In the current market landlords are experiencing changeable market conditions.
Lease lengths are shortening2and there is some reluctance from tenants to commit to FRI leases or to meeting the landlord’s costs of external repairs. There have also been increases in the volume of vacant properties and the size of lease incentives in some areas. The valuer in every valuation has to check carefully, by reading the lease or leases, to see precisely what the gross income is and what deductions or allowances need to be made to estimate net income. Where leases are on gross terms the valuer needs to check for escalation or inflation clauses which may allow for annual increases in the event of, say, increases in utility costs. Lease structures are becoming more complex and the net income assumptions of the FRI lease may no longer be the norm.
2 Investment Property Databank and British Property Federation Annual lease review report 2010 gives the 2009/10 average commercial lease length as 5.0 years.
Chapter 7
Yield
1. Introduction
To use the income approach the valuer must determine the yield. This represents the rate of return that buyers, at the valuation date, are seeking in relation to the particular interest in that type of property, of that investment quality, in that location. The yield1is normally based on the analysis of comparable transactions.
Valuers must do more than simply analyse the yield – they must also have a clear idea of what the market is doing, why the market is doing it and, if they are to advise adequately on the quality of the investment, what the market is likely to do in the future.
The valuer needs to have an understanding of the current returns from most types of investment and of the principal factors which influence them. This is because property is only one form of investment and it must compete for funds with all other forms. In some cases, the characteristics of a property investment will be similar to stock market quoted investments and thus the yields will be related to each other. This chapter considers the principles governing interest rates generally and the yields on the main types of landed property.
However, it is first necessary to dispose of two preliminary points that can cause confusion.
(a) Nominal and actual or effective rates of interest
The nominal rate of interest, or dividend, from savings or an investment in stocks or shares is the annual return to the investor in respect of every £100 saved or of every £100 face value of the stock. Where stock is selling at face value, that is at par, the nominal rate of interest and the actual rate of interest, or yield, are the same.
For example in the case of Government Stock such as 2.5% Consolidated Stock (“Consols”), the nominal rate of interest is fixed at 2.5%; that is, £2.50 interest will
1 Yield in the normal context of the income approach is called the ‘all risks yield’ (ARY) as it is the single yield most used to analyse comparable sales evidence of investment property sales. The term is considered to cover the initial yield, equivalent yield and reversionary yield (see Chapter 9).
68 Yield
be received each year for each £100 face value of the stock held. If the stock is selling at £100 for each £100 face value, then investors will receive £2.50 interest each year for every £100 invested, which gives a yield of 2.5%. But if that £100 face value of 2.5% Consols is selling at £75, or £25 below par, then each £75 of capital invested will be earning £2.50 interest annually:
∴ Yield =2.5 75 ×100
1 = 3.333%
Thus, the actual rate of interest is 3.33% whilst the nominal rate of interest remains 2.50%.
If an industrial concern declares a dividend of 25% on its ordinary shares, then the company will pay 25% of the nominal value of each share as the dividend.
Hence, if the shares are £1 shares, the dividend per share will be 25% of £1= 25p per £1 share. But if the price of each £1 share on the market is £4, then:
Yield= 25p 400p×100
1 = 6.25%
If the share price rises to £4.50 and the same dividend of 25% is paid, then:
Yield= 25p 450p×100
1 = 5.56%
From these examples, two important points can be noted:
(i) A comparison of income receivable from various types of investment can only be made on the basis of yields, and that nominal yields derived from face values are of no use for this purpose.
(ii) A rise or fall in the price of a security will cause a change in the yield of that security.
(b) Timing of payments and yields
A yield is expressed as the interest accruing to capital in a year. Hence, if an investment is made of £1,000, and £100 in interest payments are made in each year, the yield is:
100 1000×100
1 = 10%
But if the payment of interest is made in instalments then the yield will differ.
For example, if the investor receives £50 after six months and a further £50 at the end of the year, then:
50 1000×100
1 = 5% every six months
Yield 69 The payment received after six months can be re-invested. Assuming it is re-invested in a similar investment, then further interest of 5% for the remain-ing half-year will be earned. The total interest payments at the end of the year are:
£50 (after six months)+ (5% of £50) + £50 (end of year payment) which equals £102.50.
And 102.5
1000 × 100 = 10.25%
As the payment patterns change, such as quarterly in arrears or quarterly in advance, so will interest for the year change. This phenomenon is recognised in everyday life by the adoption of annual percentage rate (APR) figures which are quoted in respect of loan rates for borrowers or interest payments for credit card borrowers. The APR reflects the timing of the interest charged on the loans; this is rarely interest added solely at the end of the year. In the case of savings, an annual equivalent rate or AER will be quoted.
When reference is made to a yield, it is the yield as determined by the total annual interest expressed as a return on capital, ignoring the timing of the pay-ments. Thus, in both of the foregoing examples, the notional or nominal yield is 10% but the true yields are 10% and 10.25%, respectively. Normally the simplistic approach is adopted by valuers and property investors, although the final yield chosen will reflect the timing of the payments. Thus the yield on a property let at £1,000 per quarter payable in advance, and offered for sale at
£40,000, will be calculated by property valuers for valuation purposes as 10%
[(4 × £1,000 = £4,000) and (£4,000/£40,000) × 100 = 10%]. The APR is in fact a little over 10.657%; valuers refer to this as a True Equivalent Yield (TEY) – see Parry’s, pages 29–33, for yield conversion tables (see Chapters 9 and 12).
2. Principles governing yields from