The Income Approach

to Property Valuation
Sixth Edition

The Income
Approach to
Property
Valuation
Andrew Baum, David Mackmin
and Nick Nunnington
First published 2011 by Estates Gazette

Published 2014 by Routledge

2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN
711 Third Avenue, New York, NY 10017, USA

Routledge is an imprint of the Taylor & Francis Group, an informa business

Copyright © 2011, Andrew Baum, David Mackmin and Nick Nunnington. The copyright of Chapter
11 is retained by Howard Day.

The rights of Andrew Baum, David Mackmin and Nick Nunnington to be identified as the authors of
this work have been asserted in accordance with the UK Copyright, Designs and Patents Act 1988.

All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any
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publishers.

Notices
Knowledge and best practice in this field are constantly changing. As new research and experience
broaden our understanding, changes in research methods, professional practices, or medical treatment
may become necessary.

To the fullest extent of the law, neither the Publisher nor the authors, contributors, or editors, assume
any liability for any injury and/or damage to persons or property as a matter of products liability,
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British Library Cataloguing-in-Publication Data: 332.6′324′0941-dc22

Library of Congress Cataloging-in-Publication Data: 2011920620

ISBN: 978-0-08-096690-8 (pbk)

 Contents
Preface to the Sixth edition xi
Acknowledgements xiii
1. Introduction and Quick start to the Income Approach 1
Introduction 1
The income approach – a quick start 5
2. Financial Mathematics for Valuers 11
Introduction 11
The six functions of £1 11
The amount of £1(A) 12
The amount of £1 per annum (A £1 pa) 13
Annual sinking fund 15
The present value of £1 (PV £1) 16
The PV of £1 pa (PV £1 pa or Years’ Purchase) 17
Present Value of £1 pa in perpetuity deferred n years 
(PV £1 pa in perp defd or YP of a reversion to perpetuity) 20
PV of £1 pa dual rate (YP dual rate) 22
Annuity £1 will purchase (A £1 wp) 24
Mortgages 29
The Interrelationship of the functions 31
Properties of exponents 32
Nominal and effective rates of interest 33
Continuous compounding 35
Incomes in advance and non-annual incomes 36
Incomes receivable quarterly or monthly in advance 37
Health warning 38
Summary 38
Spreadsheet user 40
Project 1 40
Project 2 41

3. Discounted Cash Flow (DCF) 43

Introduction 43
Net Present Value (NPV) 43
Internal Rate of Return (IRR) 46
Comparative use of NPV and IRR 49
Incremental analysis 51
Summary 52
Spreadsheet user 52
Project 1: Calculating the NPV 52
Calculate the NPV of the scheme and the IRR 53
Project 2: Calculating the IRR 54
Project 3: Goal Seek 55
vi Contents

4. Basic Principles 57
Introduction 57
Definitions 57
Market value 58
Value in exchange 58
Investment value or worth 58
Price 59
Valuation 59
Valuation report 59
The Income approach 60
Valuation process 65
Income or rent 71
The concept of zoning 74
Landlords’ expenses 79
Purchase expenses 83
Income capitalisation or DCF 84
DCF 86
Summary 87
5. The Income Approach: Freeholds 89
Introduction 89
The income approach 92
Capitalisation approaches 94
DCF approaches 108
DCF and the over-rented property 116
Advance or arrears 118
Analysing sale prices to find the equivalent yield 120
A final adjustment 121
Sub-markets 121
Summary 123
Spreadsheet user 123
Project 1 123
Project 2 125

6. The Income Approach: Leaseholds 127

Introduction 127
Occupation leases 129
Investment leases 130
Medium to long-term leaseholds at a fixed head rent 131
Fixed profit rent 131
Single rate valuation of leaseholds 132
DCF valuation of leaseholds 135
DCF solution 136
Summary 138
7. The Income Approach: Taxation and Valuation 141
Introduction 141
Incomes in perpetuity 142
Finite or terminable incomes 142
 Contents  vii

Tax and deferred incomes 144

Rising freehold incomes 145
Gross funds 146
Net or gross? 146
Capital Gains Tax (CGT) 146
Value Added Tax (VAT) 147
Summary 148
8. Landlord and Tenant 149
Valuations and negotiations 149
Premiums 149
Future costs and receipts 153
Extensions and renewals of leases 155
Marriage or synergistic value 160
Market rent, non standard reviews, constant rent theory 166
Quarterly to monthly 168
Summary 169
9. The Effects of Legislation 171
Introduction 171
Business premises 171
Compensation for improvements 172
Security of tenure 174
Compensation for loss of security 176
Terms of the new lease 176
Landlord and tenant negotiations 180
Residential property 182
Private sector tenancies 183
Assured tenancies 185
Assured Shorthold Tenancies (ASTs) 185
Tenancies subject to the provisions of the Rent Act 1977 186
Tenancies with high Rateable Values (RVs) 188
Resident landlords 188
Tenancies on long leases 189

10. Development Opportunities 191

Introduction 191
Incorporating a ‘big picture’ approach 192
Garbage in – garbage out 194
Professional frameworks and methodologies 195
The highest and best use methodology 196
RICS Valuation Information Paper No 12: ‘The Valuation
of Development Land’ 197
The residual method 199
Exploring the main inputs to a residual appraisal 200
Sensitivity analysis 204
The need for adoption of the cash flow approach 206
The cash flow approach explained 207
Viability studies 210
viii Contents

Summary 212
Spreadsheet user 213
Using Excel to build an appraisal 213

11. The Profits Method of Valuation 219

Rationale behind the use of the profits method of valuation 219
Fair Maintainable Turnover (FMT) 220
Gross profitability 221
Costs 221
Fair Maintainable Operating Profit (FMOP) 221
Commentary on use of actual accounts 222
Freehold valuation and sales 222
Licensed property 223
Pubs 224
Valuation: public houses and bars 226
Comparables and market information 229
Valuation: late bars/clubs 230
Restaurants 231
Hotels 233
Other types of property 234
Cinemas and theatres 235
Care homes 235
Petrol filling stations 235
Golf courses 236
Racecourses, racetracks and stadia 236
Tenant’s improvements under the profits method 236
Summary 238
12. Investment Analysis 241
Introduction and re-cap 241
Expected returns – the cash flow 243
The discount rate 244
Some simple analytical measures 246
Initial yield 247
Yield on reversion 248
Equivalent yield 248
Reversionary potential 249
Income return 249
Capital return 249
Total return 249
Required return 249
IRR or expected return 250
Dealing with risk 250
The Risk-Adjusted Discount Rate (RADR) 251
The sub-sector and property risk premium 252
The sector premium 252
The town premium 252
The property premium 253
Risk-adjusted cash flows: using sensitivity and simulation 254
 Contents  ix

