2010 - rics - calculation of worth

8/4/2019 2010 - RICS - Calculation of Worth

1/52

CA L C U L A T I O NO F

W O R T HA n I n f o r m a t i o n P a p e r


2/52

Please note: References to the masculine include, where appropriate, the feminine.

Published by RICS Business Services Limited

a wh olly own ed subsidiary of

The Royal Institution of Chartered Surveyors

un der t he RICS Books imp rint

12 Great George Street

London SW1P 3AD

No responsibility for loss occasioned to any person acting or refraining from

action as a result of the material included in this publication can be accepted by

the author or pu blisher.

ISBN 0 85406 821 X

RICS August 1997. Copyright in all or part of this publication rests with the

RICS, and save by p rior consent of the RICS, no par t or p arts shall be reprod uced

by any m eans electronic, mechan ical, photocopy ing, record ing or other wise, now

known or to be devised.

Reprin ted 2000 (Twice) and 2004

Printed in Great Britain by RICS, Coventry


3/52

Foreword 5

Executive Summary 7

1. Int roduction 10

2. Price and W or thA discussion of the Difference between p rice (value in exchange)

and wor th (value in use), and the d istinction between valuation,

app raisal and calculation of worth. 12

3. Calculation of Worth MethodologiesA brief review of worth calculation meth odologies used for asset

classes other than prop erty. 15

4. DCF MathematicsAn introdu ction to DCF math ematics and time weighted versus

mon ey weighted calculations. 18

5. Towards an Industr y Standard Cash Flow DataAn ind ication of the data to be used in assessing cash flows, and

the cash flow tim e period. 21

6. Risk Assessment D iscount RatesAn analysis of app ropriate method ology for assessing discount

rates and consideration of the d ifference between risk adjustmen t

via cash flow variation versu s yield v ariation, with a p articular

warning on double counting of depreciation. 25

7. Instructions, Caveats and Reporting to ClientsA brief description of app ropriate instructions for the und ertakingof calculations of worth, the caveats wh ich shou ld be ad opted and

the reporting format. 31

8. Conclusion 34

Appendix 1: Glossary of DCF Term inology 36Appendix II: Adjusting DCF Calculations to Allow for

Periodic Cash Flows in Ad vance 39Appendix III: DCF Examp le Over 10 Years, as a t

December 1996 40

Appendix IV: Membership of the Joint Royal Institution ofChartered Surveyors & Investment Prop erty

Forum Working Party on Worth 50

Bibliography 51

C O N T E N T S


4/52

INFORMATION PAPERS This is an Information Paper. Information Papers

are intended to provide information and explanation to members of the

RICS on specific topics of relevance to the profession. The function of this

paper is not to recomm end or advise on professional procedure to be followed

by surveyors.

It is, however, relevant to professional competence to the extent that a

surveyor should be up-to-date and should have informed himself of

Information Papers w ithin a reasonable time of their promulgation.

M embers should note that when an allegation of professional negligence is

made against a surveyor, the Court is likely to take account of any relevant

Information Papers published by the RICS in deciding whether or not the

surveyor has acted with reasonable competence.


5/52

Many of the recommendations in my working party report

concerned m ore effective self-regulation in th e valuation profession;

all necessary but rather boring stuff. The one issue which raised my

real interest was worth. Whilst credible and reliable and

accurate identification of tradeable price is a useful, not to say

essential, function for m any clients, it is the comp arison of wor th to

that price which is the real business problem. The ability of the

profession to participate helpfully in solving that problem is the key

to our being invited to sup at the top table.

It is an inescapable feature of calculations of worth that the valuer

must draw upon material from outside his immediate professional

know ledge and app ly his knowledge to it. This is exciting and helpful

to the client but it is also potentially dangerous. As this Information

Paper makes clear, the obligation upon the valuer, contained within

th e RICS Appraisal and Valuation Manual, to ensure that he under-

stands what the client is after and records and explains what hasbeen done, therefore applies with a vengeance.

This Information Paper sets out, in a clear and helpful form, the

issues and techniques available. Those valuers unfamiliar with this

area of work may find some initial difficulty in mastering the

concepts, but the effort will prove worthwhile. Those already

familiar will welcome the drawing together of matters which are, at

present, dealt with somewhat ad hoc. I congratulate the working

party on their efforts and commend the result to all valuers.

MICHAEL MALLINS ON , CBE FRICS

5

FOREWORD


6/52


7/52

EXECUTIVE SUMMARY

1. PU RPO SE O F T HIS PAPER

The Mallinson Report of March 1994 made two specific recommenda-

tions of relevance to worth. The first (No.15) related to t he d evelopm ent

of a definition of worth together with research into the techniques of

assessing and expressing worth. The second (No.25) related to the n eed

to develop and codify Discounted Cash Flow (DCF) techniques and

related information bases with the object of reducing valuers depen-

dence on current all-risks yield m ethods of valuation.

Two w orking parties were set up to take forward these recomm endations.

This Information Paper has been p rodu ced by the second working p arty

wh ich w as charged w ith explaining the method s of assessing worth. in

relation to investment p roperty only, in order to encourage the ad option

of a consistent approach.

2. DEFIN IT IO N S

To avoid confusion, care is needed ov er the use of the word sprice, value

and worth. Price/value are market driven (value in exchange) whereas

worth is subjective and based on a clients particular circumstances

(value in use).

Calculation of worth means the provision of a written estimate of the net

monetary w orth at a stated date of the benefits and costs of ownership

of a specified interest in property to the instructing party reflecting the

purpose(s) specified by that party.

With the above in mind , the following definitions should be ad opted:

Worth is a specific investors perception of the capital sum w hich he

would be prepared to pay (or accept) for the stream of benefits

wh ich h e expects to be produced by th e investment.

Price is the actual observable exchange p rice in the op en m arket.

Value is an estimate of the price that would be achieved if the

property w ere to be sold in th e market.

3. D ISCO U N TED CASH FLOW (DCF)

DCF techniques which are used in calculating investment worth of the

equity and fixed interest asset classes should also be used for property

investment.

DCF mathematics are relatively straightforward and are based on the

following formula:

DCF Valu e = CF1 + CF2 + CF3 + ...... + CFn + ......

(1 +i) (1 +i)2 (1 +i)3 (1 +i)n

PC-based spreadsheets can be utilised to undertake calculations in an

accurate and quick way.

7


8/52

Results can be expressed in th ree ways:

Gross Present Value the current value of future cash flows

discounted at an app ropriate rate, exclud ing an initial pu rchase pr ice.

Net Present Value equals the Gross Present Value from which has

been ded ucted the initial pu rchase price.

Internal Rate of Return the discount rate at which the discounted

value of future cash flows equals the initial purchase price.

4. CASH FLOW S

Cash flows need to be carefully prep ared to cap ture explicitly all infor-

mation relating to income, expenditure and exit value (at the end of the

cash flow) and should include, as and w hen ap propr iate, rental growth,

taxation, external financing an d a ll costs. Particular care is need ed w hen

considering depreciation to ensure double counting does not occur.

Cash flows can cover any time horizon bu t are norm ally u ndertaken for10 or 15 year periods. Provided assum ptions and inpu ts remain constant,

there w ill be little difference in outcom e irrespective of the time hor izon.

Accord ingly, the characteristics of the sp ecific asset and the n eeds of th e

client should be taken fully into account when fixing the time horizon.

The cash flow must include an exit value which would normally be

calculated using conventional valu ation techniqu es. In th e case of lease-

holds where the cashflow duration coincides with the lease expiry, the

exit value can be zero, or even negative w here dilapid ations might exist.

5. D ISCO U N T RAT ES

An appropriate discount rate for cash flow analysis of property assets

can be defined as th e rate of return from an investment th at adequ ately

compensates an investor for the risk taken. There are various ap proaches

in adopting an ap propr iate discount rate:

Full Risk-Adjusted Discount Rate each explicit characteristic of an

asset is ascribed its own risk premium.

Partially Risk-Adjusted D iscount Rate areas of risk are grouped to

overcome d up lication and dou ble counting.

Single Market Risk Discount Rate a single risk premium is pre-

scribed to cover all risks associated w ith an asset.

Although each app roach has ad vantages and d isadvan tages, this Paper

commends the use of a Partially Explicit Discount Rate for general use.

Through use and experience, the practitioner should gain a working

und erstanding of the app lication of high risk into an ap propr iately high

discount rate compared to a lower discount rate being applied to a

lower risk asset.

Discount rates are likely to vary between clients and consultation is

encourag ed between valuers and clients to ensure the selection of an

appropriate rate.

