What influences the value of property?

For a business monetising a building it owns, the biggest influences on value are not the ones people usually expect — and several of them have nothing to do with the property.

The Basics

There are some obvious aspects of commercial property that influence value and to some it is just location, location, location. In this article we will look at some of the principal points that impact on property value before looking in more detail at what influences investment properties – these are buildings where the tenant occupies and an investor owns it – and this can cause some counter-intuitive outcomes.

As a business, if you can understand how an investor or a valuer thinks, you can be better prepared for engaging with them. All of the following would readily have an impact on value:

• Location

• Size of building

• Size of land

• Configuration of building

• Building condition

• Environmental issues

• Planning/Zoning use

If we start looking at more specific commercial property classes we will start seeing more specific factors such as power (Data Centres and Manufacturing), frontage (Retail units), car parking provision (Offices), demographics (Health clubs) and so on. These will have an oversized impact on value depending on what sector we are looking at. So far, so simple.

When we start looking at leased properties, particularly those with long leases in place, we see a new set of criteria come to the fore.

Investment property basics

As a brief recap, an investment property is one in which the freeholder (the owner) and the leaseholder (the tenant) are different. The leaseholder may have leased some office space in a multi-let building in a city centre from an investor. Or they may have undertaken a sale and leaseback injecting working capital into their business in exchange for paying rent going forwards. Invariably, the freeholder will be an investor who is looking to make a return on their capital from a combination of capital appreciation (rental growth and/or the yield they can sell at getting keener) and income return (the amount of rent they collect).

This leads to investors focusing on:

• Covenant strength

• Lease term

• Lease clauses

• Rent review

• Rental levels

• Liquidity

And long income investors focus on a further three areas:

• Criticality

• Replicability

• Specificity

Looking at these in turn:

Covenant strength – in a multi-let industrial estate or shopping centre, covenant is less of an issue – the volume of tenants gives you security of income and an investor will recognise that they will always have a churn of business failures but each will account for relatively little of their overall rental income. If a property is let to a single tenant, the covenant becomes a larger priority the longer the lease is. An investor committing capital for 15 to 25 years is underwriting the tenant's ability to pay throughout — so the financial strength of the business occupying the building moves pricing.

Lease term - lease length is a clear lever that a business holds. Longer commitments generally attract better pricing because they extend the certainty of income. This is why the same building can be worth materially different amounts depending on the lease attached to it. If a building has a 2 year lease, an investor needs to account for the risk of the tenant leaving and any vacancy this would cause before it is relet along with any incentives (such as rent free) that would be offered to a new incoming tenant. This risk is priced explicitly.

Lease clauses – whose responsibility is it to maintain and repair the building and to what standard? What rights do the landlord and tenant have? Who can the lease be let or assigned to? Ensuring that a lease suits both parties is a critical way of delivering value to both a landlord and tenant. A tenant break option might sound like flexibility that a business would like but there is a financial cost to it that is not always clearly expressed – is that flexibility better than £10k, £100k, £1m?

Rent reviews – a typical lease will have a mechanism by which the rent is reviewed – in most jurisdictions this is on an upwards only basis. This makes a significant impact on the ability of investors to underwrite deals and what they can pay. The key drivers are then: how frequently is the rent revised (every 1, 3 or 5 years are the most common in modern leases) and by what mechanism is the rent reviewed to (typically either linked to an index like CPI or in line with market rental levels).

Rental levels – if a building could attract a rent of, say £50 per sq ft per annum and the tenant is paying £10 psf pa or £100 psf pa then we have opposing problems. A rent of £10 psf pa would be seen as very low and the building would be considered under-rented or reversionary. This basically means that there is a strong likelihood that the rent will increase or if the tenant leaves, an investor would secure more rent. On the other hand, if the rent were £100 psf pa then building is over-rented and a strong likelihood that the tenant will leave for a cheaper building and that the rent will ultimately go down at some point.

Liquidity – some, not all, investors will look to hold their investments long term. Many will look to acquire and then after investing in or undertaking some type of initiative will look to sell in a pre-define window – often 5 years. Understanding that there is a future purchaser is key to liquidity.

Long income investors

For these investors, the covenant strength becomes more important and the quality of the building and location less so. They will often focus on:

Criticality – how important is this building to this particular business. Critical assets are those that a business cannot do without and will be the last building where a rent cheque is missed if there are financial difficulties and the first building to have their lease renewed.

Replicability – a 50 year old manufacturing site to a typical real estate investor may look tired and hard to re-let. To a long lease investor, they will see a building that suits a business and has grown with them. To replicate the same amount of space in a similar location is likely to cost significantly more so why would they move?

Specificity – similar to replicability, specificity is how well-tailored a building is to a particular business. The classic scenario to look at for this is a rope factory – they are very long and thin and completely suited to their tenant – can they get that elsewhere?

There are a lot of data points that influence value from a Real Estate and Credit perspective as discussed above. If we zoom out further, there are further macroeconomic and investor specific factors to consider also:

Sector cycles and the cost of debt have significant impact on pricing and neither is within a business's control.

Lot size can be a genuinely overlooked driver: deal size determines which investors can bid. Smaller lots draw regional buyers; mid-sized lots reach institutional capital; the largest reach international and large-cap investors. Each tier prices differently, so how assets are packaged — individually or as a portfolio — can change the pricing and liquidity.

The final word

Every property will arrive at a particular value in a different way. For a business wanting to know what its real estate is worth, we want to look at the basis of value (see different types of value) and then we can look at the drivers that are within their control. A business cannot dictate the macroeconomic environment but they can influence lease terms and reflect on the importance of the property to their business. Understanding value drivers helps businesses get the most from their assets.