Risk-adjusted valuations 259

Risk-adjusted IRRs 261
Regression analysis 262
Spreadsheet user 265
Appendix A 267
Leaseholds: Dual Rate

Appendix B 293
Illustrative Investment Property Purchase Report

Appendix C  307
Illustrative Development Site Appraisal Report

Appendix D 315
Solutions to Questions Set in the Text

Further Reading and Bibliography 331
Index 333
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 Preface to Sixth edition
This edition of the book begins with an introduction and a quick
start to the income approach; this is followed by a consideration of
the investment arithmetic which underpins the income approach
and a review of the basic principles of valuation. The application
of the approach to the assessment of the market value of freehold
and leasehold investments is then considered, before looking at
the impact of legislation on what would otherwise be a relatively
unfettered market. Finally, the book covers a number of special-
ist areas of valuation relating to the use of the profits version of
the income approach, development properties and investment
analysis. Throughout the book it is assumed that the reader has
some knowledge of who buys property, why they buy it and what
alternative investment opportunities there are, and also that the
reader will have some knowledge of the nature of property as an
investment. The reader should have some awareness of the social,
economic and political factors that influence the market for and the
value of property. For further consideration of these issues readers
are referred to the sister publication, Principles of Valuation, also by
EG Books (an imprint of Elsevier).
In preparing the sixth edition, we have taken note of comments
and reviews submitted to our editor at Elsevier. In particular, we
have reflected on the dual rate battle and have removed almost all
reference to a method which we have always had concerns over.
Those who miss it will find support in the Appendices for their
teaching and learning. We have tried to enhance the material so
as to leave readers with fewer puzzles of ‘how did they do that’ or
simply ‘why that’? We have extended some of the spreadsheet ma-
terial and uses of standard software; but left much to the reader to
discover for his or herself as finding Excel® solutions to valuation
tasks is, in itself, a powerful learning tool. Leasehold Enfranchise-
ment, which kept growing, has gone to where it belongs in the
main statutory valuation text books. One weakness has been our
consideration of the Profits Method. This has been addressed in
this edition with a new chapter by Howard Day of Howard Day
Associates Ltd, Chartered Surveyors providing property advice to
the leisure sector.
We have sought to use terminology which is consistent with the
Royal Institution of Chartered Surveyors’ (RICS) Valuation Standards
(the Red Book) and which reflects the international use of the income
approach. A particular change is the adoption, for the most part, of
the internationally recognised Present Value of £1 per annum (PV£1
pa) in place of the UK valuers’ Years’ Purchase. Whilst valuers in
the United Kingdom do use the 12th edition of Parry’s Valuation
and Investment Tables, most students now use calculators, Excel®
and valuation software; to conform to this we refer to the financial
functions rather than to tables.
xii Preface

As in previous editions, all examples are for illustration only and

are not intended to be a reflection of current market rents and yields.
The art or science of valuation has developed since the first edi-
tion and our purpose now is to provide a comprehensive review of
the income approach in as simple a style as possible, exploring the
wide range of opinions and views that have been expressed about
the how, why and when of the methodology. For practitioners, we
would ask that if you see an approach which appears to be a new
technique to you then please keep an open mind; try it and see, but
remember market value is your opinion, not just the mathematical
result of the income approach you chose to use.

Andrew Baum
David Mackmin
Nick Nunnington.
Reading, Sheffield, Abu Dhabi
2011
 Acknowledgements
Malcolm Martin BSc, FRICS, FNAEA provided much needed assis-
tance in the fifth edition on leasehold enfranchisement which has
now gone, but we have made use of the revisions he made to the
section on residential valuation. However, if we now have it wrong
please blame us, not Malcolm.
Andrew and David still recall the enthusiasm for their ideas in
1979 from Peter Byrne and David Jenkins and will continue to say
thank you.
A major change in this edition has been the recognition of the
growth in the leisure sector of the market and the coming of age
of the profits approach. We have responded with a much enlarged
chapter on this method which has been written for us by Howard
Day BSc (Hons.) FRICS, MAE, MCIArb, FAVLP of Howard Day
Associates Ltd, Liberty House, London W1B 5TR, Chartered Sur-
veyors providing property advice to the leisure sector.
Extracts from the RICS Valuation Standards (2011 edition), the
Red Book, are RICS copyright and are reprinted here with their
­permission. Readers are advised that the 7th edition of the Red Book
is effective from 2nd May 2011.
Argus Developer software has been used in Chapter 10 and
­Appendix C to illustrate various aspects of development appraisal.
This page intentionally left blank

     
 Introduction and Quick Start to the
Chapter  1
Income Approach

Introduction
Cairncross (1982), in his Introduction to Economics, expresses his
view that ‘economics is really not so much about money as about
some things which are implied in the use of money. Three of these -
exchange, scarcity and choice - are of special importance’. Legal inter-
ests in land and buildings, which for our purposes will be known as
property, are exchanged for money and are scarce resources. Those
individuals fortunate to have surplus money have to make a choice
between its alternative uses. If they choose to buy property they will
have rejected the purchase of many other goods, services, alterna-
tive investments such as stocks and shares, or of simply leaving it
in a savings account or doing nothing. Having chosen to use their
surplus money to purchase property, they will then have to make a
choice between different properties. Individuals investing in pen-
sion schemes, endowment or with profits life assurance policies are
entrusting their money to others to make similar choices on their
behalf.
Valuation is the vocational discipline within economics that
attempts to aid that choice in terms of the value of property and the
returns available from property. Value in this context can mean the
market value in exchange for property rights, as well as value to
a particular person or institution with known objectives, currently
referred to as an appraisal, or assessment of worth, or investment
value. Valuation was defined in the Royal Institution of Chartered
Surveyors (RICS) Valuation Standards (The Red Book) (2010) as:
A valuer’s opinion of the value of a specified interest or inter-
ests in a property, at the date of valuation, given in writing.
Unless limitations are agreed in the terms of engagement this
will be provided after an inspection, and any further investi-
gations and enquiries that are appropriate, having regard to
the nature of the property and the purpose of the valuation.
A valuer in the context of this book would be a member of the RICS
or Institute of Revenues Rating and Valuation (IRRV) who meets the
qualification requirements specified in Valuation Standard (VS) 1.4
and has the knowledge and skills specified in VS 1.6, and who acts
with independence, integrity and objectivity as specified in VS 1.7.
2 Introduction

