REST0005 – Property Valuation

Investment Method & DCF

Approach of Valuation

Dr Rotimi Abidoye
Master of Property and Development
UNSW Built Environment
 REST0005 – Property Valuation

Investment Method & DCF

Approach of Valuation

Dr Rotimi Abidoye
Master of Property and Development
UNSW Built Environment
Last Week

Property Valuation Process, Report and

Sources of Information

&

Information Sharing Session

Outline
 Yields

 Capitalisation Rate

 Investment Method/Income Capitalisation Approach

 Outgoings

 Term and Reversion Valuation – Freehold

 Term and Reversion Valuation – Leasehold

 Discounted Cash Flow (DCF) Valuation Method

 Discounted Cash Flow And Investment Method Of Valuation

Yields and Rate of Return
 Yield indicates the level of earnings on an investment.

 Yield defines the money released on an investment over time.

 A yield of 10% will translate into an earning of $10 on every $100 invested.

 Yield on investments can be compared by adopting the payback period approach.

𝐍𝐍𝐍𝐍𝐍𝐍 𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢
Yield = ×100%
𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂𝐂 𝐯𝐯𝐯𝐯𝐯𝐯𝐯𝐯𝐯𝐯

For the investment above it would be paid back in 10 years (100/10).

The same investment with 20% yield would be paid back in 5 years (100/20).
Types of Yields - Initial Yield
 This represents the annual return (rental income) on an investment at the point of

purchase. It is measured in terms (percentage) of the initial net income from the

investment and the purchase price/current value of the property. This yield does not

account for the future rental growth of the investment but in reality, there is a possibility

of a change in the income in the future. So, it should be relied on with caution.

 When a large sum is tied up in an investment with the aim of reverting to future market

rent, the initial yield may be small when compared to similar properties currently being

let at open market rental value.

Types of Yields - Initial Yield
Class Illustration 1

Estimate the initial yield of a property with a purchase price of $1,500,000 and

initial net income of $120,000 p.a.

Class Illustration 1 - Solution

𝐧𝐧𝐧𝐧𝐧𝐧 𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢𝐢
Initial yield = ×100%
𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩 𝐯𝐯𝐯𝐯𝐯𝐯𝐯𝐯𝐯𝐯

$𝟏𝟏𝟏𝟏𝟏𝟏,𝟎𝟎𝟎𝟎𝟎𝟎
= ×100%
$𝟏𝟏,𝟓𝟓𝟓𝟓𝟓𝟓,𝟎𝟎𝟎𝟎𝟎𝟎

= 8.00%
Types of Yields - Reversionary Yield
 This is the yield derived from an investment at the point of reversion when the

current market rent is passing on the property. This happens when a property is

under a long lease and there are rent reviews. For instance, a 20-year lease with

5 years rent reviews.

 It is expressed as the percentage of the income on reversion in relation to the

purchase price. This can be calculated using current information on the open

market rental value.

𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫 𝐨𝐨𝐨𝐨 𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫

Reversionary yield = ×100%
𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩 𝐯𝐯𝐯𝐯𝐯𝐯𝐯𝐯𝐯𝐯
Types of Yields - Reversionary Yield
Class Illustration 2

From the Class Illustration 1 of the initial yield, if the rent at reversion is

$125,000 net p.a., the reversionary yield on the investment will be:

𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫 𝐨𝐨𝐨𝐨 𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫

Reversionary yield = ×100%
𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩 𝐯𝐯𝐯𝐯𝐯𝐯𝐯𝐯𝐯𝐯

$125,000
Reversionary yield = ×100%
$1,500,000

= 8.33%
Capitalisation Rate
 Capitalisation Rate (Cap Rate) is the ratio of the net (operating)

income of a property to the property’s value.

