C A L C U L AT I O N

OF

WORTH
An In f o r m a t i o n Paper

Please note: References to the masculine include, where appropriate, the feminine. Published by RICS Business Services Limited a wholly owned subsidiary of The Royal Institution of Chartered Surveyors under the RICS Books imprint 12 Great George Street London SW1P 3AD No responsibility for loss occasioned to any person acting or refraining from action as a result of the material included in this publication can be accepted by the author or publisher. ISBN 0 85406 821 X RICS August 1997. Copyright in all or part of this publication rests with the RICS, and save by prior consent of the RICS, no part or parts shall be reproduced by any means electronic, mechanical, photocopying, recording or otherwise, now known or to be devised. Reprinted 2000 (Twice) and 2004 Printed in Great Britain by RICS, Coventry

CONTENTS
Foreword Executive Summary 1. 2. Introduction Price and Worth A discussion of the Difference between price (value in exchange) and worth (value in use), and the distinction between valuation, appraisal and calculation of worth. Calculation of Worth Methodologies A brief review of worth calculation methodologies used for asset classes other than property. DCF Mathematics An introduction to DCF mathematics and time weighted versus money weighted calculations. Towards an Industry Standard Cash Flow Data An indication of the data to be used in assessing cash flows, and the cash flow time period. Risk Assessment Discount Rates An analysis of appropriate methodology for assessing discount rates and consideration of the difference between risk adjustment via cash flow variation versus yield variation, with a particular warning on double counting of depreciation. Instructions, Caveats and Reporting to Clients A brief description of appropriate instructions for the undertaking of calculations of worth, the caveats which should be adopted and the reporting format. Conclusion 5 7 10

12

3.

15

4.

18

5.

21

6.

25

7.

31 34

8.

Appendix 1: Appendix II: Appendix III: Appendix IV:

Glossary of DCF Terminology Adjusting DCF Calculations to Allow for Periodic Cash Flows in Advance DCF Example Over 10 Years, as at December 1996 Membership of the Joint Royal Institution of Chartered Surveyors & Investment Property Forum Working Party on Worth

36 39 40

50 51

Bibliography

INFORMATION PAPERS This is an Information Paper. Information Papers are intended to provide information and explanation to members of the RICS on specific topics of relevance to the profession. The function of this paper is not to recommend or advise on professional procedure to be followed by surveyors. It is, however, relevant to professional competence to the extent that a surveyor should be up-to-date and should have informed himself of Information Papers within a reasonable time of their promulgation. Members should note that when an allegation of professional negligence is made against a surveyor, the Court is likely to take account of any relevant Information Papers published by the RICS in deciding whether or not the surveyor has acted with reasonable competence.

FOREWORD
Many of the recommendations in my working party report concerned more effective self-regulation in the valuation profession; all necessary but rather boring stuff. The one issue which raised my real interest was worth. Whilst credible and reliable and accurate identification of tradeable price is a useful, not to say essential, function for many clients, it is the comparison of worth to that price which is the real business problem. The ability of the profession to participate helpfully in solving that problem is the key to our being invited to sup at the top table. It is an inescapable feature of calculations of worth that the valuer must draw upon material from outside his immediate professional knowledge and apply his knowledge to it. This is exciting and helpful to the client but it is also potentially dangerous. As this Information Paper makes clear, the obligation upon the valuer, contained within the RICS Appraisal and Valuation Manual, to ensure that he understands what the client is after and records and explains what has been done, therefore applies with a vengeance. This Information Paper sets out, in a clear and helpful form, the issues and techniques available. Those valuers unfamiliar with this area of work may find some initial difficulty in mastering the concepts, but the effort will prove worthwhile. Those already familiar will welcome the drawing together of matters which are, at present, dealt with somewhat ad hoc. I congratulate the working party on their efforts and commend the result to all valuers. MICHAEL MALLINSON, CBE FRICS

E X E C UTIVE S UMMARY
1. PURPOSE OF THIS PAPER The Mallinson Report of March 1994 made two specific recommendations of relevance to worth. The first (No.15) related to the development of a definition of worth together with research into the techniques of assessing and expressing worth. The second (No.25) related to the need to develop and codify Discounted Cash Flow (DCF) techniques and related information bases with the object of reducing valuers dependence on current all-risks yield methods of valuation. Two working parties were set up to take forward these recommendations. This Information Paper has been produced by the second working party which was charged with explaining the methods of assessing worth. in relation to investment property only, in order to encourage the adoption of a consistent approach. 2. DEFINITIONS To avoid confusion, care is needed over the use of the words price, value and worth. Price/value are market driven (value in exchange) whereas worth is subjective and based on a clients particular circumstances (value in use). Calculation of worth means the provision of a written estimate of the net monetary worth at a stated date of the benefits and costs of ownership of a specified interest in property to the instructing party reflecting the purpose(s) specified by that party. With the above in mind, the following definitions should be adopted: Worth is a specific investors perception of the capital sum which he would be prepared to pay (or accept) for the stream of benefits which he expects to be produced by the investment. Price is the actual observable exchange price in the open market. Value is an estimate of the price that would be achieved if the property were to be sold in the market. 3. DISCOUNTED CASH FLOW (DCF) DCF techniques which are used in calculating investment worth of the equity and fixed interest asset classes should also be used for property investment. DCF mathematics are relatively straightforward and are based on the following formula: DCF Value = CF1 + CF2 + CF3 + ...... + CFn + ...... (1 +i)3 (1 +i)n (1 +i) (1 +i)2 PC-based spreadsheets can be utilised to undertake calculations in an accurate and quick way.

A L C U L A T I O N

O F

O R T H

Results can be expressed in three ways: Gross Present Value the current value of future cash flows discounted at an appropriate rate, excluding an initial purchase price. Net Present Value equals the Gross Present Value from which has been deducted the initial purchase price. Internal Rate of Return the discount rate at which the discounted value of future cash flows equals the initial purchase price. 4. CASH FLOWS Cash flows need to be carefully prepared to capture explicitly all information relating to income, expenditure and exit value (at the end of the cash flow) and should include, as and when appropriate, rental growth, taxation, external financing and all costs. Particular care is needed when considering depreciation to ensure double counting does not occur. Cash flows can cover any time horizon but are normally undertaken for 10 or 15 year periods. Provided assumptions and inputs remain constant, there will be little difference in outcome irrespective of the time horizon. Accordingly, the characteristics of the specific asset and the needs of the client should be taken fully into account when fixing the time horizon. The cash flow must include an exit value which would normally be calculated using conventional valuation techniques. In the case of leaseholds where the cashflow duration coincides with the lease expiry, the exit value can be zero, or even negative where dilapidations might exist. 5. DISCOUNT RATES An appropriate discount rate for cash flow analysis of property assets can be defined as the rate of return from an investment that adequately compensates an investor for the risk taken. There are various approaches in adopting an appropriate discount rate: Full Risk-Adjusted Discount Rate each explicit characteristic of an asset is ascribed its own risk premium. Partially Risk-Adjusted Discount Rate areas of risk are grouped to overcome duplication and double counting. Single Market Risk Discount Rate a single risk premium is prescribed to cover all risks associated with an asset. Although each approach has advantages and disadvantages, this Paper commends the use of a Partially Explicit Discount Rate for general use. Through use and experience, the practitioner should gain a working understanding of the application of high risk into an appropriately high discount rate compared to a lower discount rate being applied to a lower risk asset. Discount rates are likely to vary between clients and consultation is encouraged between valuers and clients to ensure the selection of an appropriate rate.

X E C U T I V E

S U M M A R Y

6.

REPORTING Practitioners should follow the requirements of the RICS Appraisal and Valuation Manual in taking instructions and reporting results. Clarity regarding sources of information and clearly stated assumptions are crucial and represent good practice. Reports should always be in writing.

7.

CALCULATION OF WORTH The professional undertaking of the calculation of worth, using DCF techniques, can add considerable understanding of an asset, its characteristics and performance possibilities, and is a particularly useful tool for comparison of investment opportunities. It is commended to all those involved in property investment.

SECTION 1

INTRODUCTION
1.1 1.1.1 MALLINSON RECOMMENDATIONS In January 1996, the results of an RICS sponsored survey into the use of various valuation methodologies in the assessment of price and worth, were published. This revealed that a substantial majority of respondents were using short-cut or full DCF (Discounted Cash Flow) techniques to calculate worth, but that a significant minority were using traditional techniques, involving initial yields or all-risks yields, indicating a misunderstanding of the meaning of worth, or perhaps a confusion between price and worth. The Mallinson Report, which was published in March 1994, dealt with issues and problems relating to the valuation and appraisal of commercial property and made some 43 recommendations for future action to improve not only the service provided by valuers, but also the understanding of valuation concepts and methodology by users and providers of valuations. The report dealt with the issues of price and worth and made two specific recommendations in relation to the latter: Recommendation 15: The Institution should lead in the development of a definition of worth as a valuation basis, inviting the Investment Property Forum to lead research into techniques of assessing and expressing worth. Recommendation 25: The RlCS should take the lead in codifying and disciplining DCF techniques and developing new methodology and information bases, with the object of reducing valuers dependence on current all-risks yield methods. Guidance Notes should be produced for the new techniques which should be developed and presented to common professional standards. The RICS should also encourage and monitor their use in parallel with more conventional techniques until they demonstrate validity and reliability in their own right. 1.1.3 These two recommendations are linked in that there was an untested presumption that worth is best calculated by the use of explicit DCF techniques. WORKING PARTIES The Royal Institution of Chartered Surveyors set up two working parties, one jointly with the Investment Property Forum, to take forward these recommendations. The first working party on commercial property valuation methodology assisted in the creation of a definition of worth which is now contained in the RICS Appraisal and Valuation Manual (The Red Book). In addition, the working party has published Commercial Investment Property: Valuation Methods (An Information Paper), the purpose of which is to provide a reference document for the profession to help valuers understand fully the range of valuation techniques available to them and their appropriate use. The second working party was charged with explaining the methods of assessing worth in order to encourage the adoption of a consistent approach. This Information Paper, therefore, provides a reference document for valuers in the understanding of worth calculations.

1.1.2

1.2 1.2.1

1.2.2

10

N T R O D U C T I O N

1.3 1.3.1

RELEVANT MATTERS Readers of the Information Paper should be aware of a number of matters which are germane to the calculation of worth. (a) Investment Worth: The worth working party has, at present, confined itself to the calculation of worth for commercial property investments. Worth calculations for owner occupiers and businesses involve assessments of profit flows and goodwill, and are the subject of debate elsewhere. Worth calculations for social purposes, such as public sector assets and projects, should properly be the subject of cost/benefit studies which may utilise similar techniques for calculating worth but extend far beyond the present remit. (b) Informative: Worth is a subjective concept and whilst the Information Paper attempts to provide a consistent framework for worth calculations of commercial property investments, it is not intended to be prescriptive but informative. Valuation techniques are continually evolving and there is no absolute consensus within the practical or academic arenas as to the best or correct approach to the use and/or calculation of discounted cash flows. It is, therefore, envisaged that this Information Paper will be the subject of periodic update and alteration. (c) Forecasting: Calculations of worth involve forecasts of future changes in rents, costs and yields. The Mallinson Report considered forecasting to be a separate area of activity. This is likely to be the subject of a further Information Paper in the future.