8

C A L C U L A T I O N O F W O R T H


9/52

6. REPO RT IN G

Practitioners should follow the requirements of the RICS Appraisal and

Valuation Manual in taking instructions and reporting results. Clarity

regarding sources of information and clearly stated assumptions are

crucial and represent good practice. Reports shou ld always be in w riting.

7. CALCU LAT IO N OF W ORT H

The professional undertaking of the calculation of worth, using DCF

techniques, can add considerable understanding of an asset, its charac-

teristics and performance possibilities, and is a particularly useful tool

for comparison of investment opportunities. It is commended to all

those involved in p roperty investment.

9

E X E C U T I V E S U M M A R Y


10/52

I N T R O D U C T I O N

1.1 MALLIN SO N RECO MMEN DAT IO N S

1.1.1 In Janu ary 1996, the results of an RICS spon sored su rvey into the u se ofvarious valuation m ethodologies in the assessment ofprice an d worth,

were pu blished. This revealed th at a substantial majority of respon den ts

were using short-cut or full DCF (Discounted Cash Flow) techniques to

calculate worth, but that a significant minority were using traditional

techniques, involving initial yields or all-risks yields, indicating a

misunderstanding of the meaning of worth, or perhaps a confusion

between price an d worth.

1.1.2 The Mallinson Report, which was published in March 1994, dealt withissues and problems relating to th e valuation and app raisal of comm ercial

property and made some 43 recommendations for future action to

improve not only the service provided by valuers, but also the under-

standing of valuation concepts and methodology by users and providers

of valuations. The report dealt with the issues ofprice an d worth an dmade two specific recommendations in relation to the latter:

Recommendation 15: The Institution should lead in the development of a

definition of worth as a valuation basis, inviting the Investment Property

Forum to lead research into techniques of assessing and expressing worth .

Recommendation 25: The RlCS should take the lead in codifying and

disciplining DCF techniques and developing new methodology and in formation

bases, with the object of reducing valuers dependence on current all-risks yield

methods. Guidance Notes should be produced for the new techniques which

should be developed and presented to common professional standards. The

RICS should also encourage and monitor their use in parallel with moreconventional techniques until they demonstrate validity and reliability in their

own right.

1.1.3 These two recommendations are linked in that there was an untestedpresum ption that worth is best calculated by the use of explicit DCF

techniques.

1.2 W ORKIN G PART IES

1.2.1 The Royal Institution of Chartered Surveyors set up two workingpar ties, one jointly with the Investmen t Property Forum , to take forw ard

these recomm endations. The first working p arty on commercial property

valuation methodology assisted in the creation of a definition of worth

wh ich is now contained in theRICS Appraisal and Valuation Manual (The

Red Book). In addition, the working party has published Commercial

Investment Property: Valuation Methods (An Information Paper), the purpose

of which is to provide a reference document for the profession to help

valuers und erstand fully the range of valuation techniques available to

them and their appropriate use.

1.2.2 The second w orking party w as charged with explaining the m ethods ofassessing worth in order to encourage the adoption of a consistent

app roach. This Information P aper, therefore, prov ides a reference docu -

ment for valuers in the und erstanding ofworth calculations.

10

SE C T I O N 1


11/52

1.3 RELEVAN T MAT TERS

1.3.1 Readers of the Information Paper should be aware of a number ofmatters which are germane to the calculation of worth.

(a) Investment Worth: The worth working party has, at present,

confined itself to the calculation of worth for commercial property

investments. Worth calculations for owner occupiers and busi-

nesses involve assessments of profit flows and goodwill, and are

the subject of debate elsewhere. Worth calculations for social

purposes, such as public sector assets and projects, should

properly be th e subject of cost/ benefit studies wh ich m ay u tilise

similar techniqu es for calculating worth but extend far beyond the

present remit.

(b) Informative: Worth is a subjective concept and whilst the

Information Pap er attempts to provide a consistent framew ork for

worth calculations of commercial property investments, it is not

intended to be prescriptive but informative. Valuation techniques

are continually evolving and there is no absolute consensus w ithinthe p ractical or academ ic arenas as to the best or correct appro ach

to the use and / or calculation of discoun ted cash flows. It is, there-

fore, envisaged that this Information Paper will be the subject of

periodic update and alteration.

(c) Forecasting: Calculations of worth involve forecasts of future

changes in rents, costs and yields. The Mallinson Report considered

forecasting to be a sep arate area of activity. This is likely to be th e

subject of a further Information Paper in the future.

1.4 GLO SSARY OF T ERMS

1.4.1 In order to have a proper u nd erstanding ofcalculation of investment w orthmethodologies it is important that practitioners are familiar with the

vocabulary gen erally used in d iscoun ted cash flow techn iques. Attached

as Appendix 1 is a glossary of DCF terminology which the reader may

find helpful.

1.5 GEN ERAL

1.5.1 This Information Paper follows on from the Information Paper,Commercial Investment Property : Valuation M ethods. Readers will find th at

there are some areas of overlap and du plication. This is deliberate as the

Papers have been produced with the aim of being read as stand alone

documents.

11

I N T R O D U C T I O N


12/52

PRICE AN D WORTH

PRINCIPAL MESSAGE: To avoid confusion, greater care should be takenover the use of the wordsprice, value andworth. In the context of realestate, value should always be related toprice (Value in Exchange) notworth (Value in Use). Price/value are market driven whereas worth is

subjective and based on the particular requirements/circumstances ofthe individual.

2.1 PRICE, WORTH AN D VALUE MISCONCEPTIONS

2.1.1 The property market has laboured for many years without a clearunderstanding of the difference between price, worth an d value. This

confusion derives in p art from the u se of the word value as a substitute

for price when in many peoples minds value also means worth. This

problem is exacerbated by the fact that, when asked to provide an

opinion on th e spot price of a prop erty, a valuer p rod uces a figure wh ich

is called th e open market value (OMV ).

2.1.2 The situation is not h elped w hen in most d ictionaries, the words valuean d worth are merely synonyms: value being defined as both worth

(desirability or utility) and price (value in exchan ge) and v ice versa.

2.1.3 In the language of economics worth can be considered as value in use,wh ereas price or open market value can be considered as the m ost usual

man ifestation of value in exchan ge.

2.1.4 Price/value in exchange is the outcome of the interplay of the respectivevalues in use of market m akers. In an open an d free market, no tran saction

will be likely if the value in use/worth to the putative vendor is greater

than the value in use/worth to a putative purchaser. Similarly, potentialpurchasers will not be willing to deal at a price which is greater than

their respective values in use/worth. Hence, where practitioners are

providing pu rchase/ sale advice, they should provide calculations of

worth/value in use in order to advise as to whether a sale or purchase

should proceed at any given level of price.

2.1.5 In short, in the prop erty m arket, wh at is often called a valuation is thebest estimate of the trading or spot price of a building/ land and calcula-

tion of worth is the range of individual assessments ofworth/value in u se

to a range of potential purchasers or vend ors.

2.1.6 A prospective owner may also undertake calculations of worth of two or

more different assets on a like basis to enable investment choices to bemad e in a rational way.

2.2 DEFIN IT IO N S

2.2.1 Bearing in mind the confusion between price, worth an d value, it isimportant to be fully app raised of the relevant d efinitions adop ted by

the RICS. These fall under the headings of valuation, appraisal an d

calculation of worth and are contained in the RICS Appraisal and

Valuation M anual. They identify the task being u nd ertaken by the valuer

as d istinct from th e definitions of the bases of value as listed in Practice

Statement 4, Definitions of Bases of Valuation: Assumptions (i.e. Open

Market Value, Existing Use Value and the like).

12

SE C T I O N 2


13/52

2.2.2 The RICS definitions are as follows:

Valuation means the provision of a written opinion as to capital price

or value, or rental price or value, on any given basis in respect of an

interest in p roperty, with or withou t associated information, assum ptions

or qu alifications. How ever, it does not include a forecast of value.

Appraisal means the written provision of a valuation, combined with

professional opinion, advice and/ or an alysis relating to th e suitability

or profitability, or otherwise, of the subject property for defined

pu rp oses, or to th e effects of specified circum stances thereon, as judg ed

by the valuer following relevant investigations. It may incorporate a

calculation of w orth (see below) as requirement s dictate.

Calculation of worth means the provision of a written estimate of

the net monetary worth, at a stated date, of the benefits and costs of

ownership of a specified interest in property to the instructing party

reflecting th e pu rp ose(s) specified b y that par ty.

2.2.3 Having regard to the p receding d efinitions and the commentary on thedifference betweenprice an d worth, it is felt app ropr iate that th e following

convention should be adopted by all those involved in the provision of

valuations and calculations of worth:

Price is the actu al observable exchange p rice in the op en m arket.

Value is an estimate of the price that would be achieved if the property

were to be sold in the market.

