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http://www.mcbup.com/research_registers/jpif.asp http://www.emerald-library.com

Investment

Investment valuation models valuation models

advance cash flows 225

Received 20 Ocrober

Nick French 1998

Department of Land Management and Development, Revised 1 September

The University of Reading, Reading, UK 1999

Richard Cooper

LaSalle Investment Management, London, UK

Keywords Yield, Rent, Valuation

Abstract It is well recognised that the UK commercial property market has traditionally used

nominal market benchmarks such as the all-risk yield based on the assumption that rents are

received annually in arrears. Obviously, the reality of the market is that rents are invariably

received quarterly in advance and it has been suggested that valuers should move towards

valuation techniques that reflect the actual timing of the cash flow. The Investment Property

Forum issued a paper in September 1999 promulgating the use of quarterly in advance

valuations. Parry's Tables provides quarterly in advance formulae that reflect the reality of rental

income and indicates that an annual effective yield should be used instead of a nominal yield to

compensate for the subsequent compounding resulting from an income received quarterly.

However, as will be shown, the effective yield formula provided by Parry's does not reflect

quarterly payments that are received in advance so compromising the accurate transition from

annually in arrears to quarterly in advance formulae based valuations. Tables produced by the

IPF have rectified this problem in part as they correctly work on the premise that capital values

will not change as the profession changes to a quarterly approach. It is the yield which will be

expressed differently. The use of an all risk yield technique for valuation is actually a comparative

method. The way in which the yield is expressed is not the critical issue, it is the multiplier against

the rent which will determine value. This paper provides the formula required to accurately

transfer annually in arrears data into quarterly in advance data together with the formulae

required for contemporary growth explicit discounted cash flows (DCF).

Introduction

Nominal benchmarks such as the all-risk yield and equivalent yield are used in

a valuation framework assuming that rents are received annually in arrears.

Basically, the market uses measures such as the all-risk yield as a convenient

comparative measure. If the all-risk yield on a particular property is calculated

on an annually in arrears assumption, then that figure will be directly

comparable to a similar property with an all-risk yield calculated in the same

way. For comparison purposes within a single asset class, the preciseness of

the benchmark measure is less important than the consistency of that measure.

The use of the all risk yield in a subsequent valuation should also be quite Journal of Property Investment &

straightforward. In the case of a fully let freehold, if the valuer is satisfied that Finance, Vol. 18 No. 2, 2000,

pp. 225-238. # MCB University

the all-risk yield chosen is implying the correct assumptions for the subject Press, 1463-578X

JPIF property, then its use to calculate the years' purchase multiplier to apply to the

18,2 annual rental figure will produce a good estimate of market value. The

traditional investment method of valuation is one of simple comparison, and

once again, preciseness in terms of technical analysis of the benchmark is less

important than the consistency of the measure. In fact, no yield analysis of any

type is required to carry out the valuation. It would be possible to carry out a

226 comparison valuation by reference to the multiplier alone (YP) without

translating this into a yield reference. It is simple convention in the UK

property market that has led to the reliance on the yield as the benchmark for

comparison.

However, problems arise where the subject valuation is more complicated

that a simple rack rented investment thereby requiring subjective inputs from

the valuer and where comparisons are made with other asset classes that

benchmark on a different basis.

The aim of this paper is not to be a critique of traditional or contemporary

valuation methodologies but to provide the appropriate formula to allow

annually in arrears based data to be used correctly in a quarterly in advance

valuation framework. The use of quarterly in advance formula may provide a

marginally different bottom line figure (which is arguably a more accurate

reflection of reality). However, the principal aim of these formulae should be to

provide valuers with a more robust valuation framework which is intuitively

more logical and understandable by clients. Indeed, The Mallinson Report

(RICS, 1994) commented on this particular point stating:

. . .are we wise to continue using tables which assume rent to be received annually in arrears

when the client knows that he receives it quarterly in advance (RICS, 1994, p. 34).

