Property AppraisalIntroduction

• Definitions

• Appraisal

• Investment and investors

• Appraisal techniques

• Summary

Introduction

• Market Value (value in exchange)– Estimate of exchange price– Relies on interpretation of market information– Objective

• Worth (value in use)– To a specific individual or group– Usually involves consideration of personal

circumstances (risk and return) as well as market, e.g.o financial resources available for a property

acquisition, including the split between debt and equity finance

o timescale for holding a property asseto tax position, personal tastes and specific

requirements of the decision-maker– Subjective

Definitions

Definitions - IVS• Investment Value or Worth “The value of

property to a particular investor, or a class of investors, for identified investment objectives. This subjective concept relates specific property to a specific investor, group of investors, or entity with identifiable investment objectives and/or criteria.”

Why might value and worth be different for the same property?Why might investors arrive at different appraisals of worth?

What is Appraisal?• A valuation is an objective comparison with

evidence from closely comparable properties• An appraisal is an estimation of investment

worth to an investor by determining its risk and return characteristics in relation to that investor

Market Valuation

Appraisal of Worth Forward-looking; forecast of cash-flow

Backward-looking; analysis of past transactions

Reasons for appraisal• Acquisition

– Purchasing a property is one of the key times that Appraisal is utilised

– Why will different parties pay different prices for the same building?

• Refurbishment/redevelopment• Financing arrangements• Ongoing performance• Disposal

Financial characteristics ofinvestments

• Investment = acquisition of asset(s) that are worth more than their cost

• Nature of revenue receipt– Fixed or variable income and capital value

• Liquidity

• Security of income and capital– Nominal– Real

Financial characteristics ofinvestments

• Conventional bonds– long, short, medium or undated fixed interest debt

investment– gross redemption yield (GRY) = riskless nominal rate of

return– GRY on index-linked gilts = real risk-free rate of return

• Ordinary shares– equity investment– IRR unknown and must be estimated from anticipated cash

flows (unlike gilts)– therefore shares involve risk -> premium above GRY

• Property– Direct and indirect– Commercial and residential

So who invests in property?

• Financial Institutions (general insurance companies, life assurance companies and pension funds)

• UK Property Companies

• Overseas Investors

• Traditional Estates and Charities

• Private Investors

• Limited Partnerships and Unit Trusts

Appraisal at Purchase

22-24 Queen Square,

Bristol

• Grade II listed terraced office building. The building was redeveloped in 2007 and the Grade II listed façade was retained

Sold to Invista December 2006 for £8.5m (4.87%)

Sold by Invista to Epic May 2008 for £6.2m (6.5%)

Appraisal at Purchase

1 Georges Square, Bristol

• Acquired in November 2004 by Anglo Irish Private Bank for £24,475,000 (6.20% NIY)

• Sold in May 2006 to Invista for £29, 500,000 (4.95% NIY)

• Sold in September 2008 to IVG for £21,915,000 (6.65% NIY)

• Sold in June 2010 to British Steel Pension Fund for £25,375,000 (5.75% NIY)

1 Georges Square, Bristol

Summary• Valuation is a market-based concept. An appraisal of

worth is an individual-based concept and represents a means of assessing whether a price/valuation represents ‘good value’ to an individual or group

•  A different information set is used to conduct appraisals of worth, using more client-specific information

• An appraisal of worth may vary more than a market valuation as the financial estimation moves away from an analysis of market information to greater consideration of personal investor or occupier requirements, using more sophisticated techniques

Property AppraisalInformation Requirements

Introduction

• Properties are not frequently traded in the open market and information access is limited so valuers look at comparable evidence to assess market value (PV)

• Need to compare appraisals of worth with asking price

• Example– 43 Queen Square, Bristol…

Appraisal information

• Economic indicators– Output, (un)employment , movements in corporate profits (by

sector), money supply, public sector borrowing, inflation, interest rate

• Market indicators– Rents, rental growth and depreciation rates– Redevelopment or refurbishment costs– Yields and forecasts of exit yields– Purchase and sale costs– Movements in market indices

• Portfolio information– Asset returns and correlations (to aid diversification)– Sales and purchases– Risk indicators

– Physical attributes (areas, ancillary space, quality, improvements)

