The Property Speculator » capital value

An Introduction to ‘Pricing’ Development Land

Note, this article should be read in conjunction with the Property Speculator’s Excel-based Residual Valuation Calculator.

The primary use for a residual appraisal is to produce a figure for land or undeveloped property purchase, in addition it can also be used to:

Establish a required profit from a project and place that figure into the calculation.
Consideration of the maximum value available for build costs, above which the project will become less financially attractive.

The undeveloped property might be:

Brownfield or Greenfield land where buildings have never stood.
A cleared site where the property has been demolished.
A property that requires renovation or conversion to a lesser or greater degree.

© Copyright Robin Webster and licensed for reuse under thisCreative Commons Licence

The very basic formula for a Residual Valuation is:

Gross Development Value or Value completed

Less

Costs and Profit

Equals

Amount available for Land Purchase/Pre-Development Property

The first value that has to be established is the Gross Development Value. This is essentially the total value of the completely finished project. In most cases, the comparable method of valuation will be used to obtain reasonably accurate values for Sq Ft or Sq M. Recent transactions can be analysed and the selling price or annual rent compared to the property in question. Although the comparable method is not flawless, it is about the most accurate method to establish (completed) property value available.

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 amount available for land purchase is the absolute maximum that the developer would pay for the undeveloped project. In practice however, this figure is likely to become the Gross Land Value because he has to:

Allow for professional fees and SDLT or property taxes.
Pay interest charges on any money borrowed to fund the development.

When the above have been subtracted, the Developer is left with the Net Land Value.

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) or Community Infrastructure Levy (CIL). Considerations are:

As mentioned above, build costs will include the total value of the units to be sold and any common built areas (based upon Gross Internal Area). 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). Click on the link for information on build costs. 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. Examples are: Architect 5-7.5% of build costs and a Project Manager around 2% of build costs) VAT will almost always be payable on consultant’s 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.
S.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 to 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. Pre-recession profits could be around 33% of GDV (a very crude assessment of a property development was’ 1/3^rdfor land costs, 1/3^rdfor build costs and 1/3^rd for profit’). It’s very doubtful whether this would still be attainable now, in practice a rate of around 15% of GDV is realistic. 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).

To download the very finest guide to Assessing Land Value, the Residual Valuation method and Gross Development Value currently available on the internet for only £5, please have a look at my ‘How to Price Development Land‘ page.

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Apr 29th, 2012

The Property Speculator’s Second Podcast!

The second of the Property Speculator’s Podcasts is an interview with Andrew Montlake and Julian Ingall of Coreco Group.

Andrew and Julian are real characters are were a delight to interview. As you would expect of the Directors of a firmly established Financial Broker partnership based within a stones-throw of the Gherkin in the City of London, they really know their stuff.

We speak about how the Candy Brothers started their multi-million pound property development company, why it’s often better to begin developing property as a private individual rather than a limited company and a few opinions on the attitude of finance providers prior to the recession.

Andrew and Julian can be contacted through the Coreco Webite ‘Contact Us’ page

Listen to The Property Speculator’s Coreco podcast here.

Subscribe to the podcasts here

Feb 6th, 2012

Developing a Mixed-Use Property

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A very common way of getting started in property development and investment is converting or renovating a mixed use development.

‘Mixed-Use’ can mean a combination of Residential, Office or Retail within a single development (it’s highly unlikely Industrial type properties would be included in this, for example I can’t imagine a residential flat being situated above an industrial unit). So an example of this could be a shop with a flat/flats above it, or offices with residential above. Incidentally the residential portion is situated towards the top of the property because it’s not likely to require a street-level frontage, like a shop or an office might. The residential area of the property also tends to be quieter and the commercial occupants are less likely to have cause to go upstairs into this area of the property.

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It is certainly possible to convert only part of a property to a use that’s different to the original one. Be aware though that (currently) Planning Consent is required to change the use of a property (or part of a property) from Commercial to Residential and between sub-groups within Commercial. Building Regulations also need to be fully complied with.

