Capital values

© University College of Estate Management 2016 P10488

Contents
1 Introduction....................................................................................................
1.1 Purposes of valuation......................................................................................
1.2 Method of valuation..........................................................................................
2 The investment method and constant incomes.........................................
3 Variable incomes...........................................................................................
3.1 Types of variable income.................................................................................
3.2 Alternative methods of valuation......................................................................
3.3 All risk yield method.........................................................................................
3.4 Equated yield method (DCF)...........................................................................
4 Stepped incomes.........................................................................................
4.1 Deferred income............................................................................................
4.2 Varying incomes in freehold property............................................................
4.3 The hardcore or layer method of valuation....................................................
4.4 Rents fixed in the medium term.....................................................................
4.5 Rents fixed in the long term...........................................................................
4.6 Equivalent yields............................................................................................
4.7 Equated yields...............................................................................................
4.8 Commentary on stepped income values.......................................................
5 Incomes for limited periods........................................................................
6 Terms and conditions of use......................................................................
1 Introduction
1.1 Purposes of valuation
The capital value of real estate is required for sale, purchase, investment or
mortgage purposes, taxation and condemnation (resumption or compulsory
purchase).

1.2 Method of valuation

The method employed is sales comparison or investment in most cases. Here
we shall be considering the investment method, both in conventional form and
discounted cash flow.
The investment method applies in the following contexts:
1. Constant incomes
2. Variable incomes
3. Stepped incomes (rising or falling, but some care is needed for the latter)
4. Incomes for limited periods.

2 The investment method and constant

incomes
The investment method applied to constant incomes illustrates the simplest
case. Where real estate produces a constant rent and that rent is well secured,
the investment has many similarities to a bond. The ratio of income to capital
value will tend to be similar.
For example, if a Government bond, undated, has a market yield of 5% pa. The
value of a secure, fixed rent in perpetuity is likely to reflect a yield of 6% pa.

Rent in perpetuity $5 000 pa

× 100 ÷ 6 (or YP) 16.667
Estimated capital value $83 335

The margin of the property income yield over the bond yield may vary, and
comparisons with actual property transactions should be studied to guide you
as to the relationship.
The reason for the mark-up on bonds yield is better liquidity and less
management in the case of bonds.
Constant incomes from property are not as common as variable incomes.

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3 Variable incomes
3.1 Types of variable income
The majority of incomes from real estate are variable as opposed to constant.
There are two main kinds of variable income:
1. Where the rents are set at the market level, but are subject to future
changes.
2. Where the rents are above or below the market level and will be
adjusted in future to the market level. This is referred to as ‘stepped’
income, or, in UK practice, a reversionary income.
Here we are looking at those situations where the rents are at market level but
will change in future.

3.2 Alternative methods of valuation

There are two alternative methods of approach, one relying on simple
comparisons of ratios of rent to capital value, and the other on principles of
discounted cash flow. They are referred to as ‘All Risk Yield’ (ARY) and
‘equated yield’ (or DCF) methods respectively.

3.3 All risk yield method

The simple model, applied to a fee simple interest (i.e. a perpetuity for practical
purposes), is as follows:

Current rent income $10,000

Less landlord’s expenses 1,000
Net income (before tax) 9,000

× YP perpetuity @ 7.5% (100

8 )
12.5

$112,500
3.3.1 Explanation
1. Current rent. This has been compared with rents in the locality and
judged to be equal to market rental value.
2. Landlord’s expenses. All costs of repairs, insurance, management etc
not recovered from the tenants. In modern leasing of major buildings,
such costs are usually recovered in a service charge, unless the whole
building is let and the tenant maintains and insures. Where the landlord
is responsible for repairs and other costs, an estimate must be made
from records and comparable premises to ascertain the annualised costs
(local property taxes are assumed to be paid by tenants).
3. Years’ Purchase (YP). Simply a name for the multiplier, and the
reciprocal of the rate percent required by investors. The number (yield or
capitalisation rate) is extrapolated from sales data of similar deals.

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 The rate percent employed is known as the all risk yield since it reflects
all the benefits and risks etc associated with the investment.

3.3.2 Critique
1. The model, being very simple, conveys little direct information to a buyer
or seller.
2. The selection of the capitalisation rate is critical, but subjective
adjustments have to be made in practice for various differences between
properties, e.g.:
 Location
 Building quality
 Tenants and leases
 Lease unexpired term.
3. The method is an extension of the comparative principle, using
comparison for rental value and yield. It follows the market prices, and
suffers from the weaknesses involved in that practice, e.g. backward-
looking at previous deals, not forward-looking at prospects for the estate
being valued; over-values in an overheated market.
4. The all risk yield approach was developed in times of relative stability of
prices, and is not well suited to valuation under varying inflationary
conditions.

3.4 Equated yield method (DCF)

In choosing between alternative investments, including property, an investor will
be interested in certain information. In particular he may wish to know some or
all of the following:
1. Initial yield — the relationship between initial income and capital value,
and which provides an indicator of the potential future rental growth.
2. Reversionary yield — the relationship between future income and
capital value, and which provides a measure of risk for future income.
3. Equivalent yield — the ‘weighted’ average rate of return on stepped
incomes without specific allowance for income growth (see later in this
paper).
4. Equated yield — the internal rate of return with specific allowance for
income growth.
Equated yield analysis evolved in response to the criticism of conventional
valuation methods, namely that they are based upon current estimates of
market rent and only implicitly allow for inflation by adjusting the ARY (all risks
yield). Equated yields are based upon explicit projections of estimated future
rents allowing for an assumed annual growth rate.

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 An equated yield may be defined as that discount rate which must be applied to
the projected rental income from an investment so that the summation of all
such income discounted at this equated yield rate equates with the initial capital
outlay. In other words the equated yield is the IRR (Internal Rate of Return) of
an investment, where the income is assumed to vary over time as a result of
inflation and/or real growth in values. Where income is constant over time then
IRR = ARY.

