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Understanding Property Auctions

Property auctions are one of the most popular places for prospective investors and developers to look for projects. There are many alternatives, but auctions remain very popular despite the current difficulties in obtaining finance.

The auction hall is often looked upon as the first step on the path to running a property business. However, auction day is really the very end of the first stage.

There are some terms that are used when describing auction lots that many potential bidders are not familiar with. It is so important to understand what you are getting into; auctions can be unforgiving to the unprepared:

“The vendor is a Mortgagee not in possession“.

Obviously the Vendor is the party who is selling the property at auction.
The ‘Mortgagee‘ is the bank or building society who originally provided the loan for the purchase of the property (the Lender). This is the opposite of the ‘Mortgagor’ who is the person(s) buying the property (borrower).
The term ‘Not in Possession‘ means that the party selling the property do not actually own the legal interest (whether this is Freehold or Leasehold). When a lender provides a loan (mortgage) for a person to buy a property, the lender has a ‘first charge’ on the property. This means that they retain the legal right to sell the property to recoup financial loss in the event of the borrower breaching the terms of the mortgage by defaulting on the repayments.

So, what the term above means in laymans terms, is

“that the party selling the property is a bank/building society who do not actually hold the legal title on the property, but who are exercising their legal right to get their money back by selling the property.” Essentially, it’s a repossession.

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“Therefore the accommodation and any basis of occupancy cannot be confirmed”

This means that the parties offering the property up for sale at auction (the legal firm and the auction agents providing the details) will not offer any indication of the state of current occupancy. There could be (for example) 20-odd families living in it, or there could be a terminally ill old lady….. It’s absolutely the responsibility of the person intending to buy the property to reassure themselves and investigate the situation before they bid.
If you were to bid on a particular property and actually get the winning bid, you do not have much in the way of recourse if it turns out you’ve bought something not quite right. It’s only if a property has been falsely advertised and you believe something you are told in good faith that you can take action to legally rectify this (by suing someone for example). This is why the auction agents will not give any information in respect of anything they don’t know for certain, it’s because they know they can be sued for it if it turns out to be incorrect.
If you were to successfully bid on a property and it turns out someone is already living in it (legally or otherwise), that party often has some legal rights to stay there until you obtain a court-order to evict them.

Essentially, it’s up to the bidding party to investigate the current circumstances of the property. If you want to purchase an investment property with a tenant already in place, then it’s up to you to make sure that the tenancy and lease are all in order and no-one is living there who shouldn’t be. If you intend to buy a vacant property, then it’s up to you to make sure it is indeed empty before you bid. There is often hidden legal issues in property, especially at auction. However, there is usually every opportunity to make sure that nothing comes back to bite you on the a***. If you are offered a property without actually seeing and investigating it, then (to be realistic) you shouldn’t pay much for it because you’re exposing yourself to massive financial risk.

In respect of purchasing the property at auction, it is 80%-90% a legal process. You are purchasing the legal title to a property which means you will have ‘exclusive possession’ (unless someone else is living in it and also has a legal right to be there). You should be 100% certain that you know what you’re buying into before you bid.

When buying a property at auction, it pays to be suspicious about everything; so do your homework!

Nov 30th, 2011

Applying Discounted Cash Flow (DCF) to a Property Valuation

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.

Nov 9th, 2011

Using Discounted Cash Flow (DCF) to establish Property Value

This article builds upon the use of Valuation and Investment Tables

DCF works on the concept of money available now is worth more than an identical sum in the future. To use an example, if someone were to offer you £10 today or £10 next year, you’re likely to opt for the cash today. This is for a number of reasons:

Risk. To receive money today involves no risk; the chance of money being received next year is lower.
Inflation. £10 today will provide more ‘spending power’ than £10 in a year’s time. This is because of the effect of inflation.
Alternative investment opportunities. Why opt to receive the same amount next year as you could receive today? You could take the money today and invest it and receive a greater sum next year.

DCF is used to establish a value on an investment (not only property) depending on future incomes in the form of rent or dividends, and the length of time the investor has to wait for the returns.

So, how would you establish the present-day value of a future stream of income? Firstly, a rate of discount is adopted; in practice it is common to look at several analyses each using different rates. If we use our example of £10 available now, we could assume that the economy in general will suffer inflation of (say) 6% per year. So £10 now will have the same purchasing power of around £9.43 will next year (this is calculated using valuation and investment tables). Likewise if we apply a discount rate of 10%, the sum of £10 available now will only be worth £9.09 next year.

In the context of a property investment, if a property provides a return (in the form of rent) of say, £10,000 per annum, after 5 years or so the rent will not be worth as much in actual value as it was at the outset. Clearly this is why we have rent reviews.

To calculate the present day value of a stream of income over a period of time, we compile a table of future rent payments:

This example shows that an income of £10,000 per year has a present value of £42,124 if inflation rises at 6%.

