Using Financial Leverage

Financial leverage is basically the practice of using borrowed money to supplement equity (non-borrowed money). In the field of private property development and investment, this is often done at a ratio of between around 20%-50% equity, the remainder being borrowed in the form of a mortgage.

The term ‘gearing’ is closely related to this subject. Gearing is the particular ratio of debt to equity. The proportion of debt is expressed as a percentage of the equity. So if a property is geared at a ratio of 65%, this means that the amount of capital borrowed to purchase the property is 65% of the total investment. In the world of finance, if a particular company is geared at 65%, then it would be regarded as high risk. However, private property investors might have to borrow up to 3 times the equity level. This would not be regarded as risky in the same way as corporations, but you should always acknowledge the risk factor in any investment. The return on your investment is the payback for accepting this risk.

A certain amount of financial leverage is not only (for the majority of people) inevitable, but it is also desirable. This is because of 2 reasons:

1. It enables a speculator to increase his holding several times over. It makes more financial sense to place 25% of your total investment into each of 4 properties, rather than placing 100% of it into a single one. This enables investment diversification (which helps minimise risk) and maximises potential future returns.

2. Purchasing a property using 100% equity is the most expensive way to run a development or investment company. This is because tax is payable on a company’s NET profits. If the vast majority of your return is regarded on paper as profit then you must pay tax on it. Mortgage repayments are regarded as liabilities and will subsequently reduce tax liabilities.
Property is quite unique as an investment as it enables speculators to borrow higher levels against the property value. This is because it offers a tangible investment. Even if the property remains unoccupied or unsold for an extended period of time, the lender will always have (at the very least) the land value to guard against the loss of their capital. Even if the building upon the land is destroyed somehow, the land will always have some value. Most other investments do not offer this.

An example of why financial gearing increases returns is as follows:

An investor purchases a property at a price of £100,000. Equity is £35,000, and £65,000 is borrowed.
Investment capital £100,000
Less loan £65,000
Property owners equity £35,000

Rent for initial 5 years £8,000 per annum
Less loan interest £5,200 per annum
Net income to property owner £2,800 per annum

Return on Property Investor’s equity £2,800 ÷£35,000 = 8%

So the property investor achieves a return of 8% per year for the first 5 years. However it is in the subsequent years where the advantages of leverage become clearer.

Reviewed rent for next 5 year term £10,000 per annum
Less loan interest £5,200 per annum
Net income to property owner £4,800 per annum

Return on Property Investor’s equity £4,800÷£35,000 = 13.71%

Subsequent terms will reflect even greater returns in comparison to the level of equity placed into the investment. This investment would be a 65% gearing.

It is highly unlikely that an investment of only £35,000 could produce a return of 13.71% and more if invested in stocks. Prior to the recession, Hedge Fund Managers spoke of producing returns of up to 40% per annum. However, a minimum investment is required (far in excess of our example value of £35,000) and the investment risk would be regarded as far higher than that of property. Many hedge funds have gone out of business post recession, taking their invested capital with them. Remember though, property is a tangible investment and it is difficult to foresee a situation where it would ever be worthless.

Explaining Property Yields

When investing in property, it is important to have a good understanding of the term ‘yield’.  Contrary to popular belief, it does not mean the actual sum of money received on a particular investment.

The term Yield can be defined as:

The annual return on an investment, expressed as a percentage of the capital value.

 So for example, the annual return on a property investment is currently £12,000 a year gross.  If the property has been valued at £220,000 then the yield can be calculated by:

  • Dividing the capital value (220,000) by 100, to get the value of 1%.  It works out to 2,200 in this case.
  • Divide the annual rent figure by 1% of the capital value.  This produces a figure of 5.45.
  • Therefore, the yield on this investment can be said to be 5.45%.

This is a very straight-forward calculation that is only really carried out to enable people to compare investments across types and sub-types.  This is known as the Initial Yield figure.  The annual rent figure used in the calculation is the ‘passing rent’, meaning it is not discounted in any way by rent-free periods (a common incentive).

The next type of ‘yield’ is called an ‘All-Risks Yield’ (ARY).  This is also expressed as a percentage but even if used in connection with the very same investment calculation used above, the figure is likely to be different. It is used mainly by Commercial Property valuers to be manipulated accordingly to provide an indication of the risks involved in a particular property investment.

This is done by using it in a slightly different way to the above Initial Yield figure, which is a result of the calculation.  When establishing an ARY figure, a basic principle must be followed:

  • In a falling (Bear) market, yields rise because they represent a higher proportion of the property’s capital value (rents stay fairly static, capital values fluctuate).
  • In a rising market (Bull), yields fall because the capital value increases and the annual rent figure accounts for a lower percentage of the capital value.

