12/04/2022

INCOME METHOD OF
VALUATION
• This is an approach that is used to value income producing properties
such as offices and shopping malls.
• The value of the property is determined by capitalising future cash
flows or rental income into a single market value
• There are two approaches that are used in the investment method of
valuation namely Direct capitalization and discounted cashflow
methods.

The income approach methods are based on three main areas namely:

a. Market rents

b. Operating Costs

c. Yields

1
 12/04/2022

The market Rent

• This is rent that the property will achieve on the market in line with the
given lease conditions.
• The valuer does an assessment of the current rents quoted or paid by the
occupiers and vacancy rates of the comparable property
• This assessment should be carried out in accordance with the IVS/RICS
definition of market rent
• In assessing the rental value of a property, the valuer needs to check the
basis for such calculations before turning to the market for supporting
evidence.
• Detailed analysis of the letting market must precede analysis of a specific
letting.

In every valuation the principal terms and conditions of the lease must be
noted
The following key terms can affect the level of negotiated rent:
a. Total length;
b. Rent reviews and frequency;
c. Payment frequency, e.g. monthly or quarterly in advance;
d. Incentives;
e. Responsibility and liability for repairs, insurance and management;
f. Restrictions on use and opening hours; and
g. The right to assign or sub-let the whole or part
Check RICS IVS 4 for more details on market rent

2
 12/04/2022

Net Operating Income

• All landlord expenses in terms of insurance, management, taxes,

running expenses and repairs deducted from gross rent
• Full Repairing and Insuring (FRI) exclusive of rates. This means the
tenant is responsible for all repairs and insurance of the property and
payment
• Internal repairing and insuring (IRI) lease terms that refers to the
land landlord being responsible for external repairing of the property.

Net Rent
• Net rent is arrived by subtracting operating expenses from the Gross
rent
• The rent can be expressed as Kwacha per Square meter as unit of
comparison if its necessary to do so
• The area of the property used for this stage is the area required to be
used under
• IPMS and or local measurement practices or legal requirements.
• The basis must be consistent within a market to allow for
comparison, which is one of the main forces behind the need for an
international measurement standard

3
 12/04/2022

Years Purchase (YP)

• This is a multiplier or a factor that is used to multiply the net rental

income to come up with the capital value.
• YP considers the duration of the income stream from the subject
property and the yield that achieved after proper analysis of the
comparable (Wyatt, 2013).
• YP represents the duration that the income flow will be received to
recover the present value of the property.
• The YP is the same as the calculation of present value of one kwacha
per annum.
• The multiplier of the annual rental values depends on type of interest
of the property

END OF LECTURE

4
 12/04/2022

All Risk Yield

• The yield applied in income valuation approach is commonly referred
to as the all-risks yield.
• This is the measure of rate of return of a property investment.
• The all-risk yield being reflects all of the risks and prospects of the
investment’s future income flow.
• The traditional income valuation method depends on all risk yield
which is delivered by comparison method on similar property
transactions in the same market.

• All risk yield represents the connection between price and rent paid
for a given similar property to the subject investment property
(Wyatt, 2013).
• When the yield is high, the value of property will be reduced whilst
the opposite is the truth.
• When the property is let at the Market Rent, the ARY will also be the
same as the initial yield

5
 12/04/2022

Other Type of Yields

• Initial yield is the initial income at the date of property purchase
expressed as a percentage of the purchase price including the costs of
purchase.
• In other words, yield delivered in the first year of the investment.
• Example:
• A freehold office property is located in a strong office market in the
Blantyre. The property is let at its market rent of MKW 5,000,000 pa to a
single tenant on a new 10-year full repairing and insuring lease with one
rent review after 5 years and has just been sold to a Icon Properties for
100,000,000. What rate of capitalisation does this transaction represent?

Answer

• Yield = 5,000,000 /100,000,000

• 5%
• Assuming the rent is net rent
• This figure may, for different purposes, be called the initial yield, the
capitalisation rate or the all risks yield (ARY).
• It is the initial yield because in the first year of ownership the buyer,
receiving a net, before tax, income of MKW 5,000,000 on an actual
total purchase price of 100,000,000, enjoys a before tax return in this
period of 5%

6
 12/04/2022

• It is called an all risks yield because as a single figure it reflects all

the upside and downside risks of this investment.

