Real estate: investment or operation?

Citation

Baum, A. (2003), "Real estate: investment or operation?", Property Management, Vol. 21 No. 1. https://doi.org/10.1108/pm.2003.11321aaa.001

Real estate: investment or operation?

Real estate: investment or operation?

The property revenue model is changing. In the UK, the long lease with upward only rent reviews is under threat from market changes and threatened government legislation. Around the globe, market pressure and the need to provide customer satisfaction are leading to more flexible lease arrangements. This challenges current wisdom about the nature of real estate as an asset class.

For reasons connected with risk aversion and the need to service debt finance, property owners have attempted in many markets to regularise and de-risk rental income from property. The nineteenth century UK building lease and ground rent are an extreme example; the UK 25-year lease with upward-only rent reviews every five years is another.

We should bear in mind, however, that this is not the only way to think about property revenues. The low risk rental income demanded by the owner leaves the occupier free to enjoy profits derived from occupation. These may be volatile, but they may also be very high. Shopping centre occupiers, for example, can achieve incomes which are very significant multiples of the rent they pay. As its operations become more attractive, it might evolve partnerships with investors so that revenues can be shared (turnover or percentage rents).

This challenges the traditional revenue model for property, but it is not the only example of property ownership providing a share in the revenues of the operation. The profits method, for example, helps valuers to assess the rental values of restaurants and hotels by modelling the profit and loss account in a highly simplified way.

The modern age has produced a multiplicity of new challenges, brought into focus by globalisation, corporate re-structuring, technological change and the information age. These include the increasing popularity of facilities management, broadband revenue opportunities and the increasing flexibility of building uses.

It is not a given that rent should be normalised or stable. It is a function of the methods of financing that have been used in the West for the majority of the twentieth century. The risk-averse bank lender has insisted on stabilised rent as a first call on revenues. This has led to a view of property rents as stable: and this has both supported and been supported by comparative methods of valuation, with rents assumed to be stable across space too.

The TMT revolution has added further challenges to the traditional revenue model. Aggregation is the key concept. The business model of Yahoo! is built on its position as an aggregator of 250 million users. Simon shopping centres generate a similar annual number of visitors. Shopping centre owners need to find ways to capture the revenue generated by this aggregation, including sharing the Internet-traded shopping which the centre can generate. This will not be normalised and is pure participation in the business. Office owners have similar opportunities to share broadband-based telecommunications revenues.

Facilities management (FM) has grown to rival traditional property management, so that the provision of office furniture, security, telecommunications, reception and support staff and other services earns a fuller charge for services than the rent for space charged under the simple property lease.

As public sector organisations seek more flexibility, lower staff overheads and a better quality of services, they are outsourcing FM to specialist organisations. This model of public-private partnerships is now extending to private-private partnerships, and full-service FM and property-owning specialists allow other corporations to concentrate their capital and staff resources on their core businesses.

A space-service provider generates revenues which are not normalised. The unitary charge may be level over periods of time, but will vary at least with levels of occupation and the marginal demand for additional services. Property ownership can then migrate from flat or indexed rents to a variable income delivery. It is no accident that the US REIT is most typically valued by reference to its earnings.

The capitalisation of variable incomes presents challenges to the valuer. Direct capital comparison depends on comparables, but these are highly unlikely to be available; and capitalisation of a non-normalised income using the income approach is clearly unreliable. Shopping centre turnover rents are notoriously difficult for appraisers to model

It is perhaps disappointing to find that models of equity valuation often look surprisingly similar to property valuations, using comparison and highly simplified income approaches and DCF. The earnings of a company multiplied by a P/E ratio is a simple income approach applied to profits or earnings; this may be extended to a DCF model. To apply a multiple of EBITDA is a modification to the P/E approach based on generated cash flow rather than the sometimes manipulated P and we see the cost approach, direct capital comparison and some specialist approaches akin to the valuation of a hotel (for example, the valuation of a fund management company by taking a multiple of funds under management).

The agenda, as always, is changing. It is difficult to avoid the conclusion that modern real estate analysts must be trained as business analysts with expertise in real estate, and not as property valuers.

Andrew BaumSchool of Business,University of Reading, UK