Investment Method (Continue)

Leasehold Interests Leasehold are more complex than freehold investments (a) because of their limited lives, and (b) because their investment characteristics depend on the terms of both head lease and the sub-lease. Ultimately all leasehold interests must come to an end with nil value, consequently an investor holding to the end of a lease must suffer a capital loss Equity type long-leasehold investments may have substantial growth potential over much of their lives. The profit-rental income of a leasehold investment is the difference between the rental income received from sub-tenant and the head rent payable to the landlord.

Dr K Patel, Department of Land Economy, University of Cambridge

Value profiles of freehold and leasehold investments

Value Value Total

Land

Building

Total

Time

Time

Freehold

Leasehold
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Dr K Patel, Department of Land Economy, University of Cambridge

Annual Sinking Fund The annual sinking fund may be used to calculate the annual amount to be set aside to meet a known future liability or expense. This is the annual sum, SF, required to be invested at the end of each year to accumulate to 1 in n years at i compounded interest. Since the present value of 1 is the reciprocal of the future amount of 1, so that the Annual Sinking Fund is the reciprocal of the Future Amount of 1 pa. That is

SF =

i (1 + i) n 1

Dr K Patel, Department of Land Economy, University of Cambridge

Example: The owner of an office block anticipates that he will need to provide a new escalator in 10 years time at an estimated cost of 50,000. If the capital can be invested at 8% compounded interest, what amount should be invested annually to meet his future liability?

0.08 SF = 50,000 10 (1.08) -1 = 50,000 x 0.069 = 3,450

Dr K Patel, Department of Land Economy, University of Cambridge

Dual Rate YP Dual Rate YP is used for calculating the capital value of income that is to be received for a known limited period. This will occur in land and property with leasehold interests that will expire on a specific date. Dual Rate YP is based on the assumption that the investor would annually set aside a sum out of the income received. This would be invested as a sinking fund to recoup the original capital value at the end of the term. The YP must reflect the fact that the investor has a lower spendable income than in the case of the perpetual income. Assume that the net interest on 1 to be i and the annual sinking fund to recoup 1 at the end of the limited term to be SF. Then the total income from property worth a capital value of 1 = i + SF. Assume the capital value of a stream of income to be P. Then the annual income required is P(i+SF). But Capital value = Net Income per annum x YP So that P 1

YP = = P(i + SF) (i + SF)

Dr K Patel, Department of Land Economy, University of Cambridge

Note: With the sinking fund calculation there are two different rates of interest (i) i is the rate of interest expected by the investor (known as the remunerative rate of interest) (ii) the rate of interest for SF is a low, risk-free rate (an accumulative rate of interest). Example: Calculate the capital value of an income 2,000 per annum receivable for 12 years given that the remunerative rate of interest is 6% and the accumulative rate is 3%. Net income per annum YP for 12 yrs @ 6%, 3% = 2,000 = 7.096

1 0.06 + 0.03 (1 + 0.03)12 1

Capital value

14,192

Dr K Patel, Department of Land Economy, University of Cambridge

The effect of Tax on the sinking fund element of the Dual Rate YP The Net Income receivable from property is normally taxable. In the case of the leasehold interest, the income is for a limited period and is subject to tax. In this case the sinking fund element is increased by multiplying by the adjustment factor [1/(1-x)]. The Dual Rate YP formula is adjusted to take account of this tax as follows:

YP = i+

1 i 1 n (1 + i) 1 1 - x

where x = rate of tax (in pence)/100

Dr K Patel, Department of Land Economy, University of Cambridge

Example: Source Baum & Crosby A corner shop & dwelling house in a good shopping centre in the town. The freehold is let on a 99 years lease expiring in 36 years time at a ground rent of 10 pa. The head lessee let the shop 16 years ago on a 21 year FR lease at a rent of 100 pa. The premises are now worth a rent of 180 pa on a FR lease. (a) Freeholder Ground rent 10 YP 36 yrs @ 4% 18.9083 189 Reversion to ERV 180 YP perp. def 36 yrs. @ 5.5% 2.6455 476 Valuation 665

Dr K Patel, Department of Land Economy, University of Cambridge

(b) Head leaseholder Rent received Less Ground rent Profit rent YP 5 yrs @ 6%, 3% Reversion to ERV Less Ground rent Profit rent YP 36 yrs. def. 5 yrs. @ 7%,3% Valuation