This point was reinforced by Alaistair Ross Goobey of the Investment Property

Forum who wrote:

As an investor, I find it hard to believe that valuation still assumes that rents are received

annually in arrears. Rents for all the properties owned by our clients are received quarterly in

advance. But when asked why the opposite is assumed, the professionals simply shrug and

say ``it's the convention''. Yet the industry's standard benchmark, the IPD index, has already

adjusted returns on property from its constituents to reflect reality (Ross Goobey, 1997).

the switch from annual valuations to quarterly in advance valuations. The

forum proposed a four-point plan to allow for the transition from annual to

quarterly valuations.

(1) Equivalent yields should be calculated to reflect the actual contracted

income flow (normally quarterly in advance) ± these will be called the

``true equivalent yields[1].''

(2) To avoid confusion while this new practice is introduced, during the

first year (September 1999-August 2000), any yields quoted should be

accompanied by a statement giving the actual timings and frequency of

the rental payments.

(3) Initial, running and reversionary yields should remain as simple Academic papers:

calculations of annual rent divided by price ± these are normally referred Investment

to as ``nominal yields''. valuation models

(4) This new approach should be used in all market valuations, valuation

analysis, investment particulars and press releases.

The Investment Property Forum has named the new quarterly based effective 227

yield, the ``True equivalent yield''. It is recognised that the use of this yield in a

quarterly in advance formula will produce the same multiplier for a rack rented

property as that produced using the corresponding annual equivalent rate in

the annual formula. However, they also note that there is no such relationship

for reversionary properties and that the yield must be found each time by

iteration. It should be noted that while this paper concentrates principally on

cash flows that are received quarterly in advance, the formulae presented are

equally applicable, with the appropriate adjustments made, for the number of

periods, for rents received biannually or monthly in advance.

The starting point for analysis should be that the annual all-risk yield

benchmark when applied to annually in arrears cash flow will produce a

correct estimate of market value for a fully let freehold. Similarly, when the

yield is adjusted to reflect the actual timing of payments, such as quarterly in

advance, then its use in the appropriate formula should provide an identical

valuation. The use of such an effective yield simply recognises the rational

assumption that cash flow payments can be reinvested during the annual

holding period.

Parry's, along with Bowcock's tables provides the formula below for

calculating a effective yield for use in quarterly in advance tables[1].

k p

r 1 ÿ1 1

p

Where

r = Effective capitalisation rate for incomes in perpetuity where growth and

inflation are implicit in the rate, i.e. all-risk yield adjusted for quarterly

in advance cash flows.

k = Nominal capitalisation rate for incomes in perpetuity where growth and

inflation are implicit in the rate, i.e. all-risk yield.

p = Number of payments per annum, e.g. four for quarterly in advance.

Table I illustrates the use of an effective yield based on the above formula used

in conjunction with quarterly in advance formula compared to a

straightforward annually in arrears based valuation.

JPIF As can be seen in Example 1 (Table I), there is a discrepancy in the

18,2 valuations, which on the premise that the quarterly in advance Years' Purchase

in perpetuity formula calculates the correct multiplier, indicates that the

effective yield is wrong[2].

Analysis of the effective yield formula confirms that it does not produce an

appropriate rate to apply to a quarterly in advance cash flow. Indeed, as shown

228

by analysis of a cash flow in Example 2 (Table II), the formula actually

provides an effective yield for income received quarterly in arrears.

Analysis of a quarterly in advance cash flow on the same basis used in

Example 2 (Table II) would provide an approximation for the correct effective

yield. However, unlike ``in arrears'' cash flows, the ``in advance'' effective yield

derived by this method is sensitive to the length of time over which a cash flow

is analysed. Basically, the proportion of the yield calculated due to the first

payment at time zero will decrease as the length of the analysis period

increases and the effective yield will tend towards the quarterly in arrears

effective yield.

Figure 1 graphically illustrates an exaggerated comparison of the present

value of annual incomes of perpetual cash flows with the same net present

A fully let freehold at an ERV of £10,000 p.a. and a current all-risk yield of 8 per cent (adjusted

to 8.24 per cent using effective yield formula from Parry's for quarterly in advance valuations.

Annually in Quarterly in

arrears advance

ERV £10,000 ERV £10,000

Table I. YP perp @ 8 per cent 12.5000 YP perp @ 8.24 per cent 12.7500

Example 1 Valuation £125,000 Valuation £127.500

Cash flow analysis of quarterly in arrears payments assuming investment value of £1,000

and annual income of £100.

