Alternate 1

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Reading 39
Private Real Estate Investments
by Jeffrey D. Fisher and Bryan D. MacGregor, PhD, MRICS, MRPTI
Jeffrey D. Fisher (USA). Bryan D. MacGregor, PhD, MRICS, MRTPI, is at the University of Aberdeen,
Scotland (United Kingdom).
Copyright © 2012 CFA Institute

LEARNING OUTCOMES
The candidate should be able to:
a. classify and describe basic forms of real estate investments;
b. describe the characteristics, the classification, and basic segments of real estate;
c. explain the role in a portfolio, economic value determinants, investment characteristics, and
principal risks of private real estate;
d. describe commercial property types, including their distinctive investment characteristics;
e. compare the income, cost, and sales comparison approaches to valuing real estate properties;
f. estimate and interpret the inputs (for example, net operating income, capitalization rate, and
discount rate) to the direct capitalization and discounted cash flow valuation methods;
g. calculate the value of a property using the direct capitalization and discounted cash flow valuation
methods;
h. compare the direct capitalization and discounted cash flow valuation methods;
i. calculate the value of a property using the cost and sales comparison approaches;
j. describe due diligence in private equity real estate investment;
k. discuss private equity real estate investment indices, including their construction and potential
biases;

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l. explain the role in a portfolio, the major economic value determinants, investment characteristics,
principal risks, and due diligence of private real estate debt investment;
m. calculate and interpret financial ratios used to analyze and evaluate private real estate investments.

1. INTRODUCTION
Real estate investments comprise a significant part of the portfolios of many investors, so understanding
how to analyze real estate investments and evaluate the role of real estate investments in a portfolio is
important. Real estate investments can take a variety of forms, from private equity investment in
(ownership of) real estate properties (real estate properties, hereafter, may simply be referred to as real
estate) to publicly traded debt investment, such as mortgage-backed securities. While this reading
discusses the basic forms of real estate investments and provides an overview of the real estate market,
its focus is private equity investment in commercial (or income-producing) real estate.
Private equity investment in real estate is sometimes referred to as direct ownership, in contrast to
indirect ownership of real estate through publicly traded equity securities, such as real estate investment
trusts (REITs). Similarly, lending in the private market, such as mortgage lending by banks or insurance
companies, is sometimes referred to as direct lending. Mortgages are loans with real estate serving as
collateral for the loan. Publicly traded debt investment, such as mortgage-backed securities (MBSs), are
sometimes referred to as indirect lending. Each form of real estate investment has characteristics that an
investor should be aware of when considering and making a real estate investment. Also, real estate has
characteristics that differentiate it from other asset classes.
Private real estate investments—equity and debt—are often included in the portfolios of investors with
long-term investment horizons and with the ability to tolerate relatively lower liquidity. Examples of
such investors are endowments, pension funds, and life insurance companies. Other real estate investors
may have short investment horizons, such as a real estate developer who plans to sell a real estate
property to a long-term investor once the development of the property is complete. Publicly traded,
pooled-investment forms of real estate investments, such as REITs, may be suitable for investors with
short investment horizons and higher liquidity needs.
Valuation of commercial real estate properties constitutes a significant portion of this reading.
Regardless of the form of real estate investment, the value of the underlying real estate is critical to its
value. The concepts and valuation techniques described in this reading are generally applicable to global
real estate markets. Valuation of the underlying real estate is of importance to private real estate equity
and debt investors because the value of each type of investment is inextricably tied to the value of the
underlying real estate. Also, because real estate properties do not transact frequently and are unique, we
rely on estimates of value or appraisals rather than transaction prices to assess changes in value over
time. However, transaction prices of similar properties can be useful in estimating value. In creating real
estate indices that serve as benchmarks for performance evaluation, appraised values—rather than
transaction prices—are often used. In recent years, several indices based on actual transactions have
been developed. Both types of indices are discussed in this reading.

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The reading is organized as follows: Section 2 describes basic forms of real estate investment, covering
equity and debt investments and public and private investments. Section 3 discusses characteristics of
real estate and classifications of real estate properties. Section 4 focuses on private equity investment in
real estate. It discusses benefits of and risks associated with investing in real estate. The main types of
commercial real estate markets and characteristics of each are covered. Section 5 introduces the
appraisal (valuation) process and the main approaches used by appraisers to estimate value. Section 6
discusses the income approach, and Section 7 discusses the cost and sales comparison approaches.
Section 8 discusses reconciling the results from these three approaches. Section 9 discusses the due
diligence process typically followed when acquiring real estate investments. Section 10 presents a brief
international perspective. Section 11 considers real estate market indices. Section 12 discusses some
aspects of private market real estate debt. A summary and practice problems complete the reading.

2. REAL ESTATE INVESTMENT: BASIC FORMS
Investment in real estate has been defined from a capital market perspective in the context of quadrants,
or four main areas through which capital can be invested. The quadrants are a result of two dimensions
of investment. The first dimension is whether the investment is made in the private or public market. The
private market often involves investing directly in an asset (for example, purchasing a property) or
getting a claim on an asset (for example, through providing a mortgage to the purchaser). The
investment can made indirectly through a number of different investment vehicles, such as a partnership
or commingled real estate fund (CREF). In either case, the transactions occur in the private market. The
public market does not involve such direct investment; rather, it involves investing in a security with
claims on the underlying position(s)—for example, through investments in a real estate investment trust
(REIT), a real estate operating company (REOC), or a mortgage-backed security.
The second dimension, as illustrated in the examples above, is whether the investment is structured as
equity or debt. An “equity” investor has an ownership interest: Such an investor may be the owner of the
real estate property or may invest in securities of a company or a REIT that owns the real estate property.
The owner of the real estate property controls such decisions as whether to obtain a mortgage loan on the
real estate, who should handle property management, and when to sell the real estate. In the case of a
REIT, that control is delegated to the managers of the REIT by the shareholders. A “debt” investor is in a
position of lender: Such an investor may loan funds to the “entity” acquiring the real estate property or
may invest in securities based on real estate lending. Typically, the real estate property is used as
collateral for a mortgage loan. If there is a loan on the real estate (mortgage), then the mortgage lender
has a priority claim on the real estate. The value of the equity investor’s interest in the real estate is equal
to the value of the real estate less the amount owed to the mortgage lender.
Combining the two dimensions, we have four quadrants: private equity, public equity, private debt, and
public debt, as illustrated in Exhibit 1.

Exhibit 1. Examples of the Basic Forms of Real Estate Investment

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Equity

Debt

Private

Direct investments in real estate. This can be through sole
ownership, joint ventures, real estate limited partnerships,
or other forms of commingled funds.

Mortgages

Publicly
traded

Shares of real estate operating companies and shares of
REITs

Mortgage-backed
securities
(residential and
commercial)

Each of the basic forms of real estate investment has its own risks, expected returns, regulations, legal
structures, and market structures. Private real estate investment, compared with publicly traded real
estate investment, typically involves larger investments because of the indivisibility of real estate
property and is more illiquid. Publicly traded real estate investment allows the real estate property to
remain undivided but the ownership or claim on the property to be divided. This leads to more liquidity
and allows investors to diversify by purchasing ownership interests in more properties than if an entire
property had to be owned by a single investor and/or to diversify by having claims against more
properties than if an entire mortgage had to be funded and retained by a single lender.
Real estate requires management. Private equity investment (ownership) in real estate properties requires
property management expertise on the part of the owner or the hiring of property managers. Real estate
owned by REOCs and REITs is professionally managed and requires no real estate management
expertise on the part of an investor in shares of the REOCs and REITs.
Equity investors generally expect a higher rate of return than lenders (debt investors) because they take
on more risk. The lenders’ claims on the cash flows and proceeds from sale must be satisfied before the
equity investors can receive anything. As the amount of debt on a property, or financial leverage,
increases, risk increases for both debt and equity and an investor’s—whether debt or equity—return
expectations will increase. Of course, the risk is that the higher return will not materialize, and the risk is
even higher for an equity investor.
Debt investors in real estate, whether through private or public markets, expect to receive their return
from promised cash flows and typically do not participate in any appreciation in value of the underlying
real estate. Thus, debt investments in real estate are similar to other fixed-income investments, such as
bonds. The returns to equity real estate investors have two components: an income stream resulting from
such activities as renting the property and a capital appreciation component resulting from changes in
the value of the underlying real estate. If the returns to equity real estate investors are less than perfectly
positively correlated with the returns to stocks and/or bonds, then adding equity real estate investments
to a traditional portfolio will potentially have diversification benefits.