We can use a similar table to analyse investments that must fulfil particular criteria. For example, an investor pays £100,000 for an investment that returns £30,000 after years 1 and 2, and £40,000 after years 3 and 4. However, the rate of interest charged on the initial loan of £100,000 is 12%. At the end of the 4 year period, will the investor have made a profit or a loss?

This example shows that the investor will make a small profit if the cost of borrowing is 12%. If the cost of borrowing were 10% (for example) the individual present value multiplier figures would be higher. This would produce a higher present value figure and subsequently a higher NPV value.

The advantages of using the DCF method of investment valuation are:

An element of risk can be incorporated into the calculation.
Any period of time within an investment period can be examined.
The effects of tax and inflation can be considered.
The particular timings of expenditure and returns can be looked at.
The effect of depreciation is fully considered.

It must be remembered however, to take the DCF valuation model at face value. As with all other asset valuations, if any input figure changes, the output figure will change accordingly.

Nov 6th, 2011

Using Valuation Tables to Produce an Investment Appraisal

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When an appraisal is being put together for a particular property, the Investment or Valuation Professional will refer to ‘Parry’s Valuation & Investment Tables’. This is simply a reference book full of tables (funnily enough) that assist the practitioner in carrying out mathematical analysis of investments. Admittedly this doesn’t sound a particularly interesting read; however it’s a very handy thing to know how to use because it allows a way of comparing several investments to each other and looking at them in different ways.

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One of the principles of investment is that a particular sum of money available now is worth more than the same amount at some future date. This is for 2 reasons:

The effects of inflation over time. For example £1 now is worth more than £1 in ten years.
The fact that the money could be invested in various forms. So £1, invested at a rate of 10% per annum will be worth £1.10 next year. This is the ‘compensation’ for having to wait for the money. Why would you wait a year and only receive the same amount you could have now?

Without tables, detailed analysis of financial information would be very tedious. The tables within the book give the reader a simple multiplier figure to apply to a relevant sum of money. An example of this is:

A Commercial property lease is agreed to at a rent of £10,000 per annum for 20 years. On the face of it, this would produce £200,000 for the Landlord (£10,000 x 20).

However because of the effects of inflation, the rent of £10,000 per annum would be worth considerably less in 20 years time than its present value. Using the relevant table from the book and an assumed rate of inflation, it’s possible to produce a present value of 20 years worth of rent. To calculate the present value of £10,000 at an assumed rate of say, 5% the ‘Present Value of £1 per Annum (Quarterly in Advance)’ set of tables can be used. This produces a multiplier figure of 12.85 (this particular figure is simply a multiplier, and until it’s used in conjunction with the annual rent figure means very little).

If the annual rent figure of £10,000 is multiplied by 12.85, it produces £128,500.00. Therefore if inflation is expected to rise at around 5% per year, it would be reasonable to give the 20 year lease a present value of £128,500.00.

The equation used for this is:

n = Number of years

i = the interest receivable on each £1. Therefore if the rate percentage is R, then i = R/100

In the above example, it’s only the lease of 20 years which is being valued. The Landlord actually has the ‘facility’ of receiving a similar sum into perpetuity (or until he sells the property to another investor) because the building will theoretically always have the potential of producing an income in the form of rent paid to the Landlord. If the investment potential of the property itself is valued, it produces a different figure:

Again, using a rate of 5%, we can reference a multiplier figure of 20.62 (using the ‘Years Purchase in Perpetuity’ tables). If this is applied to the annual rent figure of £10,000, a total of £206,200.00 is produced.

The equation used for this is:

r = effective yield

On reflection, the figure of £206,200.00 does not seem particularly high considering we are examining earnings into perpetuity. However it should be noted that this is not a reflection of accumulated future earnings. It simply provides a way of placing a present value of the ongoing income potential of the property.

These 2 examples demonstrate the simpler aspects of what is possible with Valuation tables. The tables can and do go much deeper. It’s possible to appraise various investments (not only property) with allowances for a large range of interest and growth rates and taxes too. For example, it’s possible to obtain the multipliers for calculation of:

The rate of Internal Rate of Return (IRR). This is the actual rate of return received when all expected rent increases are considered.
Annual Sinking Fund. This is the amount that must be put aside each year to provide capital to replace an asset (remember a leasehold interest is a wasting asset, the closer to the end of the term the less the legal interest is worth).
The Years Purchase with Dual Rate (‘Dual’ because it includes the aspect of a sinking fund). The additional tables allow consideration of tax rates of between 10% and 50%.

I have found that until an investment or valuation professional gets into the very complicated aspects of appraisal, it is not really vital to understand the actual equations. The very practice of knowing where to look to obtain the correct multiplier is far more important. The use of valuation and investment tables is like almost everything, the more frequently they are used, the easier the process becomes.

