As markets correct and the data drains from the system, the job of the valuer becomes much more challenging. Richard Lowe reports
How do you assign a value to an asset if none of its counterparts are being traded? The answer is: with great difficulty.
Valuations depend on comparables. A busy marketplace provides a wealth of up-to-date reference points, but conversely an absence of transactions renders the valuation process almost impossible.
Such an unhelpful scenario is one that currently applies to the UK commercial property market. Liquidity in the finance market has dried up, making it more difficult to fund investment purchases, and consequently the investment market has slowed. This poses significant difficulties to valuers.
"There are fewer sources of comparable evidence that valuers can use when arriving at their opinion of value," says Rupert Dodson, partner and global co-head of valuations at Cushman & Wakefield.
"So, a greater degree of judgement is required in the UK than was previously the case."
Another reason that activity has slowed down so markedly is that the UK market relies more than Europe on leveraged transactions, which today are difficult to fund given the current global credit crisis.
The investment market on the continent is itself suffering, but it remains more active than the UK, meaning values have not been affected to the same extent.
"In some cases they are still going up," Dodson says. "The reason for that is that generally the way in which the transactional market works on the continent is slower. It is slower to react."
Since valuations are based on comparable evidence, there is always a lag between prices and value. But in the UK, where IPD valuations are produced on a monthly basis, it is less pronounced than elsewhere, especially compared with the US and Germany.
"Even though there is a lag, it is less significant than anywhere else in the world," explains Peter Hobbs, head of global real estate research at RREEF.
"It is marking to market very quickly. And yes there is a lag, but it is nothing like what there is in the US or in Germany where lags will be much longer."
For example, both the UK and US are suffering from a loss of investor confidence and weakening fundamentals. But while IPD returns for the UK have dropped dramatically from 18% in 2006 into negative values in 2007, Hobbs expects the US equivalent, NCREIF NPI returns, to fall just two or three percentage points from their 2006 level of 16.6%.
"A lot of that will be down to the appraisal lag and the way in which NCREIF measures the values in its portfolio," he says.
"You get the same sort of thing in Germany due to the valuation methodology there where there is a lot of inherent smoothing in valuations."
Today, IPD produces UK reports on a monthly basis and certain countries, such as the Netherlands, Australia and Sweden, are now considering the benefits and practicalities of adopting similar monthly valuations.
But should markets such as Germany and Japan for that matter, for example, where there is a long-established tradition to smooth returns and not respond in the short term to market changes, be conforming to UK practices and marking to market more closely?
Hobbs certainly thinks so but admits there is a certain amount of logic to the philosophy commonly held in Germany, which urges the importance of maintaining an anti-inflationary safeguard.
"You don't want to respond to a market change just because of short-term volatility. Better, it could be argued, to have a more conservative approach to valuations - more smoothing - so these generally longer-term assets can be managed, rather than respond because of short-term changes."
"Many in Germany would argue that is the right approach. But I think there is also a lot of merit in marking to market much more closely than we do in real estate generally."
The stark difference in the way the UK real estate market has reacted to the situation in the financial markets compared with its continental counterparts has, as Dodson concludes, created "a kind of two-track market".
"The valuer has to work much harder to seek out support for his opinion. But I think there is a flight to quality by those who require valuations."
Of course, valuations for commercial properties are sought from two main camps: institutional investors and direct real estate investment funds requiring independent valuations for accounts purposes; and banks that seek valuations for loan security purposes.
Dodson believes both groups are increasingly keen to identify "a valuer whose judgement can be relied upon where there is a lack of empirical evidence".
Savills provides valuations for the latter camp and William Newsom, head of valuations, admits "there are fewer transactions taking place at the present time".
More importantly, he adds, the fact that values are falling as quickly as they are in certain sectors - "if not right across the market" - means that up-to-date information becomes more vital than ever. In today's scenario, "something that happened three months ago is going to be out of date".
However, Newsom argues that firms with the scope and resources to be able to grasp values across different global markets are in a stronger position to provide an accurate service in markets where comparables are scarce.
Furthermore, he believes that valuers have been working much harder than they did historically since the recession of the early 1990s. "We have had to work much harder to make more and deeper enquiries into comparables in the rental market and comparables in the investment market and provide market commentaries.
