CRE property valuation in Covid-19 times
The impacts from COVID-19 are yet to be seen in a property market context as transactions generally follow a due diligence process and are less liquid than the public market of the stock exchange. In terms of valuations, we are seeing valuers starting to utilise disclaimers highlighting ‘valuation uncertainty’. Valuers draw upon previous transactions to form opinions of value and these have now occurred in a different market environment to what we are currently experiencing. Whilst the consequences of travel bans, isolation, consumer uncertainty, supply chain disruption, stock disruption and job loss are still evolving, we set out below our considerations on the impact the pandemic may have on the property market and valuations throughout 2020.
What happens to value? To appreciate what may happen to value, it is worth remembering the definition of value which contemplates a willing buyer and a willing seller and what they are prepared to transact the property for, at the effective date. What these parties will consider in their disposal / purchase decisions are the various assumptions that feed into valuation analysis, of importance:
Rental and cashflow
Yields and discount rates
Vacancy and prolonged impacts
What happens to rental income? The government’s reaction to COVID-19 pandemic has been to enforce strict social distancing policies forcing businesses to close, with some property owners being faced with the inability for tenants to continue to pay rent in some cases. This has further been supported by the government encouraging landlords and tenants to ‘talk to each other’ about rent relief. While rent payment is the tenant’s legal obligation, loss of rent and tenant fall over can be anticipated, noting some retailers have publicly announced they will not be paying rent. We suggest an analysis of tenants can be undertaken to establish a revised cashflow for a property, taking into consideration history of tenant arrears, business models of tenants in terms of whether they provide discretionary or essential services, their trading performance since the impact of COVID-19 and their share price, if listed. In terms of retail, turnover rents are likely to dissipate except for the likes of supermarkets. Analysts may consider factoring in periods of loss of income, abatements, deferred rents, increased incentives, tenant fall over and extended periods of vacancy. Vacancy levels of 10-20% could be witnessed as small businesses and retailers already under pressure prior to the impact of COVID-19 fold.
What will cap rates do? A question a valuer always gets asked! With the above cashflow implications in mind, and having performed some analysis and discussed with clients, worldwide colleagues and auditors, we consider property will be affected on a case by case basis. Prime assets are likely to remain sought after given their more secure cashflows with stronger tenant covenants to banks, government tenants and large corporates with locked in leases and minimal near term capex requirements. Secondary grade assets of late have had almost divergent yields to prime stock. However if an asset’s tenancy profile is deemed to present cashflow and / or vacancy risk, a softening of cap rates is likely to occur. Similarly this will occur for retail assets, which had already started to be seen, prior to any influence from COVID-19. This will likely particularly apply to those heavily exposed to tenants aimed at discretionary spending. The reletting and vacancy risk will be certainly priced into an investment decision. What we can expect to see is a greater disparity of yields between prime and secondary stock. This was evident 5-10 years ago where there was 200-300bp difference in yields. That gap narrowed in 2018/19 and there was almost no difference between asset classes due to high demand and the lack of available stock with investors chasing return. Tourism and education assets are likely to have already experienced the immediate impacts of travel bans and will face a long recovery period. These assets may initially be viewed by some as having more of a cashflow crisis than a significant change in cap rates, however the uncertainty of the duration of the crisis will likely mean risk is priced in and inevitably a rerating of these assets will occur. Land and development assets are likely to exhibit the most significant value volatility. Unemployment levels and lack of consumer confidence may see these assets to be the most dramatically discounted, akin to the post GFC environment. Volatility in commercial property markets tends to be less observed as owners (other than distressed owners) tend to hold and liquidity naturally reduces during recessionary times. Owners of prime assets,also with some variation depending on geographic, have modest gearing and so transactions that do occur will tend to relate to poorer quality assets and this can further skew data available within poor market conditions. It is likely that banks will be more careful about their lending decisions, which means cashed up purchasers are more likely to be present in the market who will demand a higher return on equity. Time will tell whether there are a number of ‘forced sales’, noting that if this type of transaction regularly occurs, these transactions can tend to become the market expectation for pricing.