The different ways of occupying a property are:

Freehold. This is the closest to owning the property outright (It’s only a Government body which can carry out compulsory purchase though). The Freeholder theoretically owns the plot, the land beneath the plot and the area above it (although this isn’t really enforceable in reality). Being a Freeholder offers the luxury of selling a leasehold interest in the property if he/she wishes.
Leasehold. This is usually for a period of time (term) of 99 years or more (sometimes 999 years). The freeholder effectively sells the right to use the property for the term stated in the contract. Along with this, the Leaseholder sometimes receives the right to allow Tenants to occupy the property and collect the rent. In order to reduce the chances of confusion, this is often called the Long-Leasehold interest. It is bought in a similar way to the Freehold Interest (i.e. a large amount of capital is paid for it, rather than a monthly or quarterly rent).
Tenancy. This is really just a different way of occupying the property under a leasehold interest, however for the purpose of avoiding confusion over these occupancies, I refer to it as a Tenancy (even though the occupational contract is still called a Lease…). This is paid for in the form of rent, usually paid monthly or quarterly (depending on it being Residential or Commercial). A tenancy is always shorter than the long-leasehold interest (even if it’s only 1 day shorter) but is usually much shorter, between 3 and 25 years is usual. A tenancy does not really have much value in itself other than to the landlord. This is because it’s not really possible to sell a tenancy by itself; you can however purchase the leasehold interest with a tenant already in place.

Commercial and Residential tenancies are usually quite different. The main issue is that all Commercial tenancies are awarded Security of Tenure unless specifically contracted out of it. This means that a Commercial landlord can only make the tenant leave the premise at the end of the term in certain circumstances (for example if the landlord wants to redevelop the property and has plans in place to prove this). To contract out of this, the lease agreement must specifically state that both parties wish to contract out of the Security of Tenure provisions of Part 2 of The Landlord and Tenant Act 1954, s 24-28 (or words to the same effect). Contracting out of the act should benefit both parties (such as when a lower rent is agreed upon to reflect a lower ‘risk’ to the landlord).

In contrast, Residential tenancies tend to be more heavily weighted in favour of the Landlord. A tenant does not really have any Security of Tenure at the end of the term. Many Residential tenancies are only for an initial period of 6 months. If the tenant stays in the property with the permission of the landlord at the end of the term, a Periodic Tenancy is formed. If the tenant pays rent on a monthly or weekly basis, this period becomes the notice period for either party to bring the tenancy to an end. A periodic tenancy continues until the landlord or the tenant brings it to an end.

It’s important to have an understanding of how the different types of occupation work. When developers of mixed use properties consider their projects, they intend it to work in a slightly different way to the usual private residential developer. Where a private developer buys a property at a reduced price, spends the bare minimum but produces a good finish then sells on to a new owner, a mixed use development often requires a different approach. Of course it is possible to buy and sell a mixed use development in the same way as a small residential (i.e. the freehold), but because of the combination of property types within the development it usually makes more sense to keep the freehold of the property and sell the long-leasehold interest as and when an occupier or investor is found.

If the freehold is retained, tenants can be found to occupy the office or retail portion. The residential areas of the building can be let the same way as the commercial but this involves a lot of management of tenants taking 6 or 12 month tenancies and of course, the developer will not receive capital in return in a lump sum. It’s far better to sell the long-leasehold interest in the residential units to either investors or leasehold-occupiers. This way, a profit can be made (the value of a long-leasehold interest is more-or-less the same as the freehold price) on individual units of the property. Investors or leasehold-occupiers can buy individual long-leaseholds interests one-by-one if necessary. If the residential units are above the ground floor, it is not possible to sell any of the freehold interests in these. A freehold must always be on the ground floor or associated with a property on a ground floor. If an investor purchases any of the long-leasehold interests, they will be obliged to honour any tenancies that might have been agreed prior to their completion.

