Valuation in turbulent times

This edition of Mainly for Students is intended to make you think about the current valuation challenges in a holistic way, through a series of questions that require thoughtful answers. A holistic thought process is a vital part of understanding valuation. What is valuation? Fundamentally, valuation is an evidenced opinion. A competent valuer should be able to explain and justify the concepts behind the thought process. A valuation is the answer to a question. The question is usually: what would this property sell for on a specific date? The question is framed within the RICS’s definition of market value: “Market value is the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s-length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion.” This comes from the latest 2020 edition of RICS – Valuation Global Standards (the Red Book), which provides chartered surveyors with the basis of valuation within given practice scenarios. But what does market value actually mean? Think about a valuer coming fresh on a property up for sale. In doing so, what bid are they likely to make for the property at a given valuation date? This is the question being asked of the valuer. The valuer can use a range of methods and techniques to arrive at the answer to this question. These methods are usually summarised as follows: comparable method – the market comparison approach; investment method – capitalising income flows; residual method – working backwards from gross development value deducting costs to find site value; profits method – capitalising reasonable net profit; and depreciated replacement cost method – using costs to work out how much to build a modern equivalent and depreciating to reflect age and obsolescence. An important point to note as you study the methods is that they all have an element of comparison to a greater or lesser extent. However, in carrying out those comparisons, the weighting of comparable evidence is affected by risk and uncertainty. What are the drivers of value? When considering what influences value, we need to always keep the basis of valuation in mind and the likely bid of all possible market participants. The property market is actually a collection of sectors and sub-markets. Think about what might affect supply and demand in the real estate sector you are considering. The valuer needs an overview of the big picture and specialist knowledge in their own field. The main property market sectors/asset classes are: residential; office; industrial; retail; agricultural land and forestry; and other Other asset classes have emerged in recent years as investors spread risk and chase higher yields. These include: build-to-rent, care homes, data centres and student accommodation. How has technology affected retail valuation in the past 10 years? The online revolution in retail has meant that whether or not a company has a multi-channel strategy, a strong internet presence affects its customer base and access. Not all retailers have evolved successfully in response to that challenge – compare Asos with Marks & Spencer. This impacts on their rental bids and has affected lease terms, with a growth in turnover rents. The tax position affects bricks-and-mortar retail much more than online in respect of both business rates and corporation tax, as many internet businesses are located outside the UK. In response to the challenge, the shopping experience has become a central part of attracting customers into stores, utilising appealing elements such as demonstrations, cafés, human interaction, smell and sound. These consumers have increasing influence on their surroundings, through user-generated content on their mobile devices. In doing so they are using the comparable method themselves. This is difficult to reflect in a market rent valuation but, as it becomes the norm, the wider market and all the comparables will reflect this way of doing business. Are any other sectors affected by the internet? Yes, this has a knock-on effect into industrial storage and distribution, with an increased demand for large, high-specification warehouses on major roads, combined with smaller urban hubs for delivery of all that internet shopping. There is also a greater demand for data centres to process data and manage algorithms related to this online activity. Banking and gambling have become mostly online activities, affecting the high street further. What impact has Covid-19 had? Trying to establish market value with reference to comparable transactions is challenging in a Covid-19-affected market when there is limited economic activity: think about which companies are closed or have gone out of business completely during lockdowns. This limited real estate market activity has meant that the valuer needs to look further afield, make more adjustments and attach less weight to the evidence. This will make a valuation inherently uncertain. Valuers need to look behind the lack of deals and think more widely about economic activity affecting bids. The shape of the recovery graph in gross domestic product (whether a U or a V) will affect confidence. The sheer scale of government debt means the coronavirus crisis will be a driver of the economy and, in turn, real estate both in the short and long term and as such will dwarf any other influences. Residential The residential market has remained remarkably buoyant. Working from home has created demand for space indoors and outdoors, as well as providing cost savings for deposits. The stamp duty land tax holiday, due to end in March 2021, has also stimulated sales. Build-to-rent remains very popular for funds. Commercial The pandemic has had the effect of accelerating the retail changes already under way. Aerospace and leisure have been severely affected. This all means: tenants are more likely to exercise break clauses; more flexible, shorter leases; lower headline rents; alternative rent review bases; and more letting incentives are needed. The pandemic also affects the ability to gather information, with various levels of lockdown restrictions affecting the physical inspection of property. What about Brexit? When we leave the transition period in January, if there is no deal, further market uncertainty is likely. There have been rumours of negative interest rates, but this is uncharted territory for the UK and will make life difficult for the banks, which provide most finance for residential transactions. The referendum was in 2016 and it could be argued that Brexit uncertainty is already built into the market. House price growth declined sharply in the aftermath but has since recovered. The fundamental macro-economic truth remains that there is a chronic undersupply of housing in the UK. The climate will probably become more challenging for residential landlords amid increasing regulation and the exodus of buy-to-let landlords may accelerate. It will be almost impossible to distinguish Brexit from Covid uncertainty and valuers will need to remain market-aware. Most commercial property is owned by institutions such as pension funds or real estate investment trusts. In the run up to Brexit, there were some notable transactions, for example the sale of the Walkie Talkie, EC3, by Landsec and Canary Wharf group to a Chinese investor for £1.3bn in 2017. Since then, these funds have been to some extent exiting the market, causing a drop in demand for some sectors. Alternative and growing sectors, such as student accommodation, have made up a large chunk of transaction volumes. Confidence has waned in London for example, as after Brexit it may be a much less influential global financial centre. If multinationals pull out of the UK, many aspects of the economy will be affected. However, we do have a fairly strong economy, a stable legal system and a (relatively) strong currency. It is hard to predict how investors will behave – hence the uncertainty. Let’s not forget, there may be a last-minute deal. How are cladding concerns affecting values? In June 2017, the Grenfell Tower tragedy highlighted the dangers of combustible aluminium composite material. Flats over 18m high with this cladding have become unmortgageable and values have crashed. The RICS and UK Finance have created form EWS 1 (exterior wall survey) to provide reassurance to lenders on the type of cladding. The problem is that there are very few fire safety inspectors who can classify the cladding. As a result, the saleability of all high-rise buildings with cladding has been affected. How do we report uncertainty to clients? If the degree of material uncertainty falls outside normal parameters, the client will need to be clearly advised so the valuation report is not in any way misleading or gives a false impression to anyone likely to read it. To help this, the RICS has suggested a form of words for such statements: https://www.rics.org/uk/upholding-professional-standards/sector-standards/valuation/valuation-coronavirus . Valuers need to also consider the Red Book guidance in VPGA 10 (page 116) which applies to all uncertainty. This is a very brief overview of a very complex subject. Thinking about the key questions will help you, the student, to explain and justify the rationale underlying a valuation. The important thing is to stay alert and be market-aware so you can imagine the bid reasonable market participants might make in a world of uncertainty. What drives value? The usual drivers of value in the real estate market include: Location Lease terms Size Accommodation Quality Specification State of repair Potential to develop Outside space Natural hazards Economy Business Statute Technology Kate Taylor FRICS is author of Commercial Real Estate Revision Guide for RICS APC (5th edition, January 2021) Paul Collins is a senior lecturer at Nottingham Trent University and Mainly for Students editor. He welcomes suggestions for the column and can be contacted at paul.collins@ntu.ac.uk Picture © Dan Sparham/Shutterstock