Total annual income 100

Total interest rate 10%

Capital value 1; 000

Income Interest Income plus interest

Period (%) (%) at year end (£)

0.50 25 1.27 26.26

0.75 25 0.63 25.63

1.00 25 0 25.00

Total 103.81

Effect interest rate 10:38%

Example 2 Capital value 1; 000

Key Academic papers:

PV of Annual Income

Ann in Arr valuation models

229

Figure 1.

Comparison of the

present value of future

annual incomes for

quarterly in advance

and annually in arrears

cash flows

Time

non-linearity of the annual incomes' present values which shows why the

analysis used in Table II will not provide the correct effective yield.

As the all-risk yield is an algorithm for calculating the net present value of a

perpetual income then the effective rate for a quarterly in advance cash flow

should also reflect a perpetual income. To calculate the true effective yield, or a

close approximation, an internal rate of return could be calculated on a very

long cash flow although this would be impractical. Calculation by formula will,

of course, provide a simpler method of calculation. However, it is notable that

no valuation texts provide a formula to correctly derive an effective yield for a

quarterly in advance cash flow. Accordingly, this paper presents a formula

equation (2) to calculate the correct effective yield for a quarterly in advance

cash flow.

k ÿp

r 1ÿ ÿ1 2

p

Where

r = Effective capitalisation rate for incomes in perpetuity where growth and

inflation are implicit in the rate, i.e. all-risk yield adjusted for quarterly

in advance cash flows.

k = Nominal capitalisation rate for incomes in perpetuity where growth and

inflation are implicit in the rate, i.e. all-risk yield.

p = Number of payments per annum, e.g. four for quarterly in advance.

(This is the same formula used by the investment property forum in their

calculations, except their notation is T = (1/((1-N/4)^4)±1). Where ``T'' is the true

equivalent yield and ``N'' is the nominal (annual) equivalent yield).

JPIF By adjusting the period variable in equation (2), effective yields can be

18,2 calculated for application to rents received ``in advance'' biannually, monthly or

any other proportion of a year.

The reciprocal formula to convert back to an annually in arrears or nominal

rate is shown below and it can be noted that this formula is the denominator in

the quarterly in advance Years' Purchase formulae.

230

1

k p1 ÿ
1 rÿ1=p or k p 1 ÿ p

3

p

1r

Where

r = Effective capitalisation rate for incomes in perpetuity where growth and

inflation are implicit in the rate, i.e. all-risk yield adjusted for quarterly

in advance cash flows.

k = Nominal capitalisation rate for incomes in perpetuity where growth and

inflation are implicit in the rate, i.e. all-risk yield.

p = Number of payments per annum, e.g. four for quarterly in advance.

(Again, this is the same formula used by the investment property forum in their

calculations, except their notation is N = 4(1 ± (1/(1 + T))^0.25). Where ``T'' is

the true equivalent yield and ``N'' is the nominal (annual) equivalent yield).

The transition from an annually in arrears to a quarterly in advance

framework for the valuation of fully let freeholds is, therefore, relatively simple

requiring only an adjustment to the all-risk yield by formula (see Example 3

(Table III)). However, evidence from comparable reversionary freehold

transactions provides for a more complex basis of analysis.

Quarterly in advance cash flows are, for a given annual income, more

valuable than annually in arrears. Therefore, an upward adjustment in yield is

required when using quarterly in advance formulae to reconcile the valuations

produced by the approaches. However, comparable term yields do not imply a

perpetual income and equivalent yields are a composite measure of term and

perpetual incomes. Conversion of these measures to effective yields requires

analysis reflecting the length of the term and, in the case of equivalent yields,

A fully let freehold at an ERV of £10,000 p.a. and a current all-risk yield of 8 per cent

[adjusted to 8.24 per cent using proposed effective yield formula for quarterly in advance

valuation ± using the YP formula YP = 1/(4*(1±(1/((1+T)^0.25)))))]

Annually in Quarterly in

arrears advance

ERV £10,000 ERV £10,000

YP perp @ 8 per cent 12.5000 YP perp @ 8.42 per cent 12.5000

Valuation £125,000 Valuation £125,500

Table III.

