A GUIDE TO INSTITUTIONAL PROPERTY INVESTMENT

Over the last two decades there has been a revolution in the ownership of property in almost every town and city in the United Kingdom. Many office buildings, shops, shopping centres, ware­houses, industrial units and even agricultural holdings are now owned by large institutions such as insurance companies, pension funds and property unit trusts. A staggering £2 billion p.a. has been invested by these institutions in recent years. Yet there is relatively little informa­tion available for those who are professionally involved in making the decisions to buy property and how to manage them.

A Guide to Institutional Property Investment fills this gap. It is a practical book for anyone directly or indirectly investing in, advising on, or involved in managing institutional property. It provides informative, progressive and critical guidelines and will be of use to surveyors, accountants, bankers, architects, lawyers, estate mana­gers, large-fund managers, insurance companies, valuers, auctioneers and the investors themselves.

Property management has traditionally been concerned with day-to­day management rather than strategic planning. With the growth of property investment portfolios there is a need for a new type of expertise. This new kind of management requires financial appraisal and performance monitoring techniques, both of which are discussed by the authors in detail.

Angus P J Mcintosh BA (Econ), MPhil, ARICS, is a property market analvst with Healey and Baker, international surveyors, valuers and auctioneers. He was the Assistant Investment Surveyor for Provident Mutual Life Assurance Association until1982 and has been a Senior Lecturer at the School of Surveying, Kingston Polytechnic and a Principal Lecturer in the Department of Surveying, Portsmouth Polytechnic. He has gained wide experience of this field by holding several posts in the British Rail Property Board. He has had articles published in Estates Gazette, Journal of Valuation and International Real Estate Journal.

Stephen G Sykes BSc, CDipAF, is an independent investment analyst and computer systems design consultant, retained by a number of major investing institutions and other organisations. He

was previously a property analyst with stockbrokers Rowe and Pitman, international property consultants Richard Ellis, and latterly chartered surveyors St Quintin, being responsible for developing new and comprehensive computerisation in the areas of property valua­tion, analysis and commercial agency. More recently he established his own consultancy, Stephen Sykes Associates. He has had articles published in Investment Analyst, Journal of Valuation, Appraisal Journal, Pensions World, Estates Gazette, Estates Times, Chartered Surveyor Weekly, Property Business and Investment Markets.

A GUIDE TO INSTITUTIONAL

PROPERTY INVESTMENT

Angus P.J. Mcintosh and Stephen G. Sykes

M MACMILLAN

© Angus P .J. Mcintosh and Stephen G. Sykes 19H5

Softcover reprint of the hardcover edition 1985 978-0-333-36613-4

All rights reserved. No reproduction. copy or transmission of this publication may be made without written permission.

No paragraph of this publication may be reproduced. copied or transmitted save with written permission or in accordance with the provisions of the Copyright Act 1956 (as amended).

Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and

civil claims for damages.

First published 19H5 by

MACMILLAN PUBLISHERS LTD (Journals Division) and distributed by

Globe Book Services. Ltd Brunei Road. Houndmills

Basingstoke. Hampshire RG21 2XS

British Library Cataloguing in Publication Data Mcintosh. Angus P. J. A guide to institutional property investment. I. Real estate investment 2. Commercial buildings I. Title II. Sykes. Stephen G. 332.63'24 HDI393.55 ISBN 978-1-349-07156-2 ISBN 978-1-349-07154-8 (eBook)DOI 10.1007/978-1-349-07154-8

1st

To Patricia, Jonathan and Rebecca Janine and Francesca

Contents

Preface List of Abbreviations Introduction

PART I HISTORICAL PERSPECTIVE

1 The Financial Institutions and Their Expansion as Urban Landlords

2 The Growth of Institutional Property Investment

PART II ORGANISATION AND INVESTMENT METHODOLOGY

3 Institutional and Other Property Investment

ix X Ill

XV

3 19

Organisations 45 4 Taxation and Institutional Property Investment 62 5 Leasehold Investments and Other Rent Sharing

