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Real Estate Valuation Summary (6314M0292)
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Real Estate Valuation 1Chapter 2: Macroeconomic Considerations
2.1 The commercial property market
In comparison to the stock market, property markets are more informal, less structured
and more diverse; in many ways each property market transaction can be regarded as
unique. There are fewer, more heterogeneous transactions in the property market.
Consequently, it is more complex. The Appraisal Institute points out: the property
market has never been considered as strongly efficient due to decentralized trading, the
heterogeneity and high cost of each unit of product, the high cost and lengthy
transaction process that is common when buying and selling property, the relatively few
buyers and sellers at a single point in time in one price range and location, paucity of
market information at the individual property level, and the opportunity to exercise
monopoly power.
As a way of explaining how the commercial property market functions we can
define three interlinked sectors:
1. The user, or occupier market
2. The investment market
3. The new property, or development market
2.2 Property occupation
From the occupier’s perspective property can either be rented or owned. In the case of
owner-occupied property, annual occupation costs are often referred to as imputed
rent but whether real or imputed, rent acts as a price signal to market participants and
through its rise and fall, clears the market by equating supply and demand. Typically,
rental income from a property is fixed for five years at a time and thus offers a degree of
price stability in the occupier market.
Businesses may be reluctant to own property because it can tie up a
considerable amount of capital, and thus often choose to rent. Also, property
ownership requires management expertise to integrate the assets into core activities.
This role is often contracted out to external agents who may not be familiar with
corporate objectives and strategies of the company, and this can result in under-
occupied space and other inefficiencies. A sale and leaseback arrangement can
tackle this problem, where property ownership (and sometimes management) is
transferred to an owner-investor and capital is released to the occupying business
tenant (previously an owner-occupier) for investment in the business.
,2.3 Property investment
The advantage of indirect property investment is that many of the problems associated
with direct property investment such as illiquidity, high transaction costs and lengthy
sale time disappear but the portfolio diversification benefits are reduced.
On the supply side property investments take the form of properties that are already in
existence and occupied by one or more tenants paying rents. Property investments can
be classified in terms of their risk/return profile.
1. Prime property investments
2. Secondary property
3. Tertiary properties
Property investments can also be classified by their ownership characteristics.
1. Freeholds offer a pure equity interest to the owner-occupier and an equity/bond
mix to an investor because of the stepped income growth pattern obtained from
properties let at rents that are reviewed every five years.
2. Leaseholds.
a. Long leases on ground rents where the reversion is a long way off – like
long-dated or undated gilts but without the same level of liquidity and
with higher management and transaction costs, causing yields to be
slightly higher.
b. Shorter leases
On the demand side property competes against other forms of investment, primarily
bonds and equities. Property may be regarded as an equity/bond hybrid investment.
Property investments are like equities because they are capable of maintaining their
value in real terms (keeping pace with inflation) and hopefully growing in real terms.
Unlike equities, the capital value of a property will not fall below its inherent land value
regardless of the rent-earning capacity of the business currently in occupation.
Regarding income growth, this is receivable at rent reviews and lease renewals that
usually take place every five years. Consequently, property investments resemble a
bond-type investment between rent reviews. As well as providing a real return and
offering a relatively secure investment opportunity, property can provide corporate
identity, there may be tax advantages, and it is a useful portfolio diversifier. A final but
important feature of property as an investment vehicle is the ability to borrow money to
help purchase property investments.
However, property has a number of disadvantages too. First, it comes in large
indivisible heterogenous units that suffer from deterioration and obsolescence. Its
lumpiness makes it difficult for smaller investors to acquire big, prime investments and
almost impossible to acquire landmark developments such as shopping centers or
prestigious office buildings. It also means that only the larger investors can afford to
, assemble balanced and sufficiently diversified portfolios. Second, property is an illiquid
investment asset. Third, there are high management costs.
2.4 Property development
In financial terms development becomes viable when the value of the completed
scheme is at least equal to the development costs. As a way of reducing competition
risk, secrecy surrounds the assembly of development sites, the securing of planning
permission and finance. Short-term finance is typically used to pay for the costs
incurred throughout the development period and so money markets that deal in short-
term loans are especially important to the property development sector. Development
loans are usually short-term with variable interest rates. If the rate increases the
construction becomes expensive and reduces the number of viable projects. Also, the
longer the development period the more uncertain developers are about future costs
and the riskier it is to predict them. If the developer is looking to retain the scheme as an
investment, an arrangement can be made with a lender on completion to repay the
short-term finance that was taken out to fund the development. This long-term finance
is typically obtained from the capital markets in the form of a mortgage. The interest
rates on mortgages are typically lower than for short-term finance. If the developer sells
the scheme on completion, then long-term finance is not required.
2.5 Property and the wider economy
Macroeconomic factors are of importance for the property market. For example, if
interest rates rise sharply, consumer spending tends to decline and the demand for
retail and manufacturing property reduces and, in some instance, may even become
surplus to requirements. The interest rate is very important to the property market as
most investment and development activity is a combination of debt and equity finance,
typically a large amount of the former and a small amount of the latter. The interest rate
is also a component of yields and discount rate used in valuation and so directly affects
the property values.
The property market is slow to react to new information. For example, the
vacancy rate may begin to rise and rental growth to stagnate, but new buildings will still
be constructed in the short to medium term and landlords tend to be very reluctant to
reduce rents unless the absolutely have to. The lag in construction activity can lead to
over-supply and raise vacancy rates in times of reduced market activity. This, in turn,
causes a drop in rents and an increase in yields until such time as demand increases to
remove any surplus. However, development activity introduces only a small amount of
new property each year in comparison to the size of the total stock and so tends not to
significantly influence the property market as a whole. At the start of a market upturn
supply lags the increase in demand, which causes the vacancy rate to drop and rents to
rise and yields to fall. In the medium term, developers increase supply in response to
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