Lecture 1 Pt 2

Investment Valuations

Why Investment Property?

To gain a return on funds invested
Potential investor considers alternative
investments therefore investment
property may fall in or out of favour
dependant on the current economic
climate
Decision to buy investment property is
based on the yield compared to
alternative investments

What can be considered an

investment property?
Can be residential but for the purposes
of this lecture we are considering
industrial or commercial activities
The owner leases the property in return
for rental income

Simple v compound interest

Investment 1 is an example of simple interest e.g. received on a
term deposit or preference shares. The interest is calculated
on principal invested and paid out at defined intervals. The
maturing investment = same amount originally invested.
E.g.
Year 1 Invest 200,000 * 5% interest = 10,000
Year 2 200,000 * 5% = 10,000
Year 3 200,000 * 5% = 10,000
Year 4 200,000 * 5% = 10,000
Year 5 200,000 * 5% = 10,000
At the end of the term the investor receives back their original
investment of 200,000.
Total return was 200,000 *5% = 10,000 * 5 years = 50,000

 The effects of Compound interest has

provided many property owners with
significant gains over returns they
could have received from alternative
investments i.e. provided the gains in
property value have outstripped the
interest costs of loan servicing.
Known as the positive effects of gearing

Effects of Compound interest

The cost of the property in Year 1 was 200,000,
however, the value of the property has increased every
year by 1.5%!
Year
Principal
increase
Value end of year
1
200,000
3000
203,000
2
203,000
3045
206,045
3
206,045
3091
209,136
4
209,136
3137
212,273
5
212,273
3184
215,457
The property has compounded in value each year to
reach 215,457 by the end of year 5.

Why learn the difference between simple

and compound interest?
Because it is the compounding interest in
property that makes property investment
particularly profitable when the rate of
growth in value of the property outstrips the
rate of interest paid on borrowing!

 Why learn the difference between simple

and compound interest?
Because it is the compounding interest in
property that makes property investment
particularly profitable when the rate of
growth in value of the property outstrips
the rate of interest paid on borrowing!

Financial Mathematics using the

compound interest formula
Compound interest assumes that the investor will take the
interest earned at the end of the year and add it to the
principal
Compound Interest formula called The Amount of 1
(1+i)^n
Where
i = the rate of interest
n = the number of years
i.e. The amount to which 1 invested at the beginning of the
year will accumulate after n years at i compound interest

 Compound formula = 1 + i^n

With the formulas both i and n must be
in the same time scale.
E.g. If you are calculating one years
compound interest with interest payable
quarterly at 2.45% per quarter, then i
will be 2.45% and n will be 4.

How to determine capital value of

investment property?
Investor is looking for yield (or rate of
return on investment)
If the bank is paying 3% yield (interest rate
return on invested funds) the potential
property investor considers this in relation
to the return obtainable from investing in
property.

Yield from investment property?

Rental return / property value = Yield
OR
If you know the market yield (i.e. the return
required by property investors for this type
of property, then you can roughly (NB very
roughly) estimate the Capital Value if you
have the rental details.
E.g. market yield 6% rental 6,000
6000/0.06 = 100,000 Capital Value

What determines Yield

Yield is determined by the Return to the investor
So consider the different types of lease
1. where the tenant pays rates, insurance and
maintenance
2. where the owner pays rates, insurance and
maintenance
Ceteris paribus one may consider scenario 1
would give a higher yield

 But things are not always as straight

forward as they appear to be

Total Accomodation Cost

The tenant will determine what they are
prepared to pay in rent by
The total cost of accomodation.
Building Surveyors USP (Unique
Selling Point)?
= understanding of the quality and
operating costs of building services and
building itself

 E.g. air conditioning system, lifts, water

reticulation, sustainability measures in systems
and building structure
Can all reduce tenants operating costs
Obvious green building factors can sometimes
operate as a marketing point for particular
tenants.
Rent payable = function of total cost to tenant.
Rent + Op ex = Total Accomodation cost
Lower op ex allows for higher rental = higher
yield = higher Capital Value

Controversy re sustainability &

value
Valuation is based on historical proven data
so little evidence in market of affect of lowered
op ex due to green buildings.
BUT
Logically what do you think?

Reading doing Well by Doing Good Green Office Buildings by

John Quigley
Delivering sustainability through the adaptive reuse of commercial
buildings: the Melbourne CBD challenge by Sara Wilkinson
(Deakin University Melbourne) Sara is a UK Building Surveyor

Investment Valuations maths

Valuation of a future income stream
A basic freehold investment valuation values the
right to receive a current market rental into
perpetuity (forever).
But if leased, the rent may not be set at current
market rates
1 due to be received in the future versus 1 due
to be received today?

To value a freehold property investment

where the rental is at full market rental (MR).
The income stream (MR) is capitalised (to give the
capital value of the property) by multiplying the
annual income flow by a multiplier known as the
Years Purchase (YP).
The YP is a number (not % or ).
The YP in perpetuity (i.e. the present value of 1
per annum to be received forever) is used.

