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Direct property
 commercial office

 industrial

 retail.

The benefits typically emanate from the two major

sources of:
 rental income

 capital appreciation
The advantages of real property are:

 To provide significant diversification benefits

 To offers protection against inflation
 To offers stable income
 Prices generally less volatile than equities
 Potential to improve overall portfolio returns
The main disadvantages of real property are:

 Illiquid in the short term

 Indivisibility, i.e. it hard to off-load a portion of your
investment
 Relatively high transaction costs
 Management intensive
 Trained staff are required for analysis, valuations,
lease negotiations, rent reviews, service contracts and
so on
 The key characteristics of a property as an
investment asset:
 lack of standardisation

 durability and depreciation

 size

 fixed location

 government intervention

 status

 dual function

 asset accrual
 Where sufficient information on the transactions of similar
properties are available and can be easily found in the open
market, direct capital comparison may be possible
 However, if the similarities that can be found from market
transactions are less apparent, especially in commercial
properties, it becomes more reliable to determine rental
values from recent letting and to derive information on
yield ranges from an analysis of recent sales
 In particular, if the property is treated as an investment
property

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Principles:
 This method is based on the principle that the annual values
and capital values are related to each other and that, given
its annual income/value, the capital value can be found
 This method is widely used by valuers when properties
which produce an income flow are sold to purchasers who
are buying them for investment purpose

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Procedure : Single-tenanted investment property
 Estimate the annual gross income if it is vacant or adopting the
actual income of the property if it is currently let. This is the
effective gross income (gross income)
 Estimate the annual operating expenses which include all the
expenditures that must be made to protect the income flow
(outgoings)
 Estimate the net operating income which is that income
remaining after deducting operating expenses from the effective
gross income (net operating income / income from operation)
 Select the appropriate capitalization of interest rate (yield)

 Apply the appropriate capitalization process (YP or yield) to

convert the net operating income stream into an indicated
market value (net operating income x YP = capital value)

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Procedure – Multi-tenanted investment property
 Estimate the total annual gross potential income of the property.
Deduct from that income an allowance for vacancy and bad
debts. The result potential is the effective gross income.
 Estimate the annual operating expenses which include all the
expenditures that must be made to protect the income flow
(outgoings)
 Estimate the net operating income which is that income
remaining after deducting operating expenses from the effective
gross income (net income)
 Select the appropriate capitalization of interest rate (yield)

 Apply the appropriate capitalization process (YP or yield) to

convert the net operating income stream into an indicated
market value (net income x YP = capital value)

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 (In $million)

(Single-tenanted vs. Multi-tenanted)

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 Landed property is capable of producing an income flow over a
period of time
 Some relationship will exist between the income flow and
capital value of the property
 The capital value of the property will be proportional to the net
income which is the actual income received from a property
after all expenses have been deducted

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 To show the relationship between the net income/capital value/yield
Example : The following properties are fairly similar shops with different
floor areas. They are all situated in the same district
Net Income Capital Value
Shop A $10,000 p.a. $166,000
Shop B $8,000 p.a. $132,500
Shop C $12,000 p.a. $199,500

 YP : Capital value divided by income in each case = 16.6, signifying that the capital
value is 16.6 times of income
 Initial yield: Income divided by capital value in each case = 0.06, i.e. 6%. This is the
yield or rate of return of the investment, sometimes. This is also called All Risk Yield
(ARY) (a term used in UK), or Overall Capitalization Rate (OCR) (a term used in North
America), being used as the discounting factor.
 YP and Yield tend to be constant for the same type of property
 However, YP and Yield may vary, from district to district, for the same type of property

(All-risk yield : a yield figure to reflect all associated risks and benefits to the investor)

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  Yield is used to measure cost, which is the income brought in from rents, divided by the
purchase price : r = Annual income/purchase price
 Initial Yield is the annualized rents of a property expressed as a percentage of the
property value when the investment is launched.
 The annual rent figure used in the calculation is the ‘passing rent’ (the current
contractual rent), meaning it is not discounted in any way by rent-free periods
 All risks yield (ARY) mainly used by commercial property to provide an indication of
the risks involved in a particular property investment. The basic principle is:
 - in a falling (bear) market, yields rise (rents stay fairly static, capital values fluctuate)
 - in a rising (bull) market, yields fall (capital fluctuates faster than annual rent)
 If the tenant is a highly-regard national company – represent a yield figure of a very
high quality building, it is know as prime yield
 Cap rate A term generally used in real estate investing to describe the valuation of a
property. It is a "discount rate" used to value the income stream to the present that
implies the value of the property.

