(a) Generally
In estimating the market value of a property from an investment point of view, the valuer must first determine its market rent.
In doing so, the valuer will have regard to the trend of values in the locality and to those general factors affecting rent discussed above. These will form, as it were, the general background of the valuation, although the valuer may not be concerned to investigate in detail all the points referred to when dealing with an individual property. The two factors most likely to influence the valuer’s judgment are:
• the rents paid for other properties; and
• the rent, if any, at which the property itself is let.
When preparing an investment valuation it is necessary to make an assumption as to whether the market rent at the time when the valuation is made will con-tinue unchanged in the future. This assumption, that rent would concon-tinue either unchanged or would rise in the future, used to be the accepted rule as normal changes, either upwards or downwards, were reflected in the property yield. The rent payable at the date of the valuation would have been compared with the then current market rents, and regard would be had to the length of the lease, the incidence of rent reviews and the terms of the lease, regarding matters such as repair and user. This assumption may no longer be valid as obsolescence must now also be considered. Where the property is over-rented, i.e. the rent payable exceeds the market value, this must be allowed for in the calculation by reverting on review to a lower rent, or on reversion to either a lower rent with an allowance for a possible void, or to a development value for the actual or an alternative use.
Where obsolescence is considered to be relevant to the future rent, this would
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normally be reflected in the yield. This is further considered in greater detail in Chapter 9.
In general, if rent is likely to increase a lower yield (higher YP) will be applied, but if it looks as if it is going to decrease then a higher yield (lower YP) will be used – low risk low yield, high risk high yield.
Future variations in market rent may sometimes arise from the fact that the premises producing the income are old, so that it may be anticipated that their useful life is limited. Together with the likelihood of a fall in rent there may be a possibility that, in the future, considerable expense may be incurred either in rebuilding or in modernisation to maintain the rent. In such cases, the return which the investment will be expected to yield will be increased and the YP to be applied to the net income correspondingly reduced.
Where a future change in rent is reasonably certain it should, of course, be taken into account by a variation in the net rent. For example, a valuation may be required of a shop which is offered for sale freehold subject to a lease being granted to an intending lessee on terms that have been agreed. These terms provide for a specified increase in rent every five years. It has been ascertained that many similar shops in the immediate vicinity are let on leases for 10, 15 and 20 years with a provision for similar increases in the rents at the end of each five-year period. Assuming that the position is an improving one and that the valuers are satisfied that such increasing rents are justified, the valuers will be correct in assuming that the shop with which the valuers are dealing can be let on similar terms, and the valuers will take future increases in rent into account in preparing their valuation. The method of dealing with such varying incomes from property will be considered in detail in Chapter 9.
(b) Basis of the rent actually paid
Where premises are let at a rent and the letting is a recent one, the rent actually paid is usually the best possible evidence of market rent.
But the valuer should always check this rent with the prevailing rents for similar properties in the area or, where comparison with neighbouring properties is for some reason difficult, with the rents paid for similar properties in comparable locations elsewhere, i.e. where the socio/economic conditions are the same.
There are many reasons why the rent paid for a property may be less than the market rent. For instance, a premium may have been paid for the lease, or the lease may have been granted in consideration of the surrender of the unexpired term of a previous lease, or the lessee may have covenanted to carry out improvements to the premises or to forego compensation due to the lessee from the landlord.
In many cases the market rent may have increased since the existing rent was agreed. Differences between rent paid and market rent may also be accounted for by the relationship between lessor and lessee, e.g. father to son, parent company to a subsidiary.
Market rent 51 In some instances a rent from a recent letting may be above market rent. For example, an owner may sell an asset to realise capital and take back a lease from the buyer (a sale and leaseback). If the owner is a strong covenant, the buyer may agree to pay above market value and accept a higher rent, relying on the strength of the covenant for security of their income.
If it is clear that the actual rent paid is a fair reflection of MR, then it will be adopted as the basis of the valuation. The valuer will ascertain what outgoings, if any, are borne by the landlord and by making an appropriate deduction will arrive at the net rent.