 This can be derived from the recent property sales in the subject property

market (net income divided by the value of the property).

net (operating) income

Cap rate =
current property value

 Cap Rate is sometimes referred to as the initial yield or rate of return

on an investment.
Cap Rate
Deriving Cap Rate (yield) from similar properties

Subject property Property 1 Property 2 Property 3

Price ? $2,500,000 $2,750,000 $2,380,000

Gross income $315,000 $300,000 $325,000 $285,000

Outgoings $47,250 (15%) $36,000 (12%) $52,000 (16%) $28,500 (10%)

Net income $267,750 $264,000 $273,000 $256,500

Yield Cap rate ? 0.105 (10.56%) 0.099 (9.94%) 0.107 (10.78%)

From those arrays of yields you will then determine the cap rate you want to use. In this situation

you can choose like a cap rate of 10.5%. You can conduct a sensitivity analysis to see the

impact of slight changes (+/- .25%) to the cap rate.

Investment Method of Valuation
The basic principle of the investment method of valuation is:

𝟏𝟏𝟏𝟏𝟏𝟏
Capital Value (CV) = Annual Net Income ×
𝒊𝒊
or
Annual Net Income
Capital Value (CV) =
Cap Rate

The elements of the investment method of valuation are:

 The annual net income to be received

 The period for which the income will be received

 The (market prevailing) cap rate

Note, you value the unexpired term (mostly) when conducting property valuation
Investment Method of Valuation
The Relationship between income (rent - $100,000) received and capital value
(price paid - $2,000,000), and the yield or cap rate (5% - 0.05).

Yield or Cap Rate (% pa)

Income = Capital x Yield or Cap Rate Capital = Income / Yield or Cap Rate

$2,000,000 = $100,000 / 0.05

$100,000 = $2,000,000 x 0.05

Capital ($) Income ($)

Yield or Cap Rate = Income / Capital

0.05= $100,000 / $2,000,000
Investment Method of Valuation
 Note, that the annual income should be NET. That is the gross annual income minus

outgoings.

 It is assumed that the annual income would continue to flow in perpetuity.

 The process of converting an annual income into a capital value (CV) is called

“capitalisation” or “capitalising”.

 The constant to be multiplied by the annual net income is known as the Year’s

Purchase (YP) or to be divided by the annual net income is Cap Rate.

 In the situation of an income receivable in perpetuity, it is called YP in perpetuity (Perp).

Investment Method- Outgoings
Outgoings are the costs incurred in maintaining the property in a good state of
repair to continue to command an income.

Outgoings could be in the form of:

 Rates and utilities – council rates, water rates, land tax, electricity

 Maintenance and repairs – lifts, air-conditioning, security, fire sprinkler

 Insurance – on the property against damage

 Salaries – on-site staff

 Management charges/fees, etc.

Investment Method- Outgoings
Outgoings are provided for from the gross rent receivable from the tenant.

Some guidance of the percentage of outgoings to gross rent are:

 External repairs and maintenance – 5 per cent of rental value

 Internal repairs – 5 per cent of rental value

 Management – between 2.5 and 5 per cent of rental value

 Insurance: 1 per cent of rental value

Parry’s Valuation and Investment Tables

Download this book from the UNSW’s library website at:

https://www-taylorfrancis-com.wwwproxy1.library.unsw.edu.au/books/9781136148545
Investment Method – Interests to be Valued

 Freehold interest - Landlord

Lease
 Leasehold interest - Tenant
Investment Method
Class Example 1

What is the capital value of a freehold property with a net annual income

of $30,000 with a rate of return/yield/cap rate of 5% p.a.?

Investment Method
Class Example 1 – Solution
Annual Net Income
Capital Value (CV) =
Cap Rate
OR
𝟏𝟏𝟏𝟏𝟏𝟏
Capital Value (CV) = Annual Net Income × 𝒊𝒊

Valuation
Capital value = Net income / Cap Rate
Capital Value = $30,000 / 0.05
= $600,000
OR
Net income $30,000
100
YP in perp @ 5% ( ) 20
5
Capital value $600,000
Different (rental) valuation scenarios
Market (Rack)
Rented
Market Rent
$200

Under Rented (Rental Shortfall) Over Rented (Overage)

Market Rent
$200 $220 Contract/Passing Rent
Shortfall Surplus
$180 Contract/Passing Rent $200
Market Rent

