REA_A01.qxd 22/3/06 2:33 PM Page i Real Estate Appraisal From Value to Worth Sarah Sayce Professor and Head, School of Surveying, Kingston University Judy Smith Senior Lecturer, School of Surveying, Kingston University Richard Cooper Chartered Surveyor Piers Venmore-Rowland Visiting Professor, School of Surveying, Kingston University REA_A01.qxd 22/3/06 2:33 PM Page ii ©2006 by Blackwell Publishing Ltd Editorial offices: Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK Tel: +44 (0)1865 776868 Blackwell Publishing Inc., 350 Main Street, Malden, MA 02148-5020, USA Tel: +1 781 388 8250 Blackwell Publishing Asia Pty Ltd, 550 Swanston Street, Carlton, Victoria 3053, Australia Tel: +61 (0)3 8359 1011 The right of the Author to be identified as the Author of this Work has been asserted in accordance with the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher. First published 2006 by Blackwell Publishing Ltd ISBN-10: 1-4051-0001-X ISBN-13: 978-1-4051-0001-4 Library of Congress Cataloging-in-Publication Data Real estate appraisal: from value to worth/Sarah Sayce...[et al.]. – 1st ed. p. cm. Includes bibliographical references and index. ISBN-13: 978-1-4051-0001-4 (alk. paper) ISBN-10: 1-4051-0001-X (alk. paper) 1. Real property–Valuation. I. 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For further information on Blackwell Publishing, visit our website: www.blackwellpublishing.com REA_A01.qxd 22/3/06 2:33 PM Page iii To all our families David, Charlotte and Edd Geoff, Rebecca, Mark and Rosie Lorna, Nina, Robyn and Sasha REA_A01.qxd 22/3/06 2:33 PM Page iv REA_A01.qxd 22/3/06 2:34 PM Page v Contents Preface ix Acknowledgements xi About the authors xii 1 Introducing concepts of value and worth 1 1.1 Real estate: an introduction to the economic concepts 1 1.2 Aims of the book 4 1.3 New influences on the real estate market 5 1.4 Structure of the book 9 1.5 Worth v. price v. value: definitions 10 1.6 Conventional approaches to establishing value 12 1.7 Additional approaches to appraisal 16 1.8 An introduction to the drivers for DCF 19 1.9 Summary 21 2 Introduction to the purchase decision 24 2.1 Introduction 24 2.2 Criteria for purchase: the investment purchaser 25 2.3 Criteria for purchase: occupational property 28 2.4 The purchase transaction process 29 2.5 The regulatory framework 31 2.6 Due diligence and legal issues 36 2.7 Summary 36 3 Property investment: placing property within the multi-asset investment spectrum 39 3.1 Introduction 39 3.2 A comparative analysis of investment media 39 3.3 An introduction to investment analysis and pricing 43 3.4 Definitions and simple examples of financial return 43 3.5 Property yields and returns 46 3.6 Yield and return distinguished 48 3.7 Compounding and discounting 51 3.8 Discounted cash flow (DCF) 53 3.9 An introduction to the imperfections of the property market as compared with the equities and bonds market 56 3.10 Property as an asset class compared with gilts and equities 57 3.11 The place of property within the multi-asset portfolio 58 3.12 Summary 59 REA_A01.qxd 22/3/06 2:34 PM Page vi vi Contents 4 The market appraisal approach: rental value 62 4.1 Introduction 62 4.2 Types of rent 62 4.3 Assessing rental value 64 4.4 Establishing rental value 70 4.5 The principle of rental value established through comparison 71 4.6 Challenges in assessing with reference to comparison 71 4.7 Non-standard leases 76 4.8 Establishing rental value where headline rents are used 78 4.9 The comparative approach: a reservation 83 4.10 Continental European leases – an overview of the differences 85 4.11 Conclusion 86 5 Assessing capital value: analysing discount rates 89 5.1 Introduction 89 5.2 The valuation yield 89 5.3 The years purchase multiplier 91 5.4 Gilt yields 92 5.5 Index-linked gilts and strips 95 5.6 Property yields relative to gilts yields: the risk premium calculation 96 5.7 Property equity analysts’ approach 102 5.8 Risk adjusted discount rate 102 5.9 Unbundling a valuation yield to derive the implied rate of rental growth 103 5.10 The individual investor’s required rate of return or choice of discount rate 103 5.11 Pay back and discounted pay back 105 5.12 Certainty equivalent 105 5.13 Risk adjusted discount rate v. certainty equivalent 105 5.14 Freehold valuation approaches 106 5.15 Summary 113 6 Issues of leasehold appraisal 114 6.1 The nature of leasehold interests 114 6.2 Leasehold value: the profit rent 115 6.3 Inherent disadvantages of leasehold interest compared to a freehold interest 116 6.4 A wasting asset and the need for replacement of capital 117 6.5 Establishing capital value for a leasehold interest 118 6.6 The conventional or historic perspective 124 6.7 Summary 132 7 Structuring investment appraisals to determine investment worth 134 7.1 Introduction 134 7.2 The efficient market hypothesis 135 7.3 The efficient market hypothesis in a property market context 135 7.4 The worth approach – discounted cash flow analysis 137 7.5 Introduction to property discounted cash flows 139 REA_A01.qxd 22/3/06 2:34 PM Page vii Contents vii 7.6 Discounted cash flow analysis in practice 140 7.7 The DCF appraisal outputs 147 7.8 A summary of factors affecting cash flow data 147 7.9 Forecasting the variables 147 7.10 Cash flow modelling: useful practical pointers 150 7.11 The DCF appraisal report 151 7.12 Summary 152 8 Risk within the appraisal and worth process 155 8.1 Introduction 155 8.2 Quantitative v. qualitative risk approaches 157 8.3 Quantitative risk analysis: building a risk analysis continuum 159 8.4 Risk analysis in a practical context 160 8.5 Sensitivity analysis 161 8.6 Scenarios 163 8.7 Simulation 166 8.8 Prioritising the key variables for risk management 183 8.9 Geared property investments 184 8.10 Decision trees and associated sensitivity analysis 186 8.11 