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Introduction
Nominal benchmarks such as the all-risk yield and equivalent yield are used in
a valuation framework assuming that rents are received annually in arrears.
Basically, the market uses measures such as the all-risk yield as a convenient
comparative measure. If the all-risk yield on a particular property is calculated
on an annually in arrears assumption, then that figure will be directly
comparable to a similar property with an all-risk yield calculated in the same
way. For comparison purposes within a single asset class, the preciseness of
the benchmark measure is less important than the consistency of that measure.
The use of the all risk yield in a subsequent valuation should also be quite Journal of Property Investment &
straightforward. In the case of a fully let freehold, if the valuer is satisfied that Finance, Vol. 18 No. 2, 2000,
pp. 225-238. # MCB University
the all-risk yield chosen is implying the correct assumptions for the subject Press, 1463-578X
JPIF property, then its use to calculate the years' purchase multiplier to apply to the
18,2 annual rental figure will produce a good estimate of market value. The
traditional investment method of valuation is one of simple comparison, and
once again, preciseness in terms of technical analysis of the benchmark is less
important than the consistency of the measure. In fact, no yield analysis of any
type is required to carry out the valuation. It would be possible to carry out a
226 comparison valuation by reference to the multiplier alone (YP) without
translating this into a yield reference. It is simple convention in the UK
property market that has led to the reliance on the yield as the benchmark for
comparison.
However, problems arise where the subject valuation is more complicated
that a simple rack rented investment thereby requiring subjective inputs from
the valuer and where comparisons are made with other asset classes that
benchmark on a different basis.
The aim of this paper is not to be a critique of traditional or contemporary
valuation methodologies but to provide the appropriate formula to allow
annually in arrears based data to be used correctly in a quarterly in advance
valuation framework. The use of quarterly in advance formula may provide a
marginally different bottom line figure (which is arguably a more accurate
reflection of reality). However, the principal aim of these formulae should be to
provide valuers with a more robust valuation framework which is intuitively
more logical and understandable by clients. Indeed, The Mallinson Report
(RICS, 1994) commented on this particular point stating:
. . .are we wise to continue using tables which assume rent to be received annually in arrears
when the client knows that he receives it quarterly in advance (RICS, 1994, p. 34).
This point was reinforced by Alaistair Ross Goobey of the Investment Property
Forum who wrote:
As an investor, I find it hard to believe that valuation still assumes that rents are received
annually in arrears. Rents for all the properties owned by our clients are received quarterly in
advance. But when asked why the opposite is assumed, the professionals simply shrug and
say ``it's the convention''. Yet the industry's standard benchmark, the IPD index, has already
adjusted returns on property from its constituents to reflect reality (Ross Goobey, 1997).
Where
r = Effective capitalisation rate for incomes in perpetuity where growth and
inflation are implicit in the rate, i.e. all-risk yield adjusted for quarterly
in advance cash flows.
k = Nominal capitalisation rate for incomes in perpetuity where growth and
inflation are implicit in the rate, i.e. all-risk yield.
p = Number of payments per annum, e.g. four for quarterly in advance.
Table I illustrates the use of an effective yield based on the above formula used
in conjunction with quarterly in advance formula compared to a
straightforward annually in arrears based valuation.
JPIF As can be seen in Example 1 (Table I), there is a discrepancy in the
18,2 valuations, which on the premise that the quarterly in advance Years' Purchase
in perpetuity formula calculates the correct multiplier, indicates that the
effective yield is wrong[2].
Analysis of the effective yield formula confirms that it does not produce an
appropriate rate to apply to a quarterly in advance cash flow. Indeed, as shown
228
by analysis of a cash flow in Example 2 (Table II), the formula actually
provides an effective yield for income received quarterly in arrears.
Analysis of a quarterly in advance cash flow on the same basis used in
Example 2 (Table II) would provide an approximation for the correct effective
yield. However, unlike ``in arrears'' cash flows, the ``in advance'' effective yield
derived by this method is sensitive to the length of time over which a cash flow
is analysed. Basically, the proportion of the yield calculated due to the first
payment at time zero will decrease as the length of the analysis period
increases and the effective yield will tend towards the quarterly in arrears
effective yield.
Figure 1 graphically illustrates an exaggerated comparison of the present
value of annual incomes of perpetual cash flows with the same net present
A fully let freehold at an ERV of £10,000 p.a. and a current all-risk yield of 8 per cent (adjusted
to 8.24 per cent using effective yield formula from Parry's for quarterly in advance valuations.
Annually in Quarterly in
arrears advance
ERV £10,000 ERV £10,000
Table I. YP perp @ 8 per cent 12.5000 YP perp @ 8.24 per cent 12.7500
Example 1 Valuation £125,000 Valuation £127.500
Cash flow analysis of quarterly in arrears payments assuming investment value of £1,000
and annual income of £100.
