# Methods Of Rental Valuations Economics Essay

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Published: *Mon, 5 Dec 2016*

Rental values between similar properties usually are assessed by comparisons. The method assumes that similar properties tend to have similar rental values. The valuer tries to compare the property under consideration with other recent rented properties at the same area to determine the rental value. Some traps are involved on this process, property is heterogeneous means that every property is different, as a result adjustments should be made for an accurate evaluation. A lot of factors affect the rent of a property such as age, type of construction , arrangement for accommodation, facilities provided , location, accessibility and any other special factors.

Furthermore, the transactions in which the valuation is based should be recent, the more recent the transaction the better the estimation otherwise the evaluation will be less accurate and sometimes misleading. Also market conditions should be considered. If the market has been volatile over the last period adjustments should be made to forecast the market to apply an accurate rental value.

In comparing one property with another is often helpful to use a unit of comparison. The unit chosen for the comparison depends on the type of the property.

Hectares and acres for land

Metric units for agriculture

Square metres and square feet for industrial and commercial properties

Foot frontage for shops

No of beds for hotels

Dining spaces for restaurants

Seats for theatres & cinemas

Size is a really important factor and tends to have big impact on rent. The rule is the higher the size the higher the rent up to a certain point, after that point demand tends to decrease as a consequence rental value will drop to reach equilibrium. For example, £ per square feet tends to decrease for industrial property if the size of the property is big, corporations that can operate and use the whole property efficiently are limited.

## Example

When you want to value let’s say the a shop by compare it with another that has been recently rented you need to take into the factors that affect rental values. Once you have calculated the £/sq. ft. By dividing the rent over the total areal of the shop you should consider the terms of the lease. If the £/sq. ft. you have calculated is based on full repairing and insuring terms and the one you are valuing is based on the internal repairs landlord’s expenses should be added. In addition, different areas have different rental values , shops at high streets for example tend to have higher rentals than local shops.

## Zoning

It is widely believed that some parts of a building is more valuable than others, and that trend is translated into higher rental values for these particular parts. For example, ground floor of a residential property worth more than the rest flats within the building. If the building is new and has a lift the rest floors have approximately the same rent with each other, on the other hand, if the building is old and does not have a lift the decrease of the rent becomes higher and usually the last floor has the smallest rent.

In addition, retailers believe that the front area of the shop generate more business and for that reason they are willing to pay a premium to rent this part. Zoning is the most appropriate method to value shops. Zoning operates by dividing the property into separate zones with the unit rental changing from zone to zone. There two main methods of zoning Arithmetic and Natural.

Arithmetic Zoning

Usually divides a shop into three zones A, B and C or sometimes four. The deviation of the shop starts from the front part of the shop. Difficulties arise when the shop has entrance from two streets and it is difficult to determine which is the front, under those circumstances the most appropriate is to call front part of the shop the part on the most busiest street. The depth of the zone is not critical as long as the depths of the zones of all shops under consideration are equal, zones are usually 20 feet depth, zones A and B have the same depth and C depth’s is the remaining. Once the area is divided into parts, rents are usually ‘halved back’. Thus if the rent of zone A is £K the rent of zone B is £K/2 and the rent of zone C is £K/4. Any other lower or upper floors are worth £K/5 or less.

## Example

Let’s say that we need to value shop Z by using shop X as a comparison. Dimensions of both shops and rent of shop X are given. The most appropriate ‘unit of comparison’ for shops is £/square feet. The following steps should be followed:

At the beginning you need to find the area expressed in terms of Zone A. As it is mentioned before rents are halved back so each area has a different weight, Zone B weight is half than Zone A so if the area of A is 300sq.ft Zone B area in terms of A is 150sq.ft. And respectively Zone C weights a fourth of Zone A.

Then you add all the areas of Zone A,B,C and you have the total area in terms of Zone A.

By dividing the rent value of shop X over the total area you find £/sq.ft. of shop X. This result is your main tool to evaluate Shop Z by using the comparison method.

To finish the valuation you need to find the total area of Shop Z in terms of Zone A by following the same steps as before. In addition, you need to take into account other factors that may affect the rent value. For example may shop X is based on a better area than shop Z, in that case you need to decrease the £/sq.ft. of the Shop X to avoid misleading rental value of Shop Z and then multiply this number by the total area in terms of A to find the rental value.

Then you add an appropriate value of the external costs that the landlord will pay for repairs each month(this is applicable if tenant of shop Z carries out internal repairs and the Shop X let on full repairing and insuring terms)

Natural Zoning

This methods follows the same logic with the previous but can only effectively be used to analyse rents within a shopping street or centre where information is available on a number of units, as it is requires comparison between units. The basis of that methods is that the depths of the shops determine zones

## Example

Above there are four shops of different sizes, shop A, B, C and D respectively. Rents of shops A, B and C and dimensions of every shop are known. Rent of Shop D has to be assessed, the following steps should be followed:

Shop A which has the smallest depth will determine the rent of zone A. The rent value divided by the total area of the shop will give the £1/sq. ft. of Zone A

Shop B rental is divided into two parts Zone A and B . The area of the shop B up to the point which its depth is equal to the depth of shop A will be valued at £1/sq.ft then by taking out from the total rent this amount you will have the rent paid for zone B. Divide that amount by the area of zone B will give you £2/sq.ft for that zone.