It’s also important to understand how service charges apply to a property of mixed uses. A service charge is essentially a further charge to the tenant(s) to contribute to the upkeep of common areas such as grounds maintenance or cleaning and decorating of hallways and stairwells. Service charges should be ‘fair and reasonable’ and not produce a profit or a loss for the landlord. For Commercial tenants, The Royal Institute of Chartered Surveyors publish a Code of Practice guide on service charges. The method of dealing with dispute resolution will be stated in the lease. Residential tenancy service charges however, are very strictly regulated. A landlord who doesn’t follow the statutory procedures might find himself limited under law as to how much can be recovered from the tenant at the end of the occupancy.

Tenants should be supplied with a schedule of the previous year’s service costs and justification of the current level of charge. In a mixed use property however, tenants will occupy different sized areas and even use different facilities in the property. For example a Commercial tenant on the ground floor would not be expected to pay for the upkeep of a lift to service the residential units on the floors above. The principle way of deciding who should pay for what, is to consider which property a particular service will benefit. A Commercial tenant should have the opportunity of negotiating the service charge. It is sometimes possible to opt out of the charge for services that are available but will not be used.

Sep 4th, 2011

Using the Comparable Method of Valuation for Commercial Properties

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:

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.
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.
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:
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.
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.

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

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.
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).
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.
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.
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.
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.
The frequency of rent reviews. These are often timed to occur every 3 or 5 years. A new rent can either be negotiated between the parties or be determined by an external influence such as the Retail Price Index. ‘Upwards only’ rent reviews are common, this doesn’t necessarily mean (as the expression suggests) that the rent is guaranteed to increase. It does mean however that it won’t decrease, even in the event of an economic downturn. These various ways of structuring a lease can benefit either party, subsequently it will have some effect on the rent that the tenant is prepared to pay and what the landlord is prepared to accept.

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.

Aug 7th, 2011

Valuing a Commercial Property based on 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.

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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.

Jul 26th, 2011

Using the Investment Method of Valuation on a Commercial Property

The purchaser of a commercial investment property will be concerned with:

Security of Capital (i.e. the value of the investment will not be lost overnight like company shares could do).
Security of Income (meaning that income from the investment is guaranteed).
Ease of Sale (this is a weaker point of property; it’s one of the most illiquid of all investments, especially in an economic downturn).
Management of the Property (Again, this is a shortcoming of property as an investment, company shares and bonds do require ‘management’ to the extent that property does).

There is a basic assumption (which means it’s not necessarily true) that the higher a property’s capital value, the greater the rental value. This ‘view’ forms the basis of the investment method of valuation. The healthier the rental income, the greater the sum an investor will pay for it.

To establish the income figure, the annual sum is used. In the case of new developments, this will be the expected annual rental income (based on comparable similar lettings).

It’s not only the amount of rent that will be received though; it’s the regularity of the payments that matter too. An investor always looks for a high-quality tenant (meaning a tenant that is unlikely to breach the covenant of regular rent payments). A tenant that has a good credit history, shows healthy company accounts and has been established for some time will be regarded as a ‘good covenant’. This relates back to the security of income aspect of the investment. The majority of commercial property investors would probably be regarded as risk-averse.

If the investor is purchasing a property with a tenant already in place, the terms of the lease and the quality of the tenant will represent some value. For example, a lease with 15 years left to run, to a blue-chip company would be worth more in investment value than a lease at a similar rent but only 3 years left until expiry and to a company that is facing financial difficulty. An obvious example I know, but this is just to show the contrast.

To analyse the relationship between rental income and capital value, two aspects can be used:

1) Yield. This figure is expressed as a percentage and is calculated by dividing the capital value by the annual rent figure. So if a property had a capital value of £1,000,000 ($1,500,000), if the annual rental income was £50,000 (around $75,000) then the yield would be 5%.

2) Years Purchase (YP). This is a slightly different way of analysing things. As above, it is calculated by dividing the capital value by the rent figure but it’s not expressed as a percentage. So using the example above, if a property brought in £50,000 per annum in rent and was valued at £1,000,000 then the YP figure would be 20 (think of it as taking 20 years at £50k per year, to purchase the property at £1m. It’s a hypothetical situation but simply another way of comparing investments).

