Real Estate Appraisal and Valuation

Added on - 28 May 2020

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REAL ESTATE: VALUATION AND APPRAISALA REPORTIntroductionRental values are subjected to occasional rise and fall, hence the contractualrent, also known as ‘Passing Rent’, agreed upon in an existing lease is bound todiffer from the current market value of rent. In case the passing rent is less thanthe value of the market rent, it is considered that the investment is‘reversionary’. To evaluate the investment value of an asset, there are differentmethods employed by investors, depending on their internal contribution andthe amount borrowed. In the current case, we shall be focussing on the‘Termand Reversion’and the‘Layer / Hardcore’methods for determining the‘Market Value’ of the property under consideration.Interpreting ValuationsI will illustrate both the methods here, so that it is easy to understand thecalculations and the results shown in the Table. We need to value the propertyunder consideration by assuming that the ‘Passing Rent’ is £1,125,000 perannum and this is expected to revert to the market rent valued at £1,148,000per annum in about 7 years’ time, as perBaum & Baum, (2015).We have established that the present value at 5.10% of £1 is shown in Table-02. Through Table-01 we have also established that the initial yield is 4.95%and the reversionary yield is calculated as 6.53%. The approach adopted hereis known as the ‘Term and Reversion Method’ and as shown in Table-03, thederived cash flow is considered as ‘sliced vertically’.I have also adopted an alternative approach and this also generates the sameresult. This method is the ‘Hardcore Method’ and here the cash flow is ‘slicedhorizontally’. The results have been shown in Table-04. For the benefit of theinvestor, I wish to make a note that the ‘Total Returns’ shown in the calculationson the basis of 5.10% initial yield are not the investor’s total or overall returns.
The 5.10%, all-risks yield, is notional and has been taken to imply that theactual rental growth, which is bound to increase the income generated duringthe holding period and will also help in producing a capital gain in the event of aresale by the investor. On these basis, it is safe to assume that the investor willbe having a far higher overall rate of return, which may be somewhere between7% and 9% p.a., assertsMyers, (2012).Estimated Rental Value (ERV)14,85,000£Rent Passing (Contract Rent) p.a.11,25,000£Years to Rent Review/Lease End7Cap Rate/Initial Yield5.10%Risk Free Rate6.00%Risk Premium2.50%Required Return7.00%Rent Review Period/Lease Period10Implied Growth over Review Period26.25%Implied Growth Per Annum2.36%Initial Yield4.95%Yield on Reversion6.53%TABLE - 01DATACALCULATIONSRent Passing (Rent as per Contract)11,25,000£Cap Rate5.10%CAPITAL VALUE2,20,58,824£Rent Uplift (Top Slice)3,60,000£Cap Rate5.10%PV of £ 1@5.10%0.7060CAPITAL VALUE49,83,257£TOTAL2,70,42,081£TABLE - 02CAP RATE VALUATIONInterpreting AppraisalsMy appraisal commences with the summary of the listed office property asshown in the Data Table-01. I would like to point out that this investment may
appear to be similar to a ten-year government bond. I am making thiscomparison – by way of illustration – as such bonds offer a yield of 4% and forthe purpose of determining the IRR of this office property, the discount rateselected by me is also 4.38%. However, in case this same investment is madeby the investor with keeping an initial yield of 6%, I would be suggesting that theinvestor is planning with an anticipated additional risk while determining thecash flow of the investment, keeping it over and above of the government bond,explainsBaum, (2009).Rent Passing (Rent as per Contract)11,25,000£Year Purchase (YP)@6.00%5.5824CAPITAL VALUE62,80,179£Estimated Rental Value (ERV)14,85,000£Year Purchase (YP) Perpetual@6.00%16.6667PV of £ 1@5.10%0.6651CAPITAL VALUE1,64,60,164£TOTAL2,27,40,343£TABLE - 03CONVENTIONAL UK VALUATION (TERM & REVERSION)TERMREVERSIONRent Passing (Rent as per Contract)11,25,000£Year Purchase (YP) Perpetual@6.00%16.6667CAPITAL VALUE1,87,50,000£Rent Uplift3,60,000£Year Purchase (YP) Perpetual@6.00%16.6667PV of £ 1@5.10%0.6651CAPITAL VALUE39,90,343£TOTAL2,27,40,343£TABLE - 04CONVENTIONAL UK VALUATION (HARDCORE, LAYER, TOP SLICE)CORETOP SLICE
Although, in principal, I would say that all investment properties are bound tocarry such an additional risk premium because of the liquid nature of theinvestments, according toGoodhart & Hofmann, (2007). In the above citedoffice IPMS 3 property, the additional uncertainties in the above mentioned cashflow could include:The age of the office IPMS 3 property and would also include the inherentimpact of its ability of re-let at the end of the current lease.There can be an uncertain but potential period of vacancy after the currentlease expires and this in particular costs both time and money.Thus there can be connected uncertainty of the nature of political andeconomic issues as these can be affected by lack in occupational demandand lowering of market rents, in particular when the lease ends.There can be uncertainty which may occur due to slackness in futureinvestment demand and this may affect the overall pricing of the propertyand may also increase the level of market risk, as perKaradimitrio,Magalhaes & Verhage, (2013).The current data, shown in Table-01 has been described as Scenario-A in thisreport with the following basic facts about the IPMS 3 office property.Scenario AAddressOffice A, North Street, MiddletownConstruction year2015TenantGovernment DepartmentFloor area4,500 sq mtrLease term10 years, FRI, with 5 yearly, upwardonly, rent reviews (10 yearsunexpired term)Rent£1,125,000 p.a. (£250 per sq mtr)Market rent£1,485,000 p.a. (£330 per sq mtr)I have considered this Scenario-A only for the purpose of transactionalevidence. The above noted uncertainty factors have been projected based onthis scenario although it may not be possible to analyse accurately the impactcreated by each one of the listed factors on the final cash flow. I can safely saythat any adjustments, made to the initial yield, shall be dependent on the
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