Example 3 Note: Both method produce the same valuation of £125,000

knowledge of the yields implied for different income tranches. Therefore, Academic papers:

conversion to quarterly in advance effective rates cannot be undertaken by use Investment

of a simple formula as above. valuation models

Analysis as discussed may seem academic, but if the profession is to move

towards analysing income on an ``as received'' basis, then the distinction

between quarterly adjusted rates on an ``in arrears'' and ``in advance'' basis will

be important. 231

However, the above analysis simply reiterates that it is the multiplier (YP)

that is important to the valuation. The way in which this is expressed as a

benchmark, either quarterly (true equivalent yield) or annual (nominal

equivalent yield) is actually an issue of reporting. The ``true'' equivalent yield is

simply a more precise benchmark in advising the client of the return being

achieved. It does however still imply growth (if there is a market perception of

growth occurring); thus the stated intention of the investment property forum

that the true yield can be ``directly compared with the redemption yield on

bonds and gilts'' is strictly not applicable. A reverse yield gap may still apply.

As previously noted, there is a growing move in the UK valuation profession to

adopt more explicit valuation models (see French, 1996). A valuation model is a

mathematical or financial representation of the pricing process in the market.

In determining market value, the valuer needs to use a valuation model

which best estimates the price of exchange. In simple terms this could be one of

two types of model. It could be a method of benchmark comparison, i.e. by

looking at previous comparable sales it is possible to decant certain indicators

(such as the all-risk yield) which when applied to the subject property will

provide a reasonable estimation of sale price. This would be directly equivalent

to the valuation of equities by reference to the price-earnings ratio and in itself

should not be criticised for being over-simplistic. If there is sufficient and

reliable comparable information it is a valid and appropriate pricing tool.

While it incorporates market proven elements, it is nothing more than a

method based on the observation of previous sales. It does not attempt to

capture explicitly the underlying thinking of the players in the market, i.e. a

calculation of worth. It is a simple reflection of the result, not the mechanics of

the market. Thus the second type of valuation model is one which attempts to

assess the most likely exchange price by reference to the underlying thought

process of the players in the market. This requires the valuer to better

understand the client's requirements and leads to the adoption of more explicit

valuation models which can reflect the increased level of data and information

available. In other words, the method is a return to the fundamentals and will

reflect the thought process of determining worth.

Not withstanding the above, by adopting a different model, the valuation

figure itself should not change. For instance, the all-risk yield model is simply a

short cut to the other. There is a relationship between the two models which

should lead to a consistent result. This is illustrated in Example 4 (Table IV).

JPIF A fully let freehold at an ERV of £10,000 p.a. with a five year rent review pattern and a

18,2 current all-risk yield of 8 per cent. Equated yield assumed to be 12 per cent with implied

growth by formula of 4.633 per cent. Valued on an annually in arrears basis.

Traditional Short cut DCF

ERV £120,000 Term 1

YP prep @ 8% 12.500 Passing rent £10,000

232 Valuation £125,000 YP 5 yrs @ 12% 3.6048

£36,048

Term 2

ERV £10,000

Amt £1 5 yrs @ 4.633% 1.3541

Inflated ERV £12,541

YP 5 yrs @ 12% 3.6048

PV 5 yrs @ 12% 0.5674

£25,652

Revision

ERV £10,000

Amt £1 10 yrs @ 4.633% 1.5728

Inflated ERV £15,728

YP perp @ 8% 12.5

PV 10 yrs @ 12% 0.3220

£63,300

£125,000

Table IV.

Example 4 Note: Both methods produce the same valuations of £125,000

The explicit valuation model in Example 4 (Table IV) uses a growth explicit

discount rate or equated yield taken as an arbitrary figure of 12 per cent. An all-

risk yield of 8 per cent consequently implies a level of rental growth sufficient

to provide a return to the investor of 12 per cent. The growth figure in this

example is 4.63 per cent per annum and can be simply calculated by use of a

number of formulae, the example using such a formula derived by Fraser

(1993;) see equation (4). The explicit valuation is presented in a short-cut

discounted cash flow framework (see Baum and Crosby, 1995) although an

identical valuation can be calculated by a full discounted cash flow.