3.4.1 The calculation of the equated yield

There are four variables to be considered in equated yield analysis. These are:
1. The all risks yield
2. The annual rate of growth of rental income
3. The rent review period
4. The equated yield.
Used as an analytical technique, equated yield analysis is designed to
ascertain the equated yield itself. The equated yield of an investment is
determined as follows.
 The capital value of the investment is calculated in the conventional
way by capitalising the rent receivable using the ARY.
 The future pattern of rental income is then determined by projecting
the market rent (MR) at an appropriate growth rate, using the
relevant amount of $1 function.
 A correspondingly increased rent is therefore assumed to be
receivable from the date of each rent review.
 This growth projection continues for the holding period. The rent
then receivable is capitalised into perpetuity at the ARY to give an
‘exit’ price.
 The income flows are then discounted at that rate of interest which
will equate the sum of their present values with the capital outlay.
This rate of interest will be the equated yield.
Example 1
It is desired to calculate the equated yield of an investment yielding$100
per annum which is the current MR.
It is assumed that:
 The ARY is 7.5%
 The annual rate of growth of rental income is 5%
 The rent review period is five-yearly.
Conventional valuation
The first step is to calculate the capital value of investment using
conventional methods:

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 $
MR 100
×YP perp @ 7.5% 13.33
Capital value (initial outlay) 1,333

The second step is to calculate the equated yield (EY) by means of a

discounted cash flow analysis. The correct cash flow table is given below.

×Amt
×PV of
Initial of£1 n MR on ×YP 5yrs Present
Year £1 n yrs
MR* yrs @5% review @12.5% value
@ 12.5%
(growth)
1—5 £100 — — 3.561 £356.06
6—10 £100 1.276 £127.63 3.561 0.555 £252.18
11—15 £100 1.629 £162.89 3.561 0.308 £178.60
16—20 £100 2.079 £207.89 3.561 0.171 £126.49
21—25 £100 2.653 £265.33 3.561 0.095 £89.59
26—30 £100 3.386 £338.64 3.561 0.053 £63.45
31+ £100 4.322 £432.19 13.333ˆ 0.029 £168.28
£1,234.65
* gross of tax Less initial outlay £1,333.00
Net Present Value -£98.35
ˆ Exit yield of 7.5% in perpetuity
Try at 11.5%

×Amt of
×PV of£1
Initial £1 n yrs MR on ×YP 5yrs Present
Year n yrs@
MR* @ 5% review @11.5% value
11.5%
(growth)
1—5 £100 — — 3.6499 — £364.99
6—10 £100 1.2763 £127.63 3.6499 0.5803 £270.30
11—15 £100 1.6289 £162.89 3.6499 0.3367 £200.18
16—20 £100 2.0789 £207.89 3.6499 0.1954 £148.25
21—25 £100 2.6533 £265.33 3.6499 0.1134 £109.79
26—30 £100 3.3864 £338.64 3.6499 0.0658 £81.31
31+ £100 4.3219 £432.19 13.3333ˆ 0.0382 £219.97
£1,394.80
* gross of tax Less initial outlay £1,333.00
Net Present Value £61.80

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 ˆ Exit yield of 7.5% in perpetuity
61.80
IRR=11.5+ ×1=11.886%
160.15
Check calculation:

× Amt of
× YP 5 × PV of £1
Initial £1 n yrs MR on Present
Year yrs @ EY n yrs @ EY
MR* @ 5% review value
(11.886%) (11.886%)
(growth)
1—5 £100 — — 3.6150 — £361.50
6—10 £100 1.2763 £127.63 3.6150 0.5703 £263.13
11—
£100 1.6289 £162.89 3.6150 0.3253 £191.53
15
16—
£100 2.0789 £207.89 3.6150 0.1855 £139.42
20
21—
£100 2.6533 £265.33 3.6150 0.1058 £101.48
25
26—
£100 3.3864 £338.64 3.6150 0.0603 £73.87
30
31+ £100 4.3219 £432.19 13.33333ˆ 0.0344 £198.32
£1,329.25
* gross of tax Less initial outlay £1,333.00
-£3.75
(i.e.
Net Present Value
effectively
nil)
ˆ Exit yield of 7.5% in perpetuity
Notes
1. The equated yield is 11.886%, i.e. it is that rate of return which
discounts the cash inflows to a figure which, when summated, is
equal to the initial outlay. This may be found by trial and error or
using IRR function of spreadsheet etc.
In guessing the first trial rate, a rough approximation of the equated
yield may be found by adding the growth rate to the initial yield (e =
k + g) where k = ARY, g = % growth. This would be 7.5% + 5% or
12.5% (plus or minus 1%). This, of course, ignores the rent review
pattern but does give a starting point.
If this produces a negative for the NPV figure then the next guess
would be lower at say 11.5% to give a positive NPV, which can
then be used to interpolate, using:

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 IRR = lower trial rate +
[ NPV1
NPV1 + NPV2
× trial rates difference
]
Where
NPV1 = NPV at lower trial rate
NPV2 = NPV at higher trial rate
As such the equated yield is comparable to the redemption yield on
other kinds of investment, or the internal rate of return.
2. Each ‘tranche’ of five years for which the income is fixed may be
discounted as a whole rather than for individual years by
multiplying by the years’ purchase for five years (which is only
another name for the Present Value of $1 per annum).
3. The final estimate of MR, i.e. that payable after 30 years, is
multiplied by the years’ purchase in perpetuity at the ARY of 7.5%
to reflect (implicitly) any future growth beyond 30 years.
4. Whilst the above calculation was done on a gross-of-tax basis, the
method can easily be adapted so as to produce a net-of-tax result.
Thus both cash flow and equated yield would be reduced by the
investor’s marginal rate of tax. Incidental costs and management
expenses can also be taken into account.
Obviously, to construct a discounted cash flow table every time it is required to
find the equated yield of an investment would prove a long and arduous task.
The use of computers together with software means that the equated yield can
be readily calculated, and there are published tables (Parry’s IRR) that can also
be used.

3.4.2 Equated yield as an investment criterion

Equated yields are often used as a means of comparing property with other
forms of investment. If the equated yield of a property investment is higher than
the investor’s opportunity cost of capital, then, other things being equal, it will
be a worthwhile investment to pursue. The difficulty here lies in determining the
opportunity cost of capital. The general consensus appears to be that this
should be the yield on long or undated bonds plus a margin of 2% for risk.
A historical view of property investments, going back to the time when
inflation/growth was not a problem and bonds were regarded as the safest form
of investment, shows that investors required a higher rate of return on property
than on bonds.
It can be expected that investors still require a higher actual (net redemption or
equated) yield from property than from bonds, for the same reasons as they did
historically, i.e. property is more trouble and more costly to manage, buy and
sell, even though rents may be very secure on good class premises.