• Reversionary yield thus the income on reversion from a property

expressed as a percentage of the purchase price.
• Reversion investment thus where the property is let at below or more
the current market rents
• The equivalent yield is derived from analysis of the Market Value
of an over rented or reversionary (under rented) property and other
items as voids and expenditures.

7
 12/04/2022

• The discount rate applied to the cash flows so that the capitalised sum
of all the incomes discounted at this rate equals the capital outlay and
• All rents, now or in the future at review, lease renewal or reletting
are taken at present values current at the date of valuation.
• To calculate the equivalent yield received on an investment requires
interpolation of the discounted cash flow gross present value to find
the internal rate of return (IRR)

Traditional Method: Direct Capitalization

• The value of the property is calculated by multiplying annual rental

income from the property by a multiplier (years purchase)
• The multiplier is calculated with the use of appropriate All risk yield .
• This method is categorised as a growth- implicit method because of its
failure to project cash flows beyond market rent or contract rent
• This approach is based on the principle of anticipation where the
value of the property depends on the expected future cashflow from
the property.
• Investment property may be either under freehold or leasehold.

8
 12/04/2022

Valuation of Freehold Interest When Market

Rent is Paid

• The freehold subject property is the property whose ownership is held in

perpetuity or infinity and no fees are paid for ownership
• The freehold property may be owner occupied or leased to other people as
tenants for a fee on a given period of time.
• The freehold investment method is calculated as: net income multiply by a
single rate year purchase equal to the capital value of the investment property.
• The net income is the rental income paid by a tenant on a given lease under full
repairing and insurance
• Or income after deducting outgoings where the owner holds this responsibility.

• If the property rented, the net income may be current rent received
from tenant which is equal to current market rent thus rack rented
property.
• If the property is owner occupied, the net income may be taken from
similar properties on the market assuming that the property is let out
on the market.

9
 12/04/2022

Example One: What is the capital value of a freehold warehouse with

market annual net rent of MKW 1,000,000.00 at FRI. All risk yield from
similar properties at 10%.

• Years Purchase: 1/I where I = 10%

• YP in perp: 1/0.1 = 10

• Capital Value: 10 X 1,000,000.00 = MKW 10,000,000.00

• In this valuation, there is no need to deduct expenses from the market rent
because all expenses are paid by the tenant.

Example Two: Value a freehold interest in a single office property with

100 m2 IPMS3 let at market MKW 5000 per m2 per month based on
IPMS3 on IRI lease terms for 20 years. The property is located at
Ginnery Corner in Blantyre city. The recent similar properties show 8%
yield. The external repairs are estimated at 10% of annual rental value.

10
 12/04/2022

• Annual Market Rent (Kwacha): 5000 X 100 X 12

• 6,000,000

• Expenses

• External Repairs (Kwacha): 10% X 6,000,000

• 600,000

• Net Market Rent 5,400,000

• YP in perp = 1/0.08 12.5

• Market Value MKW 67,500,000.00

• The above examples show that the lease is granted for occupation and
the lessee (tenant) pays the full market rent to the lessor (landlord)
and there is no ‘profit’ and the lease by itself has no value on the
market.

11
 12/04/2022

Valuation of Freehold Interest when Let at

Below Market Rent (Term and Reversionary)

• There is a scenario where the current rent paid on a lease is below current
market rent
• because it was agreed some time ago when the lease started for a fixed period
or
• because the tenant paid a fixed some for the landlord to reduce the rental
fees.
• In this case it is hard to apply previous methods
• because it known that the rent will revert / rise to normal market level at the
end of the lease period or date of rent review

• In this case, the valuer adopts term and reversion method

• The time for which the rent is fixed is known as a term.
• For example, a freeholder may receive MKW 500,000.00 per annum
fixed rent for a two-year period whilst the Annual Market Rent is
MKW 750,000.00. The market yield from the market is 12%. At the
end of the year two the rent will be revised to normal rent on rental
review date.
• In this case it is unknown what will be the Market rent at the end of
year two but the current rent is above the contract rent.

12
 12/04/2022

• In this scenario, the valuer first value the term of the for which the
freeholder will receive the fixed amount.
• Selection of appropriate yield is vital.
• Yields that are based on annual market rent are commonly available
on the market hence hard to apply to reduced rents of the subject
property.
• Where the rents below the market rent, the valuer has to analyse if
the reduced rent add quality and attractiveness to the investment.

