The valuation of leasehold property 2

Citation

French, N. (2010), "The valuation of leasehold property 2", Journal of Property Investment & Finance, Vol. 28 No. 1. https://doi.org/10.1108/jpif.2010.11228aab.001

The valuation of leasehold property 2

Article Type: Education briefing From: Journal of Property Investment & Finance, Volume 28, Issue 1

Introduction

In the last education briefing we looked at the valuation of leaseholds by discounted cash flow (DCF). The advantage of the DCF basis is that the target rate of the leasehold investment can be determined by reference to the stock market with a relevant risk adjustment for the additional risk of the property investment. Thus it is possible to “value” such property investments when there is little or no evidence of recent sales.

It was also noted that in certain circumstances, traditional methods have been proved to under-value investments by failing to address the fundamental elements of the cash flow being purchased such as gearing.

Comparison with freehold investments

Whilst the cash flow from a leasehold interest is underpinned by the property itself, there is a major difference with the corresponding freehold interest and that is that the net income stream of the leasehold is finite.

There are also other differences between freeholds and leaseholds:

• •

  Gearing (see “The valuation of leasehold property” in the previous briefing).

• •

  Top slice risk – (at worst there can be a negative cash flow if the occupational tenant stops paying and the head rent continues).

• •

  Onerous repairing covenants – (normally passed on to the occupational tenant).

• •

  “Saw tooth” income flows in some instances.

A DCF approach can easily be adapted to reflect the complexity and risks of any cash flow. Yet, these differences were often overlooked by valuers historically and the “traditional” method simply valued the profit rent on the basis that it was finite and fixed.

Traditional methods

The valuation of leaseholds has traditionally been seen as a sub-set of freehold valuations. The traditional dual rate valuation (see below) is intrinsically tied with the freehold. To understand the shortcomings of the dual rate, tax adjusted valuation; it is useful to appreciate the origins of the methodology and to see its development in the context of the property market at the turn of the century. At that time, in the UK, there was little difference between a freehold interest in land for sale with vacant possession and a corresponding leasehold interest on a long lease (99 or 999 year term). There was little or no (perceived) inflation and hence there was a positive yield gap. Government stock was yielding 3-4 percent, freehold property 4-5 percent to account for addition risk with leaseholds commanding a further 1 percent above the freehold rate.

There was a clear recognisable relationship between freeholds and leaseholds and it was therefore appropriate that comparisons should be made between the two. However, the fundamental difference between leaseholds and freeholds had to be addressed and that was the finite nature of the leasehold.

A freehold interest is perpetual. That is to say, it can be sold at any time to recoup CAPITAL invested. As such, all the income from a freehold investment represents the return on capital (the yield).

A leasehold interest, however, is finite, and as such is a wasting asset. At the end of the lease, the profit rent will disappear and the investment is worthless. The Investor must, therefore, recoup the capital during the lifetime of the investment.

The income from the leasehold, therefore, represents the return on capital and the return of capital to recoup the original outlay. It was argued that to guarantee recoupment of capital, the valuation must be adjusted to allow for taxation. Thus in theory the use of a sinking fund converts a wasting asset into the equivalent of a freehold investment, where the income is perpetual and its capital value does not depreciate.

In 1930, this was a logical and realistic method; remunerative rates were 1-2 percent above the appropriate freehold rate; capital would be recouped by reinvesting in a sinking fund at a low, safe rate; sinking fund policies at 2-3 percent were common in 1930 and provided reasonable returns in relation to other yields at the time; recoupment of historic cost was sufficient to perpetuate leasehold ownership. The traditional method therefore, values the interest on the basis of using three factors; a remunerative rate (in our example 8 percent gross of tax), an accumulative rate (sinking fund rate of 3 percent net of tax) and a mathematical adjustment that allows for tax on the investment (in our example at 40 percent). This is illustrated in Table I.

The formula for the Dual Rate is:

where:

i; =8 percent (remunerative rate);;a; =3 percent (accumulative rate); and;t; =40 percent (tax rate).

In this method it should be noted that the 8 per cent capitalisation or remunerative rate would normally be derived from sales of comparable freehold properties and adjusted upwards (by 1-2 percent) to account for extra risk. The accumulative rate of 3 per cent is supposed to represent the net-of-tax return available on a guaranteed sinking fund policy taken out with an assurance company, being absolutely safe. The tax adjustment of 40 per cent counters the fact that any tax-paying purchaser of the investment would lose a portion of his profit rent in tax. While the effect on the remunerative rate or yield is not regarded as important (all, or most, investment opportunities are quoted on a gross-of-tax basis) its effect on the sinking fund payment is vital. Without adjustment, the sinking fund would become inadequate as a result of income tax reducing the whole profit rent. As it has to accurately recoup capital, a “grossing up” factor is applied to cancel out the effect of tax: this grossing-up factor (in this case 1/1 – 0.4) is the tax adjustment. A “true net” valuation (using a net profit rent, a net remunerative rate and no tax adjustment) would produce an identical result (see Table II).

