COMMERCIAL PROPERTY VALUATION USING CAP RATE (YIELDS)

Topics covered

• Rationale, role of valuations and required competencies for valuation

• The simple Net Initial Yield approach to commercial property valuation

1. Rationale, role of valuations and required competencies for valuation

To estimate Market Value for

–Doing deals (setting asking prices, working out what the ’going rate’ is for a property)

–Measuring investment performance (capital, income and total returns)

–Borrowing against the properties (banks always want to know the value of the collateral)

–Financial reporting (balance sheet, company accounts)

It is about

• Capitalising (transforming into a capital value)• Rental• Income • Streams

For example…

• Let’s say that you wanted to put a value on the right to get £100 every year for the next four years. You want to capitalise (i.e put a capital value on) this income stream. The capitalisation rate is 10%.

You could value the right to get £100 for four years using a cash flow. This is a fixed income for a fixed period.

Year Income1 £100.002 £100.003 £100.004 £100.00

PV factor0.90910.82640.75130.6830

DCF£90.91£82.64£75.13£68.30

Total £316.99As a formula this is: £100*1+0.1-1 + £100*1+0.1-2 +£100*1+0.1-3 +£100*1+0.1-4

1.0

)1.1(1(100

4Via geometric summation, this can be shortened to…

Capitalising Perpetual Fixed Income Streams

• Let’s say that you have to put a value on the right to get £100 per annum forever (i.e. in perpetuity)

• If you look at the previous equation…. and the (1+i)-n part in the top right.

• The larger ‘n’, the smaller this part of the equation becomes.

• When it is infinity , then this part of the equation becomes zero.

Fixed perpetual incomes are really simple

This becomes zero and we are left with…

i

01i

1Which is the same as

So in order to get the capital value the right to receive the right to receive £100 per annum forever, it’s basically £100 times 1 divided by the capitalisation rate or just £100 divided by the capitalisation rate.

The Simple Net Initial Yield Approach to Commercial Property Valuation

The Simple Net Initial Yield Approach

• Ignoring transaction costs, you need to obtain and process two pieces of information to get the value of a commercial property when using the NIY approach

• The current rent paid• The Net Initial Yield (this is a capitalisation rate)• The first is a fact. It is the contractually agreed rent. • The second is an estimate. The estimate is based

upon analysing deals involving comparable properties

For example

• You have been instructed to estimate the Market Value of a shop on Oxford Street let three years ago to Samsung on a 15 year lease with upwardly only rent reviews every five years

at a rent of £130,000 per annum. The Market Rent is now £175,000 per annum.

• What is the only relevant (to an NIY valuation) piece of information here?

The comparable…

• A similar shop nearby recently sold for

£3,653,000. It was let to The Gap two years and three months ago on a 15 year lease with upwardly only rent reviews every five years at a

rent of £146,100 per annum. The Market Rent is now estimated to be £200,000 per annum.”

• What are the two relevant facts here?

Analysing the Comparable

• Net Initial Yield is an expression of the relationship between the amount invested and the rental income.

• The total amount invested is price paid plus buying costs such as Stamp Duty (4% of price paid for commercial properties over £500,000), agents’ commission, legal fees , surveys, VAT on above. They work out (as I write) at about 5.8% of price paid in total – in the UK.

• The total invested in the comparable was?• £3,864,645• …and the Net Initial Yield was• £146,100 divided by £3,864,645 – 3.78%

Market Value• Going back to the subject pproperty…So £130,000

divided by 3.78% is £3,439,153. • This is the valuation before deduction of acquisition

costs• The easiest way to get to the Market Value is just to

divide £3.439 million by 1.058. • That just over £3.25 million• All you need to remember is that when working out

yields, it is normal to add on costs to the price paid. When doing a valuation in the UK, it is standard to take off transaction costs. You do that by dividing the valuation gross of transaction costs by 1+transaction costs.

You can value any income producing property like that

• A UK textbook would have something like…

Rent passing £130,000

Years Purchase in perpetuity @ 3.78% 26.4550

Valuation (gross of costs) £3,493,153

Valuation (net of costs) £3,250,000

Expectations about rental growth are included in the cap rate/yield:let’s say that we want to put a value on the right to get £100 for the next ten years (I

can’t show forever) but it is expected to grow at 3% a year and we have a target rate of return of 10%

• The obvious thing to do is to grow the income in a cash flow and discount at 10% i.e. change the cash flow to reflect growth.

Period Income PV factor @ 10% DCF1 £103.00 0.9091 £93.642 £106.09 0.8264 £87.683 £109.27 0.7513 £82.104 £112.55 0.6830 £76.875 £115.93 0.6209 £71.986 £119.41 0.5645 £67.407 £122.99 0.5132 £63.118 £126.68 0.4665 £59.109 £130.48 0.4241 £55.34

10 £134.39 0.3855 £51.81

Total £709.03

A less obvious thing to do is to change the discount rate

Period Income PV factor @ 6.7961% DCF1 £100.00 0.9364 £93.642 £100.00 0.8768 £87.683 £100.00 0.8210 £82.104 £100.00 0.7687 £76.875 £100.00 0.7198 £71.986 £100.00 0.6740 £67.407 £100.00 0.6311 £63.118 £100.00 0.5910 £59.109 £100.00 0.5534 £55.34

10 £100.00 0.5181 £51.81

Total £709.03

So we value a growing income in two ways – by changing the cash flow or by changing the discount rate. Of course, you don’t need to do a cash flow if it is in the discount rate, you just use. 0.067961

)(1.067961(1100

10

This can be obtained by (1+i)/(1+g)-1: (1.1)/(1.03)-1

If it was £100 growing at 3% p.a. forever, rather than 10 years, it is just £100/0.067961 = £1471.43