– Financial details (yield, rent passing, rental growth, market rent and capital value)

– Legal terms (tenancies and lease details, number of tenants, expiry dates, review dates, voids, future leases)

– Outgoings and capital expenditure (vacancies, voids, unrecoverable service and management costs, letting, re-letting and rent review costs, purchase and sale costs)

– Depreciation, costs & timing of redevelopment and refurbishment, cost inflation

– Planning– Taxation (Business Rates, VAT)– Occupancy / holding costs (management,

review, purchase & sale costs)– Dilapidations, service charge & other

payments for repairs and insurance if leasehold

Client specific information– Discount rate, taxation, loan / finance– Holding period

Property information

Facts and variables in appraisal

Key investment appraisalvariables

Investment appraisal involves making explicit judgments (based on evidence) about:

•Rent and rental growth– Volatile over short term– Little known about depreciation rates– Expenditures

•Target rate or return– Selection of risk premiums for individual properties is a

grey area

•Holding period– Longer period - more chance of error in selecting variables

•Exit value– Prime yields fairly stable

Rent and rental growth• Contractual rent will be known but market rent and

future lease terms must be estimated• Associated variables:

– Timing of rent reviews– Length of lease and existence of any break options

(likelihood of void periods)– Management costs and taxation– Financial impact of void periods

o How long will it take to let vacant space?

o Holding costs through void period

o Letting incentives and possible refurbishment costs to be allowed for

o Short-term lets...

Rent and rental growth• Estimate rental value of

– New– Existing– Existing but refurbished

• Estimate rental growth rate 5.00%• Depreciation

– Depreciation rate of existing property (% rent) 2.00%– Depreciation-adjusted rental growth rate

2.94%

11

1

d

g

NB. Capex of 0.5-1% p.a. means rent depreciation of 0.5-1% p.a., rising to 2% p.a. with no capex...

Associated expenditures• Acquisition costs (% acquisition

price).................................5.75%• Rent review costs (% new

rent)............................................. 4-5%• Management costs (%

income)............................................. 1-3%• Re-letting costs (% new

rent)................................................7.50%– Higher than rent review due to marketing and legal fees

• Lease renewal costs (% new rent).........................................5.00%– No marketing costs

• Property tax / business rates

Forecasting and Depreciation

• Forecasting– Forecasts of market rents and rental growth typically relate

to prime new business space in the locality concerned (i.e. no depreciation)

– National, regional and local level– Usually based on econometric models of economy and

property market– Property specifics are also vital

• Depreciation– Don’t overlook or double-count!– Think carefully about relationship between capex and

depreciation– If refurbishment expenditure is included in cash-flow then

financial benefit should be reflected in revenue (e.g. enhanced estimates of rental value, growth rate or exit yield)

Discount rate ortarget rate of return

• Must adequately compensate an investor for the risk taken

• Individual properties have individual target rates• Portfolio construction can isolate property-specific risk

from market risk• It is the cost of capital (an investment needs to

compensate investors for the use of their capital)• Several ways of deriving it:

1. Risk-adjusted discount rate (RADR)o Frequently used by investors and property analysts

2. Capital Asset Pricing Model (CAPM)3. Weighted Average Cost of Capital (WACC)4. Yield on client’s equity

1. Risk-adjusted discount rate(RADR)

The target rate of return (TRR) required by an investor may be derived from a ‘risk-adjusted discount rate’ (RADR), expressed as:

TRR or RADR = RFR + RP

Where: RFR is the risk-free rate of return or compensation for loss of liquidity

RP is the risk premium or compensation for risk, which comprises market risk (which cannot be diversified away)

RADR derived by adding a risk premium to a ‘benchmark’ risk-free rate

a) Risk-free rate (RFR)– Baseline defined by reference to the return from a

low-risk or riskless asset– Typically the income yield on a medium / long

dated gilt

b) Risk Premium – Return to compensate for market and property-specific

risks associated with holding the specific property asset– Need to decide which are best handled by building into

the cash flow and which should be incorporated by adjusting the RP

RADR components

Risk Premium• Difficult to estimate for individual property assets due

to– Paucity of data, confidentiality issues– Uniqueness of assets and complexity of markets– Overlap between risk factors