The RICS Valuation Standards adopt the International Valuation

Standards (IVS) definition of market value, namely:
The estimated amount for which an asset or liability should
exchange on the valuation date 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. (RICS VS 3.2).
It also adopts investment value as:
The value of an asset to the owner or a prospective owner.
(May also be known as worth.) (RICS VS Glossary)
At the time of preparing this edition, the International Valua-
tion Standards Council (IVSC) has a consultation draft out for a
new edition of the IVS and the RICS 7th edition of The Red Book,
which is compliant with IVS, is scheduled for publication in April
2011 with an effective date of 2nd May 2011. Readers are advised
to refer to the new edition after publication as it is compulsory
reading for valuers and there may be changes which, as yet, we have
not been able to incorporate. The 7th edition is different; for example
the word property in the definition of MV has been replaced with
asset as MV should be defined consistently for all asset classes not
just property.
Property is purchased for use and occupation or as an invest-
ment. In both cases the purchaser measures the expected returns
or benefits to be received from the property against the cost outlay.
The valuer’s task is to express these benefits in monetary terms and
to interpret the relationship between costs and benefits as a rate of
return, thus allowing the investor to make a choice between alterna-
tive investment opportunities.
Since 1945, the property and construction industries have grown
in importance; investing in property has been indiscriminately con-
sidered to be a ‘safe’ investment. The position post the banking crisis
in 2007 aptly illustrates how dangerous it can be to make such an
assumption. The growth in pension schemes, life funds, property
unit trusts, as well as direct investment by individuals, has com-
pleted the transition of the property market into a multi-billion
pound industry. As a result, there has been a growth in demand for
property to be valued in order to establish market value and for it to
be re-valued for portfolio and asset management purposes.
Property as an investment is different to other forms of invest-
ment. The most obvious difference is its fixed location geographi-
cally, hence the importance of the quality of that location for the
land’s current or alternative uses as determined by its general and
special accessibility, and its interrelationship with other competing
and complementary buildings, locations and land uses. Once devel-
oped, the quality of the investment is influenced by the quality of
the permitted planning use and the quality of the physical improve-
ments (buildings) on the site. In addition and essential to the assess-
ment of exchange value is the quality of the legal title. Is it freehold
or leasehold? The owner of a freehold title effectively owns all the
 CHAPTER 1: Introduction and Quick Start to the Income Approach 1 3

land described in the title deeds in perpetuity, including everything

below it to the centre of the earth and everything above. Freehold
rights may be restricted by covenants in the title and/or by the
rights of others, such as rights of way. A leaseholder’s rights are
limited in time (the length of the lease) and by the terms and condi-
tions (covenants) agreed between landlord and tenant and written
into the lease, or implied or imposed by law or statute. The mar-
ket value of a tenanted freehold property will also be affected by
the quality of the tenant in terms of their covenant strength and
the quality of the lease in terms of the appropriateness of the lease
conditions to that type of property used for that purpose in that
location.
To be competent, the valuer must be aware of all the factors and
forces that make a market and which are interpreted by buyers, sell-
ers and market makers in their assessment of market price. In an
active market where many similar properties with similar character-
istics and qualities are being exchanged, a valuer will, with experi-
ence, be able to measure exchange value by comparing that which is
to be valued with that which has just been sold. This direct or com-
parative method of valuation is used extensively for the valuation of
vacant possession, freehold, residential property; for the valuation
of frequently sold and easily compared commercial and industrial
property and to assess the market rent of all property. Differences in
age, condition, accommodation and location can all, within reason,
be reflected by the valuer in the assessment of value. Differences in
size can be overcome by adopting a unit of comparison such as price
per hectare, price per square metre or rent per square metre.
The more problematic properties are those for which there is no
ready market, those which display special or unique characteristics,
those which do not fully utilise the potential of their location and are
therefore ripe for development, redevelopment or refurbishment,
those that are tenanted and are sold as investments at prices reflect-
ing their income generating potential; and leasehold properties.
For each of these broad categories of property, valuers have
developed methods of valuation that they feel most accurately
reflect the market’s behavioural attitude and which may therefore
be considered to be rational methods.
In the case of special properties such as oil refineries, glassworks,
hospitals and schools, the usual valuation method is the cost or con-
tractor’s method. It is the valuer’s method of last resort, and is based
on the supposition that no purchaser would pay more for an exist-
ing property than the sum of the cost of buying a similar site and
constructing a similar building with similar utility written down to
reflect the physical, functional, environmental and locational obso-
lescence of the actual building. This approach is sometimes referred
to as a Depreciated Replacement Cost approach, or DRC for short.
Properties with latent development value are valued using the
residual or development (developer’s) method (see Chapter 10). The
logic here is that the value of the property (site) in its current state
must equal the value of the property in its developed or redeveloped
4 Introduction