"Banks are asking us to value on a variety of different bases… we are having to make more enquiries about things like global risk of flooding and the incidence of deleterious materials; we are having to work harder reading the leases, reading the solicitors' reports or structural reports.
"So, we work hard anyway. Our job is much the same, whether it is in a strong market or a weak market."
And Dodson believes the globalisation of the real estate investment market has ushered in a new level of sophistication in the way in which properties are valued across borders.
The valuation approaches used by local investors in different countries vary across borders. But with institutional investors increasingly managing property portfolios on a pan-European or global basis, valuers have needed to develop techniques to value property consistently across territories.
"We are generally getting more sophisticated about it," he says. "The valuer's job is to reflect the market - he does not make the market - and therefore the valuer's approach to the methodology must be the same as a hypothetical purchaser. And depending on where you are depends on the sophistication of that approach.
"Some people will just look at capital per square metre, while others will have a much more sophisticated approach when they are buying property in that region.
"Having said that, over the last year or two, there is much more sophistication in the way in which properties are valued than has ever been in the past. The reason for that is the globalisation of the property investment market.
"Cross-border investors obviously need a method whereby they can compare performance on a like-for-like basis. Therefore, those funds and their valuers are having to adopt the most sophisticated approach that is prevalent in the most mature country.
"Even though the local market might look at it on a fairly blunt basis, when it comes to the analysis of the value, people are looking much more at internal rates of return, because they need to ensure they can compare like for like across borders."
Yet Paul Wolfenden, global head of valuation at DTZ, believes that valuers are faced with a new challenge that is very much tied in to the current pessimism plaguing global markets.
One of the biggest problems for valuers today, he says, is the current gulf between "perception and reality", fuelled by investor pessimism and further stoked by attention-grabbing headlines.
"Everywhere you turn you are reading newspapers and headlines that tell you values have gone down by 10% or 15% or 20%. Everybody is glibly throwing headlines into the arena, such as ‘values having fallen by 15%' or ‘all shopping centres are a 5% yield'.
"The difficulty at the moment is there seems to be no differentiation between the quality of real estate and the quality of management. People are getting too hung up about generalities and I don't think people are looking at the real specifics of real estate.
"The challenge for me as a valuer is having the confidence and the belief to opine where we see the market is at a given time. Unfortunately, where the market is and where perception is in the market, often is not the same. You are criticised and held to account unless you agree with public opinion."
Wolfenden admits that certain property sectors in the UK have been overpriced and that secondary real estate has been overpriced for the last two years - largely because of the abundance of cheap debt causing prices to inflate.
"We are now seeing a market turning to fundamentals where the quality of the real estate and opportunities to add value to real estate are going to come through with premium purchases.
"There is a sort of transition at the moment. It is not helped by the scarcity of debt, but there are still transactions taking place and debt being provided."
Wolfenden says it is easy to lose sight of the fact that there is still a huge amount of global capital waiting in the wings to invest in real estate. He even suggests that for certain "high profile individuals who are capital-rich" and biding their time to enter into the market, there is some sense in "talking the market down".
And Hobbs believes that as the market corrects very quickly there may arise some natural value in the UK if cap rates were to rise to 5.5% or even 6%.
"Investors coming into the UK thought the market was very expensive at 4-4.5% [cap rates] for City offices and a lot of UK investors were starting to look overseas. But as this market corrects very quickly, there may be some natural value back here and there are already signs of some foreign investors starting to come back in."
If London cap rates were to increase in such a way, the market could look very appealing compared with some of the emerging markets in Europe that are currently attracting capital with similar cap rate levels. The question then would be: are emerging markets, such as Hungary and China, too aggressively priced, and are investors underestimating the risks associated with such markets?
"I think that is a very important issue right now," Hobbs says. "If London City cap rates were to go up to 5.5%, maybe 6%, then that market - with its lease length, lease structure, etc - looks very attractive compared with sub-6% in Budapest, or in parts of Asia face a series of institutional transparency and liquidity risks.
"When we are looking at valuations and fair value, we need to look at it relative to the risks of the market as well as obviously the performance prospects.
"There is a danger now that people have underestimated the risks of investing in some of these emerging markets, because you look at the cap rates in Beijing or Budapest and they are not much higher than Boston or Barcelona."