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Chapter 04
Chapter 04
Time
compounding
discounting
Value
Compounding...
• Calculating the interest that would be earned by the original capital
and adding interest each year
• Thus, the size of the future sum is determined by a combination of the
compound rate (i.e. the rate at which the original sum could earn
interest) and the deferment period (the delay in payment)
10%
£ 5%
0 1 2 3
YEARS
Discounting...
• Discounting is the opposite of compounding and is a basic concept
underpinning valuation
£5,000
£ ??
time
now 1 year
Single sum payments
(the return is assumed to accrue in arrears in the following formulae)
FV 1 r PV
n
• Future value, FV:
FV
• Present value, PV: PV FV (1 r ) n
1 r n
where:
– n is the number of time periods over which the investment is
held
– r is the rate of return
– PV is the present value of the investment
– FV is the future value if the investment after n periods
Multi-sum payments
• As well as discounting individual sums, we can discount a series of
future sums (an annuity)
• This forms the basis of property valuation since a property bought as
an investment will produce a series of rental incomes and the sum
paid will reflect the amount and timing of these rents
Level annuities (in arrears) where PMT is the regular payment
FV PMT
1 r 1
n
r
r
PMT FV
1 r n 1 also known as a sinking fund
Time
• So, in valuation terms, it is the rents receivable in the early years that
primarily dictate the overall value of the interest unless for some
reason there is a substantial reversionary value expected e.g. when a
landlord is able to regain possession after a long lease and perhaps
redevelop the property
• The discount rate is crucial too: the five incomes above discounted at
9% pa would have had a capital value of £21,198
• In selecting the appropriate discount rate a valuer must be mindful of
all of the following factors:
– type of property
– status of the tenant
– nature of the lease (particularly the rent review)
– yield on alternative investments
– anticipated rental growth
– when income is first received & frequency
YIELDS
(Present) values and yields
• As n gets bigger the PV of a level annuity (also known as the YP or PV
of £1 per annum) simplifies to 1/r
• When looking at property investment transactions that have recently
taken place in the market it is possible to substitute r to identify the
market rate of return, known as the yield y given a price P. The
equation remains the same but the notation changes:
1 MR
P or P for any market rent
y y (MR) other that £1
Yields
• A yield is the relationship between how much money is put in to an
investment (initial cost and subsequent expenditure) relative to how
much comes out (income and eventual sale price)
• The yield is a reflection of the attractiveness or risk attached to an
investment
• All investors like to receive the highest possible yield compatible with
the perceived risk.
• Yields are the main yardstick of property performance
• Investing institutions make buying/selling decisions on the basis of
yields rather than cost
• The effect of market forces results in popular properties having lower
initial yields than others
Simple investment analysis: yields
• By rearranging the previous equation, we can isolate y:
MR
y
P
Example
9,000m2 office block in central Bristol
Market rent is £250/m2
What is the rental value?
If investors require a return (or yield) of 8%
What is the capital value?
What if investors require a yield of
6%, 7%, 9%...?
What do you observe?
• An inverse relationship
• As yields increase values fall
• As yields decrease values rise
• Small changes in yield create large changes in value
• How does this impact land value?