Property Appraisal

1. Property Appraisal Introduction

2. Introduction • Definitions • Appraisal • Investment and investors • Appraisal techniques • Summary

3. Definitions • Market Value (value in exchange) • Estimate of exchange price • Relies on interpretation of market information • Objective • Worth (value in use) • To a specific individual or group • Usually involves consideration of personal circumstances (risk and return) as well as market, e.g. • financial resources available for a property acquisition, including the split between debt and equity finance • timescale for holding a property asset • tax position, personal tastes and specific requirements of the decision-maker • Subjective

4. Definitions - IVS • Investment Value or Worth “The value of property to a particular investor, or a class of investors, for identified investment objectives. This subjective concept relates specific property to a specific investor, group of investors, or entity with identifiable investment objectives and/or criteria.” Why might value and worth be different for the same property? Why might investors arrive at different appraisals of worth?

5. Market Valuation Backward-looking; analysis of past transactions Appraisal of Worth Forward-looking; forecast of cash-flow What is Appraisal? • A valuation is an objective comparison with evidence from closely comparable properties • An appraisal is an estimation of investment worth to an investor by determining its risk and return characteristics in relation to that investor

6. Reasons for appraisal • Acquisition • Purchasing a property is one of the key times that Appraisal is utilised • Why will different parties pay different prices for the same building? • Refurbishment/redevelopment • Financing arrangements • Ongoing performance • Disposal

7. Financial characteristics ofinvestments • Investment = acquisition of asset(s) that are worth more than their cost • Nature of revenue receipt • Fixed or variable income and capital value • Liquidity • Security of income and capital • Nominal • Real

8. Financial characteristics ofinvestments • Conventional bonds • long, short, medium or undated fixed interest debt investment • gross redemption yield (GRY) = riskless nominal rate of return • GRY on index-linked gilts = real risk-free rate of return • Ordinary shares • equity investment • IRR unknown and must be estimated from anticipated cash flows (unlike gilts) • therefore shares involve risk -> premium above GRY • Property • Direct and indirect • Commercial and residential

9. But property is... • Heterogeneous and fixed location • High unit value (lumpy) and so difficult to finance • Slow to create and long-lived • Expensive to manage • Likely to depreciate • Suffer from frequent government intervention • Difficult to price • Slow to transact (Illiquid) • In segmented markets

10. So who invests in property? • Financial Institutions (general insurance companies, life assurance companies and pension funds) • UK Property Companies • Overseas Investors • Traditional Estates and Charities • Private Investors • Limited Partnerships and Unit Trusts

11. Appraisal at Purchase 22-24 Queen Square, Bristol • Grade II listed terraced office building. The building was redeveloped in 2007 and the Grade II listed façade was retained Sold to Invista December 2006 for £8.5m (4.87%) Sold by Invista to Epic May 2008 for £6.2m (6.5%)

13. Appraisal at Purchase 1 Georges Square, Bristol • Acquired in November 2004 by Anglo Irish Private Bank for £24,475,000 (6.20% NIY) • Sold in May 2006 to Invista for £29, 500,000 (4.95% NIY) • Sold in September 2008 to IVG for £21,915,000 (6.65% NIY) • Sold in June 2010 to British Steel Pension Fund for £25,375,000 (5.75% NIY)

14. 1 Georges Square, Bristol

15. Summary • Valuation is a market-based concept. An appraisal of worth is an individual-based concept and represents a means of assessing whether a price/valuation represents ‘good value’ to an individual or group •  A different information set is used to conduct appraisals of worth, using more client-specific information • An appraisal of worth may vary more than a market valuation as the financial estimation moves away from an analysis of market information to greater consideration of personal investor or occupier requirements, using more sophisticated techniques

16. Property Appraisal Information Requirements

17. Introduction • Properties are not frequently traded in the open market and information access is limited so valuers look at comparable evidence to assess market value (PV) • Need to compare appraisals of worth with asking price • Example • 43 Queen Square, Bristol…

18. Appraisal information • Economic indicators • Output, (un)employment , movements in corporate profits (by sector), money supply, public sector borrowing, inflation, interest rate • Market indicators • Rents, rental growth and depreciation rates • Redevelopment or refurbishment costs • Yields and forecasts of exit yields • Purchase and sale costs • Movements in market indices • Portfolio information • Asset returns and correlations (to aid diversification) • Sales and purchases • Risk indicators

19. Property information • Physical attributes (areas, ancillary space, quality, improvements) • Financial details (yield, rent passing, rental growth, market rent and capital value) • Legal terms (tenancies and lease details, number of tenants, expiry dates, review dates, voids, future leases) • Outgoings and capital expenditure (vacancies, voids, unrecoverable service and management costs, letting, re-letting and rent review costs, purchase and sale costs) • Depreciation, costs & timing of redevelopment and refurbishment, cost inflation • Planning • Taxation (Business Rates, VAT) • Occupancy / holding costs (management, review, purchase & sale costs) • Dilapidations, service charge & other payments for repairs and insurance if leasehold Client specific information • Discount rate, taxation, loan / finance • Holding period