Valuation with a tenant can be conducted in 2 ways:

1. Subject to vacant possession

2. Subject to a lease
Lease Term and Reversion
Rent value
Actual market value

Reversionary rent
(High rate of return)

Term rent
(Low rate of return)
Rent review
0
Time (years)

𝟏𝟏−𝐏𝐏𝐏𝐏 𝟏𝟏
Landlord (YP single rate 𝐘𝐘𝐘𝐘 = ) Landlord (YP perp. def. YP = 𝒊𝒊 𝟏𝟏+𝒊𝒊 𝒏𝒏)
𝐢𝐢
𝟏𝟏
Tenant (YP dual rate YP = 𝐬𝐬 )
𝐢𝐢+( )
𝟏𝟏+𝐬𝐬 𝐧𝐧−𝟏𝟏 Source: Isaac (2002)
Term and Reversion Valuation

Investment method can be used to value both “freehold” and “leasehold” interests.
𝟏𝟏𝟎𝟎𝟎𝟎
For an owner-occupier - Freehold (YP in perp 𝐘𝐘𝐘𝐘 = ) (Parry’s Table Page 35)
𝐢𝐢

𝟏𝟏−𝐏𝐏𝐏𝐏
For the landlord – Term (YP single rate 𝐘𝐘𝐘𝐘 = ) (Parry’s Table Page 39)
𝐢𝐢

𝟏𝟏
- Reversion (YP perp. def. YP = 𝒏𝒏 ) (Parry’s Table Page 73)
𝒊𝒊 𝟏𝟏+𝒊𝒊

𝟏𝟏
For the tenant – Term (YP dual rate YP = 𝐬𝐬 ) (Parry’s Table Page 53)
𝐢𝐢+( 𝐧𝐧 )
𝟏𝟏+𝐬𝐬 −𝟏𝟏
(𝐬𝐬 is the annual sinking fund rate)

The interest being valued for a tenant is the profit rent (full rental value less the rent paid)
Term and Reversion - Freehold Valuation
Class Example 2

The net income receivable from a tenant occupying a freehold property is

currently $80,000 p.a. The market full rental value of similar properties is

$92,000 p.a. The current term will expire in 7 years time. Assuming the yield on

the property is 5% p.a., estimate the capital value of the property.

Term and Reversion - Freehold Valuation
Class Example 2 - Solution

Net income - $80,000

Full rental value (FRV) - $92,000

Unexpired term - 7 years

Yield - 5% p.a.

Capital value - ?
Term and Reversion - Freehold Valuation
Class Example 2 - Solution

Income

Full Rental Value

$92,000
$80,000

Reversion

Term

0 7 Time (years)
Today
Term and Reversion - Freehold Valuation
Class Example 2 - Solution

Valuation (Subject to a lease)

Term

Net income $80,000

YP 7 years @ 5% (Parry’s Table Page 42) 5.7864 $462,912

Reversion

Reversion to full rental value (FRV) $92,000

YP in perp defrd 7 years @ 6% (Parry’s Table Page 80) 11.0843 $1,019,756

Capital Value $1,482,668

Term and Reversion - Freehold Valuation
Class Example 2 - Solution
Term and Reversion - Freehold Valuation
Class Example 2 - Solution

Valuation (straight line approach – vacant possession)

Annual Net Income (market rent)

Capital Value =
Cap Rate

$92,000
Capital Value =
0.05

Capital Value = $1,840,000

When the valuation (property) is subject to lease, then you can make deductions
and adjustments to reflect the interest of the tenant (or buyer)
Term and Reversion - Freehold Valuation

Class Example 3

A freehold office property was let 5 years ago at a net rent of $750,000 p.a. for

10 years and another 10 years (rent revision) at $800,000 p.a. net. However, the

net full rental value of the property is $900,000 p.a. Assuming the yield/cap rate

on similar properties in the area is 6% p.a., value the freehold interest in the

property.
Term and Reversion - Freehold Valuation
Class Example 3 - Solution

Net income for the first 5 years unexpired term - $750,000 p.a. net.

