Have long-term low prevailing interest rates caused a shift in the way that residential investment portfolios are valued by investors? In the Sixth Edition of Valuation: Principals into Practice, the view of Eric Shapiro is that “the maximum value which can be placed on a property let on an Assured Shorthold Tenancy should be 90-95 per cent of its vacant possession value.” However it goes on to say that, “if it is the buyer’s intention to continue letting the property, 100 per cent of the VP value will be achievable.” Residential investment portfolios are evidently being bought for continued letting so why do valuers, myself included, feel it appropriate to apply a discount from aggregate vacant possession value?
NEW BUILD DISCOUNTS
It is standard practice for investor purchasers to seek a discount for bulk purchases of new build stock. From the developer/vendor’s point of view they are able to sell a number of units in one transaction, saving on time and holding costs whilst still presumably making a decent margin on the development. From the buyer’s point of view, given their bulk buying purchasing power, they expect to pay less than the aggregate of the individual Market Values of the units.
PORTFOLIOS -v- PIECEMEAL
There are many advantages for an investor buying a let portfolio of properties. Most obviously on the date of purchase the portfolio is income producing, there are no initial void periods and assuming that the properties are let to good professional covenants there should be few issues with rent collection. Also, buying a portfolio of properties is less time intensive and difficult than building a portfolio; there is no need to go through numerous negotiations in purchasing each unit individually. More than likely this single negotiation will be with another investor who is likely to be easier and more rational to deal with than a single owner-occupier. There are also savings on the professional fees associated with buying a portfolio rather than individual units; legal and valuation fees will be significantly reduced for example.
So is it still appropriate to apply a discount for a portfolio of let properties being purchased as an ongoing investment? Should this differ from the usual ‘bulk buying’ scenario?
Eric Shapiro’s view is that if it is the buyer’s intention to continue to let the property then no discount should be applied to the vacant possession value. I would agree with this, so there is no discount to be made in this regard because the properties are evidently being bought for continued letting. Therefore, the only reason to apply a discount would be because of the ‘bulk buy’ nature of the purchase, and most valuers when looking at such a portfolio would see fit to apply a discount. However as stated there are significant advantages to buying a bulk, already let, portfolio rather than building a portfolio on a piecemeal basis.
Where a well managed portfolio of say 14 units in a ‘new build’ 5-year-old block let to professional covenants is sold, at the current time investors might not consider paying 100 per cent of aggregate Market Value a bad deal. There will be no initial void periods and given the low prevailing interest rates and potential also for capital growth, on the surface it appears like a reasonable investment.
Hamptons recently valued such a residential investment portfolio of 14 units in a good north London location close to the Emirates Stadium. The units were within a development completed around three years ago, a mixture of new build and units within the conversion of a period building. The units were completed to a good specification and strongly appeal to professional tenants given the proximity to the London Underground station.
The gross rental income showed a yield across the portfolio of 4.8 per cent against the aggregate Market Values of the units, assessed by Hamptons from analysing comparable sales within the same development and other similar such developments. Even if you allow a gross to net adjustment of 75 per cent, this still gives a net yield of 3.6 per cent. This return is better than one would currently find in all but the most high interest savings accounts and also gives the possibility of capital growth.
To discount the aggregate Market Value of the units by, say, 10 per cent to allow for the bulk nature of the purchase gives a gross yield on the passing rent of over five per cent. In the prevailing economic climate, securing a gross income of over five per cent would be considered an excellent return and there would be plenty of investors in the market place who would be willing to buy at a lower gross yield than this.
RESIDENTIAL AS AN INVESTMENT CLASS
There are evidently numerous places to invest, residential property is just one option. To compare different asset classes it is necessary to compare the yields and IRRs returned on residential property versus other assets. It might be that an investor is willing to invest in residential property at a yield lower than the prevailing yield on the portfolio as mentioned above. Therefore, given that the passing rent is relatively stable, they might pay more than the capital value assessed using the comparable method of valuation, even without making any ‘bulk’ discount to the aggregate Market Values of the individual units. Unlike commercial property, standard residential property is not normally valued on a yield basis. However in the US residential investment portfolios are regularly traded, and valued for purchase in this way. It is simply an investment medium to be compared against others, and if investors look at residential property in this way, why can it not be valued in this way?
Should we apply a discount for a let portfolio being purchased as an ongoing investment?
Were we to be instructed to value the portfolio for loan security in our example, and the investor was paying more than the comparable method of valuation indicated the values, this would create a problem given this is the accepted method of valuation. However for the investor, he is buying an income stream at a yield that suits his investment horizon, why should the capital value not be driven by the rental income and yield?
VALUER VS INVESTOR METHODOLOGIES
I am not going as far as to suggest that residential should be valued on an income and yield basis like commercial property, however when a portfolio of residential property is sold this will be the way that investors look at the opportunity. The RICS definition of Market Value is, “The estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently and without compulsion.”
The investor in our example is a willing buyer and is acting knowledgeably and without compulsion, the portfolio is being properly sold and the vendor is happy, so why does this yield-driven value in excess of the comparable-driven value not represent Market Value? The RICS definition asks the valuer to represent the thought process of players in ‘the market’, if investors are assessing the value in this way, why should the valuer not.
WHEN THE NUMBERS DON’T WORK
A similar scenario was a site being sold with detailed planning consent for a multi-unit house scheme, was under offer at £9.3m. We were informed by the selling agents that other offers were received at £9m and £9.15m, and were provided with written evidence to this effect. Analysing the site with the traditional residual methodology, we worked back from a Gross Development Value and assessed through comparable evidence with a fixed Profit on Cost only produced a site value of circa £7.5m. However it is hard to argue against the Market Value of the site being £9.3m. The developers submitting bids on the site were building in capital growth of the Gross Development Value in the timeline of the project- where the problem of Value versus Worth emerges.
So should we be analysing portfolios on a rental income and yield basis, and should let and income producing portfolios be discounted to take account of the bulk nature of the purchase? It is tempting to suggest that mirroring investor’s methodology to assess how much they are willing to spend on portfolios should be taken into account. I think that the most sensible way forward is to have regard to both the investment methodology and the comparable methodology and cross-reference one with the other. I consider that the predominant methodology should still be the comparable method, after all the underlying assets are still individual residential units whose values need to assessed with regard to sales of other similar units, regardless of the level of rental being achieved. Residential Assured Shorthold Tenancies are also much shorter in length than commercial leases and upward only rent reviews evidently do not exist in the residential rental market. The residential rental market can therefore be quite volatile and this would lead to large and fast fluctuations in portfolio capital values not mirrored by fluctuations in the normal sales market. I would also add that these arguments hold more water in higher value areas, with less management intensive portfolios such as the example quoted.
I do not however consider that a bulk discount should be automatically applied to let residential portfolios, just because this is the accepted wisdom.
Jonathan Godfrey is Head of Valuation at Hamptons International.