What is the layer method of property valuation?

Posted on by Cambridge Finance

The layer (or hardcore) method of valuation is used as an alternative to the more traditional term and reversion approach. The approach has both its advantages and drawbacks which can be seen here.

The theory with the layer method of valuation is:

  • It capitalises present rent (hardcore rent) into perpetuity.
  • Then it capitalises the top slice rent (difference between the market rent and the hardcore rent) that will start from reversion into perpetuity, this defers it as is appropriate.
  • Then the two capitalised values are added.

This layer method of valuation cuts the income stream horizontally and is currently the most popular method to use. In the under-rented scenario, the top slice represents the potential capital gain of the reversion, whilst in the over-rented scenario, the top slice represents the extra income over and above market rent for the unexpired term of the lease reflecting that this is a fixed income and dependant upon the tenant’s ability to continue to pay the rent.

Calculations

YP Formula Yield
Term YP for n years (1-(1+yield)-years)/yield Initial Yield
Top Layer YP in Perpetuity def n Years (1+yield)-years/yield Reversionary Yield
Hardcore Layer YP in Perpetuity 1/yield Initial Yield
Where ‘years’ is the number of years to lease expiry and ‘yield’ is derived from a comparable property yield

Under-rented scenario – Layer method of valuation

Under-rented is where the passing rent is lower than the current market rents, so the tenant is unlikely to leave. This makes the rental income stream more certain and should be valued using a lower yield than the ERV.

Example

A good quality freehold office is let at a FRI (full repairing and insuring) rent of £50,000 pa. There are 5 years left until the end of the lease contract, the estimated market rental value is £80,000 pa. An identical property next door has just sold at a 6% equivalent yield.

  • Hardcore Layer
    • Yield 6%(0.06)
    • Passing rent 50,000
    • YP = 1/0.06 = 16.67
    • Layer = £50,000 X 16.67 = 833,333
  • Top Layer
    • Yield 7% (0.07)
    • Term remaining 5 years
    • ERV 80,000
    • Froth (ERV-Passing rent) 30,000
    • Reversionary yield
      • (1+0.07)-5 /0.07
      • 1.07-5/0.07
      • 0.713/0.07
      • 10.19
    • Top Layer X Yield
      • 30,000 X 10.19
      • £305,700
  • Valuation
    • Hardcore layer + Top Layer
    • £833,333 + £305,700
    • £1,139,033

Over-rented scenario – Layer method of valuation

Over rented is where the passing rent is higher than the market rent, as when supply exceeds demand.

Example

A good quality freehold office is let at a FRI (full repairing and insuring) rent of £80,000 pa. There are 5 years left until the end of the lease contract, the estimated market rental value is £50,000 pa. An identical property next door has just sold at a 7% equivalent yield.

  • Hardcore Layer
    • Yield 6%(0.06)
    • Passing rent 50,000
    • YP = 1/0.06 = 16.67
    • Layer = £50,000 X 16.67 = 833,333
  • Top Layer
    • Yield 7% (0.07)
    • Passing rent 80,000
    • ERV 50,000
    • Froth (Passing rent – ERV) 30,000
    • Initial yield
      • 1-(1+0.07)-5 /0.07
      • 1-( 1.07-5)/0.07
      • 1-0.713/0.07
      • .287/.07
      • 4.1
    • Froth X Yield
      • 30,000 X 4.1
      • 123,000
  • Valuation
    • Hardcore layer + Top Layer
    • £833,333 + £123,000
    • £956,333

The case for financial modelling

This valuation method can be laborious in terms of calculations and a mishit of a key on a calculator can lead to drastic errors in end valuation.

By using financial modelling, the laborious calculations are built in and a lot of potential errors mitigated. Furthermore, it is far easier, more reliable and quicker to calculate different scenarios with several potential yields and hypothetical figures.

Our financial modelling courses teach you to set up models from scratch so you can understand the formulas and rules used to ensure accuracy and usability, along with case studies to demonstrate the models in use.

Check out all our course listings below.

Financial modelling courses

  • Cambridge Finance Certificate In Real Estate Financial Modelling – An exclusive programme offered by Cambridge Finance and in line with the Royal Institution of Chartered Surveyors (RICS) financial modelling competency, this course covers the main topics related to real estate financial modelling in Excel, leading up to the Cambridge Finance Certificate in Real Estate Financial Modelling. Delegates will learn how to create interactive financial models from scratch, from traditional valuation methods to fully bespoke cash flows.