• Historically the UK long-term property RP = 2-6%• Need to consider RP over different holding periods• Need to distinguish long term (ave) RP from short term

sentiment re-ratings• Group assets to determine property sector RP, then

adjust to reflect asset-specific risk• Remaining costs (fees, management, dilapidation, etc.)

are handled in the cash flow

RADR limitationsa) Only one rate applied to all cash-flows so fails to

distinguish those parts of the cash-flow that are risky and those that are not

b) Heavily discounts distant cash-flows regardless of whether they are actually more risky

c) Ignores the importance of diversification

2. Capital Asset Pricing Model(CAPM)

• An investment’s expected return is a positive linear function of risk (measured in terms of SD & variance)

• CAPM enables estimation of the target rate of return in the light of returns available from ‘risk-free’ investments and market-related risk factors of the investment under scrutiny

• Recognises that each investment has different market risk which will influence its expected return

• Market risk is a special type of risk related to the contribution that the asset makes to a well-diversified portfolio.

CAPM

Where

E(rn) = expected return for a specific asset

rf = risk-free rate

= amount of systematic risk (indicator of the investment’s sensitivity to market movements)

E(rm) = expected market return (the reward for

bearing systematic risk)

fmpfn rrErrE

CAPM example

Expected market return and variance: E(rm) and var(rm):

CAPM exampleExpected asset return and its covariance with market return: E(ra) and cov(ra, rm):

CAPM example

Asset beta: m

maa r

rr

var

,cov = 0.0223/0.0464 = 0.48

So the asset has a low beta coefficient indicating low volatility (approx. 50% lower risk than the market)

Using the CAPM equation and assuming a RFR of 5%, we can now calculate the expected target rate of return, E(rn)

E(rn) = 0.05 + (0.48)(0.16-0.05) = 0.1028 or 10.28%

3. Weighted Average Cost of Capital (WACC)

• Discount rate (minimum expected rate of return) of an investment is the ‘cost of capital’; it represents how much the company should earn to break even

• WACC takes the cost of equity and after-tax cost of debt and calculates an average, weighted according to the market values of debt and equity

• Capital structure weights:– Debt weight, w, is the market value of debt divided by the

total market value of debt and equity– Equity weight is 1- w

Land Securities -Capital structure weights

• MVs preferred but can use book values– Equity = 6,636.6– Debt = 2,923.1

• Equity weight– 6,636.6/(6,636.6 + 2,923.1) = 69.4%

• Debt weight– 2,923.1 /(2,923.1 + 6,636.6 +) = 30.6%

• Where w is the market value weight of debt, rd is the cost

of debt, t is the corporate tax rate and re is the geared

cost of equity

• re can be estimated from CAPM

– E.g. if the of the company is 1.35, rf is 6%* and E(rm) is

12.5%, then

= 0.06 + 1.35(0.065) = 14.78%– RFR is expressed gross of tax because firm must earn 6%

after taxes so shareholders can earn RFR of 6%.

WACC formula

WACC = (1-w) re + w.rd (1 – t)

fmefe rrErrE

WACC and tax• Cash flows are after tax

• The WACC discount rate has to be consistent with cash flows

• Tax issues relate to debt– Interest offers a tax shield = rd * tc

• It is as if the government reduces the cost of debt– rd becomes rd (1 - t)

WACC example• If the geared cost of equity is 14.78%, gross interest on

debt is 9% , corporate tax is 40%, and with market value weights for equity (we) of 0.3 and debt (wd) of 0.7, WACC

can be calculated as follows:

• WACC = [0.3 x 0.1478] + [0.7(0.09(1 – 0.4)]

= 0.08214

Say 8.2%

WACC summary• Represents discount rate to be used for

– Company projects– With similar characteristics to existing investments

• What happens if investment has different risk/return profile?– Subjective approach: adjust WACC by adding premiums or

deducting discounts depending on perceived risk (high, medium, low)

• The WACC is based on figures derived from the company and so should only be used on projects with same financial structure as the company

Holding Period of Investment

• Normally specified by client...– Usually 3-5 or 10-15 years depending on type of investor

• ...or by fundamentals of the property– influenced by lease terms (break clause, lease expiry)– or by physical nature of property (redevelopment, voids)

• Longer hold period = greater risk of fluctuation of variables from prediction, or reversion to long term trends?

