Real Estate Appraisal: From Value to Worth

353 Pages·2006·2.29 MB·English

by  Sarah Sayce

REA_A01.qxd 22/3/06 2:33 PM Page i
Real Estate Appraisal
From Value to Worth
Sarah Sayce
Professor and Head, School of Surveying, Kingston University
Judy Smith
Senior Lecturer, School of Surveying, Kingston University
Richard Cooper
Chartered Surveyor
Piers Venmore-Rowland
Visiting Professor, School of Surveying, Kingston University
REA_A01.qxd 22/3/06 2:33 PM Page ii
©2006 by Blackwell Publishing Ltd
Editorial offices:
Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK
Tel: [phone]
Blackwell Publishing Inc., 350 Main Street, Malden, MA 02148-5020, USA
Tel: [phone]
Blackwell Publishing Asia Pty Ltd, 550 Swanston Street, Carlton, Victoria 3053, Australia
Tel: [phone]
The right of the Author to be identified as the Author of this Work has been asserted in accordance with the
Copyright, Designs and Patents Act 1988.
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted,
in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted
by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher.
First published 2006 by Blackwell Publishing Ltd
ISBN-10: 1-4051-0001-X
ISBN-13: 978-1-4051-0001-4
Library of Congress Cataloging-in-Publication Data
Real estate appraisal: from value to worth/Sarah Sayce...[et al.]. – 1st ed.
p. cm.
Includes bibliographical references and index.
ISBN-13: 978-1-4051-0001-4 (alk. paper)
ISBN-10: 1-4051-0001-X (alk. paper)
1. Real property–Valuation. I. Sayce, Sarah
HD1387.R365 2006
333.33′2–dc22
2005016453
A catalogue record for this title is available from the British Library
Set in 10/12.5pt Times
by Graphicraft Limited, Hong Kong
Printed and bound in India
by Replika Press Pvt Ltd, Kundli
Thepublisher’s policy is tousepermanentpaper from mills that operate a sustainable forestry policy,
andwhich hasbeenmanufacturedfrompulp processed usingacid-free andelementarychlorine-free
practices. Furthermore, the publisher ensures that the text paper and cover board used havemet
acceptable environmental accreditation standards.
For further information on Blackwell Publishing, visit our website:
www.blackwellpublishing.com
REA_A01.qxd 22/3/06 2:33 PM Page iii
To all our families
David, Charlotte and Edd
Geoff, Rebecca, Mark and Rosie
Lorna, Nina, Robyn and Sasha
REA_A01.qxd 22/3/06 2:33 PM Page iv
REA_A01.qxd 22/3/06 2:34 PM Page v
Contents
Preface ix
Acknowledgements xi
About the authors xii
1 Introducing concepts of value and worth 1
1.1 Real estate: an introduction to the economic concepts 1
1.2 Aims of the book 4
1.3 New influences on the real estate market 5
1.4 Structure of the book 9
1.5 Worth v. price v. value: definitions 10
1.6 Conventional approaches to establishing value 12
1.7 Additional approaches to appraisal 16
1.8 An introduction to the drivers for DCF 19
1.9 Summary 21
2 Introduction to the purchase decision 24
2.1 Introduction 24
2.2 Criteria for purchase: the investment purchaser 25
2.3 Criteria for purchase: occupational property 28
2.4 The purchase transaction process 29
2.5 The regulatory framework 31
2.6 Due diligence and legal issues 36
2.7 Summary 36
3 Property investment: placing property within the multi-asset
investment spectrum 39
3.1 Introduction 39
3.2 A comparative analysis of investment media 39
3.3 An introduction to investment analysis and pricing 43
3.4 Definitions and simple examples of financial return 43
3.5 Property yields and returns 46
3.6 Yield and return distinguished 48
3.7 Compounding and discounting 51
3.8 Discounted cash flow (DCF) 53
3.9 An introduction to the imperfections of the property market
as compared with the equities and bonds market 56
3.10 Property as an asset class compared with gilts and equities 57
3.11 The place of property within the multi-asset portfolio 58
3.12 Summary 59
REA_A01.qxd 22/3/06 2:34 PM Page vi
vi Contents
4 The market appraisal approach: rental value 62
4.1 Introduction 62
4.2 Types of rent 62
4.3 Assessing rental value 64
4.4 Establishing rental value 70
4.5 The principle of rental value established through comparison 71
4.6 Challenges in assessing with reference to comparison 71