YP in Perpetuity
To value the present worth today of an income
receivable into perpetuity.
Means Present Value of 1 forever
Also known as P.V. of an annuity
YP perp = 1/i
Where:
i = interest rate, or yield, expressed as a decimal
(rate/100)

Example YP in Perpetuity
Freehold interest in a commercial property just sold for 10
mill. Rental of 550,000p.a. was set 2 months ago and is a
market rent.
Analyse the sale:
550,000 * 100/10,000,000 = 5.5 per cent

Another view of this if purchasers required a 5.5% return on

investment, their purchase price would be YP perp @ 5.5% *
market rental income
YP perp at 5.5% = 1/0.05 (or 100/5.5) = 18.1818
18.1818 * 550,000 p.a. = 9,999,999.99 say 10 mill.

 To value the worth today, of a lump sum

due to be received in the future.
Use the Present Value of 1 formula.

Present Value of 1
Calculates what a lump sum due in the
future is worth today.
1/(1+i)^n
E.g. what is 10,000 due in 5 years worth
today if the investor wants a 5% yield?
1/(1+0.05)^5 = 1/1.34 = 0.7463
10,000 * 0.7463 = 7,463

May be used to estimate how much to put aside today that will compound at .i interest rate to
reach the lump sum in n years.

Present Value of 1 Per Annum

The present value of the right to receive
1 at the end of each year for n years at
i compound interest
This concept is important when valuing a
leased property with a remaining lease
term where rental is either above or below
current market rental rates.

Present Value of 1 Per Annum

Can sum total of PV of 1 for each year
discounted at 10% p.a.:
Year
1/(1 + i)^n P.V.
1 10,000 * 0.9091 = 9091
2 10,000 * 0.8265 = 8265
3 10,000 * 0.7513 = 7513
2.4869

24,869

The value of the income stream of 10,000 p.a. for 3 years is

24,867
i.e. 10,000 * 2.4869 = 24,869

 Quicker and easier way to arrive at the same

figure is to use the YPSR formula:

((1+0.10)^3 1) / ((1+0.10)^3 *0.10)

= (1.331 1) / (1.331 * 0.10)
= 0.331/0.1331
= 2.4869

10,000 rental income * 2.4869 = 24,689

 Present Value of 1 per annum for a

defined time period is also known as
Single Rate Years Purchase YP for a
number of years is used to capitalise an
income that is fixed for a period of years
commencing from now.p.92 Blackledge
Also called P.V. of an Annuity.
In valuation is used to value a defined rental income
stream from a freehold property. Parrys tables provide
factors to avoid long manual arithmetic calculations

All Risks Yield

What does this really mean?

All Risks Yields (ARY)

ARY or market yield is standard measure of the
rate of return from property investments.
Definition - The remunerative rate of interest used
in the valuation of freehold and leasehold
interests, reflecting all the prospects and risks
attached to the particular investment, such as the
likelihood of future rental and capital growth

See P. 71 Blackledge

i.e. is the rate of return required by the investor that reflects all risk according
to the type & class of property, location, quality of tenant, opportunity cost of
investment, state of the economy.

Risk can be both:A) property specific

B) market based risk.

 When valuing a property, the yield

adopted must be obtained from
comparable properties. Why?
Will a Central Business District office
building yield the same percentage return
as a low rise office building in a provincial
city?
(compare apples with apples)

Examples

1.
2.
3.
4.
5.

Calculate the yields for the following investments:

Income () Capital Value ()
30,000 600,000
150,000
1,500,000
27,500 330,000
88,000 440,000
250,000
25,000,000

Slide prepared by Scott King, Course Director, Valuations

The Investment Method of

Valuation
Rests on the idea that capital value is
directly related to the annual rent
generated by the property will this be
static?
Turns income flows into capital
Does that mean a vacant shop is worth
nothing?

 Use the same investment valuation

methodology for vacant and let properties
But how to account for the void period
especially in recessionary times?
In 1990s City of London had 20%
vacancy rate!
Empty building insurance is more
expensive, and rates must be paid.

Examples

1.
2.
3.
4.
5.

Value the following freehold interests:

Income
()
Yield
60,000
4%
300,000
10%
55,000
12.5%
160,000
3%
500,000
20%

*Which is the better investment?

Both Property A and Property B sold at
auction.

A
B
Market rent
100,000
100,000
Sale Price
1,000,000 2,000,000
Yield

 But yields reveal risk!

As the auction bid the price on B up and
up, the yield went down.
Why might more people want to buy B
than A?

 The All Risks Yield has to

reflect every risk involved in
the investment, i.e. lease,
tenant, building, land,
location, economy.

 References:
Blackledge, M. (2009) Introducing property
Valuation, Routledge: London