Exit value

• Value of the property at the end of the holding period• Usually capitalise the rent forecast at the end of the

holding period• May reflect land values if demolition is anticipated• May reflect refurbishment / redevelopment costs too• Forecast building costs if refurbishment or

redevelopment is planned

Exit Yield

• Yield a purchaser would require for the property at the point of (notional) sale

• Normally based on comparison with similar investments using ARY approach

• Assume stability of market over holding period?• Important to consider impact of depreciation but don’t

double-count its effect on value by, say, reducing the forecast rent and raising the exit yield

• Choice of exit yield is key when holding period < 20 years as resulting exit value forms a substantial element of worth

Summary

• Rent and rental growth– Growth– Depreciation– Associated costs

• Target rate or return– RADR– CAPM– WACC

• Holding period

• Exit value– Exit yield– redevelopment

PropertyAppraisalMethods

• Investment decisions involve choosing between different types of investment with different characteristics

• Investment decisions are made against a background of risk and numerous uncertain variables dependant upon future events

• A rational basis to compare investment propositions (a decision tool) is required that focuses on return / risk profile

Introduction

• Must consider:

– Financial resources available (equity and debt)

– Project timescale

– Integration with existing portfolio

• Any mismatch between the market value or price of a property investment and its worth to a particular investor should be investigated

• A rational investor should buy an asset if its price is equal to or below his assessment of worth

• The range of worth estimates is typically wider in the property market than in the equities market where a great deal more trading takes place on the more marginal differences between price and worth

Methods1. Simple screening:

a) Payback

b) Rate of return and yield

2. Project-only discounted cash-flows (DCFs):

a) Net Present Value (NPV)

b) Internal Rate of Return (IRR)

c) Capital Asset Pricing Model (CAPM)

3. Project-with-finance DCFs

a) Weighted Average Cost of Capital (WACC)

b) Flow to Equity (FTE)

1. Simple screening methods

a) Payback• Measures time taken to recoup expenditure

• Widely used technique

• Simple to perform and interpret

• Favours investments where the greater cash-flow is received in the early years because any income received after payback has been attained is ignored

Payback: Example

• Which is the best?

• Why?

Year Property A

Property B

0 -100,000 -100,0001 60,000 20,0002 40,000 60,0003 20,000 60,0004 20,000 70,000

Payback:Example

• A would be chosen because the payback is in 2 years despite the total net cash-flow for B being much greater

Year Property A

Property B

0 -100,000 -100,0001 60,000 20,0002 40,000 60,0003 20,000 60,0004 20,000 70,000

Net cash-flow 40,000 110,000

Payback Limitations• Views investments in the short term, only focusing on

cash-flows within the payback period; the shorter the payback the more attractive the investment

• Fails to measure long-term profitability beyond the payback period.

• Ignores the time value of money, the total return that can be expected from the investment and volatility of that return

• The only justification for this method can be that as one projects further into the future the more volatile returns are expected to be, so it is better to have returns sooner

Discounted payback• Variation of the payback method that considers the time

value of money by calculating how quickly a project recoups initial expenditure in discounted (present value) terms

• It is really a version of the Net Present Value method (see later) truncated to the payback year so cash-flows beyond this point are, once again, ignored

• Payback method can be used as an initial screening device prior to more sophisticated methods

b) Rate of return & Yield• If an investment is correctly priced the expected (target

rate of) return will equal the actual return

• Obviously the actual return is not known as it is in the future but we can look at past performance as a guide

• A simple but important measure of investment performance is the ratio of net annual income to capital outlay, known as the (income) yield

• Simple to calculate and can be compared to a ‘hurdle’ or target rate of return set by the investor or compared to the investor’s overall return on capital or WACC

Rate of return & Yield:Theory

• Target rate of return, rn, comprises a risk-free rate, rf, a

risk premium, rp

rn = rf + rp

•  And the yield, y, is

y = rn – g + d

= rf + rp – g + d

•  So if the market is correctly priced

rf + rp = y + g – d

(required return) = (actual return)

Rate of return & Yield:Application

Rate of return & Yield:Example

• An investor wishes to invest £5m and wants a 9% return

• A shop is available for £5m which has been let at £400,000 per annum

• Annual rental growth is expected to be less than 1%

• Should the investor purchase this investment?