If, in the valuer’s opinion, the market rent exceeds the rent paid under the existing lease, the valuation will be made in two stages. The first stage will be the capitalisation of the present net income for the remainder of the term. The second stage will be the capitalisation of the market rent after the end of the term; the term may be the period to the next rent review rather than the unexpired term of the lease if the rent review clause is not upward only.
If, on the other hand, the valuer considers that the rent fixed by the present lease or tenancy is in excess of the market rent, the valuer will have to allow for the fact that the tenant, at the first opportunity, may refuse to continue the tenancy at the present rent, and also for the possible risk, in the case of business premises, that the tenant may fail and that the premises will remain vacant until a new tenant can be found.
As a general rule, any excess of actual rent over market rent may be regarded as indicating a lack of security in the income from the property. But it must be borne in mind that rent is secured not only by the value of the premises but also by the tenant’s covenant to pay, and a valuer may sometimes be jus-tified in regarding the tenant’s covenant as adequate security for a rent in excess of the market rent, particularly where there is an upward only rent review.
An example of such cases is a sale and leaseback deal of the type referred to above. Another is where a shop is let on long lease to some substantial concern such as one of the large retail companies with many outlets – a “multiple”. Here, the value of the goodwill the tenants have created may make them reluctant to terminate the tenancy, even if they have the right to do so by a break clause in the lease; they may, however, threaten to do so unless the rent is reduced.
Where there is no such break, they will in any case be bound by their covenant to pay.
Since rent at the moment is a first charge, ranking even before debenture interest, and since such a concern will have ample financial resources behind it, the security of the income is reasonably assured, but the valuer should be aware of the true financial state of the tenant company before making this assumption. Sometimes the lease is held by a subsidiary of the major company; in the absence of a guarantee from the parent, the covenant is only as good as the accounts of the subsidiary justify.
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(c) Comparison of rents
It has been suggested that the actual rent paid should be checked by comparison with the general level of values in the district. Not only is this desirable where the rent is considered to be prima facie a fair one, but it is obviously essential where premises are vacant or let on old leases at rents considerably below market rent.
In such circumstances, the valuer has to rely upon the evidence provided by the actual letting of other similar properties. The valuer’s skill and judgment come into play in estimating the market rent of the premises under consideration in the light of such evidence. Regard must be had not only to the rents of other properties that are let, but also to the dates when the rents were fixed, to the age, condition and location of the buildings as compared with the subject property, to the terms of the lease, and to the amount of similar accommodation in the vicinity to be let or sold.
In many cases, as for instance similar shops in a parade, it may be a fairly simple matter to compare an unlet property with several that are let and to assume, e.g., that since the latter command a rent of £20,000 a year on lease it is reasonable to assume the same rental value for the shop under consideration which is similar to them in all respects.
But where the vacant premises are more extensive and there are differences of planning and accommodation to be taken into account in comparing them with other similar properties, it is necessary to reduce rents to the basis of some con-venient “unit of comparison” which will vary according to the type of property under consideration.
For example, it may be desired to ascertain the market rent of a factory having a total floor space of 1,000 m2. Analysis of the rents of other similar factories in the neighbourhood reveals that factories with areas of 500 m2or thereabouts are let at rents equivalent to £50 per m2of floor space, whereas other factories with areas of 4,000 m2or thereabouts are let at rents of £40 per m2of floor space. This indicates that size is a factor in determining the unit rent. After giving consideration to the situation, the building, and other relevant factors, it may be reasonable to assume that the market rent of the factory in question should be calculated on a basis of
£47.50 per m2of floor space.
The unit chosen for comparison depends on the practice adopted by valuers in that area or for the type of property. Notwithstanding the transition to metric units, over the past years valuers have shown a marked reluctance to abandon imperial units. Thus, the most commonly met units of measure are still values per square foot or per acre and most, if not quite all, comparative statistics are based on imperial measures. This may change, although it didn’t change over the life of the last two editions. Metric units are commonly adopted for agricultural purposes and in valuations for rating purposes. The valuer must be prepared to accept and work with either method. The practitioner will follow normal practice but needs to be aware that the RICS advocates the use of metric units, either with or without the imperial equivalent.