state, less all the costs of development including profit but excluding
the land. In those cases where the residual sum exceeds the value in
its current use, the property is considered ripe for development or
redevelopment and, in theory, will be released for that higher and
better use.
All property that is income producing or is capable of producing
an income in the form of rent, and for which there is both an active
tenant market and an active investment market, will be valued by
the market’s indirect method of comparison. This is known as the
investment method of valuation or the income approach to property
valuation and is the principal method considered in this book.
The income approach and the income-based residual approach
warrant special attention if only because they are the valuer’s main
tools for valuing the most complex and highly priced investment
properties.
Real estate (property) is an investment. There are three main
investment asset classes – stocks and corporate bonds, equity shares,
and property.
An investment can be described as an exchange of capital today
for future benefits, generally in the form of income (dividends,
rent, etc.) and sometimes in the form of capital. The investment
income from property is the net rent paid by tenants. The market
price of an investment is determined in the market by the competi-
tive bids of buyers for the available supply at a given point in time
under market conditions prevailing at that time. Short supply and
high demand that is scarcity will lead to price (value) increases,
whilst low demand and high supply will lead to falls in prices and
values.
The definition of market value requires the valuer to express an
opinion of the market price that the valuer believes would have
been achieved if that property had been sold at that time under the
market conditions at that time.
The unique characteristics of property make property invest-
ment valuation more complex an art and science than that exer-
cised by brokers and market makers in the market for stocks and
shares. In the stock market, sales volume generally allows for price
(value) comparison to be made minute by minute. As stocks, shares
and property are the main investments available, there is bound to
be some similarity between the pricing (valuation) methods used
in the various markets and some relationship between the invest-
ment opportunities offered by each. A basic market measure is the
investment yield or rate of return. The assessment of the rate of
return allows or permits comparison to be made between invest-
ments in each market and between different investments in dif-
ferent markets. There is a complex interrelationship of yields and
patterns of yields within the whole investment market. In turn
these yields reflect market perceptions of risk and become a key
to pricing and valuation methods. Understanding market rela-
tionships and methods can only follow from an understanding of
investment arithmetic.
 CHAPTER 1: Introduction and Quick Start to the Income Approach 1 5

The income approach – a quick start

The income approach or investment method of valuation is an inter-
nationally recognised method of assessing market value of property.
Buyers of property require an acceptable return or yield on their
invested money. The yield must be sufficient to compensate for the
risks of exchanging money now with today’s purchasing power for
future income with a future uncertain purchasing power.
The initial yield is a simple measure of the income/capital
relationship.
Income(I)
× 100 = Yield (r %)
Purchase Price(P)
If a buyer pays £2,000,000 for a property producing a net rent of
£100,000 which is considered to be the market rent, then this sale
price can be analysed to find the yield on money invested.

£ 100,000
× 100 = 5 %
£ 2,000,000
The market yield reflects all the risks perceived by the players in the
market at the time of the purchase. These market yields provide
the valuer with a key measure of an investment and a key tool for
the income approach.
The experienced valuer with market knowledge of the risks asso-
ciated with investing in property in general and with those of a spe-
cific property can arrive at an opinion, by comparison, of the yield
that buyers would require from a given property in order for a pur-
chase to occur. Risks to be considered will relate to: the legal title;
the physical construction and condition of the property; the location
of the property; the use of the property; the quality of the occupying
tenant, i.e. their covenant strength; the length of the lease; the lease
covenants and many other factors.

I I
Given that P × 100 = r % then ( r ) = P and so the value of a sim-
100
ilar property let at its market rent of £59,500 could be calculated as
£ 59,500 £ 59,500
( ) = = £ 1,190,000
5 0.05
100
In the income approach this is called capitalising the income or
the capitalisation approach. The value of £1 of income will vary
with the yield and the yield will vary with the perceived investment
risks. The importance of the yield can be seen in the following table;
here a fall of 1% from 12% to 11% is a 9.12% increase in the present
value of £1 pa in perpetuity, but a 1% fall from 5% to 4% increases
the present value of £1 in perpetuity by 25%.
6 The income approach – a quick start

Present Value of Change in value

Yield r% £1 pa in perpetuity per 1% fall in
Income (100/r)*† (PV£1 pa in perp). yield
£1 4% (25.00) £25 25%
£1 5% (20.00) £20 19.98%
£1 6% (16.67) £16.67 16.66%
£1 7% (14.29) £14.29 14.32%
£1 8% (12.50) £12.50 12.51%
£1 9% (11.11) £11.11 11.10%
£1 10% (10.00) £10.00 10.01%
£1 11% (9.09) £9.09 9.12%
£1 12% (8.33)* £8.33 –
*These figures are rounded to two decimal places but for valuation need to be calculated
to four decimal places.
†UK valuers use the term Years’ Purchase (YP) for the product of (100/r) or (1/i) which is

then used as a multiplier to turn income in perpetuity into its present value equivalent.

Capitalisation in its simplest form where income can be assumed to

be perpetual is simply Income ÷ i% where i% is (r ÷ 100). So at 4% it
is £1 ÷  0.04 = £25 or £1 × (1 ÷  0.04) = £1 × 25YP = £25. Capitalisation
is a market-based method of valuation which requires knowledge
of market rents derived from analysis of lettings of property and of
market yields derived from analysis of market sales.
Valuation mathematics is not always this simple. In many sit-
uations the rent being paid is not the market rent and account
must be taken of the rent actually being paid and for how long,
plus the reversion to market rent at the next rent review or lease
renewal.
Capitalisation is a short-cut discounted cash flow (DCF) or pres-
ent value calculation. Where the income changes over time, the
valuer needs to reflect the time value of money through the use of
present values.
Investors can save money or invest money. Money saved earns
interest, and interest compounds over time if not withdrawn. The
general equation for compound interest is (1 + i)n where i is the rate
of interest expressed as a decimal, i.e. in respect of £1 not as a per-
centage (£100) and n is the number of interest earning periods. So:

£ 1000 × (1 + 0.10)10 = £ 2,593.74

[Note that]
(1.10)10 = (1.10) × (1.10) × (1.10) × (1.10) × (1.10)
                × (1.10) × (1.10) × (1.10) × (1.10) × (1.10)

A thousand pounds saved today and left to earn interest at 10%

a year will compound over 10 years to £2,593.74. In which case
 CHAPTER 1: Introduction and Quick Start to the Income Approach 1 7

£2,593.74 due to be received in 10 years time will have a present

value today of:

£ 2,593.74 × 1 n = £2,593.74
(1 + i)
× 1 = £ 2,593.74 × 0.3855433 = £ 1,000
(1 + 0.10)10
The value of £1 due in 10 years time has a PV today at 10% of
£0.3855433.
Value a property let at £80,000 a year until a rent review in three
years to market rent which today is £100,000. Market yields are 8%.
This calculation can be performed easily with a standard calculator
or preferably with a financial calculator such as an HP 10bII.
The cash flow is:

End year Income (cash flow)

1 £80,000
2 £80,000
3 £80,000
Year 3 – perpetuity £1,250,000 (£100,000 ÷ 0.08)
   
Therefore, the present value at 8% is:

100,000 ÷0.08 £1,250,000

Plus £80,000 end year 3 rent £1,330,000 ÷ 1.08 £1,231,481.48
Plus £80,000 end year 2 rent £1,311,481.48 ÷ 1.08 £1,214,334.71
Plus £80,000 end year 1 rent £1,294,334.71 ÷ 1.08 £1,198,458.06
   
OR, using a Hewlett-Packard HP10bII calculator (here ƒ indicates
the need to use the function key):

Keyboard Screen display Description

ƒ C All 0.00 Clears all registers
1 ƒ P/YR 1.00 Stores payment periods per year;
here it is a single payment
0 ( ± )(CFj) −0.00 Creates a day one zero receipt
to achieve in arrears income
payments
80,000 CFj End year 1 rent
80,000 CFj End year 2 rent
1,330,000 CFj End year 3 rent plus 100,000 in
perpetuity at 8%
8 1/YR 8% nominal yield to be used
(Continued)
8 The income approach – a quick start

Keyboard Screen display Description

ƒ NPV 1,198,458.06 Is therefore the present value
of £80,000 for three years, plus
£100,000 in perpetuity beginning
after three years all discounted
at 8%.
   
As the income is constant for a number of years, there is no need to
enter as single cash flows, a quicker solution is possible.
The standard textbook valuation layout would appear as:

Term Calculation Present Value

Current rent £80,000
PV of £1 pa (YP)at 8% for 2.5771 £206,167.76
3 years
Reversion
Market rent £100,000
PV of £1 pa in perp at 8% 12.50
(YP perp)
£1,250,000
PV of £1 in 3 years at 8% 0.7938322 £992,290.25
Sum term and reversion £1,198,458.01
   

Note that the PV of £1 pa is the sum of the PV of £1 for 1 year plus

PV £1 for 2 years plus PV £1 for 3 years. The equation is 1 − 1 n .
(1 + i)
i
Kel Computing Ltd (www.kel.co.uk) have for several years pro-
vided a free student download of their Investment Valuer. This can
be accessed and downloaded from www.keldownloads.co.uk/dow
nloads/student/KELInvestmentValuer - Student Version 2010-11.
EXE or http://tinyurl.com/studentKel.
If you are using the Kel download then look at the content of the
various tabs first; then load the valuation data; then click on report
and valuation. Kel will become much clearer after Chapter 5. If you
are on a full-time course of study at university or college then you
may have access to Argus software or one of the other valuation
packages used by the profession. However, at this stage, Kel Invest-
ment Valuer for students is possibly an easier starting tool. Down-
loading is probably only possible on a home computer or laptop as
most large organisations only allow authorised staff to download
from the internet.
To benefit from this quick start you need to complete the fol-
lowing questions using one or other of the methods set out above.
Your approach will depend upon your calculator and its functions.
If your answers agree with those shown then you have discovered
 CHAPTER 1: Introduction and Quick Start to the Income Approach 1 9

how to find the present value of a given cash flow at a given yield or
discount rate. Now all that is needed is an understanding of where
the cash flow comes from in respect of a given property, and how to
deduce the correct yield. In passing, two approaches to the income
approach will be explored – income capitalisation and DCF.

Questions
A. Valuation problems where the current rent being paid is the market
rent and is a net rent.
1. A freehold interest in a shop where the unit has been let at the
market rent of £75,000. Market yields would support a valuation
at 6%. (Answer £1,250,000.)
2. A freehold interest in a business park consisting of four identical
units. Each is let at the market rent of £45,000. Market evidence
would support a valuation on a 7.5% basis. (Answer £2,400,000.)
3. A freehold interest in an office building let at the market rent of
£1,555,000. Market yields for this quality of office investment are
7%. (Answer £22,214,285.)
B. Valuation problems where the property is not let at its market rent
but there is a rent review in ‘n’ years’ time to market rent.
4. A freehold interest in a shop unit let at £65,000 a year with a rent
review in two years time to a market rent of £75,000. Comparable
market yields are 6%. (Answer £1,231,666.)
5. A freehold interest in a business park with four identical units.
Each is let at a rent of £39,500. There are rent reviews in three
years time on each unit. The market rent is £45,000. Comparable
market yields are 7.5%. (Answer £2,342,767.)
6. A freehold interest in an office building let at £1,332,000 a year for
the next five years. This was an incentive rent to secure an early
and quick letting of the building. The market rent is £1,555,000
and the rent review is in five years time. Comparable market
yields are 7%. (Answer £21,299,950.)
The following chapters explore the processes and applications of the
income approach in more detail, including the various tools or tech-
niques preferred by different valuers.
This page intentionally left blank
     
 Chapter  2
Financial Mathematics for Valuers

Introduction
This book explores the process of property valuation, with particu-
lar reference to property which is bought or sold as an investment.
In order to be able to value an investment property, a valuer must
understand how the benefits to be enjoyed from the ownership of a
freehold or leasehold interest in property can be expressed in terms
of present value (PV).
To do this, a valuer must have a working knowledge of the math-
ematics of finance and the theory of compounding and discounting
as it relates to savings and investments.
This chapter explores the mathematics behind the six investment
functions of £1 and other derived functions, and illustrates their use
in the practice of property valuation.

The six functions of £1

The six basic functions of financial mathematics are set out below;
throughout i is the rate of interest expressed as a decimal, e.g. 5% =
5/100 = 0.05, this must always be the correct rate per interest earn-
ing period (see nominal and effective rates later in this chapter); n is
the number of interest earning periods.
Percentages are used frequently by valuers. As a reminder, one
per cent (1%) is one hundredth part of the whole, or 1/100th. If a gift
of £100 is to be divided equally between 10 people then it has to be
divided into 10 parts; each person will receive 1/10th or 10% [1/10th
being (1/10 × 100) = 10%]. So 1/10th or 10% of £100 is [(£100/100) ×
10] which is £10.
The Amount of £1 (A) another name for compound interest; that
is, the future worth of £1, if invested today allowing for compound
interest at a given rate.