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 Given the facts in Example 1, however, the decision as to whether the investor
would be advised to pursue this particular investment depends upon the
amount (if any) by which the equated yield exceeds the opportunity cost of
capital rate (taken at 2% above the yield on long-dated bonds). If bonds are
assumed to be showing a yield of approximately 5%, the equated yield of
11.886% is comfortably in excess of the ‘target’ of 7% (5% plus a 2% margin to
cover risk). Consequently the investment appears to be worthwhile.

3.4.3 Note
It is a fact that in some years the initial yields from rack-rented prime
commercial property have commonly been below 6% compared with 11+%
which was obtainable from gilts. Why is this? Why should an investor accept
such a situation? The answer lies in the growth prospects of the property
investment. The difference between 11% on gilts and 6% property is the
measure of the market’s view of how rents will move in future. This statement is
a little simplistic since it ignores the existence of rent reviews, but the ‘reverse
yield gap’ (11% − 6% = 5%) is compensated by future growth, and in accepting
6% on property the market is making a judgment about what that growth will be.

3.4.4 Calculating the rate of growth implicit in an investment

Using DCF
Equated yields can also be used analytically to calculate the rate of growth,
which (see note above) has been assumed implicitly by an investor acquiring
an investment at a known ARY. The procedure is to undertake a discounted
cash flow analysis using the opportunity cost of capital as the ‘target’ equated
yield. It is then possible to calculate the rate of rental growth required to
produce a future income flow that will equate with the initial capital outlay when
discounted at the target rate and summated. Once the rate of growth has been
calculated it should then be possible to consider the probability of achieving the
rate, given suitable evidence of trends. (See Example 2.)
Example 2
A shop has recently been let at its MR of $10 000 per annum for 20
years (FRI) subject to five-yearly rent reviews. The property is on the
market for $145 000, which represents an ARY of 6.9%. Assuming that a
potential investor requires a gross ‘target’ equated yield of 12% (i.e. this
is his opportunity cost of capital rate), what is the minimum rate of rental
growth which must be achieved in order for the investor to be justified in
offering the asking price?
It is assumed that the investor will hold the property for 30 years and that
it will be readily re-let/renewed at the end of the existing lease.
Once again, trial rates should be taken and interpolated.
The final cash flow calculation is shown below:

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 Projected
income
(gross of
Presen
Cash tax) YP×PV of $1
Year t value Remarks
out $ assumin @ 12%
($)
g 7% pa
growth
($)
145,00 Purchase
0 — 1
0 price
-
8,700 153,70 + costs @ 6%
0
1−5 10,000 (YP 5 yrs) 3.6 36,000
Rent
increased by
6−10 14,026 3.6×0.567 28,630
amt of $1 in5
yrs
11−1
19,672 3.6×0.322 22,804
5
16−2
27,590 3.6×0.183 18,176
0
21−2
38,697 3.6×0.104 14,488
5
26−3
54,274 3.6×0.058 11,332
0
Sale price at
ARY adjusted
(YP perp
for
@7.5%×PV3
31 + 76,123 33,875 obsolescence
0 yrs @12%)
, deferred at
0.445
equated yield
rate
Net present
11,605
value
Therefore the required rate of growth will be approximately 7% per
annum and between 5—6% if costs at 6% are ignored.
Notes
1. The yield on sale has been adjusted by 0.6% for this example, but there
could be a greater adjustment depending on the degree of
obsolescence.

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2. It is assumed that the lease will be renewed or the property re-let at the
end of Year 20.
3. For the purposes of the example, the investor is assumed to take a 30-
year view.
Using a formula
In terms of a formula, the simple:
k≈e−g
needs to be modified to take account of the growth in rents over the review
period. This may be proved as:
k = e − (ASF × P)
where

k = capitalisation rate
expressed as a decimal;
e = equated yield expressed
as a decimal;
ASF = annual sinking fund to
replace $1 at the equated
yield over the review
period (t);
and P = rental growth over the
review period.
Using the information in Example 2: Given

k = 0.069 (i.e. ARY = 6.9%) e

= 0.12
t = 5 yrs,
0.069 = 0.12 − (ASF @ 12% over
5 yrs × P)
0.069 = 0.12 − (0.1574P)
0.1574P = 0.12 − 0.069
P = 0.324 (i.e. 32.4% over 5
years).
To find out the rate of growth per year, the compound interest formula is used,
i.e.:
P = (1 + g) t − 1
where
g = growth per annum (as decimal)
t = review period.
So

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 5
1.324= (1+g)

1+g= √1.324 (or 1.324 ^2

5

1 + g = 1.0577
g = 0.0577 (or 5.77% pa)
Thus this is the average rental growth rate in perpetuity (ignoring incidental
purchase costs).
The formula above is also shown in some texts as:
YP perp at k% - YP t years at e%
(1 + g) t =
YP perp at k% × PV t years at e%

3.4.5 Equated yields used as a method of valuation

Equated yields can also be used to calculate the value of an investment to a
particular purchaser. The technique follows five steps.
1. Ascertain the investor’s opportunity cost of capital rate or ‘target’
equated yield.
2. Calculate the future cash flows by increasing rental income at an
anticipated growth rate.
3. Discount these future cash flows at the ‘target’ equated yield.
4. Calculate the Net Present Value of the sum of the discounted cash
flows. This figure will be the price which the investor can afford to pay for
the investment.
5. Compare the price found under (4) above with that calculated in
accordance with conventional valuation methods using the ARY.
Example 3
A secondary shop investment has been offered to your clients, a charity.
The premises are let to a well-established local trader on a lease which
has 15 years to run. The rent for that period is fixed at $5 000 per annum
without review. The current market rent of the property is $12 000 per
annum. Similar rack-rented property would sell to show an ARY of 8%.
How much should your client offer for the freehold interest?
1. The first step is to ascertain your client’s opportunity cost of
capital rate or target equated yield. Assuming that long-dated gilts
show a yield of 9%, such a target would probably be 9% plus a
margin of 2—3% to reflect the additional risks of property
compared with gilts, i.e. 12%. In this case, since your client is a
charity, there is no need to consider the target return net of tax.
2. Future income must then be increased by using an assumed rate
of rental growth. In this example it is assumed that there will be