Market rent 53 The method of measuring also varies according to the type of property con-cerned. In some cases the areas occupied by lavatories, corridors, etc. are excluded and in other cases the valuer works on the gross internal area. In an attempt to bring some uniformity, the professional societies have produced recommended approaches. The RICS publishes a Code of Measuring Practice: A Guide for Prop-erty Professionals (6th edn, 2007). This Code both identifies various measuring practices, such as gross internal area and net internal area, and also recommends the occasions when such practices would be appropriate, for example gross inter-nal area for industrial valuation and net interinter-nal area for office valuation. Though the rules of conduct of the professional bodies do not bound valuers to follow the Code, such codes are regarded as “best practice” and comparable evidence and calculation of market rent are usually on the same basis when obtained from other surveyors. Failure to follow the Code could in some circumstances be regarded as negligent practice.
When quoting rental figures, the amount per annum should always be qualified by reference to the length and terms of the lease such as the liability for rates, repairs and insurances. The date and the purpose of the valuation should also be stated.
(d) Rent and lease terms
The amount of rent that a tenant will be prepared to offer will be influenced by other terms of the lease. Rent is but one factor in the overall contract and if additional burdens are placed on the tenant in one respect the tenant will require relief in another to keep the balance. For example, if landlords wish to make a tenant responsible for all the outgoings they cannot expect the rent offered to be the same as where the landlords bear responsibility for some of them.
Similarly, if a landlord offers a lease for a short term with regular and frequent upward revisions of the rent, he or she cannot expect the same initial rent as would be offered if a longer term were offered with less frequent reviews, particularly if his/her terms are untypical of the general market arrangements; if a landlord seeks to limit severely the way in which premises may be used, the rent will be less than where a range of uses is allowed.
It is clear that the market rent must reflect the other terms of the lease and cannot be considered in isolation; indeed, a rent cannot be determined until the other terms of the lease are known.
In making comparisons, it must be remembered that the terms of the lettings of different classes of property vary considerably. It is convenient, therefore, to compare similar premises on the basis of rents on the terms usually applicable to that type of property. Good shop property and industrial and warehouse premises are usually let on terms where the tenant is liable for all outgoings including rates, repairs and insurance. Thus, net rents are compared on this type of property, assuming a full repairing and insuring lease. With blocks of offices let in suites, the tenant is usually liable only for internal repairs to the suite and rates and the
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landlord for external repairs, repairs to common parts and insurance. The landlord provides services such as lifts, central heating and porters, but the cost of these are dealt with separately by means of a service charge on the tenants (and which may also include the landlord’s liability to repair and insure). Thus, rents used for comparing different suites of offices would be inclusive of external repairs, repairs to common parts and insurance but exclusive of the service charge. Having arrived at the rental value of the office block on this basis, the net income would be arrived at by deducting the outgoings which are included in the rents and for which the landlord is liable. In cases where landlords include within the service charge their liability to repair and insure and also the supervisory management fees, the rent will be the net income. This latter form of lease is known as a “clear lease” as the landlord recovers all of his/her costs from the tenants and thus the rent is usually comparable with the rent on an FRI lease.
Example 5–2
A prospective tenant of a suite of offices on the third floor of a modern building with a total floor space of 250 m2requires advice on the rent which should be paid on a five-year lease. The tenant will be responsible for rates and internal repairs to the suite. The landlord will be responsible for external repairs, repairs to common parts and insurance. Adequate services are provided, for which a reasonable additional charge will be made. The following information is available of other recent lettings on the same lease terms in similar buildings, all of suites of rooms:
Floor Area in m2 Rent, £ Rent, £ per m2
Ground 200 36,000 180
300 48,000 160
1st 150 18,000 120
2nd 160 20,000 125
4th 400 52,000 130
5th 500 67,500 135
6th 200 26,000 130
Estimate of rent payable
As these other lettings are on the same terms as that proposed, it is unnecessary for purposes of comparison to consider the outgoings borne by the landlord or to arrive at net rent.
The broad picture that emerges from this evidence is that the highest rent is paid on the ground floor but thereafter the rents are approximately the same. This is what would be expected in modern buildings with adequate high-speed lifts. In older buildings with inadequate lifts or no lifts, the higher the floor the lower will be the rent. The inconsistencies in the rents might be due to market imperfections or to differences in natural light or noise.