Total annual income 100
Total interest rate 10%
Capital value 1; 000
Income Interest Income plus interest
Period (%) (%) at year end (£)
229
Figure 1.
Comparison of the
present value of future
annual incomes for
quarterly in advance
and annually in arrears
cash flows
Time
Where
r = Effective capitalisation rate for incomes in perpetuity where growth and
inflation are implicit in the rate, i.e. all-risk yield adjusted for quarterly
in advance cash flows.
k = Nominal capitalisation rate for incomes in perpetuity where growth and
inflation are implicit in the rate, i.e. all-risk yield.
p = Number of payments per annum, e.g. four for quarterly in advance.
(This is the same formula used by the investment property forum in their
calculations, except their notation is T = (1/((1-N/4)^4)±1). Where ``T'' is the true
equivalent yield and ``N'' is the nominal (annual) equivalent yield).
JPIF By adjusting the period variable in equation (2), effective yields can be
18,2 calculated for application to rents received ``in advance'' biannually, monthly or
any other proportion of a year.
The reciprocal formula to convert back to an annually in arrears or nominal
rate is shown below and it can be noted that this formula is the denominator in
the quarterly in advance Years' Purchase formulae.
230
1
k p1 ÿ
1 rÿ1=p or k p 1 ÿ p
3
p
1r
Where
r = Effective capitalisation rate for incomes in perpetuity where growth and
inflation are implicit in the rate, i.e. all-risk yield adjusted for quarterly
in advance cash flows.
k = Nominal capitalisation rate for incomes in perpetuity where growth and
inflation are implicit in the rate, i.e. all-risk yield.
p = Number of payments per annum, e.g. four for quarterly in advance.
(Again, this is the same formula used by the investment property forum in their
calculations, except their notation is N = 4(1 ± (1/(1 + T))^0.25). Where ``T'' is
the true equivalent yield and ``N'' is the nominal (annual) equivalent yield).
The transition from an annually in arrears to a quarterly in advance
framework for the valuation of fully let freeholds is, therefore, relatively simple
requiring only an adjustment to the all-risk yield by formula (see Example 3
(Table III)). However, evidence from comparable reversionary freehold
transactions provides for a more complex basis of analysis.
Quarterly in advance cash flows are, for a given annual income, more
valuable than annually in arrears. Therefore, an upward adjustment in yield is
required when using quarterly in advance formulae to reconcile the valuations
produced by the approaches. However, comparable term yields do not imply a
perpetual income and equivalent yields are a composite measure of term and
perpetual incomes. Conversion of these measures to effective yields requires
analysis reflecting the length of the term and, in the case of equivalent yields,
A fully let freehold at an ERV of £10,000 p.a. and a current all-risk yield of 8 per cent
[adjusted to 8.24 per cent using proposed effective yield formula for quarterly in advance
valuation ± using the YP formula YP = 1/(4*(1±(1/((1+T)^0.25)))))]
Annually in Quarterly in
arrears advance
ERV £10,000 ERV £10,000
YP perp @ 8 per cent 12.5000 YP perp @ 8.42 per cent 12.5000
Valuation £125,000 Valuation £125,500
Table III.
Example 3 Note: Both method produce the same valuation of £125,000
knowledge of the yields implied for different income tranches. Therefore, Academic papers:
conversion to quarterly in advance effective rates cannot be undertaken by use Investment
of a simple formula as above. valuation models
Analysis as discussed may seem academic, but if the profession is to move
towards analysing income on an ``as received'' basis, then the distinction
between quarterly adjusted rates on an ``in arrears'' and ``in advance'' basis will
be important. 231
However, the above analysis simply reiterates that it is the multiplier (YP)
that is important to the valuation. The way in which this is expressed as a
benchmark, either quarterly (true equivalent yield) or annual (nominal
equivalent yield) is actually an issue of reporting. The ``true'' equivalent yield is
simply a more precise benchmark in advising the client of the return being
achieved. It does however still imply growth (if there is a market perception of
growth occurring); thus the stated intention of the investment property forum
that the true yield can be ``directly compared with the redemption yield on
bonds and gilts'' is strictly not applicable. A reverse yield gap may still apply.
The explicit valuation model in Example 4 (Table IV) uses a growth explicit
discount rate or equated yield taken as an arbitrary figure of 12 per cent. An all-
risk yield of 8 per cent consequently implies a level of rental growth sufficient
to provide a return to the investor of 12 per cent. The growth figure in this
example is 4.63 per cent per annum and can be simply calculated by use of a
number of formulae, the example using such a formula derived by Fraser
(1993;) see equation (4). The explicit valuation is presented in a short-cut
discounted cash flow framework (see Baum and Crosby, 1995) although an
identical valuation can be calculated by a full discounted cash flow.
