Property Appraisal Introduction.

Property Appraisal Introduction

Introduction Definitions Appraisal Investment and investors
Appraisal techniques Summary

Definitions Market Value (value in exchange) Worth (value in use)
Estimate of exchange price Relies on interpretation of market information Objective Worth (value in use) To a specific individual or group Usually involves consideration of personal circumstances (risk and return) as well as market, e.g. financial resources available for a property acquisition, including the split between debt and equity finance timescale for holding a property asset tax position, personal tastes and specific requirements of the decision-maker Subjective

Definitions - IVS Investment Value or Worth “The value of property to a particular investor, or a 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.” Why might value and worth be different for the same property? Why might investors arrive at different appraisals of worth?

What is Appraisal? A valuation is an objective comparison with evidence from closely comparable properties An appraisal is an estimation of investment worth to an investor by determining its risk and return characteristics in relation to that investor Market Valuation Appraisal of Worth Forward-looking; forecast of cash-flow Backward-looking; analysis of past transactions

Reasons for appraisal Acquisition Refurbishment/redevelopment
Purchasing a property is one of the key times that Appraisal is utilised Why will different parties pay different prices for the same building? Refurbishment/redevelopment Financing arrangements Ongoing performance Disposal

Financial characteristics of investments
Investment = acquisition of asset(s) that are worth more than their cost Nature of revenue receipt Fixed or variable income and capital value Liquidity Security of income and capital Nominal Real

Financial characteristics of investments
Conventional bonds long, short, medium or undated fixed interest debt investment gross redemption yield (GRY) = riskless nominal rate of return GRY on index-linked gilts = real risk-free rate of return Ordinary shares equity investment IRR unknown and must be estimated from anticipated cash flows (unlike gilts) therefore shares involve risk -> premium above GRY Property Direct and indirect Commercial and residential

But property is... Heterogeneous and fixed location
High unit value (lumpy) and so difficult to finance Slow to create and long-lived Expensive to manage Likely to depreciate Suffer from frequent government intervention Difficult to price Slow to transact (Illiquid) In segmented markets

So who invests in property?
Financial Institutions (general insurance companies, life assurance companies and pension funds) UK Property Companies Overseas Investors Traditional Estates and Charities Private Investors Limited Partnerships and Unit Trusts See Table 2.8 in Hoesli and MacGregor…

Appraisal at Purchase 22-24 Queen Square, Bristol
Grade II listed terraced office building. The building was redeveloped in 2007 and the Grade II listed façade was retained Sold to Invista December 2006 for £8.5m (4.87%) Sold by Invista to Epic May 2008 for £6.2m (6.5%)

Appraisal at Purchase 1 Georges Square, Bristol
Acquired in November 2004 by Anglo Irish Private Bank for £24,475,000 (6.20% NIY) Sold in May 2006 to Invista for £29, 500,000 (4.95% NIY) Sold in September 2008 to IVG for £21,915,000 (6.65% NIY) Sold in June 2010 to British Steel Pension Fund for £25,375,000 (5.75% NIY)

1 Georges Square, Bristol

Summary Valuation is a market-based concept. An appraisal of worth is an individual-based concept and represents a means of assessing whether a price/valuation represents ‘good value’ to an individual or group A different information set is used to conduct appraisals of worth, using more client-specific information An appraisal of worth may vary more than a market valuation as the financial estimation moves away from an analysis of market information to greater consideration of personal investor or occupier requirements, using more sophisticated techniques

Information Requirements
Property Appraisal Information Requirements

Introduction Properties are not frequently traded in the open market and information access is limited so valuers look at comparable evidence to assess market value (PV) Need to compare appraisals of worth with asking price Example 43 Queen Square, Bristol… AS AT DEC 2008… Basement (not lettable), ground and three upper floors 25,210 ft2 Occupied on GF only producing an income of £97,410 p.a. (net?) from two leases: 25 year lease from 24/6/84 at passing rent of £60,660 p.a. (£18 psf) 10 year lease from 28/9/96 (holding over) at rent of £36,750 p.a. (£14 psf) MR £20 psf Refurb opportunity The sale interest is a 120 year ground lease from 29/9/82, annually reviewed to 13% of ‘net revenue’. From Sep 07 to Sep 08 this was £41,286 Asking price is £3m (approx 1.9% yield on current income after ground rent!)

Appraisal information
Economic indicators Output, (un)employment , movements in corporate profits (by sector), money supply, public sector borrowing, inflation, interest rate Market indicators Rents, rental growth and depreciation rates Redevelopment or refurbishment costs Yields and forecasts of exit yields Purchase and sale costs Movements in market indices Portfolio information Asset returns and correlations (to aid diversification) Sales and purchases Risk indicators

Client specific information
Property information Physical attributes (areas, ancillary space, quality, improvements) Financial details (yield, rent passing, rental growth, market rent and capital value) Legal terms (tenancies and lease details, number of tenants, expiry dates, review dates, voids, future leases) Outgoings and capital expenditure (vacancies, voids, unrecoverable service and management costs, letting, re-letting and rent review costs, purchase and sale costs) Depreciation, costs & timing of redevelopment and refurbishment, cost inflation Planning Taxation (Business Rates, VAT) Occupancy / holding costs (management, review, purchase & sale costs) Dilapidations, service charge & other payments for repairs and insurance if leasehold Client specific information Discount rate, taxation, loan / finance Holding period This is a lot of information to assimilate and many of these factors can be grouped together and handled by adjusting either the cash-flow or the target rate of return.