The analysis continuum 187 8.12 Data handling 188 8.13 Summary 188 9 Occupational property: decision-making and appraisal 190 9.1 Introduction 190 9.2 Property as a corporate asset 191 9.3 Criteria for purchase or lease 193 9.4 Criteria for building selection 197 9.5 Appraising property for corporate decision-making 204 9.6 Appraising for financial statements 205 9.7 Corporate property: fund managers’ and equity analysts’ attitudes 210 9.8 Appraisals for corporate decision-making: the hold/sell/finance decision 211 9.9 Summary 212 10 Funding and financial structures 216 10.1 Introduction 216 10.2 Debt 217 10.3 Equity 218 10.4 The impact of gearing 220 10.5 Financing property transactions 224 10.6 Lending terminology 229 10.7 Mezzanine finance and participating loans 231 10.8 Interest rates 232 10.9 Management of interest rate risks 232 10.10 Corporate finance 235 10.11 Property investment vehicles and structures 238 10.12 Summary 248 REA_A01.qxd 22/3/06 2:34 PM Page viii viii Contents 11 Measuring return 250 11.1 Introduction 250 11.2 Simple return 250 11.3 Money-weighted returns 252 11.4 Time-weighted returns 255 11.5 Aggregation of individual assets’ returns 258 11.6 Further return calculation issues 259 11.7 Indices and return 264 11.8 Establishing benchmarks 271 11.9 Summary 272 12 Handling risks within the portfolio 275 12.1 Introduction 275 12.2 The nature of risk in financial assets 276 12.3 Portfolio management under modern portfolio theory (MPT) 278 12.4 The evolution of finance theory 283 12.5 The move towards new finance: expected return factor models 289 12.6 Expected return factor models – application to property portfolios 293 12.7 Other approaches to portfolio construction 293 12.8 Summary 294 13 Forecasting 297 13.1 Introduction 297 13.2 Forecasting and appraisals 298 13.3 Aims of forecasting 298 13.4 Methods of forecasting 299 13.5 Forecasting using linear regression models 300 13.6 Correlation 305 13.7 Ordinary least squares and multiple regression 307 13.8 Diagnostic tests 310 13.9 The use of forecasts 310 13.10 Forecast equations and their calibration 310 13.11 Property market barometers and lead indicators 311 13.12 The role of forecasts in financial and property lending markets – value at risk 312 13.13 Basle Capital Accord 314 13.14 Summary and conclusions 315 Appendix A: Valuation and finance formulae 317 Introduction 317 The formulae 318 Appendix B: Worked examples in the chapters:how to download spreadsheets from the web site 330 Index 331 REA_A01.qxd 22/3/06 2:34 PM Page ix Preface The education of the real estate professional is changing. It has become far more integrated with the world of business and this means that the texts to support both practitioners and students need to change too. Real estate was once a discipline bedded in an isolationist approach in which property was viewed as a discrete study area, but the realisation now is that pro- fessionals must view the assets on which they give strategic and operational advice in a more holistic context. This has two main implications for the role of real estate appraisal. • The pricing mechanism on which real estate professionals advise must take into account the theories and practices used in other investment markets. However, even this is not enough: investors are in competition with owner-occupiers and there- fore an understanding of how assets are appraised by owner-occupiers is vital to the process. • The owner of real estate assets may be either an investor or an owner-occupier. Both have increased needs to ensure efficient and effective management of the asset, and this determines the need for performance management techniques that allow com- parison and objective evaluation to be undertaken. However, in addition, investors and owner-occupiers alike must now take cognisance of the wider sustainability issues of social and environmental responsibility; to date, the study of this in relation to real estate is in its infancy. This book seeks to address these issues by introducing and examining some of the latest techniques employed in the marketplace. Fundamental to this are the development of both an understanding of market appraisal andworth, and an appreciation of the emerging role of sustainability as a driver for real estate decision-making. The catalyst for this book has been the authors’ experiences gained from both their interaction with those who have attended courses delivered by them and their work in practice. The courses range from degree and masters programmes for those seeking to gain admission to the Royal Institution of Chartered Surveyors (RICS), to Assessment of Professional Competence (APC) courses, to CPD lectures for practitioners. Whilst theory is very important to these students, and increasingly so, what precipitates learning is prac- tical application. Over the years our students, at all levels, have constantly challenged us to provide a context for the theories we present them with and a steer as to what the markets are really doing! Whilst no book can fully address these desires, we have endeavoured to bridge what we perceive to be the gap between theory and practice and, we hope, to address the needs not just of our students, and those of other real estate courses in the UK and beyond, but also of the practitioners who are now facing changes in their established ways of working. Our REA_A01.qxd 22/3/06 2:34 PM Page x x Preface intention has been to present the material in an approachable way that is accessible to those who come to the subject fresh as graduate students and to those in the latter stages of their undergraduate programmes. We hope that we have succeeded in our ambition. In order to keep the book ‘fresh’, we have introduced a web link to examples. Details of this can be found in Appendix B.