"r#
n
n e ÿ k1 e k
g ÿ1
4
e
Where
g = Net average annual growth rate.
e = Equated yield.
k = Nominal capitalisation rate for incomes in perpetuity where growth and
inflation are implicit in the rate, i.e. all-risk yield.
n = Interval between rent reviews in years in subject lease.
While the rationale of using a constant average annual growth rate is patently Academic papers:
questionable, such methods, in the absence of forecasts, provide the best model Investment
of market sentiment. As well as an assumption of a constant growth rate, the valuation models
all-risk yield remains constant throughout the term of the lease and the
perpetual five year income tranches are valued on the premise that the
reversionary sale could take place at any of the interim rent reviews into
perpetuity. These are the underlying principles used in the short-cut DCF 233
which in Example 4 (Table IV) allows for the (notional) sale at the second
review or reversion.
A fully let freehold at an ERV of £10,000 p.a. with a five year rent review pattern and a
current all-risk yield of 8 per cent and effective yield of 8.42 per cent. Equated yield
assumed to be 12 per cent with implied growth by formula of 3.998 per cent. Valued on an
annually in arrears basis.
Traditional Short cut DCF
ERV £10,000 Term 1
YP prep @ 8.42% 12.5000 Passing rent £10,000
Valuation £125,000 YP 5 yrs @ 12% 3.8713
£38,713
Term 2
ERV £10,000
Amt £1 5 yrs @ 3.998% 1.2165
Inflated ERV £12,165
YP 5 yrs @ 12% 3.8713
PV 5 yrs @ 12% 0.5674
£26,723
Revision
ERV £10,000
Amt £1 10 yrs @ 3.998% 1.4800
Inflated ERV £14,800
YP perp @ 8.42% 12.5
PV 10 yrs @ 12% 0.3220
£59,563
£125,000
Table V.
Example 5 Note: Both methods produce the same valuations of £125,000
those presented by Fraser (1993), are not easily adjusted to quarterly in advance Academic papers:
calculations. While they will produce the correct growth rate for an annually in Investment
arrears assumption, they do not produce the correct growth rate for the valuation models
quarterly in advance approach. Accordingly, the formula below, equation (5)
has been derived to allow for ``in advance'' rates.
v
" #
u
u 1 ÿ
1 r ÿ1=p
1 e n
ÿ 1 235
g t
1 en ÿ
n
ÿ1=p
ÿ1
5
1 ÿ
1 e
Where
g = Net average annual growth rate.
e = Equated yield.
n = Interval between rent reviews in years in subject lease.
r = Effective capitalisation rate for incomes in perpetuity where growth and
inflation are implicit in the rate, i.e. all-risk yield adjusted for quarterly
in advance cash flows.
p = Number of payments per annum, e.g. four for quarterly in advance.
Example 5 (Table V) compares a traditional approach to a contemporary short-
cut DCF approach using quarterly in advance formulae. As in Example 4
(Table IV), two terms are used in the short-cut DCF for illustrative purposes.
As shown in Example 5 (Table V), the adjustment of the growth rate
reconciles the approaches. While the validity of using a net average annual
growth rate has been touched on earlier, with rents invariably paid quarterly in
advance in the market, such analysis gives a rate more reflective of reality than
the annually in arrears formulae. Indeed, rental growth forecasts in a
calculation of worth using annually in arrears cash flows would result in an
undervaluation unless the rental growth predictions are adjusted upwards to
reflect the annually in arrears basis of calculation
The formula presented for calculating a growth rate for use in quarterly in
advance cash flows is somewhat more complicated than those used for
annually in arrears cash flows. However, the formula can be simplified if the
annually in arrears (i.e. nominal) all-risk yield is known as shown below,
equation (6).
v
" #
u
u
1 e ÿ 1 n
g t
1 en ÿ k
n
ÿ1
6
p1 ÿ
1 eÿ1=p
Where
g = Net average annual growth rate.
e = Equated yield.
JPIF n = Interval between rent reviews in years in subject lease.
18,2 k = Nominal capitalisation rate for incomes in perpetuity where growth and
inflation are implicit in the rate, i.e. all-risk yield.
p = Number of payments per annum, e.g. four for quarterly in advance.
236 As with annually in arrears formulae calculating the relationship between the
all-risk yield, equated yield and growth rate, other formulae can be derived to
calculate, for instance, the effective all-risk yield, equation (7) and the nominal
all-risk yield, equation (8) as shown below.