Therefore, the analysis of yield figures provides an insight to the property market as a whole.  It is often far easier to consider yield values of more interest than the capital values used to calculate them.  Capital values can only really be established by looking at recent transactions of similar properties, whereas yields can be comparable across all properties.  Because of this, it is common practice to apply a yield figure as a multiplier for the annual rent, resulting in an estimate of the capital value.  An example is as follows:

A commercial office building is currently let at £50,000 per year.  If an appropriate yield figure across similar properties is 6%, then the capital value will be in the region of £833,333 ((50,000 ÷ 6) x 100).

The yield figure can be manipulated to produce a different capital value.  This is done to reflect the various risks involved in letting a property to a tenant because:

  • If the tenant is likely to default on rent payments or vacate the building leaving damage, then the value of the investment as a whole will be worth less than average.  This would produce a higher yield figure.
  • Alternatively, if the tenant is a highly regarded national company and almost guaranteed to be a ‘perfect’ occupant, the value is higher to an investor because it represents a lower risk.  This would produce a lower yield figure. Incidentally, the yield figure of a very high quality building with an exceptional tenant represents a benchmark situation, this results in a ‘Prime Yield’.

The term ‘All-Risks Yield’ is therefore used to describe a yield figure that hopes to reflect all associated risks and benefits to the investor.

Net Yield is a further expression used to describe the yield after expenses have been subtracted.  An example of this is:

A residential development of flats returns £60,000 per year for the investment company.  The capital value of the development as a whole is estimated to be £1m.  This produces an initial yield of 6%.

However, if the investment company regularly spend £15,000 per year on management costs and associated fees, this changes the yield figure.  The net return is reduced to £45,000.  Therefore the net yield is 4.5% (45,000 ÷(£1m ÷100)).

Careful analysis of yield figures to this degree is unlikely to be the practice of the novice property investor.  However, when projects get bigger and budgets increase in proportion, it is important to have an understanding of how property capital values and yields work together.

 

Valuation Methods. Profits

In the case of most types of commercial property such as retail, office and industrial, it will be a reasonably straight forward job to establish a rent or a capital value (for when being sold on the open market).  The rent or capital values will likely be set by close comparison with similar property transactions in the immediate area.

Sometimes however, it’s just not possible to compare similar properties, because the information might simply not be available.  This might be because the property is very unique or because similar transactions have not occurred recently enough to be of any use.  This is often the case for leisure properties such as pubs, restaurants and hotels.  These are often sold on the open market but because they’re a specialised investment field, you probably haven’t seen them unless you’ve been looking out for them.  In fact, it’s not just professional investors  who would have an interest in how these properties are valued, prospective tenants planning on running the business themselves should also know how the valuation process works.   If you understand how the property is valued, you will have far more leverage when it comes to negotiation on the eventual rent figure.

If no comparable information is available, the only alternative is profits.  Obviously this means that the property has to have an operational business currently running from within.

I personally feel that the profits method is a far better way to place a rental value on this type of property, even if accurate and relevant information on comparables is available.  This is because these types of properties can be a similar size and closely situated but make extremely different levels of profit.  The business that’s been more shrewdly run might appear to be worth more.  It should be mentioned however that the business itself is not being valued, rather the ‘facility’ to run a business from the property.

To begin to establish the profits, the past 3 years accounts must be looked at.  It’s very important that these are accurate enough to be relied upon; a good indication is if a reputable accountancy firm have prepared them.  A very basic way of estimating the net profit figure is by the following summation:

Gross Earnings

Less Purchases

Equals Gross Profit

Less Working Expenses

Equals Net Profit

Gross Earnings is the total annual revenue that the business earns, before anything is subtracted.

Purchases are the ‘raw material’ that must be purchased in order that the business can operate.  In the case of a restaurant for example, this would be food, beverages and equipment.

Gross Profit is the resulting figure that is produced from subtracting the business purchases from the gross earnings.

Working Expenses are the everyday costs involved in running a business such as electricity, staff wages and insurance.

Net Profit is the final figure left after all expenses and purchases have been deducted from the Gross Earnings.

The valuer who establishes the rental value based on profits is obliged to use his judgement in deciding if the net profit figure is accurate enough.  Company accounts can only show what has been recorded.  However if the business has been underperforming for some time, the valuer might consider the net profit figure too low compared to what might be achievable.  Likewise if the business has been run exceptionally well, the net profit figure might be reduced for the purposes of the calculation to give a more realistic figure.  In practice, the Property Professional who values a property based on profits will be a specialist in this particular field of commercial property.

