Property Investment Appraisal

Property Investment Appraisal
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Discover an insightful examination of the property investment appraisal process from leaders in the industry    This book explains the process of property investment appraisal: the process of estimating both the most likely selling price (market value) and the worth of property investments to individuals or groups of investors (investment value).  Valuations are important. They are used as a surrogate for transactions in the measurement of investment performance and they influence investors and other market operators when transacting property. Valuations need to be trusted by their clients and valuers need to produce rational and objective solutions. Appraisals of worth are even more important, as they help to determine the prices that should be paid for assets, even in times of crisis, and they can indicate market under- or over-pricing.  In a style that makes the theory as well as the practice of valuation accessible to students and practitioners, the authors provide a valuable critique of conventional valuation methods and argue for the adoption of more contemporary cash-flow methods. They explain how such valuation models are constructed and give useful examples throughout. They also show how these contemporary cash-flow methods connect market valuations with rational appraisals.  The UK property investment market has been through periods of both boom and bust since the first edition of this text was produced in 1988. As a result, the book includes examples generated by vastly different market states. Complex reversions, over-rented properties and leaseholds are all fully examined by the authors.  This Fourth Edition includes new material throughout, including brand new chapters on development appraisals and bank lending valuations, heavily revised sections on discounted cash flow models with extended examples, and on the measurement and analysis of risk at an individual property asset level. The heart of the book remains the critical examination of market valuation models, which no other book addresses in such detail.

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Andrew E. Baum. Property Investment Appraisal