By apply the same procedure as before you can calculate the £3/sq.ft for zone C.

Shop D will be valued based on the previous figures by using the follow formula:

## Rent=Area of Zone A*£1/sq.ft + Area of Zone B*£2/sq.ft+ Area of Zone C*£3/sq.ft

## Methods of capital Valuation

## Comparative Method

As discussed previously comparative method is used to assess rental values but also is used for valuing freehold properties and most frequently for empty houses but can also be used for industrial, agricultural and land. Same principals are applied.

## Example

A 2-bedroom freehold flat has been recently sold in the area of West End for £1,000,000. The flat is on the first floor and near to the tube station. Based on those information we need to value a similar two bed flat but this is on the third floor(no lift) end the nearest tube station is 25 minutes away.

Assume that everything else is being equal.(freehold, No of bathrooms, age of the building etc)

Adjustments should be made in order to value the flat. At the beginning, we need to subtract an amount to take into account that the flat is on the third floor and no lift is provided. Lets subtract £100,000. In addition, access to public transports is more difficult so let’s subtract and additional amount of £25,000.

So an appropriate selling price for this flat would be(1,000,000-100,000-25,000) £875,000.

## Residual Approach (Hypothetical Development Method)

This method is adopted for property that has development potential, vacant land or buildings that can be extended, refurbished or redeveloped, such changes will be made to follow the changing demand of the society. It can be used either for capital or rental valuations. The method is based on that the finished property will have similar selling price compare with others recently developed less the cost of the development works. The valuer is requested to give a valuation of a land or some buildings which will be created in the future, means that a lot of figures are estimations and are based on assumptions that may not be true in the future, in consequence is a risky approach and it charges high profit margins to persuade an investor to take that risk . People who are willing to buy that property believe that after the developments the property will be worth more than before and try to benefit from that difference.

## Example

The most common process for a valuation of land using the residual approach is:

## Value of the completed development

## Less: Cost of Development such as:

Demolition of existing house (if it is applicable)

Building costs(if buildings are going to be constructed)

Professional fees at some % of building costs( architect’s fees, site engineer’s fees, quantity surveyor’s fees etc)

Finance Costs for the time period of the construction( money should be borrowed for the construction of the building , usually the whole of the building money is borrowed for half the period of development)

Legal Expenses on sale of houses

Estate agent’s fees on sale of houses

Advertising costs on sale

Developer’s profit( usually high reflects how risky is the business)

Residual Value (value of the completed development minus the sum of costs of development that, that value reflects the price of the land and the interest charges incurred on the money tied up in these items during construction period)

Less: Allowance for interest over the development period at Z%(P.V. of 1£)

Less: Acquisition costs at some K% (divide by)

Hence after the previous adjustments you have calculated the value of Land

## The Contractor’s Method(Summation)

Cost is one of the factors that affect supply and demand of property but in that method is the major determinant of the capital value. This method can be also used to assess rental values. The method calculates the cost of land plus the cost of the building and will give you the value of the property. The type of properties that are being valued with that method are usually public buildings such as hospitals, town halls, schools, libraries, police stations etc, usually those buildings are very old so an allowance for obsolescence and repairs should be made.

## Example

A public library should be valued in order to be sold and it is 100 years old.

The basic valuation approach then becomes as below:

## Cost of site

## Plus :Building cost

Less: Allowance for age and obsolescence 25%(the quite high allowance reflects how old is the building

## Less: Allowance for repair 25%

## Value of existing Property

## The Profit’s Method(Accounts Method, Treasury Method)

This method is based on the assumption that the value of the property will depend on the potential of property to generate income. That assumption implies that the person who runs the business will determine the potential of profits and therefore the capital value. Which it is not an appropriate outcome, so usually it is used when there is no evidence of comparison or a kind of monopoly exists. Monopoly can be either legal or factual. Sometimes the law does not permit competition between businesses or the property is based in an area that the other similar property is really far away so it can be treated as monopoly. Type of property usually valued under that method are hotels, public houses, cinemas, theatres and petrol filling stations. The process this method following is:

Interpret last years’ accounts

Exclude profit from activities that are not related to the property such us income generated from other investments

Exclude expenses that are not related to the property such as rent, repairs, renewals, insurance

Take into account an average annually cost of repairs relates to the property

Exclude the insurance cost of the property

Exclude tenant’s share which represents the tenant’s return based on the risk the he/she has and a remuneration for his efforts

The balance left represents the amount available for rent

## Investment Approach(Capitalisation)

This method is commonly used by investors think to buy a property which generates income or has the potential to do it in the future. Property net income(rent) and capital values are related by the yield.

Net Income means rent minus outgoings for example insurance costs, management costs, taxes, running expenses etc. In order to calculate the capital value, net income and yield of the property should be estimated usually by using comparisons with other similar properties. The yield reflects all the risks involved in that particular property compare with other similar ones. It depends on many factors such us: interest rates, legislation, age and condition of the building, inflation, location, taxation, volatility etc. Types of properties usually valued under that method are offices, industrials, warehouses and shops.

## Example

Let assume that we want to value a office base in West End, London. By using the comparative method we can obtain the yield of similar offices at West End and also the Net Income they generate. Let’s say that the yield is 4.00% and the net Income £50,000.

The capital value can be calculated by using the above equation

The above figure is based on the assumption that the net income will be constant and continue forever.

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