It is common practice to divide the net profit figure in half (or thereabouts) to produce an annual rental value.  One half is known as the ‘Tenant’s Share’ and is intended to account for the Tenant’s work and enterprise in running the business.  The other half would be regarded as the annual rental value.

So for example:

Gross earnings – £100,000

Less Purchases – £35,000

Equals Gross Profit – £65,000

Less Expenses – £25,000

Equals net profit – £40,000

Tenant’s share of 50% – £20,000

Annual rental value – £20,000

When calculating the net profit figure, the Tenant’s wages should not be included as an expense.  This is because the Tenant’s share is included at the later stage and must not be considered twice.

Valuation Methods. Residual

This article should be read in conjunction with the Property Speculator’s Residual Valuation calculator.

The Residual method of valuation is used to establish how much should be paid for development land or a project in an undeveloped state.

The first value that has to be established is the Gross Development Value (GDV).  This is essentially the total value of the completely finished project.  Some important considerations are:

  • If a project containing multiple dwellings is to be analysed, the GDV will be based upon the total value obtained from the sale of all the units. The value that can be obtained on the market can be expressed as a rate per M² and can be established through the study of comparable, similar properties recent sold prices (NOT the values they are offered at).
  • When establishing the total value of the finished project, remember that common areas such as stairways, hallways and foyers are not included within this value, but they will be included in build costs.

The second value to be looked at is the total costs of the project.  This will include build costs, consultant’s fees, finance costs, infrastructure/landscaping costs and any obligation for S.106 agreement (a contribution to the Local Council in connection with the project).  Considerations are:

  • As mentioned above, build costs will include the total value of the units to be sold and any common built areas. Build costs can range from £600 per M² to £1600 per M² depending on the area of your project (obviously London/South east will be more expensive than Northern England and Wales) the required quality of finish and who you intend to do the work (Main Contractors is the most expensive route).  An article on build costs is planned for the very near future.  VAT can often be reclaimed on many costs involved with new-builds.
  • The amount spent on consultants will vary according to the size of the project. However for the purpose of appraising the project, using percentages is the most appropriate way for the majority of projects to be looked at.  VAT will almost always be payable on consultants fees.
  • Site infrastructure will include drainage, water, gas and electricity supplies. For small projects, the cost will be negligible and the same goes for landscaping costs.  This is why a percentage calculation is appropriate.
  • Finance costs will depend heavily upon the amount borrowed and the rate it’s borrowed at. If the project is intended to be solely a development (rather than a development with the aim of letting at the end of the construction phase) then the costs should be recouped as soon as possible.  Obviously the longer it takes to recoup all construction costs; the more must be paid in finance costs.  For the purposes of calculation, a construction period of 1-12 months and a post-construction marketing period of 2-8 months should cover the vast majority of situations.
  • 106 costs will be related to how the project as a whole ‘fits in’ to the local environment. A contribution is often requested by the local authority to pay for changed infrastructure to serve the project.  This might be a widened road leading to the development to serve the occupants.  Follow the link to read more about s.106 obligations for developers.
  • Estate agents fees are quite negotiable depending on the size of the development. It would not be unreasonable to attempt negotiate a slight discount of half a percent or so for sole agents that will be acting for a large development.

The next figure is the required profit level.  This is often calculated as a percentage of the GDV value.  It’s important that the profit is considered in the equation, because it’s surprising how many novice developers regard a profit as a bonus.  To continue developing property must be regarded as a business.  If no profit is made, then the business will not survive for long.

Clearly, the higher the required profit level, the less will be available to purchase the land.  So a balance must be struck.  Profits could be around 33% of GDV (a very crude assessment of a property development was’ 1/3rd for land costs, 1/3rd for build costs and 1/3rd for profit’).  This might still be attainable now, but in practice, it certainly helps to be conservative and cautious when appraising a development.

The final and eventual figure to be generated is the sum available for land purchase.  This can be changed considerably if the input figures are changed.  In fact one of the criticisms of the residual valuation method is that for relatively small changes in the input figures, large changes in the eventual values can be seen.  This is why it helps to be cautious with input figures, overestimation of costs is better than underestimation.

The land purchase figure is the figure that forms the basis of your negotiation.  If the property is being bid on at an auction, obviously no opportunity to negotiate will exist.  It will however provide you with a good idea of how your project finances will work and if you bid above your ideal value, the other figures will be reduced accordingly (profit is usually first to suffer).

Valuation Methods. Contractor’s.

In some cases, the 4 other methods of valuation (Comparison, Residual, Profits and Investment) are just not suitable for a particular property.  Some buildings are designed to be used by Town Councils or public sector/healthcare/military workers and are therefore quite unique and it’s simply not appropriate or possible to value it for a commercial use.  These properties very rarely change hands and because of this, almost no comparable evidence is available.

In this case, the Contractors method of valuation can be used (also known as Summation). It is not without it’s limitations it has to be said and is sometimes referred to as a ‘last resort’ method.  This is because it works on the basis of a building or property’s value being the same as cost (which in most cases is a flawed concept, as ‘cost’ is a fairly definite sum, whereas ‘value’ is not).

The Contractors method works on the idea of the cost of the land plus the cost of the buildings upon it equals the value of the property as a whole.  This sounds about as simple as it’s possible to get in Real Estate valuation, however it’s in the detail that the skill lies.  The users of these non-commercial buildings could hypothetically move to a different site and have a similar building constructed.  As no aspect of competition exists, the value is quite likely to be similar whichever site is used (assuming it’s a similar size).  The value of the land should only be based upon the intended use, not best use.  This is because land where (for example) offices are permitted to be built would be worth considerably more than land upon which only a fire-station could be built.

Another consideration is that the value of a new building would be worth more (theoretically) than the value of one that which already stood on the site.  There must be some amount of depreciation for general wear-and-tear and obsolescence.  The basic equation for the Contractor’s Valuation is:

        Cost of Building

plus Cost of Site

     = Total Cost of Similar Property

   less Amount for depreciation and obsolescence

           = Value of Existing Property

In practice, the process of establishing the value would be:

  1. Apply build costs (at a rate per Sq Ft/M) at the time of valuation, and discount this by a percentage to allow for depreciation and obsolescence (this could be 25% for obsolescence and a further 15% for depreciation).
  2. Add the revised total build costs to the land value, including costs of plot works and fees.
  3. The result is the value of the property.

Clearly this method has its limitations; Not only can build costs be difficult to establish with accuracy (due to the envisaged specialist nature of the building), but the level of discount to be applied to allow for obsolescence and depreciation must be quite specific.

Valuation is (quoted from the Royal Institution of Chartered Surveyors) ‘an art, not a science’.  This means that although the methodology is reasonably straight forward, the application of it not simple.

Valuation Methods. Comparison

Of all the 5 methods of Real Estate valuation, the Comparable method (also known as the Comparison Method) is king.  It underpins all other forms of valuation to some degree.

I like to be able to work with a definition of a term so that I can truly understand it.  So I will attempt to define the term ‘Comparable Valuation’:

‘The establishment of a Property’s Capital or Rental value using recent, similar transactions as a guide’.

The first thing to mention about this valuation method is that it is not rocket science.  It is essentially the method that not only residential Estate Agents (Realtors) use to establish an initial property asking price, but also potential buyers.  That means that if you have ever got a particular ‘feel’ for the market in an area and felt that a house or flat is over or undervalued, you have used this method too.  This is because all it is is comparing one property value to another.  This might be oversimplifying slightly, because there are certain considerations to look into:

  1. The difference between the asking price and the eventual sale price (or asking rent compared to eventual agreed rent) is quite likely to be significant. This is down to the negotiation between vendor and purchaser (or landlord and potential tenant).  An example of this is when residential Estate Agents are very optimistic when placing an initial asking price on a property.  It’s very important when researching recent transactions that actual sale or ‘let at’ values are used.  Asking prices and rents can be ignored.
  2. The recent transactions should be as recent as possible. It’s far easier to use the comparable method when the commercial property market is active and stable.  This is because information is far easier to gather.  Sometimes it’s just not possible to find sale or let figures that have been produced in the preceding weeks or even months; however you must understand that the older the information on other transactions, the less accurate it is.  Property is hugely influenced by changes in demand and supply; this means that if (for example) an office building was sold 3 years ago for £1.35m (Approximately $2.025m) it does not necessarily follow that it would sell for more than that now.
  3. Transactional information should ideally be based upon properties that are located very closely together. In Central London and (presumably) other similar large cities, buildings should be on the same side of a particular street and preferably within a few hundred yards of each other before they can be considered closely comparable.  However, that leads us on to the final consideration:
  4. All properties are different in some way. This could be different Use (offices, industrial or retail plus sub-uses such as financial and professional services, general business or light industrial etc), Grade (the high profile, well-equipped and modern offices are known as Grade ‘A’, grades then go to B & C depending upon condition, level of amenities and pleasantness of the building in general), Size (the difference in sizes of buildings is addressed by dividing the rent or sale price of a property achieved by the area.  This produces a value per square foot or square metre) and Location (this might be the difference between (for example) a building in Central London and a building in Warrington; or even different areas in the same city, such as a building in Streatham, London and a building in St James’ Square, London).   These will all have an influence on value to some degree.  If rent is being negotiated, 2 apparently identical buildings side-by-side could have different rates negotiated.  This could simply be because a particular business tenant presents a lower risk to the landlord and was therefore able to negotiate a slightly lower rent than the neighbouring tenant.
  5. Economic conditions can affect the demand for property, and subsequently the agreed rent or price. The cost of borrowing is a big factor in property sales; likewise the general level of confidence in the macro-economy will affect investor’s appetite to acquire what amounts to a highly illiquid asset.  In economic downturns, businesses are much less likely to expand or move premises and this increases an investor’s exposure to risk.

It’s often said that Real Estate valuation is an art, not a science.  In relation to the considerations above, establishing a property value is not difficult.  However, establishing an accurate figure is where the skill comes in.  Determining an approximate rate per square foot or metre is not difficult; however it’s knowing where to adjust a figure and how to account for differences between apparently similar property transactions that sometimes produces unexpected results.

In the case of commercial tenancies, lease terms will have a substantial affect on the agreed rent:

  1. The lease Term (length of tenancy). A long term is normally of benefit to the landlord, except (for example) if he plans to redevelop the site in the mid to long-term.
  2. Break Clause. This allows one or either party to bring the lease agreement to a premature end.  In the UK, it is often placed into the lease terms in 3 or 5 year intervals.  It will be subject to around 6 months notice usually and might involve some reward if it isn’t exercised (such as a rent-free period).
  3. If the tenant has some Security of Tenure. In the UK this means that the landlord can only insist the tenant leaves the premises under certain circumstances.  All commercial leases in the UK are automatically subject to this unless both parties agree to exclude it at the beginning of the Term and this is specifically mentioned in the lease contract.
  4. The financial standing of the tenant. 3 years of company accounts are normally required for the landlord to consider.  This is because if the company has an excellent credit rating and has been established for quite some time, it will present far less of a risk to the landlord than a company that is in its infancy or has defaulted on some payments to creditors.
  5. Ease of use of the premises. If for example, a tenant is unable to access premises outside normal working hours, this can have an effect on agreed rent as it might be a significant inconvenience.  Likewise if an out-of-town office building does not have sufficient car-parking spaces for the staff, this is also likely to reflect in the agreed rent.
  6. Obligations regarding repairing and maintaining the building. If a tenant is obliged to take on responsibility for all building maintenance and repair, the rent is likely to be lower as the terms of the agreement are simply less favourable for him.  The same can be applied to insurance.  If the tenant is obliged to pay for insurance, it represents a burden for him.  Insurance payments are collected from the tenant by the landlord.  The landlord usually takes responsibility for arrangement and ensuring that insurance payments are made, as this way he knows that cover is in place.  The payments are recharged to the tenant under a separate arrangement.

An example of the Commercial use of the comparable valuation method is as follows:

To establish the rental value of Building A, three further buildings (B, C and D) can be considered for comparable evidence.

Building A is 3,000 Sq M office building.  It is established that rents in the area have increased by 7% in the last 12 months.

Building B is 2,000 sq M and is of poorer grade than Building A.  It was let around 2 months ago at £400,000 per annum (around $600,000).  This works out to £200 per sq M but this value would be below that expected for Building A as the grade is poorer.

Building C is also 2,000 sq M and is similar grade to building A.  It was let 12 months ago at £600,000 per annum (around $900,000).  This works out to be £300 per sq M for a similar quality of office but rents have increased since this was completed.

Building D is 1,000 sq M and is also a similar grade to building A.  It was let 1 month ago for £350,000 per annum (around $525,000).  This works out to be £350 per sq M and the information is quite recent.

It could be determined that Building A could be worth around £300 per sq M.  The justification for this is that it is a larger unit than C & D and although rents have increased since Building C was let, Building C would command a higher rent because smaller units are in higher demand.  If Building C was being valued now, it could be justified to value it at a slightly higher rate than Building A.

Clearly this example is very simplified.  However it demonstrates the technique, additional factors such as location and lease terms would have to be considered.

 

 

Calculation of Build Costs

When establishing a budget for a property development, the issue of build costs is hugely important.  An accurate build cost value is a vital component of the residual valuation.

Build costs are not just for the construction of new build properties.  If an existing property (for example) is to be renovated and the usage changed, or a residential property needs a lot of work to bring it back to a habitable state, the costs of work will be very similar to building from new. So to use new build costs is appropriate in the majority of cases.

Build costs are calculated using the gross internal floor area.  This is essentially the area of the internal space measured between the inside of the outside walls.  This includes all common areas such as hallways and toilets etc.

Build costs are generally available from 2 sources.  The first source is the subscription website BCIS (Building Cost Information Service), the second is SPONS (available in book format and updated every year).  Both sources are well-regarded in the construction industry as being accurate enough to use in detailed development appraisals but are expensive when you are beginning your venture (both sources are a fairly similar annual price).  When using the resources, you will find that a particular rate per M² or M³ is provided.  For example, when demolishing a building up to 50M³, a rate of £49.92 would be appropriate per M³.  The larger the building, the less expensive the work per M³ is to have carried out (economies of scale).

One of the recognised shortcomings of the residual method of development appraisal, is that the output (the land value) differs a great deal through only small changes in one of the inputs (in this case, build costs).  The larger the project, the more likely it is to happen.  For example, if 30 houses of 100 M² each are being constructed at a rate of £1,000 per M², the total build costs will be £3m.  If the build cost rate were to increase to £1010 per M², total build costs would increase to £3.03m.  So for just an increase of £10 per M², the total build costs would dramatically increase by £30,000.  Therefore it is important to get as accurate a figure as possible.  Fortunately the sources mentioned above are regarded as very accurate.

It should be mentioned however that the values provided in the sources referred to are based upon an average across regions and nationwide.  Clearly substantial economies can be achieved through shrewd research and good contacts.  It is certainly possible to reduce build costs if you know where to look and who to speak to.  This perhaps is one of the secrets and ‘art’ of making a healthy profit in property development.

It can be a time consuming process reading through the construction cost guides if you are unfamiliar with them (I don’t profess to be an expert myself).  They are extremely thorough and specific, however if you simply want to know how much it will be to build a 3 bedroomed house (at a rate per M²) then a far cheaper (free) option exists.  A regularly updated source of inclusive build costs is at:  www.homebuilding.co.uk/buildcosts.  It obviously depends on how deeply you want to go into the analysis of costs, but this alternative provides accurate information if it’s an inclusive rate you’re looking for.  It’s compiled for self-builders, not really private property developers but it offers a good indication and shows the degree of variance across regions.  If you do need to go into the deeper intricacies of building costs then I suggest purchasing either the SPONS book or taking out a BCIS subscription (incidentally, SPONS books are available ‘used’ at a discount at places such as Amazon Marketplace but obviously the accuracy suffers as they age).

At the last update on the ‘homebuilding-buildcosts’ site (Dec 2011) a large 2-storey house being built in the South-East to an excellent standard by main contractors would be in the region of £1291 per M² to build.  At the opposite end of the spectrum, a small single storey house built to a reasonable standard through a combination of DIY and sub-contractors in the North-East or Wales would be in the region of £793 per M².  These values have been put together by experts using the more detailed costs guides.

The more detailed guides (BCIS & SPONS) allow the reader to obtain far greater information.  For example, according to the 2011 version of SPONS:

  • High quality Inner London apartments would be in the region of £2350 – £2850 per M² to build.
  • Large budget student schemes with en-suite bathroom would be £1025 – £1275 per M² to build.
  • Warehouse conversion to apartments would be £1025 – £1275 per M².
  • Minor office refurbishment in Central London would be £435 – £530 per M².

Clearly some interpretation has to be applied to this information, as regional variations on prices can move beyond the ranges listed.  It should also be remembered that these prices are inclusive of builder’s profits and overheads, but not of professional fees associated with the work.

For the more specific prices:

  • For machine-excavated trench fill foundations at 600mm wide x 1 metre deep, a rate of £79.00 – £100.00 per metre.
  • For facing-brick walls, single skin and pointed both sides would be £81.00 – £105.00 per M².
  • For a cement and sand screed floor of 50mm thick would be £12.40 – £16.80 per M².

The SPONS books and the BCIS provide a huge amount of information (the SPONS book is over 1,000 pages).  You must remember though, that looking into the specific works and simply adding the costs together is risky because without experience, it’s easy to overlook some vital work component.  This can have a significant effect on the overall build costs.

 

 

 

An Introduction to Business Rates

Business Rates are essentially, Council Tax for commercial properties.  It is a very large consideration for companies seeking to establish themselves in new or moved premises.  This is because it represents quite a large expenditure that must be accounted for.

The Government agency responsible for establishing exactly how much should be paid by companies, is the Valuation Office Agency (VOA).  This is a large agency that has many employees many of whom are Surveyors. There job is to measure up almost all commercial properties in the UK and make a realistic assessment of the current rental value.  As you can imagine, this is not a small task.

