Valuation: part art, part science

• Decision to ignore extreme market movements undermines trust in the system
• Banks CRE positions are more robust today than in preceding years
• Korea Investment Corporation experienced its largest annual loss, but real assets outperformed traditional asset with returns of 7.6%
• Commercial values move rapidly – but 26% of investors expect growth in 2023

In Peter Wyatt's ‘Property Valuation in an economic context’, arguably the most widely used real estate valuation textbook, he admits to the struggle of defining real estate valuation. “Conventionally regarded as a professional discipline it is only in recent years that valuation has undergone serious academic scrutiny and an attempt made to place it in an academic setting. The outcome of this scrutiny is a move away from valuation being taught as a branch of surveying… and valuation might be regarded as applied economics, but practically it requires the practitioner to call upon other disciplines, particularly law, finance and land economics, geography and management.”

Vincent Glode, a Professor at The Wharton School writes that “even though [valuation] is based on principles of finance and accounting, valuation is part art, part science… at some point, you have to make a subjective prediction about what will happen in the future.” Investors today, in a challenging macro-economic climate, need to convert the conflicting signals into business practice.

Insight, a major UK pension asset manager, abandoned mark-to-market pricing during the Gilt crisis last year. After the Bank of England rescue scheme announced on September 27th caused significant price increases, Insight's five-person fund board decided to mark the books higher by disregarding that day’s gilt moves and marking to market prices that had prevailed in the middle of September 26th. Insight claimed that the markets were dysfunctional and that this decision was made in the best interest of all shareholders in the fund. The adjustment prevented Insight from making cash demands of its clients. Industry experts have criticized the decision, stating that net asset values should reflect asset values and that this undermines trust in the system.

Valuation falls impact the real economy. The February 2023 Monetary Policy Report by the Bank of England testified that the decline in commercial property values has led to a hesitance among developers and investors in starting new projects or making transactions. This reluctance is more pronounced among foreign institutional and private investors, who are also concerned about exchange rate fluctuations.

The current downturn has been notable not only for the speed at which the market has shifted, but also for the speed at which valuers have adjusted their valuations. In the past, valuers have been criticized for being slow to reflect market changes, with the Royal Institution of Chartered Surveyors conducting an independent review of the profession led by Peter Pereira Gray in response to accusations of slow valuation adjustments for retail properties. As reported in React News “The greatest criticism of the valuation profession post-GFC was that it was felt that we were slow to respond to shifts in the market,” says Caroline Bathgate, Knight Frank’s global head of valuation and advisory. “I think that was partly because we have always been a profession that likes to be able to point to evidence, but I think we took those criticisms on board and have become better at looking at alternative sources of data.”

Had stock prices been used to value assets directly, the swing in valuations would have been even more extreme. The Tritax share price peaked at ï¿¡2.51 on April 7th 2022 and fell to ï¿¡1.20 on September 28th 2022. When the portfolio revaluation was announced the annual like-for-like decline was a more modest 15.2%.

It was poor performance of equities and bonds rather than real estate valuations that drove many asset allocators and in particular the Korea Investment Corporation (KIC) to experience its largest annual loss since its inception in 2005, with a record shortfall of $29.7 billion. Its cumulative profit also fell by 34% to $58.2 billion, and its assets under management dropped from $205 billion to $169.3 billion. However, alternative investments such as private equity and real assets outperformed traditional ones, with returns of 14.7% and 7.6% respectively over the past five years. The fund increased exposure to alternative investment by 540 basis points last year, while reducing it to traditional assets by 230-340 basis points.

But deteriorating values hasn't seem to have impacted banks’ balance sheets (yet?). Barclays in their annual report published this week echo relatively modest impacts on their ￡9.7bn (2021: ￡10bn) UK Commercial Real Estate (CRE) book. Loans ranked as Stage 1 edged higher to 81% (2021: 78%) and the portfolio was well collateralised, with a coverage of 1.1%. Exposure at Stage 3 was 2% (2021: 3%) with a coverage ratio of 12% (2021: 18%). NatWest, with an average of 47% LTV on their CRE book – lower than at any time in the preceding 3 years (2019: 48%) – stated too this week that commercial property values declined by an average of approximately 20% from their mid-year peak, ending the year approximately 14% lower. Whilst they opine that the industrial sector saw values fall fastest to date, it continues to attract strong occupier demand and may, therefore, be the first sector to see values stabilise. Indeed, it has seen the most growth on their books in 2022. Secondary offices, they write, which don’t match modern sustainability standards appear most at risk from further value loss.

According to a survey conducted by the British Property Federation, which involved more than 100 industry leaders, investors are not necessarily anticipating a decline in property valuations this year. When asked about their own portfolios, 31% of respondents expected their assets to be worth less in a year, while 19% believed they would maintain their current value, and 26% predicted an increase in value. However, the survey also revealed that most respondents lacked confidence in the broader sector's outlook for the coming year, with only 15% expressing confidence compared to 60% who did not. Nevertheless, respondents were more optimistic about the longer term, with 60% expressing confidence in the sector's prospects over the next five years.

This positivity might be driven by the defensive nature of the asset class. New York Life, now the majority owner of Tristan Capital, include real estate as one of four defensive sectors which tend to be more resilient in downturns and have cash flows that are positively correlated with inflation. Two key factors are thought to be impacting the performance of growth companies. Firstly, earnings expectations have decreased due to many companies pulling forward earnings during the pandemic, although those that can innovate or benefit from new trends may still outperform. Secondly, growth companies are particularly sensitive to higher interest rates, and while a pause in Fed hikes may offer some relief, valuation pressure is unlikely to reverse.

Investors that specialize in taking over troubled companies believe that there will be fewer defaults in the next economic downturn due to the presence of resilient balance sheets and flexible loan contracts. Even though corporate debt is increasing and there are indications of an upcoming recession, they predict that corporate America is well-prepared to handle the potential economic challenges. “We are likely heading into a very unique recession, in our view,” said Ryan Mollett, global head of distressed & corporate special situations for Angelo Gordon, an asset manager with a $12 billion distressed and special situations platform.

Managers with substantial dry powder may find some solace in the impending write-downs. However, they may have to exercise patience before they can resume allocating capital. According to a former colleague, Brian Velky of SitusAMC, in an environment characterized by price discovery and rate pressures, investors are more likely to opt for a lending role to earn a return that is almost equal to equity returns based on current valuations. Consequently, he predicts that transaction activity will remain restricted until there is clarity on expected returns.

Whatever its definition, it’s clear that Valuation is a tool that market practitioners can manipulate self-servingly. Real estate valuation methodologies are opening up to disparate data sets to arrive at a value, but the value itself is just a data point. As a demonstrably defensive asset class, investors can use valuations subjectively to extricate themselves from compromising situations (equity) or exploit market opportunities (debt), because the real estate market is objectively in good shape.