Facts and variables in appraisal
Variables (assumptions) Current Rents Target rate of return Covenant Strength of Tenants Estimated Rental Value and Rental Growth Prospects Lease Expiries/Break Clauses Void Periods and other anticipated expenditure Areas Holding Period Exit Yield It is important to concentrate on the most value significant factors. This may be done using techniques such as sensitivity analysis and simulation. Snapshot assumptions or probabilities…?

Key investment appraisal variables
Investment appraisal involves making explicit judgments (based on evidence) about: Rent and rental growth Volatile over short term Little known about depreciation rates Expenditures Target rate or return Selection of risk premiums for individual properties is a grey area Holding period Longer period - more chance of error in selecting variables Exit value Prime yields fairly stable Also need to consider taxation and financing. The appraisal of standing investments may be less volatile than development appraisals because there are fewer key variables and changes in these variables are often less pronounced. This results in a more stable cash-flow. In an investment appraisal the key factors are rent, target rate of return, holding period and exit yield.

Rent and rental growth Contractual rent will be known but market rent and future lease terms must be estimated Associated variables: Timing of rent reviews Length of lease and existence of any break options (likelihood of void periods) Management costs and taxation Financial impact of void periods How long will it take to let vacant space? Holding costs through void period Letting incentives and possible refurbishment costs to be allowed for Short-term lets... Impact of voids is important particularly as lease lengths shorten and break clauses become more prevalent

Rent and rental growth Estimate rental value of
New Existing Existing but refurbished Estimate rental growth rate % Depreciation Depreciation rate of existing property (% rent) 2.00% Depreciation-adjusted rental growth rate 2.94% NB. Capex of 0.5-1% p.a. means rent depreciation of 0.5-1% p.a., rising to 2% p.a. with no capex...

Associated expenditures
Acquisition costs (% acquisition price) % Rent review costs (% new rent) % Management costs (% income) % Re-letting costs (% new rent) % Higher than rent review due to marketing and legal fees Lease renewal costs (% new rent) % No marketing costs Property tax / business rates

Forecasting and Depreciation
Forecasts of market rents and rental growth typically relate to prime new business space in the locality concerned (i.e. no depreciation) National, regional and local level Usually based on econometric models of economy and property market Property specifics are also vital Depreciation Don’t overlook or double-count! Think carefully about relationship between capex and depreciation If refurbishment expenditure is included in cash-flow then financial benefit should be reflected in revenue (e.g. enhanced estimates of rental value, growth rate or exit yield) Forecasts of market rents and rental growth typically relate to prime business space in the locality concerned because the thorny issue of how rents may depreciate as premises age can be avoided. Forecasts of rent and rental growth at the town level may be misleading if they are applied at individual property level. Little is known about the way that rents depreciate over time, either due to physical deterioration of the property itself or due to some form of obsolescence. There is a clear need for appraisal to allow for such items as obsolescence and deterioration but particular care is needed when considering how these phenomena affect value.

Discount rate or target rate of return
Must adequately compensate an investor for the risk taken Individual properties have individual target rates Portfolio construction can isolate property-specific risk from market risk It is the cost of capital (an investment needs to compensate investors for the use of their capital) Several ways of deriving it: Risk-adjusted discount rate (RADR) Frequently used by investors and property analysts Capital Asset Pricing Model (CAPM) Weighted Average Cost of Capital (WACC) Yield on client’s equity

1. Risk-adjusted discount rate (RADR)
The target rate of return (TRR) required by an investor may be derived from a ‘risk-adjusted discount rate’ (RADR), expressed as: TRR or RADR = RFR + RP Where: RFR is the risk-free rate of return or compensation for loss of liquidity RP is the risk premium or compensation for risk, which comprises market risk (which cannot be diversified away) RADR derived by adding a risk premium to a ‘benchmark’ risk-free rate Discount rate should cover: cost of borrowing / cost of capital, including inflation return from alternative investments, e.g. government bonds

RADR components Risk-free rate (RFR) Risk Premium
Baseline defined by reference to the return from a low-risk or riskless asset Typically the income yield on a medium / long dated gilt Risk Premium Return to compensate for market and property-specific risks associated with holding the specific property asset Need to decide which are best handled by building into the cash flow and which should be incorporated by adjusting the RP a) The rationale for basing the risk-free rate on this benchmark was because the term coincided with typical lease lengths. As lease lengths shorten it may be more appropriate to base this risk-free rate on short-dated gilts or five to ten year swap rates. b) Key issues affecting risk include: a) Rental growth & depreciation e) Liquidity b) Potential for letting voids f) Occupier characteristics c) Cost of ownership & management g) Investor behaviour d) Lease structure h) Property attributes