Worth is a specific investors perception of the capital sum w hich h e wou ld

be prepared to pay (or accept) for the stream of benefits which he

expects to be prod uced by the investment.

2.3 WORTH IS IN T HE EYE OF T HE BEHO LDER

2.3.1 Worth is not an abstr act concept an d is capable of calculation. How ever,because th e value in use of a property w ill vary from one u ser to another,

calculations of worth will require significant inp ut from the client/ user in

respect of their individual requirements and preferences.

2.3.2 The Red Book definition ofcalculation of worth is qualified by a riderwh ich is w orth repeating in full:

The benefits or costs to be assessed may be either the revenue and

capital flows accruing to a financial investor or the business benefits and

costs accruing to an occupier. The calculation should be differentiated

from an estimate of the market price of such benefits and costs. The

calculation should identify and record the derivation and pattern of

change of the benefits and costs, and the basis of discounting. The

elements of the calculation may be derived from the Valuers views of the

benefits and costs, or the Clients and often a combination of the two. On

occasion, criteria for the assessment may be provided by the Client and

such criteria must be stated when the calculation of worth is provided.

Calculations of Worth may need to reflect benefits and costs accruing

over a defined and pre-agreed period and may therefore commonly

involve an estimate of reversionary net sale proceeds.

(RICS Appraisal and Valuation Manual, Definitions)

13

P R I C E A N D W O R T H


14/52

2.3.3 To prod uce a valid an d useful calculation of worth, the valuer w ill need tobe in close liaison with the client in respect of his individual require-

ments and jud gements in order to agree on such matters as rates of infla-

tion, market changes and risk rates. In most cases, the Valuer will be

pro-active in advising on these issues. Therefore, a calculation of worth

can only be undertaken with full and detailed instructions from the

client. In Section 7 of this Information Paper, the issue of instructions

and reporting is covered in greater d etail.

14

C A L C U L A T I O N O F W O RT H


15/52

CALCULATION OF WORTH METHO D OLOGI ES

PRINCIPAL MESSAGE: Calculations of investment worth in asset classesother than property all involve some form of DCF techniques.There isno reason why DCF should not also be used in the property sector butadapted to meet its particular characteristics.

3.1 IN T RO DU CT IO N

3.1.1 While calculation of worth method ologies may be viewed by some in theproperty profession as relatively new, they have been extensively

emp loyed for some tim e within th e finan cial sector. An examin ation has

been undertaken as to how these techniques have been applied by

analysts within other asset classes and the conclusion is that these are

very similar to approaches currently used for property. In this section

we have only made note of the key points in relation to these other

assets.

3.1.2 Interestingly, within the equ ity sector (wh ich is examined in more d etailbelow), the price earning s, or PE ratio, is regarded as the m ost impor tant

measu re of the expen siveness or otherw ise of a share. Calculated as the

ratio of the p rice of a share to th e earnings per share (EPS), this is directly

compa rable to the concept of Years Pu rchase (YP) used in p ropert y

valuations.

3.1.3 Within the financial sector as a whole, the extent of the use of a DCFapproach to the calculation of investment worth varies between

companies and users.

3.2 EQ U IT Y MARKET

3.1.1 Within the equity m arket, many analysts will employ wh at is termed adividend discount analysis, and this is used extensively in the United

States. In simple terms, this entails the projection of what are usually

half-yearly dividend payments, based on current pay-out levels, and

forecasts of dividend growth, and discounting these back at a target or

required rate of return. This is not an easy matter as the estimation of

profitability and the proportion of these profits distributed by way of

dividend payments is not at all straightforward. Many analysts will,

therefore, forecast dividend growth only in the short term after which

growth is assum ed to revert to long-term trend levels.

3.2.2 This type of approach has been discussed extensively in the financial

press as a means of valuing stocks, and analysts adopting a ValueInvestment App roach 1 were concluding in 1996 that the equity markets

were overvalued an d that equity w eightings in p ortfolios should conse-

qu ently have been redu ced. In short, worth calculations were ind icating

over-pricing in the market.

3.2.3 Whatever the validity of this method of assessing worth (DividendDiscoun t Analysis/ Value Investment App roach), it shou ld be stressed

that it is mainly appropriate for long-term investors only.

15

1(PDFM Value Investmen t App roach: analysis of value-based investmen t.Mike Lenhoff of Capel-Cure Myers, Paul Walton of Goldman Sachs an d

Jam es P. O'Shau ghn essey (U S.))

SE C T I O N 3


16/52

3.3 GILT MARKET

3.3.1 Within th e gilt mar ket the picture is mu ch clearer. A pu rchase of 100nom inal of gilts at a given price entitles an investor to a fixed an d gu aran-

teed coupon payment, on a half-yearly basis, up until the redemption

date w hen the 100 is repaid. In this case, both the m agnitud e and timing

of all payments is known with certainty. Therefore, the return to the

investor, also known as the gross redemption yield, is simply the

discount rate wh ich equ ates the present value of the known future cash

flows, up until the final redemp tion date, with the current m arket price.

Alternatively, investors m ay adop t a required target rate of return as the

discount r ate in an attempt to determine the w orth to them of a gilt and

compare this with the current price to determine whether a particular

gilt is, in their v iew, fairly priced.

3.4 BO N D MARKET

3.4.1 Similar considerations hold within the corporate bond market. The maindifference here is that future paym ents are depend ent on the continued

success of a comp any an d, hen ce, the risk of default m ust also be factoredinto any calculations. This is generally allowed for by an addition

to the gross redemption yield for a comp arable gilt. A more d etailed

discussion as to the construction of appropriate discount rates is

contained in Section 6.

3.5 ACT UARIAL CALCU LAT IO NS

3.5.1 Within actuarial circles DCF techniques are widely used. There aremany reasons why this is the case. Firstly, and perhaps most impor-

tantly, it enables the assets of a company or p ension fund to be calculated

in a way which is consistent with the way in which liabilities are

assessed. It makes sense that, rather th an valu ing assets at mar ket valuewh ich often reflect short-term vagaries of the markets involved , they are

valued on a longer-term basis in line with the valuation of liabilities.

This means that DCF variables such as the discount rate (which will

generally be the long-term return expected to be earned on new invest-

ments in the future) are the same for both assets and liabilities and can

be varied to test a companys pension funds financial strength,

measured by the excess value of assets over liabilities, under different

scenarios.

3.5.2 Similarly, if all assets are ap pr aised in this w ay, the actua ry is able to testthe sensitivity of total asset values to the changes in the economic

factors and financial variables on wh ich they are dep end ent. Again, this

app roach ensur es that all assets are treated in a consistent w ay.

3.5.3 The use of DCF techniques within financial institutions is, therefore,widespread and ranges from asset/ liability modelling for pension fund

solvency pur poses to assessing sustainable bonu s rates on life assura nce

policies for insuran ce comp anies.

3.6 PRO PERT Y SECTO R

3.6.1 For the property m arket, the adoption of these techniques w ill help topu t the analysis of property on an equal footing with other assets. The

sole reliance on conventional method s of prop erty valuation is perceived

by professionals within other markets as being both inaccurate andillogical. Any m ovement aw ay from these methods w ould h elp promote

propertys position within the multi-asset portfolio.

16



17/52

3.6.2 Notw ithstand ing the benefits listed above, there is still a certain amou ntof unw illingness within the p roperty sector to adop t explicit app roaches.

Much of this centres around the surveyors unfamiliarity with the

number of variables needed for such appraisals, the difficulty of

analysing comparables, and the general reluctance to forecast or quantify

expectations. With respect to the latter, it is incumbent on property

researchers to dem onstrate th e same level of forecasting skills shown in

other financial markets.

3.6.3 The structure of leases in the United Kingdom, with the historic legacythat m ost were agreed for a period of 25 years with u pw ards-only rent

reviews, and the over-rented state of many sectors of the market in the

1990s, has certainly assisted in overcoming some of the uncertainty

und erlying futu re property cash flows. How ever, the movement w ithin

the industry to shorter leases means that this factor is becoming less

helpful in determining cash flows with a great degree of certainty.

3.6.4 The popular use of the PE ratio within equities markets shows thatsimple pricing techniques are applied in other financial markets just as

the YP is used in the property m arket. However, the analysis of theattractiveness of a p articular equ ity will normally be u nd ertaken using

an exp licit discounted cash flow technique. Therefore, there is no reason

why the property sector should not adopt the same explicit DCF

app roach for calculation of worth.

3.6.5 Following the old adage value as you analyse, it is likely that pricingmodels themselves will become more explicit as more people analyse

worth on this basis. This is particularly true when the cash flows

produced are either irregular or complex. The use of explicit DCF tech-

niqu es for pricing is discussed at length in the RICS Information P aper,

Commercial Investment Property : Valuation M ethods.