A = (1 + i)n
The Amount of £1 per annum (A £1 pa) that is, the future worth of
£1 invested at the end of each year accruing compound interest at a
given rate.
(1 + i)n − 1
A £1pa =
i
12 The six functions of £1

The Annual Sinking Fund (ASF) that is, the fraction of £1

which must be invested at regular intervals to produce £1 at a
given point in the future with compound interest accruing at a
given rate.
i
ASF =
(1 + i)n − 1
The PV of £1 (PV £1) that is, the PV of £1 to be received in the future,
discounted over a given period at a given rate.
1 1
PV = =
(1 + i)n A
The PV of £1 per annum (PV £1 pa) that is, the PV of a series of
payments of £1 due annually for a given period of time, discounted
at a given rate. This function is also known by valuers as the Year’s
Purchase (YP) single rate.
1
1−
PV £1pa = (1 + i)n = 1 − PV
i i
The Annuity £1 Will Purchase (AWP) that is, the amount of
money that will be paid back at the end of each year in return for £1
invested today for a given number of years at a given rate.
A £1pa = i + ASF
There are several published valuation tables such as Parry’s Valu-
ation and Investment Tables, 12th edition (2002), published by EG
Books (Elsevier), which show the value of these and other functions
for a range of interest rates and years. Some of these tables compute
income as being received quarterly in advance, as with many actual
investments. However, in order to simplify this introductory chap-
ter it is assumed initially that income is received or invested at the
beginning or end of each year in one instalment.
Whilst reference is made throughout to pounds Sterling (GBP £),
the principles apply to any currency; and the Euro or US Dollar or
any other currency can be substituted.

The amount of £1(A)

The amount of £1 is simply another term for compound interest.
Consider the building society passbook, set out below, where the
interest rate for deposits is at 10% per annum.

Date Description Deposits Withdrawals Interest Balance

01/01/12 Cash £100
31/12/12 Interest £10.00 £110.00
31/12/13 Interest £11.00 £121.00
 CHAPTER 2: Financial Mathematics for Valuers 2 13

Date Description Deposits Withdrawals Interest Balance

31/12/14 Interest £12.10 £133.10
31/12/15 Interest £13.31 £146.41
   
This table shows that the interest accumulates on both the original
£100 invested and on the interest added to it.
The formula to express this states that if £1 is invested for one
year at i interest, then at the end of one year it will have accumu-
lated to (1 + i). At 5% this will read as (1 + 0.05) and the initial £1
with interest added becomes £1.05.
At the end of the second year (1 + i) will have earned interest at
i%, so at the end of the second year it will have accumulated to:
(1 + i) + i(1 + i) which can be expressed as(1 + i)2
At the end of n years the accumulated sum will be;
(1 + i)n
Remember that interest is expressed as a decimal (i) or (r), e.g. 10% =
10 divided by 100 = 0.10 and that whilst n is normally the number of
years of interest accumulation, the formula or equation is a general
one for compound interest. So, if interest is added monthly, then n
for one year becomes 12 and i will be the monthly rate of interest.

Example 2.1
Calculate the amount of £1 after four years at 10%.
A = (1 + i)n i = 0.10; n = 4
A = (1.1)4
A = (1.1) × (1.1) × (1.1) × (1.1)
A = 1.4641
The calculation shows that £1 will accumulate to £1.4641 (£1.47 to the
nearest pound and pence) after four years at 10% compound interest
rate. Notice that if the figure produced by the formula in example 1.1
(1.4641) is multiplied by 100, the figure is the same as that shown in the
building society passbook.
The formula for the amount of £1 is therefore;

A = ([1 + i])n

The amount of £1 per annum (A £1 pa)

This function is used to calculate the future value, with compound

interest, of a series of payments made at regular intervals, normally
each year. The Latin ‘per annum’ or, as shortened, pa, is the expression
normally used for annual receipts or payments. Many investments fol-
low this pattern. Consider for example another building society pass-
book set out below where this time the investor deposits £100 at the
end of each year 01,02,03,04,05 and interest is added at 10% per annum.
14 The six functions of £1

Date Description Deposits Withdrawals Interest Balance

01 Cash £100
02 Interest £10.00 £110.00
02 Cash £100 £210.00
03 Interest £21.00 £231.00
03 Cash £100 £331.00
04 Interest £33.10 £364.10
04 Cash £100 £464.10
05 Interest £46.41 £510.51
05 Cash £100 £610.51
   
The amount of £1 pa deals with this type of investment pattern; it
indicates the amount to which £1, invested at the end of each year,
will accumulate at i interest after n years.
The table is simply a summation of a series of amounts of £1. If
each £1 is invested at the end of the year, the nth £1 will be invested
at the end of the nth year and will thus earn no interest. See last cash
entry above for 05.
Each preceding £1 will earn interest for an increasing number of
years:
 The (n – 1) £1 will have accumulated for 1 year, and will be

worth (1 + i).
 The (n – 2) £1 will have accumulated for two years, and will be

worth (1 + i)2.
 The first £1 invested at the end of the first year will be worth

(1 + i)n–1.
This series of calculations when added together is expressed as:
1 + (1 + i) + (1 + i)2 . . . (1  +  i)n−1
This is a geometric progression and when summed it can be
expressed as:
(1+i)n − 1
i
This is the formula for the amount of £1 pa.

Example 2.2
Calculate the amount of £1 per annum for five years at 10%.
n
A £ 1pa = (1 + i)i − 1 i = 0.10 ; n = 5
5
A £ 1pa = (1.10)i − 1 = 1.61051
0.10
−1

A £ 1pa = 0.061051
.10
= 6.1051
 CHAPTER 2: Financial Mathematics for Valuers 2 15

Multiplying this figure by 100 to calculate the sum that £100 invested
at the end of each year will accumulate to after five years produces the
same figure as in the building society passbook.