Table of Contents

List of Tables

List of Illustrations

Guide

Pages

Property Investment Appraisal

Preface

1 Property Investment Appraisal in its Context. 1.1 What is Appraisal?

1.2 The Appraisal Process

1.3 What Makes a Good Appraisal?

1.3.1 Accuracy, Bias, Smoothing, and Lagging of Valuations

1.3.2 Client Influence on Valuations

1.4 Conventional and Discounted-Cash-Flow Approaches to Appraisal

2 Principles of Investment Analysis. 2.1 Introduction

2.2 Types of Investments

2.2.1 Cash Deposits

2.2.2 Fixed-Interest Securities

2.2.3 Index-Linked Securities

2.2.4 Ordinary Shares (Equities)

2.2.5 Property

2.2.6 Summary of Investment Types

2.3 Qualities of Investments

2.3.1 Income and Capital Growth

2.3.2 Operating Expenses

2.3.3 Liquidity, Marketability, and Transfer Costs

2.3.4 Real Options

2.3.5 Leverage

2.3.6 Tax Efficiency

2.4 Sources of Risk

2.4.1 Business and Financial Risk

2.4.2 Nominal and Real Risk

2.4.3 Systematic and Specific Risk

2.4.3.1 Systematic Risks

2.4.3.2 Specific Risks

2.4.3.3 International Investment Risks

2.4.4 Diversifying Risk

2.5 Comparing Investments: NPV and IRR

2.6 Initial Yield Analysis and Construction

2.7 Summary

3 The DCF Appraisal Model. 3.1 The Cash Flow Model

3.2 The Inputs

3.2.1 The Holding Period

3.2.2 The Lease and Lease Events

3.2.3 Depreciation, Refurbishment and Redevelopment

3.2.4 Forecasting Rental Growth

3.2.5 The Resale Price

3.2.6 Exit Capitalisation Rate

3.2.7 Expenses

3.2.8 Void (Vacancy) Allowances

3.2.9 Transaction Costs

3.2.10 Taxes

3.2.11 Debt Finance

3.3 The Discount Rate

3.3.1 The Risk-Free Rate

3.3.2 The Risk Premium

3.4 Examples. Example 3.1The Basic Discounted-Cash-Flow Model

Example 3.2Refurbishment

Example 3.3Freehold Multi-let Property

Example 3.4Leasehold Property

Example 3.5Applying Debt

3.5 Summary

Notes

4 The Evolution of Freehold Market Valuation Models. 4.1 Introduction

4.2 The Evolution of Conventional Techniques. 4.2.1 The Changing Perception of Investors

4.2.2 Historical Application of the Basic Valuation Model

Example 4.1Rack-Rented Freehold

Example 4.2 Reversionary Freehold

4.3 Rationale of the Pre-1960 Appraisal Approach

Example 4.3Fully Let Freehold

Example 4.4 Reversionary Freehold

4.4 The Post-1960 Conventional Market Valuation Model

4.4.1 The Fully Let Freehold

4.4.2 The Reversionary Freehold

Example 4.5 Reversionary Freehold

Analysis of Transactions

Term and Reversion

Analysis

Notes

Criticisms

Layer

Analysis

Notes

Criticisms

Equivalent Yield

Analysis

Notes

Criticisms

Conclusions

4.4.3 Over-Rented Properties

Example 4.6 Over-Rented Freehold

Initial yield approach

Core and top slice approach

4.5 Conclusions

5 Contemporary Freehold Market Valuations. 5.1 Introduction

5.2 Analysing Transactions. 5.2.1 Implied Rental Growth Rate Analysis

5.2.2 Calculation of the Implied Rental Growth Rate

5.2.3 Implied Target Rate Analysis

5.3 Full Explicit and Short-cut DCF Valuation Models. 5.3.1 Introduction

5.3.2 An Explicit Cash-Flow Model Including Short Cut DCF

5.3.3 DCF by Formula

5.4 Alternatives to DCF. 5.4.1 Introduction

5.4.2 Real Value

5.4.3 Arbitrage Model

5.5 Reversionary Freehold Valuations

5.5.1 Analysis of Transactions

5.5.2 Short Cut DCF

5.5.3 Real Value

5.5.4 Arbitrage

5.6 Over-rented Contemporary Model Valuations

5.6.1 Analysis of Transactions

5.6.2 Short Cut DCF

5.6.3 Real Value

5.6.4 Arbitrage

5.7 Summary

6 Freehold Market Valuations – Applications. 6.1 Introduction

6.2 Analysis of Transactions

Equivalent yield analysis

Short cut DCF valuation analysis

Conventional Core and Top Slice

Yield Analysis Within Short-Cut DCF

Short-cut DCF valuation analysis

6.3 Rack Rented or Vacant Property Investments

Conventional Model

DCF by Formula

Explicit DCF (Assuming a Nine-Year Holding Period)

