Valuation and Over-Paying

I want to dispel a widely held notion, the strong belief in which leads to investors overpaying for shop property. It is a notion that has contributed to substantial over-valuation (along with over-mortgaging by the banks and other lenders) of shop property investments for more than three decades.

When you buy a shop property for investment, you are not buying into the existing or proposed tenant's business: the only thing you own is the property itself. That is all. How the tenant chooses to run its business, the prospects for the business including the market sector the tenant's business serves, are nothing to do with you. You are buying the property and whether it is the entire building or part of a building, that is all. Therefore, the identity of the tenant makes no difference whatsoever to the value of the property. The only relevance of what is known as the 'covenant' of the tenant that makes a difference is the chances of rent on time and other requirements of the occupancy honoured throughout the term of the lease. Therefore, if you pay a higher price because the shop property is let to a well-known covenant, then that 'premium' adds to the risk and may not be recoverable when you want to sell.

To understand why even though there is no link between the value of the property and the tenant's covenant nevertheless a strong connection is made, it is necessary to go back to events in the shop property market during the mid-1970s. In 1972, all Asians were expelled from Uganda by Idi Amin, the president of Uganda at that time. Those holding British passports came to Britain. Many had been businesspeople in Africa and rebuilt up their lives in Britain. Some became retailers while others found suitable employment.

An explosive growth in demand for shops and retail businesses led to a widespread change in attitude. Before the immigration-influx, I think it fair to say many 'white' shopkeepers were living off their laurels, for example half-day closing during the week was the norm, trading times out of kilter with an increasingly cosmopolitan society. Asian shops, the ubiquitous 'Mr Patel', opened longer hours, closing at 10pm rather than 5.30pm, and extended the shopping week to include all day Sunday. Prices obtainable in the market for selling going-concern businesses also rose. In the newsagent, confectioner, tobacconist sector, ("CTN"), it was said a 'white' buyer would pay ten times turnover, but an 'Asian' buyer would pay fifteen times turnover. The difference in price was accounted for by removing staff costs and so on, because the Asian family would work in the shop. Strictly, it shouldn't make any difference to price payable that savings can be made from being more operationally efficient, but I do not think that was the agenda. It was not so much about wanting more income, so much as wanting more capital. By modernising the business, turnover could be increased and the business re-sold for a profit. It also gave the Asian family an opportunity to establish 'roots' in the wider community.

(The presence of Asian shopkeepers in Britain was by no means new. The earliest origins of settlement of South Asians in Great Britain is uncertain, perhaps the Middle Ages. By the late 19th/early 20th centuries there were approximately 70,000 South Asians in Britain and following World War II and the break-up of the British Empire, immigration increased throughout the 1950s and 1960s as citizens of Commonwealth countries and former Caribbean colonies moved to Britain. Following restrictions on primary immigration, much of the subsequent growth in the British Asian community has come from the births of second and third-generation Asian Britons. As time passes, the formation and development of community can alter the demographics. Southall, in north-west Greater London, for example, is a case in point. In 1950, the first group of South Asians arrived in Southall, reputedly recruited to work in a factory owned by a former British Army officer. With the closeness of expanding employment opportunities such as Heathrow Airport, nowadays over 55% of Southall's population of 70,000 is Indian/Pakistani, Southall has one of the largest Sikh Temples outside India and Southall contains the largest Asian shopping centre in the London area.)

An attraction of English property law is freehold ownership. As the ultimate owner of the property, freehold provides both physical and emotional security. Owning shop property freehold can contribute to status in community and business. As anyone that has tried to buy shop property for investment will testify, it is not an easy step. The first hurdle is convincing commercial property agencies you are serious! It's not that surveyors were impossible to deal with, simply they have regular buyers and saw no reason to give newcomers a bite of the cherry. Also, many established surveyors can't be bothered with inexperienced investors. Then there is a question of credibility. Unless you pay the asking price or your offer is very close, you risk being considered a time-waster. Similarly, if you mess about and delay exchange of contract and/or fail to complete. Moreover, there may be a language barrier. Even if you fulfil the criteria, there is no certainty of being offered anything with potential. The solution is to buy at property auctions. Property auctions lend themselves to anonymity. Property auctions have long been popular with people of all nationalities, but before the mid-1970s there was a greater tacit understanding of shop valuation methodology. What the new wave of investors did not appreciate (or at least not give an impression) was that, in principle, a high yield suggests a shop property where little or no capital growth is expected, conversely a low-yield offers prospects for growth. In any event, because the cost of borrowing money is the same nationwide, it made no sense to be able to buy a shop property investment yielding say 12% for a lower price pro-rata than a shop property showing 7%. Hence, what began to happen and rapidly gathered steam, until the influence of the change in approach became the 'norm', was for shop properties having little or no growth prospects to go up price which in turn led to an increase in price for properties with growth prospects.