Rate of return & Yield:Example

• An investor wishes to invest £5m and wants a 9% return

• A shop is available for £5m which has been let at £400,000 per annum

• Annual rental growth is expected to be less than 1%

• Should the investor purchase this investment?

Yield = income / capital value

= £400,000 / £5,000,000

= 0.08 or 8%

• The shop investment does not produce a sufficient return

Rate of return & Yield :Example (continued)

• The shop investment has only been analysed in terms of its initial return and the simple relationship between initial income and price paid reveals nothing about future income and capital growth prospects

• In the UK business properties typically let on leases incorporating 5 yearly rent reviews

• The IPD retail property index indicates that rents have been growing at an average rate of 1.5% per annum

• Implied rental growth is 1.17% per annum

Rate of return & Yield:Summary

• Like payback, the yield is simple to calculate and easy to understand

• But it cannot account for financial magnitude of the investments under consideration because it is a percentage measure

• The yield, like payback, ignores the time value of money and ignores the concept of cash-flows

• Should only be used to screen investments prior to more detailed appraisal

2. Project-only DCFs• It is not necessary to account for financing when

evaluating a projecto the value of a project should not alter simply as a result

of the way that it is financed (Modigliani and Miller, 1958) (MM hypothesis)

• It is okay to assume investment is wholly equity financedo The funding decision is separate from the investment

decision but only in a world without tax...o Financing only matters when tax is involved

Discounted Cash-Flow (DCF)

• A DCF shows the present values of all revenue (including rent, premiums and sale price) and expenditure (including purchase price and any periodic expenditure)

• The present value of a future sum, whether it is revenue or expenditure, is dependent on the discount rate and the length of time over which it is discounted: the higher the discount rate and / or the longer the discount period, the lower the present value

• To assess investment worth:

– Estimate cash-flow

– Discount at target rate

DCF• Can adjust the cash-flow in each period to account for

changes in inflation, rental growth, depreciation, refurbishment and redevelopment expenditure, tax, financing, management and transfer costs, etc.

• Allows direct comparison of investments because the cash-flows are converted to a common denominator – present value

• Two widely used DCF decision tools

– Net Present Value (NPV)

– Internal Rate of Return (IRR)

a) Net Present Value (NPV)

• Sum of cash flows over holding period discounted at appropriate discount (target) rate

• Present value of a capital profit, expressed as an absolute number regardless of extent of cash flows needed to generate it, over and above target rate of return

• If NPV positive, then return higher than target rate

66

Determinants of theTarget Rate of Return

• Opportunity Cost of Capital (liquidity preference)

• Inflation / growth

• Risk

NPV:Simple example

• Positive NPV signifies viability at 10% discount / target rate

NPV:Comparison 1

NPV:Comparison 2

• 2 investments which have same net total cash-flows but timing of payments is different

• NPV will be higher if majority of cash flows are received early on

NPV:Benefit-to-cost ratio

• If capital outlays are different, calculate NPV as a proportion of PV of total costs and choose the project with the highest

• If inflation rate is used as the discount rate then it is possible to determine whether an investment meets the minimum requirement of transferring purchasing power through time

NPV:Inflation rate as the discount rate

Constructing a real estatecash-flow

*YP perpetuity at exit yield of 11%

Constructing the cash-flow:Tranching income

b) Internal Rate of Return (IRR)• Rate at which cash flow is discounted to give an NPV of 0

– Income discounted to equate with expenditure

– It is where the discount rate equals the IRR

• Rate generated internally by the cash flow of the investment

– 'Internal' denotes that the rate is asset-specific rather than derived from comparable evidence or a market rate

– NPV & IRR make different assumptions about the reinvestment rate

• IRR is a % amount whereas NPV is a money amount

• IRR higher than target rate signifies viability

75

IRR (reinvestment rate)• IRR cannot be calculated directly because as the number

of cash-flows increases so does the complexity of its polynomial expression, with multiple roots

