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6 Property valuations As with all investments, the true market value is only known when there is a transaction that equates a willing buyer with a willing seller. This happens frequently with stocks and shares that are actively traded on regulated markets, but real property changes hands infrequently. Indications of value can be taken from similar recent transactions but the uniqueness of each property means that considerable skill is needed to assess property market values. Such valuations must be regarded as a matter of the valuers opinion rather than fact. Property can be valued using an explicit discounted cashflow approach, but as with equities it is now more common to use a marketconsistent valuation of liabilities. The cashflows discounted should be net of all outgoings and should make explicit allowances for expected rental increases. Unlike equity dividend growth, which is generally assumed to happen smoothly, property rental increases are typically stepped, ie the rental income is typically level for a period and then step changes to a new level at the next rent review. Allowance needs to be made if the passing ie current rent is different from the current open market rental value. In this situation the current rent level will be valued to the next rent review, and thereafter the open market rental level is valued. In the situation where the current rent is greater than the open market rental value ie the property is over rented, then it will be necessary to know whether the terms of the lease allow for downward rent reviews. 6.1 Discounted cashflow formula Consider a freehold property that is let on a commercial lease. We can value this by applying the discounted cashflow approach. Lets assume for simplicity that rents are payable in perpetuity, rents quoted are net of expenses and tax, rents quoted are also net of any costs of modernising or refurbishing the property. Then, the value of the freehold is given by a formula on page 442, which includes the discount rate, i, ie required rate of return. The discount rate used should depend on the riskiness of the investment and could be based on the yield on a bond of suitable term, plus margins for factors such as risk and lack of marketability. Question Outline the factors that should be considered in determining a suitable margin to use in the discount rate. Solution In determining a suitable discount rate it will be necessary to consider a number of factors many of which are related to the primeness of the property, including use office, shop, factory etc and size, location a poor location may mean a significantly higher yield, prospects for rental growth, nature of lease, eg term, rent reviews, whether full repairing and insuring, quality of tenant or tenants if there is multiple occupation, quality of building, ie design, age, condition, access etc, whether there are alternative uses for the property so that rental income can be maintained if the market for the present use fails, whether there is development potential, macro and micro economic factors such as oversupply or a weak local economy. The above factors will affect the level of risk default risk, void risk, volatility, marketability risk.