1.4 1.4.1

GLOSSARY OF TERMS In order to have a proper understanding of calculation of investment worth methodologies it is important that practitioners are familiar with the vocabulary generally used in discounted cash flow techniques. Attached as Appendix 1 is a glossary of DCF terminology which the reader may find helpful. GENERAL This Information Paper follows on from the Information Paper, Commercial Investment Property: Valuation Methods. Readers will find that there are some areas of overlap and duplication. This is deliberate as the Papers have been produced with the aim of being read as stand alone documents.

1.5 1.5.1

11

SECTION 2

PRICE AND WORTH

PRINCIPAL MESSAGE: To avoid confusion, greater care should be taken over the use of the words price, value and worth. In the context of real estate, value should always be related to price (Value in Exchange) not worth (Value in Use). Price/value are market driven whereas worth is subjective and based on the particular requirements/circumstances of the individual. 2.1 2.1.1 PRICE, WORTH AND VALUE MISCONCEPTIONS The property market has laboured for many years without a clear understanding of the difference between price, worth and value. This confusion derives in part from the use of the word value as a substitute for price when in many peoples minds value also means worth. This problem is exacerbated by the fact that, when asked to provide an opinion on the spot price of a property, a valuer produces a figure which is called the open market value (OMV). The situation is not helped when in most dictionaries, the words value and worth are merely synonyms: value being defined as both worth (desirability or utility) and price (value in exchange) and vice versa. In the language of economics worth can be considered as value in use, whereas price or open market value can be considered as the most usual manifestation of value in exchange. Price/value in exchange is the outcome of the interplay of the respective values in use of market makers. In an open and free market, no transaction will be likely if the value in use/worth to the putative vendor is greater than the value in use/worth to a putative purchaser. Similarly, potential purchasers will not be willing to deal at a price which is greater than their respective values in use/worth. Hence, where practitioners are providing purchase/sale advice, they should provide calculations of worth/value in use in order to advise as to whether a sale or purchase should proceed at any given level of price. In short, in the property market, what is often called a valuation is the best estimate of the trading or spot price of a building/land and calculation of worth is the range of individual assessments of worth/value in use to a range of potential purchasers or vendors. A prospective owner may also undertake calculations of worth of two or more different assets on a like basis to enable investment choices to be made in a rational way. DEFINITIONS Bearing in mind the confusion between price, worth and value, it is important to be fully appraised of the relevant definitions adopted by the RICS. These fall under the headings of valuation, appraisal and calculation of worth and are contained in the RICS Appraisal and Valuation Manual. They identify the task being undertaken by the valuer as distinct from the definitions of the bases of value as listed in Practice Statement 4, Definitions of Bases of Valuation: Assumptions (i.e. Open Market Value, Existing Use Value and the like).

2.1.2

2.1.3

2.1.4

2.1.5

2.1.6

2.2 2.2.1

12

R I C E

A N D

O R T H

2.2.2

The RICS definitions are as follows: Valuation means the provision of a written opinion as to capital price or value, or rental price or value, on any given basis in respect of an interest in property, with or without associated information, assumptions or qualifications. However, it does not include a forecast of value. Appraisal means the written provision of a valuation, combined with professional opinion, advice and/or analysis relating to the suitability or profitability, or otherwise, of the subject property for defined purposes, or to the effects of specified circumstances thereon, as judged by the valuer following relevant investigations. It may incorporate a calculation of worth (see below) as requirements dictate. Calculation of worth means the provision of a written estimate of the net monetary worth, at a stated date, of the benefits and costs of ownership of a specified interest in property to the instructing party reflecting the purpose(s) specified by that party.

2.2.3

Having regard to the preceding definitions and the commentary on the difference between price and worth, it is felt appropriate that the following convention should be adopted by all those involved in the provision of valuations and calculations of worth: Price is the actual observable exchange price in the open market. Value is an estimate of the price that would be achieved if the property were to be sold in the market. Worth is a specific investors perception of the capital sum which he would be prepared to pay (or accept) for the stream of benefits which he expects to be produced by the investment.

2.3 2.3.1

WORTH IS IN THE EYE OF THE BEHOLDER Worth is not an abstract concept and is capable of calculation. However, because the value in use of a property will vary from one user to another, calculations of worth will require significant input from the client/user in respect of their individual requirements and preferences. The Red Book definition of calculation of worth is qualified by a rider which is worth repeating in full: The benefits or costs to be assessed may be either the revenue and capital flows accruing to a financial investor or the business benefits and costs accruing to an occupier. The calculation should be differentiated from an estimate of the market price of such benefits and costs. The calculation should identify and record the derivation and pattern of change of the benefits and costs, and the basis of discounting. The elements of the calculation may be derived from the Valuers views of the benefits and costs, or the Clients and often a combination of the two. On occasion, criteria for the assessment may be provided by the Client and such criteria must be stated when the calculation of worth is provided. Calculations of Worth may need to reflect benefits and costs accruing over a defined and pre-agreed period and may therefore commonly involve an estimate of reversionary net sale proceeds. (RICS Appraisal and Valuation Manual, Definitions)

2.3.2

13

C A L C U L AT I O N

OF

WORTH

2.3.3

To produce a valid and useful calculation of worth, the valuer will need to be in close liaison with the client in respect of his individual requirements and judgements in order to agree on such matters as rates of inflation, market changes and risk rates. In most cases, the Valuer will be pro-active in advising on these issues. Therefore, a calculation of worth can only be undertaken with full and detailed instructions from the client. In Section 7 of this Information Paper, the issue of instructions and reporting is covered in greater detail.

14

SECTION 3

CALCULATION OF WORTH METHODOLOGIES

PRINCIPAL MESSAGE: Calculations of investment worth in asset classes other than property all involve some form of DCF techniques. There is no reason why DCF should not also be used in the property sector but adapted to meet its particular characteristics. 3.1 3.1.1 INTRODUCTION While calculation of worth methodologies may be viewed by some in the property profession as relatively new, they have been extensively employed for some time within the financial sector. An examination has been undertaken as to how these techniques have been applied by analysts within other asset classes and the conclusion is that these are very similar to approaches currently used for property. In this section we have only made note of the key points in relation to these other assets. Interestingly, within the equity sector (which is examined in more detail below), the price earnings, or PE ratio, is regarded as the most important measure of the expensiveness or otherwise of a share. Calculated as the ratio of the price of a share to the earnings per share (EPS), this is directly comparable to the concept of Years Purchase (YP) used in property valuations. Within the financial sector as a whole, the extent of the use of a DCF approach to the calculation of investment worth varies between companies and users. EQUITY MARKET Within the equity market, many analysts will employ what is termed a dividend discount analysis, and this is used extensively in the United States. In simple terms, this entails the projection of what are usually half-yearly dividend payments, based on current pay-out levels, and forecasts of dividend growth, and discounting these back at a target or required rate of return. This is not an easy matter as the estimation of profitability and the proportion of these profits distributed by way of dividend payments is not at all straightforward. Many analysts will, therefore, forecast dividend growth only in the short term after which growth is assumed to revert to long-term trend levels. This type of approach has been discussed extensively in the financial press as a means of valuing stocks, and analysts adopting a Value Investment Approach1 were concluding in 1996 that the equity markets were overvalued and that equity weightings in portfolios should consequently have been reduced. In short, worth calculations were indicating over-pricing in the market. Whatever the validity of this method of assessing worth (Dividend Discount Analysis/Value Investment Approach), it should be stressed that it is mainly appropriate for long-term investors only.

3.1.2

3.1.3

3.2 3.1.1

3.2.2

3.2.3

(PDFM Value Investment Approach: analysis of value-based investment. Mike Lenhoff of Capel-Cure Myers, Paul Walton of Goldman Sachs and James P. O'Shaughnessey (U S.))

15

C A L C U L AT I O N

OF

WORTH

3.3 3.3.1

GILT MARKET Within the gilt market the picture is much clearer. A purchase of 100 nominal of gilts at a given price entitles an investor to a fixed and guaranteed coupon payment, on a half-yearly basis, up until the redemption date when the 100 is repaid. In this case, both the magnitude and timing of all payments is known with certainty. Therefore, the return to the investor, also known as the gross redemption yield, is simply the discount rate which equates the present value of the known future cash flows, up until the final redemption date, with the current market price. Alternatively, investors may adopt a required target rate of return as the discount rate in an attempt to determine the worth to them of a gilt and compare this with the current price to determine whether a particular gilt is, in their view, fairly priced. BOND MARKET Similar considerations hold within the corporate bond market. The main difference here is that future payments are dependent on the continued success of a company and, hence, the risk of default must also be factored into any calculations. This is generally allowed for by an addition to the gross redemption yield for a comparable gilt. A more detailed discussion as to the construction of appropriate discount rates is contained in Section 6. ACTUARIAL CALCULATIONS Within actuarial circles DCF techniques are widely used. There are many reasons why this is the case. Firstly, and perhaps most importantly, it enables the assets of a company or pension fund to be calculated in a way which is consistent with the way in which liabilities are assessed. It makes sense that, rather than valuing assets at market value which often reflect short-term vagaries of the markets involved, they are valued on a longer-term basis in line with the valuation of liabilities. This means that DCF variables such as the discount rate (which will generally be the long-term return expected to be earned on new investments in the future) are the same for both assets and liabilities and can be varied to test a companys pension funds financial strength, measured by the excess value of assets over liabilities, under different scenarios. Similarly, if all assets are appraised in this way, the actuary is able to test the sensitivity of total asset values to the changes in the economic factors and financial variables on which they are dependent. Again, this approach ensures that all assets are treated in a consistent way. The use of DCF techniques within financial institutions is, therefore, widespread and ranges from asset/liability modelling for pension fund solvency purposes to assessing sustainable bonus rates on life assurance policies for insurance companies. PROPERTY SECTOR For the property market, the adoption of these techniques will help to put the analysis of property on an equal footing with other assets. The sole reliance on conventional methods of property valuation is perceived by professionals within other markets as being both inaccurate and illogical. Any movement away from these methods would help promote propertys position within the multi-asset portfolio.

