Valuations during the time of corona: beware of parallel realities
During the time of corona, there was a discussion on PropertyNL about the concept of market value. People wrote that this concept might not adequately account for the long-term value of real estate and could lead to disastrous consequences for financiers and investors. They feared that there may be too much depreciation.
By Willem Rodermond, Executive Director of Valuation & Advisory Services at CBRE
Public opinion during the previous crisis was that appraisers were not depreciating hard enough. I researched this during my MRE studies in 2011, then I investigated whether this was correct by looking at transactions and comparing valuations of vacant offices. It transpired that public opinion was incorrect, at least when going by the transaction data that I researched.
The NRVT defines market value as: the estimated amount at which real estate would be transferred between a willing buyer and a willing seller in a business transaction, on the valuation date, and after marketing it properly; and where the parties would have acted with full knowledge of the facts, prudently and not under duress.Things can go wrong when appraisers do not determine the market value but instead confuse it with a forced sale value, with a short sale period. As per the definition, it is not needlessly complex in the case of market value and proper marketing is assumed; for instance, over a sales period of, say, 6–12 months. Sales terms of more than 18 months were used during the previous crisis.Appraisers almost always work with the income capitalisation method to determine investment real estate value. You use a BAR/NAR, often in combination with a DCF model. These models are based on the discounting of income in line with the market in the foreseeable future. This implies continuity and a long-term view. Corrections are made for vacancy, investments and loss of rent.
In the corona crisis that we are currently living through, an adjustment is made for loss of income and for tenants who go bankrupt or terminate (their leases). These cash-flow adjustments only have a minor impact on valuations, since the cashflows are liquidated in perpetuity. It is only when assumptions regarding market rent and discount rate/return are adjusted that the difference in value becomes truly significant. In these cases, the valuer should not speculate on the developments of these parameters, but instead look for evidence to support assumptions. This process is easier in a market with many transactions because there is more publicly available data. When there is a decline in activity within the transaction market, the valuer then needs to increase contact with market participants, such as brokers, investors, financiers and users, in order to stay abreast of relevant market developments. That way, the valuer can estimate where the various sub-markets are currently located.It is also important to look at international developments and capital flows. For instance, at what is now happening in Asia. Countries in that region have been out of lockdown for a long time, and there have accordingly been significant increases in real estate market activity. At CBRE, we have weekly contact with our colleagues located in various international locations about the development of value in the various sectors. We then understand what deals can and can’t take place on a global level, and we closely watch developments in the investment markets. All of this leads to a sharing of valuable information that enables us to improve our predictions about how the relevant market is moving.
The Anglo-Saxon calculation
Value concepts outside of market value can be added to a valuation report in order to exclude short-term disruptions to the market value, such as the corona crisis. In the Netherlands, CBRE more often adds this ‘stabilised value’ to valuation reports. This is a common value concept among Anglo-Saxon financiers and investors. It means that an object is valued on the basis of the current market rent and at a long-term expected occupancy rate. The property is subsequently valued at an initial yield based on an average of recent years. During the current crisis, this value concept could be useful along with the concept of market value. That will then represent the value without taking short-term cash flow and initial yield shocks into account, which does occur in the market.
The German method
In an earlier edition of the PropertyNL magazine, there was an argument made to switch to the German mortgage loan value. That value is determined by applying a statutory calculation method using parameters under which fixed bandwidths are applicable. These valuations are resultingly very conservative. The mortgage lending values for offices in the Netherlands can easily be 40-50% lower than market value as a rule, which is why this method is less suitable.
The danger of leaning too strongly on stabilised value or value concepts outside of market value is that you create a parallel reality – one in which valuations of objects may never again be sold at these prices. If actual transactions puncture this parallel reality, then there will be a huge shock to the financial system with huge write-downs within a short time period. This outcome does not seem desirable in my view and can lead to major problems for banks. Concepts such as stabilised value can provide insights by abstracting the current market shocks, but they are no real substitute for market value.
In conclusion, I believe that the market value is still a relevant value concept, also when looking at the longer-term. Appraisers should not confuse this with a forced-sale value. The future may be uncertain, but market value is still the best parameter to use to measure current value because it accounts for current knowledge about future prospects. Long-term values can be helpful, but they do assume that history will repeat. That has proved to be very uncertain, particularly in the last decade: just look at the changing use of retail real estate.