reletting subject to a 12-month rent-free
period. The current headline rental value is considered to be £40,000 p.a., expected to increase
to approximately £50,000 p.a. by the June 2012 reletting date.
 The lease of the 1st floor (4,000 sq. ft) at £40,000 p.a. expires in December 2013. Assume 6
months void, 6 months rent-free; void outgoings £6psf; property tax £9psf after 3 months; £40psf
refurbishment cost. Current headline ERV £60,000 p.a. expected to increase to approx. £69,000
p.a. by the June 2014 re-letting date.
 The lease of the 2nd to 5th floors (16,000 sq. ft) at £190,000 p.a. runs until September 2017,
subject to a rent review in September 2012. The current headline rental value is estimated to be
£240,000 p.a., expected to increase to £262,000 p.a. by September 2012 when a 5% effective
rent discount is expected to be applicable at rent review.
A 5-year holding period is assumed. At that date, the 1st floor will have just become income-producing
again. At the exit date, the investment will be reversionary with passing rents totalling £337,000 p.a.
against ERVs totalling £403,000 p.a. The expiry of the lease of the 2nd to 5th floors will be 2¾ years
away so the void, void costs, refurbishment cost and re-letting at ERV need to be factored in to the all-
risks exit valuation. Having regard to the risk profile of the investment at the exit date and anticipated
market conditions, an equivalent yield of 7.25% is considered appropriate, producing an exit value, net
of purchaser’s costs of £4.48 million.
The cash flows can then be totalled and discounted back at a discount rate reflecting the perceived
risk profile of the investment. At a 10% discount rate the value is £3,569,000 or £3,370,000 net of 5%
purchaser’s cost.
Calculation of worth by discounted cashflow
Risk

Risk factors that may affect the discount rate (i.e. the target rate of return) include:
 illiquidity upon sale (e.g. lot size, transaction times, availability of finance);
 failure to meet market rental expectations (forecast rental growth);
 failure to meet market yield expectations (forecast yield shift);
 risk of locational, economic, physical and functional depreciation through structural change;
 risks associated with legislative change (e.g. planning/privity of contract, changes in fiscal
policy);
 risk of tenant default (covenant risk);
 risk of sale of the business changing the nature/strength of the covenant;
 risk of exercise of lease breaks; and
 risk of failure to re-let (void risks).
Determination of the appropriate adjustments to the target rate of return (discount rate) to reflect each
of these risks is the subject of much discussion and research.
In carrying out an explicit DCF valuation, take care to avoid the double-counting of risks by reflecting
them both in the cashflows and in the discount rate. For example, if the cashflow assumes the
exercise of all lease breaks and consequent voids then the discount rate can be lower, since the risk –
the downside – has already been reflected in the cash flow.

Effective rental values

On the grant of a new lease it is customary for the tenant to be granted a rent-free period to cover the
period needed to fit out the premises ready for occupation (in the case of an office) or trading (in the
case of a shop).
In weak market conditions this rent-free period may be substantially extended as an incentive for the
tenant to take the lease. This is attractive to the tenant during a period of weak economic conditions in
that it reduces overheads (improves cash flow). Rather than negotiating a lower rent, the tenant is
effectively borrowing from the landlord in return for paying a higher rent later. The arrangement also
suits landlords because the higher ‘headline’ rent helps to sustain capital value, especially if the tenant
signs a long lease and the rent-reviews are upwards-only.
However, this higher headline rent does not represent the true market rental value. In the absence of
the incentive, the effective rent (or net effective rent) would have been significantly lower. This
effective rental value needs to be determined as it is that rent which will be applied at rent review
(since rent reviews are not accompanied by a rent-free period).
The rental level determined by the machinery of the lease at rent review is formally known as the
estimated rental value (ERV), which may differ significantly from the market rent of the property (the
rent agreed in an open market letting). This is because rent review clauses often require that the rent
at review is determined on hypothetical (at odds with reality) assumptions and disregards. Note that
the term ERV is often used less formally as a catch-all term for the rental value of a property
regardless of whether this is a net effective rent or headline rent, a market rent or the rent produced by
the assumptions or disregards at a rent review.
In market conditions where incentives apply they tend to be applied universally, so no market evidence
of net effective rents exists. Valuers (and arbitrators) therefore need a theoretical basis for converting
headline rents into net effective rents. This involves devaluing or amortising the incentive – converting
it into an annual equivalent – and deducting it from the headline rent. Opinions differ as to how this
should be done. See also RICS Valuation – Professional Standards UK January 2014 (revised April
2015), UKGN 6 Analysis of commercial lease transactions.
As a rule of thumb, a reversion to a rent review would employ an effective rent. A reversion to a lease
expiry will be to a headline rent, after appropriate allowances for void, void costs and rent-free period.