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Real estate markets in each of the four quadrants in Exhibit 1 have evolved and matured to create
relatively efficient market structures for accessing all types of capital for real estate (i.e., public and
private debt and equity). Such structures are critical for the success of the asset class for both lenders and
equity investors. The categorization of real estate investment into the four quadrants helps investors
identify the form(s) that best fit(s) their objectives. For example, some investors may prefer to own and
manage real estate. Other investors may prefer the greater liquidity and professional management
associated with purchasing publicly traded REITs. Other investors may prefer mortgage lending because
it involves less risk than equity investment or unsecured lending; the mortgage lender has a priority
claim on the real estate used as collateral for the mortgage. Still other investors may want to invest in
each quadrant or allocate more capital to one quadrant or another over time as they perceive shifts in the
relative value of each. Each quadrant offers differences in risk and expected return, including the impact
of taxes on the return. So investors should explore the risk and return characteristics of each quadrant as
part of their investment decisions. The balance of this reading focuses on private investment in real
estate—particularly, equity investment.
EXAMPLE 1

Form of Investment
An investor is interested in adding real estate to her portfolio for the first time. She has no
previous real estate experience but thinks adding real estate will provide some diversification
benefits. She is concerned about liquidity because she may need the money in a year or so.
Which form of investment is most likely appropriate for her?
A. Shares of REITs
B. Mortgage-backed securities
C. Direct ownership of commercial real estate property

Solution:
A is correct. She is probably better-off investing in shares of publicly traded REITs, which
provide liquidity, have professional management, and require a lower investment than direct
ownership of real estate. Using REITs, she may be able to put together a diversified real estate
investment portfolio. Although REITs are more correlated with stocks than direct ownership of
real estate, direct ownership is much less liquid and a lot of properties are needed to have a
diversified real estate portfolio. Also, adding shares of REITs to her current portfolio should
provide more diversification benefits than adding debt in the form of mortgage-backed securities
and will allow her to benefit from any appreciation of the real estate. Debt investments in real
estate, such as MBSs, are similar to other fixed-income investments, such as bonds. The
difference is that their income streams are secured on real estate assets, which means that the
risks are default risks linked to the performance of the real estate assets and the ability of
mortgagees to pay interest. In contrast, adding equity real estate investments to a traditional
portfolio will potentially have diversification benefits.

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3. REAL ESTATE: CHARACTERISTICS AND
CLASSIFICATIONS
Regardless of the form of investment, the value of the underlying real estate property is critical to the
performance of the investment. If the property increases in value, the equity investor will benefit from
the appreciation and the debt investor is more likely to receive the promised cash flows. If the property
declines in value, however, the equity investor and even the debt investor may experience a loss.

3.1. Characteristics
Real estate has characteristics that distinguish it from the other main investment asset classes and that
complicate the measurement and assessment of performance. These include the following:
Heterogeneity and fixed location: Whereas all bonds of a particular issue and stocks of a particular
type in a specific company are identical, no two properties are the same. Even identically
constructed buildings with the same tenants and leases will be at different locations. Buildings
differ in use, size, location, age, type of construction, quality, and tenant and leasing arrangements.
These factors are important in trying to establish value and also in the amount of specific risk in a
real estate investment.
High unit value: The unit value of a real estate property is much larger than that of a bond or stock
because of its indivisibility. The amount required to make a private equity investment in real estate
limits the pool of potential private equity investors and the ability to construct a diversified real
estate portfolio. This factor is important in the development of publicly traded securities, such as
REITs, which allow partial ownership of an indivisible asset.
Management intensive: An investor in bonds or stocks is not expected to be actively involved in
managing the company, but a private real estate equity investor or direct owner of real estate has
responsibility for management of the real estate, including maintaining the properties, negotiating
leases, and collecting rents. This active management, whether done by the owner or by hired
property managers, creates additional costs that must be taken into account.
High transaction costs: Buying and selling of real estate is also costly and time consuming
because others, such as appraisers, lawyers, and construction professionals, are likely to be
involved in the process until a transaction is completed.
Depreciation: Buildings depreciate as a result of use and the passage of time. A building’s value
may also change as the desirability of its location and its design changes from the perspective of
end users.

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Need for debt capital: Because of the large amounts required to purchase and develop real estate
properties, the ability to access funds and the cost of funds in the credit markets are important. As
a result, real estate values are sensitive to the cost and availability of debt capital. When debt
capital is scarce or interest rates are high, the value of real estate tends to be lower than when debt
capital is readily available or interest rates are low.
Illiquidity: As a result of several of the above factors, real estate properties are relatively illiquid.
They may take a significant amount of time to market and to sell at a price that is close to the
owner’s perceived fair market value.
Price determination: As a result of the heterogeneity of real estate properties and the low volume
of transactions, estimates of value or appraisals rather than transaction prices are usually necessary
to assess changes in value or expected selling price over time. However, the transaction prices of
similar properties are often considered in estimating the value of or appraising a property. The
limited number of participants in the market for a property, combined with the importance of local
knowledge, makes it harder to know the market value of a property. In a less efficient market,
those who have superior information and skill at evaluating properties may have an advantage.
This is quite different from stocks in publicly traded companies, where many buyers and sellers
value and transact in the shares in an active market.
The above factors fundamentally affect the nature of real estate investment. To overcome some of these
problems, markets in securitized real estate, most notably through REITs, have expanded. REITs are a
type of publicly traded equity investment in real estate. The REIT provides or hires professional property
managers. Investing in shares of a REIT typically allows exposure to a diversified portfolio of real
estate. The shares are typically liquid, and active trading results in prices that are more likely to reflect
market value. A separate reading discusses REITs in greater detail.
EXAMPLE 2

Investment Characteristics
An investor states that he likes investing in real estate because the market is less efficient. Why
might an investor prefer to invest in a less efficient market rather than a more efficient market?

Solution:
In a less efficient market, an investor with superior knowledge and information and/or a better
understanding of the appropriate price to pay for properties (superior valuation skills) may earn a
higher return, provided that market prices adjust to intrinsic values, by making more informed
investment decisions.

3.2. Classifications

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There are many different types of real estate properties. One simple classification distinguishes between
residential and non-residential properties. Another potential classification is single-family residential,
commercial, farmland, and timberland.
Residential properties include single-family houses and multi-family properties, such as apartments. In

general, residential properties are properties that provide housing for individuals or families. Singlefamily properties may be owner-occupied or rental properties, whereas multi-family properties are rental
properties even if the owner or manager occupies one of the units. Multi-family housing is usually
differentiated by location (urban or suburban) and shape of structure (high-rise, low-rise, or garden
apartments). Residential real estate properties, particularly multi-family properties, purchased with the
intent to let, lease, or rent (in other words, produce income) are typically included in the category of
commercial real estate properties (sometimes called income-producing real estate properties).
Non-residential properties include commercial properties other than multi-family properties, farmland,
and timberland. Commercial real estate is by far the largest class of real estate for investment and is the
focus of this reading. Commercial real estate properties are typically classified by end use. In addition to
multi-family properties, commercial real estate properties include office, industrial and warehouse,
retail, and hospitality properties. However, the same building can serve more than one end use. For
example, it can contain both office and retail space. In fact, the same building can contain residential as
well as non-residential uses of space. A property that has a combination of end users is usually referred
to as a mixed-use development. Thus, the classifications should be viewed mainly as a convenient way of
categorizing the use of space for the purpose of analyzing the determinants of supply and demand and
economic performance for each type of space.
Office properties range from major multi-tenant office buildings found in the central business
districts of most large cities to single-tenant office buildings. They are often built to suit or
considering the needs of a specific tenant or tenants. An example of a property developed and built
considering the needs of prospective tenants would be a medical office building near a hospital.
Industrial and warehouse properties include property used for light or heavy manufacturing as
well as associated warehouse space. This category includes special purpose buildings designed
specifically for industrial use that would be difficult to convert to another use, buildings used by
wholesale distributors, and combinations of warehouse/showroom and office facilities. Older
buildings that originally had one use may be converted to another use. For example, office space
may be converted to warehouse or light industrial space and warehouse or light industrial space
may be converted to residential or office space. Frequently, the conversion is based on the
desirability of the area for the new use.
Retail properties vary from large shopping centers with several stores, including large department
stores, as tenants to small stores occupied by individual tenants. As indicated earlier, it is also
common to find retail space combined with office space, particularly on the ground floor of office
buildings in major cities, or residential space.

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Hospitality properties vary considerably in size and amenities available. Motels and smaller hotels
are used primarily as a place for business travelers and families to spend a night. These properties
may have limited amenities and are often located very close to a major highway. Hotels designed
for tourists who plan to stay longer usually have a restaurant, a swimming pool, and other
amenities. They are also typically located near other attractions that tourists visit. Hotels at
“destination resorts” provide the greatest amount of amenities. These resorts are away from major
cities, where the guests usually stay for several days or even several weeks. Facilities at these
resort hotels can be quite luxurious, with several restaurants, swimming pools, nearby golf
courses, and so on. Hotels that cater to convention business may be either in a popular destination
resort or located near the center of a major city.
Other types of commercial real estate that can be owned by investors include parking facilities,
restaurants, and recreational uses, such as country clubs, marinas, sports complexes, and so on.
Retail space that complements the recreational activity (such as gift and golf shops) is often
associated with, or part of, these recreational real estate properties. Dining facilities and possibly
hotel or residential facilities may also be present. A property might also be intended for use by a
special institution, such as a hospital, a government agency, or a university. The physical structure
of a building intended for a specific use may be similar to the physical structure of buildings
intended for other uses. For example, government office space is similar to other office space.
Some buildings intended for one use may not easily be adapted for other uses. For example,
buildings used by universities and hospitals may not easily be adapted to other uses.
Some commercial property types are more management intensive than others. Of the main commercial
property types, hotels require the most day-to-day management and are more like operating a business
than multi-family, office, or retail space. Shopping centers (shopping malls) are also relatively
management intensive because it is important for the owner to maintain the right tenant mix and promote
the mall. Many of the “other” property types, such as recreational facilities, can also require significant
management. Usually, investors consider properties that are more management intensive as riskier
because of the operational risks. Therefore, investors typically require a higher rate of return on these
management-intensive properties.
Farmland and timberland are unique in that each can be used to produce a saleable commodity. Farmland
can be used to produce crops or as pastureland for livestock, and timberland can be used to produce
timber (wood) for use in the forest products industry. While crops and livestock are produced annually,
timber has a much longer growing cycle before the product is saleable. Also, the harvesting of timber
can be deferred if market conditions are perceived to be unfavorable. Sales of the commodities or
leasing the land to another entity generate income. Harvest quantities and commodity prices are the
primary determinants of revenue. These are affected by many factors outside of the control of the
producer and include weather and population demographics. In addition to income-generating potential,
both farmland and timberland have potential for capital appreciation.
EXAMPLE 3

Commercial Real Estate Segments
Commercial real estate properties are most likely to include:

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A. residential, industrial, hospitality, retail, and office.
B. multi-family, industrial, warehouse, retail, and office.
C. multi-family, industrial, hospitality, retail, and timberland.