As a property investor or developer, it is very likely that once you have carried out a few residential projects and made a success of them, you will be drawn to the commercial side.  In some respects, the commercial side of property is just like the residential one, and in other ways it can be very different.  Knowledge (at least a basic understanding) of Business Rates is important if you intend to choose the commercial route.  This is because when allowing for rent voids (periods when the property has no paying tenant) unless the property is below a certain value, you will need to cover them (if a tenant is in occupation, they should cover the payment of Business Rates for the property).  This can prove to be a substantial change to the financial side of your plan.

A commercial building is valued using the following procedure:

  • The building will be measured up, and a usable area will be determined.  These measurements and the area will stay on record on a very large database held by the VOA (records are viewable on-line).  If these areas have changed in any way since assessment, it is up to the occupant to notify the VOA as they might receive a business rates reduction.
  •  The property area will have a particular rate applied to it (in Sq Metres) this area will be multiplied by an appropriate value to produce a value for the building (so for example if an office property has an area of 200 Sq Metres, and a rate of £40 per Sq Metre is applied, then the value will be £8,000 (£40 x 200). If the property has rooms and areas that are incidental to the main area, those smaller areas will be assessed on a different rate.
  • The VOA re-assesses each property every 5 years.  This means that although it doesn’t have to be re-measured, a new rate per Sq M is used to establish a value.  This value is known as the Rateable Value.  This means that the VOA believes a certain property is worth a certain amount, on a certain date.  It does not have to reflect a current market rate.

A quick referral to the website of the VOA (link here), will provide you with a multiplier.  This is then used to calculate the property business rates that the occupier must pay each year.  For example:

Using the methods above, a property rateable value is established to be £20,000.  This figure is essentially what the VOA believe would have been an appropriate annual rent in the year the property was last assessed by them.

The ratings multiplier for 2010/2011 was 41.4.  This multiplier changes every fiscal year, so regular checks are important.  The multiplier means that for every £1 of property rateable value, the occupant must pay 41.4 pence to the Local Authority for Business Rates.

So, if a property has a rateable value of £20,000, the Business Rates will come to £8,280 ((20,000 ÷100) x 41.4) per year.

A Small Business Rate relief scheme is in place, which allows qualifying companies to use a slightly lower multiplier figure.  For 2010/2011, it is 40.7.  Obviously this doesn’t make a huge difference, but for qualification of the status of ‘Small Business’, the company must occupy premises with a rateable value of less than £6,000, in which case it will receive a 50% discount from Business Rates (note that a full relief from business rates has been temporarily introduced until Sept 2011 if premises have a rateable value of less than £6,000).  Tapered relief is the applied if properties have rateable values of between £6,001 and £12,000.

Please note that the above paragraph is also liable to change on a fairly frequent basis, so check regularly with local authorities and the VOA. 

There is currently certain business rate relief for empty properties:

  • Shops and office properties are exempt from paying business rates for the first 3 months of being empty.  After this period, full rates are payable.
  • Industrial properties are exempt for the first 6 months of being vacant.  After this (in common with the above) full rates will apply. 

Some properties are exempt from business rates for the full duration of their vacancy:

  • Properties with a rateable value of less than £18,000
  • Empty properties of companies that are in liquidation or administration.
  • Listed buildings 

To find the details of a particular property on the website of the VOA, follow this link.  To find a property, you can search by postcode.  You are likely to be presented with a list of properties, which are listed by property number or name.  Some patience is likely to be needed for this, as some properties are listed under postcodes and addresses that you might not expect them to be.  Quite detailed results will be available (around 90% of all commercial properties are available on the database) and it is usually possible to obtain area calculations of included properties too. 

A list of publications is available on the VOA website (link here) for properties that seem to be neither fully residential nor commercial, such as stables or guest houses.

Application of Discounted Cash Flow

Building upon the previous articles explaining the use of Valuation and Investment tables and how Discounted Cash Flow and Net Present Values work, we are now looking at how we can establish the true return on a property according to an assumed rate of growth and expected rents over a particular term.

This technique is known in financial circles as Internal Rate of Return (IRR), whereas property professionals refer to it as Equated Yield.

A Net Present Value appraisal allows an analysis of expected rents over the term of a lease and can produce an end figure that shows a profit or loss according to an expected rate of return.  To use the example in the article on DCF (see below), an investor pays £100,000 for the expected return of £30,000 at the end of years 1 and 2, and £40,000 at the end of years 3 and 4.  However he is borrowing the entire initial capital sum at an interest rate of 12% per annum.  Is the investment worth pursuing?

The table shows that the investor will end up with a profit of £4,585.00 after the costs of borrowing are taken into consideration.   Whether this is worth his effort or not is not relevant to us at this point, it does show however that as long as the return exceeds 12%, the remainder is profit.