Gearing (or 'leverage')

Property investments are often acquired with the benefit of debt finance. If the debt interest rate is
lower than the total return from the investment, the return on the remaining equity proportion of the
investment will be ‘geared’ or ‘leveraged’ upward (and, of course, debt financing reduces the amount
of equity capital that needs to be found.) Hence, the use of debt increases an investor’s return on
equity, or increases their equity IRR.
The availability of debt finance will affect market values. For example, since risk is reduced by a long
lease to a tenant with a sound covenant, this will increase the amount of debt that can be raised and
possibly reduce the interest rate payable. This will increase the attractiveness of the investment,
bidding up the price and so reducing the cap rate (all-risks yield/input yield) or discount rate (DCF).
In some markets (such as the UK), debt does not customarily pass to the purchaser on sale of a
property, so properties are always valued on an ungeared/unleveraged basis, i.e. ignoring the debt. In
other regimes (such as the US), debt usually passes with the property, so valuations are customarily
carried by applying an equity cap rate or discount rate to the equity income to arrive at a market value
for the equity.

Quarterly in advance

In the UK, commercial rents are customarily payable quarterly in advance. However, all-risks yields
are expressed as annual returns assuming incomes receivable annually in arrears. An investment with
a gross price of £10,000 producing an income of £1,000 p.a. (in perpetuity) actually shows a return
higher than 10% p.a. because of the benefit of income being receivable sooner.
True equivalent yield

There was an attempt in the 1990s to persuade valuers and investors to use what were called true
equivalent yields. The true equivalent yield from the above investment is 10.38%. The argument was
that by not reflecting the benefit of income receivable earlier, the returns from property investment
were being understated.
A DCF appraisal, which models cash flows explicitly, will reflect the actual rent payment frequency and
the discount rate adopted is therefore a true rate of return.

Discounted cash flow

Implicit methods of valuation employ all-risks yields as input yields with most real-life complications
wrapped up into/implied in the input yield/s chosen. An alternative approach is to make all the cash
flow assumptions explicit. This requires the investor and/or valuer to articulate all cash flow
assumptions and attitudes to risk. Such an approach tends to be more applicable to complex
investments and/or to markets in which sophisticated investors operate.
This methodology is usually referred to as a discounted cash flow (DCF) method. This is something
of a misnomer since the discounting of cash flows is the basis of all investment valuation methods
including the all-risks yield approach.
In the DCF method, the projected cash flows are explicitly estimated over a finite period – commonly
5, 10 or 15 years – the investor’s holding period for the asset or investment horizon, reflecting such
matters as:
 income changes resulting from anticipated variations in market rents;
 effects of obsolescence on rental growth and/or on required capital outlays;
 income voids;
 void costs (property outgoings and taxes);
 re-letting costs (marketing, agents and legal fees);
 refurbishments and upgrades;
 an exit value at the end of the cash flow period, to reflect both anticipated market conditions and
the anticipated condition of the investment at the end of the cash flow/holding period.
The cash flows are then discounted back to the present, not at the all-risks yield, but at a discount rate
reflecting the investor’s overall target rate of return/hurdle rate of return or hurdle IRR.
The final year's net income stream is also capitalised at an all-risks-yield or cap rate, known by many
names including:
 the exit yield;
 exit cap rate; or
 terminal cap rate.
This terminal value or exit value, which assumes a sale of the property at the end of the DCF holding
period, is also discounted by the discount rate and added to the discounted sums of each year's cash
flow in the present.
These sums create a net present value (NPV), which, in the case of a valuation, is the market value of
the property, or the amount that a third party investor could afford to bid for the property on the
assumption that they are achieving their minimum hurdle rate of return (the discount rate).
Because every investor's expectations and required rate of return will differ, the DCF method is often
used to derive an opinion of worth or investment value to a specific investor, for analysing potential
investment returns, comparing investment options for assets or for scenario testing/sensitivity analysis
. However, DCFs are very versatile and can be used to analyse open market transactions by adopting
a set of assumptions that the valuer considers to be typical of investors in the market place and which,
in combination, will equate to the observed market price. Those assumptions can then be used to
assess the market value of another property.