(All-risk yield : a yield figure to reflect all associated risks and benefits to the investor)

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Example : Shop D is a fairly similar shop to Shop A, B and C in the
previous examples in the same area. It is capable of producing a net
income of $9,000 p.a. From the evidence obtained in the previous
example, estimate the capital value of Shop D

a. Net income $9000

YP in perp @ 6% 16.6
Capital value $149,400

b. Net income $9000

Divided by yield 6%
Capital value 150,000

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Summary

 YP = Sale price / Net income

 Capital value = Net income x YP
 Yield = Net (rental) income / Sale price
 Yield = 1 / YP (for perpetual income only)

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Example: The freehold interest in a property which produces a net
income of $2,500 was recently sold at auction for $41,500. Analyze
this transaction so that evidence of the yield obtained may be used in
future for the valuation of similar properties

a. Yield Net income / Sale price

= $2500 / 41500 x 100%
= 6%

b. YP = Sale price / Net income

= $41500 /2500
= 16.6
Yield = 1/16.6
= 6%

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Example : Analysis of transactions over the last eight months shows
that the yields from shops in a particular area have been as follows:
No. of transactions Yield obtained
2 6%
5 6.5%
1 8%
The freehold interest in a shop in this area sold last week for $12,300.
From the evidence available estimate the rental value of the shop.

Note:
 Do not attempt to average the yield
 The yield of 8% should be treated with suspicion. Possibly some
special relationship existed between the parties to the transaction or
due to inferior location of the comparable.

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 No. of transactions Yield obtained
2 6%
5 6.5%
1 8%

The freehold interest in a shop in this area sold last week for $12,300.
From the evidence available estimate the rental value of the shop.

Yield = Net income / Sale price

Net income = Sale price / yield
= $12,300 x 6.5%
= $799.5
Say = $800 p.a.

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 (Fair/market)Rental value : The rent at which a property would be let at a
particular point in time in the open market
 Net rental value : In making a valuation, outgoings must be deducted
from the rent paid
 Ground rent : Building leases are granted by a lessor (landlord) to a lessee
(tenant) and under the terms of the lease, the lessee covenants to pay a
‘ground rent’, i.e. the rental value of the land at the time when he enters
into the lease; and to erect on the land buildings approved by his landlord
(the lessor). Land and buildings will be reverted back to the lessor at the
end of the building lease term
 Occupation rent : The rent paid by the lessee or tenant for occupying the
land and building
 Rack rent : The rent reserved in a lease which represents the full rental
value of land and buildings, i.e. on that date could reasonably be expected
to be obtained in the open market

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The rack rental value may be calculated in several ways
 By reference to the rent currently being paid - a reasonable
guide but could be less (or more) than the rack rental value
 By comparison with similar property – the practical difficulties
are that there are no identical properties in the same district at
the same time
 By considering rent as a proportion of turnover or profit
applicable to commercial properties (turnover rent)
 By relating the rent to cost – an annual return to the use of land
+ annual repayment to the cost of buildings
 By relating to the yield of similar type of investment properties

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Example: A man owns a plot of land worth a ground rent of $800,000 p.a.
He finds there is a brisk demand in the immediate neighborhood for
shops to let at net rents from $3,250,000 to $3,750,000 p.a. He therefore
erects a shop of the type in demand at a total cost of $36,000,000.
Estimate the rental value if interest rate is found to be at 7.5%

Ground rental value of site $800,000p.a.

Total cost of bldg $36,000,000
Building rent on 0.075
$36,[email protected]%
$2,700,000p.a.

Rental value $3,500,000p.a.

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 Net Income = Annual Rent – Outgoings

 When making a valuation by the investment method, it is essential

to find the actual net income.
 In many cases where a landlord receives a rent this will not
represent the net income from that property. The landlord may
have to bear certain annual costs of ownership and these will be
payable out of the rent. Such costs are known as outgoings.
 Outgoings paid by the landlord must be deducted from the rent in
order to find the net income derived from his interest in the
property

Note: In Hong Kong, there are no analyses of outgoing items such as

repairs and insurance in the general practice. The Hong Kong valuers
in most cases only allow rates and management fee as outgoings before
capitalizing the rent to arrive at the Capital Value.