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 growth in the market rent of 5% per annum. The market rent at
the end of the lease in 15 years’ time will therefore be $12 000
multiplied by the amount of $1 in 15 years @ 5% (or $12 000 ×
2.08 = $24 960 per annum). Future rental growth beyond 15
years (on the assumption of five-yearly rent reviews thereafter)
can be allowed for in a similar way, although in this example the
rent in 15 years’ time is capitalised at the ARY of 8% to reflect
rental growth beyond that date.
3. Discounting the cash flows at the target equated yield of 12%
produces the following ‘short-cut’ DCF calculation:

$ $
Term income 5,000
× YP 15 yrs @ 12% 6.81 34,050
Reversionary income 24,960
× YP perp @ 8% 12.5
× PV of $1 in 15 yrs @ 0.182 2.275 56,784
12%
90,834
4. Net Present Value (i.e. value to the investor) = $90 834.
5. A conventional valuation of the same property would produce the
following result:

$ $
Term income 5,000
× YP 15 yrs @ 10% 7.61 38,050
Reversionary income 12,000
× YP perp def 15 yrs @ 8% 3.94 47,280
Market Value (MV) $85,330

A yield of 10% is taken to value the term income in order to reflect the
fact that the rent is fixed, and therefore inflation-prone, for a long period.
From this example it will be noted that the investor would be prepared to
pay the Market Value of $85 330 given an opportunity cost of capital rate
of 12% and an assumed annual rate of rental growth of 5%.
Allowance for outgoings can be built into the DCF valuation by deducting
the anticipated outgoings (i.e. adjusted so as to reflect inflation) as a
negative cash flow.

3.4.6 ‘Real value’ approach

A second DCF-related approach is the so-called ‘real value’ approach of Wood
(1973), and developed by Baum & Crosby (1988). In broad outline the method
uses an Inflation Risk Free Yield (IRFY) which measures return by stripping out
and isolating the inflationary risk. It is thus a real rate of return.

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 The main difference between this and the equated yield approach is that the
equated yield model defines the growth in money terms as ‘g’ whilst real value
theory discounts income using a yield made up of IRFY and inflation.
In Example 3 a real value approach would produce the following valuation:

Term $5,000
× YP 15 yrs @ 12% 6.81 $34,050
Reversion $12,000
YP perp @ 8% 12.5
150,000
× PV $1 in 15 yrs @ 0.378 (1) 56,705
6.67%
Value 90,755 (compare with point 4
in Example 3)

3.4.7 Note
Notice how the term valuation produces the same figure as in point 3 of
Example 3. The approach on reversion is somewhat different, however: rent is
not inflated, and the IRFY is used to discount the income at a rate of 6.67%.
This is derived from:
1+e
i= -1
1+g
i.e.
1.12
i= -1
1.05
= 0.0667 or 6.67%

3.4.8 Criticism of equated yields

The growth rate
It is a fundamental criticism of equated yield analysis that the assessment of
the rate of growth is a matter of conjecture, particularly in view of the
requirement to assess both the likely course of inflation and potential changes
in real value. Critics often quote the example of the problems which would have
been created in 1972 had the level of growth in City of London office rents been
projected into the future, given the imminent collapse of the ‘property boom’.
Nevertheless there is a long-term tendency for rental values to rise, and
equated yield analysis seeks to provide an estimate of such long-term growth
using the evidence of past trends, combining this with the skill and informed
judgment of the valuer. Despite this, long-term predictions are most appropriate
for pension funds and institutions rather than for short-term investors looking,
say, to a 10— to 15—year ‘time horizon’.

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Many of the major surveying firms publish the results of research undertaken
specifically for the purpose of providing advice for investors on the likely future
pattern of rental and capital growth. It is undoubtedly true that today there is a
relatively sounder empirical base for predicting growth.
It is important to distinguish the valuer’s role as an adviser on market value and
an adviser on investment. In both, rental growth predictions will be important
but in the latter role he may be in a position to judge, for instance, that a
particular purchase is unwise because it is based on future income predictions
with which he does not agree.
The opportunity cost of capital
Equated yield analysis is also criticised for its use of the yield on gilt-edged
stock as the basis of the ‘target rate’ against which to measure the equated
yield from a property investment. Many investors, particularly the large
institutions, will seek a diversity of investments within their portfolio and it does
not necessarily follow that the overall yield required will exceed that on
Government stock. Diversification often entails a sacrifice of yield in the short
term, and if the rate on gilts is adopted, then investment decisions would tend
to be made with a view to short-term expediency rather than long-term
planning.
Nor should a single yield criterion necessarily be applied to the whole range of
property investments, particularly one which is largely determined by external
factors such as the minimum lending rate. The correlation between changes in
the Base Rate and changes in the initial yields of property is not readily
apparent. There is a considerable time lag before economic trends will affect
property yields, and consequently changes in the Base Rate, which are quickly
reflected in changes in the yield on gilts, will produce sudden changes in the
implied rate of rental growth which may not be warranted in practice in the
market.
(Note: The adoption of the yield on gilts as the basis of the ‘target’ equated
yield does not necessarily mean the adoption of that rate on any particular day.
A long-term view of the likely average level of the rates on gilts should be
taken.)
Exit price
The method for calculating the equated yield, which was described above,
capitalised the rental value after 30 years at ARY, thereby allowing for
continuing rental growth. It could be argued that the likelihood of physical and
economic obsolescence after this time would be more accurately reflected by
using the equated yield (the ‘non-growth’ rate) to capitalise such rent. The
result of this would be to lower the equated yield.
Thus for an investment with an initial yield of 10%, five-yearly rent reviews and
growth at 10% per annum, the corresponding equated yield would be 18.46% if

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 the rent is capitalised after 30 years at the initial yield. It would be 17.96% if the
non-growth capitalisation factor were used.

3.4.9 What happens in practice?

As always, with the techniques on offer in a vocational subject such as property
valuation, it is worth asking which techniques practitioners use. The report
produced by Crosby (1991) provides valuable information on freehold
reversionary investment techniques. Certainly most academic commentators
and practitioners would argue that explicit DCF-based approaches are
appropriate for appraisal or analysis of worth (or valuation to an individual
purchaser). It is a matter of considerable debate whether such techniques
should be used for market valuation as well, however.
DCF-based models for property appraisal fall into two main groups, as we have
seen:
 growth-explicit DCF such as equated yield analysis
 real value approaches.
The former is more common in practice, as the survey found. An appraisal of
worth was found to be carried out by substantial numbers of valuers for
purchasers and sellers (Table 1).