Solution:
B is correct. Commercial real estate properties include multi-family, industrial, warehouse, retail,
and office as well as hospitality and other. Residential properties include single-family, owneroccupied homes as well as income-producing (commercial) residential properties. Timberland is
a unique category of real estate.

4. PRIVATE MARKET REAL ESTATE EQUITY
INVESTMENTS
There are many different types of equity real estate investors, ranging from individual investors to large
pension funds, sovereign wealth funds, and publicly traded real estate companies. Hereafter, for
simplicity, the term investor refers to an equity investor in real estate. Although there may be some
differences in the motivations for each type of investor, they all hope to achieve one or more of the
following benefits of equity real estate investment:
Current income: Investors may expect to earn current income on the property through letting,
leasing, or renting the property. Investors expect that market demand for space in the property will
be sufficient to produce net income after collecting rents and paying operating expenses. This
income constitutes part of an investor’s return. The amount available to the investor will be
affected by taxes and financing costs.
Price appreciation (capital appreciation): Investors often expect prices to rise over time. Any
price increase also contributes to an investor’s total return. Investors may anticipate selling
properties after holding them for a period of time and realizing the capital appreciation.
Inflation hedge: Investors may expect both rents and real estate prices to rise in an inflationary
environment. If rents and prices do in fact increase with inflation, then equity real estate
investments provide investors with an inflationary hedge. This means that the real rate of return, as
opposed to the nominal rate of return, may be less volatile for equity real estate investments.
Diversification: Investors may anticipate diversification benefits. Real estate performance has not
typically been highly correlated with the performance of other asset classes, such as stocks, bonds,
or money market funds, so adding real estate to a portfolio may lower the risk of the portfolio (that
is, the volatility of returns) relative to the expected return.

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Exhibit 2 shows correlations of returns, for the period 1978–2009, between several asset classes in the

United States based on various reported indices. The indices used are the National Council of Real
Estate Investment Fiduciaries (NCREIF) Property Index for private real estate equity investments, the
S&P 500 Index for stocks, the Barclays Capital Government Bond for bonds, the National Association
of Real Estate Investment Trusts (NAREIT) Equity REIT Index for publicly traded real estate
investments, 90-day T-bills, and the all items US Consumer Price Index for All Urban Consumers (CPIU).
Note that the correlation between the NCREIF index and the S&P 500 is relatively low and the
correlation between the NCREIF index and bonds is negative. This indicates the potential for
diversification benefits of adding private equity real estate investment to a stock and bond portfolio. Also
note that publicly traded REITs have a higher correlation with stocks and bonds than private real estate,
which suggests that public and private real estate do not necessarily provide the same diversification
benefits. When real estate is publicly traded, it tends to behave more like the rest of the stock market
than the real estate market. However, some argue that because the NCREIF index is appraisal based and
lags changes in the transactions market, its correlation with stock indices that are based on transactions
is dampened. This issue is discussed in more detail later in the reading. As a final note on the
correlations, note that the NCREIF index had a higher correlation with the CPI-U than the other
alternatives with the exception of T-bills. This suggests that private equity real estate investments may
provide some inflation protection.
Although the correlations discussed above are based on US data, evidence suggests that real estate
provides similar diversification benefits in other countries.

Exhibit 2. Correlation among Returns on Various Asset Classes (1978–2009)

CPI-U
CPI-U
Bonds
S&P 500
T-bills
NCREIF
REITs

Bondsa

1
–0.2423
1
0.0114
0.0570
0.4885 0.1586
0.3214 –0.0978
0.1135
0.1258

S&P 500

T-Bills

NCREIFb

REITsc

1
0.0953
0.1363
0.5946

1
0.3911
0.0602

1
0.2527

1

a Barclays Capital Government Bond
b National Council of Real Estate Investment Fiduciaries Property Index (NPI)
c National Association of Real Estate Investment Trusts Equity REIT Index

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Tax Benefits: A final reason for investing in real estate, which may be more important to some
investors in certain countries than others, is the preferential tax benefits that may result. Private
real estate investments may receive a favorable tax treatment compared with other investments. In
other words, the same before-tax return may result in a higher after-tax return on real estate
investments compared with the after-tax return on other possible investments. The preferential tax
treatment in the United States comes from the fact that real estate can be depreciated for tax
purposes over a shorter period than the period over which the property actually deteriorates.
Although some real estate investors, such as pension funds, do not normally pay taxes, they
compete with taxable investors who might be willing to pay more for the same property. Publicly
traded REITs also have some tax benefits in some countries. For example, in the United States,
there is no corporate income tax paid by the REIT. That is, by qualifying for REIT status, the
corporation is exempt from corporate taxation as long as it follows certain guidelines required to
maintain REIT status.
EXAMPLE 4

Motivations for Investing in Real Estate
Why would an investor want to include real estate equity investments in a portfolio that already
has a diversified mixture of stocks and bonds?

Solution:
Real estate equity offers diversification benefits because it is less than perfectly correlated with
stocks and bonds; this is particularly true of direct ownership (private equity investment). In
other words, there are times when stocks and bonds may perform poorly but private equity real
estate investments perform well and vice versa. Thus, adding real estate equity investments to a
portfolio may reduce the volatility of the portfolio.

4.1. Risk Factors
Investors want to have an expected return that compensates them for incurring risk. The higher the risk,
the higher should be the expected return. In this section, we consider risk factors associated with
investing in commercial real estate. Most of the risk factors listed affect the value of the real estate
property and, therefore, the investment—equity or debt—in the property. Leverage affects returns on
investments in real estate but not the value of the underlying real estate property. Following are
characteristic sources of risk or risk factors of real estate investment.
Business conditions: Fundamentally, the real estate business involves renting space to users. The
demand for space depends on a myriad of international, national, regional, and local economic
conditions. GDP, employment, household income, interest rates, and inflation are particularly
relevant to real estate. Changes in economic conditions will affect real estate investments because
both current income and real estate values may be affected.

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Long lead time for new development: New development projects typically require a considerable
amount of time from the point the project is first conceived until all the approvals are obtained, the
development is complete, and it is leased up. During this time, market conditions can change
considerably from what was initially anticipated. If the market has weakened, rents can be lower
and vacancy higher than originally expected, resulting in lower returns to the developer.
Alternatively, the demand can be greater than was anticipated, leading to a shortage of space to
meet current demand. These dynamics tend to result in wide price swings for real estate over the
development period.
Cost and availability of capital: Real estate must compete with other assets for debt and equity
capital. The willingness of investors to invest in real estate depends on the availability of debt
capital and the cost of that capital as well as the expected return on other investments, such as
stocks and bonds, which affects the availability of equity capital. A shortage of debt capital and
high interest rates can significantly reduce the demand for real estate and lower prices.
Alternatively, an environment of low interest rates and easy access to debt capital can increase the
demand for real estate investments. These capital market forces can cause prices to increase or
decrease regardless of any changes in the underlying demand for real estate from tenants.
Unexpected inflation: Inflation risk depends on how the income and price of an asset is affected by
unexpected inflation. Fixed-income securities are usually negatively affected by inflation because
the purchasing power of the income decreases with inflation and the face value is fixed at maturity.
Real estate may offer some inflation protection if the leases provide for rent increases due to
inflation or the ability to pass any increases in expenses due to inflation on to tenants. Construction
costs for real estate also tend to increase with inflation, which puts upward pressure on real estate
values. Thus, real estate equity investments may not have much inflation risk depending on how
net operating income (NOI) and values respond to inflation being higher than expected. In a weak
market with high vacancy rates and low rents, when new construction is not feasible, values may
not increase with inflation.
Demographics: Linked to the above factors are a variety of demographic factors, such as the size
and age distribution of the population in the local market, the distribution of socio-economic
groups, and rates of new household formation. These demographic factors affect the demand for
real estate.
Lack of liquidity: Liquidity is the ability to convert an asset to cash quickly without a significant
price discount or loss of principal. Real estate is considered to have low liquidity (high liquidity
risk) because of the large value of an individual investment and the time and cost it takes to sell a
property at its current value. Buyers are unlikely to make large investments without conducting
adequate due diligence, which takes both time and money. Therefore, buyers are not likely to
agree to a quick purchase without a significant discount to the price. Illiquidity means both a
longer time to realize cash and also a risk that the market may move against the investor.
Environmental: Real estate values can be affected by environmental conditions, including
contaminants related to a prior owner or an adjacent property owner. Such problems can
significantly reduce the value because of the costs incurred to correct them.