"r#

n

n e ÿ k1 e k

g ÿ1
4

e

Where

g = Net average annual growth rate.

e = Equated yield.

k = Nominal capitalisation rate for incomes in perpetuity where growth and

inflation are implicit in the rate, i.e. all-risk yield.

n = Interval between rent reviews in years in subject lease.

While the rationale of using a constant average annual growth rate is patently Academic papers:

questionable, such methods, in the absence of forecasts, provide the best model Investment

of market sentiment. As well as an assumption of a constant growth rate, the valuation models

all-risk yield remains constant throughout the term of the lease and the

perpetual five year income tranches are valued on the premise that the

reversionary sale could take place at any of the interim rent reviews into

perpetuity. These are the underlying principles used in the short-cut DCF 233

which in Example 4 (Table IV) allows for the (notional) sale at the second

review or reversion.

If valuation models are to become more explicit, then it is appropriate that they

should reflect the timing of cash flows more realistically. Thus, models should

be developed to allow for quarterly in advance receipts discounted at an

appropriate discount rate.

From Example 4 (Table IV), the underlying assumption is that the figure of

£12.5 million is the ``correct'' market value for the investment. In other words,

the market is pricing this investment at £12.5 million knowing that the income

flows are receivable quarterly in advance. The fact that an annually in arrears

benchmark is used as the principal tool of analysis is not in itself a problem.

The adjustment of the traditional all-risk yield approach, using a quarterly in

advance effective yield in conjunction with quarterly in advance Years'

Purchase formula has been addressed earlier. However, adjustments will be

required in the DCF approach to calculate the same answer when using

quarterly in advance formulae. The question raised, therefore, is whether it is

appropriate to adjust the growth rate or the equated yield, or indeed both.

The use of DCF frameworks for valuation, as already stated, is to reflect the

underlying thinking of the players in the market. Accordingly, by whatever

method it is derived, for instance by the redemption yield on long dated

government fixed interest bonds plus a margin, the equated yield should

represent the required and expected return for a given property investment if

the purpose of the valuation is to calculation market value. By providing a

market derived measure, the all-risk yield implicitly discounts at the required

and expected return of the market while allowing for growth and depreciation.

MacGregor (1993) expands on this point:

An investment is correctly priced when the net present value of the expected cash flow,

discounted at the required return, is zero. . .Thus the required return will equate to the

expected return. If actual outcomes are other than expected, the delivered return will be

different from the expected and required returns.

producing the same annual income will, for a given equated yield, produce a

different valuation or net present value. Obviously, the quarterly in advance

cash flow will be of higher value as the earlier receipt of income allows for

JPIF earlier reinvestment. Accordingly, for a given required return, the quarterly in

18,2 advance cash flow will have a higher value to provide the same expected return

as the annually in arrears cash flow.

With the purpose of this exercise to reconcile the annually in arrears and

quarterly in advance valuation approaches, then it is not the equated yield

which should be adjusted as cash flow patterns are addressed by the

234 discounting process in a DCF. Consequently, it is the rate of growth which must

change to reconcile the approaches.

While an in depth examination of equated yield construction is beyond the

scope of this article, it is pertinent to address the particular argument that ``rule

of thumb'' approaches to arrive at an equated yield such as ``gilts plus 2 per

cent'' implicitly imply that rent is received quarterly in advance, while the

mathematics of the valuation are based on an annually in arrears cash flow.

Although such rules of thumb are a blunt instrument to arrive at an equated

yield, they would suggest that some adjustment should be made to the rate

when used to explicitly discount quarterly in advance cash flows. However,

such arguments are flawed when the purpose of adopting DCF approaches is to

make the valuation process explicit in its assumptions and use of such equated

yields makes implicit assumptions of receipt timing.

As is illustrated later in Example 5 (Table V), to reconcile the approaches, a

lower growth rate must therefore be used. However, growth formulae such as

A fully let freehold at an ERV of £10,000 p.a. with a five year rent review pattern and a

current all-risk yield of 8 per cent and effective yield of 8.42 per cent. Equated yield

assumed to be 12 per cent with implied growth by formula of 3.998 per cent. Valued on an

annually in arrears basis.