3.4 3.4.1

3.5 3.5.1

3.5.2

3.5.3

3.6 3.6.1

16

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WORTH METHODOLOGIES

3.6.2

Notwithstanding the benefits listed above, there is still a certain amount of unwillingness within the property sector to adopt explicit approaches. Much of this centres around the surveyors unfamiliarity with the number of variables needed for such appraisals, the difficulty of analysing comparables, and the general reluctance to forecast or quantify expectations. With respect to the latter, it is incumbent on property researchers to demonstrate the same level of forecasting skills shown in other financial markets. The structure of leases in the United Kingdom, with the historic legacy that most were agreed for a period of 25 years with upwards-only rent reviews, and the over-rented state of many sectors of the market in the 1990s, has certainly assisted in overcoming some of the uncertainty underlying future property cash flows. However, the movement within the industry to shorter leases means that this factor is becoming less helpful in determining cash flows with a great degree of certainty. The popular use of the PE ratio within equities markets shows that simple pricing techniques are applied in other financial markets just as the YP is used in the property market. However, the analysis of the attractiveness of a particular equity will normally be undertaken using an explicit discounted cash flow technique. Therefore, there is no reason why the property sector should not adopt the same explicit DCF approach for calculation of worth. Following the old adage value as you analyse, it is likely that pricing models themselves will become more explicit as more people analyse worth on this basis. This is particularly true when the cash flows produced are either irregular or complex. The use of explicit DCF techniques for pricing is discussed at length in the RICS Information Paper, Commercial Investment Property: Valuation Methods.

3.6.3

3.6.4

3.6.5

17

SECTION 4

DCF MATHEMATICS
PRINCIPAL MESSAGE: The DCF methodologies which underlie any investment appraisal are based on sound and widely accepted mathematical techniques. 4.1 4.1.1 INTRODUCTION Before looking in more detail at the topic of DCF mathematics, it is useful to reiterate both the concept and definition of the Net Present Value (NPV) and Internal Rate of Return (IRR) in a financial appraisal. The NPV of an investment is the present value of all future expected income and capital flows, discounted at the investors target or required rate of return, and in this case it is the assessment of current worth which is the unknown. In the case of IRR analysis, the price of an investment is known, with the unknown being the IRR. This is the discount rate which, when applied to all future expected income and capital flows, equates the price with the present value of these discounted income flows. There are generally accepted mathematical approaches to DCF calculations which can be further expanded to provide additional levels of sophistication. The aim of this section of the Paper is, however, to give a reasonably simplistic overview of the DCF process and, therefore, it will exclude some of the more complicated theoretical issues which can arise, although some of these will be touched on briefly later in this section. DCF CALCULATION The basic form of any DCF calculation is as follows: DCF GPV = CFl + CF2 + CF3 + ....... + CFn + ....... (l + i) (l + i) 2 (l + i) 3 (l + i) n where CFn is the net cash flow in period n, and i is the discount rate or required rate of return per period. 4.2.2 The formula suggests that the analysis is performed by valuing cash flows in perpetuity which is naturally correct for a freehold investment. What actually happens in practice is that a notional sale is assumed at a given date in the future, say after 10 or 15 years or, if more convenient, at the expiry of a lease. This means that the value of the property at this time also has to be estimated and this is generally performed using conventional valuation techniques. Naturally, the further away this notional sale or exit value is, the less impact it has on the calculated net present value because of the effect of discounting. The first stage of any analysis is then to produce forecasts of net cash flows over a specified time period and to decide on the appropriate discount rate to use. For property, which generally produces rental income on a quarterly in advance basis, it is logical to produce estimates of such flows also on a quarterly basis and, hence, the discount rates used in the equation above will also need to be quarterly rates.

4.1.2

4.1.3

4.1.4

4.2 4.2.1

4.2.3

18

D C F M AT H E M AT I C S

4.2.4

It is important to remember that it is net cash flows that are required so that positive income flows in the form of rental income should be adjusted to reflect any necessary expenditure. A further complication is that because of the individual nature of the majority of leases, which naturally has an impact on future rental flows, it is necessary to calculate forecasts of rental income on a lease-by-lease basis. While this may sound like an enormous task, particularly in the case of large shopping centres, there are valuation packages available in the market which do much of the hard work required. In addition, spreadsheets can be used for such purposes and these are reasonably easy to construct and manipulate. An examination of how the necessary cash flows should be generated is shown in Section 5 of this Paper with the derivation of an appropriate discount rate explored further in Section 6. Having established expected cash flows and selected an appropriate discount rate, it is now possible to calculate an estimate of property investment worth. As mentioned above, this can be performed using a spreadsheet. These software packages have built-in functions which perform the necessary calculations automatically, based on given inputs for net cash flows and discount rates. The basic format of the functions to calculate the NPV and IRR within these is as follows: Net Present Value Internal Rate of Return % = NPV (discount rate, range) = IRR (range, guess)

4.2.5

4.2.6

where range represents the range of cells in the spreadsheet containing the cash flow data for each period and the discount rate relates to the target rate of return per period and is expressed as a decimal (e.g. for annual cash flows and an annual target return of 10%, discount rate would be input as 0.1). 4.2.7 Within the IRR function, the result is worked out basically by using a complex method of trial and error. To do this, it is necessary to input an educated guess of the answer to get the process started. Again, this should be entered as a decimal and should relate to the IRR per period. In some instances, particularly in those cases where the calculated cash flows move from positive to negative and back again (or vice versa), there may not be a unique IRR. This is a mathematical aberration. Normally, the differing answers will be far apart, but it would be prudent to test the most likely figure by checking that, at the IRR rate adopted, the NPV does sum to zero. Note that the NPV formula within packages often calculates the net present value of the specified cash flows assuming they are received at the end of each period rather than in advance. If the NPV is to be calculated on the basis that cash flows are received at the beginning of a period, which may often be the case for property, the NPV calculated should be multiplied by (l+i/100) where (i) is the discount rate % per period (see Appendix 2 for an illustrated example). An IRR could be similarly calculated, and in this case the first cash flow should be adjusted to reflect the initial cost or outlay of the investment under consideration (which would be the Gross Purchase Price or Value [GPV] for a new proposition). Clearly, if a purchase is be made at the

4.2.8

4.2.9

4.2.10

19

C A L C U L AT I O N

OF

WORTH

GPV, then the IRR thus calculated will be the target rate of return. If a purchase can be made at a figure below GPV then the purchaser will exceed the required rate of return and vice versa. 4.3 4.3.1 PERFORMANCE MEASUREMENT AND DCF Finally, it is useful to consider how the IRR fits in with the concepts of time-weighted and money-weighted rates of return as ways of measuring property performance, albeit that the latter two are normally used as retrospective measures. These rates of return are defined as follows: (a) Money Weighted Rate of Return (MWRR) The money weighted rate of return is the same as the internal rate of return so that it is calculated by finding the discount rate which equates the initial outlay with the present value of all future cash flows as defined above. (b) Time Weighted Rate of Return (TWRR) This is simply the geometric mean rate of return. It is calculated by taking the nth root of a series of intermediate returns over n periods. For instance, if the returns over four successive periods are 1%, 2%, 3% and 4% say, the TWRR is given by: TWRR = ( (1.01) x (1.02) x (1.03) x (1.04) ) - 1 = 0.024939 (or 2.4939%) It is interesting to note that if there are no intermediate cash flows over the period of analysis, then these two measures will be identical. 4.3.2 The MWRR is currently used by the Investment Property Databank (IPD) to calculate annual property performance. However, such a measure fails to recognise the significance of the timing and magnitude of capital inflows and outflows throughout the measurement period. If one fund experiences a large inflow of investment capital just before a bull market, whereas a competing fund suffers a capital outflow at the same time, the first might appear superficially to have performed better than the latter. The use of TWRR neutralises the effect of cash flow timings so that the relative skill of an individual fund manager can be assessed over the time period. The TWRR is used by IPD to calculate the average annual performance over a number of years. Most analysts within the property profession will adopt an MWRR approach to investment performance measurement. This is driven by general market practice and the methods employed by software packages used for such calculations. Any client instructing a number of valuers to produce assessments of worth on a recognised system can, therefore, be reasonably certain that given the same input for any one asset data, the assessment of worth will not alter markedly between valuers. DCF WORKED EXAMPLE A detailed example of a DCF calculation of worth is attached at Appendix 3.

4.3.3

4.4 4.4.1

20

SECTION 5

TOWARDS AN INDUSTRY STANDARD CASH FLOW DATA

PRINCIPAL MESSAGE: All factual data relating to a property should be incorporated into DCF including the costs of ownership. Care should be taken to avoid the double counting of depreciation through both adjusting rental expectations and exit yields, whilst also allowing for refurbishment and upgrading costs in the cash flow. Worth calculations require the use of output from forecasting techniques.Tax and finance costs can be included at the clients behest, but adjustments to discount rates may be necessary to reflect changed risk profiles. 5.1 5.1.1 INTRODUCTION The use of DCF techniques involves the valuer in assessing a whole variety of variables in order to arrive at a calculation of worth, this being the net monetary worth at a stated date of the benefits and costs of ownership. The process can, however, be divided into three elements: Cash Flow Data Time Horizon Discount Rate This section deals with the first two elements and Section 6 deals with discount rates. 5.1.2 In the Information Paper, Commercial Investment Property: Valuation Methods, differentiation was made between market information and client's judgement on specific information in the undertaking of a DCF valuation. Market information was identified as being current factual data on a property which should not be affected by the specific criteria of clients, and future data, such as future rental value changes and appreciation rates, future redevelopment or refurbishment costs, and exit yield forecasts was identified as being subjective to the client and/or his advisor. Clients specific information included factors such as holding period, loan facilities, taxation and discount rates. In undertaking calculations of worth rather than market valuations, the valuer must have regard to the client's judgement on the inputs to be adopted, other than the current factual matrix of data (i.e. tenure, physical attributes and lease terms). However, he may well ask for the valuers opinions on the inputs and, if requested, the valuer should adopt market-based forecasts for rental and yield movements, rather than the clients own views, and should advise on appropriate discount rates having regard to sector and property specific factors. CASH FLOW DATA Set out in Table 1 are the relevant data and forecasts which should generally be included in the creation of a cash flow. Further comment is appropriate on a number of matters. TAXATION In assessing market value (price), taxation is not usually explicitly factored into the calculation, as comparison-based evidence is generally analysed on rentals and expenditures gross of tax. The use of DCF

5.1.3

5.2 5.2.1

5.2.2 5.3

21

C A L C U L AT I O N

OF

WORTH

TABLE 1: INFORMATION FOR DISCOUNTED CASH FLOW MIGHT INCLUDE: Type of Information Tenure Current Data Title including headlease details (if applicable) Outgoings Head Rents Unfulfilled S106 and highway obligations Floor areas (net and gross) Ancillary ares and car parking Building specifications Tenants improvements Tenancy details Lease expiry dates Break clauses Rent review dates Rent review terms Rents passing (including stepped rents) Estimated rental values Vacancy/void costs Unrecoverable service costs Unrecoverable management costs Letting and review costs Purchase and sale costs Costs of redevelopment/ refurbishment Dilapidations Loan details Break costs Income and capital gains VAT election Capital Allowances Planned or possible changes in areas/parking provision Forecasts

Physical Attributes

Lease/sublease and occupational interests

Future voids Perpetual void allowance

Value

Future local market rents Future rents for the property Future exit yield Inflation in maintenance and running costs