17

C A L C U L A T I O N O F W O RT H M ET H O D O L O G I ES


18/52

D CF MATHEMATICS

PRINCIPAL MESSAGE:The DCF methodologies which underlie any invest-ment appraisal are based on sound and widely accepted mathematicaltechniques.


4.1.1 Before looking in m ore detail at th e topic of DCF mathem atics, it is use-ful to reiterate both th e concept and definition of the Net Present Value

(NPV) an d Internal Rate of Return (IRR) in a financial app raisal.

4.1.2 The NPV of an investment is the present value of all future expectedincome and capital flows, discounted a t the investor s target or required

rate of return, and in this case it is the assessment of current worth

wh ich is the unknow n.

4.1.3 In the case of IRR analysis, the p rice of an inv estment is kno wn , with th e

unkn own being the IRR. This is the d iscount rate wh ich, wh en app liedto all future expected income and capital flows, equates the price with

the present value of these discounted income flows.

4.1.4 There are generally accepted mathematical approaches to DCF calcula-tions which can be further expanded to provide additional levels of

soph istication. The aim of th is section of the Pap er is, however, to give

a reasonably simplistic overview of the DCF process and, therefore, it

will exclude some of the more complicated theoretical issues which

can arise, althou gh som e of these will be touched on briefly later in this

section.

4.2 DCF CALCU LAT IO N

4.2.1 The basic form of an y DCF calculation is as follows:

DCF GPV = CFl + CF2 + CF3 + ....... + CFn + .......

(l+i) (l+i) 2 (l+i) 3 (l+i) n

where CFn is the net cash flow in p eriod n, an d i is the discount rate

or required rate of return p er period.

4.2.2 The formula suggests that the analysis is performed by valuing cashflows in perpetu ity which is natur ally correct for a freehold inv estment .

What actually hap pen s in practice is that a notion al sale is assum ed at agiven d ate in th e futu re, say after 10 or 15 years or, if more convenient,

at the expiry of a lease. This means tha t the valu e of the proper ty at this

time also has to be estimated and this is generally performed using

conventional valuation techniques. Naturally, the further away this

notional sale or exit value is, the less imp act it has on the calculated n et

present v alue because of the effect of discoun ting.

4.2.3 The first stage of any analysis is then to produce forecasts of net cashflows over a specified time period and to decide on the appropriate

discount rate to use. For property, which generally produces rental

income on a quarterly in adv ance basis, it is logical to prod uce estimates

of such flows also on a quarterly basis and, hence, the discount ratesused in the equation above w ill also need to be quarterly rates.

18

SE C T I O N 4


19/52

4.2.4 It is important to remember that it is net cash flows that are requiredso that positive income flows in the form of rental income should be

adjusted to reflect any necessary expend iture. A further comp lication

is that because of the individual nature of the majority of leases,

which naturally has an impact on future rental flows, it is necessary to

calculate forecasts of rental incom e on a lease-by-lease basis. While this

may sound like an enormous task, particularly in the case of large

shopping centres, there are valuation packages available in the market

wh ich d o mu ch of the hard work requ ired. In add ition, spreadsheets can

be used for such purposes and these are reasonably easy to construct

and manipulate.

4.2.5 An examination of how th e necessary cash flows shou ld be generated isshown in Section 5 of this Paper with the d erivation of an ap propr iate

discoun t rate explored fu rther in Section 6.

4.2.6 Having established expected cash flows and selected an appropriatediscount rate, it is now possible to calculate an estimate of property

investment worth. As mentioned above, this can be p erformed using a

spreadsheet. These software packages have built-in functions whichperform the necessary calculations autom atically, based on g iven inpu ts

for net cash flows and discount rates. The basic format of the functions

to calculate th e NPV and IRR within th ese is as follows:

Net Present Value = NPV (d iscount rate, range)

In ter na l Ra te of Ret ur n % = IRR (r an ge, g uess)

wh ere range represents the r ange of cells in the sp readsheet containing

the cash flow data for each period and the discount rate relates to the

target rate of return per period and is expressed as a decimal (e.g. forann ual cash flows and an an nu al target return of 10%, discoun t rate would

be input as 0.1).

4.2.7 Within the IRR function, the result is worked out basically by using acomplex meth od of trial and error. To do th is, it is necessary to inpu t an

educated guess of the answer to get the process started. Again, this

should be entered as a d ecimal and should relate to the IRR per period.

4.2.8 In some instan ces, par ticularly in t hose cases where th e calculated cashflows move from positive to negative and back again (or vice versa),

there may not be a unique IRR. This is a mathematical aberration.

Normally, the differing answers will be far apart, but it would be

prudent to test the most likely figure by checking that, at the IRR rateadop ted, the NPV does sum to zero.

4.2.9 Note that the NPV formula within packages often calculates the netpresent value of the specified cash flows assuming they are received at

the end of each period rather than in advance. If the NPV is to be

calculated on th e basis that cash flows are received a t the beginn ing of a

period, which may often be the case for property, the NPV calculated

should be m ultiplied by (l+i/ 100) wh ere (i) is the discount rate % per

period (see Appendix 2 for an illustrated example).

4.2.10 An IRR could be similarly calculated, and in this case the first cash flow

should be adjusted to reflect the initial cost or outlay of the investmentun der consid eration (wh ich w ould be the Gross Purchase Price or Value

[GPV] for a new proposition). Clearly, if a purchase is be made at the

19

D C F M A T H EM A T I C S


20/52

GPV, then the IRR thus calculated will be the target rate of return. If a

purchase can be made at a figure below GPV then the purchaser will

exceed the required rate of return and vice versa.

4.3 PERFO RM AN C E M EA SU REM EN T AN D D CF

4.3.1 Finally, it is useful to consider h ow the IRR fits in with the concepts oftime-weighted and m oney-weighted rates of return as w ays of measuring

property performance, albeit that the latter two are normally used as

retrospective measures. These rates of retur n are d efined as follows:

(a) Money Weighted Rate of Return (MWRR)

The money w eighted rate of return is the same as the internal rate

of return so tha t it is calculated by findin g the d iscoun t rate w hich

equates the initial outlay with the present value of all future cash

flows as defined above.

(b) Time Weighted Rate of Return (TWRR)

This is simply the geometric mean rate of return. It is calculated

by taking the nth root of a series of intermediate returns over

n per iods. For instan ce, if the return s over four su ccessive periods

are 1%, 2%, 3% and 4% say, the TWRR is given by:

TWRR = ( (1.01) x (1.02) x (1.03) x (1.04) ) - 1

= 0.024939 (or 2.4939%)

It is interesting to n ote that if there are no in term ediate cash flows over

the period of analysis, then these two measures will be identical.

4.3.2 The MWRR is currently used by the Investment Property Databank(IPD) to calculate annual property performance. However, such a mea-

sure fails to recognise the significance of the timing and magnitude of

capital inflows and outflows throu ghout the measurement period. If one

fund experiences a large inflow of investment capital just before a bull

market, wh ereas a comp eting fund suffers a capital outflow at th e same

time, the first might app ear sup erficially to h ave performed better than

the latter. The use of TWRR neut ralises the effect of cash flow timin gs so

that the relative skill of an individual fund manager can be assessed

over th e time per iod. The TWRR is used by IPD to calculate th e average

annu al performan ce over a num ber of years.

4.3.3 Most analysts within the property profession will adopt an MWRRapproach to investment performance measurement. This is driven by

general market practice and th e method s employed by software packages

used for such calculations. Any client instru cting a num ber of valuers to

prod uce assessments ofworth on a recognised system can, therefore, be

reasonably certain that given th e same inpu t for any on e asset d ata, the

assessment ofworth will not alter m arkedly between valuers.

4.4 DCF W ORKED EX AMPLE

4.4.1 A detailed example of a DCF calculation of worth is attached at Append ix 3.

20



21/52

T O WA R D S A N I N D U S T RY S TA N D A R D

CAS H FLOW D ATA

PRINCIPAL MESSAGE: All factual data relating to a property should beincorporated into DCF including the costs of ownership. Care should betaken to avoid the double counting of depreciation through both

adjusting rental expectations and exit yields, whilst also allowing forrefurbishment and upgrading costs in the cash flow.Worth calculationsrequire the use of output from forecasting techniques.Tax and financecosts can be included at the clients behest, but adjustments to discountrates may be necessary to reflect changed risk profiles.


