Investment Appraisal Reading

Investment Appraisal Reading Section 1 Introduction 1.1 This report is an investment appraisal for the property Pink Plaza. Pink Plaza is a 17 year old six storey office building located in the centre of Reading. 1.2 The report includes both a short and long term appraisal of Pink Plaza. The short term appraisal assumes a five year holding period, whilst the long term appraisal assumes a major refurbishment of the whole building after the lease expiry of the ground and first floors (from March 2019). In each scenario an investment value for Pink Plaza has been calculated. 1.3 Pink Plaza was constructed as prime office space in 1989. It is located in Reading town centre and is in close proximity to the mainline railway station. The property is a six storey office block currently let to 4 different tenants. Each storey has a gross internal area of 34,432 sq ft, of which 31,204 sq ft is useable office space. The property has never been refurbished. Section 2 Reading Office Market 2.1 Reading is an established regional commercial centre, located approximately 40 miles west of central London, and 4 miles north of junctions 10, 11 and 12 of the M4 Motorway. The town has good rail, road and air links. 2.2 In terms of employment 9% of the Reading workforce is employed in financial intermediation compared to 4.7% in England and Wales. 2.2 The Reading office market benefited particularly from the rapid growth of high-tech industries in the 1990s. However 2000 saw rapid consolidation in this sector of the market with the sudden end of the â€Å"Dot Com† boom. As a result take-up of office space in Reading fell significantly. Since then take-up has gradually begun to improve with 2005 seeing the highest Reading town centre office take-up (107,331 sq ft) since 2001. 2.3 With the end of the â€Å"Dot Com† boom the Reading office market saw a considerable increase in the amount of surplus office space available. Since then the market has stabilised with the amount of available office space still high but the lack of occupier demand putting developers off building any new speculative office developments. Office supply in the town centre now stands at 761,109 sq ft (2004: 809,647 sq ft). Section 3 Reading Rental Values 3.1 Recent deals on Grade A space suggest that prime market rents in Reading town centre are  £23- £25 per sq ft. This can be seen with Apex Plaza (Barclays Bank plc) achieving a rent of  £23.50 per sq ft, Davidson House (Lloyds TSB) achieving a rent of  £24 per sq ft and Abbey Gardens (Huntswood Ltd) achieving a rent of  £25 per sq ft. Therefore within this appraisal it will be assumed that a prime market rent within Reading is currently  £24 per sq ft. The current rental value of Pink Plaza is estimated to be  £20.90 per sq ft. This figure is based on rental evidence from four comparable properties. 3.2 Apex Plaza -3.2.1 Apex Plaza is a landmark office building in central Reading. It consists of four linked office buildings totalling approximately 205,000 sq ft. -3.2.2 It was originally built in 1989, and is located in a prime position next to Reading railway station. In 2004 Apex Plaza underwent a  £2 million re-fit. -3.2.4 On 2 October 2006 Barclays Bank plc took 6148 sq ft of office space within Apex Plaza on a 14-year lease at  £23.50 per sq ft. -3.2.5 Apex Plaza is a very good comparable property with similarities in size, location and age. However due to the fact that it underwent a re-fit in 2004 its rental value of approximately  £23.50 per sq ft will be higher than that of Pink Plaza. 3.3 Aquis House -3.3.1 Aquis House is a 5 storey office property of approximately 50,000 sq ft. The property is located directly opposite the railway station in the centre of Reading. -3.3.2 The property is on the site of the former Reading central post and sorting office and was redeveloped in 1994. -3.3.3 On 1 May 2006 Horwath Clark Whitehill took 9815 sq ft of second-floor office space on a 7-year lease at  £21 per sq ft. -3.3.4 Aquis House is a good comparable property due to its similarity in terms of location. The property was redeveloped in 1994, five years after Pink Plaza was built, and therefore its rental value of approximately  £21 per sq ft will be higher than that of Pink Plaza. 3.4 Minerva House -3.4.1 Minerva House is located in central Reading. It comprises of office accommodation arranged over 5 floors totalling approximately 59,200 sq ft. -3.4.2 The property was originally built in 1987 and now requires a major refurbishment. -3.4.3 On 1 July 2005 Provecta Car Plan Ltd took 465 sq m of office space on a new three year FRI lease at  £17 per sq ft. -3.4.4 Despite similarities in terms of age and location the property currently requires major refurbishment. It can therefore be concluded that Pink Plaza would command a higher rental value. 3.5 Abbey Gate -3.5.1 Abbey Gate was constructed in 1986 and comprises of a headquarter specification office building arranged over the ground and three upper floors together with storage space on the fourth floor, totalling approximately 44,203 sq ft. -3.5.2 The property is reasonably centrally located with Reading railway station approximately 0.6 miles away. -3.5.3 On 4 November 2005 an undisclosed tenant took 13,117 sq ft of third floor office space on a sublease expiring in May 2010 at  £20.80 per sq ft. -3.5.4 Abbey Gate is three years older than Pink Plaza and is less centrally located. Pink Plaza would therefore be expected to command a higher rental value. 