Traditional Short cut DCF

ERV £10,000 Term 1

YP prep @ 8.42% 12.5000 Passing rent £10,000

Valuation £125,000 YP 5 yrs @ 12% 3.8713

£38,713

Term 2

ERV £10,000

Amt £1 5 yrs @ 3.998% 1.2165

Inflated ERV £12,165

YP 5 yrs @ 12% 3.8713

PV 5 yrs @ 12% 0.5674

£26,723

Revision

ERV £10,000

Amt £1 10 yrs @ 3.998% 1.4800

Inflated ERV £14,800

YP perp @ 8.42% 12.5

PV 10 yrs @ 12% 0.3220

£59,563

£125,000

Table V.

Example 5 Note: Both methods produce the same valuations of £125,000

those presented by Fraser (1993), are not easily adjusted to quarterly in advance Academic papers:

calculations. While they will produce the correct growth rate for an annually in Investment

arrears assumption, they do not produce the correct growth rate for the valuation models

quarterly in advance approach. Accordingly, the formula below, equation (5)

has been derived to allow for ``in advance'' rates.

v

" #

u

u 1 ÿ
1 r ÿ1=p

1 e n

ÿ 1 235

g t
1 en ÿ

n

ÿ1=p

ÿ1
5

1 ÿ
1 e

Where

g = Net average annual growth rate.

e = Equated yield.

n = Interval between rent reviews in years in subject lease.

r = Effective capitalisation rate for incomes in perpetuity where growth and

inflation are implicit in the rate, i.e. all-risk yield adjusted for quarterly

in advance cash flows.

p = Number of payments per annum, e.g. four for quarterly in advance.

Example 5 (Table V) compares a traditional approach to a contemporary short-

cut DCF approach using quarterly in advance formulae. As in Example 4

(Table IV), two terms are used in the short-cut DCF for illustrative purposes.

As shown in Example 5 (Table V), the adjustment of the growth rate

reconciles the approaches. While the validity of using a net average annual

growth rate has been touched on earlier, with rents invariably paid quarterly in

advance in the market, such analysis gives a rate more reflective of reality than

the annually in arrears formulae. Indeed, rental growth forecasts in a

calculation of worth using annually in arrears cash flows would result in an

undervaluation unless the rental growth predictions are adjusted upwards to

reflect the annually in arrears basis of calculation

The formula presented for calculating a growth rate for use in quarterly in

advance cash flows is somewhat more complicated than those used for

annually in arrears cash flows. However, the formula can be simplified if the

annually in arrears (i.e. nominal) all-risk yield is known as shown below,

equation (6).

v

" #

u

u
1 e ÿ 1 n

g t
1 en ÿ k

n

ÿ1
6

p1 ÿ
1 eÿ1=p

Where

g = Net average annual growth rate.

e = Equated yield.

JPIF n = Interval between rent reviews in years in subject lease.

18,2 k = Nominal capitalisation rate for incomes in perpetuity where growth and

inflation are implicit in the rate, i.e. all-risk yield.

p = Number of payments per annum, e.g. four for quarterly in advance.

236 As with annually in arrears formulae calculating the relationship between the

all-risk yield, equated yield and growth rate, other formulae can be derived to

calculate, for instance, the effective all-risk yield, equation (7) and the nominal

all-risk yield, equation (8) as shown below.

" #ÿp

1 en ÿ
1 gn 1 ÿ
1 eÿ1=p

r 1ÿ ÿ1
7

1 en ÿ 1

Where

r = Effective capitalisation rate for incomes in perpetuity where growth and

inflation are implicit in the rate, i.e. all-risk yield adjusted for quarterly

in advance cash flows.

e = Equated yield.

n = Interval between rent reviews in years in subject lease.

g = Net average annual growth rate.

p = Number of payments per annum, e.g. four for quarterly in advance.

" #

1 en ÿ
1 gn 1 ÿ
1 e1=p

kp
8

1 en ÿ 1

Where

k = Nominal capitalisation rate for incomes in perpetuity where growth and

inflation are implicit in the rate, i.e. all-risk yield.

p = Number of payments per annum, e.g. four for quarterly in advance.

e = Equated yield.

n = Interval between rent reviews in years in subject lease.

g = Net average annual growth rate.