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Availability of information: Of increasing importance to investors, especially when investing
globally, is having adequate information to make informed investment decisions. A lack of
information to do the property analysis adds to the risk of the investment. The amount of data
available on real estate space and capital markets has improved considerably. While some
countries have much more information available to investors than others, in general, the
availability of information has been increasing on a global basis because real estate investment has
become more global and investors want to evaluate investment alternatives on a comparable basis.
Real estate indices have become available in many countries around the world. These indices
allow investors to benchmark the performance of their properties against that of peers and also
provide a better understanding of the risk and return for real estate compared with other asset
classes. Indices are discussed in more detail in Section 11.
Management: Management involves the cost of monitoring an investment. Investment
management can be categorized into two levels: asset management and property management.
Asset management involves monitoring the investment’s financial performance and making
changes as needed. Property management is exclusive to real estate investments. It involves the
overall day-to-day operation of the property and the physical maintenance of the property,
including the buildings. Management risk reflects the ability of the property and asset managers to
make the right decisions regarding the operation of the property, such as negotiating leases,
maintaining the property, marketing the property, and doing renovations when necessary.
Leverage: Leverage affects returns on investments in real estate but not the value of the underlying
real estate property. Leverage is the use of borrowed funds to finance some of the purchase price
of an investment. The ratio of borrowed funds to total purchase price is known as the loan-tovalue (LTV) ratio. Higher LTV ratios mean greater amounts of leverage. Real estate transactions
can be more highly leveraged than most other types of investments. But increasing leverage also
increases risk because the lender has the first claim on the cash flow and on the value of the
property if there is default on the loan. A small change in NOI can result in a relatively large
change in the amount of cash flow available to the equity investor after making the mortgage
payment.
Other risk factors: Many other risk factors exist, such as unobserved physical defects in the
property, natural disasters (for example, earthquakes and hurricanes), and acts of terrorism.
Unfortunately, the biggest risk may be one that was unidentified as a risk at the time of purchasing
the property. Unidentified risks can be devastating to investors.
Risks that are identified can be planned for to some extent. In some cases, a risk can be converted to a
known dollar amount through insurance. In other cases, risk can be reduced through diversification or
shifted to another party through contractual arrangements. For example, the risk of expenses increasing
can be shifted to tenants by including expense reimbursement clauses in their leases. The risk that
remains must be evaluated and reflected in contractual terms (for example, rental prices) such that the
expected return is equal to or greater than the required return necessary to make the investment.
EXAMPLE 5

Commercial Real Estate Risk

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An investor is concerned about interest rates rising and decides that she will pay all cash and not
borrow any money to avoid incurring any risk due to interest rate changes. This strategy is most
likely to:
A. reduce the risk due to leverage.
B. eliminate the risk due to inflation.
C. eliminate the risk due to interest rate changes.

Solution:
A is correct. If less money is borrowed, there is less risk due to the use of financial leverage.
There is still risk related to changes in interest rates. If interest rates rise, the value of real estate
will likely be affected even if the investor did not borrow any money. Higher interest rates mean
investors require a higher rate of return on all assets. The resale price of the property will likely
depend on the cost of debt to the next buyer, who may be more likely to obtain debt financing.
Furthermore, the investor may be better off getting a loan at a fixed interest rate before rates rise.
There is still risk of inflation, although real estate tends to have a low amount of inflation risk.
But borrowing less money doesn’t necessarily mean the property is less affected by inflation.

4.2. Real Estate Risk and Return Relative to Stocks and Bonds
The characteristics of real estate and the risk factors described above ultimately affect the risk and return
of equity real estate investments. The structure of leases between the owner and tenants also affects risk
and return. More will be discussed about the nature of real estate leases later in this reading, but in
general, leases can be thought of as giving equity real estate investment a bond-like characteristic
because the tenant has a legal agreement to make periodic payments to the owner. At the end of the lease
term, however, there will be uncertainty as to whether the tenant will renew the lease and what the rental
rate will be at that time. These issues will depend on the availability of competing space and also on
factors that affect the profitability of the companies leasing the space and the strength of the overall
economy in much the same way that stock prices are affected by the same factors. These factors give a
stock market characteristic to the risk of real estate. On balance, because of these two influences (bondlike and stock-like characteristics), real estate, as an asset class, tends to have a risk and return (based on
historical data) profile that falls between the risk and return profiles of stocks and bonds. By this, we
mean the risk and return characteristics of a portfolio of real estate versus a portfolio of stocks and a
portfolio of bonds. An individual real estate investment could certainly have risk that is greater or less
than that of an individual stock or bond. Exhibit 3 illustrates the basic risk–return relationships of stocks,
bonds, and private equity real estate. In Exhibit 3, risk is measured by the standard deviation of expected
returns.

Exhibit 3. Returns and Risks of Private Equity Real Estate Compared with Stocks and
Bonds

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EXAMPLE 6

Investment Risk
Which is a riskier investment, private equity real estate or bonds? Explain why.

Solution:
Empirical evidence suggests that private equity real estate is riskier than bonds. Although real
estate leases offer income streams somewhat like bonds, the income expected when leases renew
can be quite uncertain and depend on market conditions at that time, which is unlike the more
certain face value of a bond at maturity.

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4.3. Commercial Real Estate
In this section, the main economic factors that influence demand for each commercial real estate
property type and typical lease terms are discussed. It is important to discuss lease terms because they
affect a property’s value. The main property types included in institutional investors’ portfolios are
office, industrial and warehouse, retail, and multi-family (apartments). These property types are often
considered the core property types used to create a portfolio that is relatively low risk, assuming the
properties are in good locations and well leased (fiscally sound and responsible tenants, low vacancies,
and good rental terms). Another type of property that might be held by an institutional investor is
hospitality properties (for example, hotels). Hotels are usually considered riskier because there are no
leases and their performance may be highly correlated with the business cycle—especially if there is a
restaurant and the hotel depends on convention business.
For each property type, location is a critical factor in determining value. Properties with the highest
value per unit of space are in the best locations and have modern features and functionality. Moderately
valued properties are typically in adequate but not prime locations and/or have slightly outdated features.
Properties with the lowest values per unit of space are in poor locations and have outdated features.

4.3.1. Office
The demand for office properties depends heavily on employment growth—especially in those industries
that use large amounts of office space, such as finance and insurance. The typical amount of space used
per employee is also important because it tends to increase when the economy is strong and decline
when the economy is weak. There also has been a tendency for the average amount of space per
employee to decrease over time as technology has allowed more employees to spend more time working
away from the office and less permanent space is needed.
The average length of an office building lease varies globally. For example, leases on office space
average 3–5 years in the United States and around 10 years in the United Kingdom. However, lease
lengths may vary based on a number of factors, including the desirability of the property and the
financial strength of the tenant as well as other terms in the lease, such as provisions for future rent
changes and whether there are options to extend the lease.
An important consideration in office leases is whether the owner or tenant incurs the risk of operating
expenses, such as utilities, increasing in the future. A “net lease” requires the tenant to be responsible for
paying operating expenses, whereas a “gross lease” requires the owner to pay the operating expenses.
The rent for a net lease is lower than that for an equivalent gross lease because the tenant must bear the
operating expenses as well as the risk of expenses being higher than expected.

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Not all office leases are structured as net or gross leases. For example, a lease may be structured so that
in the first year of the lease, the owner is responsible for paying the operating expenses and for every
year of the lease after that, the owner pays for expenses up to the amount paid in the first year. Any
increase in expenses above that amount is “passed through” to the tenant as an “expense
reimbursement.” That is, the tenant bears the risk of any increase in expenses, although the owner
benefits from any decline in expenses. In a multi-tenant building, the expenses may be prorated among
the tenants on the basis of the amount of space they are leasing. While having a small number of tenants
can simplify managing a property, it increases risk. If one tenant gets into financial difficulties or decides
not to renew a lease, it can have a significant effect on cash flows.
There are differences in how leases are structured over time and in different countries. It is important to
have an understanding of how leases are typically structured in a market and to stay informed about
changes in the typical structure. Lease terms will affect the return and risk to the investor. For example,
in the United Kingdom, until the early 1990s, lease terms averaged about 20 years in length, but they
have now fallen by nearly half. Rents are typically fixed for five years and then set at the higher of the
then market rent or contract rent upon review; these are known as upward-only rent reviews. Leases are
typically on a full repairing and insuring (FRI) basis; the tenant is responsible for most costs. Therefore,
detailed cost (expense) analysis is much less important in deriving net operating income—a critical
measure in estimating the value of a commercial property—in the United Kingdom than in markets
where operating costs are typically the responsibility of the owner.
EXAMPLE 7

Net and Gross Leases
What is the net rent equivalent for an office building where the gross rent is $20 per square foot
and operating expenses are $8 per square foot?

Solution:
On a gross lease, the owner pays the operating expense, whereas on a net lease the tenant pays.
So we might expect the rent on a net lease to be $20 – $8 or $12 per square foot. Because the risk
of change in operating expenses is borne by the tenant rather than the owner, the rent might even
be lower than $12.

4.3.2. Industrial and Warehouse
The demand for industrial and warehouse space is heavily dependent on the overall strength of the
economy and economic growth. The demand for warehouse space is also dependent on import and
export activity in the economy. Industrial leases are often net leases, although gross leases or leases with
expense reimbursements, as described above for office properties, also occur.

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4.3.3. Retail
The demand for retail space depends heavily on trends in consumer spending. Consumer spending, in
turn, depends on the health of the economy, job growth, population growth, and savings rates.
Retail lease terms, including length of leases and rental rates, vary not only on the basis of the quality of
the property but also by the size and the importance of the tenant. For example, in the United States, the
length of leases for the smaller tenants in a shopping center are typically three to five years and are
longer for larger “anchor” tenants, such as a department store. Anchor tenants may be given rental terms
designed to attract them to the property. The quality of anchor tenants is a factor in attracting other
tenants.
A unique aspect of many retail leases is the requirement that the tenants pay additional rent once their
sales reach a certain level. This type of lease is referred to as a “percentage lease.” The lease will
typically specify a “minimum rent” that must be paid regardless of the tenant’s sales and the basis for
calculating percentage rent once the tenant’s sales reach a certain level or breakpoint. For example, the
lease may specify a minimum rent of $30 per square foot plus 10 percent of sales over $300 per square
foot. Note that at the breakpoint of $300 per square foot in sales, we obtain the same rent per square foot
based on either the minimum rent of $30 or 10 percent of $300. This is a typical way of structuring the
breakpoint, and the sales level of $300 would be referred to as a “natural breakpoint.”
EXAMPLE 8

Retail Rents
A retail lease specifies that the minimum rent is $40 per square foot plus 5 percent of sales
revenue over $800 per square foot. What would the rent be if the tenant’s sales are $1,000 per
square foot?

Solution:
The rent per square foot will be $40 plus 5% × ($1,000 – $800) or $40 + $10 = $50. We get the
same answer by multiplying 5% × $1,000 (= $50) because $800 is the “natural breakpoint,”
meaning that 5 percent of $800 results in the minimum rent of $40. A lease may not have the
breakpoint set at this natural level, in which case it is important that the lease clearly defines how
to calculate the rent.

4.3.4. Multi-Family

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The demand for multi-family space depends on population growth, especially for the age segment most
likely to rent apartments. In other words, population demographics are important. The relevant age
segment can be very broad or very narrow depending on the propensity to rent in the culture.
Homeownership rates vary from country to country. The relevant age segment for renters can also vary
by type of property being rented out or by locale. For example, in the United States, the typical renter
has historically been between 25 and 35 years old. However, the average age of a renter of property in an
area attractive to retirees may be higher.
Demand also depends on how the cost of renting compares with the cost of owning—that is, the ratio of
home prices to rents. As home prices rise and become less affordable, more people will rent. Similarly,
as home prices fall, there may be a shift from renting to owning. Higher interest rates will also make
homeownership more expensive because for owners that partially finance the purchase with debt, the
financing cost will be higher and for other homeowners, the opportunity cost of having funds tied up in a
home will increase. This increase in the cost of ownership may cause a shift toward renting. If interest
rates decrease, there may be a shift toward homeownership.
Multi-family properties typically have leases that range from six months to two years, with one year
being most typical. The tenant may or may not be responsible for paying expenses, such as utilities,
depending on whether there are separate meters for each unit. The owner is typically responsible for the
upkeep of common property, insurance, and repair and maintenance of the property. The tenant is
typically responsible for cleaning the space rented and for insurance on personal property.
EXAMPLE 9

Economic Value Determinants
1. The primary economic driver of the demand for office space is most likely:
A. job growth.
B. population growth.
C. growth in savings rates.
2. The demand for which of the following types of real estate is likely most affected by
population demographics?
A. Office
B. Multi-family
C. Industrial and warehouse

Solution to 1:

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A is correct. Job growth is the main economic driver of office demand, especially jobs in
industries that are heavy users of office space, such as finance and insurance. As jobs increase,
companies need to provide office space for the new employees. Population growth may indirectly
affect the demand for office space because it affects demand and job growth. Growth in savings
rates affects consumer spending and the demand for retail space.

Solution to 2:
B is correct. Population demographics are a primary determinant of the demand for multi-family
space.

5. OVERVIEW OF THE VALUATION OF COMMERCIAL
REAL ESTATE
Regardless of the form of real estate investment, the value of the underlying real estate is critical because
the value of any real estate investment is inextricably tied to the value of the underlying real estate.
Commercial real estate properties do not transact frequently, and each property is unique. Therefore,
estimates of value or appraisals, rather than transaction prices, are used to assess changes in value or
expected selling price over time. Appraisals are typically done by individuals with recognized expertise
in this area. These can be independent experts hired to do the appraisals or in-house experts.

5.1. Appraisals
Appraisals (estimates of value) are critical for such infrequently traded and unique assets as real estate
properties. For publicly traded assets, such as stocks and bonds, we have frequent transaction prices that
reflect the value that investors are currently placing on these assets. In contrast, commercial real estate,
such as an apartment or office building, does not trade frequently. For example, a particular building
might sell once in a 10-year period. Thus, we cannot rely on transactions activity for a particular
property to indicate how its value is changing over time.
There are companies, such as real estate investment trusts, that invest primarily in real estate and have
publicly traded shares. REITs are available in many countries around the world. REIT prices can be
observed as with any publicly traded share. REITs are businesses that buy and sell real estate; often do
development; decide how properties are to be financed, when to refinance, and when to renovate
properties; and make many other ongoing management decisions that determine the success of the REIT.
Therefore, the prices of REIT shares reflect both the performance of the management of the company
that owns the real estate and the value of the underlying properties.

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Thus, although it is useful to know how the values of REIT shares are changing over time as an indicator
of changing conditions in the real estate market, it does not substitute for the need to estimate the value
of individual properties. In fact, knowing the appraised value of properties held by REITs is helpful in
estimating the value of the REIT, although, as suggested above, many other factors can affect REIT
share prices over time.
Appraisals can be used to evaluate the performance of the investment or to determine an estimate of
price or value if a transaction is anticipated. Even if there has been a recent transaction of the property,
because it is only one transaction between a particular buyer and seller, the transaction price at which the
property sold may not reflect the value a typical investor might place on the property at that time.1 There
may be circumstances under which a buyer may be willing to pay more than a typical buyer would pay
or a seller may be willing to accept less than a typical seller would accept. Thus, even when there is a
transaction, an appraisal is often used as a basis for estimating the value of the property rather than just
assuming that the agreed upon transaction price equals the value. For example, an appraisal is likely to
be required if the purchaser of the property wants to finance a portion of the purchase with debt. The
lender will typically require an independent appraisal of the property to estimate the value of the
collateral for the loan. Even if the purchaser is not borrowing to finance a portion of the purchase, the
purchaser may have an appraisal done to help establish a reasonable offer price for the property.
Similarly, the seller may have an appraisal done to help establish the asking price for the property.
Properties are also appraised for other reasons. Another important use of appraisals is for performance
measurement—that is, to measure the performance of real estate that is managed for a client. For
example, a pension fund may have decided to invest in real estate in addition to stocks and bonds to
diversify its portfolio. It may have invested directly in the real estate or through an investment manager
that acquires and manages the real estate portfolio. In either case, the pension fund wants to know how
its real estate investments are performing. This performance can be evaluated relative to the performance
of stocks and bonds and against a benchmark that measures the performance of the relevant real estate
asset class. The benchmark is used in the same way that a stock index might be used as a benchmark for
measuring the performance of a stock portfolio.
Measuring the performance of a real estate portfolio requires estimating property values on a periodic
basis, such as annually. Although more frequent measures may be desirable, it may not be practical
because appraising property values is a time-consuming and costly process. It may involve an
independent appraisal by a firm that specializes in appraising investment properties, or it may be done by
an appraiser who works for the investment management firm. In either case, the appraiser is tasked with
estimating the value of the property.

5.1.1. Value

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The focus of an appraisal is usually on what is referred to as the market value of the property. The
market value can be thought of as the most probable sale price. It is what a typical investor is willing to
pay for the property. There are other definitions of value that differ from market value. For example,
investment value (sometimes called worth) is the value to a particular investor. It could be higher or
lower than market value depending on the particular investor’s motivations and how well the property
fits into the investor’s portfolio, the investor’s risk tolerance, the investor’s tax circumstances, and so on.
For example, an investor who is seeking to have a globally well-diversified portfolio of real estate that
does not already have any investments in New York City and Shanghai may place a higher value on
acquiring a property in either of those locations than an investor who already has New York City and
Shanghai properties in his or her portfolio.
There are other types of value that are relevant in practice, such as value in use, which is the value to a
particular user—for example, the value of a manufacturing plant to the company using the building as
part of its business. For property tax purposes, the relevant value is the assessed value of the property,
which may differ from market value because of the way the assessor defines the value. In most cases, the
focus of an appraisal is on market value.
Potential sellers and buyers care about market value because it is useful to know when negotiating price.
The market value may differ from the value that the potential buyer or seller originally placed on the
property and from the price that is ultimately agreed upon.2 A seller in distressed circumstances may be
willing to accept less than market value because of liquidity needs, and a particular buyer (investor) may
be willing to pay more than market value because the worth (investment value) to that buyer exceeds the
value to a typical investor.
Lenders usually care about market value because if a borrower defaults on a mortgage loan, the market
value less transaction costs is the maximum that the lender can expect to receive from the sale of the
property. But there are some exceptions. In some cases, the lender may ask for a more conservative
value, which can be referred to as a mortgage lending value. For example, in Germany the mortgage
lending value is the value of the property which, based on experience, may throughout the life of the
loan be expected to be generated in the event of sale, irrespective of temporary (e.g., economically
induced) fluctuations in value on the relevant property market and excluding speculative elements. In
determining the mortgage lending value, the future saleability of the property is to be taken as a basis
within the scope of a “prudent valuation,” taking into consideration the long-term, permanent features of
the property, the normal regional market situation, and the present and possible alternative uses. Some
have argued that over the decades in which it has been applied, the mortgage lending value has helped
mortgage lending in Germany to have a stabilizing effect on the German real estate market by evening
out current, possibly exaggerated market expectations. The mortgage lending value contrasts with the
notion of “mark-to-market” or “fair value” accounting, which would value an asset at its market value at
the time the loan is made.
EXAMPLE 10

Market Value

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A property that was developed two years ago at a cost of ¥60.0 million, including land, is put on
the market for that price. It sells quickly for ¥50.0 million. After the closing, the purchaser
admits he would have paid up to ¥65.0 million for the property because he owned vacant land
next to the property purchased. A very similar property (approximately the same size, age, etc.)
recently sold for ¥55.0 million.
1. The purchaser is most likely a:
A. typical investor.
B. particular investor.
C. short-term investor.
2. The market value of the property is closest to:
A. ¥50.0 million.
B. ¥55.0 million.
C. ¥65.0 million.
3. The investment value of the property to the buyer is closest to:
A. ¥50.0 million.
B. ¥60.0 million.
C. ¥65.0 million.