Net income for the next 10 years unexpired term - $800,000 p.a. net.

Full rental value (FRV) at reversion - $900,000 p.a. net.

Yield/cap rate - 6% p.a.

Capital value - ?
Term and Reversion - Freehold Valuation
Class Example 3 - Solution

Income
Today
Full Rental Value
$900,000

$800,000

Reversion
$750,000
Current Next 10 years
5 years (Term)
(Term)

0 5 15 Years
Unexpired Term
Term and Reversion - Freehold Valuation
Class Example 3 - Solution

Valuation
Term (1st 5 years unexpired)

Net income $750,000

YP for 5 years @ 6% (Parry’s Table Page 44) 4.2124 $3,159,300

Term (2nd 10 years unexpired)

Net income $800,000

YP for 10 years @ 6% (Parry’s Table Page 44) 7.3601

×PV $1 in 5 years @ 6% (Parry’s Table Page 96) 0.7473

YP for 10 years @ 6% defrd 5years 5.5002 $4,400,162

Term and Reversion - Freehold Valuation
Class Example 3 - Solution

Term (1st 5 years unexpired) $3,159,300

Term (2nd 10 years unexpired) $4,400,162

Reversion

Reversion to full rental value (FRV) $900,000

YP in perp @ 7% defrd 15 years (Parry’s Table Page 82) 5.1778 $4,660,020

Capital Value $12,219,482

Term and Reversion - Leasehold Valuation
Class Example 4

A tenant pays an annual rent of $35,000 p.a. for occupying a residential

property. The full rental value (market rent) of a similar property is $45,000 p.a.

The current term will expire in 5 years time. Assuming the yield on the property

is 5% p.a. and a sinking fund rate of 3% p.a., calculate the leasehold interest in

the property.
Term and Reversion - Leasehold Valuation
Class Example 4 - Solution

Rent paid - $35,000

Full rental value - $45,000

Unexpired term - 5 years

Yield – 5% p.a.

Sinking fund rate - 3% p.a.

Term and Reversion -Leasehold Valuation
Class Example 4 - Solution

Valuation
Term

Full rental value (market rent) (p.a.) $45,000

Contract rent paid (p.a.) $35,000

Profit rent (p.a.) $10,000

YP 5 years @ 5% and 3% (Parry’s Table Page 60) 4.1954 $41,954

Capital value say $42,000

Term and Reversion -Leasehold Valuation
Discounted Cash Flow Method of Valuation
(the prior knowledge of DCF concept is assumed)
Discounted Cash Flow (DCF) Method of Valuation
 The discounted cash flow (DCF) valuation method can be used to appraise and
compare the value of properties (investments).

 This method is also widely adopted by finance professionals.

 This method did not receive more attention before now because of the complexity
involved in its application. However, the advent of ICT has made its application
easier.

 DCF is used to value properties that have annual income-generating capacity.

It is based on analysing the income and expenses of the subject property.

 DCF is based on the principle of the investment method, but it makes provision
for changes that may occur during the life of the property in terms of void
periods, rental growth, capital expenditure etc.
DCF Method of Valuation
 The DCF method is used to assess the returns from a property investment or
property development project.

 Other traditional methods of valuation could be used as a check for DCF output.

 The DCF method is used to estimate the Net Present Value (NPV) of the cash flow

expected from a property (investment) and the precise rate of return that a property

(cash flow) would produce. The latter is called the internal rate of return (IRR).

 This method is used to value properties that would generate a substantial annual
income (cash flow) through their life cycle to arrive at the value that the investor
should pay for the interest.
DCF Method of Valuation
 One of the advantages of DCF over the traditional methods is its versatility and

transparency in adopting it to value properties (large commercial, shopping centres,

residential etc.) that have varying inflows and outflows during their lifecycle.

 By using DCF, the future cash flows from the property, as well as the expenditure are

to be converted to the present values (PV) at a given interest rate (discount rate).

 DCF takes into account the time value of money (TVM) concept.

