Chapter 06 – What determines the value of an investment property?

Dinner parties abound with theories about what determines the value of a property.

But for a land economist the answer is decidedly simple: expected future net cash flow adjusted for inflation determines value.

Expected future cash flow comprises rent and capital gain on ultimate sale to a third party. Most clients do the sums intuitively rather than a formal calculation, but if you can use discounted cash flow methodologies to assess properties for purchase. In summary, the expected future net rents plus the expected future capital gain, discounted for inflation, are computed, and if this amount is greater than the required purchase price, the investment should be proceeded with, and the greater the excess the better the investment is expected to be.

But the land economist’s cold clinical analysis does not really satisfy our question. It’s just a calculation, not an explanation. To really understand what determines the value of a property one needs to look much further, and to enquire into a whole range of factors relating to both the individual property and the wider macro-economic environment. These factors, particularly when they require forecasts, are inherently subjective. This is where the art takes over from the science: a good property clients can see the future and accurately assess the state of the market five, ten and, we would stress, even twenty years down the track, and make astute decisions now.

Location, location, location…

Location is clearly a critical factor in valuing a property.

Location determines desirability. Desirability determines price.

In the case of a residential property, identical houses in two different suburbs will have different values, reflecting the premium or cache attached to each, and even in the same suburb identical houses may have different values, reflecting subtleties of view, access, proximity to services and the character of neighbouring properties.

In the case of non-residential property, the same phenomenon holds. Identical shops in two different suburbs may have significantly different values, reflecting these same factors as residential property, perhaps with lower weighting, and also reflecting the related concept of “rentability”, which ultimately comes down to supply and demand, that infinite list of subjective circumstances which determines why an enterprise wants to be in a certain location, rather than an alternative location, and how much it is prepared to pay to be there.

The issues become even more complex as one moves from an inter-city analysis, ie comparing Bondi to Campbellfield in Sydney, to intra-city analysis, say Bondi to Bermagui. In many ways the properties are not comparable and they are simply in different markets.

What makes for a good location? Three factors can be identified, being:

  1. its economic base and demographic features, including local aesthetics, population and, we stress, expected future population growth;
  2. an element of monopoly, in the sense of something that cannot easily be replicated elsewhere, a coveted “prime location”, but think about what will be the “prime” location in twenty years’ time, and consider investing in emerging prime locations;
  3. zoning and town planning controls enforced by state and local governments.

Residential property and location

The local economy is a major variable here. The larger the city the less risky the local economy is. Smaller regional centres can be 100% dependent on one or two industries, or even employers, and show appropriate volatility: this is another reason to be careful with boom time mining towns.

Immigration is important. 100,000 or so new arrivals to Melbourne keep values simmering even when interest rates are up and economic news is not good. The immigrant attitude is significant too: very home aspirational with the economic means to achieve these aspirations.

As noted above, subtleties of view, access, proximity to services and the character of neighbouring properties, and changing patterns over time, generate value variations both within suburbs, between suburbs and between cities and regions.

Office property and location

Are the offices convenient to residential areas? Commute time is more important each year. What are the alternatives like? Being close to cafes, gyms, child care facilities and schools help too: it’s all about the location working for the residents.

The long term trend to increased tertiary industry and overall economic growth create demand for offices outside of the major cities, ie Melbourne, Sydney, Brisbane, Adelaide and Perth. The Federal Government’s Broadband Network project and improving communications technology will make city centres less and less relevant in coming decades. Smaller offices in areas adjacent to fashionable suburbs with easy access to the city and airports will do well.

The two speed economy, ie the booming mining and support industry compared to the moribund traditional industry is not apparent: offices are well priced around Australia in all industries.

Retail property and location

The drop in bricks and mortar retail sales does not portent well for retail property, since it is the bricks and mortar in the equation. The internet and satiation with physical goods and services and an increasing tendency to spend discretionary dollars on services and experiences are relevant here. But it’s the fringe dwellers that will feel the pain and the classic prime locations will remain just that, ie classic prime locations.

An opportunity exists to pick the classic prime locations in areas of increasing population growth and gentrification, ie the waves of movement in higher spending higher income workers.

Synergistic tenancy mixes are important. But malls and larger shopping centres are off the radar for most clients: too big and too risky. The classic main street shopfront will always have a tenant. Fashionable shopping strips in fashionable suburbs will do better than others.

Industrial property and location

Here it’s all about easy access to major traffic pathways and ease of access to major destinations. Prices have increased alongside new major road infrastructure projects in the major cities. Town planning is important, particularly for heavier industrial uses.

Light industry close to preferred living spaces makes great sense in our post-industrial Australia.

Macro-economics is very important. Witness the plight of Shepparton’s fruit industry (ie SPC) as cheaper imported fruit is allowed into Australia, with the perfect storm of a record high dollar making exports harder than ever. This flows through the local economy into the industrial property market. Excessive dependency on one or two main industries or even one or two main employers is always a problem. As a general rule, the closer to the large, diversified city, the lesser the risks since there are more potential tenants and uses for the property if the current tenant gets into difficulty.