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Property value’s relationship with interest rates

If a commercial property is offered for sale for £400,000 ($600,000), and the current annual rent is set at £32,000 ($48,000), then the yield on this investment can be calculated as:

£32,000 ÷ ($400,000 ÷ 100) = 8%

$48,000 ÷ ($600,000 ÷ 100) = 8%

The investor will usually have a particular yield figure in mind and 8% might or might not be suitable. The rate is comparable to other investments, allowing an initial direct comparison to be made. For the purpose of illustration, examples of alternative average returns might be:

Government bonds – 5%

Company Shares – 6.5%

Bank Deposits – 2%

In comparison, if the investor can receive a return of 8% on the property above then he/she is likely to go for that. However, a direct comparison between these investments is tricky for the following reasons:

1) The investment property is the most illiquid of all of these investments.

2) The property will entail risks such as non payment of rent, vandalism and rent voids.

3) It will be subject to management costs to ensure it remains in optimum condition.

4) Property value can be increased through building work.

If interest rates were to go up, the increased return on bank deposits might influence an investor to simply place the capital in a bank rather than face the risk and work involved in property investment.

If interest rates were to go down, it would have the effect of investors looking for alternatives to bank deposits, shares and bonds. If investors felt that property was a shrewd buy, then values would tend to go up because of the increase in demand. If the capital value goes up and the rent stays the same, then the yield figure will fall. This is because the annual rent figure will account for a lower percentage of the property capital value.

Using the example above, if all comparable properties yield can be calculated at around 7%, we can calculate the increased capital value:

(£32,000 ÷7) x 100 = £457,000 (originally £400,000 at 8%)

($48,000 ÷7) x 100 = $686,000 (originally $600,000 at 8%)

This illustrates the change in property capital value when interest rates and demand change the yield figure. It also shows perfectly the Investment method of valuation. Essentially the 2 variables involved are:

Annual rent
Yield

With these 2 components, the capital value can be calculated extremely quickly using the equation:

(Annual Rent ÷Yield) x 100 = Capital Value

This is a very simplistic but unrefined way of establishing the capital value, the larger the property, the less accurate this is. What the equation is good at however is providing a very quick way of gaining an idea of what the capital value will be in the region of. Remember, no two properties are the same.

Property Investment and Risk

Investment in property is risky. It is the element of risk however that effectively provides the return. If a particular property reflects a high risk, for example if it’s looking tired and the tenant has only 3 years left in occupation and is unlikely to renew, then the capital value of the property will not be particularly high. If the rent is set at a level that compares with similar properties, the yield figure will be high. This means the rent will be high in comparison to the purchase value. This way, the investor will stand to recoup as much of the capital outlay as possible, as quickly as possible.

So the risk that a particular property presents can be assessed by the rate of yield. High yield can mean high risk, and vice-versa. This enables valuers, Surveyors and investors to compare risk levels between investment properties. A yield figure can be applied with the intention reflecting all the risks involved in an investment. This is simply called the ‘all risks yield’ and works by using a particular rate (as a percentage) that goes up when the risk is high, and drops when the risk falls. It is intended to ‘reflect all future benefits and risk’. This method is open to debate though, as many property professionals feel that it is a crude way of valuation and furthermore, investment risk cannot be solely expressed simply as a rate of yield.

A property that represents an extremely low risk would be well located, with modern design and in good condition. Let on a long lease to a good, reliable tenant who is responsible for repairs. This property would be regarded as ‘Prime’ or Grade A (in the case of offices).

A high risk property would be the opposite of the above, poorly located and with an older design that is becoming more expensive to maintain. It would be let on a short lease to an unreliable Tenant who is not responsible for repairs. This property would be regarded as either ‘Secondary’ or ‘Tertiary’.

Jul 19th, 2011

13 Steps to Getting a Property Sold

If you are planning on developing a property, the very final stage is the sale at the end. No developer wants a long wait to sell the property, no capital or rent is coming in and meanwhile mortgage repayments have to be covered. The longer it stays on the market, the more the developer will financially lose out.