Arrangements 91 6 The 'Institutional Lease' 109 7 The Location and Design of Institutional Property 130 8 The Marketing of Investment Property 174

PART III ASSET VALUATION

9 Freehold Investment Valuations 10 Leasehold Investment Valuations

187 208

PART IV INVESTMENT MANAGEMENT AND ANALYSIS

11 Active Portfolio Management 1? Portfolio Analysis and Property Performance 13 Valuatton and Performance- the Uncertainties 14 Risk and Investment

vii

221 231 273 287

Vlll Contents

Epilogue: Some Personal Views Appendixes

I Implied Rental Growth Rate II The 'Rent Adjustment' Factor

III The Town and Country Planning (Use Classes) Order 1972

IV A Property Unit Purchaser's Check List References and Further Reading

Index

309 316 318

320 322 325

333

Preface

The UK commercial property market is astonishingly devoid of texts relating to the practice of investment and evaluation. Despite the enormous real estate holdings of the financial institutions and the rapid acceleration in monies channeled into direct property acquisi­tion and development in recent years, the institutional property investment world remains singularly insular. Yet ironically the results of such investment of the general public's savings are creating and changing literally the very fabric of our urban environment for anyone to see.

Property is a complex business and as a medium of investment for the institutions it involves a whole spectrum of problems and solutions not encountered in the equity and gilt-edged markets.

A factor contributing to the often simplistic, even offhand manner in which commercial property investment is treated by many invest­ment advisers must lie firmly at the door of the property market itself. It has generally relished the apparent secrecy and so-called mystique surrounding its activities. Nearly two decades ago Oliver Marriott's book The Property Boom offered a fascinating insight into the post-war property world. However, much has changed since the 1960s. Institutional investment in property was then only embryonic, but it is now the dominant force in the field of commercial property.

The idea for this present book was borne out of a requirement to fulfil three rather diverse needs. Firstly to offer guidance to the non-property professional investor/adviser who nevertheless is in­terested in, or may be required to have some knowledge of, the institutional property market. Secondly, because of the enormous scope of the property market itself, it was felt that a text dealing with the more important aspects of commercial property and portfolios would prove useful as a source of reference to the property specialist. Thirdly, the important area of property investment appraisal has been very much neglected. Rather than merely show the usual simplistic measures which are invariably undertaken, we have ex-

lX

X Preface

plored in some depth analytical techniques covering the assessment of both performance and risk in a practical manner to assist invest­ment decision taking. However, it is not our intention to justify property as a suitable investment medium for Institutional monies. That is a matter of judgement on the part of the investor, and is entirely dependent upon circumstances. As with any form of invest­ment, the specific risk/reward characteristics will be more suitable to some investors than others.

Overall responsibility for the content of the first two sections of the book lies with Angus Mcintosh, whilst that for the last section dealing with analytical approaches lies with Stephen Sykes. The middle section which looks at aspects of asset valuation is essentially collaborative and indeed the entire text has been 'edited' jointly. We would like to express thanks to Norman McFarlane, David Clinch and Chris. Mellor for offering useful comments in certain specific areas. However, responsibility for the content, tone and accuracy of the book lies entirely with the authors. We also wish to acknowledge that certain sections of Parts III and IV are based on original papers previously published by the authors in The Investment Analyst, the Journal of Valuation and The Appraisal Journal. So far as we are aware, all statistics quoted are correct at the time of writing.

A considerable amount of the last two sections of the book which deal with the valuation and analysis (appraisal) of property, relates to ideas and techniques used and/or originated by Stephen Sykes in recent years and published elsewhere (including the journals men­tioned above) in separate papers. We hope these ideas, and their interrelationships, may aid property investors and form the basis for further research into the problems encountered in property invest­ment analysis.

In addition to being a source of reference, we have endeavoured to offer personal views on many aspects where appropriate. In view of the broad nature of the property market, we have necessarily been somewhat selective in certain areas. Nevertheless, our aim is that the book should be seen to provide not only a guide but an informative, progressive and critical insight into the workings of the institutional property investment market.

