Property Investment

A property or building can be owner-occupied or rented; the latter being an investment property. In the present market (1996) it may of course be vacant, resulting from being surplus to the owner’s requirements or a poor investment! A large proportion of property is owner-occupied but most of the conventional texts and theories in property are applied to the investment market. The investment market for property cannot be seen in isolation from other investment markets. The application of funds to property has to reflect competition from other forms of investment. The decision to invest in a particular area will be a comparison of return and security and thus knowledge of alternative investments and their analysis could be very important. The application of financial techniques to property investment can also be important and this can clearly be seen in the securitisation and unitisation of property which is a key area of development in property investment. Another important point to be made concerns the nature of the lender and the property to which finance is applied. At its simplest, the financial arrangement may deal with an individual purchasing a single property with a single loan, but it is usually more complex. Finance is generally raised by corporate entities, such as property companies, using existing property and other assets as collateral for the purchase of a portfolio of assets which may include property assets but not exclusively. Finally, it is important to realise the significance of property and property investment to the economy. The importance can be shown in three different ways: as a factor of production, as a corporate asset and as an investment medium.

The market for commercial property is an established investment market but because there is no central market place for property and because investment properties are unique there is a difficulty in understanding how the market works. This is compounded by the fact that information of the product in the market and the nature of transactions is restricted; information is passed verbally rather than properly documented in the press or reports. The actual detail of the transaction in the market, the details of rents passing, the nature of the lease terms agreed and the yield used in any capital transaction may remain confidential. The property market is thus a dangerous place for the lay person to invest in.

The main investors in the market are: financial institutions, overseas investors and property companies. The financial institutions are the pension funds and the insurance companies. Other investors are High Street clearing banks, foreign banks, building societies, merchant banks and finance houses. In their recent report on the sources of money flowing into property, DTZ Debenham Thorpe and the Central Statistical Office provided the figures shown in Table 3.1.

The established classification of property investments changed in the 1980s with the addition of high-tech developments, retail warehouses, retail parks, mixed used developments and speciality shops. Workshop conversions with residential or studio space also created an innovative sub-sector. Some of these new categories were encouraged by the changes in planning controls. The Town and Country Planning Use Classes Order 1987 lists the categories of property use and within each classification it is possible to change use without any additional planning consent. This legislation established the class B1, which is a business class allowing movement across the divide from light industrial use to office use. This change caused a remarkable shake-up in the office sector but more so in the industrial sector. Business space became a recognised sector of the investment market dealing with B1 properties, and in addition the concept of business parks was established as opposed to dealing with a block of offices or an industrial estate. The legislation allowed this change of use within the band of uses as long as substantial external physical alterations were not required. However, any change of use which required movement between one class and another required specific consent. Class B1, as well as combining office use with light industrial use, also generally indicated a high-tech usage or specification to the building.

Investment appraisal systems need a clear criterion on which to measure the proposals for investment in a project. The appraisal can only deal with money considerations; items can then be quantified in cash terms. It cannot deal with qualitative assumptions, thus the criterion is measured on a cash yard stick. The method used must also allow other alternative investment projects to be measured against one another. In this section we look at the development of capital appraisal techniques in the business sector for comparison with methods in the property sector. Just as in the property field there is a comparison of traditional methods of appraisal with discounted cash flow approaches; the development of capital appraisal techniques in business mirrors this. The traditional methods in business, however, are more basic than those in the property field. Property valuation methods take into account the concept of discounting income and costs in the future, which illustrates the time value of money in the sense that a £1 available today is worth more than a £1 in a year’s time even ignoring an inflation effect. This is because if a £1 is immediately consumed, the benefit is obtained a year earlier or the £1 can be invested and earn interest over the year. In property valuation the traditional Years Purchase approach takes into account the time value of money, whereas in business valuation traditional methods ignore this. The more advanced approaches of discounted cash flow involving net present value (NPV) and internal rate of return (IRR) are dealt with later in this chapter. The two basic approaches discussed first are the payback period method and the rate of return on investment method.

This book is concerned with property investment and it is not intended to go into great detail on appraisal techniques. However, this chapter and the next will look at issues related to conventional and contemporary appraisal techniques. For a more detailed exposition of the fundamentals, you are referred to Enever and Isaac (1995) and Isaac and Steley (1991). This chapter looks at reversionary property, leasehold interests, growth and inflation and valuation accuracy.

Explicit DCF models can be developed using growth in the calculation and discounting using the investor’s target rate or equated yield. Freehold property requires an infinite cash flow and this means the process needs to be shortened. This can be done by assuming a certain holding period and then resale of the investment at the initial capitalisation rate.