So, to ensure that you have the very best chance of getting the completed property sold, here is a checklist to run through so that you know you are less likely to miss out.

© Copyright Carl Ayling and licensed for reuse under this Creative Commons Licence

Establish your position. You have to realistic about selling the property; if the market is currently flat in the area you are selling in you might well have to reduce the price at some point in the marketing process. If you are not in a particular hurry to sell, you might feel that reducing the asking price is not an option you want to consider. Don’t rule it out though.
Consider the purchaser’s aspect when pricing the property. Clearly it will depend on what the property is valued at but remember that houses are usually priced strategically just below the Stamp Duty Land Tax thresholds. This is not coincidence. If a property is priced just below the threshold and a competing one is just above it, the difference between them might only be a few thousand pounds but the cheaper one is likely to be on the market for a shorter length of time.
Consider your market. Much is made on TV property programmes of selling to ‘young professionals’; however there are occasionally people outside this category who buy properties. Of course, I recommend buying a development property with a particular customer in mind but you should certainly be selling it knowing who should be buying it. Students for example (or rather their parents), will be considering different things than a young family or a retired couple. Far better to cater for an existing local need than trying in vain to sell a property that’s being marketed to the wrong people. Speak to Estate Agents (several), they should be able to tell you where the local needs lie.
Ensure that the work that needs to be done, is actually done. If you’ve just had work done on the property then there shouldn’t be any excuse for leaking gutters, damp or mildew on walls or dodgy hinges on doors (for example). Not every developer will be carrying out a complete ‘gutting’ of the property, so if the turn-round is a rapid one to get it back on the market, make sure nothing is overlooked. If someone is having a viewing and looking round the property, if they find one obvious fault they might start to look for others.
Always have an idea of what the property is worth. Property valuation is not rocket science; it’s easy to get to know a particular area’s property market. After a few weeks you will probably be able to gauge neighbouring property prices to within around 5% of what a professional valuer would put it at. This will definitely help when it does finally get to the stage of accepting an offer, you will be able to distinguish between a silly offer and a realistic one. Having a look on a couple of property websites will help to get an idea of what neighbouring properties sold for (www.nethouseprices.com or www.rightmove.co.uk).
Choose the right estate agent. Some are good, some are bad but it’s highly likely you will be stuck with them for at least 6 months if the property does not sell. Word of mouth is a good way to get an idea of true reputation, and don’t be taken in by their sales pitch, remain sceptical! If you choose to put the property on the market with a single agent, there’s no reason why you should have to pay more than 1% (plus VAT) of the sale price. If you go with dual agents, it’s very likely you will be charged 2% (plus VAT).
Once the property is on the market, make sure it’s kept tidy inside and out whenever possible. Potential purchasers will do ‘drive-byes’, where they drive past a property to have a quick, discreet look and get a feel for the area without committing to a viewing. If there’s rubbish or builders waste left outside the property, it can be really off-putting for them.
If the estate agent has promised you that the property is displayed in their window and being aggressively marketed, periodically check that they’re telling the truth. Speaking from experience, an agent had stressed that the particulars of a house was in their window for all passers-by to see; but upon arriving at the shop, my wife and I found that not only was it not in the window it wasn’t displayed inside the shop either. They were poor agents and this was the final straw in making the decision to sack them.
Be picky about the property details produced by the agent. Their job is to get your property sold as quickly and efficiently as possible. If you feel that the details are not satisfactory, don’t be afraid of telling them. You will ultimately be paying for this service so they should always be acting in your best interests.
Pester the agent for feedback on viewings. Agents are not always the most communicative of people so they might need prompting occasionally. You might be fobbed off with a vague comment the agent picked up from the viewee, but after a few weeks of pestering them for accurate feedback, they’ll make sure they have proper answers for you. Some aspects of the property might be unavoidable, such as parking. However some things might be easily solved such as borrowing some furniture to ‘pad-out’ an empty property.
Consider exactly what you might be prepared to put in the property for the purchasers. For example you could throw in all the fitted carpets if the purchasers pay full asking price; they don’t know that you managed to get a load of inexpensive carpet from a friend. Same for curtains, you (as developer and vendor) might feel that putting up some (decent quality) curtains is of such little consideration as to be next-to worthless to the purchaser. This is not the case, buying and fitting good quality curtains and rails can run into thousands of pounds in some cases. If you can source them cheaply, you might well swing the deal in your favour.
When an offer does come along, you should have a figure in your mind that marks the border between what would be acceptable and what wouldn’t. This value has to be realistic though. In the current climate, buyers are looking for bargains and if you won’t consider dropping the price at all then it might be a while before the property sells. It’s a difficult market and sellers have to do what they can to keep their businesses running. Obviously a reduction in selling price over what you might have expected will reduce your profit margin, therefore consider this very carefully.
Do anything possible to increase the exposure of the property. Sarah Beeny’s website Tepilo is very good, and free. You won’t lose anything by making use of it! If you look around, websites and blogs can be free too these days (for example www.wordpress.com), give the property its own site! You have nothing to lose and it should not affect the arrangement you have with your estate agent.