Risk Premium Difficult to estimate for individual property assets due to Paucity of data, confidentiality issues Uniqueness of assets and complexity of markets Overlap between risk factors Historically the UK long-term property RP = 2-6% Need to consider RP over different holding periods Need to distinguish long term (ave) RP from short term sentiment re-ratings Group assets to determine property sector RP, then adjust to reflect asset-specific risk Remaining costs (fees, management, dilapidation, etc.) are handled in the cash flow Sector risk: illiquidity, depreciation Asset risk: location, covenant strength, lease terms

RADR limitations Only one rate applied to all cash-flows so fails to distinguish those parts of the cash-flow that are risky and those that are not Heavily discounts distant cash-flows regardless of whether they are actually more risky Ignores the importance of diversification a) E.g. rental income return might be regarded as fairly secure whereas capital return might be considered to be more volatile over the holding period. It is possible to discount different parts of cash-flow at different rates using a ‘sliced income approach’ (Baum and Crosby, 1995) or an arbitrage approach (French and Ward, 1995) but such methods are not frequently used in property investment appraisal. In property valuations a core and top-slice or term and reversion approach is used when the risk profile of a rent changes significantly at some future date. b) It is unlikely that the growth in risk is going to be at exactly the same exponential rate as the growth inherent in the risk premium. Furthermore, cash-flow after a refurbishment or redevelopment programme is likely to be more uncertain.

2. Capital Asset Pricing Model (CAPM)
An investment’s expected return is a positive linear function of risk (measured in terms of SD & variance) CAPM enables estimation of the target rate of return in the light of returns available from ‘risk-free’ investments and market-related risk factors of the investment under scrutiny Recognises that each investment has different market risk which will influence its expected return Market risk is a special type of risk related to the contribution that the asset makes to a well-diversified portfolio.

CAPM Where E(rn) = expected return for a specific asset rf = risk-free rate b = amount of systematic risk (indicator of the investment’s sensitivity to market movements) E(rm) = expected market return (the reward for bearing systematic risk) E(rn) depends on: Risk-free rate (RFR) Reward for bearing systematic risk (Market RP) Amount of systematic risk (beta) a specific asset has relative to an average one E(rm) can be assessed from either regression analysis of a suitable market index or a scenario approach. Latter requires an estimate of expected outcomes for market and property over defined time horizon under different economic conditions, e.g....

CAPM example Expected market return and variance: E(rm) and var(rm):
Scenario Prob (p) rm p(rm) (rm –E(rm)) (rm –E(rm))2 p(rm –E(rm))2 Severe recession 0.2 -0.2 -0.04 -0.36 0.1296 Mild recession 0.3 0.1 0.03 -0.06 0.0036 Recovery 0.4 0.12 0.14 0.0196 Strong recovery 0.5 0.05 0.34 0.1156 E(rm) = 0.16 var(rm) =

p(ra –E(ra))(rm–E(rm))
CAPM example Expected asset return and its covariance with market return: E(ra) and cov(ra, rm): Scenario Prob (p) ra p(ra) (ra –E(ra)) (rm–E(rm)) p(ra –E(ra))(rm–E(rm)) Severe recession 0.2 -0.05 -0.01 -0.195 -036 Mild recession 0.3 0.15 0.045 0.005 -006 Recovery 0.4 0.20 0.08 0.055 0.14 Strong recovery 0.1 0.30 0.03 0.155 0.34 E(ra) = 0.145 covar(ra, rm) = 0.0223

CAPM example Asset beta: = 0.0223/0.0464 = 0.48
So the asset has a low beta coefficient indicating low volatility (approx. 50% lower risk than the market) Using the CAPM equation and assuming a RFR of 5%, we can now calculate the expected target rate of return, E(rn) E(rn) = (0.48)( ) = or 10.28% The SML examines individual asset risk premiums against risk measure appropriate for individual assets. With individual assets the only relevant risk is systematic risk, hence we examine beta. SML represents the reward for bearing systematic risk. New investments must offer at least the same reward. If they are higher the NPV will be +ve and IRR > one offered by market.

3. Weighted Average Cost of Capital (WACC)
Discount rate (minimum expected rate of return) of an investment is the ‘cost of capital’; it represents how much the company should earn to break even WACC takes the cost of equity and after-tax cost of debt and calculates an average, weighted according to the market values of debt and equity Capital structure weights: Debt weight, w, is the market value of debt divided by the total market value of debt and equity Equity weight is 1- w

Land Securities - Capital structure weights
MVs preferred but can use book values Equity = 6,636.6 Debt = 2,923.1 Equity weight 6,636.6/(6, ,923.1) = 69.4% Debt weight 2,923.1 /(2, , ) = 30.6% The debt:equity ratio reflects a company target (Land Sec = 0.70, real estate sector = 0.81). The cost of capital will reflect this target

WACC formula WACC = (1-w) re + w.rd (1 – t)
Where w is the market value weight of debt, rd is the cost of debt, t is the corporate tax rate and re is the geared cost of equity re can be estimated from CAPM E.g. if the b of the company is 1.35, rf is 6%* and E(rm) is 12.5%, then = (0.065) = 14.78% RFR is expressed gross of tax because firm must earn 6% after taxes so shareholders can earn RFR of 6%.

