(Part A) - Traditional Investment Valuation Introduction to Term & Reversion PDF

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Applied valuation Traditional Investment Valuation Introduction to Term & Reversion (Part A)

Traditional methods of valuation:  

Term and Reversion Hardcore/Layer

Later on in the term Lynn Johnson will also review Discounted cash Flows:   

How we calculate a Net Present Value? What an Internal Rate of Return is? Short Cut DCF

Rack rented properties We need to think about how we value property, there are a few things that we need to think about. If We are valuing a property that is already let at market rent then we can establish what is called an all risk yield which we can then capitalize this yield into perpetuity (into forever). This is a quite simple calculation.

Term and reversion Other calculations may include term and reversion where you have a current passing rent (Currently being achieved on the property), which is different and lower than the market rent. So what we need to do for the term aspect is multiply by what we call the years purchase (YP) single rate. This again will be as a certain percentage which will be the yield that is appropriate to that type of property and for how many years you will achieve that income for. When we come to the reversion, we look at the market rent based on comparables. You will then need to apply Years purchase (YP) in Perp (Into forever) at a certain percentage depending on how the market is operating. But you're not going to achieve that income straight away as you still have that term which has got to come into finish. So this is where you apply PV of £1 at a percentage (Yield) for a certain n of years until you achieve that particular market rent. Therefore you have a Term and a reversion that you need to calculate in order to establish a value for that property.

The Term

The term is the passing rent that you are going to receive until reversion, which could be at the end of the lease or at the next rent review. If there were any break clauses in the lease, then you'd have to consider that as well. Your YP Single rate is always applied for the length of the term up until the reversion point E.g. the next rent review. The Reversion This is the amount of market rent that you are going to achieve from the date of that first reversion. You’re going to capitalise this value by your YP in perpetuity (into forever) but We need to discount this value because we're not going to achieve this for a certain number of years. Traditional cash flows

Valuing a rack rented -

Town Centre office building Let to Government office as the Job Centre Let on a 15-year lease from 2020 Lease subject to 5 yearly rent reviews NIA 1,672.20 sq. m (18,000 sq. ft) Market Rent £189,000 per annum ARY 9%

property

Valuing an under rented property -

Detached industrial unit on popular industrial estate in Durham Let on 10 year FRI lease 2017 5 yearly rent reviews Passing rent of £71,000 per annum Market Rent £76,000 per annum ARY 9.5% (good covenant with 15 years unexpired & potential rental growth

So what you would do here he's calculate your term by using your passing rent at 71,000 and multiply it by your YP at 9.5%. Which gives you 1.7473 Which few times by 71,000 to give you a total of £124,055. Reversion we know the rent is going up in this case to £76,000. Again at your YP in perp @9.5% which gives you 10.5263. PV of £1 for 2 years @9.5% because we're going to wait for this gives you 0.8340. We then Times the three figures together (market rent, YP in perp @9.5%, PV of £1 for 2years @9.5% giving you £667,209. You would then need to add this into your term as both aspects need to be incorporated into the valuation giving you a total figure of £791,264 giving you a market value of £790,000. In this particular scenario the yield percentage applied was 9.5% for both the term and reversion however you might need to adjust this in different scenarios but we will explore this later on in the lecture. Risk at Reversion We do need to consider whether there is any risk attached to the Reversion, So thinking about what that risk could be changes to the market etc. The reversionary income carries an element of risk. -

The Term rent is perceived to be relatively secure But the Market Rent is subject to fluctuations/market conditions Market Rents can go up or down at Rent Review The Tenant may vacate, and property may not re-let at Market Rent The Tenant may exercise a break option and the property may not re-let at Market Rent The ARY can be adjusted to reflect this risk

Yield Application There are three types of yield application: 1. Traditional - The traditional yield at application will look at the passing rent and think of it being more secure. The value at then may consider reducing the yield on the term. 2. Equivalent - No distinction is made between the term and reversion. Therefore as shown in the example prior the value of applies the same yield to each income (Term & Reversion). 3. Modern - Might look at the passing rent as a fixed income, could be prone to inflation. The value of may apply a higher yield to reflect the lack of growth potential.

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Traditional reduces yield on term, Equivalent there both the same, Modern the yield is higher in the term

Term & Reversion reflecting risk So in this scenario we have applied the modern application by increasing the yield to 10% but keeping the reversion at 9.5%.

Valuing more than one reversion Example: Guisley Way, Teesside Industrial Estate, Stockton A new letting has taken place of the above property. The Tenant is a small distribution company who have taken a new 10-year lease at a stepped rent. They have agreed to pay £25,000 in the first year rising to £26,000 in the second year and £28,000 in the final three years with a rent review at year 5 to Market Rent. Cash Flow:Year 1 £25,000 Year 2 £26,000 Year 3 £28,000 Year 4 £28,000 Year 5 £28,000 Local covenant, 10-year lease at stepped rent ARY 11%

Valuing more than one reversion So this is where you'll have to consider the different aspects of valuing more than one reversion. Your term here you're only receiving £25,000 for one year. You're getting a year at £26,000 but we have to PV that because you’re not getting it for one year. Then you can revert to market rent.

Calculation would look like: Term = £25,000 x 0.901 = £22,523 Rev to intermediate rent = £26,000 x 0.897= £ 23,322 then 23,322 x 0.897 = £20,913 Rev to Market Rent = £28,000 x 8.696 = £243,488 then £243,488 x 0.804 = £195,844 Finally = £22,523+£20,913+£195,844 = £239,280 Summary      

There are two traditional approaches to property valuation The term and reversion approach is the more transitional of the two The term illustrates the passing rent The reversion illustrates the Market Rent at review/new letting The risks are reflected in the yields applied to each tranche of income There are three approaches to the yield application depending on the scenario

Term and Reversion example:

Yield adjustments

Further Reading 1. Blackledge, M. (2017) Introducing Property Valuation, 2nd Edition, Routledge  2. Shapiro, E., Mackmin, D. and Sams, G. (2013) Modern Methods of Valuation, 11th Ed. London, Routledge and EG Books 3. Davidson, A (2013) Parry's Valuation and Investment Tables, Estates Gazette Books...