Criticisms of dual rate valuations

With leasehold interest, the resale price becomes lower over time, and this part of the annual income represents the initial sum invested being returned to the investor in stages.

As the return on capital provides the most convenient means of comparison between investments, leasehold interests are traditionally valued dual rate to separate the return on and return of capital, which accrue to the investor as income.

Criticisms

Severe criticisms have been made of the dual rate approach:

• •

  Do investors actually take out sinking fund policies with insurance companies?

• •

  If the investor has to borrow money to finance the investment, he will pay off the loan first (at say 12 percent interest) rather than invest in a sinking fund.

• •

  The vast majority of investors in leasehold interests invest in more than one unit. The large investor may receive enough income in any one year to purchase another leasehold investment.

• •

  When a leasehold interest produces a varying profit rent, a mathematical error is produced by a dual rate valuation.

• •

  The sinking fund only replaces the initial capital outlay.

• •

  The combination of the variables (the remunerative rate, accumulative rate and tax rate) and the subjective adjustment thereof makes a full analysis of transactions difficult.

Traditional alternatives to dual rate, tax-adjusted valuations

A number of different approaches have been suggested to overcome the above criticisms.

Dual rate, unadjusted for tax (not illustrated here)

In this method the end effect is that a slightly higher net accumulative rate is used here to allow what might be seen as more realistic valuations to be made. It is significant that the 1978 (10th) edition of Parry’s Valuation Tables includes dual rate tables with 4 per cent accumulative rates for the first time. It is interesting to note, however, that, if this technique is designed for the gross fund, the gross rate of sinking fund accumulation – 4 per cent – is actually lower than the equivalent rate in the previous example (3 per cent net at 40 per cent tax is equal to 5 per cent gross). A tax adjustment is superfluous in this case as the income of a gross fund is not reduced by tax. If this, however, represented a market valuation, any bidding taxpayer would have to accept a very low yield in order to compete while allowing for recoupment of capital.

Single rate (not illustrated here)

The valuation of a leasehold interest on a single rate basis is not substantially different from the dual rate approach. A sinking fund is still allowed for within the valuation although this is at a yield that equates with the rate of return required from the investment. The major justification for using the same rate for the sinking fund is that many investment institutions will reinvest the proceeds in similar investments and thus secure rolling recoupment at the same yield.

Single rate net of tax

The single rate valuation in Table III would be for a gross fund, if the potential purchaser is a tax payer, then a net of tax valuation is required. It should be noted that the single rate net of tax valuation produces a similar answer to the traditional dual rate tax adjusted valuation.

Criticisms of traditional alternatives

In varying degrees the above alternative methods counter some of the criticisms levelled against the dual rate tax adjusted method. The accumulative rate is no longer critically low; the single rate approaches assume reinvestment at the remunerative rate. However, on further investigation a fundamental problem remains which relates to all conventional leasehold valuations. As previously noted, the remunerative or capitalisation rate (k) is derived directly from evidence of sales of similar freehold properties, adjusted for risk. The assumption is that the level of rental growth enjoyed by the owner of the freehold interest as implied by k must be exactly the same in the case of the comparable leasehold. Any adjustment of k is to account for risk, and not growth, differential.

There is nothing inherently wrong with the use of initial yields or capitalisation rates to imply rental growth. But for two reasons the capitalisation rate k (or k+1, or k+2) is likely to be incorrectly applied in the case of leaseholds because:

1. 1.

   Leaseholds produce complex rental growth. Rental growth depends upon the relationship of head lease and sub-lease. Where the term or review dates do not coincide, the profit rental pattern can be complex and unrelated to the growth potential in a freehold.

2. 2.

   The sensitivity of the top slice leasehold income can be expressed in another way by leverage or gearing. Small changes in full rental value will produce geared, exaggerated changes in profit rent in the same way that equity increases at a faster rate than the capital value of a partially loan-financed asset.

This complex gearing effect is certainly not accurately reflected by the use of a k-based rate derived from freehold analysis and implying a constant percentage increase in income. As the term goes on, the fixed head rent takes up an increasingly less significant part of the rental value, so that the profit rent growth tends towards freehold growth; but in the early years, more dramatic growth is enjoyed, and the use of k is inappropriate. For the above reasons, single rate valuations are little improvement on the dual rate approach. A defensible, modern approach to the valuation of leaseholds should be capable of addressing the problems related not only to the sinking fund but also to gearing and other fluctuations in the profit rental pattern. A DCF approach, discussed in the previous briefing, is suggested as the most appropriate valuation method.

Nick French