It should again be noted that the quarterly in advance formulae presented can

simply be adjusted to reflect other regular patterns of in advance receipts by

changing the number of periods variable.

Conclusion Academic papers:

The underlying purpose of this paper is not to question the theoretical Investment

framework within which valuation takes place. It does, however, attempt to valuation models

identify a real problem that needs to be addressed if the valuation profession is

to move towards valuation calculations based on reality instead of convention.

If the valuation profession takes on board the proposals of the Investment

Property Forum and starts to analyse all transactions on a quarterly in advance 237

basis, the problem of determining the correct quarterly rate, as illustrated, will

not occur.

The arithmetic problem arises because the profession analyses on an

annually in arrears basis, and then takes this information and attempts to

estimate the quarterly equivalents from annual data. The method of calculating

the effective rate by compounding a quarter of the annual rate has been shown

to be flawed. It assumes quarterly in arrears payments. While the error is in

most cases small, it is nevertheless wrong.

One of the principal problems with using annual data to determine the true

equivalent rate for freehold property is that the analysis differs between rack

rented and reversionary properties. For a perpetual valuation (rack-rented)

property is relatively straightforward and can be analysed by the formulae given.

With reversionary properties, the solution varies with the length of the term.

Similarly, the use of a DCF approach (full or modified) requires an analysis

to determine the appropriate equated yield or target rate. The question to be

addressed is whether the market will start benchmarking by reference to the

true equivalent or equated yield respectively. If the market chooses to ``talk'' in

terms of annual in arrears benchmark, then the use of valuation techniques

using quarterly figures will be pure sophistry. The value will be the same

regardless of the technique used. There is a strong argument that the annual

approach should be retained for its simplicity and functionality.

There is no argument that performance measurement should be precise and

reflect the actual cash flow under contract, but pricing models (valuations) do

not have to be so sophisticated. But if the decision is made to value by more

explicit models, it is important that the new models adopted are fully rational

and not half-way attempts to address the perceived shortcoming of using

annual data. This paper may be considered a pedantic exercise, but if the

valuation profession wishes to embrace more explicit pricing models, then

those models should be using inputs that are logical, consistent and reflective

of reality.

Notes

1. It should also be noted that the use of the term ``equivalent yield'' is its correct (property

term) usage as the internal rate of return (IRR) for the property implying growth. The

corresponding term in property for the IRR where growth is allowed for explicity in the

cash flow is the ``Equated yield''.

JPIF 2. The quarterly in advance formula given in Parry's tables:

18,2 YP in perpetuity

1

p1 ÿ
1 rÿ1=p

1 ÿ
1 rÿn

YP for n years

p1 ÿ
1 rÿ1=p

238

Where

r = Effective capitalisation rate for incomes in perpetuity where growth and inflation are

implicit in the rate, i.e. all-risk yield adjusted for quarterly in advance cash flows.

p = Number of payments per annum, e.g. four for quarterly in advance.

3. The authors' analysis concluded that the quarterly in advance Years' Purchase formula

given in Parry's tables are arithmetically correct.

References

Baum, A. and Crosby, N. (1995), Property Investment Appraisal, 2nd ed., Routledge, London.

Bowcock, P. (1978), Property Valuation Tables, Macmillan, London.

Davidson, A. (1989), Parry's Valuation and Investment Tables, 11th ed., Estates Gazette, London.

Fraser, W.D. (1993), Principles of Property Investment and Pricing, Macmillan, London.

French, N. (1996), ``Investment valuations: developments from the Mallinson report'', Journal of

Property Valuation and Investment, Vol. 14 No. 5, pp. 48-58.

MacGregor, B. (1993), ``Risk, diversification and property'', paper presented at the RICS Cutting

Edge Conference.

Mallinson Report (1994), Commercial Property Valuations, Royal Institution of Chartered

Surveyors, London.

Ross Goobey, A. (1997), ``Viewpoint: in favour of a three for all'', Estates Gazette, 7 June, p. 50.

Royal Institution of Chartered Surveyors (1994), The Mallinson Report: Commercial Property

Valuations, RICS, London.

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