5.1.1 The use of DCF techn iques involves the va luer in assessing a w hole vari-ety of variables in order to arrive at a calculation of worth, this being the

net monetary worth at a stated date of the benefits and costs of ownership. The

process can, however, be divided into three elements:

Cash Flow Data

Tim e H or izon

Discou n t Ra te

This section deals with the first two elements and Section 6 deals with

discount rates.

5.1.2 In the Information Paper, Commercial Investment Property: ValuationMethods, differentiation was made between market information and

client's judgement on specific information in the undertaking of a DCF

valuation. Market information was identified as being current factual

data on a property which should not be affected by the specific criteriaof clients, and future data, such as future rental value changes and

appreciation rates, future redevelopment or refurbishment costs, and

exit yield forecasts was identified as being subjective to the client

and / or h is advisor. Clients specific information included factors such as

holding period, loan facilities, taxation and d iscoun t rates.

5.1.3 In undertaking calculations of worth rather than market valuations, thevaluer must have regard to the client's judgement on the inputs to

be adopted, other than the current factual matrix of data (i.e. tenure,

physical attributes and lease terms). However, he may well ask for the

valuers opinions on the inputs and, if requested, the valuer should

adopt market-based forecasts for rental and yield movements, rather

than th e clients own views, and should ad vise on ap propriate discoun trates having regard to sector and property specific factors.

5.2 CASH FLOW DATA

5.2.1 Set out in Table 1 are the relevant data and forecasts which shouldgenerally be includ ed in the creation of a cash flow.

5.2.2 Further comment is approp riate on a nu mber of matters.

5.3 TAX AT IO N

In assessing market value (price), taxation is not usually explicitlyfactored in to the calculation, as comp arison-based evid ence is generally

analysed on rentals and expenditures gross of tax. The use of DCF

21

SE C T I O N 5


22/52

Type of Information

Tenure

Physical Attributes

Lease/sublease andoccupational interests

Value

Costs of property ownershipand holding costs

Redevelopment/refurbishment

Finance

Taxation

Current Data

Title including headlease details(if applicable)OutgoingsHead Rents

Unfulfilled S106 andhighway obligations

Floor areas (net and gross)Ancillary ares and car parkingBuilding specificationsTenants improvements

Tenancy detailsLease expiry datesBreak clausesRent review datesRent review terms

Rents passing(including stepped rents)Estimated rental values

Vacancy/void costsUnrecoverable service costsUnrecoverable managementcostsLetting and review costsPurchase and sale costs

Costs of redevelopment/refurbishmentDilapidations

Loan detailsBreak costs

Income and capital gainsVAT electionCapital Allowances

Forecasts

Planned or possible changes inareas/parking provision

Future voidsPerpetual void allowance

Future local market rentsFuture rents for the propertyFuture exit yield

Inflation in maintenance andrunning costs

Inflation in building costs

Changes in interest rates

22


techniques allows taxation to be factored into the calculation.

Accord ingly, the valuer m ay feel it appr opr iate to un d ertake calculations

of worth both w ith and without taxation imp lications.

5.4 FIN AN CE

Investment worth calculations should take into account the clients

return on equity emp loyed w here required, and w hen instructed by the

client, the costs of finance (i.e. interest payments, arrangement fees)

can be factored into the cash flow itself. Further adjustment may be

necessary to the discount rate adopted to reflect the additional risk

incurred by adopting a geared position as opposed to an investment

wh ich is 100% equity finan ced.

5.5 FO RECAST S

5.5.1 To undertake calculations of worth, it is necessary to forecast likelychanges in rental and capital values, yields and inflation in building

TABLE 1:IN FORMATIO N FOR DISCOU NT ED CASH FLOW MIGHT IN CLUDE:


23/52

costs, over th e holdin g p eriod. There is a section of the Mallinson Report

(paragraphs 9.23 9.28) which deals with the issue of forecasting.

Paragraph 9.25 of the Report is worth repeating:

True forecasting, in our view, inv olves the construction of models of the

property market derived from in sight in to the motors of that market and

utilising fundamentals derived from wider economic and financial

market models. It ut ilises intellectual disciplines and data sources quit e

different from those needed for valuation to price. Valuations to

[calculations of] worth will utilise the product of such models to assess

their variables but do not, in themselves, include forecasting techniques.

5.5.2 The implication of the above is that forecasting should only be under-taken by those w ho either h ave, or hav e access to, the necessary skills to

undertake forecasting. It is, therefore, important to establish with the

client the basis upon which estimates of future changes in values and

yields are to be made. If the client requests the valuer to provide fore-

casts rather th an instructing the valuer to adop t forecasts given by the

client, then the valuer shou ld consider wh ether he has the qu alifications

app ropriate to p rovide the n ecessary ad vice.

5.5.3 The situation is made more complicated by the fact that forecasting atthe local level is very much less well-developed than forecasting at the

national or regional level. The latter is norm ally based up on econometric

modelling of the economy and the property market, identifying

relationships which have occurred in the past and using leading

indicators or forecasts to produce an estimate of each variable in the

future. The former, du e to the p aucity of the quality and quantity of data

at a local level, coupled with the increased importance of the supply

side, makes forecasts of property market m ovements at the ind ividual

prop erty level difficult.

5.5.4 It should also be noted that there is a distinct difference between a(n)(econometric) forecast and a market expectation. An expectation could

be described as an exposition of market sentiment. For example, by

knowing that investors require a target return of r%, it is possible to

analyse transactions to determine expectations of average annual rental

growth. The fact that similar properties are selling for similar prices

indicates that this growth expectation is a reflection of market senti-

ment. It is, therefore, possible within any calculation of worth to simply

test the impact of this expectation withou t the need to resort to a formal

forecast. In addition, sensitivity analysis can be undertaken by the

valuer b y varying rental growth rates above and below p erceived m arket

sentiment.

5.5.5 Valuers who do not have access to formal forecasts should still be ableto make informed comments on prospects for an individual property,

but the basis and background to any assumptions made about future

changes in rental values, yields and costs should be made clear to the

client.

5.5.6 Care should be exercised not to double count on depreciation. Forecastchanges in rent mu st take into account the changing p hysical and func-

tional state of the property over time. Where allowance is made on the

cash flow for upgrading, by way of refurbishment costs, rental expecta-

tions must also be adjusted.

23

T O W A RD S A N I N D U ST RY ST A N D A RD C A S H FL O W D A TA


24/52

5.6 EX IT YIELD

5.6.1 Where a time horizon or holding period of mu ch less than 20 years isadop ted, particular care should be taken in considering the ap propr iate

exit yield, as it determines the residual/ exit value and may h ave a

significant impact on the worth figure.

5.6.2 The exit yield should normally use conventional valuation techniquesand also generally reflect the anticipated state of the property, both in

phy sical as well as in tenu re/ leasing term at th e exit date. This should be

overlaid with forecast m ovements in general interest rates and property

yields. These forecasts should follow anticipated trend lines and not

try to catch volatile market movements in property yields (e.g. as in

1988/ 89 and 1991/ 92). It ma y w ell be that the exit value reflects land

values where demolition of the building(s) is anticipated.

5.6.3 In add ition, valuers should be careful to avoid the d ouble coun ting ofdepreciation. Where allowance has been made for refurbishment and

upgrading in the annual cash flow during the holding period, the exit

yield should reflect the anticipated state of the property having regardto the completion of the refurbishment programme. This is particularly

relevant in m ulti-tenanted buildings, such as shop ping centres, where

the landlord can control physical and, to a certain extent, functional

obsolescence.

5.7 T IME H ORIZ ON / H OLDIN G PERIO D

5.7.1 The time horizon adop ted for the calculation of worth mu st be driven bythe requirements of the client, although m ost mod els used by investors

utilise a 5 to 15 year h orizon. If details of the cash flow remain the sam e,

there is very little difference in ou tcome irrespective of wh ether you use

a 10, 15 or 20 year horizon. How ever, with time hor izons mu ch un der 10years, there will be d istortions du e to the significant imp act of pu rchase

and sale costs on th e cash flow.

5.7.2 The time period to be adopted for the cash flow exercise will also beinfluenced by material events in relation to the property itself, such as

break clauses or lease expiries which can lead to substantial refurbish-

ment expenditure or voids. However, care has to be exercised if worth

calculations for different properties are used to compare the advantage

of buying one particular property over another, as IRRs used over

different time periods do not always make it possible to determine

automatically which is the superior investment from the prospective

owners point of view.

24



25/52

RISK ASS ESS MEN T D ISCOUN T RATES

PRINCIPAL MESSAGE: In calculatingworth using DCF techniques, careshould be taken in the adoption of an appropriate discount rate. Thelatter can be fully explicit (full risk-adjusted discount rate), part iallyexplicit (partially risk-adjusted discount rate) or the more implicit

(single market risk discount rate).The preferred approach can vary butis typically part ially explicit. Anyone undertaking a calculation ofworth should be careful to avoid double counting of risks either byallowance both in the cash flow and in the exit yield or by allowanceboth in the cash flow and in the discount rate.