Risk

Risk may be defined as the possibility, or probability, that the actual outcome will differ from the expected outcome. This means there is good risk and bad risk, since actual outcomes may be better or worse than expected outcomes. Good risk is often called “up-side” risk and bad risk is often called “down-side” risk.

Down-side causes the most problems and it’s what we look at in this manual.

Most commentators nominate three main types of risk. These are:

  1. market risk, which effects all properties in a particular market;
  2. financial risk, usually connected to finance risk; and
  3. property specific risk, normally connected to locality, building and tenant.

Market risk

Market risk generally refers to macro-economic variables applying broadly to all properties, or types of properties, within a certain market or sub-market.

Examples include the risk that a major employer will downsize or even abandon a particular region, which can significantly reduce property values across all classes of property. On the up-side, the arrival of a new major employer in a particular region often leads to higher property values across all classes of property as new employees bid up prices and economic benefits flow on to related industries and service providers, possibly including extra government services such as schools, transport and health.

Market risk also encompasses wider national or state trends, such as rising unemployment rates or changes (often by stealth) to state land tax charges and similar costs. But unemployment rates and land tax charges can fall too.

Financial risk

Financial risks are risks connected to property loans.

Typically they include the risk of rising interest rates and the risk that a fixed term loan will not be extended at the end of the term.

In the GFC the Australian Government acted to significantly lower interest rates, to stimulate spending and to take pressure off property owners. Owners with good tenants actually experienced better net cash flows throughout the GFC period, another example of up-side risk at work.

Financial risks are guarded against by not over-borrowing and generally being prudent in financial dealings. Most property failures are more connected to greed and over-ambition, and poor judgement, than uncooperative lenders.

Property specific risks

Does the building have rising damp? Termites? Asbestos? Concrete cancer? All necessary permits? Any illegal extensions? Noisy neighbours? Will the zoning laws change? Is the tenant about to go broke? Is the council about to remove the parking spaces to create extra roadway?

How do you guard against these risks? You cannot eliminate them but you can minimise them by taking care and exercising “due diligence”. “Due diligence” is not a defined term and generally refers to the process by which a person verifies the circumstances connected to a property (or other asset) before acquiring it. In the context of real estate, the golden rule is to not trust anything you are told by the seller’s agent. The seller’s agent is not the buyer’s agent and does not owe the buyer a duty of care or a contractual duty, other than a duty not to mislead or deceive. Verify everything.

Verification may include:

  1. building inspections by qualified personnel;
  2. pest inspections and other specific inspections;
  3. using a buyers’ advocate, (strongly recommended on larger purchases, but make sure they do not charge too much!);
  4. careful research on the fundamentals;
  5. solicitors to vet leases and make sure all is in order;
  6. talking to other selling agents about other properties to get a better feel for the market;
  7. internet research.

Building obsolescence

Valuers assess the depreciated value of a building by identifying, quantifying and assessing “building obsolescence”, in the sense of its appropriateness to current uses and expected future uses. This lack or appropriateness, or obsolescence, does not happen overnight. Rather, it sneaks up over the decades so what was once, in 1980, a beautifully appointed and elegant office building will be completely inadequate for use by a government department in 2015.

Building obsolescence occurs when the expected cost of an up-grade exceeds the expected benefit of an up-grade, and is not directly connected to age. A 100 year old building may be wonderfully appropriate to its tenant’s uses and expected future uses.  A 10 year old building may be the opposite, empty, and need of a good tearing down

Obsolescence must be managed, with constant re-investment back into the building to ensure it remains appropriate to current and expected future uses. A building’s value will otherwise fall, since future tenants will not be prepared to pay as high a rent for a building that is not as appropriate to their current or future needs.

The concept of building obsolescence applies to all forms of property, ie residential, retail, office and industrial, and is normally connected four sub-species, being:

  1. physical obsolescence;
  2. functional obsolescence;
  3. economic obsolescence; and
  4. in more recent years, many say, sustainability obsolescence.

In his book “Australian Property Investment and Financing” Patrick Rowland provides a useful practical table summarising building features and obsolescence. It is reproduced here:

Property use Building feature Signs of obsolescence
Residential Number and size of rooms, age, durability, style, facilities and fittings. Lack of second bathroom, games room, or home theatre, unsecured parking, lack of air-conditioning or lifts in a block of flats.
Offices Functional floor plate (position of internal columns, window mullions and corridors) natural light, views, finishes to entrances and lobbies, quality of air conditioning, telecommunications and IT services, availability of car parking. Awkward floor plan, cramped foyer, slow lifts or a low green rating.
Retail Width of shop front(s), finishes to shopping mall, lighting and temperature control. Poor pedestrian circulation, tired appearance, water penetration, insufficient on-site parking or inferior customer facilities.
Industrial Truss Height, wall cladding, floor loading, loading docks, (natural) lighting, ancillary offices and/or showroom. Inconvenient internal columns, insufficient height for pallet or other storage, insufficient office space.

Creative capitalism

Behind every new development is an obsolete older building. It’s capitalism at its most creative.

Most buildings eventually outlive their economic usefulness and are be demolished, and a new building is put up in their place.  This is what happens when the expected cost of an upgrade exceeds the expected benefit of an upgrade, ie a building is obsolescent.

It’s out with the old and in with the new.

The Dover Group