Table 1: Appraisal of worth

Purchasers % Sellers %
Yes 76.2 61.9
No 13.8 29.4
No response 10.0 8.7

As regards the type of growth-explicit DCF analysis caused, Table 2 shows the
details.

Table 2: Investment analysis techniques (%)

DCF (gross of
DCF (net of tax) Other
tax)
Yes 30.08 20.33 15.45
No 31.71 39.02 20.33
No response 38.21 40.65 64.22

© UCEM 2016 Page 15 of 33

 The most popular approach (30%) is DCF gross of tax. The survey did,
however, find some confusion over the distinction between market valuation
and appraisal of worth.
Most recent surveys suggest that many valuers use several methods and
compare results before aiming at a final valuation figure. Whichever method is
used, they always need to ‘look over their shoulder’ at what is happening in the
market itself.

4 Stepped incomes
4.1 Deferred income
A deferred income is an income which will not be received until after a given
number of years. Where no income at all is receivable while the investor is
waiting for the deferred income, the expected income is referred to simply as a
deferred income, or an income in a deferred investment. (See Example 4.)
Example 4
A property has a current market rent of $1 000 per annum. Your client is
entitled to receive this income, but not until 10 years have expired. Value
your client’s interest assuming a rate of 5%.

a) Value of deferred interest $

Current MR 1000
YP perp @ 5% 20
Capital value if receivable now 20 000
PV of $1 in 10 yrs @ 5% .614
Capital value of deferred income 12 280
It should be noted that the method of valuing a deferred interest is to
value it as if it were not deferred, and then to multiply this sum by the
present value for the period of deferment. This is consistent with the
basic principle of investment valuation, which is to discount future
income.
A neater way to set out the valuation of such a deferred interest is to
multiply the YP by the PV of $1 figure first, and then to use the modified
YP, as shown below.

b) Value of deferred interest $

1000
Net income (as before)
pa
YP perp @ 5% 20.00
PV of $1 in 10 yrs @ 5% .614

© UCEM 2016 Page 16 of 33

 YP perp deferred 10 yrs @ 5% 12.28
Present Value of deferred income 12 280

Where the future income is receivable in perpetuity, as in this example,

the same result can be obtained by using the table as shown in (c)
below. However, this table is not applicable to leasehold interests and it
is well for you to become thoroughly familiar with method (b) which
applies to all deferred incomes.

c) Value of deferred interest $

Net income receivable in perpetuity, but 1000
starting 10 yrs hence pa
PV of a reversion to a perpetuity of $1
12.28
per annum* @ 5% after 10 yrs
Present Value of deferred income 12 280

* Note that PV of reversion to a perpetuity of $1 pa is another name for

YP of a reversion in perpetuity.
A special type of deferred income arises when a property gives a current
income, together with the right to a higher or lower income in the future. In this
case the higher or lower income in the future may be regarded as a deferred
income, known as a reversion. The income receivable until the reversion is due
is referred to as the income during the term. Typical cases of this sort arise
when a landlord is receiving a rent less than the market rent of a property
because he may have granted a lease at a fixed rent for a given term some
time ago, and rental values have risen since the grant of the lease; or where
the building is old and the reversion is to a lower income in the site only.
When a lease ends the landlord can expect to receive the market rent on
reversion, but until then the landlord’s interest is said to comprise a term and
reversion. A purchaser of this investment would be purchasing a varying
income.
When valuing a deferred income which is receivable in perpetuity, no question
can arise as to whether a figure of years’ purchase should be based upon the
single or the dual rate percent principle. One rate percent only has to be
considered because in the case of a perpetual income, no sinking fund has to
be invested.

© UCEM 2016 Page 17 of 33

4.2 Varying incomes in freehold property
If the income from a property is likely to increase or decrease at some future
date, the valuer will need to use the technique of valuing a deferred income to
account for this anticipated change.
As mentioned above, such a situation will usually arise in circumstances where
a property is let for an unexpired term and the rent reserved currently is below
or above the market rent.
Example 5 (See Figure 1)
A shop is let on a lease on full repairing and insuring terms with three
years of the lease unexpired, the rent reserved being $20,000 pa. The
current market rent is at present $50 000 pa on full repairing and
insuring terms. What is the value of the freeholder’s interest?
From first principles
The value of the shop is equal to the present value of the future income,
discounted at the appropriate rate percent derived from analysis of
comparable transactions. Assuming the appropriate yield to be 8%, the
value of the term would be as follows.
Term

PV of $@ Net present
Income $ Year $
8% value
20,000 1 .926 18,520
20,000 2 .857 17,140
20,000 3 .794 15 880
(Term) 51
(2.577)
540
To this must be added the value of the reversion:

Net present value

$
$
Value of reversion:
Market rent 50,000
YP (PV of $1 pa) in perp @ 8% 12.5
625,000
Discounted: PV of $1 in 3 yrs @
.794 (Reversion) 496,250
8%
Capital value 547,790
The problem is more conveniently dealt with as follows:

© UCEM 2016 Page 18 of 33

 Freehold shop $ $
Term income 20,000 51,540
(compare
above)
YP (PV of $1 pa) in perp @ 8% 2.577
Reversionary income 50,000
YP perp deferred 3 yrs @ 8% 9.925 496,250
547,790

It may be suggested that the income could be higher (or lower) than $50 000 in
another three years. This factor is, however, reflected in the discount rate of 8%
which is determined by the market as the appropriate rate to reflect prospects
of growth or decline.
Note the use of the single rate YP table, which gives the same result as the
present value of each year’s rent considered separately.
Two further points should be considered.
1. The figure for ‘years’ purchase of a reversion to a perpetuity’ can be
derived from the valuation tables directly, but it is simply the product of
YP in perpetuity and present value of $1 after t years, where t is the term
or deferment period.
2. The income during the term may be more secure than a full rent if the full
rent exceeds the rent currently payable. The tenant is very unlikely to
default, e.g. when in financial difficulty or if rental values fall, and it is
usually therefore valued at a lower rate. A 1% reduction from the 8%
‘going rate’ is appropriate here. At very low yields an adjustment of 0.5%
and at high yields 2% are suggested, but it is not possible to be precise.
The valuation of the term and reversion in Example 5 is as follows:
Example 6 Shop: freehold interest subject to occupation lease

