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Market Valuation

• Estimate of selling price in the market based on consensus views on required returns, rental growth, and yields

• Assumes a tax-exempt investor with no leverage

• Reflects average buyer and seller opinions, same-for-all approach

Investment Valuation

• Assessment of worth specific to an investor’s assumptions and circumstances (e.g., risk, tax, borrowing ability)

• Incorporates investor-specific views on yields, implied returns, and expected rental growth

• Considers tax exposure, leverage use, and individual investment objectives.

1. Cash-on-Cash Return

• Definition: Measures the annual return on the cash invested.

• Formula:Cash-on-Cash=Annual Cash / FlowEquity Invested

• Pros: Easy to calculate; useful for quick comparisons.

• Cons: Ignores time value of money; limited to pre-tax cash flow.

2. Net Present Value (NPV)

• Definition: The difference between the present value of future cash flows and the initial investment.

• Formula:NPV=(∑Cash Flowt/(1+r)^t)−Initial Investment

• Pros: Adjusts for time and risk; clear indicator of investment quality.

• Cons: Requires discount rate; assumes cash flow forecasts are accurate.

3. Internal Rate of Return (IRR)

• Definition: The discount rate at which NPV equals zero.

• Formula: Solves for rr where:0=∑Cash Flowt(1+r)t−Initial Investment0=∑(1+r)tCash Flowt​​−Initial Investment

• Pros: Accounts for time value of money; shows compounded return.

• Cons: Assumes reinvestment of cash flows at IRR; may be ambiguous.

4. Equity Multiple

• Definition: Measures total return on equity invested.

• Formula:Equity Multiple=Total Cash InflowsTotal Equity InvestedEquity Multiple=Total Equity InvestedTotal Cash Inflows​

• Pros: Simple to understand; focuses on total return.

• Cons: Ignores time value of money; less informative for timing of returns.

Key Differences:

• Time Value of Money: NPV and IRR account for it, Cash-on-Cash and Equity Multiple do not.

• Focus: IRR emphasizes return rate, NPV highlights value creation, Cash-on-Cash focuses on liquidity, and Equity Multiple captures total return.

reversionary yield = market rental value / market price

a distorted measure if the building has a long period to review

does not discount the step up to market rent

1. Definition: Discount rate equalizing present value of income flows to the capital value.

2. Key Features:

   • Internal Rate of Return (IRR) assuming rise to Market Rent (MR) at the next review.

   • No further rental growth beyond the next review.

3. Characteristic: Weighted average yield; implicitly accounts for cash flow variations

1. General Convention:

   • Apply ARY to reversion; use lower yield (e.g., ARY -1%) for term income.

   • Reasons:

     • Term income is fixed, not subject to uncertain growth.

     • Tenant might struggle with higher reversionary rent, weakening the covenant.

2. Alternative Approach:

   • Use bond yield + default risk for term income, reflecting tenant default and inflation risks.

   • In strong markets, re-letting after default could be beneficial, so a lower term yield may not always apply.

3. Conclusion: Split yields should be justified, not a rule of thumb

1. Definition: Property where passing rent > Market Rent (MR).

   • Over-renting is called “over-rented top slice,” “overage,” or “froth.”

   • Formula: (Rent - Market Rent) / Rent

2. Next Change in Rental Income:

   • At lease end: Assume re-let at MR.

   • At rent review: If MR rises above passing rent.

3. Challenge:

   • Requires forecasting future rental growth.

   • UK valuers generally avoid forecasting future rents.

Conventional Valuation

• Characteristics:

  • Simplified and opaque, financially peculiar to property.

  • Based on directly observable inputs (objective).

  • Treats term income and growth implicitly.

• Pros:

  • Mostly objective, easier to apply.

• Cons:

  • Limited flexibility, lacks financial sophistication.

DCF (Discounted Cash Flow)

• Characteristics:

  • Reflects reality, uses explicit assumptions, and enables stress testing.

  • Relies on unobservable inputs (e.g., consensus rental growth, required returns).