100 10 90 4.0265 362 180 10 170 7.923 1,346 1,708

Dr K Patel, Department of Land Economy, University of Cambridge

(c) Sub-leaseholder ERV Less Rent paid Profit rent YP 5 yrs @ 8%, 3% Valuation

180 100 80 3.7264 298

Dr K Patel, Department of Land Economy, University of Cambridge

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Example: Dual Rate YP, tax-adjusted A leasehold interest has 20 years to run, subject to a fixed head rent of 100,000 pa. The current value is 200,000 pa, subject to 5-yearly reviews. Market evidence suggests a freehold capitalization rate k of 6% for this type of property. Rent received Less Rent paid Profit rent YP 20 yrs @ 6%, 3%, tax 40% i.e.1/[0.06+(0.03/((1.03)20 - 1)]x(1/0.6) Analysis Yield = 6% x 819,500 Sinking fund (gross) 200,000 100,000 100,000 8.195 819,500 = 49,170 = 100,000 - 49,170 = 50,830 Sinking fund (net) = 50,830 (0.60) = 30,498 x A 1 pa, 20 yrs @ 3% 26.8704 Capital recouped

819,500
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Dr K Patel, Department of Land Economy, University of Cambridge

Comments/Criticism The capitalization rate (6% in the previous example): normally derived from sales of comparable freehold and adjusted upwards to account for extra risk. The accumulative rate of 3%: supposed to represent the net-of-tax return on a guaranteed sinking fund to replace initial capital outlay on what is a wasting asset. Bank deposits have earned considerably more than 3% safe rate since 1960. The initial capital outlay, regarded as an investment of cash in a business, is normally recouped out of investing in profit rents in similar investments. The tax adjustment: (40% in the previous example) counters the fact that any tax paying purchaser of the investment would lose a portion of his profit rent in tax. Without adjustment, the sinking fund would become inadequate. This may be the case for small-scale investors but not for tax exempt funds or companies paying corporation tax. Trott 1980 in the RICS research report pointed out that different values of the three variables ( remunerative rate, accumulation rate and tax rate) may combine to produce the same YP figure!
Dr K Patel, Department of Land Economy, University of Cambridge 12

Over-rented Properties In the early 1990s rental values fell in nominal terms. According to IPD (1992) by May 1992 70% of Central London offices were over-rented by an average of 35%. Example: Baum & Crosby A Central London office building is to be valued in June 1992. It was let on a 20year FRI lease in 1990 with 5-year reviews passing rent of 2million pa. The ERV has now fallen to 1million pa. The fully let rack rented capitalization is estimated to be 8%. Gilts yielding approx. 10%.

Rent 2 m ER 1 m

Years

17.75

Perpetuity
13

Dr K Patel, Department of Land Economy, University of Cambridge

Conventional approach: (i) capitalize the core income as if the property was fully let at the appropriate ARY (ii) then capitalize the top-slice income for the unexpired term of the lease at a rate which reflects the fact that it is a fixed income supported by the upwards only rent review and is dependent on the tenants ability to continue to pay the rent. Core income ERV 1,000,000 YP perp. @ 8% ARY 12.50 12,500,000 Top-slice Passing rent 2,000,000 ERV 1,000,000 Overage 1,000,000 YP 17.75 yrs. @ 13% 6.8135 6,813,459 Valuation 19,313,459
Dr K Patel, Department of Land Economy, University of Cambridge 14

There are two problems with the conventional approach:

If the ARY implies long-term rental growth (which is the case with 8% yield) then ERV may rise to exceed the passing rent before the lease expires. Therefore, it may be incorrect to capitalize the top-slice income for the whole of the unexpired term. Capitalizing the top-slice ignores the rental growth implied by the ARY. If it is assumed that the overage is eliminated by the review in 12.75 years time, then the term of 12.75 years could be valued at a risk-free rate subject to a risk premium and the reversion valued at the ARY. Term rent 2,000,000 YP 12.75 yrs @ 13% 6.0731 12,146,170 Reversion to ERV 1,000,000 YP perp. def. 12.75 yrs @ 8% 4.685 4,685,513 16,831,683

Dr K Patel, Department of Land Economy, University of Cambridge

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Shortcomings There is a problem with the yield choice on the reversion in that the 8% yield (in the previous example) implies that rental growth is anticipated every 5 years. The PV relates to the behaviour of the ERV in the waiting period. The ERV grows continually and therefore the reversion should be deferred at a lower yield to imply a better growth potential. Theoretically the growth potential of reversionary properties is greater than for the fully let properties. However, the market does not perceive reversions in this light and it is rear for a reversionary property to be valued at an equivalent or average yield which is lower than the all risks yield of the fully let property.

