Property/ Developer/ Property Valuation 0 comments

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The property sector has received much attention from late 2005 onwards, propelled by a spate of positive future developments such as the IRs, the BFC (Business and Financial Centre) and the coming Orchard Road revamp, and also the rise of a seller's market on property-related assets including hotel assets (Raffles Holdings' hotel sales at a premium), residential assets (mad rush for high-end condominiums like the Sail@Marina), commercial assets (bidding wars for Orchard Turn and other Orchard Road properties). It is however important to remember that property valuation, at the end of the day, is driven by rental yield.

Rental yield, of course, is the value of the rent divided by the value of the property. There are two facets to yield -- gross yield: the yield before all costs, and net yield: the yield accruing to the investor after subtracting all relevant costs such as agent's fees, management fees, depreciation and repairs (quite substantial, typically taking 2-5% off the gross). The latter is the one that the property investor should look at.

The theoretical relationship between equilibrium net rental yield and property price movement adheres to the following rule: the price of property should move over time to make the net yield equal to the nominal rate of interest, plus the risk premium attached to property, less the expected increase in property prices.

In equation form,
Net rental yield= Nominal Interest Rate + Risk Premium - Expected Property Price Rise

An easy way to remember this is to re-cast the equation such that the LHS reflects the Total Investor Return (ie. Yield + Capital Gains, a la typical securities) ie:

Net rental yield + Expected Property Rise = Nominal Interest Rate + Risk Premium
--> the standard capital asset pricing model

A discussion of the terms:
Risk Premium: Typically property risk premiums are low due to their inflation hedge nature. That's why old-school tycoons invest in real estate. In times of economic or political volatility it may rise (risk and volatility are synonymous). Also, there is liquidity risk, as property is more difficult to sell due to its high-value nature.

Expected Property Rise: Driven by macroeconomic demand-supply dynamics. Demand factors include long-term economic growth and population growth. Supply factors include government restrictions on new property developments driving up scarcity value.

Those mathematically inclined will naturally be able to manipulate the algebra and figure out property valuation as a function of rent, interest rate, risk premium and expected property price appreciation (remember that yield equals rent/property valuation).

References:
(1) The Investor's Guide to Economic Fundamentals (John Calverley)