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Determine the price for investment property.

The purchaser of an industrial property will be concerned with:

Security of Capital (Location issues ).

Capital or acquisition cost.Security of Income (Risk factors).

Ease of Sale (Liquidity).

Management of the Property (Simplicity).

To establish the net income figure, the annual sum is used. In the case of new developments, this will be the expected annual rental income (based on comparable similar lettings).

It’s not only the amount of rent that will be received though; it’s the regularity of the payments that matter too. An investor always looks for a high-quality tenant who is likely to pay his rental regularly. A tenant that has a good credit history, shows healthy company accounts and has been established for some time will be regarded as a ‘good covenant’. This relates back to the security of income aspect of the investment.

If the investor is purchasing a property with a tenant already in place, the terms of the lease and the quality of the tenant will be indicative of current value. For example, a lease with 15 years left to run, to a blue-chip company would be worth more in investment value than a lease at a similar rent but only 3 years left until expiry and to a company that is facing financial difficulty.

To analyse the relationship between rental income and capital value, two aspects can be used:

1) Yield. This figure is expressed as a percentage and is calculated by dividing the net annual rent by the capital cost of the property. So if a property had a capital value of R15,000,000, and the net annual rental income is R1, 500,000 then the yield would be 10%.

2) Years Purchase (YP). This is a slightly different way of analysing things. As above, it is calculated by dividing the capital value by the rent figure but it’s not expressed as a percentage. So using the example above, if a property brought in R1,500,000 per annum in net rent and was valued at R15,000,000 then the YP figure would be 10 (think of it as taking 10 years at R1500k per year, to purchase the property at R15m. It’s a hypothetical situation but simply another way of comparing investments). Escalating rentals are not considered.

The investor will usually have a particular yield figure in mind and 10% might or might not be suitable. The rate is comparable to other investments, allowing an initial direct comparison to be made. For the purpose of illustration, examples of alternative average returns might be:

Government bonds –5%

Equity market –8%

Bank Deposits – 7%

In comparison, if the investor can receive a return of 10% on the property above then he/she is likely to go for that (depending on risk factors). However, a direct comparison between these investments is tricky for the following reasons:

1) The investment property is the most illiquid of all of these investments.

2) The property will entail risks such as non payment of rent, vandalism and rent voids.

3) It will be subject to management costs to ensure it remains in optimum condition.

4) Property value can be increased through strong demand pulls and conversely through weakening demand for property in the area.

If interest rates were to go up, the increased return on bank deposits might influence an investor to simply place the capital in a bank rather than face the risk and work involved in property investment.

If interest rates were to go down, it would have the effect of investors looking for alternatives to bank deposits, shares and bonds. If investors felt that property was a shrewd buy, then values would tend to go up because of the increase in demand. If the capital value goes up and the rent stays the same, then the yield figure will fall. This is because the annual rent figure will account for a lower percentage of the property capital value.

Using the example above, if all comparable properties yield can be calculated at around 9%, we can calculate the increased capital value:

(R1,50,000 ÷9) x 100 = R16,666,666 (originally R15,000,000 at 10%)

This illustrates the change in property capital value when interest rates and demand change the yield figure. It also shows perfectly the Investment method of valuation. Essentially the 2 variables involved are:

Annual net rent
With these 2 components, the capital value can be calculated extremely quickly using the equation:

{Annual Net Rent / yield } x 100 = Capital Value

This is a very simplistic but unrefined way of establishing the capital value, the larger the property, the less accurate this is. Other methods would be considered such as using DCF to arrive at a more representative yield( IRR ). What the equation is good at however is providing a very quick way of gaining an approximate value.

Investment in property is risky. It is the element of risk however that effectively provides the return. If a particular property reflects a high risk, for example if it’s looking tired and the tenant has only 3 years left in occupation and is unlikely to renew, then the capital value of the property will not be particularly high. If the rent is set at a level that compares with similar properties, the yield figure will be high. This means the rent will be high in comparison to the purchase value. This way, the investor will stand to recoup as much of the capital outlay as possible, as quickly as possible.

So the risk that a particular property presents can be assessed by the rate of yield. High yield can mean high risk, and vice-versa. This enables valuers, and investors to compare risk levels between investment properties. A yield figure can be applied with the intention reflecting all the risks involved in an investment. This is simply called the ‘all risks yield’ and works by using a particular rate (as a percentage) that goes up when the risk is high, and drops when the risk falls. It is intended to ‘reflect all future benefits and risk’. This method is open to debate though, as many property professionals feel that it is a crude way of valuation and furthermore, investment risk cannot be solely expressed simply as a rate of yield.

A property that represents an extremely low risk would be well located, with modern design and in good condition. Let on a long lease to a good, reliable tenant who is responsible for repairs. This property would be regarded as ‘Prime’ or Grade A (in the case of offices).

A high risk property would be the opposite of the above, poorly located and with an older design that is becoming more expensive to maintain. It would be let on a short lease to an unreliable Tenant who is not responsible for repairs. This property would be regarded as either ‘Secondary’ or ‘Tertiary’.

A more reliable assessment of yield would be to use the discounted cash flow method to arrive at an Internal rate of return (IRR). This is a metric used in capital budgeting measuring the profitability of potential investments. IRR is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero

Thanks to thepropertyspeculator.co.uk