• The valuer has to also analyse if current tenant is financially strong

to show consistency in the payment of the rents.
• The applied market yield may be reduced if the above-mentioned
analysis is positive in a reduced rent to reflect high quality of the
investment.
• The valuation of the reduced rent from above mentioned example is as
follows

13
 12/04/2022

• Reduced Annual rent (Kwacha): 500,000.00

• YP for two-year term: PV MKW1per annum @ 12% for 2 years

• (1-PV)/I

• (1-(1.12-2))/0.12: 1.6901
845,050.00

• The time after the term is commonly called reversion.

• This is when the rent is revised to market rent.
• The valuer adopts the current rent at reversion because it shows that
at least the property will achieve a minimum of the existing rent with
the recognition that the applied yield will reflect the future rental
changes

14
 12/04/2022

• Therefore, the rent receivable at reversion in our example will be

MKW 750,000.00 at 12% in perpetuity. The calculation is done as
follows:

• Rent on Reversion (Kwacha): 750,000.00

• YP in perp @ 12%: PV MKW1 per annum in perp @12%

• 1/i: 1/0.12 8.3333

•
6,249,975

• However, the reversion will be done in two years’ time but the investor
will need the value now.
• This requires the valuer to discount the value to present time thus
multiplying with Present value of MKW1.

6,249,975

PV MKW1: (1+12)-2 0.7972

4,982,480.07

15
 12/04/2022

• Therefore, the value of the freehold interest on term and reversion is

the sum of term and reversion values.
• In this case it is:
• Market value 845,050.00 + 4,982,480.07 = 5,827,530.07

Calculation in Summary

Term

Reduced Annual rent (Kwacha): 500,000.00

YP for two-years @ 12%: 1.6901

845,050.00
Reversion

Market Rent 750,000.00

YP in Perp Deferred 2 years @12% 6.6432

4,982,400.00

Market Value 5,827,450.00

16
 12/04/2022

• Alternative method to find the YP in perpetuity differed to present

value
• Can be found by subtracting YP in perp with PV MKW1 per annum
for the term. ‘
• In this case, it will be: 8.3333 minus 1.6901 thus 6.6432. Then we
multiply this factor with the market rent thus
• 750,000 X 6.6432 = 4,982,400.00.
• There is a slight different due to error of rounding the figures.

CLASS EXERCISE

• A freehold property has just been let to a tenant with the first two years rent-
free and with market rent payable thereafter. The building has a floor area of
750 square metres and current market rents for similar properties are 5000 per
square metre per month. Allowing for an all risks yield of 6.2 per cent, what is
the present value of this freehold?

17
 12/04/2022

Valuation of Freehold Interest when Let at Below Market

Rent (Hardcore or Layer Method)

• This is another method to term and reversion approach of freehold interest

valuation method.
• The reduced rent is valued with YP in perpetuity with a market yield
• The difference between market and reduced rent is valued in perpetuity
and differed for the term of the term of the reduced rent.
• The sum of the capitalised hardcore and top slice incomes provides the
assessment of market value.

• The difference of the rents is commonly called top slice or top layer whilst
• The first capitalization of reduced rent is called hardcore or bottom slice or
layer.
• This method is taken as more modern than term and reversion approach
and it is applied by most valuers because
• it is simple to calculate (Blackledge, 2016).

18
 12/04/2022

EXAMPLE

Hardcore/Bottom Layer

Reduced Rent: 500,000.00

YP in perp at 12% 8.3333

4,166,650.00

Top Slice/Layer

Difference 250,000.00

YP in Perp Deferred 2 years @12% 6.6432

1,660,800.00

Market Value 5,827,450.00

Valuation of Freehold Interest when Let at Below Market

Rent (Deductive Method)

• This is applied by some valuers where the property with reduced rent is
taken as the same as the property with market rent
• but the subject property experience loss of income over the term of the
reduced fixed rent.
• The valuer capitalizes the market rent in perpetuity and then deduct the
present value of the rent that will not be received over the term (Shapiro,
Mackmin, & Sams, 2019).
• Using our example, this can be calculated as follows:

19
 12/04/2022

Market Rent: 750,000.00

YP in perp at 12% 8.3333

6,249,975.00

Income lost over the term 250,000.00

YP for two-year term 1.6901

422,525

Market Value 5,27,450.00

CLASS WORK

• Apply hardcore/ top slice method on previous class exercise

• Apply deductive method on previous class exercise

20
 12/04/2022

Valuation of Freehold Interest when Let at More than

Market Rent

• There is where the current rent paid on a lease is more than current
market rent
• This is because it was agreed some time ago when the lease started for a
fixed period or
• there was high demand for the property and the tenants outbid the
market to high the rental fees
• This case is about valuation of overrented property.
• In over case the tenant might pay more because of the falling market
such as the effects of COVID-19 to the market.
• The tenant will likely suffer rent loss.

• The valuation approach for this case is that the market rent is valued
in perpetuity at all risk yield.
• Thereafter, the excess rent is capitalized for term till the rent is
renegotiated to much the market rent at a yield to reflect the risk
attached to it
• The summation of the two values equal to the market value
• The term period is based on the consideration of the rent review, the
remaining lease period and any break clause if available in the lease
covenants.

21
 12/04/2022

• Value the freehold industrial property located in Maone industrial site,

Blantyre. The property is let at MKW 450,000.00 per month on FRI. The
current market rent for similar properties in the location is MKW 400,000.00
per month. The rent is upward only reviewed to reflect market conditions
and the lease will elapse in 5years time. ARY for comparable properties at
10%.

Annual Market Rent (Kwacha): 4,800,000.00

YP in perp at 10%: 10

48,000,000.00

Excess Annual Rent: 600,000.00

YP in 5 years @10% 3.7908

2,274,480.00

MK50,274,480.00

22
 12/04/2022

• In this calculation, there is double counting where ARY reflect future

rental growth and excess rent will be valued twice.
• Shapiro, Mackmin, & Sams, (2019) argue that using DCF is more
accurate to value over-rented properties where projecting changes in
MR will identify when, in the future, MR might exceed rent reserved
and thereby avoid double counting.

Valuation of Leasehold Interest

• Leasehold is the interest in which a landlord or freeholder grant a

lease to a tenant for a given period of time for a specific consideration
• This shows that is limited time given to the tenant and the tenant pay
rent on the given rights occupy the property for different purposes
• Leasehold interest is deemed to have value when:
• The terms of the lease is assignable and allows the tenant to earn a
profit rent from subletting and enjoying notional profit rent (Baum,
Mackmin, & Nunnington, 2017).

23
 12/04/2022

• The tenant can sublet the premises by offering a sublease to a new

tenant for a term equal or less than the lease with the landlord.
• In this scenario, the tenant is head-lessee
• whilst the new tenant is the sub-lessee.
• The sublessee pays sub-rent to head-lessee whilst
• The head-lessee pays heard rent to the landlord.

• Assigning the leasehold interest, the tenant will transfer all rights to
the property to the assignee (incoming tenant) for the full remaining
term of years.
• The head-lessee is responsible to the landlord
• There are two recognized leaseholds investments namely short term
and long-term leaseholds.
• Sayce, Smith, Cooper, & Venmore-Rowland, (2006) state that the long
term leasehold are originated from ground lease on which the land
has been leased from the government.

24
 12/04/2022

• In Malawi, the long term land leasehold period is 99 years leased to a

leaseholder to construct a property on the land and
• thereafter, the leaseholder may occupy or let out the property as an
investment.
• The leaseholder pays ground rent to the landlord till the end of the
lease.

• For example, an individual will be given a 99 year lease by the

Ministry of land (as landlord) to construct a commercial property. The
ministry of lands collects a fixed ground rent from this leaseholder
over the 99 year period on land only.
• The leaseholder will construct the property and let out to other tenant
who will pay rent over the period of the lease.

25
 12/04/2022

• The short period leasehold term is the standard long term leaseholds
and created by subletting to new tenants by the head-tenant ( Sayce,
Smith, Cooper, & Venmore-Rowland, 2006).
• Profit Rent: is achieved when the rent paid by the tenant to the
landlord is below what the sublessee pays to the tenant or when the
rent paid by the lessee is less than market rent over a given term
• The profit rent applicable for valuation must be net of outgoing in
case the head-tenant is responsible for all outgoing i.e., if the lease is
on FRI (Blackledge, 2016).