• Also, projects with +ve and –ve cash-flows can have > 1 IRR

• Use interpolation or iteration instead

IRR:Interpolation

IRR lies between 15% and 16% If NPVs are plotted on a graph against discount

rates a curved line depict exact IRRs We can interpolate a straight line between these

two rates to determine where NPV = 0, so long as we have a positive and a negative NPV to work from

IRR:Interpolation

Discountrate (%)

NPV (£)

+11,456

-6,886

0 15% 16%

x

IRR estimate

Actual (non-linear) relationship between NPV and discount rate

Assumed (linear) relationship between NPV and discount rate

True IRR

Using similar triangles, we can interpolate a linear estimate of the IRR between the two trial rates

Where TR1 = lower trial rate NPV1 = NPV at lower trial rate

TR2 = higher rate NPV2 = NPV at

higher rate

and + and - signs are ignored

Therefore IRR estimate is 15% + 0.63% =15.63%

IRR:Interpolation

%63.0432,18

546,11%1 x

21

112 NPVNPV

NPVTRTRx

IRR:Interpolation example• Freehold office investment recently let on an full

repairing and insuring (FRI) lease with 10 years left

• Price is £1m, current rent is £100,000p.a., expected to rise to £125,000p.a. at next rent review

• At the end of the lease the property could be refurbished at a cost of £1.5m and would then expected to sell for £3m (these are forecasts, not current values). The refurbishment is expected to take a year to complete

Using 10% trial rateYr Income and Costs £(+) £(-) Net Flow PV @

10% DCF

0 Purchase Price 1,000,000 -1,000,000

1.0000 -1,000,000

1 Rental Income 100,000 100,000 0.9091 90,910 2 Refurbishment 100,000 100,000 0.8264 82,640 3 Rental Income 100,000 100,000 0.7513 75,130 4 Rental Income 100,000 100,000 0.6830 68,300 5 Rental Income 100,000 100,000 0.6209 62,090 6 Rental Income 125,000 125,000 0.5645 70,563 7 Rental Income 125,000 125,000 0.5132 64,150 8 Rental Income 125,000 125,000 0.4665 58,313 9 Rental Income 125,000 125,000 0.4241 53,012 10 Rental Income 125,000 125,000 0.3855 48,188 11 Sale Proceeds/

Refurb Costs 3,000,000 1,500,000 1,500,000 0.3505 525,750

Net Present Value £199,047

Using 15% trial rate

Yr Income and Costs £(+) £(-) Net Flow PV @

15% DCF

0 Purchase Price 1,000,000 -1,000,000

1.0000 -1,000,000

1 Rental Income 100,000 100,000 0.8696 86,960 2 Rental Income 100,000 100,000 0.7561 75,610 3 Rental Income 100,000 100,000 0.6575 65,750 4 Rental Income 100,000 100,000 0.5718 57,180 5 Rental Income 100,000 100,000 0.4972 49,720 6 Rental Income 125,000 125,000 0.4323 54,038 7 Rental Income 125,000 125,000 0.3759 46,987 8 Rental Income 125,000 125,000 0.3269 40,863 9 Rental Income 125,000 125,000 0.2843 35,538 10 Rental Income 125,000 125,000 0.2472 30,900 11 Sale Proceeds/

Refurb Costs 3,000,000 1,500,000 1,500,000 0.2149 322,350

Net Present Value -134,104

Interpolate IRRIRR = TR1 + [(TR2 – TR1) x NPV1 ]

NPV1 + NPV2

= 10 + [(15 – 10) x 199,043 ]

134,091+ 199,043

= 10 + [5 x 199,043 ]

333,134

= 10 + 2.9875

= 12.99%, say 13%

IRR:Iteration

• Rent is £12,000 pa with 5 year rent reviews

• ARY is 11% and rental growth is 6% pa

• Asking price is £100,000

• Using the IRR function, the IRR of this investment is found to be 11.25%

NB. IRR function in Excel assumes 1st cash flow is period 0

Property Risk Analysis

What is risk?