WACC and tax Cash flows are after tax
The WACC discount rate has to be consistent with cash flows Tax issues relate to debt Interest offers a tax shield = rd * tc It is as if the government reduces the cost of debt rd becomes rd (1 - t) Need to check current gvt policy to see if the tax shield is now capped at £3m...

WACC example If the geared cost of equity is 14.78%, gross interest on debt is 9% , corporate tax is 40%, and with market value weights for equity (we) of 0.3 and debt (wd) of 0.7, WACC can be calculated as follows: WACC = [0.3 x ] + [0.7(0.09(1 – 0.4)] = Say 8.2% The WACC is based on figures derived from the company and so should only be used on projects with same financial structure as the company.

WACC summary Represents discount rate to be used for
Company projects With similar characteristics to existing investments What happens if investment has different risk/return profile? Subjective approach: adjust WACC by adding premiums or deducting discounts depending on perceived risk (high, medium, low) The WACC is based on figures derived from the company and so should only be used on projects with same financial structure as the company

Holding Period of Investment
Normally specified by client... Usually 3-5 or years depending on type of investor ...or by fundamentals of the property influenced by lease terms (break clause, lease expiry) or by physical nature of property (redevelopment, voids) Longer hold period = greater risk of fluctuation of variables from prediction, or reversion to long term trends? As a rule of thumb, large institutional investors might be considered to have longer holding periods than niche investors and investor-developers who may be more interested in the capital growth opportunities afforded by redevelopment potential than long-term income growth. A longer holding period will mean that it is more difficult to predict the values of key variables in the medium to long-term (a problem that is usually hidden by using an exit yield or exit value at the end of a shorter holding period). So a long holding period is associated with greater risk of fluctuation from predictions of long-term trends and a greater chance of error in selecting exit variables. An additional consideration is whether the market is assumed to be stable over the holding period.

Exit value Value of the property at the end of the holding period
Usually capitalise the rent forecast at the end of the holding period May reflect land values if demolition is anticipated May reflect refurbishment / redevelopment costs too Forecast building costs if refurbishment or redevelopment is planned In selecting an appropriate exit yield at which to capitalise the rent we are asking what yield a purchaser would require for the property at the point of (notional) sale. The exit yield is usually based on fairly stable prime yields and is normally derived by comparison with similar investments. It is important to consider the impact of depreciation but care should be taken so as not to double-count its the effect on value by, say, reducing the forecast rent and raising the exit yield. The choice of exit yield is central to the appraisal when the holding period is less than 20 years as the resulting exit value forms a substantial element of the overall worth of the investment.

Exit Yield Yield a purchaser would require for the property at the point of (notional) sale Normally based on comparison with similar investments using ARY approach Assume stability of market over holding period? Important to consider impact of depreciation but don’t double-count its effect on value by, say, reducing the forecast rent and raising the exit yield Choice of exit yield is key when holding period < 20 years as resulting exit value forms a substantial element of worth

Summary Rent and rental growth Target rate or return Holding period
Depreciation Associated costs Target rate or return RADR CAPM WACC Holding period Exit value Exit yield redevelopment

Property Appraisal Methods

Introduction Investment decisions involve choosing between different types of investment with different characteristics Investment decisions are made against a background of risk and numerous uncertain variables dependant upon future events A rational basis to compare investment propositions (a decision tool) is required that focuses on return / risk profile Cash-flow modelling seeks to quantify the price at which a property might exchange in a market situation AND the criteria on which such pricing decisions are made; for example the required rate of return, the holding period for the property and risk factors.

Must consider: Financial resources available (equity and debt) Project timescale Integration with existing portfolio Any mismatch between the market value or price of a property investment and its worth to a particular investor should be investigated A rational investor should buy an asset if its price is equal to or below his assessment of worth The range of worth estimates is typically wider in the property market than in the equities market where a great deal more trading takes place on the more marginal differences between price and worth

Methods Simple screening: Project-only discounted cash-flows (DCFs):
Payback Rate of return and yield Project-only discounted cash-flows (DCFs): Net Present Value (NPV) Internal Rate of Return (IRR) Capital Asset Pricing Model (CAPM) Project-with-finance DCFs Weighted Average Cost of Capital (WACC) Flow to Equity (FTE)

1. Simple screening methods

a) Payback Measures time taken to recoup expenditure
Widely used technique Simple to perform and interpret Favours investments where the greater cash-flow is received in the early years because any income received after payback has been attained is ignored

Payback: Example Which is the best? Why? Year Property A Property B
-100,000 1 60,000 20,000 2 40,000 3 4 70,000 Which is the best? Why?

Payback: Example Year Property A Property B -100,000 1 60,000 20,000 2
-100,000 1 60,000 20,000 2 40,000 3 4 70,000 Net cash-flow 110,000 A would be chosen because the payback is in 2 years despite the total net cash-flow for B being much greater

Payback Limitations Views investments in the short term, only focusing on cash-flows within the payback period; the shorter the payback the more attractive the investment Fails to measure long-term profitability beyond the payback period. Ignores the time value of money, the total return that can be expected from the investment and volatility of that return The only justification for this method can be that as one projects further into the future the more volatile returns are expected to be, so it is better to have returns sooner Some types of investment may yield low returns in the short-term but benefit from substantial increases in income and capital value in the medium to long-term: a reversionary freehold property investment or a shopping centre where units are let on periodic tenancies while redevelopment is planned are examples of this type of cash-flow. The payback method would not adequately reflect the potential worth of these types of investment.