This chapter looks at cash flow methods in property investment appraisals. Cash flows into the future are forecasts, but valuations and forecasts are fundamentally different. This aspect has been discussed to a degree in Chapter 5, but essentially the valuation is about market price as a snapshot in time. It may be based on assumptions as to what will happen in the future but it is not a forecast A forecast will be concerned entirely with the future. In development appraisals assumptions need to be made about project costs and future rents, and potential changes can be incorporated. Formal forecasting is used in property development, but its overall lack of use is based on the problems of risk and uncertainty in the development process (Schiller 1994). Cash flow approaches are aided by computers, and the use of spreadsheets for calculations involving cash flow statements is vital. Some texts suggest the use of bespoke computer programs (Darlow 1988); these bespoke programs can examine the answers relating to changes of inputs into the calculations, but it is difficult to examine the changes in detail as they occur, and for this a spreadsheet is more useful. The computer spreadsheet is a useful tool for investment appraisals and the examples in this book have been calculated using this software.

Risk is a major determinant of return. Modern Portfolio Theory sees the investment decision as a trade-off between risk and expected return; see Figure 91. Much research in property risk has been devoted to the application of measures, already devised for equity investment, to the property market and these are related to portfolio risk analysis which is covered in the following chapters. Waldy (1991) suggests that the main argument for considering single asset risk to be equally as important in practice is that most investors in the UK are not able to diversify away the individual property element of risk adequately. Aspects of risk analysis have already been discussed in Chapter 8. Waldy suggests there is a hierarchy of these approaches, starting with the intuitive approach used in traditional valuation for the assessment of the all risks yield (ARY) which is assessed in accordance with the risk profile of the property; the ARY is thus an implicit valuation which is open to criticisms of subjectivity. Explicit approaches used in discounted cash flow appraisals include sensitivity analysis and scenario testing. Sensitivity analysis measures the effect upon capital value by a change in variable inputs to the calculation. Scenario testing postulates situations by assigning appropriate values to the variables to test for different scenarios. Risk-adjusted discount rates provide for a premium to reflect risk; certainty equivalent techniques through probability and the removal of downside risk calculates risk-free cash flows which can be capitalised using the risk-free rate of return. Probability analysis is inherent in these calculations.

Because of the nature of property as an investment, which has been detailed in earlier chapters, there is a great need to manage it effectively. Generally larger investment amounts are being dealt on the market and the collectivisation of savings into the financial institutions has led not only to their growth but also their need to be accountable. Proper management of property investment is part of this need, coupled with the requirements to match the efficient management of other asset classes, if property is to be treated as a significant player in the investment portfolio. Some property investment managers concentrate on opportunities which require management and active development, redevelopment or refurbishment; others are content to hold fully let prime investment properties on institutional leases and almost treat the investment as a paper investment with little active management. The main problems of property as an investment have been summarised as the lotting problem (the size and indivisibility of lots for sale); illiquidity; the need for management; and the complexity of financing development (Dubben and Sayce 1991). These areas all require effective management. The investment decision will relate to the amount of property within the institutional portfolio. To compete with gilts and equities the property portfolio will need to consider the proportion of the property investment placed in different sectors. For instance, some commentators in the past have made generalised statements suggesting that the ideal pension fund portfolio could be around 50% retail, 30% office and 20% industrial. This chapter will indicate some of the complexities of such a decision.

This distinction may sound confusing but it is based on an analysis relating to debt and equity investments. To begin with, one must consider a single property rather than a portfolio. For a single property, if we divide the interest into a number of holdings, then we divide the equity, and this is unitisation. If we divide the interest and add debt securities, in the way a company may have shares and loan stock, this is securitisation. In fact securitisation is rather like imposing a corporate finance structure on a property, that is, a single-asset property company, but this approach simplifies matters because it is important to understand the objectives of securitisation and unitisation, which will differ from the operation of a property company. From the above, securitisation thus includes unitisation and can be used as a general term incorporating unitisation and this will be done here except when discussing securitisation historically or when the securitisation of the equity alone is considered. The distinction between securitisation and unitisation is shown in Figure 12.1.

For investment appraisal, a knowledge of property accounts is essential. This provides the analysis of the corporate entity and can be used to analyse the strength of tenants, business partners and companies which are being invested in. This chapter provides an outline of financial management for these purposes.

In their report on commercial property in the UK economy, Currie and Scott (1991) concluded that commercial property represented an important sector of the economy and had a major influence on the rest of the economy. They were surprised that despite this importance, property received relatively little attention from economic commentators and policymakers. A key conclusion of the report was that the current state of statistics in the sector was poor for commercial property, a situation which contrasted with the level of statistical data in the private housing market which was well documented. A number of various areas of research are now being developed. Areas of research sponsored by the RICS include the relationship of property cycles to business cycles. In addition, interest has been created by the opening of Eastern Europe and the property markets in that region. In terms of valuation principles and methods, further research has continued into portfolio investment and the development of existing appraisal methods which are dealt with in more detail below.