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ACADEMIC PAPERS Academic papers:


Investment
Investment valuation models valuation models

Annually in arrears data in quarterly in


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).

As a result, in September 1999, the Investment Property Forum promulgated


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.

Nominal and effective rates


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 ˆ 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 ˆ ˆ ˆ 10%
Capital value 1; 000
Income Interest Income plus interest
Period (%) (%) at year end (£)

0.25 25 1.92 26.92


0.50 25 1.27 26.26
0.75 25 0.63 25.63
1.00 25 0 25.00
Total 103.81

Table II. Total annual compounded income 103:81


Effect interest rate ˆ ˆ ˆ 10:38%
Example 2 Capital value 1; 000
Key Academic papers:
PV of Annual Income

Qtr in Adv Investment


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

value received quarterly in advance and annually in arrears. It highlights the


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 ˆ 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 ˆ p‰1 ÿ …1 ‡ r†ÿ1=p Š or k ˆ p 1 ÿ p 
 …3†
p
1‡r

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.

Implicit and explicit valuation models (annually in arrears)


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 kŠ‰1 ‡ eŠ ‡ k
gˆ 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.

Implicit and explicit valuation models (quarterly in advance)


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.

An annually in arrears cash flow and a quarterly in advance cash flow


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
Š‰…1 ‡ e† n
ÿ 1Š 235
g ˆ t…1 ‡ e†n ÿ
n

ÿ1=p
ÿ1 …5†
‰1 ÿ …1 ‡ e† Š

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 1Š n
g ˆ t…1 ‡ e†n ÿ k
n
ÿ1 …6†
p‰1 ÿ …1 ‡ e†ÿ1=p Š

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 ‡ e†n ÿ …1 ‡ g†n Š‰1 ÿ …1 ‡ e†ÿ1=p Š
r ˆ 1ÿ ÿ1 …7†
…1 ‡ e†n 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 ‡ e†n ÿ …1 ‡ g†n Š‰1 ÿ …1 ‡ e†1=p Š
kˆp …8†
…1 ‡ e†n 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 ˆ
1
p‰1 ÿ …1 ‡ r†ÿ1=p Š

1 ÿ …1 ‡ r†ÿn
YP for n years ˆ
p‰1 ÿ …1 ‡ r†ÿ1=p Š
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
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