6.1.1 An appropriate discount rate for cash flow analysis of property assetscan be defined as that rate of return from an investmen t that adequ ately

compensates any investor for the risk taken. As risk rises, the compen-

sation for the level of risk rises; this is reflected in a rise in the discount

rate. Likewise, if risk falls, the d iscoun t rate follows su it. An ad equat ecompensation is usually defined by reference to the return on an alter-

native form of low risk or riskless asset (usually the gross redemption

yield on govern men t gilts or cash). Typically, the riskless return is taken

to be the income yield on a long/ med ium d ated government gilt, with

15 to 25 year duration. An adequate return from property investment

can then be calculated by adding a suitable allowance for the risk of

holding a property asset (a risk premium RP) to the return on a

riskless a sset (Risk-Free Rate RFR).

6.1.2 While this seems a relatively straightforward process, actually determiningthe risk premium attributable to property assets or indeed any other

asset is more complex. Propertys heterogeneity makes the choice orcalculation of an appropriate risk premium particularly problematic.

Unlike shares in a Public Limited Company (PLC) two property assets

are very rarely identical and technically their risk prem ium will differ on

the v ast m ajority of occasions.

6.1.3 What then are the salient factors in deriving a p roperty risk premium ?

(a) Risk-free rate of investmen t;

(b) Illiquid ity up on sale (e.g. lot size, transaction times, availability of

finance);

(c) Failure to m eet market rental expectations (forecast rental growth );

(d) Failure to meet m arket yield exp ectations (forecast yield shift);

(e) Risk of locational, econom ic, physical and functional d epreciationthrough structural change;

(f) Risks associated w ith legislative change (e.g. planning/ privity of

contract, changes in fiscal policy);

(g) Tenant d efault on rental paym ent (covenan t risk);

(h) Risk of failure to relet (void risks);

(i) Costs of ownership and management; and

(j) Differing lease structures (e.g. rent review stru cture, lease breaks)

6.1.4 Factor (a) is commonly taken to be the gross redemption yield on U.K.gilts. The choice of gilt can v ary; typically a med ium -dated gilt is taken

although some investors prefer to match their choice of gilt term with

the un expired lease term on an in vestmen t. Ad ditionally, some investorsmay choose to use the real return of index-linked gilts. If this approach

is adopted, then inflation expectations become a factor which must be

explicitly incorporated into the r isk premium .

25

SE C T I O N 6


26/52

6.1.5 Factors (b)(f) are generally regard ed a s the risks of structu ral change ormarket failure which may affect the market as a whole, particular sub-

sectors or groups of property. The structural impacts on the in-town

retail market brought about by the introduction of out-of-town retailing

and changes to p roperty taxation such as Value Ad ded Tax (VAT) wou ld

be good examp les of this. As such, these risks could be called marketor

systematic risks.

6.1.6 Factors (g)(j) are, broadly speaking, risks associated with individualassets. These risks could be described as property, non-market or unsys-

tematic risks.

6.1.7 These definitions (market/ non-market) are relatively broad as none offactors (b)(j) are entirely sep arable or mu tua lly exclusive. For examp le,

the risk of failure to m eet mark et yield expectations could be a fun ction

of any one of, or a combina tion of, factors. Quite clearly then , the d egree

of separation of the various risk factors and their incorporation into a

DCF are of key importance in the validity of an appraisal.

6.1.8 The accepted m arket norm has been that certain elements of risk are bestincorporated through adjustment of the discount rate and that certain

risks are best incorporated in the cash flow itself. In terms of property

risks, market risks (factors (b)(j)) are typically incorporated in the

discount rate, whereas non-market property risks (factors (g)(j)) are

built into the cash flow. However, there are a number of technically

correct app roaches to incorporating risk into the cash flow wh ich requires

examination.

6.2 FU LL RI SK-A D JU ST ED D I SC O U N T RAT E ( FRA D R)

6.2.1 Simp listically, if it w ere possible to ascribe a r isk prem ium to each of the

above factors, their sum (taking into account separat ion/ exclusivity)wou ld then give an accurate risk premium for each property asset. When

combined with t he ap prop riate Risk-Free Rate this wou ld effectively be

a Full Risk-Adjusted Discoun t Rate (FRADR) for an ind ividu al asset to

be app lied to the cash flow.

6.2.2 However, there are a number of inconsistencies and problems in thisapproach:

(a) Determin ing separate risk prem ia for each risk factor is a complex

and time consum ing p rocess, requiring sp ecific research, which in

the vast m ajority of cases wou ld be either im possible to calculate

(given the pau city of, and secrecy attached to, ind ividu al prop erty

dat a) or impr actical given the scope and size of the variou s invest-ment m arkets; and

(b) We have already seen th at there is some degree of overlap

between risk factors. Even in such a risk explicit approach, it is

very difficult to eliminate double counting of risk in some form.

This is largely a reflection of th e valuer s tendency to include som e

reflection of risks implicitly w ithin an exit yield in establishing th e

residu al/ exit value in a DCF. Additionally, it is comm only regarded

as more approp riate to incorporate some of the risks in the cash

flow appraisal itself (e.g. reflecting the risk of increased void

levels in a property by ad justing the length of the v oid period in

the appraisal while still adjusting the discount rate applied).

26



27/52

6.2.3 It is, therefore, necessary to qu estion w hether th ere are more ap prop riatemethodologies which are both less time consuming and allow for a

clearer separation of risks within the appraisal.

6.3 SI N G LE M ARKET RI SK PREM I U M ( SM RP)

6.3.1 When combined with the risk-free rate of return, one such approachwou ld be the app lication of a single risk prem ium for all proper ty assets.

6.3.2 This assum es that investmen t in any assets carries more risk than inv est-ment in cash, and that irrespective of type of assets (equities, property,

etc.) there are common risks of investment which do not differ substan-

tially across asset classes.

6.3.3 How ever, in actual terms it is recognised that investment h eld in p rop-erty is generally less liquid than that held in shares. Hence, a premium

can be derived to account for the return required to compensate an

investor in a single mar ket (e.g. prop erty as opp osed to gilts or equities)

for the risks (of market failure or liquid ity).

6.3.4 This risk premium is then app lied in add ition to th e risk-free rate to givean appropriate discount rate for the calculation of investment worth.

However, it should be recognised that risks may also differ within

single markets between sub-sectors (e.g. in equities between FTSE 100

and FTSE All Share stocks, or in p ropert y between high street shop s and

secondary industrials) or indeed between single assets (e.g. BT shares

and MEPC shares).

6.3.5 This is accounted for in the SMRP app roach to p roperty app raisals byassuming that where risks differ substantially between the SMRP

approach to investment sub-sectors and assets (e.g. high street shops to

M25 offices) such differentials can be reflected in a DCF implicitly byadjusting the exit yield (in the case of property) applied to the asset in

the DCF. This then accounts for future market risks (changes to the

stru cture and ma tu rity of parts of the market, shifts in rates of dep reciation

or changes to legislation).

6.3.6 Further property risks (e.g. voids, management costs) are then incor-por ated explicitly in the income/ expend iture side of the cash flow itself.

6.3.7 Hen ce, it is possible to app ly a single risk premiu m to all prop erty assetsand allow th e DCF to mop up the other m ore property-related factors by

adjusting both th e exit value an d the income stream in the cash flow itself.

6.3.8 The SMRP app roach is based on the assump tion that different types ofrisks can be group ed together and accounted for in a single premium . A

grouped app roach requ ires that, rather than assess every risk for each

asset, it is possible to grou p assets with similar investm ent characteristics

and ascribe risks on a grou ped basis to these comm on characteristics. It

is an approach to DCF appraisal known to be used by the actuarial

profession in calculating investmen t worth.

6.3.9 In strict mathematical terms, this methodology is perfectly valid, inmuch the same way as the FRADR. Indeed, it is by nature considerably

easier both to d erive and to app ly a single risk prem ium to an app raisal

and allow the valuer to alter the cash flow and the exit value at his

discretion. How ever, ma ny of the problems associated with th e app lica-tion an d use of FRADR apply to the SMRP.

27

R I SK A SSESS M EN T D I SC O U N T RA T ES


28/52

6.3.10 The SMRP app roach d oes not make it any easier to eliminate doublecounting of risks and actually determ ining the significance placed up on

various market risk issues (depreciation, structural market shifts, etc.)

becomes more d ifficult as th ey are largely imp licitly incorp orated in the

exit value of the cash flow rather than explicitly being reflected in the

discount rate.