20. Facts and variables in appraisal

21. Key investment appraisalvariables Investment appraisal involves making explicit judgments (based on evidence) about: • Rent and rental growth • Volatile over short term • Little known about depreciation rates • Expenditures • Target rate or return • Selection of risk premiums for individual properties is a grey area • Holding period • Longer period - more chance of error in selecting variables • Exit value • Prime yields fairly stable

22. Rent and rental growth • Contractual rent will be known but market rent and future lease terms must be estimated • Associated variables: • Timing of rent reviews • Length of lease and existence of any break options (likelihood of void periods) • Management costs and taxation • Financial impact of void periods • How long will it take to let vacant space? • Holding costs through void period • Letting incentives and possible refurbishment costs to be allowed for • Short-term lets...

23. Rent and rental growth • Estimate rental value of • New • Existing • Existing but refurbished • Estimate rental growth rate 5.00% • Depreciation • Depreciation rate of existing property (% rent) 2.00% • Depreciation-adjusted rental growth rate 2.94% NB. Capex of 0.5-1% p.a. means rent depreciation of 0.5-1% p.a., rising to 2% p.a. with no capex...

24. Associated expenditures • Acquisition costs (% acquisition price).................................5.75% • Rent review costs (% new rent)............................................. 4-5% • Management costs (% income)............................................. 1-3% • Re-letting costs (% new rent)................................................7.50% • Higher than rent review due to marketing and legal fees • Lease renewal costs (% new rent).........................................5.00% • No marketing costs • Property tax / business rates

25. Forecasting and Depreciation • Forecasting • Forecasts of market rents and rental growth typically relate to prime new business space in the locality concerned (i.e. no depreciation) • National, regional and local level • Usually based on econometric models of economy and property market • Property specifics are also vital • Depreciation • Don’t overlook or double-count! • Think carefully about relationship between capex and depreciation • If refurbishment expenditure is included in cash-flow then financial benefit should be reflected in revenue (e.g. enhanced estimates of rental value, growth rate or exit yield)

26. Discount rate ortarget rate of return • Must adequately compensate an investor for the risk taken • Individual properties have individual target rates • Portfolio construction can isolate property-specific risk from market risk • It is the cost of capital (an investment needs to compensate investors for the use of their capital) • Several ways of deriving it: • Risk-adjusted discount rate (RADR) • Frequently used by investors and property analysts • Capital Asset Pricing Model (CAPM) • Weighted Average Cost of Capital (WACC) • Yield on client’s equity

27. 1. Risk-adjusted discount rate(RADR) The target rate of return (TRR) required by an investor may be derived from a ‘risk-adjusted discount rate’ (RADR), expressed as: TRR or RADR =RFR+ RP Where:RFRis the risk-free rate of return or compensation for loss of liquidity RPis the risk premium or compensation for risk, which comprises market risk (which cannot be diversified away) RADR derived by adding a risk premium to a ‘benchmark’ risk-free rate

28. RADR components • Risk-free rate (RFR) • Baseline defined by reference to the return from a low-risk or riskless asset • Typically the income yield on a medium / long dated gilt • Risk Premium • Return to compensate for market and property-specific risks associated with holding the specific property asset • Need to decide which are best handled by building into the cash flow and which should be incorporated by adjusting the RP

29. Risk Premium • Difficult to estimate for individual property assets due to • Paucity of data, confidentiality issues • Uniqueness of assets and complexity of markets • Overlap between risk factors • Historically the UK long-term property RP = 2-6% • Need to consider RP over different holding periods • Need to distinguish long term (ave) RP from short term sentiment re-ratings • Group assets to determine property sector RP, then adjust to reflect asset-specific risk • Remaining costs (fees, management, dilapidation, etc.) are handled in the cash flow

30. RADR limitations • Only one rate applied to all cash-flows so fails to distinguish those parts of the cash-flow that are risky and those that are not • Heavily discounts distant cash-flows regardless of whether they are actually more risky • Ignores the importance of diversification

31. 2. Capital Asset Pricing Model(CAPM) • An investment’s expected return is a positive linear function of risk (measured in terms of SD & variance) • CAPM enables estimation of the target rate of return in the light of returns available from ‘risk-free’ investments and market-related risk factors of the investment under scrutiny • Recognises that each investment has different market risk which will influence its expected return • Market risk is a special type of risk related to the contribution that the asset makes to a well-diversified portfolio.