Discounted payback Variation of the payback method that considers the time value of money by calculating how quickly a project recoups initial expenditure in discounted (present value) terms It is really a version of the Net Present Value method (see later) truncated to the payback year so cash-flows beyond this point are, once again, ignored Payback method can be used as an initial screening device prior to more sophisticated methods

b) Rate of return & Yield
If an investment is correctly priced the expected (target rate of) return will equal the actual return Obviously the actual return is not known as it is in the future but we can look at past performance as a guide A simple but important measure of investment performance is the ratio of net annual income to capital outlay, known as the (income) yield Simple to calculate and can be compared to a ‘hurdle’ or target rate of return set by the investor or compared to the investor’s overall return on capital or WACC

Rate of return & Yield: Theory
Target rate of return, rn, comprises a risk-free rate, rf, a risk premium, rp rn = rf + rp And the yield, y, is y = rn – g + d = rf + rp – g + d So if the market is correctly priced rf + rp = y + g – d (required return) = (actual return)

Rate of return & Yield: Application
rf + rp = R - g y Bond 4.5 Equity 6.3 10.8 3 7.8 Property 3.2 7.7 1 6.7

Rate of return & Yield: Example
An investor wishes to invest £5m and wants a 9% return A shop is available for £5m which has been let at £400,000 per annum Annual rental growth is expected to be less than 1% Should the investor purchase this investment?

Rate of return & Yield: Example
An investor wishes to invest £5m and wants a 9% return A shop is available for £5m which has been let at £400,000 per annum Annual rental growth is expected to be less than 1% Should the investor purchase this investment? Yield = income / capital value = £400,000 / £5,000,000 = 0.08 or 8% The shop investment does not produce a sufficient return

Rate of return & Yield : Example (continued)
The shop investment has only been analysed in terms of its initial return and the simple relationship between initial income and price paid reveals nothing about future income and capital growth prospects In the UK business properties typically let on leases incorporating 5 yearly rent reviews The IPD retail property index indicates that rents have been growing at an average rate of 1.5% per annum Implied rental growth is 1.17% per annum 1.17% per annum is the growth rate needed if the client’s target rate of 9% is to be achieved If past performance of rental growth reported by the IPD is indicative of future performance then this level of growth appears sustainable

Rate of return & Yield: Summary
Like payback, the yield is simple to calculate and easy to understand But it cannot account for financial magnitude of the investments under consideration because it is a percentage measure The yield, like payback, ignores the time value of money and ignores the concept of cash-flows Should only be used to screen investments prior to more detailed appraisal

2. Project-only DCFs It is not necessary to account for financing when evaluating a project the value of a project should not alter simply as a result of the way that it is financed (Modigliani and Miller, 1958) (MM hypothesis) It is okay to assume investment is wholly equity financed The funding decision is separate from the investment decision but only in a world without tax... Financing only matters when tax is involved

Discounted Cash-Flow (DCF)
A DCF shows the present values of all revenue (including rent, premiums and sale price) and expenditure (including purchase price and any periodic expenditure) The present value of a future sum, whether it is revenue or expenditure, is dependent on the discount rate and the length of time over which it is discounted: the higher the discount rate and / or the longer the discount period, the lower the present value To assess investment worth: Estimate cash-flow Discount at target rate

DCF Can adjust the cash-flow in each period to account for changes in inflation, rental growth, depreciation, refurbishment and redevelopment expenditure, tax, financing, management and transfer costs, etc. Allows direct comparison of investments because the cash-flows are converted to a common denominator – present value Two widely used DCF decision tools Net Present Value (NPV) Internal Rate of Return (IRR) DCF is often used as a worth appraisal technique as well as a market valuation technique. In fact DCF techniques are often used to test the estimate of market value rather than derive it; in other words they are more frequently used in appraisal than valuation. PV and IRR tools operate on the net cash flow which includes all actual flows but not profit or interest on borrowings

a) Net Present Value (NPV)
Sum of cash flows over holding period discounted at appropriate discount (target) rate Present value of a capital profit, expressed as an absolute number regardless of extent of cash flows needed to generate it, over and above target rate of return If NPV positive, then return higher than target rate NPV is the difference between PV of payoff and current investment

Determinants of the Target Rate of Return
Opportunity Cost of Capital (liquidity preference) Inflation / growth Risk

NPV: Simple example Year Cash-flow (£) PV 10% DCF (£) -880,000 1.0000 1 200,000 0.9091 181,820 2 400,000 0.8264 330,560 3 440,000 0.7513 330,572 4 220,000 0.6830 150,260 NPV 113,212 Positive NPV signifies viability at 10% discount / target rate

NPV: Comparison 1 Year 1 2 3 4 5 Cash flow from A -140,000 60,000
1 2 3 4 5 Cash flow from A -140,000 60,000 40,000 20,000 PV 10% DCF 1 -140,000 0.9091 54,546 0.8264 33,056 0.7513 15,026 0.6830 27,320 0.6209 24,836 NPV 14,784 Cash flow from B -140,000 20,000 40,000 60,000 PV 10% 1 -140,000 0.9091 18,182 0.8264 33,056 0.7513 30,052 0.6830 40,980 0.6209 37,254 NPV 19,524 The one with the highest NPV will be the best, provided the capital outlay on each is the same.