• Risk is uncertainty regarding the expected future rate of return from an investment

• It is perceived in terms of security of capital, security of expected income and liquidity

• More risky an investment is perceived to be, less attractive it is and thus less valuable; this translates to a higher yield / return

• Main concerns are– probability of making a loss– estimating most likely (capital and income) return– estimating variability of returns

Types of risk

• Systematic risk– affects all investments– caused by inflation, economic cycles, interest rate

fluctuations, etc.– cannot be diversified away

•  Unsystematic risk– affects specific investments– caused by business, financial or liquidity risks– can be diversified (or can it?) using a portfolio of

investments

Sources of propertyinvestment risk

• Tenant risk– Non-payment of rent or other contractual obligations

• Sector and geographical risk– See return characteristics of property sectors and regions– ‘Lumpiness’ of property investment accentuates this type of risk– International diversification can ameliorate some of this type of

risk

• Structural risk– Future expenditure– Prime much less prone

• Legal risk– landlord and tenant legislation– fiscal policy

• Planning– Ownership– other legislation; Sunday trading

• Location risk

Risk analysis

• Despite widespread use of DCF appraisal techniques, risk measurement is rare

• Competition, globalisation and securitisition pressures on property to align with other investment classes

• Traditionally, ARY accounts for risks associated with a property investment

• Investors are starting to quantify risk and allow for it separately using methods used to analyse non-property investments

Risk-return analysis1. Expected Net Present Value (ENPV)

Calculate NPV for each option using expected values for variables in the cash flow. The likelihood of these values being obtained are then quantified using probability analysis

Period Cash flow (£)

Discount rate 7% DCF (£)

0 (1750000) 1 1750000 1 60000 0.9345 56070 2 80000 0.8734 69872 3 2000000 0.8160 1632000

NPV 7942

ENPVAssume previous cash flow has probability of 40% and and that the following outcomes and associated probabilities are deemed possible:

Period Cash flow (£) Period Cash flow (£)0 (1750000) 0 (1750000)1 50000 1 400002 70000 2 600003 90000 3 800004 2000000 4 2000000

NPV(7% discount rate)

(42,895)Probability 20%

NPV(7% discount rate)

(69,126)Probability 10%

Period Cash flow (£) Period Cash flow (£)0 (1750000) 0 (1750000)1 70000 1 800002 90000 2 1000003 2000000 3 2000000

NPV(7% discount rate)

(26,021)Probability 20%

NPV(7% discount rate)

(44,100)Probability 10%

Outcome (£) Probability NPV x Probability(69,126) 0.10 (6,913)(42,895) 0.20 (8,579)

7,942 0.40 3,17726,021 0.20 5,20444,100 0.10 4,410

Total 1.00 Expected NPV (2,701)

ENPV

• Positive NPV using point estimate has become a negative ENPV using probabilities

• Probability estimates are subjective but the process does focus the mind on likelihood of achieving predicted returns

• Not a true measure of risk as it does not measure variation, just a prediction for expected return, e.g. consider the two options below

ENPV

Option A Option B NPV Probability Prob. x NPV NPV Probability Prob. x NPV

(200) 0.2 (40) 150 0.2 30 300 0.6 180 250 0.6 150 500 0.2 100 300 0.2 60

ENPV 240 240

Identical ENPVs but very different volatilities (150 for B and 700 for A with a negative possibility)

Risk-return analysis

2. Probability analysisUse Standard Deviation (SD) to evaluate risk

outcome

probability

-200

0.2

0.6

300 500 outcome

probability

150

0.2

0.6

250 300

Option A Option B

Probability analysis• SD for A is £233.24 and for B is £48.99 so B is less

volatile

• ‘Coefficient of variation’ allows investments with different ENPVs to be compared:

CoV = SD/ENPV

Risk-return analysis3. Sensitivity analysis• Examines change in NPV / IRR caused by

changes in key variables• Usually a margin of 10-20% either side of the

expected values of key variables (rent, yield, etc) is tested

• More sophisticated analysis may use more realistic variations in the key variables or use different % changes depending on the variable

• Does not consider the likelihood of particular outcomes

Risk-return analysis4. Scenario Modelling

• Combine possible values for key variables into scenarios and examine effect on IRR / NPV

• Usually best, worst and realistic scenarios

• Focus on pessimistic scenario due to assumption of risk aversity

• Can assign probabilities to scenarios

Scenario FRV (£) rental growth (%)

ARY when sold (%)

Value (£)

Optimistic 25,000 9 4.25 578,000 Realistic 24,000 8.25 4.35 525,000 Pessimistic 23,000 7.5 4.5 459,000