Term $ $
Rent passing 20,000
Outgoings: nil
YP 3 yrs @ 7% 2.62 52,400
Reversion
Market rent (at today’s prices) net 50,000
YP reversion to a perp after 3 yrs @ 8% 9.923 496,150
548,550

© UCEM 2016 Page 19 of 33

 Estimated value as at date of valuation (say) 550,000
The rents and the yields reflect the various factors to be considered in the
valuation. These include physical factors, such as location, condition and
quality of buildings, size and environment; and economic and statutory aspects,
such as the local economy and planning policies. The type of tenant, whether a
national company, local company or private individual, is reflected in the yield.
Any valuation is subject to structural survey and legal investigations as to the
title and the rights of leaseholders and other interested persons, if any.

Figure 1: Rising income: freehold shop (Example 5)

4.3 The hardcore or layer method of valuation

The ‘traditional’ or term and reversion approach to valuation is based, as we
have seen, on the premise that income received during the term is valued at a
lower yield to reflect the additional security over reversionary income which is
valued on the ‘reversionary’ or ‘market’ yield basis.
During the 1970s, however, valuers in the UK began to use an alternative
approach to valuing incomes in freehold property. The ‘hardcore’ or ‘layer’
method, as it is known, values the current rent receivable into perpetuity and
then capitalises the marginal rent receivable on reversion at a higher rate of
interest to reflect the risky, top-slice nature of the marginal (or incremental)
income. Effectively, the difference is that the term and reversion approach
divides the income vertically whilst the hardcore divides it horizontally.
The main reason why the hardcore method, using different rates, gained
popularity during this period was that the UK government introduced a rent
freeze between 1972 and 1975. This, together with the general property slump
in the mid-1970s, meant that reversionary income was considered to be a
higher risk than term income which could be valued in ‘perpetuity’ as the
hardcore ‘slice’. The rent freeze meant that market rent might not actually be
achieved on review, and this was the ‘marginal income’ traditionally valued at a
higher rate reflecting risk.

© UCEM 2016 Page 20 of 33

Example 7 shows the two methods, with capitalisation rates designed to
produce similar answers.
Example 7
Refer to Figure 2 and Figure 3.
Suppose a property was producing an income of £6 000 pa (on FRI
terms) and that a review to MR of £10 000 pa was expected in three
years’ time. Given that the appropriate reversionary yield was 5%, the
two methods of valuation would take the following form:
1) Term and reversion

$ $
Rent received 6,000
YP 3 yrs @ 4.5% 2.75 16,500
Reversion to MR 10,000
YP perp @ 5% def. 3 yrs 17.28 172,800
Capital value 189,300

2) Hardcore

$ $
Rent received 6,000
YP perp @ 4.5% 22.22 133,300
Marginal top slice income 4,000
YP perp @ 6.0% def. 3 yrs 14 56,000
Capital value 189,300
Figure 2: Term and reversion

© UCEM 2016 Page 21 of 33

 Figure 3: Hardcore

1. In order to arrive at the same value as the term and reversion method, a
yield of 6% on the marginal income (compared with the true reversionary
yield of 5%) has to be used in the hardcore method. The derivation of
this yield is found by an incremental approach and is essentially an
arithmetical manipulation, which may not be a logical reflection of the
market. Critics also argue that the method involves an artificial division of
income in reversion, since the whole income is at risk and not just the
marginal income.
2. In the hardcore method, if rates of 4.5% for hardcore income and 5% for
the increment were used, a different answer from the term and reversion
method would be obtained because of the mathematics of the respective
calculations. This raises the related issue to (1) above of what rates to
use or whether arithmetical manipulation is carried out to give the same
result as the term and reversion method. It is for these reasons that an
equivalent yield approach is often used in practice because it is a single
yield approach which will give the same answer whether it is applied in
the term and reversion approach or the hardcore approach.
However, this poses the question of which valuation method to adopt in
particular circumstances in the market, especially as valuers faced a volatile
market in the late 1980s. Two types of situation could arise, for example, when
different approaches could be adopted.
 Scenario A. A relatively long term, say nine years, to a review; a
sizeable uplift to MR; and an ‘average’ tenant in occupation.
 Scenario B. A short term, with a review to MR and a top class
tenant in occupation.
In Scenario A, a conventional term and reversion method will reflect the fixed
nature of the term income compared to a relatively risky increase to MR in nine
years’ time.
In Scenario B, the general market practice is to use an ‘equivalent yield’ or
same yield approach for the term and reversion because the quality of the

© UCEM 2016 Page 22 of 33

 tenant means term and reversion are equally well secured. However,
circumstances may vary this; e.g., a large rental uplift, or a longer term to
review, increase risk in reversion and may lead to an upward adjustment of
reversionary yield. The equivalent yield approach is explained in more detail
later in this paper, as is the use of such approaches in practice.
The hardcore method with rate variations is therefore difficult to justify, although
the method is still appropriate under certain circumstances:
1. ‘Turnover’ rents where income falls naturally into ‘slices’ (i.e. a secure
‘base rent’ and an additional ‘marginal turnover rent’ which is based on
shop sales and is more risky).
2. Dealing with capital recoupment in variable profit rent (leasehold)
calculations (dealt with later).
3. Dealing with cases of ‘over-rented’ property. For example a 1960s office
block with five years to run, a MR of $80/m² but where the rent received
is $100/m²; or the case of temporary planning consent on a property
which provides a valuable user and a rent above the MR obtainable in
an alternative use when the permission expires. This would produce a
secure base rent and a higher risk top slice which would be lost when
the property became vacant or the planning permission expired.