NPV: Comparison 2 Year Property A Property B -750,000 1 90,000 -500,000 2 70,000 3 4 5 6 7 8 2,000,000 Net Total 1,250,000 2 investments which have same net total cash-flows but timing of payments is different NPV will be higher if majority of cash flows are received early on A yields higher income in early years and then requires refurbishment in year 7, whereas B is in need of refurbishment in year 1 NPV 563,303 323,484

NPV: Benefit-to-cost ratio
If capital outlays are different, calculate NPV as a proportion of PV of total costs and choose the project with the highest Year Income from Investment A 10% DCF Income from Investment B -50,000 1 -70,000 30,000 0.9091 27,273 40,000 36,364 2 20,000 0.8264 16,528 24,792 3 15,000 0.7513 11,270 15,026 Despite a lower NPV, because of its magnitude in relation to the outlay, Project A would be chosen NPV 5,071 6,182 PV total costs 50,000 70,000 NPV/PV Total Costs 10.14% 8.83%

NPV: Inflation rate as the discount rate
If inflation rate is used as the discount rate then it is possible to determine whether an investment meets the minimum requirement of transferring purchasing power through time Year Cash-flow Discount / Inflation Rate (4%) DCF -200,000 1.0000 1 15,000 0.9615 14,423 2 20,000 0.9246 18,492 3 200,000 0.8890 177,800 Net 35,000 NPV 10,715 The nominal increase in value is £35,000 and the real increase is £10,713 after a loss of purchasing power to inflation at a rate of 4% per annum. NPV is a lot less than the net cash flow in nominal terms because the bulk of the cash-flow is received at the end of year 3. A loss to inflation is the first barrier to investing and is a financial cost just like operating expenses and taxes. But inflation is only one component of the discount rate; others include a return for risk taken and possibly adjustments to reflect depreciation

Constructing a real estate cash-flow
Period Income (£) Net Cash Flow (£) Growth rate Real Cash Flow (£) YP 5 16% PV 16% Discounted income (£) Initial outlay -£100,000 0-4 12,000 1.0000 3.2743 39,292 5-9 1.2763 15,315 0.4761 23,876 10-14 1.6289 19,547 0.2267 14,508 15-19 2.0789 24,947 0.1079 8,816 20-Perp 2.6533 31,840 9.0909* 0.0514 14,874 Net Present Value (NPV) £1,365 Rack-rented freehold property investment is on the market for £100,000. The rent is £12,000 per annum, rent reviews are every five years, the assumed holding period is 20 years over which time you expect rent to grow at an average rate of 5% per annum. At the end of the holding period you assume a sale at an exit yield of 11%. Target rate is 16%. *YP perpetuity at exit yield of 11%

Constructing the cash-flow: Tranching income
Cash-flow has been concatenated into five-yearly income blocks The exit yield may well be higher than current initial yields because the property will be 20 years older, so it is important to use comparable evidence of similar but 20 year older properties than the subject property. Rental growth rate will probably decline, become static or even negative, so a spreadsheet can be used to model various outcomes.

b) Internal Rate of Return (IRR)
Rate at which cash flow is discounted to give an NPV of 0 Income discounted to equate with expenditure It is where the discount rate equals the IRR Rate generated internally by the cash flow of the investment 'Internal' denotes that the rate is asset-specific rather than derived from comparable evidence or a market rate NPV & IRR make different assumptions about the reinvestment rate IRR is a % amount whereas NPV is a money amount IRR higher than target rate signifies viability IRR can be compared with the investor's target rate or the cost of borrowing capital IRR can be monitored throughout life of investment, if it drops below market rates it may be time to sell

IRR (reinvestment rate)
IRR cannot be calculated directly because as the number of cash- flows increases so does the complexity of its polynomial expression, with multiple roots Also, projects with +ve and –ve cash-flows can have > 1 IRR Use interpolation or iteration instead IRR can be compared with the investor's target rate or the cost of borrowing capital IRR can be monitored throughout life of investment, if it drops below market rates it may be time to sell

IRR: Interpolation Year Cash-flow PV 15% (TR1) Present value PV 16% (TR2) Present Value -880,000 1.0000 1 200,000 0.8696 173,920 0.8621 172,420 2 400,000 0.7561 302,440 0.7432 297,280 3 440,000 0.6575 289,300 0.6407 281,908 4 220,000 0.5718 125,796 0.5523 121,506 NPV1 +11,456 NPV2 -6,886 IRR lies between 15% and 16% If NPVs are plotted on a graph against discount rates a curved line depict exact IRRs We can interpolate a straight line between these two rates to determine where NPV = 0, so long as we have a positive and a negative NPV to work from When we discounted this cash-flow at 10% earlier the NPV was positive so we know that the IRR (which produces an NPV of zero) must be higher than 10%. To calculate the IRR use two trial rates to give a positive and a negative NPV But what trial rate to start with? Basic rule relating to a rack-rented investment is ARY + growth rate approx = IRR So let’s take two trial IRRs of 15% (TR1) and 16% (TR2)...

