What to know about valuation for APC

At level 3, the Valuation competency relates to the provision of valuation advice to enable clients to make informed decisions. This advice needs to conform with the RICS Valuation – Global Standards (Red Book Global Standards), which was last updated in January 2025.

In this article, we will focus on:

• the three valuation approaches set out in VPS 3 of Red Book Global Standards
• the five valuation methods that sit underneath the three valuation approaches
• when to use the investment method of valuation
• the different techniques or calculations used in the investment method, including traditional and discounted cash flow (DCF) calculations.

We will finish with three example valuations: the first two using traditional calculations – growth implicit – and the last using a DCF calculation – growth explicit.

VPS 3 of Red Book Global Standards discusses the three valuation approaches: market, income and cost. The valuer's choice of approach must align with the asset type, valuation purpose and any other statutory or mandatory requirements.

• The market approach requires the valuer to compare the rent or price of the subject property with recent, relevant transactions of comparable properties. Underneath this sits the comparable method – method one of five.
• The income approach relates to the capitalisation of present and future cashflows to arrive at a single current value. Underneath this sits the investment and profits methods – methods two and three of five.
• The cost approach is based on the principle that the market will pay no more for a property than the equivalent replacement cost. Underneath this sits the depreciated replacement cost method and the residual method – although this combines some of the other methods, such as the comparable and investment methods to calculate the gross development value, so this is sometimes called a mixed approach – methods four and five of five. The depreciated cost method is typically used for properties so specialised in nature that there is no market or evidence for them, such as a school or hospital. The residual is typically used to value development sites, with the output being the residual amount left over to purchase the site or land.

In some cases, more than one valuation approach and method may be used to cross check or sense check the final valuation output. For example, a redevelopment site may include a retail unit that is being retained and let as an investment (investment method), a plot of land to be developed (residual method) and a pub (profits method). 

This investment method also requires the use of the comparable method to establish comparable rents and yields.

A yield is simply defined as the relationship between income and capital value. The following formula can be used to calculate any of these three variables as long as you know the other two.

• Yield = annual income (rent)/capital value.
• Capital value = annual income/yield.

For example, a property has a capital value of £200,000 and a market rent of £10,000 per annum. What is the yield? £10,000/£200,000 x 100 = 5%.

If this is for a market rent, it will also be a market yield. This is otherwise known as an initial yield, or it could be called an all-risks yield if it is applied to a specific property and represents all risks and rewards associated with it.

It may seem counterintuitive, but a safer investment will have a lower yield because the market is willing to pay more for it. Higher yields are typically associated with riskier investments, i.e. the market wants to pay less when something is risky.

If you were buying a vacant shop in a tertiary area, would you want a higher yield to compensate you for the higher risk? Yes.

If you were buying a prime tenanted retail unit with a blue-chip covenant, would you be happy to accept a lower yield as the associated risk is fairly minimal? Yes.

Where the investment return is accumulated over multiple years, we need to apply the principle of compounding. The yield is then expressed on an annual basis. This is no different to interest rates quoted for savings accounts.

It is not just your initial capital that grows each year; the accumulated interest that is added to your initial capital each year also grows. Over time, this effect is compounded – thus the term compound interest.

You may remember using Parry's Valuation and Investment Tables at university, which allow you to apply the principles of compounding, discounting and the time value of money.

The amount of a £1 table allows you to apply compounding, i.e. what does an initial deposit increase to over a given period of time at a given interest rate yield.

By way of example, you purchased an antique copy of Parry's Tables for £3,000 and sold it nine years later for £5,400. What was the yield expressed in annual percentage terms?

To find this out, we need to allow for the effect of compound interest using the amount of a £1 table.

In this example, each £1 invested increased to £1.80 (£5,400/£3,000). Using Parry's Tables, you can look along the nine-year row to find 1.8, which is achieved at 6.75%. This is the interest rate per annum required to achieve this rise over a nine-year period.

Discounting – using the present value of a £1 table – is the opposite of compounding, i.e. what is a future sum worth today? This reflects the fact that cashflows in the future are less valuable than if they were received today. This is the basic principle underpinning the investment method of valuation.

In the traditional method, there are four key techniques to be aware of.

• Initial yield – for a property where the passing rent is also the market rent and the yield is a market yield – established using comparable evidence. This method uses years' purchase in perpetuity, calculated by one divided by the yield (i.e. expressing it as a percentage), as the rent is already at a market level and there is no reversion.
• Term and reversion – where a property is under-rented and the market rent will be achieved at a future reversion, such as a rent review or lease expiry. The income receivable for the term, i.e. until the reversion, will be at a below market rent and is less risky, so the yield should be shifted down, while the reversion will be at the market rent so a market initial yield is adopted.
• Hardcore and top slice – otherwise known as layer and hardcore – where a property is over-rented and the rent will reduce at a future reversion, such as a break option, lease expiry or up-down or down-only rent review. The hardcore is the market rent – which extends beyond the reversion – so a market yield is adopted, whereas the top slice is the element of above market rent receivable until the reversion. This is riskier so the yield is shifted upwards.
• Equivalent yield – used for either of the above two techniques, where an average weighted yield is applied to both tranches of income, rather than the yield being adjusted for each. Linear interpolation and a spreadsheet or valuation software can be used to calculate this.

The traditional method is known as growth implicit as all risks and rewards – thus the use of the term, all-risks yield – are built into the choice of yield, rather than being modelled specifically in the calculation.

In a DCF, all assumptions are explicit – so rental growth, expenditure and all other cashflows are modelled in the cashflow. DCFs include many inputs and assumptions, so any errors can lead to substantial differences in the outcome.

A DCF will include a number of formulae, including:

• the amount of £1 – to calculate rental growth
• the present value of £1 – to discount cashflows back to the present value
• the years' purchase – to capitalise blocks of rental income
• the years' purchase in perpetuity – for the last line of a DCF for a freehold property, as rental income is receivable indefinitely.

The term income is received now for two years so you need the years' purchase formula at the term yield. The reversion income is received in perpetuity, but not for another two years' time. Thus the reversion income needs to be discounted back at the reversion yield and expressed in perpetuity, as we are assuming it will be received for the rest of time.

The two tranches of income for the term and the reversion added together give you the total capital value.

Adding together all of the net present values for each block of income gives you the total capital value.