32. CAPM Where E(rn) = expected return for a specific asset rf = risk-free rate b = amount of systematic risk (indicator of the investment’s sensitivity to market movements) E(rm) = expected market return (the reward for bearing systematic risk)

33. CAPM example Expected market return and variance: E(rm) and var(rm):

34. CAPM example Expected asset return and its covariance with market return: E(ra) and cov(ra, rm):

35. CAPM example Asset beta: = 0.0223/0.0464 = 0.48 So the asset has a low beta coefficient indicating low volatility (approx. 50% lower risk than the market) Using the CAPM equation and assuming a RFR of 5%, we can now calculate the expected target rate of return, E(rn) E(rn) = 0.05 + (0.48)(0.16-0.05) = 0.1028 or 10.28%

36. 3. Weighted Average Cost of Capital (WACC) • Discount rate (minimum expected rate of return) of an investment is the ‘cost of capital’; it represents how much the company should earn to break even • WACC takes the cost of equity and after-tax cost of debt and calculates an average, weighted according to the market values of debt and equity • Capital structure weights: • Debt weight, w, is the market value of debt divided by the total market value of debt and equity • Equity weight is 1- w

37. Land Securities -Capital structure weights • MVs preferred but can use book values • Equity = 6,636.6 • Debt = 2,923.1 • Equity weight • 6,636.6/(6,636.6 + 2,923.1) = 69.4% • Debt weight • 2,923.1 /(2,923.1 + 6,636.6 +) = 30.6%

38. WACC formula WACC = (1-w) re + w.rd (1 – t) • Where w is the market value weight of debt, rdis the cost of debt, t is the corporate tax rate and reis the geared cost of equity • recan be estimated from CAPM • E.g. if the b of the company is 1.35, rf is 6%* and E(rm) is 12.5%, then • = 0.06 + 1.35(0.065) = 14.78% • RFR is expressed gross of tax because firm must earn 6% after taxes so shareholders can earn RFR of 6%.

39. WACC and tax • Cash flows are after tax • The WACC discount rate has to be consistent with cash flows • Tax issues relate to debt • Interest offers a tax shield = rd * tc • It is as if the government reduces the cost of debt • rd becomes rd (1 - t)

40. WACC example • If the geared cost of equity is 14.78%, gross interest on debt is 9% , corporate tax is 40%, and with market value weights for equity (we) of 0.3 and debt (wd) of 0.7, WACC can be calculated as follows: • WACC = [0.3 x 0.1478] + [0.7(0.09(1 – 0.4)] = 0.08214 Say 8.2%

41. WACC summary • Represents discount rate to be used for • Company projects • With similar characteristics to existing investments • What happens if investment has different risk/return profile? • Subjective approach: adjust WACC by adding premiums or deducting discounts depending on perceived risk (high, medium, low) • The WACC is based on figures derived from the company and so should only be used on projects with same financial structure as the company

42. Holding Period of Investment • Normally specified by client... • Usually 3-5 or 10-15 years depending on type of investor • ...or by fundamentals of the property • influenced by lease terms (break clause, lease expiry) • or by physical nature of property (redevelopment, voids) • Longer hold period = greater risk of fluctuation of variables from prediction, or reversion to long term trends?

43. Exit value • Value of the property at the end of the holding period • Usually capitalise the rent forecast at the end of the holding period • May reflect land values if demolition is anticipated • May reflect refurbishment / redevelopment costs too • Forecast building costs if refurbishment or redevelopment is planned

44. Exit Yield • Yield a purchaser would require for the property at the point of (notional) sale • Normally based on comparison with similar investments using ARY approach • Assume stability of market over holding period? • Important to consider impact of depreciation but don’t double-count its effect on value by, say, reducing the forecast rent and raising the exit yield • Choice of exit yield is key when holding period < 20 years as resulting exit value forms a substantial element of worth

45. Summary • Rent and rental growth • Growth • Depreciation • Associated costs • Target rate or return • RADR • CAPM • WACC • Holding period • Exit value • Exit yield • redevelopment

46. PropertyAppraisal Methods

47. Introduction • Investment decisions involve choosing between different types of investment with different characteristics • Investment decisions are made against a background of risk and numerous uncertain variables dependant upon future events • A rational basis to compare investment propositions (a decision tool) is required that focuses on return / risk profile

48. Must consider: • Financial resources available (equity and debt) • Project timescale • Integration with existing portfolio • Any mismatch between the market value or price of a property investment and its worth to a particular investor should be investigated • A rational investor should buy an asset if its price is equal to or below his assessment of worth • The range of worth estimates is typically wider in the property market than in the equities market where a great deal more trading takes place on the more marginal differences between price and worth

49. Methods • Simple screening: • Payback • Rate of return and yield • Project-only discounted cash-flows (DCFs): • Net Present Value (NPV) • Internal Rate of Return (IRR) • Capital Asset Pricing Model (CAPM) • Project-with-finance DCFs • Weighted Average Cost of Capital (WACC) • Flow to Equity (FTE)

50. 1. Simple screening methods