  • Often regarded as the most precise and globally consistent method.

• Pros:

  • Accounts for more factors, provides detailed profit/return analysis.

• Cons:

  • Requires many assumptions, subject to potential manipulation of inputs.

Key Differences:

• Conventional valuation is simplified (implicit growth); DCF is precise (explicit assumptions).

• DCF requires more inputs and is widely used for its accuracy in estimating potential profits.

1. Valuation Methods: Different countries prioritize specific approaches, such as the sales comparison approach in the US, the income approach (Ertragswertverfahren) in Germany, and the investment method (ARY) in the UK.

2. Regulation and Standardization: Valuations are influenced by local regulations and standards, such as RICS standards in the UK, ImmoWertV in Germany, and varied state regulations in the US.

3. Market Transparency and Data Availability: The US has highly transparent markets with extensive data platforms (e.g., CoStar), while Germany and the UK may face limitations in comparable data, impacting valuation precision.

Definition:

Valuation models where future rent growth is implicitly included in the yield (cap rate).

Key Points:

1. Yield Formula:

   • Yield = Required Return - Growth Rate

   • Includes first-year income and future rent growth.

   • Applied only to the first year’s income.

2. Comparison to Discount Rate:

   • Yield: Reflects first-year income and implicit growth.

   • Discount Rate: Required return over the entire holding period.

3. Constant Growth Assumption:

   • If income and value grow at a constant rate:

   • Yield < Required Return (Discount Rate)

United States:

• Residential Properties: Sales comparison approach (recent sales of comparables).

• Income-Generating Properties: Income capitalization method (NOI ÷ Cap Rate).

• Financial Modelling: Discounted Cash Flow (DCF) analysis for large commercial properties.

• Key Feature: Transparency supported by platforms like CoStar.

Germany:

• Regulated System: Governed by the German Valuation Ordinance (ImmoWertV).

• Methods:

  • Comparative Value Method (Vergleichswertverfahren): Similar to US sales comparison but limited data.

  • Income Approach (Ertragswertverfahren): Focus on market rent and sustainable net income.

  • Cost Approach (Sachwertverfahren): Based on construction costs and depreciation (unique or limited comparables).

• Key Feature: Conservative, often underestimates values.

United Kingdom:

• Income-Generating Properties: All-Risks Yield (ARY) approach (Net rental income ÷ ARY).

• Development Projects: Residual method (GDV - costs - developer profit).

• Key Feature: Influenced by RICS standards ensuring consistency and professionalism.

Key Similarities:

• All use income-based approaches (capitalization methods or net rental income).

• All apply sales comparison for residential properties.

Key Differences:

• US: Data-driven, forward-looking (DCF analysis).

• Germany: Detailed, regulated, and conservative (Ertragswertverfahren, Sachwertverfahren).

• UK: Simplified yield approach (ARY), growth expectations embedded in a single yield.

• Data Transparency: US excels with comprehensive platforms, while Germany and UK face limitations.

Why Valuation is Considered an Art:

1. Subjective Assumptions:

   • Relies on expert judgment for inputs like future cash flows, market conditions, and discount rates.

2. Market Volatility:

   • External factors (e.g., economic trends, interest rates) add variability and unpredictability.

3. Asset Uniqueness:

   • Unique qualities (e.g., location, design, tenant profile) require creative interpretation.

Limitations of Pinpoint Accuracy:

1. Incomplete Data:

   • Historical data or comparables may not fully reflect current or future conditions.

2. Dynamic Influences:

   • Changes in regulations, interest rates, or economic shifts can affect accuracy.

3. Range-Based Results:

   • Valuations are often expressed as ranges (e.g., RICS standards) due to inherent uncertainties.

Importance of Methodology:

• Scientific Framework:

  • Uses standardized methods (e.g., DCF, residual appraisal) for consistency.

• Judgment is Key:

  • Interpretation of data and results remains critical despite rigorous methodologies.

Conclusion:

Valuation combines art (professional judgment) and science (structured methods), providing informed estimates rather than absolute precision.