Discover an insightful examination of the property investment appraisal process from leaders in the industry
This book explains the process of property investment appraisal: the process of estimating both the most likely selling price (market value) and the worth of property investments to individuals or groups of investors (investment value).
Valuations are important. They are used as a surrogate for transactions in the measurement of investment performance and they influence investors and other market operators when transacting property. Valuations need to be trusted by their clients and valuers need to produce rational and objective solutions. Appraisals of worth are even more important, as they help to determine the prices that should be paid for assets, even in times of crisis, and they can indicate market under- or over-pricing.
In a style that makes the theory as well as the practice of valuation accessible to students and practitioners, the authors provide a valuable critique of conventional valuation methods and argue for the adoption of more contemporary cash-flow methods. They explain how such valuation models are constructed and give useful examples throughout. They also show how these contemporary cash-flow methods connect market valuations with rational appraisals.
The UK property investment market has been through periods of both boom and bust since the first edition of this text was produced in 1988. As a result, the book includes examples generated by vastly different market states. Complex reversions, over-rented properties and leaseholds are all fully examined by the authors.
This Fourth Edition includes new material throughout, including brand new chapters on development appraisals and bank lending valuations, heavily revised sections on discounted cash flow models with extended examples, and on the measurement and analysis of risk at an individual property asset level. The heart of the book remains the critical examination of market valuation models, which no other book addresses in such detail.
Table of Contents
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