3.6 Conclusion From looking at evidence from four comparable properties it is possible to establish a current rental value for Pink Plaza. Its rental value appears to be between  £20.80 and  £21 per sq ft. It has therefore been concluded that the current rental value for Pink Plaza is approximately  £20.90 per sq ft. From this estimate it can be concluded that Pink Plaza is currently over rented as passing rents in the building range from approximately  £22 per sq ft up to  £28 per sq ft. Section 4 Rental Growth 4.1 Office rental growth The Investment Property Forum forecasts rental growth for all offices between 2006 and 2010 to be approximately 4.5% pa. 4.2 Depreciation 4.2.1 Depreciation has been defined as â€Å"the rate of decline in rental/capital value of an asset (or group of assets) over time relative to the asset (or group of assets) valued as a new contemporary specification.† (Law, 2004) 4.2.2 There have been a number of previous studies of the impact of depreciation on real estate, particularly in the UK. Law (2004) analysed all of these studies and found that the seemingly consistent results were an illusion as they all used a variety of measurement methods and data. 4.2.3 The figure used for depreciation in this report is based on findings from the Investment Property Forum report, ‘Depreciation in Commercial Property Markets (2005). 4.2.4 It must be highlighted that results are complicated by the period of analysis that the report uses, with analysis starting in the aftermath of the major U.K. real estate recession of the early 1990s. 4.2.5 The report, using a 19 year sample, from 1984 to 2003, establishes office rental depreciation to be approximately 1.0%. 4.3 Conclusion 4.3.1 From these findings the assumed net rental growth rate used in this appraisal will be 3.47%. 4.3.2 This figure is established using the following formula: -Net rental growth rate = ((1 + Rental Growth) / (1 + Depreciation)) -1 = ((1 + 4.5%) / (1 + 1.0%)) -1 = 3.47% Section 5 Reading Office Yields 5.1 In the second quarter of 2006 it has been reported that in the Thames Valley prime yields are just below 5% net initial yield (NIY). Within Reading prime yields appear to be higher than this figure. This can be seen in the example of Prudential Campus, 121 Kings Road: 5.2 Prudential Campus, 121 Kings Road -121 Kings Road is located in central Reading. It comprises of office accommodation arranged in three linked blocks with five floors totalling approximately 179,929 sq ft. The property was completed in 1992 and was formerly Huntley Palmer factory. -On 9 August 2006 Oppenheim Property Fund Management purchased the freehold interest from IM Properties plc for  £66 million, as an investment, reflecting a NIY yield of 6.17% and an ARY of 7.22%. 5.3 Using figures from the CBRE UK Prime Rent and Yield Index it can be seen that there has been a steady compression of yield levels in the South East office sector and in the overall national office sector since 2004. Graph 1 below demonstrates this. Graph 1 5.4 This yield compression can be linked to the strong investor demand for U.K. property that has been seen during this period. Direct property has performed extremely well during this period and once again 2006 sees direct property outperforming gilts and equities. 5.5 Despite continued investor demand for U.K property, latest forecasts predict that yield compression in the office sector will gradually slow. But higher levels of rental value growth over the next few years will provide valuable support to maintain current yield levels. 5.6 This report has forecasted an ARY for a refurbished Pink Plaza of 6.75%. This figure is based upon current prime ARY comparables and by forecasting an ARY trend line using the CBRE UK Prime Rent and Yield Index. 5.7 Clearly the unrefurbished Pink Plaza cannot expect to achieve such a low yield as an equivalent prime (new or refurbished) property in Reading. There are a number of comparables that can be used when forecasting an ARY for an unrefurbished Pink Plaza. 5.8 Minerva House -Minerva House is located in central Reading. It comprises of office accommodation arranged over 5 floors totalling approximately 59,200 sq ft. The property requires major refurbishment. -On 10 June 2006 Schroders plc purchased the freehold interest from Miller Developments Ltd for  £12 million, as an investment, reflecting a NIY of 6.75% and an ARY of 8.0%. 5.9 Reading Bridge House -Reading Bridge House is located in central Reading. It comprises of office accommodation arranged over 9 floors totalling approximately 114,960 sq ft. The property was built in 1975 and was refurbished in 1986, since then no further work has been carried out. -On 1 December 2006 Jones Lang LaSalle Limited purchased the freehold interest from Exemplar Properties Limited for  £30 million reflecting a net initial yield of 6.40% and an ARY of 7.65%. 5.10 Added to this comparable evidence it is forecasted that in the Thames Valley office sector investors will continue to chase well-located, rack-rented stock with a significant percentage seeking active management and refurbishment/development opportunities. Therefore it is likely that there will be continued yield compression for properties that match these characteristics such as Pink Plaza. 5.11 The ARY for Pink Plaza unrefurbished is estimated to be 7.75%; this is based upon comparable evidence and forecasted information. Section 6 Building Costs 6.1 The BCIS provide current estimate building costs for office refurbishment. Unfortunately the BCIS only provide estimate figures for (a) 3-5 storey and (b) 6+ storey buildings. Pink Plaza is a 6 storey building. Within this appraisal the figures provided for a 3-5 storey building will be of greater accuracy and would be more appropriate to use than those of a 6+ storey building. The BCIS estimates that it currently costs  £37.64 per sq ft to refurbish an office building of 3-5 storeys. This figure is a mean average and may differ significantly from the actual cost of refurbishing Pink Plaza. 