Dr K Patel, Department of Land Economy, University of Cambridge

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Purchases with a Special Interest: A purchaser who can afford to pay more than other investors because of creation of marriage value. Marriage value will occur if: (i) two or more legal interests are merged in the same property (ii) two or more adjacent pieces of land in separate ownership are merged into one ownership. Example: Nos 1, 2 & 3 Church Street are shops with living accommodation over as follows
No. 1 2 Freeholder Mr D Mr H Net rack rental value pa 3,000 3,500 Occupier & type of shop Mr D (Grocer) Mr W (Hardware) Mr B (book shop) Details of any lease

Mr S

3,300

Let to Mr W on an internal repairing lease with 5 yrs. unexpired at a rent of 2,500 pa Let to Mr B on an internal repairing lease with 10 yrs. unexpired at a rent of 3,000 pa
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Dr K Patel, Department of Land Economy, University of Cambridge

Mr D plans to acquire freehold interests in shops 2 & 3. The shops would cost 25,000 to alter and convert into a supermarket, giving a net rack rental of 16,000 pa. Value all the interests, and advise Mr D as to the gain he will enjoy by the merger of interests. Value of the supermarket assuming a freehold yield of 7% Net rack rental value pa 16,000 YP in perp. @ 7% 14.28 228,480 Less cost of alteration 25,000 Capital Value 203,500 (approx) Shop No. 1 Mr Ds interest assuming a freehold yield let at a rack rent of 8% Net rack rent pa 3,000 YP in perp. @ 8% 12.5 Capital value 37,500

Dr K Patel, Department of Land Economy, University of Cambridge

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Shop No. 2 Mr Hs interest assuming a freehold yield let at a net rack rent of 8% and external repairs & insurance cost of 440 pa. Unexpired term lease in 5 yrs. Rent pa 2,500 Less external repair pa 440 Net Income 2,060 YP 5 yrs @ 15% 3.352 6,905 Reversion Net rack rental value pa 3,500 YP perp. Def. 5 yrs @ 8% 8.507 29,774 Capital value 36,700 (approx) Mr Ws interest assuming a leasehold yield of 9%, external repairs & insurance cost of 440 pa, sinking fund of 2 % and tax 30%. Rack rental value 3,500 Less external repairs & insurance pa 440 Less rent paid pa 2,500 Profit rent 1,440 YP 5 yrs. @ 9%, 2% & tax 30% 2.764 19 Capital value 4,000 (approx)

Shop No.3 Mr Ss interest assuming a freehold yield of 8% let on a net rack rent and external repairs & insurance cost of 400 pa. Unexpired term of lease is 10 yrs. Rack received pa 3,000 Less external repairs & insurance pa 440 Net income pa 2,600 YP 10 yrs. @ 15% 5.019 Capital value 13,049 Reversion Net rack rental value pa 3,300 YP in perp. Def 10 yrs @ 8% 5.79 19,107 Capital value 32,150 (approx) Mr Bs interest assuming a yield of 9%, external repairs & insurance of 440 pa, sinking fund of 2 % and tax 30%. Net rack rental value pa 3,700 Less external repairs & insurance 400 Profit rent 700 YP 10 yrs @ 9%, 3% and tax 30% 4.597 Capital value 3,200 (approx) 20

Summary Value of the supermarket Less Mr Ds interest Mr Hs interest Mr Ws interest Mr Ss interest Mr Bs interest Marriage value

203,500 37,500 36,700 4,000 32150 3,200 113,550 89,950

Mr D will enjoy a gain on the merger of the interests of 89,950. He can use this surplus to over-bid any other investors who may wish to purchase the interests in shops 2 and 3.

Dr K Patel, Department of Land Economy, University of Cambridge

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