Costs of property ownership and holding costs

Redevelopment/refurbishment

Inflation in building costs

Finance

Changes in interest rates

Taxation

techniques allows taxation to be factored into the calculation. Accordingly, the valuer may feel it appropriate to undertake calculations of worth both with and without taxation implications. 5.4 FINANCE Investment worth calculations should take into account the clients return on equity employed where required, and when instructed by the client, the costs of finance (i.e. interest payments, arrangement fees) can be factored into the cash flow itself. Further adjustment may be necessary to the discount rate adopted to reflect the additional risk incurred by adopting a geared position as opposed to an investment which is 100% equity financed. 5.5 5.5.1 FORECASTS To undertake calculations of worth, it is necessary to forecast likely changes in rental and capital values, yields and inflation in building

22

TOWARDS

AN

I N D U S T RY S TA N DA R D C A S H F L OW DATA

costs, over the holding period. There is a section of the Mallinson Report (paragraphs 9.23 9.28) which deals with the issue of forecasting. Paragraph 9.25 of the Report is worth repeating: True forecasting, in our view, involves the construction of models of the property market derived from insight into the motors of that market and utilising fundamentals derived from wider economic and financial market models. It utilises intellectual disciplines and data sources quite different from those needed for valuation to price. Valuations to [calculations of] worth will utilise the product of such models to assess their variables but do not, in themselves, include forecasting techniques. 5.5.2 The implication of the above is that forecasting should only be undertaken by those who either have, or have access to, the necessary skills to undertake forecasting. It is, therefore, important to establish with the client the basis upon which estimates of future changes in values and yields are to be made. If the client requests the valuer to provide forecasts rather than instructing the valuer to adopt forecasts given by the client, then the valuer should consider whether he has the qualifications appropriate to provide the necessary advice. The situation is made more complicated by the fact that forecasting at the local level is very much less well-developed than forecasting at the national or regional level. The latter is normally based upon econometric modelling of the economy and the property market, identifying relationships which have occurred in the past and using leading indicators or forecasts to produce an estimate of each variable in the future. The former, due to the paucity of the quality and quantity of data at a local level, coupled with the increased importance of the supply side, makes forecasts of property market movements at the individual property level difficult. It should also be noted that there is a distinct difference between a(n) (econometric) forecast and a market expectation. An expectation could be described as an exposition of market sentiment. For example, by knowing that investors require a target return of r%, it is possible to analyse transactions to determine expectations of average annual rental growth. The fact that similar properties are selling for similar prices indicates that this growth expectation is a reflection of market sentiment. It is, therefore, possible within any calculation of worth to simply test the impact of this expectation without the need to resort to a formal forecast. In addition, sensitivity analysis can be undertaken by the valuer by varying rental growth rates above and below perceived market sentiment. Valuers who do not have access to formal forecasts should still be able to make informed comments on prospects for an individual property, but the basis and background to any assumptions made about future changes in rental values, yields and costs should be made clear to the client. Care should be exercised not to double count on depreciation. Forecast changes in rent must take into account the changing physical and functional state of the property over time. Where allowance is made on the cash flow for upgrading, by way of refurbishment costs, rental expectations must also be adjusted.

5.5.3

5.5.4

5.5.5

5.5.6

23

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OF

WORTH

5.6 5.6.1

EXIT YIELD Where a time horizon or holding period of much less than 20 years is adopted, particular care should be taken in considering the appropriate exit yield, as it determines the residual/exit value and may have a significant impact on the worth figure. The exit yield should normally use conventional valuation techniques and also generally reflect the anticipated state of the property, both in physical as well as in tenure/leasing term at the exit date. This should be overlaid with forecast movements in general interest rates and property yields. These forecasts should follow anticipated trend lines and not try to catch volatile market movements in property yields (e.g. as in 1988/89 and 1991/92). It may well be that the exit value reflects land values where demolition of the building(s) is anticipated. In addition, valuers should be careful to avoid the double counting of depreciation. Where allowance has been made for refurbishment and upgrading in the annual cash flow during the holding period, the exit yield should reflect the anticipated state of the property having regard to the completion of the refurbishment programme. This is particularly relevant in multi-tenanted buildings, such as shopping centres, where the landlord can control physical and, to a certain extent, functional obsolescence. TIME HORIZON / HOLDING PERIOD The time horizon adopted for the calculation of worth must be driven by the requirements of the client, although most models used by investors utilise a 5 to 15 year horizon. If details of the cash flow remain the same, there is very little difference in outcome irrespective of whether you use a 10, 15 or 20 year horizon. However, with time horizons much under 10 years, there will be distortions due to the significant impact of purchase and sale costs on the cash flow. The time period to be adopted for the cash flow exercise will also be influenced by material events in relation to the property itself, such as break clauses or lease expiries which can lead to substantial refurbishment expenditure or voids. However, care has to be exercised if worth calculations for different properties are used to compare the advantage of buying one particular property over another, as IRRs used over different time periods do not always make it possible to determine automatically which is the superior investment from the prospective owners point of view.

5.6.2

5.6.3

5.7 5.7.1

5.7.2

24

SECTION 6

RISK ASSESSMENT DISCOUNT RATES

PRINCIPAL MESSAGE: In calculating worth using DCF techniques, care should be taken in the adoption of an appropriate discount rate. The latter can be fully explicit (full risk-adjusted discount rate), partially explicit (partially risk-adjusted discount rate) or the more implicit (single market risk discount rate).The preferred approach can vary but is typically partially explicit. Anyone undertaking a calculation of worth should be careful to avoid double counting of risks either by allowance both in the cash flow and in the exit yield or by allowance both in the cash flow and in the discount rate. 6.1 6.1.1 INTRODUCTION An appropriate discount rate for cash flow analysis of property assets can be defined as that rate of return from an investment that adequately compensates any investor for the risk taken. As risk rises, the compensation for the level of risk rises; this is reflected in a rise in the discount rate. Likewise, if risk falls, the discount rate follows suit. An adequate compensation is usually defined by reference to the return on an alternative form of low risk or riskless asset (usually the gross redemption yield on government gilts or cash). Typically, the riskless return is taken to be the income yield on a long/medium dated government gilt, with 15 to 25 year duration. An adequate return from property investment can then be calculated by adding a suitable allowance for the risk of holding a property asset (a risk premium RP) to the return on a riskless asset (Risk-Free Rate RFR). While this seems a relatively straightforward process, actually determining the risk premium attributable to property assets or indeed any other asset is more complex. Propertys heterogeneity makes the choice or calculation of an appropriate risk premium particularly problematic. Unlike shares in a Public Limited Company (PLC) two property assets are very rarely identical and technically their risk premium will differ on the vast majority of occasions. What then are the salient factors in deriving a property risk premium? (a) Risk-free rate of investment; (b) Illiquidity upon sale (e.g. lot size, transaction times, availability of finance); (c) Failure to meet market rental expectations (forecast rental growth); (d) Failure to meet market yield expectations (forecast yield shift); (e) Risk of locational, economic, physical and functional depreciation through structural change; (f) Risks associated with legislative change (e.g. planning/privity of contract, changes in fiscal policy); (g) Tenant default on rental payment (covenant risk); (h) Risk of failure to relet (void risks); (i) Costs of ownership and management; and (j) Differing lease structures (e.g. rent review structure, lease breaks) 6.1.4 Factor (a) is commonly taken to be the gross redemption yield on U.K. gilts. The choice of gilt can vary; typically a medium-dated gilt is taken although some investors prefer to match their choice of gilt term with the unexpired lease term on an investment. Additionally, some investors may choose to use the real return of index-linked gilts. If this approach is adopted, then inflation expectations become a factor which must be explicitly incorporated into the risk premium.
25

6.1.2

6.1.3

C A L C U L AT I O N

OF

WORTH

6.1.5

Factors (b)(f) are generally regarded as the risks of structural change or market failure which may affect the market as a whole, particular subsectors or groups of property. The structural impacts on the in-town retail market brought about by the introduction of out-of-town retailing and changes to property taxation such as Value Added Tax (VAT) would be good examples of this. As such, these risks could be called market or systematic risks. Factors (g)(j) are, broadly speaking, risks associated with individual assets. These risks could be described as property, non-market or unsystematic risks. These definitions (market/non-market) are relatively broad as none of factors (b)(j) are entirely separable or mutually exclusive. For example, the risk of failure to meet market yield expectations could be a function of any one of, or a combination of, factors. Quite clearly then, the degree of separation of the various risk factors and their incorporation into a DCF are of key importance in the validity of an appraisal. The accepted market norm has been that certain elements of risk are best incorporated through adjustment of the discount rate and that certain risks are best incorporated in the cash flow itself. In terms of property risks, market risks (factors (b)(j)) are typically incorporated in the discount rate, whereas non-market property risks (factors (g)(j)) are built into the cash flow. However, there are a number of technically correct approaches to incorporating risk into the cash flow which requires examination. FULL RISK-ADJUSTED DISCOUNT RATE (FRADR) Simplistically, if it were possible to ascribe a risk premium to each of the above factors, their sum (taking into account separation/exclusivity) would then give an accurate risk premium for each property asset. When combined with the appropriate Risk-Free Rate this would effectively be a Full Risk-Adjusted Discount Rate (FRADR) for an individual asset to be applied to the cash flow. However, there are a number of inconsistencies and problems in this approach: (a) Determining separate risk premia for each risk factor is a complex and time consuming process, requiring specific research, which in the vast majority of cases would be either impossible to calculate (given the paucity of, and secrecy attached to, individual property data) or impractical given the scope and size of the various investment markets; and (b) We have already seen that there is some degree of overlap between risk factors. Even in such a risk explicit approach, it is very difficult to eliminate double counting of risk in some form. This is largely a reflection of the valuers tendency to include some reflection of risks implicitly within an exit yield in establishing the residual/exit value in a DCF. Additionally, it is commonly regarded as more appropriate to incorporate some of the risks in the cash flow appraisal itself (e.g. reflecting the risk of increased void levels in a property by adjusting the length of the void period in the appraisal while still adjusting the discount rate applied).

