Annex A: Methods for informing decapitalisation rates
There are three generally accepted methods for providing an acceptable basis for the decapitalisation rate:
A. use of borrowing to fund replacement property;
B. use of debt and equity to fund replacement property; and
C. property investment yields.
The first two of these methods are based on the costs of funding associated with building a replacement building. The third considers the returns that could be expected to be associated with the replacement building. In all cases, adjustments may need to be applied before the decapitalisation rate is finalised.
A. Use of borrowing to fund replacement property
This approach assumes that the replacement property is funded through borrowing alone. If this was the case, the relevant interest rate that the private sector would have to pay would be based on the Bank of England base rate, adjusted for inflation and a borrowers premium.
If the public sector were to replace a building in this way, funding would generally be secured from the Public Works Loan Board (PWLB). Assessment of current PWLB rates would form the basis of any decapitalisation rate arrived at through this method.
Both of these rates would need to be adjusted to reflect the benefits of ownership.
The main benefit of this approach is that it reflects the fact that debt is often used to finance property development.
The main drawback is that it is unlikely that property development would be financed entirely from debt (e.g. government grants could be used in the public sector).
B. Use of debt and equity to fund replacement property
Often, new private-sector property developments are funded by a mixture of debt and equity. The common method of determining the cost of finance from debt and equity is the weighted average cost of capital (WACC).
The WACC involves assumptions around the balance between debt and equity and the costs of equity. These will vary for each project; however in order to arrive at a single, nationwide decapitalisation rate, a uniform value for the costs of equity and the balance of debt and equity would need to be assumed.
This estimate of the cost of finance would need to be adjusted for a number of factors, including the benefits of ownership and depreciation.
The main benefits of this approach are that it reflects a truer picture of how property is funded in the private sector, and that it reflects modern theory on the cost of capital.
The main drawbacks are that there are a number of assumptions required to generate a single nationwide decapitalisation rate, and that equity is generally not relevant when considering public-sector property development.
C. Property investment yields
This approach moves away from the cost of finance approached covered in methods A and B, and instead uses rental costs and rent-to-cost relationships for similar types of property as an indicator of what the rental market would look like for properties valued under the contractor's basis if they were regularly rented.
For example, rental information is available for general industrial properties, and they are valued on this basis. As a result, it is possible to use this information in setting an appropriate rate. It is possible to make an adjustment for those properties on the lower decapitalisation rate to reflect the cheaper sources of finance available.
Analysis of yields provides a direct link between capital value and rental value, so no additional adjustments are required.
The main benefit of this approach is that it uses evidence from the market, and is therefore less subjective than some other methods.
The main drawbacks are that, by definition, yields are only available on classes in which there is rental information and therefore not valued on the contractor's basis (little or no yield information exists for such properties), and that there is no specific relevance for the lower decapitalisation rate (however, an adjustment could be made). Market yields also vary widely depending on the covenant of the tenant, use, location, condition and so on, and can themselves also require adjustment.
Each of the above approaches requires adjustments to account for a number of factors. The rationale for the main adjustments is outlined below.
Lower decapitalisation rate
Certain properties (churches, education, and healthcare) are currently prescribed a lower decapitalisation rate, as they have been considered to have special characteristics which merit consideration.
These properties often have access to cheaper sources of funding (e.g. grants and donations). As they could be at least part funded in this way, there is a lower borrowing requirement associated with replacement.
Properties that are valued on the contractor's basis have generally not been rented by the occupier. There are a range of benefits and drawbacks to owning as opposed to renting property. Ownership benefits from any increase in capital value; full flexibility in adapting the property to changing circumstances; title to the land (a non-wasting asset); and ability to sell. Drawbacks of ownership include effects of obsolescence and, where let, management responsibilities and the risks of tenant default and void periods.
The borrower's premium is an adjustment to reflect that the cost of borrowing on the open market is higher than the Bank of England Base Rate. This higher rate reflects the potential of default of late payment, the lender's required return on their investment and a requirement to guard against future inflation which erodes the value of the outstanding debt.
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