4.7 Non-standard leases 76
4.8 Establishing rental value where headline rents are used 78
4.9 The comparative approach: a reservation 83
4.10 Continental European leases – an overview of the differences 85
4.11 Conclusion 86
5 Assessing capital value: analysing discount rates 89
5.1 Introduction 89
5.2 The valuation yield 89
5.3 The years purchase multiplier 91
5.4 Gilt yields 92
5.5 Index-linked gilts and strips 95
5.6 Property yields relative to gilts yields: the risk premium calculation 96
5.7 Property equity analysts’ approach 102
5.8 Risk adjusted discount rate 102
5.9 Unbundling a valuation yield to derive the implied rate of
rental growth 103
5.10 The individual investor’s required rate of return or choice of
discount rate 103
5.11 Pay back and discounted pay back 105
5.12 Certainty equivalent 105
5.13 Risk adjusted discount rate v. certainty equivalent 105
5.14 Freehold valuation approaches 106
5.15 Summary 113
6 Issues of leasehold appraisal 114
6.1 The nature of leasehold interests 114
6.2 Leasehold value: the profit rent 115
6.3 Inherent disadvantages of leasehold interest compared to
a freehold interest 116
6.4 A wasting asset and the need for replacement of capital 117
6.5 Establishing capital value for a leasehold interest 118
6.6 The conventional or historic perspective 124
6.7 Summary 132
7 Structuring investment appraisals to determine investment worth 134
7.1 Introduction 134
7.2 The efficient market hypothesis 135
7.3 The efficient market hypothesis in a property market context 135
7.4 The worth approach – discounted cash flow analysis 137
7.5 Introduction to property discounted cash flows 139
REA_A01.qxd 22/3/06 2:34 PM Page vii
Contents vii
7.6 Discounted cash flow analysis in practice 140
7.7 The DCF appraisal outputs 147
7.8 A summary of factors affecting cash flow data 147
7.9 Forecasting the variables 147
7.10 Cash flow modelling: useful practical pointers 150
7.11 The DCF appraisal report 151
7.12 Summary 152
8 Risk within the appraisal and worth process 155
8.1 Introduction 155
8.2 Quantitative v. qualitative risk approaches 157
8.3 Quantitative risk analysis: building a risk analysis continuum 159
8.4 Risk analysis in a practical context 160
8.5 Sensitivity analysis 161
8.6 Scenarios 163
8.7 Simulation 166
8.8 Prioritising the key variables for risk management 183
8.9 Geared property investments 184
8.10 Decision trees and associated sensitivity analysis 186
8.11 The analysis continuum 187
8.12 Data handling 188
8.13 Summary 188
9 Occupational property: decision-making and appraisal 190
9.1 Introduction 190
9.2 Property as a corporate asset 191
9.3 Criteria for purchase or lease 193
9.4 Criteria for building selection 197
9.5 Appraising property for corporate decision-making 204
9.6 Appraising for financial statements 205
9.7 Corporate property: fund managers’ and equity analysts’ attitudes 210
9.8 Appraisals for corporate decision-making: the hold/sell/finance
decision 211
9.9 Summary 212
10 Funding and financial structures 216
10.1 Introduction 216
10.2 Debt 217
10.3 Equity 218
10.4 The impact of gearing 220
10.5 Financing property transactions 224
10.6 Lending terminology 229
10.7 Mezzanine finance and participating loans 231
10.8 Interest rates 232
10.9 Management of interest rate risks 232
10.10 Corporate finance 235
10.11 Property investment vehicles and structures 238
10.12 Summary 248
REA_A01.qxd 22/3/06 2:34 PM Page viii
viii Contents
11 Measuring return 250
11.1 Introduction 250
11.2 Simple return 250
11.3 Money-weighted returns 252
11.4 Time-weighted returns 255
11.5 Aggregation of individual assets’ returns 258
11.6 Further return calculation issues 259
11.7 Indices and return 264
11.8 Establishing benchmarks 271
11.9 Summary 272
12 Handling risks within the portfolio 275
12.1 Introduction 275
12.2 The nature of risk in financial assets 276
12.3 Portfolio management under modern portfolio theory (MPT) 278
12.4 The evolution of finance theory 283
12.5 The move towards new finance: expected return factor models 289
12.6 Expected return factor models – application to property portfolios 293