6.1.6

6.1.7

6.1.8

6.2 6.2.1

6.2.2

26

R I S K A S S E S S M E N T D I S C O U N T R AT E S

6.2.3

It is, therefore, necessary to question whether there are more appropriate methodologies which are both less time consuming and allow for a clearer separation of risks within the appraisal. SINGLE MARKET RISK PREMIUM (SMRP) When combined with the risk-free rate of return, one such approach would be the application of a single risk premium for all property assets. This assumes that investment in any assets carries more risk than investment in cash, and that irrespective of type of assets (equities, property, etc.) there are common risks of investment which do not differ substantially across asset classes. However, in actual terms it is recognised that investment held in property is generally less liquid than that held in shares. Hence, a premium can be derived to account for the return required to compensate an investor in a single market (e.g. property as opposed to gilts or equities) for the risks (of market failure or liquidity). This risk premium is then applied in addition to the risk-free rate to give an appropriate discount rate for the calculation of investment worth. However, it should be recognised that risks may also differ within single markets between sub-sectors (e.g. in equities between FTSE 100 and FTSE All Share stocks, or in property between high street shops and secondary industrials) or indeed between single assets (e.g. BT shares and MEPC shares). This is accounted for in the SMRP approach to property appraisals by assuming that where risks differ substantially between the SMRP approach to investment sub-sectors and assets (e.g. high street shops to M25 offices) such differentials can be reflected in a DCF implicitly by adjusting the exit yield (in the case of property) applied to the asset in the DCF. This then accounts for future market risks (changes to the structure and maturity of parts of the market, shifts in rates of depreciation or changes to legislation). Further property risks (e.g. voids, management costs) are then incorporated explicitly in the income/expenditure side of the cash flow itself. Hence, it is possible to apply a single risk premium to all property assets and allow the DCF to mop up the other more property-related factors by adjusting both the exit value and the income stream in the cash flow itself. The SMRP approach is based on the assumption that different types of risks can be grouped together and accounted for in a single premium. A grouped approach requires that, rather than assess every risk for each asset, it is possible to group assets with similar investment characteristics and ascribe risks on a grouped basis to these common characteristics. It is an approach to DCF appraisal known to be used by the actuarial profession in calculating investment worth. In strict mathematical terms, this methodology is perfectly valid, in much the same way as the FRADR. Indeed, it is by nature considerably easier both to derive and to apply a single risk premium to an appraisal and allow the valuer to alter the cash flow and the exit value at his discretion. However, many of the problems associated with the application and use of FRADR apply to the SMRP.

6.3 6.3.1

6.3.2

6.3.3

6.3.4

6.3.5

6.3.6

6.3.7

6.3.8

6.3.9

27

C A L C U L AT I O N

OF

WORTH

6.3.10

The SMRP approach does not make it any easier to eliminate double counting of risks and actually determining the significance placed upon various market risk issues (depreciation, structural market shifts, etc.) becomes more difficult as they are largely implicitly incorporated in the exit value of the cash flow rather than explicitly being reflected in the discount rate. Although the SMRP technique is easier to apply in practice and, therefore, deals with many of the complexities highlighted in the FRADR approach, it is opaque as an analysis tool and, therefore, is not an appropriate choice in a calculation of worth for a sophisticated investor/owner of property. PARTIALLY RISK-ADJUSTED DISCOUNT RATE (PRADR) Despite the drawbacks of an SMRP approach, it does offer a more simplistic and usable analysis tool. This suggests that an intermediate approach may offer an alternative and more sophisticated mechanism for assessing worth. Certain investors have adopted an intermediate analysis tool which could be defined as a Partially Risk-Adjusted Discount Rate (PRADR) for use in DCF appraisals. Using the same risk-free rate of return, the PRADR assumes that it is possible to group asset classes in a similar manner as the SMRP approach (as detailed in 6.3.4). This permits the derivation of an overall asset class risk premium (i.e. property risk premium). The PRADR approach then differentiates between the different risk profiles of sub-sectors of individual asset classes (e.g. within property high street shops, secondary industrials) by adjusting up or down the market risk premium to reflect the risks associated specifically with the sub-sector of property being analysed. This is a less time-consuming methodology and can also be extended to grouping individual property risk characteristics (e.g. properties with similar covenant risks or lease structures). If such risks are grouped, each may also be ascribed a risk premium. When added to the risk-free rate and the market risks rate, the total represents a Partially RiskAdjusted Discount Rate. In doing so, the PRADR then becomes more transparent and sophisticated than the single premium approach without necessarily becoming onerous to perform. This approach is often associated with the phrases target rate or hurdle rate. The following example shows how such an intermediate approach may be built up: HIGH STREET SHOPS Risk-Free Rate Market Risks + Sub-Sector Risk of Market Failure (liquidity, poor rental or yield performance) + Allowance for Sub-Sector Depreciation Property Risks + Covenant Adjustment for Sub-Sector (or lease structures) = Partially Risk-Adjusted Rate of Return for High Street Shops (incorporating grouped property risks)

6.3.11

6.4 6.4.1

6.4.2

6.4.3

6.4.4

6.4.5

6.4.6

28

R I S K A S S E S S M E N T D I S C O U N T R AT E S

Any remaining cost issues (e.g. fees, management, dilapidation and minor works) are then reflected in the cash flow itself. 6.4.7 Does this methodology solve all the problems? It does allow the investor to build a relatively transparent model for the appropriate discount rate, making a great deal of the process explicit without necessarily committing to intensive research for each property appraisal. However, it is not a panacea, and if applied in too much detail it merely becomes a FRADR approach. It should be emphasised that while the more explicit analysis limits the effects of double counting of risk in an appraisal, this methodology is not an improvement on the FRADR but merely a simplified form. It is, therefore, a less adequate methodology for determining if any double counting of risk occurs. It would seem that irrespective of approach to the selection of the discount rate, the problems of double counting risk can only be dealt with by careful application of the analysis tool chosen. CHOICE OF THE APPROPRIATE RATE In the majority of circumstances, investors will already have set appropriate discount rates (target rates) for a calculation of worth. However, it is not uncommon for a valuer to be asked to contribute an opinion in the selection process. At the very least, the valuer should be conversant with the clients thinking in determining the discount rate as this may affect his treatment of other elements of the cash flow. In practical terms calculations of worth will typically take the form of a partially adjusted approach (PRADR). This reflects the fact that worth to an investor/owner incorporates perceptions of risk in the market that are particular to the individual and likely to differ between groups of assets. This coincides with the practical need to apply methodology, which is relatively explicit without being onerously complex in practice (the FRADR being too impractical and in many cases impossible to apply in practice). Although the Partially Risk-Adjusted Discount Rate (PRADR) relies on the simpler principle of grouping risks, particular risk factors specific to an individual asset may occasionally be reflected in the discount rate (e.g. it would not be unusual for a valuer to adjust a discount rate for a shopping centre to reflect the risk of direct competition from a nearby scheme under construction). This reinforces the idea that the PRADR lies between a FRADR and SMRP approaches and as such any PRADR analysis can be adapted to the level of complexity individual investors/ owners (or valuers) wish to (or think appropriate to) incorporate in their analysis. It will, therefore, be common practice to apply a single discount rate, constructed in a manner reflecting the differing risks in the cash flow and the degree of complexity of the analysis. However, there are occasions when calculating GPV that valuers commonly use more than one discount rate when two or more sources of cash flow have quite different risk profiles, most particularly for over-rented type investments. While this is a mathematically correct approach to reflect the differing risks on income flows, this further increases the problems associated with double counting and care should be taken in ensuring the integrity of the cash flows analysed.

6.4.8

6.5 6.5.1

6.5.2

6.5.3

6.5.4

29

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OF

WORTH

6.5.5

It should be noted that none of these approaches can in their own right provide a foolproof methodology by which an individual calculating investment worth can eliminate the problem of double counting risks. As such, the approaches should be applied with care to ensure the least amount of overlap practically possible.

30

SECTION 7

INSTRUCTIONS, CAVEATS AND REPORTING TO CLIENTS

PRINCIPAL MESSAGE: Valuers should follow the requirements of the RICS Appraisal and Valuation Manual in taking instructions and reporting the results. Clarity regarding sources of information and assumptions used is good practice. Calculations of worth are not valuations and publication should be discouraged. 7.1 7.1.1 INTRODUCTION In Section 2, the calculation of worth was differentiated from an estimate of the market price of an asset which may be assessed by use, inter alia, of the definitions of Market Value, Open Market Value, and Estimated Realisation Price. Special care needs to be taken to clarify the basis of worth calculations, to avoid misleading or confusing those who are relying upon them. This section sets out practical guidelines for those preparing worth calculations. INSTRUCTIONS Instructions to provide a calculation of worth should be made or confirmed in writing, and it is recommended that the relevant provisions of Practice Statement 2 (PS 2), on the Clarification and Agreement of Conditions of Engagement, be applied. PS 2 refers to the Valuer and the Valuation. These words have been retained for use in this section although the calculation of worth is clearly differentiated from a valuation. The Principal Message of PS 2 is that, Valuers must establish their Clients needs and confirm the service to be provided before the valuation is reported. The following steps are, therefore, recommended, using the words and intent of PS 2 wherever possible: (a) Establishing the Clients needs and requirements To achieve client satisfaction and minimise the scope for misunderstanding and subsequent dispute, it is essential that whenever possible the Valuer seeks to establish and understand at the outset the Clients needs and requirements. The process also enables the Valuer to satisfy himself that he is able to meet these needs and requirements and the Client and/or his professional advisers to know in advance what they can reasonably expect to receive and what responsibilities the Valuer will and will not accept. (PS 2.1.1) (b) Recording the service to be provided Since disputes may arise many years after... [the calculation of worth]... has been provided, it is important to ensure that the agreement between the parties is contained in, or evidenced by, comprehensive documents. (PS 2.2.1) There are standard conditions and model conditions of engagement provided in the Manual for preparation of valuations and appraisals, which would not normally be relevant in their entirety for the preparation of calculations of worth. However, it is recommended that in advance of carrying out the work the valuer sets

7.2 7.2.1

7.2.2

7.2.3

31

C A L C U L AT I O N

OF

WORTH

out in writing the purpose and basis of his calculations, and the limit to the valuers liability for them (see Caveats in 7.4). As the calculation of worth is not generic but designed for the Client in question, the Valuer should confirm to the Client that the calculation is to be used by the Client and its professional advisers, but is not intended to be available or suitable for use by third parties. The Client may well supply information to the Valuer to assist in the calculation, including in-house forecasts of rental growth, yields or interest rates and property specific data. The source of such data should be given from the outset. It is acknowledged that chartered surveyors may not always have the capability of undertaking economic modelling and forecasting themselves and will rely on material provided by the Client, or by relevant and reputable commentators, or on commonly held market assumptions. All of the above are acceptable, so long as the basis is agreed in advance with the Client and the report makes clear the source and the nature of the assumptions utilised. 7.3 7.3.1 REPORTS Calculation of worth should be provided in writing with supporting notes and calculations. The basis of the calculation must be clearly explained, and the basis or source of the following should be clearly identified: (a) (b) (c) (d) 7.3.2 The discount rate; The timescale; The mathematical calculation; and The factual and estimated data.