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 The responsibility of payment of outgoing should be stated in the lease.
 Leases for a long period are often full repairing and insuring (FRI), i.e.,
the tenant will be responsible for all repairs and insurance
 The only cost remaining to the landlord is that of management charges
 Majority of lettings make tenants liable for internal repairs, rates, lighting
and cleaning
 The landlord is left with the cost of external and major structural repairs,
insurance and management costs
 When a person buys or rents property, the costs or outgoings will have
some influence on the price or rent paid.
 In general, the higher the annual costs, the less the price or rent which can
be paid

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Cost of repairs
 Repairs are difficult to assess and reference has to be made with age and
condition of the buildings. Various methods are available
- by reference to past costs – to average them out to work out an annual
allowance
 - by working out a planned maintenance programme – to inspect the
properties concerned and to find out items needed to be repaired and their
estimated costs and at which period
 - by expressing repairs as a percentage of rack rental value - this varies
with types of properties, usually between 5 -10% (5% for internal repair
and 5% for external and structural repair)
 Disrepair : where property is in a state of disrepair, the cost of
outstanding repairs is assessed. (a) The property is valued in good repairs
and (b) the cost of the outstanding repairs will be deducted from the
capital value at the end of the valuation (also note the references on the
actual valuation)

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Fire Insurance
 Where the premises are let on lease, the lessee will normally
insure the premises under FRI terms.
 Where the property is let on a weekly or monthly tenancy, or if
there is no provision in a lease, the cost of this outgoing will be
borne by the landlord
 The premises is usually assessed at:

 - 0.1 – 0.125% of the cost of reinstatement of the premises, or

 - 1 – 2% of the full rental value

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Example :

1. A factory which has a full rental value of $40,000 p.a. is let on a lease with 4
years to run at a rent of $25,000 p.a. These rents are based on the fact that the
landlord is responsible for structural repair and insurance. Estimate the allowance
that the landlord should make for his repairing and insuring liability
Repair: 5% of FRV (fair rental value) @ $40,000 p.a. $2,000 p.a.
Fire insurance: 2% of FRV @ $40,000 p.a. $800 p.a.

2. A semi-detached house would cost $40,000 to rebuild if burnt down by fire.

Assess the amount that should be deducted from rent as an allowance for fire
insurance

b. Fire insurance premium @ 0.125% of $40,000 = $50

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Management

 A landlord will need to inspect his property and ensure that his tenant is
complying with the obligations contained in the lease. He will also have
to collect rent due to him and supervising repairs
 Where the property is let on an FRI lease, the cost is around 2% of the
rent received
 For other cases, the cost is from 5 to 10% of the rent received

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Rates
 Rates are payments for communal public services

 Rates are levied at a percentage of the rateable value of the

property
 Rates are normally paid by the occupier, and where the tenant is
responsible for rates, the rent paid is said to be exclusive of rates
 Rent inclusive of rates, landlord pays; Rent exclusive of rates,
tenant pays

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Building Management
 These occur in the case of premises let in multiple occupations, such as flats,
offices and shops let in suites or units
 Services of building management (charges) include:

 - cleaning, and lighting of common areas

 - running and maintenance of lifts

 - employment of management personnel

 - provision of furniture and fittings to common parts, etc

 There are two ways of dealing with the cost of building management

 1. To be included in the rent that is charged. In this case the cost must be
deducted from the rent received as a normal outgoing
 2. A service charge may be levied as a separate item over and above the rent.
In this case, no deduction from the rent is necessary.

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 Net Income = Annual Rent – Outgoings
Example: Freehold industrial premises have been let recently for $600,000 p.a. on a
5 year lease. The landlord is responsible for repairs and insurance and employs
managing agents to look after the property. His account indicates the following
expenses:
Repair cost on average $50,000 p.a.
Insurance cost $12,000 p.a.
Managing agent’s fee $30,000 p.a.
Assuming that the rent of $600,000 represents full market rental value for the
property and that yield on industrial premises of this type is 10% p.a., what is the
capital value of this property?

Rent receivable $600,000p.a.

Less outgoings
Repairs $50,000
Insurance $12,000
Management $30,000 $92,000p.a.
Net income $508,000p.a.
YP in perpetuity @10% 10
Estimated capital value $5,080,000

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Hong Kong Practice :
 Valuers only allow Rates and Management Charges as outgoings (FRI are
borne by occupiers)
 No allowance for charges, mortgages or others arising from any encumbrances

Source: Extract from the Draft Valuation Report, Vigers

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 Freehold Term and Reversion Valuations
 In many transactions, the lease was entered into some time before the sale took place with
regular rent review
 Such circumstances require an approach where the valuation is made in two tranches
 1st stage : the initial rent is capitalized for the period up to the next review date
 2nd stage : the remainder is capitalized with the reviewed rental and deferred for the period
before which the new rent is charged

 Example : Retail shop premises in a main shopping street were let three years ago at
$29,000 per annum on FRI terms on a 15-year lease with rent reviews at the end of every
fifith year. The current rental value is $33,000 pa. There is evidence of sales to support a
yield of 7%. Estimate the capital value of the premises.