 Also, it can also allow for the assumptions of rental growth and inflation on the

investment.
Present Value (PV) & Year’s Purchase (YP)
PV $1 for 1 year @ 6% = 0.9433

PV $1 for 2 years @ 6% = 0.8899

PV $1 for 3 years @ 6% = 0.8396

PV $1 for 4 years @ 6% = 0.7921

PV $1 for 5 years @ 6% = 0.7473

Total 4.2122

YP for 5 years @ 6% = 4.2124 (Parry’s Table pp. 44)

0.9433 0.8899 0.8396 0.7921 0.7473 = 4.2124

1 2 3 4 5
DCF  YP is most appropriate when it is certain or assumed that the future income
Method of (cash flow) would be constant.
Valuation
 It is worth noting that those cash flows may not be constant or fixed in most

situations, hence, the DCF approach can capture the irregularities in the flow

of income and expenditure.

 In adopting the DCF approach, the discount rate is an important factor, and

this is to be determined. The discount rate represents the acceptable rate of

return which factors in the cost of capital, returns on the investment and

the risks involved in the investment. Also, this can be derived from the

market through market research.

DCF - NPV
Class Example 5

A commercial property is expected to generate an annual gross income of

$750,000 and with an outgoing of 15% p.a. It is assumed that the annual income

will not grow during the holding period. The investor intends to sell the property

after the 8th year and the terminal value will be $10,000,000. The investor

expects a 6% p.a. rate of return on the investment. Estimate the NPV of the

property i.e., how much should be paid for the property.

DCF - NPV
Class Example 5 – Solution

Year Income Expenditure Net cash flow PV @ 6% DCF

0 - - - - -
1 $750,000 $112,500 $637,500 0.9434 $601,415
2 $750,000 $112,500 $637,500 0.8900 $567,373
3 $750,000 $112,500 $637,500 0.8396 $535,257
4 $750,000 $112,500 $637,500 0.7921 $504,960
5 $750,000 $112,500 $637,500 0.7473 $476,377
6 $750,000 $112,500 $637,500 0.7050 $449,412
7 $750,000 $112,500 $637,500 0.6651 $423,974
8 $10,750,000 $112,500 $10,637,500 0.6274 $6,674,099
NPV $10,232,867
DCF& Investment Method
Class Example 6

A freehold residential property is to be let at a rent of $45,000 p.a. (net) for 20

years with a 5 years rent revision clause. Evidence from the market shows

that similar properties have a rental income growth of about 2.5% p.a. and a

yield of 5% p.a. Your client is interested in buying the property, advise your

client if it is worth pursuing this purchase or not.

DCF& Investment Method

Class Example 6 – Solution

Valuation

Net income $45,000

÷ Cap rate @ 5% 0.05 $900,000

Capital value (purchase price) $900,000

DCF& Investment Method
Class Example 6 – Solution
Rent review
Years YP 5 years @ 5%* PV @ 5% ** DCF
(Rent X growth)
1 to 5 $45,000 4.3295 1 $194,828

6 to 10 $50,913 4.3295 0.7835 $172,712

11 to 15 $57,604 4.3295 0.6139 $153,107

16 to 20 $65,173 4.3295 0.4810 $135,728

49
21 to perp. $73,738 20.0000 0.3769 $555,820

Total $1,212,194

Purchase price $900,000

NPV $312,194
* Parry’s Table Page 42 ** Parry’s Table Page 94
DCF- IRR
 The IRR of an investment represent the discount rate applied to the income and

expenditure from the investment that makes the NPV equals to zero.

 Also, could mean the actual average annual return of an investment expressed as a
percentage (%). The IRR can be compared against other investments.

 To estimate the IRR of an investment, the NPV of the investment would be

estimated at two different interest rates that would generate a positive and a

negative NPV figures. The NPV figures are then interpolated to estimate the actual

IRR of the investment.