Areas of potential value or cost which have been excluded should be identified. The validity of the principal assumptions should be examined, and the Clients attention should be drawn to assumptions which are not standard market practice. This particularly applies to estimates of inflation, rental growth and interest rates. CAVEATS Reliance upon Assumptions and Information Provided: The report should confirm that the calculation of worth is based upon information provided and assumptions made, and if these are varied, the calculation may provide a different result. Distinction between a Valuation and Calculation of Worth: Whenever a calculation of worth is to be provided, a statement as to the extent to which it differs from the Valuers opinion of Market Value or Open Market Value must be given. A calculation of worth must never be described in a Report or published reference thereto as a valuation. (PS 3.1.3)

7.4 7.4.1

7.4.2

7.4.3

If the Valuer has not been instructed to provide an opinion of Market Value or Open Market Value, the report should state that the calculation of worth is not to be regarded as a substitute for an opinion of Market Value or Open Market Value and should not be relied upon as such. Published Reference to Calculations of Worth: Whilst valuations are frequently contained in published documents, it is not normally appropriate for calculations of worth to be made public as they will vary

7.4.4

32

I N S T R U C T I O N S , C AV E AT S

AND

REPORTING

TO

CLIENTS

depending on the specific use as determined by the Client which may involve volatile and subjective assumptions about the future. Where published reference is to be made to the calculation, a statement should accompany the reference stating that the calculation is specific to the Client, and that it is not suitable for use by any third parties. The basis of the calculation should be clearly set out, and attention drawn to any unusual assumptions that have been made. 7.4.5 Extent of Liability: As a general principle the Valuer has a duty of care to the Client in relation to the preparation of calculations of worth, including the mathematical integrity of the calculation, the incorporation of relevant information and the use of any unusual assumptions. However, the Valuer is not responsible to the Client in relation to purchase decisions made upon a calculation of worth, which is necessarily subjective and specific. It is good practice, therefore, for the Valuer to incorporate the following caveat: No responsibility can be held by the Valuer for the use of this calculation of worth, which incorporates assumptions about the future which may or may not prove to be correct.

33

SECTION 8

CONCLUSION
8.1 The Mallinson Report has served to highlight the need to understand the difference between worth, price and value. This Paper has sought to explain the difference and to set the framework for the methods considered generally appropriate for the calculation of worth for investment purposes. The brief survey of the approach to the subject of worth calculations in other investment markets has led to the conclusion that the use of explicit Discounted Cash Flow techniques is appropriate for property investment worth calculations. As worth is personal to each investor, valuers should only undertake calculations of worth in conjunction with the investor utilising, if so instructed, the parameters set out by the investor. In practice, the investor is more than likely to seek the valuers own views on most of the ingredients which are used in a DCF-based worth calculation. However these ingredients are determined, the valuer must clearly identify them in the report to the investor. The product of the Discounted Cash Flow is usually very sensitive to changes in the main elements such as the discount rate, the levels of income growth and the amount of the exit value. It is helpful to the investor if sensitivity analyses are carried out to demonstrate the level of variation in the Gross Present Value resulting from changes to the inputs, thereby establishing the robustness of the worth figure. Calculations of worth can assist the valuer in undertaking a normal Open Market Valuation, particularly where there is a dearth of relevant comparable evidence, provided that the ingredients used in undertaking such a calculation reflect general market sentiment. Where a property investment agent is asked to give advice to an investor on a purchase or a sale, the agent may well be expected to respond at two levels. The first is to advise whether the price reflects, in the opinion of the agent, the lowest (purchase) or highest (sale) figure achievable in all the circumstances. The second is whether the property is worth the price negotiated. This second question is now more frequently being asked of investment agents even though they may not be retained by the investor in a fund advisory role. The ability or otherwise of agents to provide calculations of worth will increasingly determine whether they are retained on investment agency work. One of the most contentious areas of the use of Discounted Cash Flows is the method adopted to reflect risk. This can either be accounted for by adjustments to the cash flow or by adjustments to the risk rate (discount rate). Even if the valuer or investor chooses to reflect risk entirely through varying the discount rate, the market has not developed mechanisms for determining with certainty the amount of adjustment to the discount rate to reflect variations to the risk profile of different properties. This is an issue which the property industry would be well advised to investigate or research further so as to improve market efficiency and reduce the chances of general mispricing of property against other asset classes, or within property sectors. This Paper relates to the calculation of worth of investment properties. Occupational worth introduces wider ranging issues which in many

8.2

8.3

8.4

8.5

8.6

8.7

8.8

34

CONCLUSION

respects are more complex, but this should not deter the property world from attempting to establish appropriate methods of calculation in the future. 8.9 This Paper is intended to be informative rather than prescriptive not least because the processes involved in calculations of worth are likely to be subject to evolutionary change. This is to be welcomed.

35

APPENDIX I

GLOSSARY OF DCF TERMINOLOGY

The aim of this appendix is to define and provide guidance on the vocabulary generally used in discounted cash flow appraisal work. This will concentrate on the definitions of yields, rates and returns usually encountered in the area of property valuation, appraisal and calculation of worth. Definitions marked (*) are taken from The Glossary of Property Terms, compiled by Jones Lang Wootton in association with Estates Gazette and South Bank University (previously South Bank Polytechnic) and are used with the permission of the bodies noted.

All-Risks Yield (*)

The remunerative rate of interest used in the conventional valuation of freehold and leasehold interests, reflecting all the prospects and risks attached to a particular investment. The increase or decrease in value over a given period, after allowing for capital expenditure, expressed as a percentage of the capital employed over the period. Decrease in value of real property caused by obsolescence, deterioration in its condition or other factors. Technique used in investment and development appraisal whereby future inflows and outflows of cash associated with a particular project are expressed in present-day terms by discounting. The rate, or rates, of interest selected when calculating the present value of some future cost or benefit. In valuing an investment property the internal rate of return, being the discount rate which needs to be applied to the explicit flow of income expected during the life of the investment so that the total amount of income so discounted at this rate equals the capital outlay. Rents at review, lease renewal or reletting take account of expected future rental changes due to variations in the value of money, i.e. the calculation reflects the valuer's views on the impact of inflation (or if he thinks so, deflation) as well as their views on rental changes due to other factors. It is the IRR where cash flow changes are allowed for explicitly.

Capital Return

Depreciation (*)

Discounted Cash Flow (DCF)(*)

Discount Rate (*)

Equated Yield (*)

Equivalent Yield (*) In valuing an investment property, the one rate of discount which, when applied to all income flows being discounted, produces a present value equal to the capital value of the investment. The income reflects current actual rents and costs and current levels of rental values. It is the IRR where cash flow changes are allowed for implicitly. Exit Value In DCF appraisals, the capital value of the investment property at the end of the period of analysis, often calculated using traditional techniques.

36

GLOSSARY

OF

DCF TERMINOLOGY

Exit Yield

In DCF appraisals, the yield adopted in the calculation of the exit value. This is often expressed in terms of either an initial or equivalent yield. When applied to investment performance, the average rate of return over a given period. This is calculated by compounding individual period returns over n periods say and taking the nth root of this product. An example of this would be the TWRR. The discounted or present value of a series of future cash flows where the initial outlay is not included as an outflow. The GPV is therefore the worth of the cash flow at the investor's target rate of return. Usually relating to government fixed interest stock or gilts, the guaranteed return to an investor before tax given a purchase at the market price and the stock is held until redemption. The net income receivable in a given period expressed as a percentage of the capital employed over the same period. The rate of interest (expressed as a percentage) at which all future cash flows (positive and negative) must be discounted in order that the net present value of those cash flows should be equal to zero. The money weighted rate of return is the same as the internal rate of return.

Geometric Mean

Gross Present Value (GPV)

Gross Redemption Yield (*)

Income Return

Internal Rate of Return (IRR) (*)

Money Weighted Rate of Return (MWRR) (*) Net Present Value (NPV)

The discounted or present value of a series of future cash flows where the initial outlay is included as an outflow. The NPV is therefore the surplus or deficit present valued monetary sum above or below the initial outlay (purchase price). The return on an investment calculated by reference to cash flows expressed in monetary or actual terms. (See also real return.) This is one of the causes of depreciation. It may be a decline in utility (economic obsolescence), physical usage (physical obsolescence) or due to changes in user preference over time (functional obsolescence).

Nominal Return

Obsolescence

Opportunity Cost (*) The return or other benefit foregone in pursuing one particular investment opportunity rather than another. Overage Income (Froth Income) That part of income receivable in excess of a base rent. It will commonly, but not exclusively, be a rent in excess of the rental value which is secured only by the ability of the tenant to pay the rent. The investment return remaining after the effects of inflation have been stripped out of the performance calculation being used.

Real Return

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OF

WORTH

Rental Growth

The rate of change, increase or decrease, applied to current market rental values to derive a forecast level of rental value at a date in the future. The target rate of return.

Required Rate of Return Risk-Adjusted Discount Rate

Derived from the sum of the risk-free rate of return plus the risk premium, the rate of interest used to discount future cash flows in an appraisal of investment value. Often quoted with reference to a fixed interest gilt, this is the guaranteed nominal annual return (redemption yield) that can be obtained by holding such an asset to its redemption date. This is the addition made to the risk-free rate of return to reflect the extra return required by an investor, over and above the risk-free rate, which fully compensates for the extra risks associated with a given investment.

Risk-Free Rate of Return

Risk Premium

Sensitivity Analysis A series of calculations in a financial appraisal or calculation of worth which involves one or more variables, where the variables are modified in a structured manner to show differing results. Both sensitivity analysis and simulation analysis are sometimes termed scenario testing. Simulation Analysis A method of investment or development appraisal analysis which involves a statistical extrapolation in the selection of the variables used in the appraisal process. This may be done by a number of methods. However, the most popular is Monte Carlo simulation analysis which is normally based on the generation of variables related to a random number generator. Alternatively, other statistical techniques, such as fuzzy logic, might be used. Both sensitivity analysis and simulation analysis are sometimes termed scenario testing. Target Rate of Return A criterion rate selected in a particular instance to reflect the opportunity cost of money. This is often based on the redemption yield of government stock with a percentage addition or a discount to reflect the nature and risks of the project, but it may be comparative with other potential property investments. The geometric mean rate of return. It is calculated by taking the nth root of a series of intermediate returns over n periods. The sum of capital return and income return as defined above. This is a form of money weighted rate of return.

Time Weighted Rate of Return (TWRR) Total Return

38

APPENDIX II

ADJUSTING DCF CALCULATIONS TO ALLOW FOR PERIODIC CASH FLOWS IN ADVANCE

The NPV formula within spreadsheet packages often calculates the Net Present Value of the specified cash flows assuming they are received at the end of each period rather than in advance. If the NPV is to be calculated on the basis that cash flows are received at the beginning of a period, which may often be the case for property, the NPV calculated should be multiplied by (1 + i/100) where (i) is the discount rate % per period. The above is best illustrated by way of an example. Assume the net quarterly cash flows including the notional sale value at the end of the period of analysis for a ten year DCF appraisal are entered into cells A1 to A40 of a spreadsheet. A1 represents the net cash flow in quarter 1, A2 the flow in quarter 2 and so on up to cell A40 containing the exit value. Then, to calculate the net present value using an annual discount rate of i%, with i expressed as a decimal, and to show the answer in cell A41, simply type the following formula into cell A41: = NPV((1+i)^0.25-1, A1...A41)*(1+i)^0.25 The expression (1+i)^0.25-1 converts the annual discount rate i to an equivalent quarterly rate, while (1+i)^0.25 is used to convert the payments to be discounted from quarterly in arrears to quarterly in advance. Note that in both expressions, the ^ character is a to the power of and * is a multiplication.