4.4 Rents fixed in the medium term

Example 8 introduces the special problem which arises when the term income
is fixed for an unusually long period, in the example 20 years.
Comparable data used to derive yields will most commonly be from sales
where rents are reviewable at fairly regular intervals. The yields so derived are
applicable to capitalisation of rents fixed for the short term but are not directly
applicable to rents fixed for longer periods.
Rents which are fixed for terms of, say, 60 years or more, usually ground rents,
and which may often be treated as fixed in perpetuity (Example 9) can be
compared with fixed interest Government bonds (gilts) or (preferably) with other
ground rents, and the yields will be found to be relatively high (over 6% until
recently). The reason for the high yield is the inflation-prone nature of such
incomes. We should therefore expect yields to increase with the intervals
between rent reviews or, as in the following example, with the length of the
unexpired term.
Although the term rent is secure in actual terms, in real terms it is not so
secure, because the income itself diminishes in value in an inflationary period.
The yield has been adjusted upwards to reflect this.
Example 8
The property is a freehold warehouse of modern construction in a good
location. The warehouse is let on lease having 20 years unexpired at a

© UCEM 2016 Page 23 of 33

 fixed rent of $5 000 pa. The tenants are responsible for all repairs and
insurance etc.
Similar warehouses let on leases with regular rent reviews have been
sold to show initial yields of 8%.

Term $ $
Rent passing 5,000
Outgoings: nil
YP 20 yrs @ 10% 8.51 42,550
Reversion
MR (from comparables) 7,500
YP perp deferred 20 yrs @ 8% 2.68 20,100
Capital value 62,650

4.5 Rents fixed in the long term

The most common example of long-term fixed rents are ground rents. UK
ground leases are usually granted for terms of 99 years or more, and until the
1960s the rent was usually fixed. Provisions for rent review are common in
leases granted since that date, but not universal, and the intervals between
reviews vary considerably. The freehold owner of property which is subject to
ground lease is entitled to the ground rent and the reversion to the building at
the end of the lease.
Whether the building has any economic value by the end of the term will
depend inter alia on the standard of construction and maintenance and the
character of the neighbourhood. There are, of course, many examples of
buildings which are life-expired in 100 years or less, and of buildings which are
still valuable though many years older. From a valuation point of view, distant
reversions are somewhat speculative, and by the time they have been deferred
for 60 years or more, make very little difference to a valuation. Therefore when
valuing ground rents fixed in the long term, it is usual to treat them as
perpetuities.
The valuations show that at these rates of interest, the significance of the
reversion is small. This tendency increases with the length of term and rate of
interest.

© UCEM 2016 Page 24 of 33

 Example 9
Value the freehold interest in Alpha House, a block of offices erected
under the terms of a building agreement and lease. The lease has 60
years unexpired at a ground rent of $250pa. The offices are let at rents
totalling $20 000pa and the premises have been well maintained and
modernised.
Valuation of freehold interest

$ $
1 Ground rent 250
YP 60 yrs @ 12% 8.32 2,080
Reversion to site value 50,000
PV in 60 yrs @ 12% 0.0011 55
2,135
Alternatively
2 Ground rent 250
YP perp @ 12% 8.33
2,083

4.6 Equivalent yields

The equivalent yield represents the ‘overall’ rate of return on a reversionary
investment and is therefore the ‘weighted average’ yield, and will lie
somewhere between the capitalisation rates for term and reversion.
Example 10
It is desired to calculate the equivalent yield of a freehold investment
which is presently let at $10,000pa but which is due to revert to the MR
of $20,000pa in three years’ time. The full rental market yield is 8%, and
the term rent is to be valued at 6% for demonstration purposes.

$ $
Term rent receivable 10,000
YP 3 yrs @ 6% 2.673
26,730
Reversion to MR 20,000
YP perp def 3 yrs @ 8% 9.9229
198,458
Estimated capital value of freehold
225,188
interest

© UCEM 2016 Page 25 of 33

 The investor now wishes to know the rate of return if the property is
purchased for a total cost of $225,188.
a. The initial yield
This represents the yield in Year 1 and is as follows:
10,000 (Rent)
×100 = 4.4%
225,188 (Capital)
This is not a lot of use, because it ignores the benefits of the
reversion. (But some investors have certain minimum initial yield
requirements.)
b. Yield on reversion
This relates reversionary rent to price:
20,000
× 100 = 8.88%
225,188
This is of interest to some investors, but is not very meaningful as
it ignores the effect of the term and in particular the length of time
until it is received.
c. Equivalent yield
This is the actual yield over time, reflecting the rent change and
term length.
Calculating the equivalent yield
The mathematics of the calculation are somewhat laborious since
there is no method which avoids trial and error.
A financial calculator with an ‘Internal Rate of Return’ programme
can do the necessary trials quickly, or a computer may be used.
a. Trial and error
By experience one can often make a reasonable guess for the
first trial yield. For example, it will lie between 6% and 8% (the
rates used in the valuation), and in this case nearer 8% than 6%
since most of the value lies in the reversion. Trying 7.5% we get:
Analysis to find equivalent yield
$ $
Term rent 10,000
YP 3 yrs @ 7.5% 2.6005 26,005
Reversionary rent 20,000

© UCEM 2016 Page 26 of 33

 YP perp def 3 yrs @ 7.5% 10.7328 214,656
240,661

The result is too high; at a price of $225,188 the investor will

receive more than 7.5% (lower price = higher yield).
We therefore need to try again at 8% (which gives $210,351)and
interpolate between the ‘over’ and ‘under’ values to give
approximately 7¾%.
b. Solution of equivalent yield by formula
(AEG = Annual equivalent of gain)
Present income + AEG
Equivalent yield = ×100
Capital value
Gain on reversion × PV of $1 for the term
AEG =
YP for the term
Gain on reversion = Value on reversion less capital value

Value on reversion = MR$ 20,000

YP perp @ 8% 12.5
$250,000

∴Gain on reversion = $250,000 − $225,188 = $24812

$24,812 × PV of $1 in 3 yrs @ X%
∴ AEG =
YP 3 yrs @ X%
where X% is the equivalent yield and must be determined by trial and
error. An approximation of 7.5% is taken.
$24,812 × PV of $1 in 3 yrs @ 7.5% (0.805)
∴ AEG = = $7,682,002
YP 3 yrs @ 7.5% (2.6)
($10,000 + $7,682)
∴ Equivalent yield = ×100 = 7.85%
$225,188

The figure of 7.85% should be the same as that used to calculate the annual
equivalent of the gain. This latter figure was 7.5% and so the process should be
repeated until the two rates are equalised. The exact rate is 7.84% and often
the approximation used to calculate the annual equivalent of the gain will be
sufficiently close to ensure a reasonably accurate result. This formula solution
may be compared with the discounted cash flow method of solving the same
problem.