Arbitrage/Real Value

6.4 Two-Stage Reversionary Freeholds. 6.4.1 Basic Two-Stage Reversionary Freeholds

6.4.2 Long Reversions

Conventional valuation

Short cut DCF valuation analysis

Arbitrage/real value

6.4.3 Over-rented Properties

Average Tenant. Conventional Valuation

Initial Yield

Core and Top Slice

Term and Reversion

Growth-Explicit Shortcut DCF

Arbitrage/Real Value

Arbitrage/real value

Strong Tenant

Core and Top Slice

Arbitrage/Real Value

Growth-Explicit Shortcut DCF

6.5 More Complex Reversionary Freeholds

6.5.1 Lease Events and the Valuation of Multi-let Property

Growth Explicit DCF

Real Value/Arbitrage

Valuation of multi-let property

Conventional Equivalent Yield Valuation of Unit 1

Short Cut DCF Valuation of Unit 1

6.5.2 Alternative Review Forms: Indexation and Fixed Increases

Conventional Valuation

Contemporary Approaches. Explicit DCF. Indexed Lease

Stepped Lease

Arbitrage/Real Value

Indexed Lease

Stepped Lease

6.5.3 Summary

6.6 Comparing Conventional and Contemporary Techniques. 6.6.1 Defending Conventional Techniques

6.6.2 Target-Rate Choice

6.6.3 Fully Let Freeholds: Contemporary Versus Conventional Valuations

Conventional Valuation

Contemporary Valuation Using an Explicit-DCF Format

6.6.4 Reversionary Freeholds: Contemporary Versus Conventional Valuations

The Availability and Analysis of Transaction Evidence

Conventional valuation

Explicit DCF valuation

Applying Comparable Evidence

6.7 Taxation and Market Valuation

Contemporary approach

6.8 Conclusions

7 Leasehold Valuations. 7.1 Introduction

7.2 The Evolution of Conventional Leasehold Valuations

Example 7.1Leasehold

Example 7.2Conventional Leasehold Valuation

Dual rate, tax-adjusted

Criticisms

Dual rate, unadjusted for tax

Criticisms

Single rate

7.3 Contemporary Leasehold Valuations

7.3.1 Fixed Leasehold Profit Rents

a. Explicit DCF

b. Short-cut DCF, Real Value/Arbitrage

7.3.2 Geared Leasehold Profit Rents Reviewable Rent Received, Fixed Rent Paid

a. Explicit DCF

b. Real Value/Arbitrage

7.3.3 Synchronised Reviews in Head- and Sub-leases

a. Explicit DCF

b. Real Value

7.3.4 Reversionary Leaseholds Reviewable Rent Received, Fixed Rent Paid

a. Explicit DCF

b. Real Value

7.3.5 Reviewable Rent Received, Unsynchronised Reviewable Rent Paid

a. Explicit discounted cash flow

b. Real Value

7.3.6 Over-rented Leaseholds

a. Explicit DCF

b. Real Value

7.4 Conventional Versus Contemporary Techniques

7.5 The Limitations of the Contemporary Models for Leaseholds

7.5.1 Analysis and Valuation Using Leasehold Comparables

7.5.2 Analysis and Valuation Using Freehold Comparables

7.6 Taxation and the Market Valuation of Leaseholds

Net-of-tax IRFY approach

7.7 Conclusions

8 Measurement and Pricing of Risk in Appraisals. 8.1 Introduction

8.2 Nature and Sources of Risk

8.3 Measuring Risk

Example 8.1 Two Competing Property Investments

Investment A

Investment B

8.3.1 Risk-Adjusted Discount Rate

8.3.2 Sensitivity Analysis

8.3.3 Scenarios

8.3.4 Simulations

8.4 Risk Pricing

8.4.1 Assessing the Risk Premium

8.4.2 Certainty-Equivalent Cash Flows

8.4.3 The Sliced-Income Approach

8.5 Summary

Notes

9 Development Appraisal. 9.1 Introduction

9.2 Valuation Methods

9.2.1 Basic Residual Method

9.2.2 Discounted Cash Flow Residual Method

Example 9.1Development Appraisal (Wyatt 2013)

9.3 Developer's Profit

9.4 Changes in Costs and Values and Phasing of Developments

9.5 Finance

9.6 Conclusion

Notes

10 Bank Lending Appraisals. 10.1 Introduction

10.2 The Bank Lending Valuation Problem

10.3 Market Value

10.4 Mortgage Lending Value

10.5 Basel III Definition of Long-term Value

10.6 Investment Value

10.7 Illustration of the Three Established Approaches

10.7.1 Market Value (Equivalent Yield 6.5%)

10.7.2 Mortgage Lending Value

10.7.3 Investment Value

10.8 Performance of the Three Valuation Bases over the Last Two Property Market Downturns in the UK

10.9 Summary and Conclusions

11 Conclusions

Bibliography

Index

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Fourth Edition

Andrew E. Baum

.....

International and national valuation standards have become more demanding in regulating communication between clients and appraisers. This communication involves the selection and appointment of an appraiser as well as the reporting of the valuation itself. There has been concern over the relationship between valuers and their clients, and academic research discussed below has suggested reasons why valuations might not be totally accurate and objective. The data now exists in some mature property markets to undertake long-term analyses of valuation accuracy and bias (measuring how close Market Value estimates were to subsequent sale prices). This includes variation between different valuers, the extent to which valuers anchor on past evidence and smooth peaks and troughs within cyclical markets, and whether valuers succumb to pressure from clients and other stakeholders in the process, and alter valuations as a result.

Since valuations are estimates of what the exchange price or investment worth might be, it follows that such estimates are subject to a degree of uncertainty. The principle of uncertainty around valuations is now firmly embedded in valuation standards and both the IVSC and the RICS have addressed this with guidance on reporting uncertainty around the valuation and its causes (IVSC 2019; RICS 2014). These discussions around the reporting of uncertainty have been given added momentum by the GFC and COVID-19 globally and Brexit within the UK. For example the “RICS Material Valuation Uncertainty Leaders Forum” meets weekly during any “unusual” events that may cause valuations to be subject to abnormal uncertainty and both RICS and IVSC have produced additional advice in 2020 in response to the COVID-19 pandemic (IVSC, 2020; RICS 2020b). Nonetheless, there is an expectation that appraisers will produce a solution that lies within certain parameters. In some countries, these parameters have been discussed by courts during valuation negligence cases.

.....

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