Example 2.3
If Mr A invests £60 in a building society at the end of each year, and
at the end of 20 years has £4,323, at what rate of interest has this sum
accumulated?
Annual sum invested £60
A £1 pa for 20 years at i % x
Capital Value (CV) of Investment at the end of 20 years is £4,323
   
Rephrasing as a simple equation:
£60x = £4,323, i.e. £60 multiplied by an unknown number x will produce
a sum of £4,323 and so:
£ 4,323
x= = 72.05
£ 60
Substituting in the formula for the A £1 pa and solving to find i or if the
reader prefers by checking in Parry’s Amount of £1 pa table, it will be seen
that 72.05 is the value for 20 years at 12% which is the rate of compound
interest at which this regular investment has accumulated.

Annual sinking fund (ASF)

Property investors may need to make provision from today for some
future expenditure. This may be for some form of maintenance, for
example, a building may require a new roof or service roads may
require resurfacing.
Such obligations may be passed on to the tenant in the form
of service charges, payable in addition to rent, which include
the provision of a fund to be used for major works in the future.
However, in some cases, the landlord may be responsible for
major repairs which cannot be recovered from the tenant. Such
obligations should be reflected in the purchase price of the
investment. Such expenditure can be budgeted for by investing a
lump sum today or by investing a regular sum from today, both
of which will grow due to compound interest. A property owner
may need to know how much should be invested now or on an
annual basis.
The first step is to estimate the probable amount needed at an
expected future date. The investor could then either invest a lump
sum immediately which, with the accumulation of interest, will
meet the estimated outlay when it arises. This can be calculated
using the PV of £1 (see later). However, it may be more effective to
set aside part of the income received from the investment (i.e. rent)
regularly in an account known as a sinking fund, which is planned
to accumulate to the required sum by the date in the future when the
expenditure is required.
16 The six functions of £1

This is similar to the amount of £1 pa described above. Example

2.4 demonstrates how the annual sinking fund (ASF) and A £1 pa
can be used to calculate the sum required to be set aside in a sinking
fund to meet a known future expense.

Example 2.4
An investor is considering the purchase of a small shop in which the
window frames have begun to rot. It is estimated that in four years time
they will require complete replacement at a cost of £1,850. The shop
produces a net income of £7,500 pa.
How much of this income should be set aside each year to meet the
expense, assuming the money is invested with a guaranteed fixed return
of 3% per year?
The ASF is the reciprocal of A £1 pa. The use of ASF enables this sum to
be calculated easily.
Calculate the ASF to accumulate to £1 after 4 years at 3% given that the
ASF is:
i
ASF =
(1 + i)n − 1

i 0.03 0.03
ASF = = = = 0.0239027
(1 + i)n − 1 (1.03)4 − 1 1.1255088 − 1

Sum required £1,850

X by ASF to replace £1 in 4 years at 3% 0.239027
ASF £442.20
   
It can be seen that this calculation performs the function of the amount
of £1 pa in reverse. The annual sum was found by multiplying the
sum required by the ASF to replace £1 at the end of four years with
compound interest at 3%. Using the A £1pa, the sum of £1,850 could be
divided by the A £1pa for four years at 3%, thus £1,850/4.1836 = £442.20.
Therefore, as mentioned above, the ASF is the reciprocal of the amount
of £1 pa:
i
ASF =
(1 + i)n − 1

The present value of £1 (PV £1)

The first three functions of £1 have shown how any sum invested
today will be worth more at some future date due to the accumu-
lation of compound interest. This means that £1 receivable in the
future cannot be worth the same as £1 at the present time. What it
is worth will be the sum that could be invested now to accumulate
to £1 at a given future date at a given rate of interest. This sum will
obviously depend upon the length of time over which it is invested
and the rate of interest it attracts.
 CHAPTER 2: Financial Mathematics for Valuers 2 17

If £1 were invested now at a rate of interest i for n years, then at

the end of the period it would be worth (1 + i)n .
If £x was to be invested now at i% for n years and it accumulates
to £1:
1
If £ x × (1 + i)n = £ 1 then £ x = £ 1 ×
(1 + i)n
This is the formula for the PV of £1 and it is the reciprocal of the
Amount of £1.
1 1
PV = =
(1 + i)n A
Proof:
 PV £1 in 7 years at 10% = 0.51316 [1/(1.10)7].
 A £1 in 7 years at 10% = 1.9487 [(1.10)7].

 And 0.51316 × 1.9487 = 1.00.

Example 2.5
If X requires a return of 10% pa, how much would you advise X to pay for
the right to receive £200 in five years time?
1 1 1
PV = n = = = 0.6209 × £ 200 = £ 124.18
(1 + i) (1 + .10)5 1 . 16105
This means that if £124.18 is invested now and earns interest at 10%
each year then it would accumulate with compound interest to £200 in
five years time. £124.18 is the present value of £200 due to be received in
five years time at 10%.

The PV of £1 pa (PV £1 pa or Years’ Purchase)

The amount of £1 pa was seen to be the summation of a series of
amounts of £1. Similarly, the PV of £1 pa is the summation of a series
of PVs of £1. It is the PV of the right to receive £1 at the end of each
year for n years at i%.
The PV of £1 receivable in one year is:
1
(1 + i)
in two years it is:
1
(1 + i)2
and so the series reads:
1 1 1 1
+ + ...
(1+i) (1+i)2 (1+i)3 (1+i)n
18 The six functions of £1

This is a further geometric progression which when summated can

be expressed as:

1
1−
(1 + i)n
i

This is the formula for the PV of £1 pa, and if:

1
= PV
(1 + i)n

then the PV £1 pa can be simplified to:

1 − PV
i

Example 2.6
Calculate the PV of £1 pa at 5% for 20 years given that the PV of £1 in
20 years at 5% is 0.3769

1 − PV 1 − 0.3769 6231
PV £ 1 pa = = .05 = 0. .05 = 12.462
i 0 0

Example 2.7
How much should A pay for the right to receive an income of £675 for
64 years if A requires a 12% return on the investment?
Income per year £675
X PV £1 pa for 64 years at 12% 8.3274
PV (or value today) £5,621
   
The PV of £1 pa is referred to by UK property valuers as the ‘Years’
Purchase’ (YP). The Oxford English Dictionary gives a date of 1584
for the first use of this phrase ‘at so many years’ purchase’, which was
used in stating the price of land in relation to the annual rent in
perpetuity. This term is sometimes confusing as it does not relate to
the other investment terms. However, the terms are interchangeable
and both are used by valuers, but internationally the more accept-
able term is PV £1 pa.
Obviously, the PV £1 pa will increase each year to reflect the addi-
tional receipt of £1. However, each additional receipt is discounted
for one more year and will be worth less following the PV rule estab-
lished above. The PV £1 pa in fact approaches a maximum value
at infinity. However, as the example below shows, the increase
in PV £1 pa becomes very small after 60 years and is customarily
assumed for the purpose of property valuation to reach its maxi-
mum value after 100 years. In valuation terminology this is referred
to as ‘perpetuity’.
 CHAPTER 2: Financial Mathematics for Valuers 2 19

Example 2.8

1 − PV
In the formula what happens to PV as the time period increases?
i
What effect does this have on the value of the PV £1 pa?