© UCEM 2016 Page 27 of 33

4.7 Equated yields
The methods considered above, i.e. term and reversion, hardcore and
equivalent yield, are built on the all risk yield approach, which uses today’s
rental values and makes no attempt to predict future rents.
The equated yield method, considered in the context of variable incomes, can
be used in the valuation of stepped incomes. It overcomes the problem of
subjectivity in yield adjustments in stepped incomes.
Example 11
Value retail premises let for four years at $40 000 per annum net.
Estimated rental value now $60,000.
k (initial yield at MR) = 6 % (5-yearly reviews)
e (equated yield) = 10 %
Find g:
K = e−(asf×P)
0.06 = 0.10−(asf at 10% for 5 yrs×P)
0.06−0.10 =−0.1638P
P = 24.42 % over 5 years
= 4.467 % pa
Given the implied growth from the analysis of sales on an equated yield
basis, either a ‘short-cut’ DCF, or full equated yield model, can be used.
Short-cut DCF

PV @
Value $
EY 10%
Current income $40,000 ×3.1699 126,796
Reversionary income $60,000
Increase over 4 years @ 0.04467 ×1.1910
71 460
YP Perp @ 6% 16.6667
1,191,001 ×0.6830 814,749
941,545
Compare ARY @ 6%
Current income$ 40,000
PV of $1 pa 4 years @ 6% 3.4651 138,604
Reversion $60,000

© UCEM 2016 Page 28 of 33

 PV of $1 pa in perp deferred 4 years
13.2016 792,096
@ 6%
930 700

4.8 Commentary on stepped income values

1. A great deal of paper has been consumed in the debate on valuation
methods for reversionary incomes in the UK context. The models on
offer — term and reversion, hardcore and equivalent yield — have
theoretical advantages and disadvantages, but the differences they
produce in valuation terms are often overshadowed by other
considerations.
2. In a weak market, lease length and tenant quality are key
considerations, and property let on a short-term lease is relatively risky,
regardless of current rent level.
3. The use of equated yield rather than ARY models has been shown to
change valuation figures significantly, which suggests that all three ARY
methods are suspect. According to the Mallinson Report (1995), none of
the methods actually represents buyer behaviour. Nevertheless,
provided we ‘value as we devalue’, i.e. on the same basis and using the
same assumptions, the results are usually within an acceptable margin
of error.
4. The application of ‘product analysis’ to stepped rents or reversion shows
them to have some distinctive differences from rack-rented properties.
For example the financing of under-rented properties is a problem while
the income is low. For some buyers, this is important. Gains on resale
are higher for under-rented investments — an advantage for other
buyers.

5 Incomes for limited periods

Such incomes may be valued:
 On a single rate, present value basis at an all risks yield appropriate
to the relative risk, security, growth aspects etc.
 On an equated yield basis, which is appropriate for investment
worth.
 On a dual rate basis.
The last method has been used in the UK for very many years and became the
rule for many statutory purposes.
Increasing criticism has caused it to decline in open market transactions, but
the concept still has some uses.

© UCEM 2016 Page 29 of 33

 Reflection
2. A shop is let at $100 000pa for five years. It has a current rental
value of $140,000.
k (initial yield for rack-rented shops) is 5.5%; e (equated yield) is10%.
Value the fee simple interest by:
a. Term and reversion method
b. Hardcore method
c. DCF method, assuming a holding period of 20 years
d. Short-cut DCF method.
Note: The answer to this question is given overleaf.
3. Outline alternative methods to value an office building let at$140
000pa for the next 12 years, rent reviews after year 2 and year 7.
The current rental value is $100 000pa.
Assume k = 8%; e = 11%.

© UCEM 2016 Page 30 of 33

 Answers to Self-Assessment Question 1
a. Term and reversion valuation

Current rent 100,000

YP 5 yrs @ 5.5% 4.27
427,000
Reversion to MR
MR 140,000
YP perp @ 5.75% 17.3913
PV of $ after 5 yrs @ 5.75% 0.756
1,840,695
$2,267,696
b. Hardcore method

Core income
Current rent 100,000
YP perp @ 5.5% 18.1818
21,818,182
Additional slice
MR 140,000
Core rent 100,000
Additional slice 40,000
YP perp @ 6.5% 15.38462
PV of $ after 5 yrs @ 6.5% 0.73
449,231
$2,267,413

c. DCF method over 20 years (assuming 5-yearly reviews)

Since k = 5.5%, e = 10%, therefore, (using k≈e - g) g = 4.5%approx
Calculate rental growth:

Amt of $ @ Rent with

MR Review
4.5% p.a. growth
$140,000 1.246 $174,440 After 5 yrs
1.55 $217,000 After 10 yrs
1.935 $270,900 After 15 yrs
2.412 $337,680 After 20 yrs

© UCEM 2016 Page 31 of 33

 YP 5 yrs
Year Rent PV @ 10% NPV
@ 10%
0—5 $100,000 3.79 1 $379,000
6 — 10 $174,440 3.79 0.6209 $410,494
11 — 15 $217,000 3.79 0.3855 $317,047
16 — 20 $270,900 3.79 0.2394 $245,795
20+ $337,680 17.39* 0.1486 $872,683
TOTAL $2,225,018
* YP perpetuity @ 5.75%
d. Short-cut DCF method
As calculated above, g = 4.5% approx.

Term
Rent passing 100,000
YP 5 yrs @10% 3.79
$379,000
Reversion
Reversion to MR
($140,000)
X Amount of $ for 5 yrs 1.246 $174,440
@4.5%
YP perp @ 5.75% 17.391
$3,033,739
PV of $ 5 yrs @ 10% 0.6209
$1,883,649
$2,262,649

Comment
For this simple example, all four methods produce essentially the same
result after rounding to about $2 250 000 (remember, valuation is not an
exact science).
However, if the property had been over-rented, the first two methods
would, owing to their implicit growth assumptions in the yields adopted,
have produced too high a figure.
It should also be noted that the final yield in examples (c) and (d) has
been moved up by 0.25% to allow for obsolescence to the building.

© UCEM 2016 Page 32 of 33

6 Terms and conditions of use
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