THE BUDGET 1984

In his budget speech on 13 March 1984 the Chancellor of the Exchequer put forward a number of proposals. As the text of the

Preface xi

book was writteh before March 1984 the following is a resume of those principal proposals which may influence institutional property investment. Although the methodology of the calculations referred to in the text remains unaltered, the actual figures used may need to be amended if the proposals form part of the finance act later in the year.

Life Assurance

In the longer term the most significant of the changes announced in the budget could be the abolition of tax relief on new life insurance policies. This may reduce the premium income of such companies, with a commensurate reduction in the purchasing of new invest­ments. However, the insurance industry is renowned for its innova­tive flair and it would be surprising if ultimately the life companies do not meet the challenge.

Stamp Duty

The lowering of stamp duty from 2% to 1% on the purchase of property has already caused the net values of investment properties to rise slightly due to the fact that commercial property capitalisation rates are based on the concept of gross capital values inclusive of all purchase costs. Agreements for lease of over 35 years will, however, no longer be exempt but purchases of £30, 000 or less will be completely exempt from this tax.

Development Land Tax

The first £75,000 of development value realised in a tax year will now be exempt. If the development is for an owner's own use he may now defer payment of DLT indefinitely unless within 12 years he sells his interest. If tax is to be paid it may now be by 10 annual instalments.

Value Added Tax

VAT will now become payable on all building alterations irrespective of whether they are repairs, maintenance or new works. However,

XII Preface

confusion may arise between the definition of alterations and new construction which remains zero rated. HM Customs and Excise have issued guidelines in this respect.

Capital Allowances and Corporation Tax

With the proposed reduction of Corporation Tax from 52% to 50% and eventually down to 35% by 1986 the Chancellor proposes to reduce Capital Allowances and eventually abolish first year and initial allowances. Initial Industrial Building Allowances fall in 1984/85 from 75% to 50%, to 25% in 1985/86 and to 0% thereafter. Expenditure may continue to be written off on an annual 4% straight line basis. Plant and machinery first year allowances fall in 1984/85 from 100% to 75%, to 50% in 1985/86 and to 0% thereafter but the annual allowance on a 25% reducing balance basis will remain. Although this allowance will now apply as soon as expenditure occurs, the effect of these capital allowance changes will mean that the tax allowance funding arrangements used by a few property funds recently will become less attractive over the next 3 years.

It should also be noted that the case of Furniss v Dawson (Weekly Law Reports, val. 12, 1984, p. 226 and 270 EG 6180) brings into question the validity of certain tax planning techniques previously regarded by the Inland Revenue as acceptable.

Other Recent Legislation

The Rating (Exemption of Unoccupied Industrial Hereditaments) Regulation 1984 has now made certain industrial property exempt from rates. The Agricultural Holdings Act 1984 has now also become law altering, inter alia, the method of assessing rent at review and the provisions regarding succession.

APJMcl SGS

London

List of Abbreviations

ACT ASF CAPM CGT cuv DCF DLT DoTI DPC EG ERV FRI FV GOP IBA In Perp IRR MLR MPF NAY NPV ODP p.a. PUT RICS RPI SF VAT yp

Advance Corporation Tax annual sinking fund capital asset pricing model Capital Gains Tax current use value discounted cash flow Development Land Tax Department of Trade and Industry damp proof course Estates Gazette estimated rental value full repairing and insuring (lease) future value Gross Domestic Product industrial building allowance in perpetuity internal rate of return minimum lending rate (Bank of England) managed property fund net asset value net present value office development permit per annum property unit trust Royal Institution of Chartered Surveyors Retait Prices Index sinking fund Value Added Tax years' purchase

xiii

Introduction

Owners of life insurance policies and contributors to pension schemes have all become indirect investors in commercial property.

Over the last two decades there has been a revolution in the ownership of property within almost all towns and cities of the United Kingdom. Many office buildings, shops, shopping centres, ware­houses, industrial units and even agricultural holdings are now owned by insurance companies, pension funds and property unit trusts. In recent years around £2 billion p.a. has been invested in 'institutional' property compared to only some £0.4 billion p.a. in 1970, and £0.1 -0.2 billion p.a. in the 1960s.

