INVESTMENT PROPERTIES

An investment property is a property bought for future income and benefits such as capital gain. For example, a block of flats. Economic investment criteria is used to value such property.

VALUATIONS FOR INVESTMENT PURPOSES

This valuation standard consists of 6 elements:

• investment valuation applications.
• complex investment valuation applications
• non routine analysis methods.
• client type
• type of property being valued.
• report content.

DETERMINE VALUATION OF INVESTMENT PROPERTIES

The elements under the national standard are:

• interpret outcomes of analysis.
• analyse data on subject investment property.
• determine investment value.
• record value, analytical approaches used and qualifications required.

If utility is the major component of value, the property is an investment property and should be valued with the capitalization method. Investment properties are properties bought by real estate investors for expected future income and benefits (capital gains). Examples of investment properties include hotels, motels, shopping centres, office blocks, industrial warehouses and residential flats.

See utility diagram

THE CAPITALIZATION RATE (CR)

The market value of an investment property is the present value of all future income and benefits from day 0 (date of valuation) into perpetuity. This is shown on the following time line:

TIME LINE DIAGRAM

The time line is taken into perpetuity because the basis of ownership is freehold which allows the owner to enjoy all rights of the land in perpetuity. Even Canberra's leasehold system can be considered "quasi freehold" based on the long term of the original lease and the almost certain lease rollover at the end of the current lease period.

ANALYZING THE CAPITALIZATION RATE

The basic measure of rate of return on property is the initial yield or capitalization rate. This is simply the ratio of the initial or starting net rent to the sale price expressed as a percentage:

CR = NAI/SP*100

Where:
CR = the capitalization rate as a %
NAI = net annual income
SP = sale price

EXAMPLE

Sale price: \$1 000 000
Net annual income: \$110 000

CR = 110000/1000000 * 100 = 11 or 11 % per annum

Because 11%pa is determined using the CURRENT net annual income of the property, this method is known as the initial yield rate of return. The higher the capitalization rate, the higher the risk of investment. For example, investment properties on the outskirts of the CBD are riskier investments than those near the centre. Therefore, potential buyers of such properties require a higher rate of return as compensation for the extra risk.

If the above sale meets the criteria of the willing seller willing buyer theory, the initial yield can be used to value comparable investment properties. Market value is determined with the following formula:

MV = NAI * 100/CR

Where:

MV = market value
NAI =net annual income
CR= capitalization rate as a %

EXAMPLE

Net annual income:\$200 000
Capitalization rate:11%pa

MV = \$200 000 * 100/11 = \$1 818 200 say \$1 820 000

YEARS PURCHASE (YP)   THE MULTIPLIER

The factor used to multiply the net annual income in the capitalization method (100/CR) is called the years purchase or multiplier. The name is derived from a commercial method for the valuation of businesses using the "payback period". However, the real estate industry prefers the initial yield capitalization rate (CR) and it has become a universal measure of the investment return on property. The years purchase is found with the following formula:

YP =100/CR

Where:

YP = years purchase
CR = capitalization rate as a %

The years purchase for the above property is as follows:

YP = 100/CR = 100/11 = 9.09 years.

NET INCOME

The periodic income from real estate can be expressed as either gross or net income. Net income is the gross income less all relevant outgoings associated with the "day to day" running of the subject property, that is, capital and unusual costs are excluded. The “day to day” running costs are also known as the operating costs. The net Income is the better measure of return than gross income because it takes into account all those outgoings that may be specific and peculiar to the subject property.

EXAMPLE

Compare the following two properties:

PROPERTY A:
Gross annual income (GAI) = \$200 000

PROPERTY B:
Gross annual income (GAI) = \$200 000

If a 15% GROSS capitalization rate (analyzed from sales of comparable properties) is used, the calculated market value of each property is identical:

MV = \$200000 * 100/15 = \$1 333 300

However, after further investigation it is found that property B has higher outgoings than property A because of higher property taxes and insurances (it is located within a primary fire zone). The net annual incomes are:

PROPERTY A: \$120 000

PROPERTY B: \$100 000

By analyzing comparable sales it is found that the appropriate NET capitalization rate is 9% per annum. The resultant market values are:

PROPERTY A: \$120 000 * 100/9 = \$1 333 300

PROPERTY B: \$100 000 * 100/9 = \$1 111 100

Therefore, by using the net annual income and thus accounting for the specific costs relating to property B, a difference of \$222 200 in value has been accounted for.

Note that the net capitalization rate is lower than the gross capitalization rate for the same property. Therefore, a capitalization rate should always be quoted as either net or gross so as to avoid confusion. Generally, if a capitalization rate only is quoted, it is assumed to be a net rate.

VARIATIONS TO THE CAPITALIZATION METHOD

The following are the main variations to the capitalization method: