Property valuations and the investment market

RICS, Moscow

Andrew BaumDepartment of Land EconomyUniversity of Cambridge

25 March 2014

Why are valuations needed?

• For sale and purchase– transaction and due diligence support

• For bank lending – loan to value ratios

• For balance sheets– asset valuation

• For performance measurement– manager track records and performance fees

Consistent valuation standards are important

• Valuations need to be – accurate and unbiased– professional and regulated– consistent within and across borders

• RICS Valuation: Professional Standards (the 2014 Red Book) covers the valuation of assets in the form of real estate (land, buildings and interests therein). Fully compliant with International Valuation Standards (IVS) 2013

Cross-border investing has boomed

Source: University of Cambridge

2011

2009

2007

2005

2003

2001

1999

1997

1995

1993

1991

1989

1987

1985

1983

1981

1979

1977

1975

1973

0%

10%

20%

30%

40%

50%

60%

Foreign Ownership of City Offices

Other/UnknownInternationalMiddle EastEuropeJapanUSAGermany

Some places get more than their fair share of capital

• International capital flows are explained by a combination of formal and informal barriers

• Formal barriers– taxation, capital controls, limits on foreign owners

• Informal barriers– legal and title risk– liquidity risk/limits on exit – currency, culture, transparency

• information asymmetry/market research• valuation

JLL Transparency Index, 2012

• Direct Property Indices

• Listed Real Estate Indices

• Unlisted Fund Indices

• Valuations  

• Market Fundamentals Data

• Offices, Retail, Industrial, Hotels, Residential

• Financial Disclosure

• Corporate Governance

• Regulation• Land and

Property Registration

• Eminent Domain• Debt Regulation

• Sales Transactions

• Occupier Services

5 Sub-Indices

13 Transparency Topics

83 individual questions and data-points for each market

Composite Score

Performance Measurement

Market Fundamentals

Transaction Process

Governance of Listed Vehicles

Regulatoryand Legal

JLL Transparency Index 2012 - Europe

Source: Jones Lang LaSalle, LaSalle Investment Management

United Kingdom, NetherlandsFrance, Finland, Sweden, Switzerland

Germany, Denmark, IrelandSpain, Belgium, Norway

Italy, Austria, Portugal

Greece

Highly Transparent

Transparent

Semi Transparent

Low Transparency

Opaque

Poland

Czech Republic, Hungary

Turkey, SlovakiaRussia (Tier 1-2 Cities), Romania

Croatia, Russia (Tier 3 Cities), BulgariaUkraine, Slovenia

Serbia

Kazakhstan

Belarus

Western Europe CEE

• Remarkable surge in cross border flows over the last decade; sharp differences among countries

• Each country should receive capital flows commensurate with the size of its respective economy or, more accurately, the total size of its investible real estate market

• Key finding: improving real estate market transparency appears to have a stronger positive impact on cross-border flows than an increase in historic and prospective returns

Cambridge research

Transparency and investment activity are correlated

Sources: Jones Lang LaSalle, LaSalle Investment Management

1 1.5 2 2.5 3 3.5 40.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

Real Estate Transparency 2012

Ratio

of G

loba

l Tra

nsac

tion

Shar

eto

Glo

bal G

DP S

hare Above Average Share of

Global Volume Relative to GDP

OpaqueTransparent

Below Average Share ofGlobal Volume Relative to GDP

R2= 0.39

Australia

Vietnam

UK

Italy

Norway

Hong Kong

Sweden

Bulgaria

South Korea Macau

HungaryNetherlands

Switzerland Croatia

Czech RepublicFinland

USA

Germany

Taiwan

PortugalIreland

Singapore

Russia

ChinaBrazil

Japan

Are valuations accurate?

• International investment requires valuations which are – accurate and unbiased– professional and regulated– consistent across borders

• Smoothing: valuations are conservative• How close are valuations to sale prices? Is there evidence of bias?• Is there evidence of client influence?

Smoothing

• Real estate is said to offer a reasonable return for low volatility, and diversifies the portfolio

• But volatility is under-stated by valuations– anchoring and valuer conservatism– temporal averaging - when are year end valuations undertaken?– lagging effects - the use of ageing comparables

Smoothed property values

81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97100

120

140

160

180

200

220

Smoothed Unsmoothed

ReturnSD 10%

ReturnSD 14%

Optimal portfolios, rising returns

0%

10%

20%

30%

40%

50%

60%

70%

11.5% 13.0% 14.5%

UK stocks UK property UK gilts

Observedmean

Valuation uncertainty

“… the valuer and most informed users of the valuation recognise that there will be a degree of uncertainty associated attached to the figure provided.” (RICS, 1997, p. 26)

“All valuations are estimates and carry with them a degree of uncertainty. The range of uncertainty may vary in different market conditions and for different types of property” (RICS, 1997, p. 26)

Source: Merrill Lynch, Bloomberg October 2007

Do public markets lead?

-100

-80

-60

-40

-20

0

20REIT Fund Derivative IPD monthly

Derivative margin is divided by 10

Higher volatility, but no evidence of different turning points

Sale prices are more volatile than valuations

Sale prices are more volatile than valuations...

Source IPD

-10.0%

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

2004 2005 2006 2007 2008 2009 2010 2011% D

iffe

ren

ce

France Germany Netherlands UK

...but some countries are more volatile than others

Client influence: the principal/agent problem

Fund managers

• Reduce fees – or pass them on• Maximise performance

• Achieve performance fee

Valuers

• Maximise fees• Increase market share

• Increase client satisfaction

Who appoints the valuer? The investor or his agent?Are valuers rotated?

Client influence

• Portfolio valuations are often submitted in draft and sometimes subject to ‘negotiation’

• The process invariably includes a client meeting to review draft figures - end of year valuations can be particularly difficult

• Two main effects - improvement and biasing

• Evidence of ‘shock’ to valuations when new valuers and/or managers are appointed

Consistent across borders

• Are markets different?– UK v Germany

• Do valuers apply different standards?– UK and German valuations of the same market sector

Capital value change, 1996-2011

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

-30

-25

-20

-15

-10

-5

0

5

10

15

Germany UK

% Y

ear

on

Yea

r

Consistent across borders?

Source: IPD

Central London office capital growth 2000-2009

-30

-20

-10

0

10

20

30

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

% p

a

UK valuers

German valuers

Consistent across borders?

Source: IPD

Central London office capital growth, 2000-2009

Average Standard deviation

German valuers 0.37% pa 3.67% UK valuers 1.20% pa 13.54%

Consistent across borders?

Source: IPD

Issues – property appraisal methods

• Market price - observed exchange price

• Market value - estimate of most likely selling price• theoretically, one figure but practically a point on a distribution of possible values• usually comparable based• Germany v UK

• Investment worth - how much should an investor pay for the property?• can be different for each individual or group, also a point in a distribution• usually explicit cash flow (DCF)

• Discount rate• Cash flow

Fair value, market value

• In accounting and economics, fair value is a rational and unbiased estimate of the potential market price of a good, service, or asset

• Market value is the estimated amount for which an asset should exchange on the date of valuation between a willing buyer and a willing seller in an arm's length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently and without compulsion

• Must be based on comparable evidence

Problems with fair/market value

• No market, no evidence

• Temporary distress (Brixton, 2009), temporary bubbles

• Bank balance sheets?

Is market value always best?

• A Vision for Real Estate Finance in the UK – from the Real Estate Finance Group – highlights that poor commercial real estate valuation and lending can invariably “cause or prolong” a financial crisis

• “The recent crisis has been no exception. The natural consequence of the 45 per cent collapse in UK commercial property prices between mid-2007 and early 2009 has been a pro-cyclical evaporation of financing capacity”

Sustainable or mortgage lending value - definition

• The mortgage lending value is the prudently calculated value of a property. It represents the value which throughout the entire life of the loan can probably be achieved for a property that is sold on the free market – irrespective of temporary (for example, economically-induced) value fluctuations in the respective property market. This requirement serves to eliminate speculative influences

• But how volatile is real estate as an asset class?

Investment worth

• The value of the property to a particular owner, investor or class of investor, for identified investment objectives. This subjective concept relates specific property to a specified investor, group of investors, or entity with identifiable investment objectives and/or criteria.

• Must be DCF and cash flow based

• Can clearly indicate under-pricing or over-pricing in the market

Conclusion

• We need internationally consistent valuation approaches– accurate and unbiased– professional and regulated– consistent across borders

• But we need three bases– market/fair value (UK/US) – performance, transaction advice– sustainable/mortgage value (Germany) – balance sheet, bank lending– investment worth (DCF) – consulting advice, bank lending?

References

• Baum, A and Hartzell, D (2012): Global Property Investment - Strategies, Structures, Decisions, Wiley Blackwell, 2012

• Crosby, N. and Hughes, C. (2011): The basis of valuations for secured commercial property lending in the UK, Journal of European Real Estate Research, Vol. 4(3): 225 - 242

• Crosby, N. Lizieri, C. and McAllister, P. (2010): Means, Motive and Opportunity? Disentangling Client Influence on Performance Measurement Appraisals, Journal of Property Research 27(2): 181-201

• www.ipd.com