Scenario modelling

Scenario Boom Normal Recession Probability 0.2 0.6 0.2

0 (10,000) (10,000) (10,000 1 5,500 5,000 4,000 2 6,000 5,500 4,000 3 6,400 6,000 4,000

IRR 37.8 28.8 9.7

Expected return = (0.2)(37.8) + (0.6)(28.8) + (0.2)(9.7)

= 26.8%

Scenario modelling

Economy Probability Estimated DevelopmentReturn

Boom 0.30 35%Steady 0.40 20%Slump 0.30 5%

Scenario modellingReturn Probability 35% x 0.30 = 10.5% 20% x 0.40 = 8.0% 5% x 0.30 = 1.5%

Expected Return = 20.0%

And(Return – mean return)2 x Probability(35% - 20%)2 x 0.30 = 67.5(20% - 20%)2 x 0.40 = 0( 5% - 20%)2 x 0.30 = 67.5

Expected Risk = 135 = 11.62%

Risk-return analysis5. Simulation• Subjectively estimate values and associated

probability distributions for each key variable• Computer program randomly selects a combination

of values in accordance with their probabilities and performs appraisal (e.g. NPV / IRR calculation)

• Selection repeated many (1000) times with each value of each variable selected according to its assigned probability

• Mean snd standard deviation of the NPV/IRR calculates and pattern of results graphically portrayed

Simulation

• @Risk or Crystal Ball

• Can enter ranges, standard deviations, correlations, etc to model mean, variation

• e.g Rental value and exit yield standard deviations based upon comparable ranges, growth forecast ranges based on standard errors of forecasts, costs based upon BCIS current costs and forecast ranges, depreciation rate ranges based on past studies?

Basic process

• Build spreadsheet model

• Run simulation

• Analyse results

Defining model assumptions

• Types of data cells– Assumption cells (numbers not formulae)– Forecast cells

• Determine appropriate probability distribution for each stochastic variable

• Define assumptions

• Specify correlations

Run simulation

• Forecast chart– Can input % uncertainty, level of required figure...

Simulation parameters• ERV refurbished 110,000 (SD 5,000)

• ERV existing 100,000 (SD 5,000)

• Exit yield 7.25% (SD 0.5%)

• Cost of refurbishment £750,000 (SD £50,000)

• Rental value growth 5% (SD 1%)

• Depreciation rate 2% (SD1%)

• Refurbishment cost growth 5% (SD 2%)

Simulation results

Frequency Chart

.000

.005

.010

.015

.020

0

5

10

15

20

-£651,965 -£317,545 £16,876 £351,297 £685,717

1,000 Trials 5 Outliers

Forecast: Net Present Value

Simulation resultsSummary:

Display Range is from -£656,496 to £685,214 Entire Range is from -£956,130 to £755,757 After 1,000 Trials, the Std. Error of the Mean is £8,137

Statistics: ValueTrials 1000Mean £15,920Median £13,115Mode ---Standard Deviation £257,315Variance £66,211,084,541Skewness -0.19Kurtosis 3.25Coeff. of Variability 16.16Range Minimum -£956,130Range Maximum £755,757Range Width £1,711,887Mean Std. Error £8,137.02

Risk Free Rate Comparison

• What is the chance of getting less than the risk free rate or return of 5%?

• Redo Appraisal at a 5% RF discount rate gives an NPV of £674,357

• But real question is what chance of getting less than 5%?

• Answer is over 90% chance of beating 5%,

• 1SD means 84% chance of beating target which is good enough even for risk averse investor

Risk Free Rate Analysis

Output at risk free rateStatistic Forecast values

Trials 1,000

Mean £733,276

Median £711,941

Mode ---

Standard Deviation £514,088

Variance £264,286,052,100

Skewness 0.06391

Kurtosis 3.28

Coeff. of Variability 0.70108

Minimum -£970,856

Maximum £2,535,205

Mean Std. Error £3,506,061

Risk analysis - summary

• Investors primarily concerned with level of return, typically measured against a benchmark

• Less concerned with assessment of volatility of returns

• Risk is regarded as the chance of not achieving benchmark return

• Main measure of risk is standard deviation and focus is always on downside potential