Valuation in Perpetuity

25 Jun 2020 2:38:14 PM / by Quoin Online

An important aspect of the property industry worth discussing is the impact of the Coronavirus pandemic on valuations. Valuations assert a calculated value on a property based on a set of parameters. Usually, the value is based on historical values, the transaction value (better known as the market value), and the income-generating value. During the lockdown, the property industry and its processes were halted as workplaces closed their doors. Deals were put on the backburner and no transactions occurred for several weeks. Deals that were concluded did not transfer as the Deeds Office was closed and so re-opening faces a huge backlog.

Now, with lockdown easing and industries opening up, the property process may restart, albeit slowly. Our previous blog mentioned that not all points in the property process are open, such as the NHBRC and the Deeds Office. With the downward phase in the market and the slow pace of reopening, businesses have been looking at their properties and their values. But the question is whether valuing properties now is sensible because the economy most certainly does not display a fair market value.

Valuers have been trained to look at historical data as the basis of the value of a property. They take historical data to calculate current market prices. This aspect is used in the Market-Extraction Method, where recent comparables are used to determine a particular property value. Another method of valuation is the Income Capitalization Approach which is based on the long bond yield and discount rates.

Property, by its nature, is not volatile, it acts as a stabilization asset within many portfolios. So when valuing, you look into the future, you consider cashflows, cap rates, and discount rates. Currently, valuers need to remain conservative and use defendable cap rates which are only expected to change by half a percent because of the market’s structural changes. Erwin Rode, Managing Director of Rode and Associates, has commented that if there is a riskier tenant, a slightly higher cap rate could be used for that particular property’s cashflow. Some of the risk experienced with tenants is due to the long-term trend of shorter leases. These shorter leases show uncertainty but it is advised not to be hasty with changing the cap rate because it is based on both the long bond yield and the projected cashflow growth and not only the length of the lease.

Rode says that valuers are not expected to be smarter than the market. Property professionals previously used various rules of thumb. An example was the 12% escalation on net rental, 15% on operational costs, a 5-year lease period and an IRR of 21% are the assumptions used for a commercial property investment. The residential market also had its own rules of thumb: the annual increase of 10% on property values. It is argued by both Rode and Viruly that these are no longer viable rules to implement because of the volatility of the market.

François Viruly and Robert McGaffin, from the Urban Real Estate Research Unit, suggested that there is a need to adjust the methodologies in valuation. Rode agreed and said that he and his team use the discounted cashflow for a 5-year period method or capitalize the income into perpetuity. The two methods should give you the same answers as long as you are internally consistent with assumptions and if you understand what the normalized first year’s income is. Valuers can also use the opportunity cashflow (otherwise known as the Top Slice Method) which represents the amount of cash over or under the market at the date of valuation of the property. If the valuer uses this method, they would then discount this amount and subtract or add it to the calculated property value.

Viruly added that many developments had the first year’s income as negative, mainly due to the initial costs. Rode responded that his team doesn’t use the first year’s income, but rather the normalized market income which is capitalized in the Direct Capitalization Method. The chosen valuation method should not be the only aspect to review, but that valuation reports should have a disclaimer to emphasize the uncertainty because of where the economy finds itself. There is a difference between risk (measurable, insurable) and uncertainty. The level of uncertainty could be factored in by a standard deviation to the value assessed or a minimum and maximum range can be given. Accountants may find this problematic because they need to work with specific numbers to generate accurate reports.

Lastly, Rode iterates that there is a difference between market value and fundamental value. Market value is what the value is perceived at because it’s based on the transactional value. Fundamental value is used for investment purposes as it values the profitability/return of a property. Market value can be below or above the fundamental value depending on the stage in the property cycle. Additional factors to forecast, when valuing, are the inflation and interest rates. Presently, an average of 4,5% increase in inflation is used. However, interest rates are much harder to predict because of many underlying factors. Examples of these include international factors and politics which play a big role in interest rates. In conclusion, the valuer can’t be expected to be smarter than the market, they can only attempt to reflect it.

Topics: property market, Covid-19, Rode, valuations

Quoin Online

Written by Quoin Online

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