Investment Method

Question 1

When should the investment method be used?

Answer 1

Use when there is rental income from the property

Question 2

What is the investment principle?

Answer 2

Convert a flow of income into a lump sum and vice versa

Question 3

Explain the following key terms:
– Investment
– Capitalisation
– Decapitalisation
– Analysis
– Worth
– Net Present Value

Answer 3

Investment: provider of income
Capitalisation: convert flow of income into capital sum
Decapitalisation: calculate rental income from capital sum
Analysis: compare range and yields
Worth: value based on own assumptions (not market)
Net Present Value: sum of discounted cash flows; positive = exceeds target rate of return, negative = does not achieve target rate of return

Question 4

Explain the time value of money.

Answer 4

Money in the future is worth less than money today because:
Risk: you may not receive it
Return: opportunity cost (inability to invest elsewhere)
Inflation: goods and services will cost more in the future
Conclusion: income flows in the future need to be discounted

Question 5

What assumptions apply to the investment method?

Answer 5

Opportunity cost of capital: money is more valuable today than in the future
Anticipation: value can be created by future expected profits
Perspective: income is generated by the property
Resale value: future sale contributes to overall value

Question 6

How do you calculate Capital Value?

Answer 6

Rent x YP x PV factor

Question 7

What is yield?

Answer 7

Yield is the annual return on investment expressed as a percentage of capital

Yield = Rent/Capital
Net Initial Yield = Rent/Capital+Costs

Question 8

What are the different types of yield?

Answer 8

All Risk Yield: takes account of risks, returns, and growth expectations
Net Initial Yield: reflects purchase costs
Gross Initial Yield: simple percentage of capital value
Equivalent Yield: weighted average yield
Equated Yield: investor’s true return through actual payment rather than nominal
Reversionary Yield: reflects future rental growth

Question 9

What is equivalent yield?

Answer 9

Equivalent yield is the weighted average return a property investor expects, combining income from current rent and future reversionary rent
It reflects both the initial income and the anticipated rental growth
Used when a property has a mix of passing rent and estimated rental value
Expressed as a single rate that equates the present value of future cash flows to the capital value

Question 10

How does the investment method reflect income streams?

Answer 10

By structuring the calculation to reflect timing and certainty of income

Question 11

What is Term and Reversion?

Answer 11

Horizontal split of income stream
Term: income from current lease at passing rent
Reversion: anticipated future income once lease ends, often at market rent

Question 12

What is Hard Core and Top Slice?

Answer 12

Vertical split of income stream
Hard Core: secure rent valued at lower yield
Top Slice: excess rent valued at higher yield due to greater risk

Question 13

When would you use discounted cash flow?

Answer 13

Use when there are complex or irregular cash flows
Calculates the present value of future income and expenditure
Cash flow model incorporates a wide range of assumptions
Typically reflects a risk-free rate plus a property risk premium
Based on client-driven assumptions, reflecting investment value rather than market value

Question 14

Talk through an investment valuation.

Answer 14

Assume a projected increase in value and annual rental income
Use discounted cash flow to calculate present value
Part 1: Calculate present value of the future sale price
Part 2: Calculate present value of income over the holding period
Part 3: Total both and compare against the purchase price to assess

Question 15

How to calculate market value rent with a rent-free period:

Answer 15

1. Work out the capital value of the lease (discounting any rent-free period using a PV factor - rent x YP x PV factor)
2. Divide that capital value by the Years’ Purchase (YP) for the full term.
   Result: The adjusted Open Market Rent that reflects the incentive.