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Emerald Group Publishing Limited
Copyright © 2001, MCB UP Limited
I have now been involved with the journal in its various guises for over 19 years and apart from beginning to feel too old, I am constantly amazed at how the timing of the acceptance of the papers often enables them to form a theme of their own, even though there was no such intention at the outset. In this issue all five papers address pricing issues, from the suggestion of new valuation models to the analysis of transaction prices over time.
Historically, valuation models have relied upon comparison as the principal tool of analysis. However, comparison can only be relied upon where there is a degree of uniformity in the market. As the papers in this issue discuss, markets are becoming more eclectic and it is now difficult to compare previous lettings with current letting as the terms of the lettings might be very different.
There is an old adage in valuation that dictates that one should value using the same approach as was used in the analysis of the information underlying the valuation. On this basis, it is understandable why the use of a capitailsation rate model has prevailed in the marketplace. The analysis, and thus the valuation, is simply the ratio of capital value to rental value. It is a simple calculation and in "normal" markets provides a reasonable estimation of price of exchange in the marketplace.
It is no more, or less, than a crude form of benchmarking. It provides a reference point on which to base the subject valuation. The method is simply a crude method of comparison, it does not attempt to analyse the worth of the property investment from first principles. As a result, the valuation profession has forgotten how to determine the "worth" of a property from the viewpoint of the user.
The purpose of any method of valuation, capital or rental, is to model the thought process of the players in the market. The aim of a valuation is to determine the price at which it is expected that a property asset might change hands in the free market. The model should therefore attempt to reflect how the buyers in that market would assess the worth of that property. The valuation papers in this issue address this pertinent area. If all property and all users were homogeneous there would be one method of valuation. On a pro-rata basis all property would tend toward one unit price. An analogy to this hypothetical situation is the stock market. Any one share is priced the same as any other share in the same company, and that price is determined by what buyers in the market are currently willing to pay. At a fundamental level, the buyers will assess the worth of the shares to them, based on their own perceptions and expectations on the future performance of that company. If they think the future cash flow to be generated from the dividends (and/or capital changes) will produce satisfactory returns, they will pay a high price to receive that cash flow. If they believe the growth prospects are less attractive, they will pay less for the shares. In other words, prices are determined by the buyers' perception of worth. The sale will occur at the point that reflects the worth of that share to the investor with the highest expectation of growth. That investor will outbid those with lower expectations. If the market is efficient, it is likely that this price will reflect the consensus view.
In terms of property, it can be argued that the market is less efficient and that value in use and value in exchange have diverged and that rental levels have become disengaged from the tenant's ability to pay. In the long run, rents cannot afford to be out of equilibrium with those fundamental drivers. If they become too disengaged, then the market will crash and readjust. Price should coincide with worth.
A fundamental valuation model should therefore reflect this thought process of determining worth. For example, in the office letting market, the rent that is paid by the tenant should bear relation to the ability of that tenant to trade profitably from that location. This has always been a salient criterion but as competition has forced companies to accept lower margins for their profit levels, the impact of "costs" on the profit equation has become more important. Companies have been forced to look at the costs equation in terms of their space requirements. They are therefore less willing to accept the level of rents in the market and may consider relocating if they feel that current rentals are too high for their cost requirements. This should mean that the market(s) will adjust to ensure that value in exchange (rental level) and value in use (worth to the company) will converge.
In this issue of the Journal of Property Investment & Finance, the papers presented add to the literature in the area of pricing and valuation. We hope that this theme will be revisited in future issues.