The precise nature of “interest” and the relationship between, and the levels of, long-term, medium-term and short-term rates of interest are subjects for the economist and market analyst and are not dealt with in this book. The valuer is interested in why investors require investment A to yield 6%, investment B 3%
and investment C 12%.
A reasonably simple explanation of the many complex matters that the investor must take into account in determining the yield required from an investment can be
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derived from the creation of an imaginary situation. For this purpose the following assumptions are made:
• the real value of money is being maintained over a reasonable period of years – that is, £1 will purchase the same quantity of goods in, say, 10 years time as it will now; and either
• there is no taxation, or the rates of tax are so moderate as not to influence the investor significantly, or
• the system of taxation is such that taxes bear as heavily on capital as on income.
In these circumstances the yield required by the investor would depend on:
• the security and regularity of the income;
• the security of the capital;
• the liquidity of the capital; and
• the costs of transfer, i.e. the costs of buying and selling.
The general principle is that the greater the security of capital and the greater the security and regularity of income, the greater the ease with which the investor can turn the investment into cash; and the lower the costs of transfer, the lower will be the required yield.
For example, if investment D offers a guaranteed income payable at regular intervals with no possibility of loss of capital, with capital repayable in cash immediately on request at no cost to the investor, then the investor will require the minimum yield necessary to induce him to make the investment. If investment E offers the same terms as D except that six months notice is needed in order to withdraw the capital, then a yield sufficiently higher than the minimum will be required to offset this difference. If investment F offers the same terms as E except that there are some transfer costs, the investor will require a still higher yield.
This imaginary situation must now be adjusted to reflect actual market conditions.
First, money does not retain its real value during periods of inflation. Thus, where an investor investing during a period of inflation is guaranteed a secure income of, say, £100 a year, yet finds the value of the pound is halved in 10 years, then this “secure” income will have a real value of only £50 a year. So, if “security” of capital means merely that if £1,000 is invested now and £1,000 can be withdrawn on demand, then the real value of the capital would be halved over a period of 10 years. If, in these circumstances, 10% for an income of £100 a year from an investment of £1,000 is a reasonable yield, the investor should be prepared to accept a lower initial yield from an investment which will protect the capital and income from the erosion of inflation. Thus, they might be prepared to accept a yield of 5% now on an investment of £1,000 if there is a reasonable chance that:
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• the income of £50 a year now will have doubled to £100 a year in 10 years’
time, thus maintaining its real value; and
• the capital of £1,000 will increase to £2,000 in 10 years’ time, thus maintaining its real value.
An investment that offers the investor the opportunity of maintaining the real value of capital and income is described as a “hedge against inflation” and is said to be “inflation proof”.
The second and third assumptions for the imaginary situation are related to the level and incidence of taxation. Over recent years taxable events and the rates of tax have changed frequently. Tax tends to divide between tax on capital and tax on income.
Until 1962 there was no tax on capital apart from estate duty. This led to surpluses arising from the sale of capital assets being free of tax. In 1962, a capital gains tax (CGT) was imposed on short-term gains, followed in 1965 by the establishment of CGT on all gains. This tax remains today, having been substantially revised in 2008. From 23 June 2010 the rates for individuals are 18% or 28%, for trustees and personal representatives 28% and for gains qualifying for Entrepreneurs’ relief 10%; for companies, other provisions operate under corporation tax. In the past various other taxes have applied to gains from development land.
Estate duty was a tax imposed on the assets of a person on their death, but careful tax planning made it possible to keep this down to modest levels or even to avoid it altogether: it was regarded as an avoidable tax. Estate duty was replaced by capital transfer tax in 1975. This was a tax charged not only on assets at death but also on the value of gifts made during a person’s lifetime. In 1986 capital transfer tax was replaced by inheritance tax which is more akin to estate duty. The rates of tax assessed on the value of the assets in the estate varied from 30% to 60%, but since 1988 a single rate of 40% has been imposed above an annually determined base on which no tax is levied.
As to tax on income, this has seen some significant changes in the rates of tax over the same period, but the taxes imposed (corporation tax on companies and income tax on individuals) have existed in some form for many years. Tax can be a significant factor in respect of investments and is subject to frequent change and fluctuation; in general the tax on income has tended to be more penal than the tax on capital, particularly on capital gains. For current rates readers should refer to www.direct.gov.uk.
The four principles listed above, adapted to meet conditions of inflation and levels of income and capital taxation, have governed yields in the investment market in the UK in recent years. This is apparent from examination of yields from different types of security during this period. British government securities, which in times of stable prices and moderate taxation have been described as “ideal securities”, offer the minimum yield because they are practically riskless. In about 1955, the yield on government securities rose above that on ordinary shares in sound companies and for quality properties; this became known as the reverse
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yield gap; In the current economic climate, short-dated stock redemption yields have fallen to all time lows of less than 1% with undated stock at around 3.75%.
There are many reasons for the current financial position, which has seen the price of government stock rise and yields fall. Of particular importance is the security factor at a time when there is uncertainty over corporate profits, suggest-ing dividend cuts or in some cases short-term freezes on dividends. In addition, the historic expectation that share prices would keep pace with inflation appears to have taken, in some cases, a severe battering by the market. The market for stocks and shares is experiencing considerable readjustment to changing domestic and world economic conditions. Historic low prices for stocks and high yields reflecting the inflation-prone nature of stocks, compared to high prices and low yields from equities reflecting their inflation-proof characteristics, would appear to have been reversed. All-time low base rates and anticipated falling rates of inflation have caused investors to revise their investment expectations. The val-uer has to observe and be familiar with every type of investment and with the macro and micro economic forces which influence buyers and sellers in the var-ious markets. The general principles of risk referred to here are sound, but the effects of the 2007/08 credit crunch, following the impact on the financial markets of the sub-prime lending practices in the US and elsewhere, have led to significant repositioning of many investors across a range of markets. This has impacted on the UK property market. Under changing market conditions such as these, val-uers must understand the underlying forces of market movement and must not only observe the affect on yields but also consider possible future movements in yields.