Finance plays a pivotal role in the commercial property market. It is said that property investment is more about finance than property. When a buyer wants to mortgage an investment property, or needs a mortgage in order to buy the property in the first place, ways to repay the mortgage include the borrower's other sources of income and whether the yield on the property exceeds the instalment for payment of the mortgage. Whilst a lender will assess the credit-worthiness of the borrower, a lender is not normally interested in the prospects for the investment: all a mortgagee cares about is whether the borrower could honour the requirements of the mortgage, or in the event of default the property could be sold to repay the loan. The fact that high-yielding investments are more risky is of no consequence to the lender, and may in fact be considered more secure simply because of a higher yield. In effect, thanks to their mortgage criteria, what the banks have imposed on buyers of shop property is the equivalent of a business plan, whereby never mind whether the shop property constitutes an investment, all that matters is that the financial side of things stack up.

What stemmed from inexperience became the 'norm' thanks to mortgage valuation surveyors. The task of a mortgage valuation surveyor, often a chartered surveyor, is to give an opinion of the market value of the property. However, the market value of a property is only the value of the property itself. It is not the value of the investment. The investment comprises the property and any existing or proposed 'tenancy' involving that property. So, since the value of the investment can vary depending upon terms of the tenancy, arguably a valuation surveyor should make that clear in the report, otherwise there is the risk the banks could be misled into thinking lending on the property is more secure than it is.

The fact that a layer of variable value can be added to the intrinsic value of a property is not something lost on sellers. The marketing of commercial property for investment involves very sophisticated and shrewd techniques. For example, one of the most obvious ways to maximise the price is to create an investment that is readily mortgageable. When selling a shop property investment, the seller is not interested in the value of the property as such, but how much the property and all that comes with it is likely to fetch in the market. It is the existence of that subtle difference for which the inexperienced investor can pay a hefty price. Selling a shop property for investment is no different to any other form of selling. Dress it up to look its best and hope the buyer doesn't spot what's wrong. Any complaints afterwards can be met by caveat emptor: the buyer alone is responsible for checking the quality and suitability of goods before making the purchase. Moreover, unlike products and services where the seller might be concerned to safeguard reputation for future custom, a seller of shop property is unlikely to care a jot about goodwill.

Although the seller of shop property is unlikely to care about goodwill, the seller's agents are mindful of their reputation in the market. To maximise the selling process whilst attempting to minimise the repercussions of overpayment, auctioneers have, for some time, highlighted the financial status of the tenant in the auction catalogue, for example the retailer's number of branches, latest turnover and profit figures.

Covenant and early review lots are guaranteed to fetch top prices. In the details, much emphasis is given to the date of review, with the estimated rental value suggested, either by having issued the rent review notice quoting a very high proposal, or by stating the vendor's opinion of rental value, or by citing a brief mention of a nearby new letting.

Pre-occupation with quality of covenant has driven investment yields down to levels which, for the type of property, is more commonly expected for prime propositions, offering assured long-term growth!

Consequently, what has happened is that not only has the way shop property is valued disconnected from fundamental principles, but also the banks and vested interests have create a market that is completely divorced from the reality of property itself. The test of that claim is easy to pass, for example: imagine two shop properties, next door to each other, both shops identical size, layout, etc, both let for 20 years at the same rent with rent reviews at five yearly intervals. One shop is let to a national multiple retailer with dozens of branches, the other to a local shopkeeper with just that one shop. Both properties are offered for sale by auction on the same date by the same auctioneer. What's the betting the shop let to the multiple retailer would fetch a higher price?

In my opinion, it is not up to valuation surveyors to insist banks lend only on the value of the property, as distinct from the market value of the investment. That decision is for the banks alone. However, I do consider valuation surveyors have a duty of care to ensure the banks understand there is a difference which might not necessarily be allowed for in the 'forced' sale valuation. A definition of 'forced sale' valuation is "the highest price which a property can reasonably be expected to bring, if offered for sale without the consent or concurrence of the owner by virtue of judicial process, in what may be a restricted market place, within a restricted time frame, to a prudent, willing and able purchaser who may have limited knowledge about the property, its uses and capability." If the forced sale valuation is a percentage of the market value of the property then in my opinion the mortgage is likely to be more secure, than if the forced sale value is the valuation of the investment.