" #ÿp
1 en ÿ
1 gn 1 ÿ
1 eÿ1=p
r 1ÿ ÿ1
7
1 en ÿ 1
Where
r = Effective capitalisation rate for incomes in perpetuity where growth and
inflation are implicit in the rate, i.e. all-risk yield adjusted for quarterly
in advance cash flows.
e = Equated yield.
n = Interval between rent reviews in years in subject lease.
g = Net average annual growth rate.
p = Number of payments per annum, e.g. four for quarterly in advance.
" #
1 en ÿ
1 gn 1 ÿ
1 e1=p
kp
8
1 en ÿ 1
Where
k = Nominal capitalisation rate for incomes in perpetuity where growth and
inflation are implicit in the rate, i.e. all-risk yield.
p = Number of payments per annum, e.g. four for quarterly in advance.
e = Equated yield.
n = Interval between rent reviews in years in subject lease.
g = Net average annual growth rate.
It should again be noted that the quarterly in advance formulae presented can
simply be adjusted to reflect other regular patterns of in advance receipts by
changing the number of periods variable.
Conclusion Academic papers:
The underlying purpose of this paper is not to question the theoretical Investment
framework within which valuation takes place. It does, however, attempt to valuation models
identify a real problem that needs to be addressed if the valuation profession is
to move towards valuation calculations based on reality instead of convention.
If the valuation profession takes on board the proposals of the Investment
Property Forum and starts to analyse all transactions on a quarterly in advance 237
basis, the problem of determining the correct quarterly rate, as illustrated, will
not occur.
The arithmetic problem arises because the profession analyses on an
annually in arrears basis, and then takes this information and attempts to
estimate the quarterly equivalents from annual data. The method of calculating
the effective rate by compounding a quarter of the annual rate has been shown
to be flawed. It assumes quarterly in arrears payments. While the error is in
most cases small, it is nevertheless wrong.
One of the principal problems with using annual data to determine the true
equivalent rate for freehold property is that the analysis differs between rack
rented and reversionary properties. For a perpetual valuation (rack-rented)
property is relatively straightforward and can be analysed by the formulae given.
With reversionary properties, the solution varies with the length of the term.
Similarly, the use of a DCF approach (full or modified) requires an analysis
to determine the appropriate equated yield or target rate. The question to be
addressed is whether the market will start benchmarking by reference to the
true equivalent or equated yield respectively. If the market chooses to ``talk'' in
terms of annual in arrears benchmark, then the use of valuation techniques
using quarterly figures will be pure sophistry. The value will be the same
regardless of the technique used. There is a strong argument that the annual
approach should be retained for its simplicity and functionality.
There is no argument that performance measurement should be precise and
reflect the actual cash flow under contract, but pricing models (valuations) do
not have to be so sophisticated. But if the decision is made to value by more
explicit models, it is important that the new models adopted are fully rational
and not half-way attempts to address the perceived shortcoming of using
annual data. This paper may be considered a pedantic exercise, but if the
valuation profession wishes to embrace more explicit pricing models, then
those models should be using inputs that are logical, consistent and reflective
of reality.
Notes
1. It should also be noted that the use of the term ``equivalent yield'' is its correct (property
term) usage as the internal rate of return (IRR) for the property implying growth. The
corresponding term in property for the IRR where growth is allowed for explicity in the
cash flow is the ``Equated yield''.
JPIF 2. The quarterly in advance formula given in Parry's tables:
18,2 YP in perpetuity
1
p1 ÿ
1 rÿ1=p
1 ÿ
1 rÿn
YP for n years
p1 ÿ
1 rÿ1=p
238
Where
r = Effective capitalisation rate for incomes in perpetuity where growth and inflation are
implicit in the rate, i.e. all-risk yield adjusted for quarterly in advance cash flows.
p = Number of payments per annum, e.g. four for quarterly in advance.
3. The authors' analysis concluded that the quarterly in advance Years' Purchase formula
given in Parry's tables are arithmetically correct.
References
Baum, A. and Crosby, N. (1995), Property Investment Appraisal, 2nd ed., Routledge, London.
Bowcock, P. (1978), Property Valuation Tables, Macmillan, London.
Davidson, A. (1989), Parry's Valuation and Investment Tables, 11th ed., Estates Gazette, London.
Fraser, W.D. (1993), Principles of Property Investment and Pricing, Macmillan, London.
French, N. (1996), ``Investment valuations: developments from the Mallinson report'', Journal of
Property Valuation and Investment, Vol. 14 No. 5, pp. 48-58.
MacGregor, B. (1993), ``Risk, diversification and property'', paper presented at the RICS Cutting
Edge Conference.
Mallinson Report (1994), Commercial Property Valuations, Royal Institution of Chartered
Surveyors, London.
Ross Goobey, A. (1997), ``Viewpoint: in favour of a three for all'', Estates Gazette, 7 June, p. 50.
Royal Institution of Chartered Surveyors (1994), The Mallinson Report: Commercial Property
Valuations, RICS, London.