12.7 Other approaches to portfolio construction 293
12.8 Summary 294
13 Forecasting 297
13.1 Introduction 297
13.2 Forecasting and appraisals 298
13.3 Aims of forecasting 298
13.4 Methods of forecasting 299
13.5 Forecasting using linear regression models 300
13.6 Correlation 305
13.7 Ordinary least squares and multiple regression 307
13.8 Diagnostic tests 310
13.9 The use of forecasts 310
13.10 Forecast equations and their calibration 310
13.11 Property market barometers and lead indicators 311
13.12 The role of forecasts in financial and property lending markets –
value at risk 312
13.13 Basle Capital Accord 314
13.14 Summary and conclusions 315
Appendix A: Valuation and finance formulae 317
Introduction 317
The formulae 318
Appendix B: Worked examples in the chapters:how to download
spreadsheets from the web site 330
Index 331
REA_A01.qxd 22/3/06 2:34 PM Page ix
Preface
The education of the real estate professional is changing. It has become far more integrated
with the world of business and this means that the texts to support both practitioners and
students need to change too.
Real estate was once a discipline bedded in an isolationist approach in which
property was viewed as a discrete study area, but the realisation now is that pro-
fessionals must view the assets on which they give strategic and operational advice
in a more holistic context. This has two main implications for the role of real estate
appraisal.
• The pricing mechanism on which real estate professionals advise must take into
account the theories and practices used in other investment markets. However, even
this is not enough: investors are in competition with owner-occupiers and there-
fore an understanding of how assets are appraised by owner-occupiers is vital to the
process.
• The owner of real estate assets may be either an investor or an owner-occupier. Both
have increased needs to ensure efficient and effective management of the asset, and
this determines the need for performance management techniques that allow com-
parison and objective evaluation to be undertaken. However, in addition, investors
and owner-occupiers alike must now take cognisance of the wider sustainability issues
of social and environmental responsibility; to date, the study of this in relation to real
estate is in its infancy.
This book seeks to address these issues by introducing and examining some of the latest
techniques employed in the marketplace. Fundamental to this are the development of both
an understanding of market appraisal andworth, and an appreciation of the emerging role
of sustainability as a driver for real estate decision-making.
The catalyst for this book has been the authors’ experiences gained from both their
interaction with those who have attended courses delivered by them and their work in
practice. The courses range from degree and masters programmes for those seeking to gain
admission to the Royal Institution of Chartered Surveyors (RICS), to Assessment of
Professional Competence (APC) courses, to CPD lectures for practitioners. Whilst theory
is very important to these students, and increasingly so, what precipitates learning is prac-
tical application. Over the years our students, at all levels, have constantly challenged us to
provide a context for the theories we present them with and a steer as to what the markets
are really doing!
Whilst no book can fully address these desires, we have endeavoured to bridge what we
perceive to be the gap between theory and practice and, we hope, to address the needs not
just of our students, and those of other real estate courses in the UK and beyond, but also of
the practitioners who are now facing changes in their established ways of working. Our
REA_A01.qxd 22/3/06 2:34 PM Page x
x Preface
intention has been to present the material in an approachable way that is accessible to those
who come to the subject fresh as graduate students and to those in the latter stages of their
undergraduate programmes. We hope that we have succeeded in our ambition.
In order to keep the book ‘fresh’, we have introduced a web link to examples. Details of
this can be found in Appendix B.