Jul 3rd, 2011

5 Taxes on Property you can’t Avoid, Part1

This article is intended to give you a basic understanding of the different taxes involved in property. You will certainly come into contact with most of these taxes, property transactions are unfortunately an excellent source of revenue for HMRC.

1. Income Tax

As the label suggests, this is simply a tax on income. Taxes are collected over a period of 12 months, this runs from 6th April one year, until the 5^th April the next. For the purposes of income tax, this year is known as the ‘year of assessment’ (for corporation tax it’s known as a ‘financial year’).

If the rules concerning tax are slightly ambiguous or deficient, it might give a taxpayer the opportunity to avoid tax. This is known as tax avoidance, and is legal. The alternative is to deliberately not follow the laws on tax, which is tax evasion, and is illegal.

All UK residents who are liable for income tax are given a tax-free allowance. The income minus this allowance is known as taxable income. It is on this taxable income that the current income tax rates are applied to, this arrives at the total income tax payable for that person. For the tax year 2011-2012 the personal allowance is £7,475.00, the basic rate is 20% and that is payable on all income up to £35,000. On income between £35,001 and £150,000 the rate is 40%. So to use an example, if a person is paid £45,000 per year, his tax will be calculated as follows:

The first £35,000 will be taxed at 20%, however from this the allowance of £7,475 is deducted to produce £27,525. This sum will be taxed at 20%.

The remaining £10,000 will be taxed at 40%.

20% of £27,525 is £5,505

40% of £10,000 is £4,000

£5,505 + £4,000 = £9505

Therefore on an income of £45,000 per annum, £9,505 will be payable in tax.

Note. The upper rate of income tax is 50%, payable on income exceeding £150,000. This wasn’t mentioned in the main body because it’s almost certain that if you fall into this bracket, you will have an excellent idea of the tax you will have to pay.

2. Corporation Tax

This is a tax charged on the net profit of companies resident in the UK. It is calculated in a similar way to income tax. The basic rate of corporation tax is 26%, but this is payable on net profits that exceed £300,000.

Corporation tax is calculated on all net profits arising over the period of a financial year. This means that all the company expenditure that it must pay throughout the tax year, is not included in the final taxable amount. This does not mean however that a company can purchase anything just to lower their tax liability. Some items are regarded as fixed assets; these are items that do not depreciate immediately, such as property, IT equipment and motor vehicles. Fixed assets value can contribute to the profit figure. Net profit means that all the company’s salaries, rent payments on premises and any tax already paid is subtracted from the profit figure. The remainder is charged at the corporation tax rate to produce the sum payable.