39

APPENDIX III

DCF EXAMPLE OVER 10 YEARS, A S AT D E CE MBE R 1996

This appendix contains two examples of calculations of worth using Discounted Cash Flow techniques. These highlight the fact that the approaches adopted may often vary depending on the nature of the investment being appraised. E XAMPLE N O. 1 SINGLE-LET MODERN RACK-RENTED OFFICE (Worth calculation as at December 1996) 1. Lease Details Area 4,645 sq.m. (50,000 sq.ft.) Blue Chip Tenant Open Market Rental Value 1,000,000 p.a. (215 per sq.m./20 per sq.ft.) Rent Passing 1,000,000 p.a. (215 per sq.m./20 per sq.ft.) New 10-year lease from December 1996, with 5-year reviews. In view of the term of the lease, it is logical to perform the analysis over a 10-year period. 2. Assumptions on Lease Expiry Property is immediately relet by way of lease renewal. No refurbishment costs, letting fees or incentives are necessary. 3.
YEAR

Economic Assumptions
RENTAL GROWTH % PER ANNUM ESTIMATED RENTAL VALUE () AT YEAR END 1,000,000 10 2 1 -3 2 4 4 4 4 4 1,100,000 1,122,000 1,133,220 1,099,223 1,121,208 1,166,050 1,212,698 1,261,206 1,311,655 1,364,121

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

4.

Exit Value Exit value in December 2006 calculated using an all-risks yield of 8%.

40

DCF EXAMPLE

OVER

10 YEARS

5.

Discount Rate A single discount rate or equated yield of 10.75% per annum, equivalent to a quarterly rate of 2.59% is constructed as follows: Risk-Free Rate 7.75% Market Risk Property-Tenant Risk 2.00% 1.00% 10.75% per annum

6.

Explanation of Calculations The attached Discounted Cash Flow Schedule, Figure 1, results from the factors outlined above. The following provides an explanation of individual elements of these calculations.

6.1

Rent Passing This is fixed at 1,000,000 per annum or 250,000 per quarter for the first five years. In December 2001, on rent review, and assuming the rental growth rates given above apply, then the rental value is projected to be:

1,000,000 x 1.10 x 1.02 x 1.01 x 0.97 x 1.02

= 1,121,208 per annum = 280,302 per quarter

This is fixed until lease expiry in December 2006. 6.2 Exit Value In December 2006, at lease expiry, the rental value is projected to be 1,364,121 per annum. At an all-risks yield of 8%, the gross exit value, assuming the property is immediately relet at the then rental value, is calculated as: Rent passing YP perp @ 8% 1,364,121 per annum 12.5 17,051,513 6.3 Exit Costs It is noteworthy that the Exit Value adopted in this example is not adjusted to reflect notional purchasers costs or vendor/sale costs which would be incurred if an actual sale is contemplated at the end of the tenth year. The arguments in favour of using Exit Values gross of costs are based on the fact that conventional valuations do not deduct such costs, usually because the valuer is anticipating that cash flows will continue in perpetuity. There is no right or wrong answer to this point. Worth calculations should be undertaken and reported in an open fashion and the assumptions clearly stated. Consistency of approach is the important issue.

41

C A L C U L AT I O N

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WORTH

6.4

Other Costs No deductions have been made for rent review costs, management fees or lease renewal costs. These could legitimately be deducted but the policy of the user of the worth calculation to cost deductions should be incorporated. Care should be taken not to burden the calculation with too much insignificant detail which will lead to a degree of spurious accuracy.

7.

Worth The attached Discounted Cash Flow Schedule, in Figure 1, shows a Gross Present Value as at December 1996 of 12,776,977. This is the worth to the investor of this property given the assumptions adopted. It can be used to compare one investment with another or the particular investment with its Open Market Value. Care should be taken when comparing worth with Open Market Value either to adjust the former downwards or the latter upwards to allow for notional purchasers costs.

42

DCF EXAMPLE

OVER

10 YEARS

FIGURE 1: DISCOUNTED CASH FLOW SCHEDULE

EXAMPLE 1: SINGLE-LET MODERN RACK-RENTED OFFICE

Quarterly Cash Flows Quarter 1997.00 1997.25 1997.50 1997 75 1998.00 1998.25 1998.50 1998.75 1999.00 1999.25 1999.50 1999.75 2000.00 2000.25 2000.50 2000.75 2001.00 2001.25 2001.50 2001.75 2002.00 2002.25 2002.50 2002.75 2003.00 2003.25 2003.50 2003.75 2004.00 2004.25 2004.50 2004.75 2005.00 2005.25 2005.50 2005.75 2006.00 2006.25 2006.50 2006.75 2007.00 Rental Income 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 17,051,513 Exit Value Net Cash Flow 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 250,000 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 280,302 17,051,513 10.75% 2.59% 12,776,977 12,435,000 Present Value Factor 1.000000 0.974797 0.950229 0.926280 0.902935 0.880178 0.857994 0.836370 0.815291 0.794743 0.774713 0.755187 0.736154 0.717601 0.699515 0.681885 0.664699 0.647946 0.631616 0.615697 0.600180 0.585053 0.570308 0.555934 0.541923 0.528265 0.514951 0.501972 0.489321 0.476989 0.464967 0.453248 0.441825 0.430689 0.419835 0.409253 0.398939 0.388884 0.379083 0.369529 0.360216 TOTAL Present Value 250,000 243,699 237,557 231,570 225,734 220,044 214,499 209,093 203,823 198,686 193,678 188,797 184,039 179,400 174,879 170,471 166,175 161,987 157,904 153,924 168,232 163,992 159,858 155,830 151,902 148,074 144,342 140,704 137,158 133,701 130,331 127,046 123,844 120,723 117,680 114,715 111,823 109,005 106,258 103,580 6,142,223 12,776,977

Discount Rate Per Annum Discount Rate Per Quarter DCF Value (Gross) at December 1996 Total DCF Value (Net), say

43

C A L C U L AT I O N

OF

WORTH

E XAMPLE N O.2 SINGLE-LET OVER-RENTED FREEHOLD CITY OF LONDON OFFICE (Worth calculation as at December 1996) 1. Lease Details Area 4,645 sq.m. (50,000 sq.ft.) Blue Chip Tenant Rent Passing 2,000,000 p.a.(431 per sq.m./40 per sq.ft.) Open Market Rental Value 1,000,000 p.a.(215 per sq.m./20 per sq.ft.) Lease Expiry Date 2. March 2001

Assumptions on Lease Expiry All Costs in Present-Day Terms Property is modestly refurbished at a cost of 377 per sq.m. (35 per sq. ft.). Refurbishment takes 6 months, followed by a 6-month void. Letting fees at 15% of agreed rent. Marketing costs of 20,000, spread evenly over the void period, and 12 month rent-free period. Empty rates at 108 per sq.m. (10 per sq. ft.) p.a. Holding costs at 27 per sq.m. (2.50 per sq. ft.) p.a. ERV of refurbished space 269 per sq.m. (25 per sq.ft.) p.a. Assume rateable value does not change over the analysis period.

3.

Economic Assumptions
Rental Growth % p.a.* Current 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 5 9 2 0 -2 2 2 2 2 2 Refurbished 7 12 5 2 0 3 3 3 3 3 Estimated Rental Value (p.a.) at Year End Current 1,000,000 1,050,000 1,144,500 1,167,390 1,167,390 1,144,042 1,166,923 1,190,262 1,214,067 1,238,348 1,263,115 Refurbished 1,250,000 1,337,500 1,498,000 1,572,900 1,604,358 1,604,358 1,652,489 1,702,063 1,753,125 1,805,719 1,859,891

* Property specific growth rates

BCIS Inflation General Price Inflation 4. Exit Value

5% p.a. throughout 3% p.a. throughout

December 2006 calculated using an equivalent yield of 8.00%. 5. Explanation of Calculations The attached Discounted Cash Flow Schedules 2a and 2b result from the factors outlined above. The following provides an explanation of individual elements of these calculations.

44

DCF EXAMPLE

OVER

10 YEARS

5.1

Rent Passing This is fixed at 2,000,000 per annum or 500,000 per quarter until lease expiry in March 2001. If there was a rent review between the analysis date and expiry, it would be necessary to check the level of rent passing at this time against the projected level of ERV, allowing for rental growth on current, unrefurbished space, as shown above. Generally, but depending on the terms of the lease, the expected rent from this date would be taken as the higher of rent passing and the projected rental value. In March 2001, a six-month refurbishment takes place followed by a sixmonth void before letting in March 2002. The letting is expected to be at the projected level of market rents for refurbished space in March 2002 and is calculated as: 1,250,000 x 1.07 x 1.12 x 1.05 x 1.02 x 1.00 x 1.0074* = 1,616,258 p.a. = 404,064 p.q. assuming rental growth is spread evenly throughout each year. (* the quarterly compound equivalent of 3% per annum growth)

5.2

Miscellaneous Costs In quarters 2001.25 to 2002.25 there are a number of costs/outgoings which are more particularly described as follows: Quarters 2001.25 to 2001.50 Refurbishment: Todays costs of 377 per sq.m. (35 per sq.ft.) for 4,645 sq.m. (50,000 sq.ft.) totalling 1,750,000 have been inflated at the building cost inflation forecast of 5% per annum over a period of 4.25 years to March 2001. 1,750,000 x (1.05)4.25 = or 2,153,240 1,076,620 per quarter for 2 quarters

Quarter 2001.75 Rates 4,645 sq.m. (50,000 sq.ft.) x 108 per sq.m. (10 per sq.ft.) Holding Costs 4,645 sq.m. (50,000 sq.ft.) x 27 per sq.m. (2.50 per sq.ft.)

= 500,000 per annum = 125,000 per quarter 125,000 per annum 31,250 per quarter 31,250 x (1.03)4.75 35,961 10,000 x (1.03)4.75 11,507 172,468

= = Plus inflation at 3% per annum for 4.75 years = = Marketing costs @ 10,000 per quarter Plus inflation at 3% per annum for 4.75 years = = Total costs for quarter 2001.75 =

Quarter 2002.00 Rates (as above) = 125,000 per quarter Holding Costs 4,645 sq.m. (50,000 sq.ft.) x 27 per sq.m. (2.50 per sq.ft) = 125,000 per annum = 31,250 per quarter Plus inflation at 3% per annum for 5 years = 31,250 x (1.03)5 = 36,227

45

C A L C U L AT I O N

OF

WORTH

Marketing costs @ 10,000 per quarter Plus inflation at 3% per annum for 5 years Total costs for quarter 2001.75 Quarter 2002.25 Letting fees Agreed rent Letting fees @ 15%

= 10,000 x (1.03)5 = 11,593 = 172,820

= 1,616,258 per annum = 1,616,258 x 0.15 = 242,439

No deductions for management costs have been adopted but similar comments apply to those made in Section 6.4 in Example 1. 5.3 Exit Value At December 2006, the rent passing is still 1,616,258 per annum and the projected level of market rents is 1,859,891 per annum (see table above, Example 2, point 3). The next review is in March 2007, three months from this exit valuation date. At an equivalent yield of 8%, the gross exit value is calculated as: Rent Passing YP perp @ 8% 1,616,258 per annum 12.50 YP 20,203,225

Reversion 243,633 YP perp @ 8% deferred 1/4 year) 12.2618 YP 2,987,379 Gross Value, December 2006 23,190,603.00

The issue of deduction of Notional Purchasers costs and sale costs has been discussed in Section 6.3 of Example 1. 5.4 Discount Rates, and Core and Froth Income As with Example 1, an overall discount rate or equated yield can be constructed for this property as follows: Risk-Free Rate Market Risk Property/Tenant Risk 7.25% 2.00% 1.00% 10.75%

This is equivalent to 2.59% per quarter. There is, of course, additional risk existing in this example, being that associated with the refurbishment and reletting following the lease expiry in March 2001. Allowance for this risk can be made either explicitly through the inclusion of a developers profit in the cash flow or implicitly through an addition to the discount rate employed. For the sake of simplicity such allowances have not been made in this example. In view of the over-rented nature of this property, and, notwithstanding the overall discount rate described above, it is possible to divide the income into the two elements of core income and froth income.