6.3.11 Although the SMRP technique is easier to app ly in practice and , therefore,deals with man y of the comp lexities highlighted in th e FRADR approach,

it is opaque as an analysis tool and, therefore, is not an appropriate

choice in a calculation of worth for a sophisticated investor/ owner of

property.

6.4 PARTIALLY RISK-ADJUSTED D ISCOUNT RATE (PRADR)

6.4.1 Despite the draw backs of an SMRP app roach, it does offer a moresimplistic and usable analysis tool. This suggests that an intermediate

app roach m ay offer an alternative and more soph isticated m echanism

for assessing worth. Certain investors have adopted an intermediate

analysis tool which could be defined as a Partially Risk-AdjustedDiscoun t Rate (PRADR) for u se in DCF app raisals.

6.4.2 Using the same risk-free rate of return, the PRADR assumes that it ispossible to group asset classes in a similar manner as the SMRP

app roach (as detailed in 6.3.4). This perm its the derivat ion of an overall

asset class risk premium (i.e. property risk premium).

6.4.3 The PRADR app roach then d ifferentiates between the d ifferent risk pro-files of sub-sectors of individual asset classes (e.g. within property

high street shops, secondary industrials) by adjusting up or down the

mar ket risk pr emiu m to reflect th e risks associated specifically with the

sub-sector of property being analysed.

6.4.4 This is a less time-consum ing meth od ology and can also be extend ed togrouping individual property risk characteristics (e.g. properties with

similar covenant risks or lease structures). If such risks are grouped,

each m ay also be ascribed a risk p remium. Wh en ad ded to the risk-free

rate and the market risks rate, the total represents a Partially Risk-

Adjusted Discount Rate.

6.4.5 In doing so, the PRADR then becomes m ore transparent an d sophisti-cated th an th e single premium app roach w ithout necessarily becoming

onerous to p erform. This approach is often associated with th e ph rases

target r ate or hurd le rate.

6.4.6 The following example shows how such an intermediate app roach m aybe built up :

HIGH STREET SHOPS

Risk-Free Ra te

Market Ri sks

+ Sub-Sector Risk of M arket Failure (liquid ity, poor rental or yield

performance)

+ Allowan ce for Sub-Sector Depreciation

Property Risks

+ Covenan t Adjustmen t for Sub-Sector (or lease structu res)

= Part ially Risk-Adj usted Rat e of Return for High Street Shops

(incorporating group ed p roperty risks)

28



29/52

Any remaining cost issues (e.g. fees, management, dilapidation and

minor wor ks) are then reflected in the cash flow itself.

6.4.7 Does this method ology solve all the problem s? It does allow the investorto build a relatively transparent model for the appropriate discount

rate, making a great deal of the process explicit without necessarily

committing to intensive research for each property appraisal.

6.4.8 How ever, it is not a pan acea, and if applied in too m uch d etail it merelybecomes a FRADR approach. It should be emphasised that while the

more explicit analysis limits the effects of d ouble coun ting of risk in an

app raisal, this methodology is not an im provement on the FRADR but

merely a simplified form. It is, therefore, a less adequate methodology

for determining if any double counting of risk occurs. It would seem

that irrespective of approach to the selection of the discount rate, the

problems of double counting risk can only be dealt with by careful

app lication of the an alysis tool chosen.

6.5 C HO ICE O F T H E A PPRO PRI AT E RAT E

6.5.1 In the majority of circumstances, investors will already have set appro-priate discount rates (target rates) for a calculation of worth. However, it

is not uncommon for a valuer to be asked to contribute an opinion in the

selection p rocess. At the v ery least, the valuer shou ld be conversan t w ith

the clients thinking in determining the discount rate as this may affect

his treatm ent of other elem ents of the cash flow.

6.5.2 In practical terms calculations of worth will typically take the form of apar tially ad justed app roach (PRADR). This reflects the fact th at worth to

an investor/ owner incorporates perceptions of risk in the m arket that

are particular to the individu al and likely to differ between group s of

assets. This coincides with the practical need to apply methodology,wh ich is relatively explicit withou t being onerou sly comp lex in p ractice

(the FRADR being too impractical and in many cases impossible to

app ly in practice).

6.5.3 Althou gh the Par tially Risk-Ad justed Discoun t Rate (PRADR) relies onthe simp ler prin ciple of group ing risks, particular risk factors specific to

an individual asset may occasionally be reflected in the discount rate

(e.g. it would not be u nu sual for a valuer to adjust a d iscount rate for a

shopping centre to reflect the risk of direct competition from a nearby

scheme under construction). This reinforces the idea that the PRADR

lies between a FRADR and SMRP app roaches and as such any PRADR

analysis can be ad apted to the level of comp lexity ind ividu al investors/

owners (or valuers) wish to (or think ap prop riate to) incorporate in th eiranalysis.

6.5.4 It will, therefore, be common practice to apply a single discount rate,constructed in a manner reflecting the differing risks in the cash flow

and the degree of complexity of the analysis. However, there are

occasions when calculating GPV that valuers commonly use more than

one discoun t rate when two or more sources of cash flow have qu ite

different risk profiles, most particularly for over-rented type invest-

ments. While this is a mathematically correct approach to reflect the

differing risks on income flows, this further increases the problems

associated with double counting and care should be taken in ensuring

the integrity of the cash flows analysed.

29

R I SK A SSESS M EN T D I SC O U N T RA T ES


30/52

6.5.5 It should be noted that none of these approaches can in their own rightprovide a foolproof methodology by which an individual calculating

investment worth can elimina te the problem of dou ble coun ting risks. As

such, the approaches should be applied with care to ensure the least

amount of overlap practically possible.

30



31/52

31

IN STRUCTION S, CAVEATS A N D REPORTINGTO CLIEN TS

PRINCIPAL MESSAGE:Valuers should follow the requirements of theRICSAppraisal and Valuation Manual in taking instructions and reportingthe results. Clarity regarding sources of information and assumptions

used is good practice. Calculations of worth are not valuations andpublication should be discouraged.


7.1.1 In Section 2, the calculation of worth was differentiated from anestimate of the market price of an asset which may be assessed by use,

inter alia, of the definitions of Market Value, Open Market Value, and

Estimat ed Realisation Price. Special care needs to be taken to clarify th e

basis ofworth calculations, to avoid misleading or confusing those who

are relying upon them. This section sets out practical guidelines for

those preparing worth calculations.

7.2 IN ST RU CT IO N S

7.2.1 Instructions to provide a calculation of worth should be made orconfirmed in wr iting, and it is recomm ended that the relevant provisions

of Practice Statement 2 (PS 2), on the Clarification and Agreement of

Conditions of Engagement, be applied.

7.2.2 PS 2 refers to the Valuer and the Valuation. These words have beenretained for use in this section althoug h the calculation of worth is clearly

differentiated from a valuation.

7.2.3 The Principal Message of PS 2 is that , Valuers must establish their Client sneeds and confirm the service to be provided before the valuation is reported.The following steps are, therefore, recommended, using the words and

intent of PS 2 wherever p ossible:

(a) Establishing the Clients needs and requirem ents

To achieve client satisfaction and minimise the scope for misunder-

standing and subsequent dispute, it is essential that whenever possible

the Valuer seeks to establish and understand at the out set the Client s

needs and requirements. The process also enables the Valuer to satisfy

himself that he is able to meet these needs and requirements and the

Client and/or his professional advisers to know in advance what t hey

can reasonably expect to receive and what responsibilities the Valuerwill and will not accept. (PS 2.1.1)

(b) Recordin g the service to be prov ided

Since disputes may arise many years after... [the calculation of worth]...

has been provided, it is important to ensure that the agreement between

the parties is contained in, or evidenced by, comprehensive

documents. (PS 2.2.1)

There are standard conditions and model conditions of engage-

ment provided in the Manual for preparation of valuations and

app raisals, which w ould not nor mally be relevant in their entiretyfor the preparation ofcalculations of worth. However, it is recom-

mend ed that in ad vance of carrying out the work th e valuer sets

SE C T I O N 7


32/52


out in writing the p urp ose and basis of his calculations, and the

limit to the valuer s liability for them (see Caveats in 7.4).

As the calculation of worth is not generic but designed for the Client in

question, the Valuer should confirm to the Client that the calculation is

to be used by the Client and its professional advisers, but is not intended

to be available or suitable for u se by third p arties.

The Client may well supply information to the Valuer to assist in the

calculation, including in-house forecasts of rental growth, yields or

interest rates and p roper ty specific da ta. The source of such d ata shou ld

be given from the ou tset. It is acknowledged that chartered surveyors

may not always h ave the capability of und ertaking economic modelling

and forecasting themselves and will rely on material provided by the

Client, or by relevant and reputable commentators, or on commonly

held m arket assu mp tions. All of the above are acceptable, so long as th e

basis is agreed in adv ance with the Client and th e report m akes clear the

source and the nature of the assump tions utilised.

