The calculation of investment worth – Issues of market efficiency, variable estimation and risk analysis
| Pages | 33-52 |
| Date | 01 February 2000 |
| DOI | https://doi.org/10.1108/14635780010316645 |
| Published date | 01 February 2000 |
| Author | Norman Hutchison,Nanda Nanthakumaran |
| Subject Matter | Property management & built environment |
Academic papers:
The calculation of
investment worth
33
Journal of Property Investment &
Finance, Vol. 18 No. 1, 2000,
pp. 33-51. #MCB University Press,
1463-578X
Received September
1997
Revised November 1998
ACADEMIC PAPERS
The calculation of investment
worth
Issues of market efficiency, variable
estimation and risk analysis
Norman Hutchison and Nanda Nanthakumaran
Centre for Property Research, Department of Land Economy, University
of Aberdeen, UK
Keywords Investment, Market, Efficiency, Sensitivity analysis, Simulation
Abstract The Mallinson Report, published in 1994, emphasised the need for valuers to develop
expertise for the purpose of estimating the worth of property investments. Implicit in attempts to
estimate worth is the assumption that the property market displays some level of inefficiency and
that, in such a market, price and worth may diverge. It is believed that astute investors can exploit
such inefficiencies in the market to add value to their portfolios. This paper reviews the main
issues relating to the calculation of worth. Specifically it examines market efficiency, individual
and market worth, and the use of risk analysis in the calculation. Finally, it recommends a shorter
analysis period in view of the uncertainty in the estimation of the variables.
1. Introduction
In recent years, there has been a growing interest in the estimation of the
investment worth of commercial property investments. The Mallinson Report
(RICS, 1994), which recommended that the RICS should lead ``in the
development of a definition of worth'', and the development of property market
forecasts by a number of research consultancies as well as the pressure to
adopt techniques which are widely used in the capital market, may have
provided the catalyst.
The management of property portfolios by the larger institutional investors
is being driven increasingly by modern investment management techniques
which are well established in the management of equity portfolios. A principal
component of these techniques is stock selection, which seeks to acquire
mispriced assets with a view to adding value to the portfolios. This approach
requires the estimation of the investment worth of assets based on their future
income flows.
Two recent texts: Property Investment Appraisal (Baum and Crosby, 1995)
and European Valuation Practice (Adair et al., 1996) cover this topic in some
detail reflecting the growing interest in this area. The RICS Appraisal and
Valuation Manual (RICS, 1995), for the first time, makes specific reference to
the calculation of worth and the RICS has recently published an information
paper, Calculation of Worth (RICS, 1997), to further raise awareness,
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JPIF
18,1
34
understanding and stimulate debate. However, in spite of these developments,
the calculation of worth still remains an under-researched area.
The purpose of this paper is to review the main issues relating to the
calculation of worth. Specifically, the paper examines market efficiency,
individual and market worth, variable estimation and methods of incorporating
risk analysis into the calculation. The paper is structured as follows: Section 2
provides a brief summary of previous work in this area. In Section 3
definitional issues are discussed, while in Section 4, the relevance of market
efficiency is addressed. The divergence between price and worth is covered in
Section 5. The problems of variable estimation and methods of analysing risk
are discussed in Sections 6 and 7. Finally, Section 8 provides some conclusions.
2. Previous work
Published work in this area refers to the inefficiencies of the property market
and to the opportunities for astute investors to identify and trade mispriced
assets (Baum and MacGregor, 1992). All writers agree on the need to use
explicit cash flow analysis for the estimation of investment worth (Baum and
Crosby, 1995; Baum et al., 1996; French, 1997; Hutchison and Nanthakumaran,
1995; 1996; Mallinson, 1997; Peto, 1997; RICS, 1997). Baum and Crosby (1995)
provide an illustrative appraisal of the worth of an over-rented property. They
use causal models to generate rental growth rates in the short term (up to five
years) and combine these rates with a long-term growth rate to generate the
cash flows, although no details of the rental forecast model are given. Also
using an over-rented property as a case study, Hutchison and Nanthakumaran
(1995) estimate cash flows subjectively and use a simulation model to analyse
risk in the estimation of investment worth. Crosby and MacGregor (1996)
highlight the problems associated with the estimation of the inputs into the
cash flow models which are used to estimate worth.
The literature suggests that an explicit cash flow model is the appropriate
one to use but there are problems with the estimation of the inputs for the cash
flow model. Furthermore, there are definitional issues which need to be
clarified. The earlier literature (Baum and MacGregor, 1992) was concerned
with the estimation of the investment value or worth which may be regarded as
a market consensus estimate while the recent literature tends to focus on the
estimation of individual worth thus drawing a distinction between the two (see,
Baum and Crosby, 1995; Crosby and MacGregor, 1996; Peto et al., 1996; RICS,
1997).
3. Definitions
In any exercise involving an estimation of worth it is useful to have clear
definitions of the terms used. Following Baum et al. (1996) the following
definitions are given:
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