So what if we have to find the actual return on an investment?   It’s all very well just ensuring that the return exceeds a certain level, but what if we need the precise figure that the investment will return?  We use the equated yield method.

It can be stated that as the NPV value gets closer to zero, the adopted yield figure (for the calculation) will be closer to the true return.  For example if the required return was placed higher at 14%, the profit would be absolutely minimal:

The NPV at this rate is clearly much closer to zero.  This signifies that after the negative and positive cashflows have been accounted for, the actual return on the investment is very close to 14%.

Calculating the actual equated yield figure is initially a process of trial and error.  This is because 2 trial rates should be used (these can actually be quite far apart) so that the true rate ends up somewhere in between them.

Again, using the example above, we know that the true rate will be very close to 14%, but for the purposes of demonstration a higher rate of 16% will be adopted and the lower rate of 12% will be re-used.

Clearly the resulting NPV figure is a negative one.  The effect of this is that the investment will make a significant loss if a return of 16% is required.  It does however, provide us with an upper rate with which to calculate the true investment return (or equated yield figure).

In order to calculate the equated yield, an equation is used:

Note:  LTR – Lower Trial Rate; HTR – Higher Trial Rate.

Therefore we can establish that the actual return on the original investment is 14.1%

When applying this technique to the context of a lease, the expected returns are incorporated and if the lease is expected to include a particular pattern of rent reviews (for example 5 yearly) the expected rate of rent increase should also be incorporated.

Capital Gains Tax

The present UK system of Capital Gains Tax (CGT) was introduced in 1965 by the Finance Act.  The intention back then was simply to tax individuals on the realisation (liquidation) of assets.  However, the secondary effect was a tax on the inflationary appreciation in value of these assets.

A definition of Capital Gains Tax could be:

‘A tax on chargeable gains when an individual disposes of assets’

Each UK resident has an allowance that enables him/her a certain amount of tax relief on CGT.  Any amount over and above the allowance will be charged at the appropriate rate.  The current rates can be found on the website of the HMRC on this link.

To be regarded as a UK resident:

  • A person must spend at least 6 months of a tax year in the UK or have a residence in the UK (whether it is used or not, or owned or not).
  • The person must have spent at least 3 years continually in the UK.
  • For a company to be considered resident in the UK, it must be incorporated in the UK or have its registered office and main correspondence address in the UK.

People and companies exempt from CGT are:

  • Local Authorities
  • Trade Unions
  • Non-residents, not having a business in the UK.
  • Registered Charities
  • Pension funds

The definition of ‘Disposal’ is (in the words of HMRC):

‘An asset is disposed of whenever its ownership changes or whenever the owner divests himself of his rights in or interests over that asset, for example by sale, exchange or gift’.

This includes the sale of a leasehold property interest, receiving substantial insurance money or gifts.  However, it does not include death.

To calculate the amount of Capital Gains a taxpayer will be taxed upon, the following should be subtracted from the eventual amount received:

  • The cost of original acquisition.
  • Any expenditure made to improve the quality of the asset that has been disposed of.  This has to be an ‘identifiable change’ in the asset value.
  • Any costs incurred by the owner in defending or establishing his right to ownership of the asset.  For example, if someone has to incur legal costs to prove inherited ownership of a deceased relative’s property.

So to use an example, a person sells their second property that was bought 5 years ago.  From the eventual sum the property sells for, the value at purchase, the amount spent on it to increase value and any legal costs incurred when the owner had to establish a boundary are subtracted.  The remaining sum is the amount that will be taxed.  Subsequently, it is the amount of gain that is taxed, not the value that is received.

Calculating the amount of CGT payable on the net gain, can be quite complicated.  This is because there are 2 different rates of CGT, an individual allowance and Entrepreneurs relief to consider.   However, I’ll do my best to explain using another example:

Amount subject to CGT – £50,000

Individual CGT exemption allowance – £10,100 (for tax year 2010-2011)

Subtotal liable for CGT – £39,900

Entrepreneurs Relief allows all gains that qualify* to be taxed at 10% (for June 2010 onwards).  Therefore from the initial sum of £50,000, a CGT tax bill of £3,990.00 would be likely†.

Note * to qualify for Entrepreneurs relief, the capital must have come from the disposal of a business asset, not a personal one.   There is also now (from April 2011) a lifetime limit of £10m.

Note † this figure is merely a guide.  It should not be relied upon and professional advice should be sought.

An alternative relief to Entrepreneurs Relief is Business Asset Roll-Over Relief.  This applies to capital income from the sale of a business asset such as a property, provided the capital is used to purchase another business property or certain type of asset.  If it ‘leaves’ the company, it will be subject to CGT.