Rent Indexation in Implicit Cash Flow
One of the differences between implicit and explicit cash flow is the question of how the indexation of rents is taken into account. I have written in a little more detail about both types of cash flow here.
As is well known in explicit cash flow, the valuer can introduce indexation into the cash flow projection both during and after the term of the leases, thus indexing market rents. This is therefore a kind of projection of rental income growth in the market, which is perfectly acceptable in this type of cash flow.
However, we know that in implicit cash flow, market projections are not allowed and changes in property yields in subsequent projection years can only result from the condition of the property or its surrounding. Market rents cannot therefore be indexed. What about contractual ones?
Emerging controversies
Some controversies arise against this background. Is the indexation of the contractual rent a market forecast? If the lease provides for the indexation of the rent by some fixed percentage it is not a forecast. It is a fact describing part of the state of the property, specifically its commercialisation.
The situation is less clear in the more common situations encountered in the market, where the lease agreement provides for the indexation of the rent with some type of index that will be published at certain periods in the future, e.g. the GUS inflation index, or the European HICP. In such a case, the fact is that rents will be indexed but it is not certain what size the index will take in the future. This could suggest that we are already confronted here with some form of forecast if the valuer adopts a particular percentage level of such an index in his valuation. Is he then allowed to do so?
In my opinion, yes, and I am not alone in this belief.
The assumption implicit in the yield
Indeed, it should be noted that by adopting a yield in a valuation as a result of an analysis of the market for investment transactions in similar properties, we introduce certain assumptions into our valuation that are, as it were, “imposed” by market participants. If we accept that it is a market standard that rents in leases are indexed, it must also be assumed that rational property buyers are aware of this. Thus, in making their decisions about the price they are prepared to pay for a property, they are guided by the expectation of receiving periodic rental income that will be increased to some extent by indexation. The relationship of such ‘enhanced’ income to the transaction price gives the rate of return that the valuer observes in the market and then uses in his valuation.
However, if the aforementioned hypothetical buyer of the property had paid the same price for the property, but in the belief that the rents would not be indexed, the rate from such a transaction would be slightly lower than in a transaction taking indexation into account. This is, of course, due to the fact that the numerator of the fraction (D/C=R) would be smaller and thus the dividing result in the form of the rate of return would also be lower.
Conclusions
If, therefore, a valuer observes the market practice of including rent indexation clauses in leases, he can assume with a high degree of probability that they were also present in the transactions he analysed. Ideally, of course, this should be known for sure, but we will probably have to wait a little longer for such market transparency. Thus, if we know that the rents in the analysed sold properties were indexed during the contractual period, the uield derived from such transactions will be slightly higher than it would have been had the properties not had indexed rents. Thus, following the principle “As you analysed so value”, the indexation of rents in the contractual period should also be introduced into the cash flow in the valuation in order to balance the used “pessimistic” rate of return with this “optimistic” assumption. This is because using this “slightly higher” yield (than it would have been if the transactions analysed did not involve properties with indexed rents) for a cash flow that does not take indexation into account would result in some understatement of the final result.
Side comments
Despite the position that contractual rents in implicit cash flow projections can (and perhaps should) be indexed, it is worth recalling that in property valuation (especially in the income approach!) nothing can be done mechanically. Common sense and logic always take precedence. I would therefore advise great caution when introducing rent indexation for contracts with very long durations. This is because it may turn out that after 10 or 20 years, indexation will have increased rental income so much that it will have distorted the valuation. In addition, such long leases can hardly be considered a standard in the market, so whether market yields include an inflationary element for such long leases is highly questionable. It would be prudent to compare the results of such valuations ‘with’ and ‘without’ indexation, so as to be aware of how much of the value has been generated by this one assumption.
The second comment is a little more on the ground of law. For there is a difference between the word ‘indexation’ and ‘valorisation’ of rent, the latter carrying with it the assumption that it is an upward change in rent only. In the case of indexation, at least theoretically, it could also be a downward change if the indexation index happened to be negative.
Finally, it is worth adding an explanation that the considerations presented above about the thinking of a potential property buyer in the presence and absence of contractual indexation are strongly theoretical and were intended to provide some mechanism for the impact of indexation on the yield. In practice, an investor considering an investment in a property providing contractual rent indexation (or not) is likely to adjust, depending on the situation, the price he is prepared to pay. Therefore, in practice, the potential for rent increases has a diminishing effect on the capitalisation rate. However, in the above discussion, for the sake of clarity of the argument, I have assumed price invariance, regardless of the presence or absence of contractual rent indexation.