46

DCF EXAMPLE

OVER

10 YEARS

The core income represents that part of the income flow underpinned by market rental levels while the froth is the overage above the core which is receivable due to the over-rented nature of the lease. In considering a discount rate appropriate to a worth calculation of this type of over-rented investment, there are a number of approaches which could be adopted depending on the covenant strength of the tenant. The lease and tenant assumptions adopted in this Example 2, in effect, provide for a fixed short-term income stream until lease expiry in March 2001 secured against a blue chip tenant. It may, therefore, be considered appropriate to discount this part of the income at a rate reflecting the tenant-risk only, possibly having regard to corporate bond rates relevant to the quality of the tenant. In the attached worth calculation, identifed as Example 2a, a tenant-risk discount rate of 8.75% per annum or 2.12% per quarter has been adopted for the short-term income expiring in March 2001, comprising both the core and froth incomes. No difference is made between the risks associated with both these elements of the total rental income. Thereafter, in January 2003, the overall discount rate of 10.75% (2.59% per quarter) is adopted on completion of the refurbishment and reletting. An alternative approach would be to differentiate between the risks associated with the two elements of the current income stream. The risk attached to the froth income, could be perceived to be greater than the risk pertaining to the core income as, whilst a tenant default would result in the loss of all the rental income stream, the froth income would be lost permanently, whereas the core income could be regained by reletting the property at its open market rental value. This approach is shown in the attached Example 2b where the overall property discount rate of 10.75% (2.59% per quarter) is adopted for the cash flow excluding the froth income and a higher risk discount rate of 11.75% per annum (2.87% per quarter) is used for the latter to reflect the greater uncertainty of the cash flow. The overall single discount rate for the cash flows and Gross Present Values identified in examples 2a and 2b are 10.51% per annum and 10.80% per annum respectively. It should be noted that the core income is changing quarterly to match the forecast changes in Open Market Rental Value. As it is assumed that rental values are generally rising, the more risky froth element of the income is conversely diminishing on a quarterly basis. In practice, which approach is adopted may depend on the covenant strength of the tenant, the length of the unexpired term and the degree of over-renting. 6. Worth The attached Discounted Cash Flow Schedules in Examples 2a and 2b (see Figures 2 and 3) show Gross Present Values as at December 1996 of 16.543 million and 16.253 million respectively. These are the worth to the investor of this property given the assumptions adopted. Care should be taken when comparing worth with Open Market Value either to adjust the former downwards or the latter upwards to allow for notional purchasers costs.
47

C A L C U L AT I O N

OF

WORTH

FIGURE 2: DISCOUNTED CASH FLOW SCHEDULE

EXAMPLE 2a: SINGLE-LET OVER-RENTED FREEHOLD, CITY OF LONDON OFFICE
S H O R T

T E R M

I N C O M E

Quarter 1997.00 1997.25 1997.50 1997.75 1998.00 1998.25 1998.50 1998.75 1999.00 1999.25 1999.50 1999.75 2000.00 2000.25 2000.50 2000.75 2001.00 2001.25 2001.50 2001.75 2002.00 2002.25 2002.50 2002.75 2003.00 2003.25 2003.50 2003.75 2004.00 2004.25 2004.50 2004.75 2005.00 2005.25 2005.50 2005.75 2006.00 2006.25 2006.50 2006.75 2007.00 Discount Rate per annum Discount Rate per quarter DCF Value (gross) Total DCF Value (gross) Total DCF Value (net)

Income After Re-Let 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 404,064 404,064 404,064 404,064 404,064 404,064 404,064 404,064 404,064 404,064 404,064 404,064 404,064 404,064 404,064

Rent Passing 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

Core Income 250,000 253,068 256,174 259,318 262,500 268,217 274,058 280,027 286,125 287,545 288,972 290,406 291,848 291,848 291,848 291,848 291,848 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

Froth Income 250,000 246,932 243,826 240,682 237,500 231,783 225,942 219,973 213,875 212,455 211,028 209,594 208,152 208,152 208,152 208,152 208,152 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

Variation Costs & Exit Value 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 -1,076,620 -1,076,620 -172,468 -172,820 -242,439 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 23,190,603

10.75% 2.59% 2,694,198 16,543,662 16,100,888 16,101,000 say 48

8.75% 2.12% 3,986,703

8.75% 2.12% 3,238,496

10.75% 2.59% 6,624,266

Present value factors are calculated and applied in a similar fashion to Example 1.

DCF EXAMPLE

OVER

10 YEARS

FIGURE 3: DISCOUNTED CASH FLOW SCHEDULE

EXAMPLE 2b: SINGLE-LET OVER-RENTED FREEHOLD, CITY OF LONDON OFFICE
S H O R T

T E R M

I N C O M E

Quarter 1997.00 1997.25 1997.50 1997.75 1998.00 1998.25 1998.50 1998.75 1999.00 1999.25 1999.50 1999.75 2000.00 2000.25 2000.50 2000.75 2001.00 2001.25 2001.50 2001.75 2002.00 2002.25 2002.50 2002.75 2003.00 2003.25 2003.50 2003.75 2004.00 2004.25 2004.50 2004.75 2005.00 2005.25 2005.50 2005.75 2006.00 2006.25 2006.50 2006.75 2007.00 Discount Rate per annum Discount Rate per quarter DCF Value (gross) Total DCF Value (gross) Total DCF Value (net)

Income After Re-Let 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 404,064 404,064 404,064 404,064 404,064 404,064 404,064 404,064 404,064 404,064 404,064 404,064 404,064 404,064 404,064

Rent Passing 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 500,000 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

Core Income 250,000 253,068 256,174 259,318 262,500 268,217 274,058 280,027 286,125 287,545 288,972 290,406 291,848 291,848 291,848 291,848 291,848 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

Froth Income 250,000 246,932 243,826 240,682 237,500 231,783 225,942 219,973 213,875 212,455 211,028 209,594 208,152 208,152 208,152 208,152 208,152 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

Variation Costs & Exit Value 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 - 1,076,620 - 1,076,620 - 172,468 - 172,820 - 242,439 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 23,190,603

10.75% 2.59% 2,694,198 16,253,542 15,818,532 15,819,000 say 49

10.75% 2.59% 3,849,166

11.75% 2.82% 3,085,912

10.75% 2.59% 6,624,266

Present value factors are calculated and applied in a similar fashion to Example 1.

APPENDIX IV
Membership of the Joint

R O YA L I N S T I T U T I O N O F C H A RT E R E D S U RV E Y O R S & I N V E S T M E N T P R O P E RT Y F O R U M
Working Party on Worth

CHAIRMAN Robert Peto, MA FRICS DTZ Debenham Thorpe

MEMBERS Stuart Beevor, BSc FRICS Legal & General Property Ltd. Michael Brodtman, FRICS St Quintin Nick French, BSc ARICS The University of Reading Simon Martin, BSc (Hons) DTZ Debenham Thorpe Stuart Milford, BSc (Hons) Norwich Union Investment Management Nick Price, FRICS Norwich Union Investment Management Nick Thompson, FRICS Prudential Portfolio Managers Ltd.

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BIBLIOGRAPHY Books
Adair, Alaistair, et al. (eds.) (1996 a) Adams, Andrew (1989) Alexander, Gordon, Bailey, Jeffrey and Sharpe, William (1993) Baum, Andrew (1991) Baum, Andrew and Crosby, Neil (1995 a) Baum, Andrew and Mackmin, David (1989) Brett, Michael (1990) Brown, Gerald (1991) Chapman, Colin (1994) Donald, D.W.A. (1975) Dickson, Martin (1989) Dubben, Nigel and Sayce, Sarah (1991) Enever, Nigel and Isaac, David (1995) Fraser, William (1993) Hargitay, Stephen and Yu, Shi-Ming (1993) Jones Lang Wootton, Estates Gazette and South Bank Polytechnic (compilers) (1989) Lee, E. Michael (1986) Lumby, Stephen (1994) MacLeary, Alastair and Nanthakumaran, Nanda (eds.) (1988) Mott, Graham (1993) Robinson, Jon (1989) European Valuation Practice: Theory and Technique, E & FN Spon Investment, Graham and Trotman Fundamentals of Investments, Prentice Hall Property Investment Depreciation and Obsolescence, Routledge Property Investment Appraisal, Routledge The Income Approach to Property Valuation, Routledge Property and Money, Estates Gazette Property Investment and the Capital Markets, E & FN Spon How the Stock Markets Work, Century Business Compound Interest and Annuities-Certain, Heinemann (for the Institute of Actuaries) A Guide to Financial Times Statistics, FT Publications Property Portfolio Management: An Introduction, Routledge The Valuation of Property Investments, Estates Gazette Principles of Property Investment and Pricing, Macmillan Property Investment Decisions: A Quantitative Approach, E & FN Spon The Glossary of Property Terms, Estates Gazette An Introduction to Pension Funds, Institute of Actuaries Investment Appraisal and Financing Decisions, Chapman and Hall Property Investment Theory, E & FN Spon Investment Appraisal, M & E Handbooks Property Valuation and Investment Analysis: A Cash Flow Approach, Law Book Company, Sydney RICS Appraisal and Valuation Manual, RICS Books

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C A L C U L AT I O N

OF

WORTH

Rutterford, Janette (1994) Whipple, Tom (1996)

An Introduction to Stock Exchange Investment, Macmillan Property Valuation and Analysis, Law Book Company, Sydney

Articles and Reports

Valuation and Calculation of Worth
Baum, A.E. and MacGregor, B. (1992). Explicit valuations and the future of property investment. Journal of Property Valuation and Investment, 10.4: 709-724 Baum, A.E., Crosby, N. and MacGregor, B. (1996). Price formation, mispricing and investment analysis in the property market. Journal of Property Valuation and Investment, 14.1: 36-49 Brown, G. (1985). Property investment and performance measurement: a reply. Journal of Valuation, 4: 33-44 Peto, R., French, N. and Bowman, G. (1996). Price and worth: developments in valuation methodology. Journal of Property Valuation and Investment, 14.4: 79-100 Royal Institution of Chartered Surveyors (1994). The Mallinson Report: Commercial Property Valuations. RICS

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