Solution to 1:
B is correct. This investor may be willing to pay more than the typical investor because of his
particular circumstances.

Solution to 2:
B is correct. The purchaser paid ¥50.0 million rather than the ¥65.0 million he was willing to pay
for the property. However, we have to be careful about using a transaction price as an indication
of market value because the market may have been thin and the seller may have been distressed
and willing to accept less than the property would have sold for if it had been kept on the market
for a longer period of time. The quick sale suggests that the price may have been lower than what
a typical investor may be willing to pay. There was a comparable property that sold for ¥55.0
million. Combining these facts and based only on this information, it is reasonable to assume that
the market value is closest to ¥55.0 million. Note that what it cost to develop the property two
years ago is not particularly relevant. Markets may have deteriorated since that time, and new
construction may not be feasible.

Solution to 3:

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C is correct. The investment value of the property is ¥65.0 million. The purchaser was willing to
pay up to ¥65.0 million, suggesting that his investment value was higher than the amount paid.
He paid only as much as he had to, based on negotiations with the seller.

5.2. Introduction to Valuation Approaches
In general, there are three different approaches that appraisers use to estimate value: the income
approach, the cost approach, and the sales comparison approach. The income approach considers
what price an investor would pay based on an expected rate of return that is commensurate with the risk
of the investment. The value estimated with this approach is essentially the present value of the expected
future income from the property, including proceeds from resale at the end of a typical investment
holding period. The concept is that value depends on the expected rate of return that investors would
require to invest in the property.
The cost approach considers what it would cost to buy the land and construct a new property on the site
that has the same utility or functionality as the property being appraised (referred to as the subject
property). Adjustments are made if the subject property is older or not of a modern design, if it is not
feasible to construct a new property in the current market, or if the location of the property is not ideal
for its current use. The concept is that you should not pay more for a property than the cost of buying
vacant land and developing a comparable property.
The sales comparison approach considers what similar or comparable properties (comparables)
transacted for in the current market. Adjustments are made to reflect comparables’ differences from the
subject property, such as size, age, location, and condition of the property and to adjust for differences in
market conditions at the times of sale. The concept is that you would not pay more than others are
paying for similar properties.
These approaches are unlikely to result in the same value because they rely on different assumptions and
availability of data to estimate the value. The idea is to try to triangulate on the market value by
approaching the estimate three different ways. The appraiser may have more confidence in one or more
of the approaches depending on the availability of data for each approach. Part of the appraisal process is
to try to reconcile the differences in the estimates of value from each approach and come up with a final
estimate of value for the subject property.

5.2.1. Highest and Best Use
Before we elaborate on the three approaches to estimating value, it is helpful to understand an important
concept known as highest and best use. The highest and best use of a vacant site is the use that would
result in the highest value for the land. This concept is best illustrated with an example. Suppose you are
trying to determine the highest and best use of a vacant site. Three alternative uses—apartment, office,
and retail—have been identified as consistent with zoning regulations and are financially feasible at the
right land value. The physical characteristics of the site make construction of buildings consistent with
each of these uses possible. Exhibit 4 summarizes relevant details for each potential use:

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Exhibit 4. Highest and Best Use

Value after construction
Cost to construct building
Implied land value

Apartment

Office

Retail

$2,500,000
(2,000,000)

$5,000,000
(4,800,000)

$4,000,000
(3,000,000)

$500,000

$200,000

$1,000,000

The value after construction is what the property would sell for once it is constructed and leased. The
cost to construct the building includes an amount for profit to the developer. The profit compensates the
developer for handling the construction phase and getting the property leased. Subtracting the cost to
construct from the value after construction gives the amount that could be paid for the land. In this case,
the retail use results in the highest price that can be paid for the land. So retail is the highest and best use
of the site, and the land value would be $1 million.
The idea is that the price would be bid up to that amount by investors or developers who are competing
for the site, including several bidders planning to develop retail. Note that the highest and best use is not
the use with the highest total value, which in this example is office. Even though office has a higher
value if it is built, the higher construction costs result in a lower amount that can be paid for the land. A
developer cannot pay $1 million for the land and build the office building. If they did, they would have a
$5.8 million total investment in the land and construction cost but the value would be only $5 million.
So that would result in an $800,000 loss in value because an office building is not the highest and best
use of the site.
The theory is that the land value is based on its highest and best use as if vacant even if there is an
existing building on the site. If there is an existing building on the site that is not the highest and best use
of the site, then the value of the building—not the land—will be lower. For example, suppose that a site
with an old warehouse on it would sell for $1.5 million as a warehouse (land and building). If vacant, the
land is worth $1 million. Thus, the value of the existing building (warehouse) is $500,000 (= $1,500,000
– $1,000,000). As long as the value under the existing use is more than the land value, the building
should remain on the site. If the value under the existing use falls below the land value, any building(s)
on the site will likely be demolished so the building that represents the highest and best use of the site
can be constructed. For example, if the value as a warehouse is only $800,000, it implies a building
value of negative $200,000. The building should be demolished, assuming the demolition costs are less
than $200,000.
EXAMPLE 11

Highest and Best Use

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Two uses have been identified for a property. One is an office building that would have a value
after construction of $20 million. Development costs would be $16 million, which includes a
profit to the developer. The second use is an apartment building that would have a value after
construction of $25 million. Development costs, including a profit to the developer, would be $22
million. What is the highest and best use of the site and the implied land value?

Solution:

Value on completion
Cost to construct building
Implied land value

Office

Apartment

$20,000,000
(16,000,000)

$25,000,000
(22,000,000)

$4,000,000

$3,000,000

An investor/developer could pay up to $4 million for the land to develop an office building but
only $3 million for the land to develop an apartment building. The highest and best use of the site
is an office building with a land value of $4 million. Of course, this answer assumes a
competitive market with several potential developers who would bid for the land to develop an
office building.

We will now discuss each of the approaches to estimating value in more detail and provide examples of
each.

6. THE INCOME APPROACH TO VALUATION
The direct capitalization method and discounted cash flow method (DCF) are two income
approaches used to appraise a commercial (income-producing) property. The direct capitalization
method estimates the value of an income-producing property based on the level and quality of its net
operating income. The DCF method discounts future projected cash flows to arrive at a present value of
the property. Net operating income, a measure of income and a proxy for cash flow, is a focus of both
approaches.

6.1. General Approach and Net Operating Income

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The income approach focuses on net operating income3 generated from a property. There are two
income approaches, each of which considers growth. The first, the direct capitalization method,
capitalizes the current NOI using a growth implicit capitalization rate. When the capitalization rate is
applied to the forecasted first-year NOI for the property, the implicit assumption is that the first-year NOI
is representative of what the typical first-year NOI would be for similar properties. The second, the DCF
method, applies an explicit growth rate to construct an NOI stream from which a present value can be
derived. As we will see, there is some overlap because, even for the second method, we generally
estimate a terminal value by capitalizing NOI at some future date.
Income can be projected either for the entire economic life of the property or for a typical holding period
with the assumption that the property will be sold at the end of the holding period. We will see that there
are many different ways of applying the income approach depending on how complex the income is for
the property being valued. But no matter how the approach is applied, the concept is that the value is
based on discounting the cash flows, typically represented by NOI in real estate contexts. The discount
rate should reflect the risk characteristics of the property. It can be derived from market comparisons or
from specific analysis; we will examine both cases.
When the property has a lot of different leases with different expiration dates and complex lease
provisions, the income approach is often done with spreadsheets or software.4 At the other extreme,
when simplifying assumptions can be made about the pattern of future income, simple formulas often
can be used to estimate the value.
To value a property using an income approach, we need to calculate the net operating income for the
property. NOI is a measure of the income from the property after deducting operating expenses for such
items as property taxes, insurance, maintenance, utilities, repairs, and insurance but before deducting any
costs associated with financing and before deducting federal income taxes. This is not to suggest that
financing costs and federal income taxes are not important to an investor’s cash flows. It simply means
that NOI is a before-tax unleveraged measure of income.5
There may be situations where the lease on a property requires the tenants to be responsible for some or
all of the expenses so that they would not be deducted when calculating NOI. Or they might be
deducted, but then the additional income received from the tenants due to reimbursement of these
expenses would be included when calculating the NOI. Of course, when the tenant must pay the
expenses, we might expect the rent to be lower. It is necessary to consider specific lease terms when
estimating NOI. As mentioned before, typical lease terms vary from country to country.
A general calculation of NOI is shown in Exhibit 5.

Exhibit 5. Calculating NOI
Rental income at full occupancy
 + Other income (such as parking)
= Potential gross income (PGI)

 – Vacancy and collection loss

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= Effective gross income (EGI)

 – Operating expenses (OE)
= Net operating income (NOI)

EXAMPLE 12

Net Operating Income
A 50-unit apartment building rents for $1,000 per unit per month. It currently has 45 units rented.
Operating expenses, including property taxes, insurance, maintenance, and advertising, are
typically 40 percent of effective gross income. The property manager is paid 10 percent of
effective gross income. Other income from parking and laundry is expected to average $500 per
rented unit per year. Calculate the NOI.