7.3 REPO RT S

7.3.1 Calculation of worth should be provided in writing with supp orting notesand calculations. The basis of the calculation mu st be clearly explained,

and the basis or source of the following shou ld be clearly iden tified:

(a) The discount ra te ;

(b) The timescale;

(c) The mathematical calculation; and

(d) The factual and estimated data.

7.3.2 Areas of potential value or cost which have been excluded should be

identified. The validity of the principal assumptions should be exam-ined, and th e Clients attention should be draw n to assum ptions which

are not standard market practice. This particularly applies to estimates

of inflation, rental growth and interest rates.

7.4 CAVEAT S

7.4.1 Reliance upon Assumptions and Information Provided: The reportshould confirm that the calculation of worth is based upon information

provided and assump tions made, and if these are varied, the calculation

may provide a different result.

7.4.2 Distinction be tween a Valuation and Calculation of Worth:

Whenever a calculation of worth is to be provided, a statement as to the

extent to which it differs from the Valuers opinion of Market Value or

Open M arket Value must be given. A calculation of worth must never

be described in a Report or published reference thereto as a valuation.

(PS 3.1.3)

7.4.3 If the Valuer has not been instructed to provide an opinion of MarketValue or Open Market Value, the report should state that the calculation

of worth is not to be regarded as a substitute for an op inion of Market

Value or Op en Market Value and should n ot be relied u pon as such.

7.4.4 Published Reference to Calculations of Worth: Whilst valuations arefrequently contained in pu blished d ocuments, it is not norm ally app ro-

priate for calculations of worth to be made public as they will vary

32


33/52

I N ST R U C T I O N S , C A V EA T S A N D REPO RT I N G TO C L I EN T S

depend ing on th e specific use as determined by the Client w hich m ay

involve volatile and subjective assumptions about the future. Where

pu blished reference is to be mad e to the calculation, a statem ent shou ld

accompany the reference stating that the calculation is specific to the

Client, and that it is not suitable for use by any third parties. The basis

of the calculation shou ld be clearly set out, and attention d rawn to any

unu sual assump tions that have been mad e.

7.4.5 Extent of Liability: As a general principle the Valuer has a duty ofcare to the Client in relation to the preparation ofcalculations of worth,

including the mathematical integrity of the calculation, the incorporation

of relevant information and the use of any un usual assump tions.

However, the Valuer is not responsible to the Client in relation to

purchase decisions made upon a calculation of worth, wh ich is necessarily

subjective and specific. It is good practice, therefore, for the Valuer to

incorporate the following caveat:

No responsibility can be held by the Valuer for the use of this calculation

of worth, which incorporates assumptions about the future which mayor may not prove to be correct.

33


34/52

34

8.1 The Mallinson Report has served to highlight the need to understandthe difference between worth, price an d value. This Paper h as sought to

explain the difference and to set the framew ork for the method s consid-

ered generally appropriate for the calculation of worth for investment

purposes.

8.2 The brief survey of the approach to the subject ofworth calculations inother investment markets has led to the conclusion that the use of

explicit Discounted Cash Flow techniques is appropriate for property

investment worth calculations.

8.3 As worth is personal to each investor, valuers should only undertakecalculations of worth in conjunction with the investor utilising, if so

instructed, the parameters set out by the investor. In practice, the

investor is more than likely to seek the valuers own views on most of

the ingredients which are used in a DCF-based worth calculation.

However these ingredients are determined, the valuer must clearlyidentify them in the report to th e investor.

8.4 The product of the Discounted Cash Flow is usually very sensitive tochanges in the main elements such as the discount rate, the levels of

income growth and the amount of the exit value. It is helpful to the

investor if sensitivity analyses are carried out to demonstrate the level

of variation in the Gross Present Value resulting from changes to the

inputs, thereby establishing the robustness of the worth figure.

8.5 Calculations of worth can assist the valuer in u nd ertaking a n ormal OpenMarket Valuation, particularly where there is a dearth of relevant

comparable evidence, provided that the ingredients used in undertakingsuch a calculation reflect general m arket sentim ent.

8.6 Where a property investment agent is asked to give advice to aninvestor on a purchase or a sale, the agent may well be expected to

respon d at tw o levels. The first is to ad vise wh ether th e pr ice reflects, in

the opinion of the agent, the lowest (purchase) or highest (sale) figure

achievable in all the circumstances. The second is whether the property

is worth the price negotiated. This second question is now more

frequently being asked of investment agents even though they may

not be retained by the investor in a fund advisory role. The ability or

otherwise of agents to provide calculations of worth will increasingly

determine w hether they are retained on investment agency work.

8.7 One of the most contentious areas of the use of Discounted Cash Flowsis the method ad opted to reflect risk. This can either be accoun ted for by

adjustments to the cash flow or by ad justments to the risk rate (discount

rate). Even if the valuer or investor chooses to reflect risk entirely

through varying the discount rate, the market has not developed m ech-

anisms for determining with certainty the am ount of ad justment to the

d iscoun t rate to reflect variations to the risk profile of different p roperties.

This is an issue wh ich the p roperty indu stry wou ld be well advised to

investigate or research further so as to improve market efficiency and

redu ce the chan ces of general mispricing of property ag ainst other asset

classes, or w ithin pr operty sectors.

8.8 This Paper relates to the calculation of worth of investment properties.Occupational worth introduces wider ranging issues which in many

C O N C L U S I O N

SE C T I O N 8


35/52

respects are more complex, but this should n ot deter the p roperty w orld

from attempting to establish ap propr iate methods of calculation in the

future.

8.9 This Paper is intended to be informative rather than prescriptive notleast because th e processes involved in calculations of worth are likely to

be subject to evolut ionary chan ge. This is to be w elcomed .

35

C O N C L U SI O N


36/52

36

GLOSS ARY OF D CF TERMIN OLOGY

The aim of this appendix is to define and provide guidance on the

vocabulary generally used in discounted cash flow ap praisal work. This

will concentrate on the definitions of yields, rates and returns usually

encoun tered in the area of property valuation, appr aisal and calculation

of worth.

Definitions marked (*) are taken from The Glossary of Property Terms,

compiled by Jones Lang Wootton in association with Estates Gazette and

South Bank University (previously South Bank Polytechnic) and are

used w ith the perm ission of the bodies noted.

All-Risks Yield (*) The remunerative rate of interest used in the conventional

valuation of freehold and leasehold interests, reflecting all

the prospects and risks attached to a p articular investment.

Capital Return The increase or d ecrease in value ov er a given p eriod, after

allowing for capital expend iture, expressed as a percentage

of the capital employed over th e period.

Depreciation (*) Decrease in value of real prop erty caused by obsolescence,

deterioration in its condition or other factors.

Discounted Cash Technique u sed in investment and development ap praisal

Flow (DCF)(*) whereby future inflows and outflows of cash associated

with a particular project are expressed in p resent-day term s

by d iscounting.

Discount Rate (*) The rate, or rates, of interest selected when calculating the

present v alue of some futu re cost or benefit.

Equated Yield (*) In valuing an investment property the internal rate of

return, being the d iscount rate wh ich n eeds to be app lied

to the explicit flow of income expected during the life of

the investment so that the total amount of income so

discounted at this rate equals the capital outlay.

Rents at review, lease renewal or reletting take account of

expected future rental changes due to variations in the

value of money, i.e. the calculation reflects the valuer's

views on the impact of inflation (or if he thinks so, defla-tion) as well as their views on rental changes due to other

factors. It is the IRR where cash flow changes are allowed

for explicitly.

Equivalent Yield (*) In valuing an investment prop erty, the one rate of d iscount

which, when app lied to all income flows being d iscounted ,

produ ces a p resent value equ al to the capital value of the

investment. The income reflects current actual rents and

costs and cu rrent levels of rental values. It is the IRR wh ere

cash flow changes ar e allowed for imp licitly.

Exit Value In DCF app raisals, the capital value of the investm ent pr op-erty at the end of the period of analysis, often calculated

using traditional techniques.

A P P E N D I X I


37/52

Exit Yield In DCF appraisals, the yield adopted in the calculation of

the exit value. This is often expressed in term s of either an

initial or equ ivalent yield.

Geometric Mean When ap plied to investment p erforman ce, the average rate

of return over a given period. This is calculated by com-

poun ding individual period returns over n periods say and

taking the nth root of this product. An example of this

would be the TWRR.

Gross Present The discount

2010 - rics - calculation of worth

Documents