6.2 The building will be available for refurbishment in March 2019, the refurbishment will take up to two years (including sale period) and therefore the building cost is inflated over a 14 year period. The assumed growth rate is 5.84%. This figure is an average of the building cost inflation forecast for 2006 to 2011. Section 7 Other Costs 7.1 The management cost of this property is calculated as 1% pa of the value of the rental income. 7.2 The cost of rent review is assumed to be 4% of the new annual rent at each review. 7.3 The cost of purchase is assumed to be 5.75% of the purchase price. 7.4 The cost of sale is assumed to be 2.5% of the sale price. Section 8 Target Rate of Return 8.1 The Target Rate of Return (TRR) is 3% above the rate on a medium term Government bond. 8.2 The current rate on a medium term Government bond is currently 5.09%. 8.3 TRR= Risk Free Return + Risk Premium = 5.09% + 3% = 8.09% Section 9 Pink Plaza- Lease Considerations 9.1 It has been reported that during 2005, in the U.K office market, 26% of expired leases were renewed. 9.2 In terms of occupiers exercising break clauses it has been reported that in the office sector the propensity to break for over rented units is 61%. More detailed analysis has shown that it was tenants in larger office units that have been taking advantage of the option to exercise their breaks. 9.3 The standard void rate for South East offices is approximately 14 months. Within this report it has been assumed to be 15 months. This is due to the high supply of office space that exists within Reading (See 2.3) in comparison to other areas within the South East region. 9.4 In the U.K office sector the tenant default rate was 0.6%. 9.5 Large Financial Institution A occupies a net usable space of 62,408 sq ft on the ground and first floors of Pink Plaza. They currently pay  £1,750,000 pa which works out as  £28.04 per sq ft. Their thirty year lease began in March 1989 and provides for upwards only rent reviews (UORRs) every 5 years. There are no breaks. Therefore it is assumed that the space will be occupied until March 2019. 9.6 A Major Bank occupies a net usable space of 62,408 sq ft on the second and third floors. They currently pay  £1,750,000 pa which works out at  £28.04 per square foot. Their twenty-five year lease began in March 1990 and provides for UORRs every five years. There is a break at years ten and twenty. It has been assumed within this report that the Bank will exercise its break clause in March 2010. This is due to the fact that the property is currently over rented and that it has been found that tenants in larger office units are more likely to exercise their break clauses. There will then be a void period for five quarters until it is re-let for the current market rent on a seven year lease. It has been assumed that this lease will have an UORR in year five, and will expire in June 2018 with the occupiers then vacating the premises ready for the refurbishment in March 2019. 9.7 Large Financial Institution B occupies a net usable space of 31,204 sq ft on the fourth floor. They currently pay  £775,000 pa which works out at  £24.84 per sq ft. Their ten year lease began in December 2000 and provides for UORRs every 5 years. There are no breaks. It is assumed that the accommodation will be occupied until December 2010. It has then been assumed that the space will remain vacant for five quarters until it is re-let for the current market rent. The new lease will be a seven year lease with a UORR in year five. The lease will expire in March 2019 with the occupiers vacating the premises in time for the planned refurbishment. 9.8 Large Solicitors occupies a net usable space of 31204 sq ft on the fifth floor. They currently pay  £700,000 pa which works out as  £22.43 per sq ft. Their fifteen year lease began in March 1998 and provides for UORRs every 5 years. There is an opportunity to break at year ten. The company has just recently laid off 10% of its staff. It has been assumed that the solicitors will exercise their break in March 2008 due to the property being over rented and the fact that they are downsizing. It has then been assumed that the space will remain vacant for five quarters until it is re-let for the current market rent. The new lease will be a nine year lease with a UORR in year five. The lease will expire in June 2018 with the occupiers vacating the premises for the planned refurbishment. Section 10 Summary 10.1 Based upon the specific requirements set out in the clients instructions and the figures that have been forecasted within this report, a short term investment appraisal of Pink Plaza estimates an investment value of  £66,859,450. Therefore if the client, based on their current requirements, decided to purchase Pink Plaza as a short term investment with an assumed five year holding period their maximum offer should be equal to this figure. 10.2 The long term investment appraisal estimates an investment value for Pink Plaza of  £70,129,034. This assumes a 15 year holding period with a major refurbishment planned after the lease expiry of the ground and first floor in March 2019. Therefore if a long term strategy is adopted for Pink Plaza the clients maximum offer should be equal to this figure. 10.3 It should be noted that these figures do not include any purchase costs which are currently estimated to be 5.75% of the purchase price. 10.3 Many of the figures used in this investment appraisal are based upon short-term forecasts and current comparables. Forecasting 15 years in advance on the basis of this data is problematic. Therefore close attention should be paid to the Reading business market in relation to the wider office market. Current trends suggest that Reading will maintain its position as a key location for business services. Constraints on town centre supply will also favour growth in this sub-market and with Pink Plazas prime location in Reading there is reason for optimism.