Through the use of Valuation and Investment tables, quite complex calculations can be made such as Discounted Cash Flow.

Oct 16th, 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

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

An introduction to Commercial Office Investment

As an aspiring property developer or investor, it is by no means compulsory that you must look for residential properties to renovate, or buy to let. Many people choose to bypass the more conventional approach (i.e. residential property) and just go straight for commercial.

There are some advantages in taking this route:

If you aim to eventually be a commercial developer and/or investor then it makes sense to begin to find your way in the market as soon as possible. The commercial side of property is quite different to residential.
The demand for commercial property (for both purchasing and letting) is often different to that of residential. It may be that demand for residential is weak, while demand for commercial is stronger. The two markets are not always synchronised.
The potential for large scale projects is higher in commercial property. Banks will be keen to work with you on large projects (their money is tied up in your plan) but expect to be quizzed hard about your experience if you haven’t been in the commercial sector for long.
Inexperienced developers are not tempted to fall into the trap of purchasing a property with their heart, not their head. Few people fall in love with a commercial property!
When investing, it is generally easier to find properties that have an existing tenant. This is important if you don’t want the hassle of using a commercial agent to find a tenant for you.

It probably will not surprise you to learn that the market in offices and commercial property as a whole is more biased towards letting property rather than purchasing it. It is reasonably unusual for a commercial property occupant to purchase a property outright, rather than having a tenancy agreement in place. The vast majority of commercial property owners are private investors, property companies, commercial investment funds and insurance companies. These companies tend to be the only ones who have the capital to purchase large buildings and not concern themselves too much if the buildings remain empty for a few months to a year (known as ‘Rent Voids’).

It is sometimes possible to find poor quality office properties and renovate them. If this is done well, it can prove a very shrewd way of increasing the investment value. However, if properties are found that are in need of work, it’s normally because they’ve been neglected due to the location. If an area does not have strong demand, it is rare that the renovation of one building does much to change that. If a high-quality renovated office property is offered for rent in a scruffy area, it can be expected to be worth £5-£7 per square foot (£50-£70 per Sq Metre) more than an un-renovated one (this is a very generalised figure across the UK).

Professional property developers are not very keen on taking too much of a risk in their ventures. This is why they use to great effect, pre-let arrangements (or an Agreement to Occupy). The way this works is a company will be intending to establish a presence in a particular area. Their requirements will be discussed between them, a property development company, and a property investment company. The investment company agrees to purchase the building from the developer when it is completed. The company intending to occupy the building then signs an agreement with the investment company to occupy it. All this is agreed to before work actually starts on a building and the bank that provides funding will certainly be taking a very active role in making sure the agreements and work go according to plan.

Unfortunately, the smaller scale developer is less likely to be in a position to use the pre-let method. This is because it’s usually only done on buildings above a certain area because of the risk that the developer faces without this sort of agreement in place. Then again, the risk in purchasing smaller office properties is considerably less. A smaller office is generally easier to fill than a large one.

If investment in office property is what interests you, there are plenty of opportunities for you to begin with a small unit. A browse through the auction catalogue of any of the commercial property auctioneers (such as Cushman & Wakefield or Allsops) will show you that you do not need to invest millions to begin in commercial property.

The recent trend is for many high street banks to sell off their premises on a sale and leaseback arrangement. This means that the bank sells the individual premises through auction (often, a dozen or more of these lots spread all over the UK are offered in any single auction). The bank staff who occupy the premises stay there, and nothing really changes for them. However, the legal title of the bank changes, it becomes Tenant instead of owner. The purchaser of the freehold interest (the party with the winning auction bid) becomes the Landlord. The bank will have put a lease in place to allow it to remain in occupation for several years into the future. This is definitely an interesting deal, because the purchaser is buying the right to receive rent from the bank (as Tenant) for many years, 15-20 years is fairly common.

This is merely an example of the type of opportunities available for private investors. Be aware though, that an excellent understanding of tenancy agreements is important if you intend to follow this route. It is reasonably common for nasty things to surprise people who have spent a lot of money on something they don’t fully understand. If in any doubt whatsoever about a lease, ask a good Solicitor.

A reasonable quality office property can be expected to return a yield of around 6-7%. This means that the annual rent will amount to around 6-7% of the property’s capital value. A poorer quality office building will produce a higher yield figure, because the rent will amount to a higher percentage of its capital value.

In conclusion, investment in office properties can be very financially rewarding but in practice, it’s rare that an investor can do much with a very small portfolio. Successful commercial property developers and investors need high cashflow to cater for maintenance, repair and rent voids. Commercial properties need to be maintained far more frequently than residential, as they have substantially higher daily use. Upkeep on a commercial property is vital to keep the Tenant happy and ensure that any rent voids are kept to a minimum.

Mar 29th, 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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