This phenomenal growth in the institutional acquisition of property has been unique to the UK- yet it did not happen by design. A wide variety of factors has contributed to the production of market forces which have caused this expansion, often associated with government economic policy.

Unlike the other principal investment media, namely equities and gilt-edged securities, commercial property is generally acquired only by the larger institutions in view of the often substantial capital involvement and the complexities of its subsequent management. Because of the discrete nature of an individual property, a number of acquisitions are advisable within a single portfolio in order to diversify risk. To cope with the problem of acquisition and diver­sification for the smaller tax-exempt funds, units may be purchased in a number of property unit trusts and managed funds; these organisa­tions purchase direct property and issue units based on the market value of the holdings.

The fundamental difference between the property market and the equity and fixed interest markets lies in the individual characteristics of a real estate investment. Every single property is unique. Unlike the stock market which can be absolutely defined and monitored, the institutional property market is effectively only a concept. This is primarily a result of its extensive, subjective and evolving nature.

The book is divided into four principal parts:

XV

XVI Introduction

HISTORICAL PERSPECTIVE

No understanding of the role of the institutions as investors in, and developers of property can be complete without consideration of the historic events which resulted in their present dominance in the commercial property market.

ORGANISATION AND INVESTMENT METHODOLOGY

What are the property funds? The range and methodology of the institutionalproperty investors is complex and can be perplexing. In the second part of the book we look at the various organisations and show how their very constitution may be somewhat confusing to investors.

How can the avoidance of taxation and the correct use of capital allowances improve a property fund's performance? The ramifica­tions of tax and allowances for these institutions are explored.

What legal property interests do they own? Most of the larger funds' portfolios nowadays include both freehold and leasehold investments. The actual nature of leaseholds may vary and signi­ficantly influence an investor's decision making. The subtleties of bottom-slice and top-slice, vertical and horizomal leaseback arrange­ments are exemplified.

How is rental income controlled? Over the years the occupational lease used by institutional landlords to control the use of their property has gone through a process of metamorphosis. These changes are examined from a property management point of view.

No two property investments are identical. Location, design of the building, tenure arrangements, occupying tenant and lease structure may all be different when one property is compared to another. The investment criteria which have created the institutional property market as it is today are investigated.

ASSET VALUATION

The property market's methods of traditionally valuing property are largely a relic of the 19th century and are an anachronism in the 1980s. Considering the fundamental importance of techniques used in valuing property funds, it is perhaps surprising that these time-

Introduction XVll

honoured methods have remained in use. The established methods of both freehold and leasehold valuation are outlined. At the same time, alternative approaches to valuing property are highlighted.

INVESTMENT MANAGEMENT AND ANALYSIS

Historically, there has often been a general presumption that an investment property can be acquired, placed within a portfolio and the rental income simply collected. This myth is slowly being exploded. In the future far more active management and marketing will be needed if funds are to optimise the financial returns from their property portfolios.

Property management has traditionally been concerned with day­to-day management, rather than strategic planning. With the growth of property investment portfolios there is a growing need for a new type of portfolio management. The refurbishment of existing build­ings and the restructuring of inefficient occupational leases are all part of this active management. In addition to direct property acquisition, many funds are now involved with development pro­grams or financing arrangements with property development com­panies.

This new kind of management also requires financial appraisal and performance monitoring techniques. Within the property world, such analyses are still in their infancy and when set against the vast sums of money now invested in property, this is somewhat surprising. Not only should investors look more critically at the few performance statistics currently available, but analytical techniques, similar to those commonly used in other areas of financial investment, should be made more readily available and acceptable.

Rather than merely consider what analysis of property and port­folios is currently available and carried out, we go on to consider more sophisticated techniques which attempt to shed more light onto the behavioural and risk characteristics of property as a medium of investment.

We believe it is vitally important that property investors should not only realise the often overly-simplistic, and at times misleading, nature of their traditional approaches, but be prepared to look at new ideas. The market is generally all too quick to reject, and all too reticent to accept different methodologies.