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The Actuary The magazine of the Institute & Faculty of Actuaries
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From property valuation to real estate finance

Real estate has features which make it different
from other investments (mainly that it is often purchased freehold as a physical asset).
At City University Business School the Department of Property Valuation and Management (DPVM) has increasingly integrated real estate research into mainstream finance. This article looks briefly at three areas of research interest.

Embedded options
The first area is the valuation of options embedded in property contracts. Break clauses within leases, upward-only rent review clauses, and so on are all options which are written into property contracts to the benefit of one party or another. In pricing property interests and contractual obligations, it is important to be able to value such options in a sound analytical framework.
The importance of the upward-only rent review clause dates back to the periods of high inflation when rent review periods were reduced significantly (commonly to about five years). At every review, within a lease period, the rent could be changed to the higher of the level of market rents and the passing rent (ie the rent before the review).
The underlying asset could be regarded as the passing rent with a call option to purchase the market rent for the passing rent if the market rent is higher. The option has a higher value if there is a higher probability of a fall in nominal rents. Such a fall then gives rise to the phenomenon of ‘overrented’ property. A fall in nominal rents is more likely to happen if inflation is low and if market rental volatility, on a particular property, is high. The motivation for the work was to determine the extent to which the value of the upward-only rent review option would increase as we moved to a low-inflation environment.
Standard option pricing techniques cannot be used to price such an option. The underlying asset is not freely tradable, rents do not follow the simple pattern which has to be assumed for the application of most option-pricing techniques, and a succession of rent reviews leads to ‘path dependency’. Using two different techniques, we have found that with a property with one rent review remaining, allowing for the value of the option was shown to increase the assessed value of the property by virtually nothing at rates of inflation and nominal rental growth above 5%, and increase the assessed value by about 2.5% at rates of inflation and nominal rental growth between 0% and 2%. The increases in assessed value were much higher at higher standard deviations of rental growth.
Within the department of Actuarial Science and Statistics at City University, Duncan Walsh and I started this work, financed by a research grant from the Institute of Actuaries. The work on break clauses was undertaken jointly by the DPVM and the Department of Accounting and Finance. Work continues to be undertaken in this area by Charles Ward at Reading University and by George Matysiak, Gordon Gemmill, and Bill Rodney at City University.

Different interests
A developing area of work within the department is the pricing of different interests in property. Two separate but related trends can be identified. The first is the development of the private finance initiative (now public/private partnerships). Here the government seeks private sector investment in the building of hospitals, roads, etc. The government then leases them back with a variety of different contract terms being involved.
Different forms of contract have different service flows, different risks attached, and require the delivery of different forms of service in exchange for the income. Interests in the cashflows from PFI projects need to be priced in the bidding process. There is no reason why different slices of income could not be securitised and traded and used as long-term investments for pension funds they would both provide diversification and have the necessary matching characteristics.
This notion has not been developed as yet but if it were to develop, it would be necessary to have analytical techniques to value such investments. Those techniques should have their pedigree in the finance literature but still take account of the special nature of the physical asset. At the same time as PFI, purely private-sector projects have developed which involve more complex financial interests than has hitherto been the case. Again, these interests need to be priced, with reference to the values of similar tradable instruments available in the market.

Corporate property holdings
The final area is a specific project being undertaken with the Department of Accounting and Finance for a subsidiary of Goldman Sachs, on the impact on shareholder value of corporate property holdings. Property is usually both a significant asset and a significant cost for most companies, but for the most part companies do not judge real estate issues to be a key resource for them. Rather they see the major role of property as a support function for their core operational activities.
In corporate finance literature property is included as one of the capital investments a firm makes, but little is discussed about how it should be operated or financed. Intense competitive pressures and proposed changes by the Accounting Standards Board are contributing to create a greater awareness of property’s potential to enhance shareholder wealth. Few companies will in future be able to neglect the scope for improved use of capital, cost savings, and enhanced risk control. The company’s property assets represent potential matching risk and abnormal returns while costs come straight off the bottom line.
A major obstacle to researching this issue is the difficulty in measuring lease liabilities from sources which are publicly available. This arises because companies are currently required to include only finance (capital) leases on their balance sheets, and not assets that have been financed by operating leases. Since the standard came into operation, company management has tended to switch the contractual nature of their leases towards operating leases. Recent UK research has identified that operating leases are now a major source of long-term debt-type financing.
The research will draw on accountancy, real estate finance, and capital budgeting techniques to establish the share of total costs represented by property holdings of the top 100 UK companies, the percentage of assets (balance sheet total) accounted for by property and the impact this can have on market value. The quantitative work will be supplemented by a survey of finance directors to assess awareness and knowledge of the financial implications of their company’s property assets and perceptions of the key issues. Analysts will also be consulted about their perception of the effect of property on stock market prices and the potential for releasing value.

Successful integration
There will always be a role for university departments which view property in the context of the economy, through a subject which could be described as ‘urban economics’. Similarly, some university departments will still concentrate on the physical aspects of property through architecture, building surveying, facilities management, and so on. These subjects still have to be reflected in property courses.
However, real estate is also a tradable financial asset which has to be priced, which contains complex financial options, the value of which is related to economic trends, and which is increasingly being divided into interests which each have different financial characteristics, each having to be priced and valued. This, and the importance of real estate as an institutional investment and as a corporate asset, highlight the increasing importance of at least part of the professional and academic world developing real estate finance and investment as a field of interest and study.

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