From Table 2.1, two facts are clear, the PV decreases over time and
the PV £1 pa increases over time. In addition it can be seen that the
PV £1 pa is the accumulation of the PVs.
As n approaches perpetuity, the PV tends towards 0; the PV of £1
to be received such a long time in the future is reduced to virtually
nothing.

Table 2.1 

Years PV at 10% PV £1 pa at 10%

1 0.90909 0.90909
2 0.82645 1.736
3 0.75131 2.487
4 0.68301 3.170
5 0.62092 3.791
6 0.56447 4.355
7 0.51316 4.868
8 0.46651 5.335
9 0.42410 5.759
10 0.38554 6.145

90 0.0001882 9.998
91 0.0001711 9.998
92 0.0001556 9.998
93 0.0001414 9.999
94 0.0001286 9.999
95 0.0001169 9.999
96 0.0001062 9.999
97 0.0000966 9.999
98 0.0000878 9.999
99 0.0000798 9.999
100 0.0000726 9.999
Perp. 10.000
20 The six functions of £1

Therefore, if PV tends to 0 at perpetuity and if n is infinite then

given that:

1 − PV 1−0 1
PV £ 1pa = then PV £ 1 pa in perpetuity will tend to =
i i i

1
At a rate of 10% the PV £1pa in perp.= = 10
0.10

Example 2.9
A freehold property produces a net income (annual net rent) of £15,000
a year. If an investor requires a return of 8%, what price should be paid?
The income is perpetual so a PV £1 pa in perpetuity should be used.

Income £15,000
PV £1 pa in perp. at 8% 12.5 (1/0.08 = 12.5)
Estimated price £187,500
   
It should be noted that £15,000/0.08 = £187,500 which is a commonly
used way to set out an income in perpetuity PV calculation.

Present Value of £1 pa in perpetuity deferred n

years (PV £1 pa in perp defd or YP of a reversion
to perpetuity)
A further common valuation application of the PV of £1 pa is known
as the PV of £1 pa in perpetuity deferred (‘years’ purchase of a rever-
sion to perpetuity’). It shows the PV of the right to receive a perpet-
ual income starting at a future date and is found by multiplying PV
£1 pa in perpetuity by the PV of £1 at the same rate of interest for the
period of time that has to pass before the perpetual income is due
to commence. It is useful to property valuers, as often property will
be assumed to revert to a perpetual higher income after an initial
period of time, such as following a rent review or renewal of a lease
after a period of under renting.

1 1
PV £ 1 pa perp deferred = PV £ 1 pa in perp × PV £ 1 = ×
i (1 + i)n

Example 2.10
Calculate in two ways the PV of a perpetual income of £600 pa
beginning in seven years’ time using a discount rate of 12%:
Income £600
PV £1 pa in perp at 12% 8.33
Capital value (CV) £5,000
PV £1 in 7 years at 12% 0.45235
PV £2,262
   
or
 CHAPTER 2: Financial Mathematics for Valuers 2 21

Income £600
PV £1 pa perp def’d 7 years at 12% 3.7695*
PV £2,262
   
*Note that 8.33 × 0.45235 = 3.7695

The answer can also be found by deducting the PV £1 pa for seven years
at 12% from the PV £1 pa in perpetuity at 12% 8.3334 – 4.5638 =3.7695.
The use of this PV or discounting technique to assess the price to be
paid for an investment or the value of an income-producing prop-
erty ensures the correct relationship between future benefits and
present worth; namely that the investor will obtain both a return on
capital and a return of capital at the market-derived rate of interest
used (yield or discount rate) in the calculation.
This last point is important and can be missed when PVs are
added together to produce the PV of £1 pa and labelled ‘Years’ Pur-
chase’ by the UK property valuation professional; the emphasis is
on the UK, as few valuers in other countries use this old term which
invariably has to be translated for non-UK clients into PV of £1 pa.

Example 2.11
An investor is offered five separate investment opportunities on five
separate occasions; each will produce a certain cash benefit of £10,000,
the first in exactly one year’s time and the other four at subsequent
yearly intervals. The investor is seeking a 10% return from his money.
What price should be paid for each investment?

Year 1 Year 2 Year 3 Year 4 Year 5

Benefit £10,000 £10,000 £10,000 £10,000 £10,000
PV £1 at 10% 0.9090 0.8264 0.7513 0.6830 0.6209
PV (investment £9,090 £8,264 £7,513 £6,830 £6,209
price today)
Amount of £1 1.1000 1.2100 1.3310 1.4641 1.6105
at 10%
£10,000 £10,000 £10,000 £10,000 £10,000
   
The figures of PV – £9,090, £8,264, £7,513, £6,830, £6,209 – show the
individual prices to be paid today for each investment in order that the
investor can achieve a 10% return on capital invested and obtain the return of
the capital invested. For example, £7,513 is paid for a future benefit of £10,000
in three years time, in three years time the receipt of £10,000 repays the
investment of £7,513; the difference represents the equivalent compound
interest at 10% on the £7,513. This is what is meant by a 10% return.
In other words, the investor is exchanging a sum of money today for
a known future sum which will be equal to the sum of money today,
plus the interest forgone if the capital had been invested elsewhere at
the same rate of interest. In each case the receipt of £10,000 at the due
date returns the respective capital sum or price paid and the difference
between the price today and the £10,000 is equivalent