IRR: Interpolation x Discount rate (%) NPV (£) +11,456 -6,886 15% 16%
15% 16% x IRR estimate Actual (non-linear) relationship between NPV and discount rate Assumed (linear) relationship between NPV and discount rate True IRR When we discounted this cash-flow at 10% earlier the NPV was positive so we know that the IRR (which produces an NPV of zero) must be higher than 10%. To calculate the IRR use two trial rates to give a positive and a negative NPV But what trial rate to start with? Basic rule relating to a rack-rented investment is ARY + growth rate approx = IRR So let’s take two trial IRRs of 15% (TR1) and 16% (TR2)...

IRR: Interpolation Using similar triangles, we can interpolate a linear estimate of the IRR between the two trial rates Where TR1 = lower trial rate NPV1 = NPV at lower trial rate TR2 = higher rate NPV2 = NPV at higher rate and + and - signs are ignored Therefore IRR estimate is 15% % =15.63% Because we get a positive NPV when the discount rate is 15% and a negative one when it is 16% we know the IRR lies somewhere between 15% and 16%. We also know that the true relationship between discount rate and NPV is non-linear but because our two trial rates are pretty close to the IRR we could assume that, between them, the relationship is linear.

IRR: Interpolation example
Freehold office investment recently let on an full repairing and insuring (FRI) lease with 10 years left Price is £1m, current rent is £100,000p.a., expected to rise to £125,000p.a. at next rent review At the end of the lease the property could be refurbished at a cost of £1.5m and would then expected to sell for £3m (these are forecasts, not current values). The refurbishment is expected to take a year to complete

Using 10% trial rate

Using 15% trial rate But what trial rate to start with?
Basic rule relating to a rack-rented investment (where ARY + growth rate approx = IRR) does not necessarily apply to a property which is to undergo refurbishment. However, as the investment will cost £1m and give an initial rental income of £100,000 per annum, this produces an initial yield of 10%. So the IRR must be >10% because if not why would anyone refurbish?

Interpolate IRR IRR = TR1 + [(TR2 – TR1) x NPV1 ] NPV1 + NPV2 = 10 + [(15 – 10) x 199,043 ] 134, ,043 = 10 + [5 x 199,043 ] 333,134 = = 12.99%, say 13%

IRR: Iteration Rent is £12,000 pa with 5 year rent reviews
Income Growth rate (6% per annum) Real Cash Flow 1 12000 1.0000 2 3 4 5 6 1.3382 16059 7 8 9 10 11 1.7908 21490 12 13 14 15 16 2.3966 28759 17 18 19 20 20-perp 3.2071 349869a IRR 11.25% IRR: Iteration Rent is £12,000 pa with 5 year rent reviews ARY is 11% and rental growth is 6% pa Asking price is £100,000 Using the IRR function, the IRR of this investment is found to be % NB. IRR function in Excel assumes 1st cash flow is period 0 a This is the projected rent capitalised in perpetuity at a yield of 11%

NPV & IRR: Summary NPV – positives NPV – negatives Accurate
Shows total profitability NPV – negatives Need to choose discount rate Can’t deal with uncertainty; market knowledge can only do so much, struggle with macro issues - inflation, fluctuating interest rates, changes to tax regimes , etc.

NPV & IRR: Summary IRR – positives IRR – negatives
Needn’t select discount rate Can compare against a target rate Simpler to appraise a stand alone opportunity against own benchmark IRR – negatives Highest IRR doesn’t mean highest NPV (if cash-flow profiles on NPV/discount rate graph cross over at a point above hurdle rate) Returns (i.e. income) are reinvested at the IRR and this is unrealistic, particularly if the IRR is significantly higher than target rate Because IRR function is a polynomial it can have multiple roots (although this is rarely a problem and lowest values is the IRR)

NPV v IRR IRR is by far the more commonly used appraisal methodology in commercial property, particularly amongst institutional investors Why? Education and Inertia! Individuals like a common benchmark that allows discussion, comparison through time and benchmarking Allows a one-off appraisal of a single project against a pre- determined hurdle rate But… Basic principles are the same, variables are being examined and then cash-flows are predicted, and discounted

Property Risk Analysis

What is risk? Risk is uncertainty regarding the expected future rate of return from an investment It is perceived in terms of security of capital, security of expected income and liquidity More risky an investment is perceived to be, less attractive it is and thus less valuable; this translates to a higher yield / return Main concerns are probability of making a loss estimating most likely (capital and income) return estimating variability of returns

Types of risk Systematic risk Unsystematic risk
affects all investments caused by inflation, economic cycles, interest rate fluctuations, etc. cannot be diversified away Unsystematic risk affects specific investments caused by business, financial or liquidity risks can be diversified (or can it?) using a portfolio of investments