Solution:
Rental income at full occupancy
Other income
Potential gross income

50 × $1,000 × 12 =
50 × $500 =

$600,000
+25,000

Vacancy loss
Effective gross income

5/50 or 10% × $625,000 =

$625,000
–62,500

Property management
Other operating expenses
Net operating income

10% of $562,500 =
40% of $562,500 =

$562,500
–56,250
–225,000
$281,250

6.2. The Direct Capitalization Method
The direct capitalization method capitalizes the current NOI at a rate known as the capitalization rate, or
cap rate for short. If we think about the inverse of the cap rate as a multiplier, the approach is analogous
to an income multiplier. The direct capitalization method differs from the DCF method, in which future
operating income (a proxy for cash flow) is discounted at a discount rate to produce a present value.

6.2.1. The Capitalization Rate and the Discount Rate

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The cap and discount rates are closely linked but are not the same. Briefly, the discount rate is the return
required from an investment and comprises the risk-free rate plus a risk premium specific to the
investment. The cap rate is lower than the discount rate because it is calculated using the current NOI.
So, the cap rate is like a current yield for the property whereas the discount rate is applied to current and
future NOI, which may be expected to grow. In general, when income and value are growing at a
constant compound growth rate, we have:
Equation (1) 
Cap rate = Discount rate – Growth rate  
The growth rate is implicit in the cap rate, but we have to make it explicit for a DCF valuation.

6.2.2. Defining the Capitalization Rate
The capitalization rate is a very important measure for valuing income-producing real estate property.
The cap rate is defined as follows:
Equation (2) 
Cap rate = NOI/Value  
where the NOI is usually based on what is expected during the current or first year of ownership of the
property. Sometimes the term going-in cap rate is used to clarify that it is based on the first year of
ownership when the investor is going into the deal. (Later, we will see that the terminal cap rate is based
on expected income for the year after the anticipated sale of the property.)
The value used in the above cap rate formula is an estimate of what the property is worth at the time of
purchase. If we rearrange the above equation and solve for value we see that:
Equation (3) 
Value = NOI/Cap rate  
So, if we know the appropriate cap rate, we can estimate the value of the property by dividing its firstyear NOI by the cap rate.
Where does the cap rate come from? That will be an important part of our discussion. A simple answer is
that it is based on observing what other similar or comparable properties are selling for. Assuming that
the sale price for a comparable property is a good indication of the value of the subject property, we
have:
Equation (4) 
Cap rate = NOI/Sale price of comparable  

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We would not want to rely on the price for just one sale to indicate what the cap rate is. We want to
observe several sales of similar properties before drawing conclusions about what cap rates investors are
willing to accept for a property. As we will discuss later, there are also reasons why we would expect the
cap rate to differ for different properties, such as what the future income potential is for the property—
that is, how it is expected to change after the first year. This is important because the cap rate is only
explicitly based on the first-year income. But the cap rate that investors are willing to accept depends on
how they expect the income to change in the future and the risk of that income. These expectations are
said to be implicit in the cap rate.
The cap rate is like a snapshot at a point in time of the relationship between NOI and value. It is
somewhat analogous to the price–earnings multiple for a stock except that it is the reciprocal.6 The
reciprocal of the cap rate is price divided by NOI. Just as stocks with greater earnings growth potential
tend to have higher price–earnings multiples, properties with greater income growth potential have
higher ratios of price to current NOI and thus lower cap rates.
It is often necessary to make adjustments based on specific lease terms and characteristics of a market.
For example, a similar approach is common in the United Kingdom, where the term fully let property is
used to refer to a property that is leased at market rent because either it has a new tenant or the rent has
just been reviewed. In such cases, the appraisal is undertaken by applying a capitalization rate to this
rent rather than to NOI because leases usually require the tenant to pay all costs. The cap rate derived by
dividing rent by the recent sales prices of comparables is often called the all risks yield (ARY). Note that
the term “yield” in this case is used like a “current yield” based on first-year NOI. It is a cap rate and
will differ from the total return that an investor might expect to get from future growth in NOI and value.
If it is assumed, however, that the rent will be level in the foreseeable future (like a perpetuity), then the
cap rate will be the same as the return and the all risks yield will be an internal rate of return (IRR) or
yield to maturity.
In simple terms, the valuation is:
Equation (5) 
Market value = Rent/ARY  
Again, this valuation is essentially the same as dividing NOI by the cap rate as discussed earlier except
the occupant is assumed to be responsible for all expenses so the rent is divided by the ARY.7 ARY is a
cap rate and will differ from the required total return (the discount rate) an investor might expect to get
by future growth in NOI and value. If rents are expected to increase after every rent review, then the
investor’s expected return will be higher than the cap rate. If rents are expected to increase at a constant
compound rate, then the investor’s expected return (discount rate) will equal the cap rate plus the growth
rate.
EXAMPLE 13

Capitalizing NOI

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A property has just been let at an NOI of £250,000 for the first year, and the capitalization rate on
comparable properties is 5 percent. What is the value of the property?

Solution:
Value = NOI/Cap rate = £250,000/0.05 = £5,000,000

Suppose the rent review for the property in Example 13 occurs every year and rents are expected to
increase 2 percent each year. An approximation of the IRR would simply be the cap rate plus the growth
rate; in this case, a 5 percent cap rate plus 2 percent rent growth results in a 7 percent IRR. Of course, if
the rent review were less frequent, as in the United Kingdom where it is typically every five years, then
we could not simply add the growth rate to the cap rate to get the IRR. But it would still be higher than
the cap rate if rents were expected to increase.

6.2.3. Stabilized NOI
When the cap rate is applied to the forecasted first-year NOI for the property, the implicit assumption is
that the first-year NOI is representative of what the typical first-year NOI would be for similar
properties. In some cases, the appraiser might project an NOI to be used to estimate value that is
different from what might actually be expected for the first year of ownership for the property if what is
actually expected is not typical.
An example of this might be when a property is undergoing a renovation and there is a temporarily
higher-than-typical amount of vacancy until the renovation is complete. The purpose of the appraisal
might be to estimate what the property will be worth once the renovation is complete. A cap rate will be
used from properties that are not being renovated because they are more typical. Thus, the appraiser
projects what is referred to as a stabilized NOI, which is what the NOI would be if the property were
not being renovated—in other words, what the NOI will be once the renovation is complete. This NOI is
used to estimate the value. Of course, if the property is being purchased before the renovation is
complete, a slightly lower price will be paid because the purchaser has to wait for the renovation to be
complete to get the higher NOI. Applying the cap rate to the lower NOI that is occurring during the
renovation will understate the value of the property because it implicitly assumes that the lower NOI is
expected to continue.8
EXAMPLE 14

Value of a Property to be Renovated

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A property is being purchased that requires some renovation to be competitive with otherwise
comparable properties. Renovations satisfactory to the purchaser will be completed by the seller
at the seller’s expense. If it were already renovated, it would have NOI of ¥9 million next year,
which would be expected to increase by 3 percent per year thereafter. Investors would normally
require a 12 percent IRR (discount rate) to purchase the property after it is renovated. Because of
the renovation, the NOI will only be ¥4 million next year. But after that, the NOI is expected to
be the same as it would be if it had already been renovated at the time of purchase. What is the
value of or the price a typical investor is willing to pay for the property?

Solution:
If the property was already renovated (and the NOI stabilized), the value would be:
Value if renovated = ¥9,000,000/(0.12 – 0.03) = ¥100,000,000
But because of the renovation, there is a loss in income of ¥5 million during the first year. If for
simplicity we assume that this would have been received at the end of the year, then the present
value of the lost income at a 12 percent discount rate is as follows:
Loss in value = ¥5,000,000/(1.12) = ¥4,464,286
Thus, the value of the property is as follows:
Value if renovated
Less loss in value
= Value

¥100,000,000
– ¥4,464,286
¥95,535,714

An alternative approach is to get the present value of the first year’s income and the value in a
year when renovated.
{¥4,000,000 + [¥9,000,000(1.03)]/(0.12– 0.03)]}/(1.12) = ¥95,535,714

6.2.4. Other Forms of the Income Approach

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Direct capitalization usually uses NOI and a cap rate. However, there are some alternatives to the use of
NOI and a cap rate. For example, a gross income multiplier might be used in some situations. The gross
income multiplier is the ratio of the sale price to the gross income expected from the property in the first
year after sale. It may be obtained from comparable sales in a similar way to what was illustrated for cap
rates. The problem with using a gross income multiplier is that it does not explicitly consider vacancy
rates and operating expenses. Thus, it implicitly assumes that the ratio of vacancy and expenses to gross
income is similar for the comparable and subject properties. But if, for example, expenses were expected
to be lower on one property versus another because it was more energy efficient, an investor would pay
more for the same rent. Thus, its gross income multiplier should be higher. Use of a gross rent multiplier
is also considered a form of direct capitalization but is generally not considered as reliable as using a
capitalization rate.