 The IRR would lie in between the two rates used to estimate the negative and
positive NPV figures.
DCF - IRR

𝑁𝑁𝑁𝑁𝑁𝑁@𝑅𝑅1
𝐼𝐼𝐼𝐼𝐼𝐼 = 𝑅𝑅1 + 𝑅𝑅2 − 𝑅𝑅1 ×
𝑁𝑁𝑁𝑁𝑁𝑁@𝑅𝑅2 + 𝑁𝑁𝑁𝑁𝑁𝑁@𝑅𝑅1

R1 – The lower target rate of return NPVR1 – NPV at the lower rate

R2 – The higher target rate of return NPVR2 – NPV at the higher rate

Note: ignore the “+” or “–” signs of the NPV figures, only the absolute values
should be entered in the formula.
DCF - IRR

Source and more insights: https://ablesim.com/project-internal-rate-of-return/

DCF - IRR
Class Example 7

An investor wants to know the IRR of an investment. The details of the subject

property are as follows:

The property is to be bought at $15,000,000 and the investment will be held for

10 years. The income for the first year is $1,050,000 (net) and this is expected to

grow at the rate of 2% p.a. throughout the holding period. The terminal value of

the property is $14,000,000. Advise the investor accordingly.

DCF- IRR
Class Example 7 – Solution
Year Income Expenditure Net cash flow PV @ 7% DCF
0 0 -$15,000,000 -$15,000,000 1.0000 -$15,000,000
1 $1,050,000 0 $1,050,000 0.9346 $981,308
2 $1,071,000 0 $1,071,000 0.8734 $935,453
3 $1,092,420 0 $1,092,420 0.8163 $891,740
4 $1,114,268 0 $1,114,268 0.7629 $850,070
5 $1,136,554 0 $1,136,554 0.7130 $810,347
6 $1,159,285 0 $1,159,285 0.6663 $772,480
7 $1,182,471 0 $1,182,471 0.6227 $736,383
8 $1,206,120 0 $1,206,120 0.5820 $701,973
9 $1,230,242 0 $1,230,242 0.5439 $669,170
10 $15,254,847 0 $15,254,847 0.5083 $7,754,791
NPV $103,716
DCF - IRR
Class Example 7 – Solution
Year Income ($) Expenditure ($) Net cash flow ($) PV @ 8% DCF ($)
0 0 -$15,000,000 -$15,000,000 1.0000 -$15,000,000
1 $1,050,000 0 $1,050,000 0.9259 $972,222
2 $1,071,000 0 $1,071,000 0.8573 $918,210
3 $1,092,420 0 $1,092,420 0.7938 $867,198
4 $1,114,268 0 $1,114,268 0.7350 $819,021
5 $1,136,554 0 $1,136,554 0.7130 $810,347
6 $1,159,285 0 $1,159,285 0.6302 $730,546
7 $1,182,471 0 $1,182,471 0.6227 $736,383
8 $1,206,120 0 $1,206,120 0.5403 $651,629
9 $1,230,242 0 $1,230,242 0.5002 $615,427
10 $15,254,847 0 $15,254,847 0.4632 $7,065,946
NPV -$813,070
DCF - IRR
Class Example 6 – Solution

R1 = 7%, NPVR1 = 103,716, R2 = 8%, NPVR2 = - 813,070

103,716
𝐼𝐼𝐼𝐼𝐼𝐼 = 7 + 8−7 ×
813,070 + 103,716

103,716
𝐼𝐼𝐼𝐼𝐼𝐼 = 7 + 1 ×
916,786

𝐼𝐼𝐼𝐼𝐼𝐼 = 7 + 1 × 0.1131

𝐼𝐼𝐼𝐼𝐼𝐼 = 7 + 0.1131

𝐼𝐼𝐼𝐼𝐼𝐼 = 7.1131

𝑰𝑰𝑰𝑰𝑰𝑰 = 𝟕𝟕. 𝟏𝟏𝟏𝟏%

Reflection
 Capitalisation rate

 Yields

 Income capitalisation approach

 Outgoings

 Term and reversion valuation – Freehold

 Term and reversion valuation – Leasehold

 Discounted Cash Flow (DCF) valuation method

 Discounted Cash Flow and investment method of valuation

Next Week

Methods of Valuation – Comparison and Cost Methods

 Questions & Answers

UNSW Built Environment 59