Sources of property investment risk
Tenant risk Non-payment of rent or other contractual obligations Sector and geographical risk See return characteristics of property sectors and regions ‘Lumpiness’ of property investment accentuates this type of risk International diversification can ameliorate some of this type of risk Structural risk Future expenditure Prime much less prone Legal risk landlord and tenant legislation fiscal policy Planning Ownership other legislation; Sunday trading Location risk

Risk analysis Despite widespread use of DCF appraisal techniques, risk measurement is rare Competition, globalisation and securitisition pressures on property to align with other investment classes Traditionally, ARY accounts for risks associated with a property investment Investors are starting to quantify risk and allow for it separately using methods used to analyse non-property investments

Risk-return analysis 1. Expected Net Present Value (ENPV) Calculate NPV for each option using expected values for variables in the cash flow. The likelihood of these values being obtained are then quantified using probability analysis

ENPV Assume previous cash flow has probability of 40% and and that the following outcomes and associated probabilities are deemed possible:

ENPV Positive NPV using point estimate has become a negative ENPV using probabilities Probability estimates are subjective but the process does focus the mind on likelihood of achieving predicted returns Not a true measure of risk as it does not measure variation, just a prediction for expected return, e.g. consider the two options below

ENPV Identical ENPVs but very different volatilities (150 for B and 700 for A with a negative possibility)

Risk-return analysis 2. Probability analysis
Use Standard Deviation (SD) to evaluate risk Option A Option B

Probability analysis SD for A is £ and for B is £48.99 so B is less volatile ‘Coefficient of variation’ allows investments with different ENPVs to be compared: CoV = SD/ENPV

Risk-return analysis 3. Sensitivity analysis
Examines change in NPV / IRR caused by changes in key variables Usually a margin of 10-20% either side of the expected values of key variables (rent, yield, etc) is tested More sophisticated analysis may use more realistic variations in the key variables or use different % changes depending on the variable Does not consider the likelihood of particular outcomes

Risk-return analysis 4. Scenario Modelling
Combine possible values for key variables into scenarios and examine effect on IRR / NPV Usually best, worst and realistic scenarios Focus on pessimistic scenario due to assumption of risk aversity Can assign probabilities to scenarios

Scenario modelling Expected return = (0.2)(37.8) + (0.6)(28.8) + (0.2)(9.7) = 26.8%

Scenario modelling Economy Probability Estimated Development Return
Boom % Steady % Slump %

Scenario modelling Return Probability 35% x 0.30 = 10.5%
Expected Return = 20.0% And (Return – mean return)2 x Probability (35% - 20%)2 x = 67.5 (20% - 20%)2 x = ( 5% - 20%)2 x = 67.5 Expected Risk = Ö135 = %

Risk-return analysis 5. Simulation
Subjectively estimate values and associated probability distributions for each key variable Computer program randomly selects a combination of values in accordance with their probabilities and performs appraisal (e.g. NPV / IRR calculation) Selection repeated many (1000) times with each value of each variable selected according to its assigned probability Mean snd standard deviation of the NPV/IRR calculates and pattern of results graphically portrayed

Simulation @Risk or Crystal Ball
Can enter ranges, standard deviations, correlations, etc to model mean, variation e.g Rental value and exit yield standard deviations based upon comparable ranges, growth forecast ranges based on standard errors of forecasts, costs based upon BCIS current costs and forecast ranges, depreciation rate ranges based on past studies?

Basic process Build spreadsheet model Run simulation Analyse results

Defining model assumptions
Types of data cells Assumption cells (numbers not formulae) Forecast cells Determine appropriate probability distribution for each stochastic variable Define assumptions Specify correlations

Run simulation Forecast chart
Can input % uncertainty, level of required figure...

Simulation parameters
ERV refurbished 110,000 (SD 5,000) ERV existing 100,000 (SD 5,000) Exit yield 7.25% (SD 0.5%) Cost of refurbishment £750,000 (SD £50,000) Rental value growth 5% (SD 1%) Depreciation rate 2% (SD1%) Refurbishment cost growth 5% (SD 2%)

Simulation results

Risk Free Rate Comparison
What is the chance of getting less than the risk free rate or return of 5%? Redo Appraisal at a 5% RF discount rate gives an NPV of £674,357 But real question is what chance of getting less than 5%? Answer is over 90% chance of beating 5%, 1SD means 84% chance of beating target which is good enough even for risk averse investor

Risk Free Rate Analysis

Output at risk free rate
Statistic Forecast values Trials 1,000 Mean £733,276 Median £711,941 Mode --- Standard Deviation £514,088 Variance £264,286,052,100 Skewness Kurtosis 3.28 Coeff. of Variability Minimum -£970,856 Maximum £2,535,205 Mean Std. Error £3,506,061

Risk analysis - summary
08_RISK.PPT Risk analysis - summary Investors primarily concerned with level of return, typically measured against a benchmark Less concerned with assessment of volatility of returns Risk is regarded as the chance of not achieving benchmark return Main measure of risk is standard deviation and focus is always on downside potential

Property Appraisal Introduction.

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