6.3. The Discounted Cash Flow (DCF) Method
The direct capitalization method typically estimates value by capitalizing the first-year NOI at a cap rate
derived from market evidence.9

6.3.1. The Relationship between Discount Rate and Cap Rate
If the income and value for a property are expected to change over time at the same compound rate—for
example, 3 percent per year—then the relationship between the cap rate and discount rate is the same as
in Equation 1:
Cap rate = Discount rate – Growth rate
To see the intuition behind this, let us solve for the discount rate, which is the return that is required to
invest in the property.
Discount rate = Cap rate + Growth rate
Recall that the cap rate is based on first-year NOI. The growth rate captures how NOI will change in the
future along with the property value. Thus, we can say that the investor’s return (discount rate) comes
from the return on first-year income (cap rate) plus the growth in income and value over time (growth
rate). Although income and value may not always change at the same compound rate each year, this
formula gives us insight into the relationship between the discount rate and the cap rate. Essentially, the
difference between the discount and cap rates has to do with growth in income and value.
Intuitively, given that both methods start from the same NOI in the first year, you would pay more for an
income stream that will grow than for one that will be constant. So, the price is higher and the cap rate is
lower when the NOI is growing. This is what is meant by the growth being implicit in the cap rate. If the
growth rate is constant, we can extend Equation 3 using Equation 1 to give:
Equation (6) 
V = NOI/(r – g)  

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where:
r = the discount rate (required return)
g = the growth rate for income (given constant growth in income, value will grow at the same rate)
This equation is analogous to the dividend growth model applied to stocks. If NOI is not expected to
grow at a constant rate, then NOIs are projected into the future and each period’s NOI is discounted to
arrive at a value of the property. Rather than project NOIs into infinity, typically, NOIs are projected for
a specified holding period and a terminal value (estimated sale price) at the end of the holding period is
estimated.
EXAMPLE 15

Growth Explicit Appraisal
NOI is expected to be $100,000 the first year, and after that, NOI is expected to increase at 2
percent per year for the foreseeable future. The property value is also expected to increase by 2
percent per year. Investors expect to get a 12 percent IRR given the level of risk, and therefore,
the value is estimated using a 12 percent discount rate. What is the value of the property today
(beginning of first year)?

Solution:
V = NOI/(r – g)
= $100,000/(0.12 – 0.02)
= $100,000/0.10
= $1,000,000

6.3.2. The Terminal Capitalization Rate
When a DCF methodology is used to value a property, generally, one of the important inputs is the
estimated sale price of the property at the end of a typical holding period. This input is often referred to
as the estimated terminal value. Estimating the terminal value of a property can be quite challenging in
practice, especially given that the purpose of the analysis is to estimate the value of the property today.
But if we do not know the value of the property today, how can we know what it will be worth in the
future when sold to another investor? This means we must also use some method for estimating what the
property will be worth when sold in the future.

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In theory, this value is based on the present value of income to be received by the next investor. But we
usually do not try to project NOI for another holding period beyond the initial one. Rather, we rely on
the direct capitalization method using the NOI of the first year of ownership for the next investor and a
cap rate. The cap rate used to estimate the resale price or terminal value is referred to as a terminal cap
rate or residual cap rate. It is a cap rate that is selected at the time of valuation to be applied to the NOI
earned in the first year after the property is expected to be sold to a new buyer.
Selecting a terminal cap rate is challenging. Recall that the cap rate equals the discount rate less the
growth rate when income and value are growing constantly at the same rate. Whether constant growth is
realistic or not, we know that the cap rate will be higher (lower) if the discount rate is higher (lower).
Similarly, the cap rate will be lower if the growth rate is expected to be higher, and vice versa. These
relationships also apply to the terminal cap rate as well as the going-in cap rate.
The terminal cap rate could be the same, higher, or lower than the going-in cap rate depending on
expected discount and growth rates at the time of sale. If interest rates are expected to be higher in the
future, pushing up discount rates, then terminal cap rates might be higher. The growth rate is often
assumed to be a little lower because the property is older at the time of sale and may not be as
competitive. This situation would result in a slightly higher terminal cap rate. Uncertainty about what the
NOI will be in the future may also result in selecting a higher terminal cap rate. The point is that the
terminal cap rate is not necessarily the same as the going-in cap rate at the time of the appraisal.
EXAMPLE 16

Appraisal with a Terminal Value
Net operating income (NOI) is expected to be level at $100,000 per year for the next five years
because of existing leases. Starting in Year 6, the NOI is expected to increase to $120,000
because of lease rollovers and increase at 2 percent per year thereafter. The property value is also
expected to increase at 2 percent per year after Year 5. Investors require a 12 percent return and
expect to hold the property for five years. What is the current value of the property?

Solution:
Exhibit 6 shows the projected NOI for this example. Because NOI and property value are

expected to grow at the same constant rate after Year 5, we can calculate the cap rate at that time
based on the discount rate less the growth rate. That gives us a terminal cap rate that can be used
to estimate the value that the property could be sold for at the end of Year 5 (based on the income
a buyer would get after that). We can then discount this value along with the income for Years 1–
5 to get the present value.

Exhibit 6. Projected Income

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Step 1 Estimate resale price after five years.
Resale (residual) or “terminal” cap rate = 12% − 2% = 10%
Apply this to NOI in Year 6:
Resale = $120,000/0.10 = $1,200,000
Note: The value that can be obtained by selling the property at some point in the future
is often referred to as the “reversion.”
Step 2 Discount the level NOI for the first five years and the resale price.10
PMT = $100,000
FV = $1,200,000
n=5
i = 12%
Solving for PV, the current value of the property is estimated to be $1,041,390.

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Note that the implied going-in cap rate is $100,000/$1,041,390 = 9.60%.

In Example 16, the going-in cap rate is lower than the terminal cap rate. An investor is willing to pay a
higher price for the current NOI because he or she knows that it will increase when the lease is renewed
at market rents in five years. The expected rent jump on lease renewal is implicit in the cap rate.
As noted earlier, we often expect the terminal cap rate to be higher than the going-in cap rate because it
is being applied to income that is more uncertain. Also, the property is older and may have less growth
potential. Finding a lower implied going-in cap rate in this example is consistent with this. However,
there are times when we would expect the terminal cap rate to be lower than the going-in cap rate—for
example, if we thought that interest rates and thus discount rates would be lower when the property is
sold in the future or we expected that markets would be a lot stronger in the future with expectations for
higher rental growth than in the current market.
EXAMPLE 17

Appraisal with Level NOI
Suppose the NOI from a property is expected to be level at $600,000 per year for a long period of
time such that, for all practical purposes, it can be assumed to be a perpetuity. What is the value
of the property assuming investors want a 12 percent rate of return?

Solution:
In this case, the growth rate is zero, so we have:
Value = NOI/Discount rate
Value = $600,000/0.12 = $5,000,000
Note that in this case the cap rate will be the same as the discount rate. This is true when there is
no expected change in income and value over time.

6.3.3. Adapting to Different Lease Structures

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Lease structures vary across locales and can have an effect on the way value is typically estimated in a
specific locale. For example, in the United Kingdom, lease structures have influenced the development
of specific approaches to appraisal. In the United Kingdom, the term valuation is typically used rather
than the term appraisal. A valuation, like an appraisal, is usually an assessment of “the most likely
selling price” of a property or its market value (MV). While the cost approach (discussed in Section 7.1)
is used in particular circumstances and the sales comparison approach dominates the single-family home
market, the most common approach to valuing commercial property combines elements of direct
capitalization (often with implicit discounted cash flow analysis) and explicit discounted cash flow
analysis. This combination has been developed in response to the typical structure of UK leases.
In Section 6.2.2, we discussed the use of a cap rate called the all risks yield to value a fully let property
(a property fully leased at current market rents with the tenant[s] paying all operating expenses) in the
United Kingdom. If the appraisal date falls between the initial letting (or the last rent review) and the
next rent review, adjustments have to be made because the contract rent (referred to as passing rent) is
not equal to the current market rent (referred to as the open market rent). If the current market rent is
greater than the contract rent, then the rent is likely to be adjusted upward at the time of the rent review
and the property has what is referred to in the United Kingdom as a “reversionary potential” because of
the higher rent at the next rent review.11 This expected increase in rent has to be included in the
appraisal.
There are several ways of dealing with this expected change in rent, but each should result in a similar
valuation. One way, which is referred to as the “term and reversion approach” in the United Kingdom,
simply splits the income into two components. The term rent is the fixed passing (current contract) rent
from the date of appraisal to the next rent review, and the reversion is the estimated rental value (ERV).
The values of the two components of the income stream are appraised separately by the application of
different capitalization rates.
The capitalization rate used for the reversion is derived from sales of comparable fully let properties, on
the basis that the reversion is equivalent to a fully let property, because both have potential for income
growth every five years due to rent review.12 However, the capitalized reversionary income is a future
value, so it has to be discounted from the time of the rent review to the present. By convention, the rate
used to discount this future reversionary value to the present is the same as the capitalization rate used to
calculate the reversionary value, although they do not have to be the same.
The discount rate applied to the term rent is typically lower than that for the reversion because the term
rent is regarded as less risky because it is secured by existing leases and tenants are less likely to default
when they have leases with below-market-rate rents. Example 18 illustrates estimating the value of a
property with term rent and reversion.
EXAMPLE 18

A Term and Reversion Valuation

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A property was let for a five-year term three years ago at £400,000 per year. Rent reviews occur
every five years. The estimated rental value (ERV) in the current market is £450,000, and the all
risks yield (cap rate) on comparable fully let properties is 5 percent. A lower rate of 4 percent is
considered appropriate to discount the term rent because it is less risky than market rent (ERV).
Exhibit 7 shows the assumed cash flows for this example. Estimate the value of the property.

Exhibit 7. Assumed Cash Flows

Solution:
The first step is to find the present value of the term rent of £400,000 per year for two years. At a
4 percent discount rate, the present value of £400,000 per year for two years is £754,438. The
second step is to estimate the present value of the £450,000 ERV at the time of the rent review.
At a 5 percent capitalization rate, this value is £9,000,000 (= £450,000/0.05). This value is at the
time of rent review and must be discounted back for two years to the present. Using a discount
rate that is the same as the capitalization rate of 5 percent results in a present value of
£8,163,265. Adding this to the value of the term rent of £754,438 results in a total value of
£8,917,703. In summary:
Term rent
PV 2 years at 4%
Value of term rent
Reversion to ERV

£400,000
× 1.8860947
= £754,438
£450,000