Term
Current rent pa net $29,000
YP 2 yrs @ 7% 1.8080 $52,432
Reversion
Current rental value $33,000
YP perp @ 7% 14.2857
PV $1 in 2 yrs @ 7% 0.87344 12.4777 411,764
Capital value $464,196

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 Freehold Term and Reversion Valuations
Example : Retail shop premises in a main shopping street were let three years ago at $29,000
per annum on FRI terms on a 15-year lease with rent reviews at the end of every fifth year.
The current rental value is $33,000 pa. There is evidence of sales to support a yield of 7%.
Estimate the capital value of the premises.

Term
Current rent pa net $29,000
YP 2 yrs @ 6.5% 1.8206 $52,797
Reversion
Current rental value $33,000
YP perp @ 7% 14.2857
PV $1 in 2 yrs @ 7% 0.87344 12.4777 411,764
Capital value $464,561

- Slight different rates are used in “Term” and “Reversion”

- Well-established practice to use a slightly lower yield for the initial rent, the
reason behind is that because the current rent is less than the market rent it is
considered to be more secured

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 Freehold Term and Reversion Valuations
Example : A modern freehold office block is let on a FRI lease for a term of 15 years granted
four years ago at a rent of $50,000 per annum. The lease contains provision to review the rent
at the end of the 7th year of the lease. The premises are occupied by a government department.
Current rental value on the lease with 5-year reviews would be $60,000. The investment
market is fairly active, recent sales have taken place to show a yield of 8%. Calculate the
market value of the investment.

The terms of the lease are uncommon:

- The present tenants offered the best convenant and that the landlord was anxious to
conclude a letting
- No direct comparables that only one review allowed in the lease

Term
Current rent pa net $50,000
YP 3 yrs @ 7.5% 2.6005 3.3493 $130,025
Reversion
Current rental value $60,000
YP perp @ 8% 12.5
PV $1 in 3 yrs @ 8% 0.79383 9.922875 595,373
Capital value $725,398

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 Freehold Term and Reversion Valuations
 If the present tenants offered a weak covenant, the valuer would reflect the higher risk
by adopting a higher all-risks yield
 Example : A similar office block to the one described in previous example was let four
years ago to a local business at a rent of $50,000 on FRI terms for a term of 15 years
with 5-yearly rent reviews. In investment terms, the covenant of the tenant is not as
good as that of the government department and actually is a weak one. The property
is now offered for sale as an investment. Provide the capital value.
Term
Current rent pa net $50,000
YP 1 yrs @ 9% 0.9174 $45,870
Reversion
Current rental value $60,000
YP perp @ 9.5% 10.5263
PV $1 in 1 yrs @ 9.5% 0.9132 9.6126 576,757
Capital value $622,627
 In Term: the covenant of the tenant is not as good as the government department
 In Reversion: the valuer has also selected a higher rate on the reversion to indicate the
higher market expectation of return given this tenant’s relatively weaker convenant
strength

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 Freehold Term and Reversion Valuations

Criticism of the use of two yields method:

 The approach overlooks the fact that the investment is one
transaction
 Thus same yield should be used to reflect the true risk of the
investment
 Further, the valuer is unable to analyse the market to find two
yields within the same property
 The difference between the two is no more than a personal view
unsupported by evidence but simply reflecting an instinct that a
lower income must be more secured and household therefore be
reflected in the calculation

 An alternative is to use the equivalent yield approach to valuation

in which both term and reversion are valued using the same yield

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 Freehold Term and Reversion Valuations

Example : A shop is let at an annual net rent of $40,000. The market is

estimated to be $60,000 pa. The valuer has set the parameters (yields)
between 5% and 7%. Given that there are three years remaining on the lease,
a valuer has used the term and reversion method to find the capital value as
follows:

Term
Rent passing $40,000
YP 3 yrs @ 5% 2.7232 $108,928
Reversion
Current rental value $60,000
YP perp @ 7% deferred 3 yrs 11.6614 11.6614 699,684
Capital value $808,612

The equivalent yield must be somewhere between 5% and 7%

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 Freehold Term and Reversion Valuations
To solve equivalent yield by use of DCF (Discount Cash Flow) method

Years Cash flow YP 3yrs @5% YP in perp @5% PV $1 in 3yrs @5% DCF
1-3 $40,000 2.7232 $108,928
3 in perp $60,000 20 0.8638 $1,036,560
$1,145,488
Less capital value $808,612
$336,876

Years Cash flow YP 3yrs @7% YP in perp @7% PV $1 in 3yrs @7% DCF
1-3 $40,000 2.6243 $104,972
3 in perp $60,000 14.2857 0.8163 $699,685
$804,657
Less capital value $808,612
-$3,955

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 HKIS (2012) The HKIS Valuation Standards, The Hong Kong
Institute of Surveyors.
 Scarrett and Osborn, Property Valuation – The Five Methods,
Routledge
 Vigers (2016) Draft letter: summary of values and valuation
certificates, Vigers Appraisal and Consulting Limited, 2016

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