What will the long term impacts be? Following the GFC, a flight to quality was observed in the demand for property assets. The COVID-19 crisis could result in structural changes to how the real estate market evaluates tenants in terms of risk, noting that occupiers providing essential services diversify risk under these circumstances and tenants offering essential services may be considered to offer a robust covenant. Assets with a diversified income, including government and essential services tenants, and a broader spread of tenant type are likely to be sought after. We may see the change of use of some more secondary assets to a higher and better use. Other decisions around property may include sale and leaseback arrangements becoming more prevalent as businesses seek to improve cashflow, their balance sheet and reinvest capital in their businesses. Assets with direct exposure to offshore visitors such as tourism will likely reveal, at least for the medium term, structural repricing. In terms of occupier demand, tenants may not necessarily demand lower rents, but will look to be more efficient with their space requirements. Tenants are likely to realize efficiencies in terms of space requirements following adapting to working from home and similar arrangements. A reduction of floor space may occur as tenants who have evolved to utilize digital technology over this hibernation period, look to reduce nonessential spaces that were previously utilised for group gatherings and functions. We may see renegotiating and restructuring of leases and an emphasis on a healthy and hygienic environment in the office sector. In the industrial market, occupiers involved in key supply chain activity will be more highly sought after, whereas businesses reliant on offshore demand will be less sought after. Retail is likely to face a challenging recovery period as confidence needs to rebuild amongst households. Job losses, job security and uncertainty may cause more people to save or pay down debt which will further increase the period of recovery. Some retailers may use the hibernation period as an opportunity to permanently shut down underperforming stores and restructure their operations following having to adapt to an online platform. It will be interesting to see how food and beverage retailers recover from social distancing and the impact their struggle has on retail assets as they have represented a large proportion of lettable area within centers. Overall a challenging reletting market is likely to occur coupled with expectations of incentives. We may see new clauses drafted by the legal profession to cover similar events providing more flexibility for the tenants in times of significant uncertainty.
How are valuers going to approach COVID-19? Valuers are required to report at a specific date and reflect market conditions at that time. Events such as COVID-19 create valuation uncertainty, because the only inputs and metrics available for the valuation are likely to relate to the market before the event occurred and the impact of the event on prices will not be known until the market has stabilized. Currently, there is no way of confirming the movement through transaction data as yet and valuers will need to rely on all information available to them when they complete and submit their market value assessments. Valuers can reflect, for example, historical evidence that suggests how property markets might move under differing economic, monetary and fiscal conditions. Expect valuers completing valuations during the COVID-19 crisis to:
caveat their advice, referencing some of the issues outlined above
reference the high valuation uncertainty, and that there is more downside than upside value estimation error
reserve the right to reconsider their advice as events unfold and if these events are likely to have a material impact on value. This might extend to valuers recommending that they review their advice prior to the next financial reporting date and as market evidence occurs. More regular valuation reporting will likely be needed to keep advice up to date.
Valuers will have to estimate the appropriate discount and/or capitalisation rate to apply for their analysis. When markets are stressed, valuers will need to consider issues such as the need for liquidity premiums and whether it is appropriate to consider additional risk premiums to account for the greater degree of uncertainty in estimating cash flows. Care will need to be taken in deciding on the appropriate level of additional risk premia and significant judgement will be required. We would recommend that the reasoning for any additional premia is documented within valuation reports to provide transparency. The Royal Institute of Chartered Surveyors (RICS), which provides global guidance to valuers, suggests on their website (as at 29 March 2020) that its members consider advising their clients that they: “… attach less weight to previous market evidence for comparison purposes, to inform opinions of value. Indeed, the current response to COVID-19 means that we are faced with an unprecedented set of circumstances on which to base a judgement.”; and report their valuations “on the basis of ‘material valuation uncertainty’ as per VPS 3 and VPGA 10 of the RICS Red Book Global. Consequently, less certainty – and a higher degree of caution – should be attached to [our] valuation than would normally be the case. Given the unknown future impact that COVID-19 might have on the real estate market, we recommend that you keep the valuation of [this property] under frequent review.” Notwithstanding the above, valuers will need to advance their thinking on how they structure their valuation reports to ensure they communicate their opinions and assumptions in a way that assists their clients with evaluating the valuation advice and presenting it in a meaningful way to their stakeholders.
In Conclusion Considering the likely impacts on the major assumptions of value, we suggest a softening of capitalisation rates is likely to occur across most asset classes. We see ‘value add’ properties climbing higher up the risk curve with an emphasis placed on well leased property to secure tenants with fixed growth, such as prime assets, where capital will continue to seek diverse and secure cashflows. A short term effect on cashflow from discretionary type tenants and those businesses which can be called non-essential services may eventuate. Pricing in for risk of vacancy and letting up allowances is likely to occur. The recovery time for tourism and retail assets will depend on the duration of the crisis. The longer it goes on, the longer the recovery time will likely be, as unemployment and uncertainty perpetuate and households move to saving and paying down debt. Valuers will include new disclaimers and utilise evidence available to them at the time and should ensure to articulate fully their assumptions and opinions. Valuers should be open to having transparent dialogues with clients and their auditors as this crisis evolves. Their advice may require more regular updating, noting as more transactions occur throughout the crisis these will reveal how the market is responding.