Types of Profit Rents

1. Fixed Profit Rent

• This is profit that are achieved where the head-rent and sub-rent has
the same lease expiry date and no rent reviews are applicable to
either head-rent or sub-lease.
• In this case, the profit rent might increase as the tenants may enjoy
lower rents where the market rents have increased over the lease
period.
• For example, a freeholder may offer a leasehold for 20 years to a
prospective tenant (head-tenant) at 1 million per year then at the
same time the head-tenant may offer 20 years lease to a sub-tenant at
1.2 million without review.

26
 12/04/2022

2. Variable Profit Rent

• This is where the head-rent and sub-rents differ in their respective
lease periods or both have lease review periods at different dates.
• It may also happen because the head-rent has fixed rent while the
sub-rent has rental review over a given lease period (Wyatt, 2013;
Sayce, Smith, Cooper, & Venmore-Rowland, 2006).

• For example, a freeholder may offer a leasehold for 20 years to a prospective

tenant (head-tenant) at 1 million kwacha per year with 5-year rent review then
at the same time the head-tenant may offer 10 years lease to a sub-tenant at
1.2 million kwacha per year with 2-year review. A head tenant may secure 99-
year leasehold from the ministry of land at fixed ground rent and then develop
the site, let out to another tenant at rent more than the fixed ground rent.

27
 12/04/2022

• Shapiro, Mackmin, & Sams, (2019) state that before valuation of

leasehold interest, the valuer should ensure checking of the following:
a. There are no lease terms that are or don’t permit assignment of the
lease.
b. Where lease terms that are permit assignment of the lease, they
must be expressed in terms such as “not to assign without the
landlord’s consent which shall not be unreasonably withheld”
c. The profit rent is based on the same terms of the head lease and sub-
lease.

Valuation Approaches for Leasehold Valuation

• There two main income approaches that are applicable in leasehold

investment valuation namely:
• Direct capitalization with ARY where the leases are not complicated
whilst
DCF is applicable where the leases are complicated ( Sayce, Smith,
Cooper, & Venmore-Rowland, 2006).
• Application of DC refers to the multiplication of net profit with
appropriate years purchase to find the capital value of the lease.
• The capital value represents the value the head-tenant will seek if he/she
was wanted to sell the current lease to another sub-tenant (Blackledge,
2016)

28
 12/04/2022

Valuation of Leasehold Interest using Single Rate

Approach

• This is modern way of valuing leasehold interest where a single ARY

is used to capitalize profit rent to find out the capital value of a lease.
• An example for this approach is as follows:
• An office property is under leasehold interest for 10 years at annual
rent of 4 million kwacha. The market rent of the subject property is
4.5 million kwacha. The similar properties lease at sold at 8% ARY.
The head-tenant has permission to sublet the property. Value the
leasehold interest for this subject property.

Example One

Market Rent (Kwacha): 4,500,000

Less

Rent Paid: 4,000,000

Net Profit Rent: 500,000

YP in 10yrs @8%: 6.7101

Market Value 3,355,050.00

29
 12/04/2022

• Assuming, the head-lessee sublet the subject property for 10 years

without rent review at Market Rent.
• The same approach will be applied and the answer will be the same.
• If the variable profit rent is applicable, it means the head-rent has
review period that is different from the review period of the sub-rent.
• In this case, we apply Term and Revision Method to value the
leasehold interest.

• For example,
• An office property remaining leasehold interest period is 8 years at
annual ground rent of 25,000 kwacha with 8-year rent review. The
property current sub-let at 4.5 million per year with 4-year rent
review. The current market rent of the subject property is 5 million
kwachas. The similar properties lease at sold at 8% ARY. The head-
tenant has permission to sublet the property. Value the leasehold
interest for this subject property.

30
 12/04/2022

Term of the current sub lease

Rent 4,500,000

Ground Rent 25,000

Profit Rent 4,475,000

YP in 5years 3.3121

14,821,647.50

Reversion

Rent 5,000,000

Ground Rent 25,000

Profit Rent 4,975,000

YP in 5years @ 8% 3.3121

Deferred @ 8% 0.7350

2.4344

12,111,140.00

Market Value 26,932,787.50

CLASS WORK

31