Valuation Methods. Comparison

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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



An Introduction to Business Rates

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

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

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

A commercial building is valued using the following procedure:

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

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

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

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

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

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

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

There is currently certain business rate relief for empty properties:

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

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

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

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

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

Application of Discounted Cash Flow

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Budgeting for a Development Project

It is of paramount importance when planning a property development that a budget is prepared and followed.   Many TV shows feature aspiring developers that always seem to go over budget because of a combination of self-indulgent luxuries and a lack of foresight regarding potential problems.   I strongly suspect that when filming, sensible and prudent developers are omitted from the eventual screening because they don’t make for ‘involving’ viewing.

Budgeting is in no way a difficult concept to understand.  Private, novice developers and professionals alike should follow a similar process when planning projects.  It is only the scale that will differ.

When planning a development, the initial method of forming a budget is to carry out a financial appraisal.  This means that a basic plan is drawn up which sets out how much the project as a whole will cost; and how that total will be broken down into different aspects such as building/development costs, fees (estate agents, architects, surveyors, solicitors (including VAT) and Stamp Duty), and cost of land/property.  As this is only a basic plan, it does not have to be accurate down to the last penny at this stage.  However, the purpose of it is to establish if the project is financially viable for you.

My favourite method of appraising a development is the ‘residual’ method.  This is simply as follows:


Note: ‘Gross Development Value’ is the total value that you (realistically) expect to achieve when the finished property is sold on the open market.

This method allows for the required profit to be placed into the plan.  Profit is something that many novice developers almost forget about until the finished development is valued.  However profit is vital if your property venture is to succeed.   Obviously if the expected profit level is too high, the plan is less likely to work.  Likewise, if the profit is too low then it leaves you less capital to begin your next property.  On development projects at the height of the market in 2007, a realistic profit figure could have been around 30% of the Gross development value (GDV).  Currently, a profit of around 20% might be considered quite optimistic (but still possible).

The next aspect is build/development costs.  It is impossible to say what this will be in the region of, because it will depend entirely on the scope of the work, the required standard of finish and the size of the property.   Professional property developers, who are building a property from scratch will usually calculate this on an area basis and apply a rate per square foot or metre.  This method can also be applied to development properties that are not being built from scratch, but are having extensive work carried out.  This rate could be between £30 per square foot (very approximately £300 per square metre) for a very basic job, or up to around £100 per square foot for a very top-end finish.   Currently £50 per square foot (approximately £500 per sq Metre) might be a realistic figure.  So if the development property is planned to be 2,000 sq ft in area, build costs of around £100,000 will be a ‘ballpark’ figure (depending on scope and standard).

If the work you intend to carry out is not that extensive, then calculating build costs will not be appropriate.  It is more sensible to get quotes from builders for the work you want them to do.  Always make a list to give to them (keep a copy too!) so that they have a formal record of your required works.  This will form the basis of the quote that they will provide.  Simply explaining to them what you want is not clear enough; it should be set out on paper.  This will also allow you the opportunity to think about what the builders can do, and what you can do.  You might find that much of the work you have written down could be carried out by yourself, obviously this will save money.    If you obtain several quotes from builders, you will very soon form a picture of what is or isn’t a fair price for the required work.  If at all possible, always try to get a fixed price deal from the builder.  This will contribute a great deal in forming a budget that is less likely to change.  Be warned however that this fixed-price deal is certain to contain conditions.  A builder will not adhere to a fixed price if much additional work is added to the plan.  This includes changes of your plan and unforeseen problems such as the need for more extensive ground works or compatibility problems with individual build components.

Fees for involved professionals must also be included into the budget.  Solicitor’s fees are likely to be around £500-£1,000 inclusive of search fees, VAT and a small amount of additional work (phone calls & letters etc).   Obviously this will depend (again) on the scope of the work the Solicitor must carry out for you.  Complicated legal matters will certainly result in the fee increasing.

Estate agents fees should not be more than 1% of the sale price.  The estate agent might attempt to convince you that you should pay more for a ‘top-rank’ service; this is definitely not the case.  Most estate agents will acknowledge that 1% is competitive and they can still afford to provide you with an excellent service on this fee.

If the development project is a new-build property, then you might be considering the services of a Project Manager.  The fee for this is likely to be from a couple of hundred pounds for a ‘phone/email based’ service, up to £5,000 or more for a dedicated service by a Project manager who can source the best materials at the best price and even find suitable temporary accommodation for you.

All these elements can be used to provide the vital components to your project appraisal.  In these financially troubled times, if you’re looking to secure lending to help finance your venture, that lender will be far more inclined to consider your request if it is clear that an appraisal has been produced to establish the project’s financial viability.