APC Series: Investment method 101

In this APC Series article, Jen Lemen provides a practical overview of the investment method – aiming to demystify and clarify a method of valuation which is often a source of confusion for APC candidates. As a starting point, VPS5 (Valuation approaches and methods) in RICS Valuation Global Standards 2022 (the Red Book Global) defines three valuation approaches: market, income and cost. The income approach includes the investment method, which is based on the capitalisation of present and future income to produce a single current capital value (or “market value”, following VPS 4). The investment method also incorporates aspects of the market approach when considering the analysis of comparable evidence to assess a market rent and market yield. There are also five methods of valuation: investment, profits, contractor’s, comparable and residual. The other four methods can also be categorised within the three VPS 5 approaches highlighted above. The investment method The investment method is used for investment properties with an income stream, typically shops, offices and industrial units. Investment methods can follow a traditional calculation (as discussed in this article) or using a discounted cash flow (DCF). The use of the latter has been promoted by the recent RICS Review of Real Estate Investment Valuations, although it can be more complex and requires a greater number of inputs and assumptions (which must be accurate and reliable to produce a high-quality output). The first principles to understand relate to discounting, which is a topic that many candidates will have covered at university or in valuation-related CPD. Familiar terms will be present value, years purchase and years purchase in perpetuity, together with the use of Parry’s tables. We will not delve into this topic in detail for the purposes of this article; instead we will focus on the practical application of the investment method. Moving on through our first principles, the three key elements of an investment valuation are highlighted in the diagram below. A yield is simply the relationship between the capital and the return, expressed as a percentage. Effectively, yield (%) = (annual rent ÷ capital value) x 100. This equation can be flipped around to calculate the annual rent or capital value very easily. This can be used for rack-rented investments using years purchase in perpetuity. An investment could be rack-rented where it has recently been let or where the lease has been renewed or the rent reviewed (to open market rent). Taking an example of a £60,000 per annum market rent and a 5% net initial yield, the capital value can be calculated as £1.2m. Where an investment is reversionary (ie the passing rent is below market rent), the calculation will be slightly more complex. This is because it needs to account for the fact that the market rent will not be received for a period of time, and the time value of money means that £1 in the future is not worth as much as £1 received today. In this scenario, a term and reversion calculation can be used. This effectively mirrors the income profile with the term relating to the period that the passing rent is received for (ie until it is reviewed) and the reversion relating to the period to perpetuity that the market rent (ie reversion) will be received for. The term is generally less risky as a below-market rent is being received and this can be reflected by reducing the yield slightly. Taking a second example of a £50,000 per annum passing rent with a rent review in two years’ time, a market rent of £60,000 per annum (this is not inflated or forecasted to a future market rent but is taken at today’s figure) and a 5% net initial yield, capital value can be calculated as in the table below. Where an investment is over-rented (ie the passing rent is above market rent), the calculation is again slightly more complex. This is because it needs to account for the fact that there is an over-rented element of the passing rent that will only be received until the reversion, whereas the (lower) market rent will be received in perpetuity. In this scenario, a hardcore and topslice calculation can be used. This effectively mirrors the income profile, with the hardcore relating to the market rent and the topslice relating to the over-rented element. The hardcore is generally far riskier, as it is above the market rent, and this can be reflected by increasing the yield appropriately.  Taking a third example of a £70,000 per annum passing rent with an upward/downward rent review in two years’ time, a market rent of £60,000 per annum (again, not inflated or forecasted to a future market rent but taken at today’s figure) and a 5% net initial yield, capital value can be calculated as in the table below. Just the beginning Investment valuation calculations can reflect a variety of lease arrangements and income profiles – for example, voids, rent frees, stepped rents and inclusive rents. However, the key to accuracy is to ensure that you accurately model the income profile and adjust the yield according to the level of risk. Although this is a very basic explanation of the investment method, it should be a helpful starting point for candidates concerned about how to explain this method within their APC interview. In all investment valuations, purchaser’s costs need to be deducted from the final capital value to reflect the fact that an investor would factor these costs into the price they are willing to pay. Professional guidance alert RICS money laundering update RICS client relationships and handling data update New Homes Quality Code Further reading and resources RICS Valuation – Global Standards 2022 (Red Book Global) Mainly for Students: Yields in property investment explained RICS guidance note – Discounted cash flow for commercial property investments The quick quiz 1. What is the correct formula to calculate annual rent? Annual rent = (capital x yield) ÷ 100 Annual rent = (capital ÷ yield) ÷ 100 Annual rent = (capital ÷ yield) x 100 2. What is the correct formula to calculate capital value? Capital value = (yield ÷ annual rent) x 100 Capital value = (annual rent x yield) ÷ 100 Capital value = (annual rent ÷ yield) x 100 3. What is another name for the contractor’s method? Dilapidated replacement cost Depreciated replacement cost Depreciated residual cost Answers: 1: a   2: c   3: b   Jen Lemen BSc (Hons) FRICS is a partner at Property Elite Photo © Christopher Bill/Unsplash