Although a company that operates in the ‘Property’ sector can use mortgage repayments to reduce corporation tax payable (as the debt is classed as a liability), there are limits on this. The UK uses rules known as International Accounting Standards (IAS); IAS 16 covers the accounting treatment of property, plant and equipment. In the case of property it stipulates the Revaluation Model, which means:

The asset is carried (between financial reporting periods) at a revalued amount, being its fair value at the date of revaluation less subsequent depreciation and impairment, provided that fair value can be measured reliably. [IAS 16.31]

The Revaluation Model

Under the revaluation model, revaluations of the asset should be carried out regularly, so that the carrying amount of an asset does not differ materially from its fair value at the balance sheet date. [IAS 16.31]

If an item is revalued, the entire class of assets to which that asset belongs should be revalued. [IAS 16.36]

If a revaluation results in an increase in value, it should be credited to other comprehensive income and accumulated in equity under the heading “revaluation surplus” unless it represents the reversal of a revaluation decrease of the same asset previously recognised as an expense, in which case it should be recognised as income. [IAS 16.39]

A decrease arising as a result of a revaluation should be recognised as an expense to the extent that it exceeds any amount previously credited to the revaluation surplus relating to the same asset. [IAS 16.40]

When a revalued asset is disposed of, any revaluation surplus may be transferred directly to retained earnings, or it may be left in equity under the heading revaluation surplus. The transfer to retained earnings should not be made through the income statement (that is, no “recycling” through profit or loss). [IAS 16.41]

What this means, is that property assets should be regularly revalued. If the value increases, this sum is placed into the accounts as ‘revaluation surplus’. This is because this increase is not trading profit and does not represent a tangible amount of money anyway. If the revaluation figure represents a decrease, it should be covered up to a certain point by that accumulated in the revaluation surplus account, once the deficit exceeds this, it is regarded as an expense, and therefore a liability.

Close companies (known as such because the shares are not available for widespread public purchase) that offer benefits and distributions to their members, must pay tax on these payments.

In Part 2, we’ll cover Capital Gains Tax (CGT), Inheritance Tax (IHT) and Stamp Duty Land Tax (SDLT).

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May 1st, 2011

Property Investment Yield

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.

Mar 30th, 2011

Placing an Investment Value on a Residential Property

The most accurate way to establish a value for a property is by using the Comparative method. This is used to get the best idea of what the property might fetch on the open market when sold to a willing party (otherwise known as Capital Value). However, if you are considering purchasing an investment property that is currently occupied by a tenant, where do you start if you want to establish a suitable price to pay?

The comparative valuation method is important because this is where you must start if you want to find an appropriate capital value. The problem is that the capital value for an investment property is different to that of an owner occupied property. This is mainly because of the increased cost of insuring it and the risk involved of letting the property to a tenant; essentially there is a risk to both the investor and his/her insurance company.

There is also a risk to the mortgage company. In normal circumstances (on an owner-occupied property) the mortgage company can take possession of the property if the investor defaults on the mortgage payments. Whereas with a buy-to let mortgage, the tenant can usually only be evicted if the mortgage company secures a court order to evict them. Until that point, the mortgage company cannot take possession. So it is almost certain (especially in the current financial climate) that the investor will be paying a higher interest rate than that of a normal residential mortgage to reflect this risk.

The value of the investment property is rarely more than 90%-95% of the vacant possession value. So the initial part of the calculation is very straight forward:

However, this appears to be too simplistic. The secondary part of the calculation takes into consideration the passing (current) rent, annual maintenance, management costs and value at the point of reversion.

The following part of the calculation applies a discount to the net income (rent). The reason for this will be covered in a post of its own, but what it means is that a figure is produced that reflects a present day value, for a future stream of rent. The concept of this is that money receivable in the future is worth less than the same amount now, because of the effects of inflation. So for example, a rent of £12,000 per year is worth more this year than it will be worth in ten years. The purpose of this calculation is to provide a very specific and mathematical way of establishing a rental value.

In practice, the novice/intermediate developer will not be considering what particular rate to discount the figures at. This is because whether you use 5% or 10% in anticipation of future inflation, the effect is highly unlikely to make so much of a difference in the price you offer, that it will be outside your negotiation range anyway.

If a professional developer is considering a residential block of 6 or more flats, then a complicated mathematical calculation is justified. For most prospective property developers, calculation 1 will suffice, together with a solid desire to negotiate and settle on a good price.

Mar 24th, 2011

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