Some valuation practices short-change investors. It is time for valuers to use all available evidence, says Andrew Baum
The UK property investment market has entered a period of relative crisis. Prices have been falling, liquidity has disappeared, and open-ended funds have closed their doors to those trying to exit.
This is not good news for the industry. An efficient market for assets, including property, requires that trading can take place. Investors can accept falling prices, but why the loss of liquidity? Why have investors become trapped within an asset class which had been performing well but has suddenly frozen?
The answer lies in the unique nature of property as an asset class, but more in the defects inherent within the practice of property valuation.
Figure 1 shows property yields and index-linked gilt yields for the period 1995-2007. It shows a remarkable correlation. The market appears to treat these asset types similarly, as excellent inflation hedges. However, by late 2006 the gap had closed, making property relatively expensive. This is illustrated more clearly in figure 2.
So property was looking expensive as we entered 2007. By this point, average premiums to NAV on unlisted fund had begun to fall, followed quickly by falls in REIT premiums and derivative margins. However, it was not until the summer of 2007 that returns on the IPD monthly index - the best indicator of prices in the direct UK market - began to turn down (meaning a reduction in the rate of increase in process).
Figure 3 shows average three (calendar) year property swap margins over LIBOR from August 2006 to September 2007, turning from 0.4% over LIBOR to 9% under LIBOR (Merrill Lynch estimates). Unlisted fund premiums over NAV fell (according to JLL estimates) from 4% on average to minus 9% in September. REIT prices collapsed from premiums to NAV at the start if 2007 to big discounts by summer 2007 and 7% averages in September.
Meanwhile, the IPD monthly index (unlike the other indicators, including income) produced its first negative return (-0.1%) in September 2007. This - at the very least - suggests some lagging in the IPD monthly index.
Why has the IPD monthly index lagged other property indicators? The answer lies in the conservatism built into UK property valuation practice.
Property is just one of a set of conventional and alternative assets for investment funds and must compete directly with them. Equities have performed best over the long term, property second best and bonds third. But the volatility of property is much lower than the other two, as measured by the standard deviation of those returns.
However, there are problems with this argument. The capital values of property used in the performance calculations are produced by valuations and are not transaction-based. It is commonly argued that the way in which valuations are produced means they tend to lag market movements, producing a lagging effect in the performance figures which tend to smooth the peaks and troughs of movements in prices.
Valuation issues, along with considerations of liquidity and the depreciation of property, have been cited as issues which have been used to disadvantage property in the asset allocation process. Yet when these differences are exposed they provide an opportunity for professional investors to make money through the identification of pricing anomalies, which hedge funds (for example) increasingly try to do.
In the UK, the recent introduction of a UK
REIT and the development of derivative products are both illustrations of the driving together of property and the capital markets, the opportunity for arbitrage and the impossibility of property appraisal methods standing apart from these markets. This is a good thing for markets, investment managers and investors.
However, property is different in as far as market valuations are required for performance measurement purposes. The established doctrine underpinning the identification of market value requires best evidence of trading prices of other similar assets.
This doctrine is underpinned by the courts and by the perceived best practice of other competent practitioners. ‘Other similar assets' is invariably interpreted as other similar property assets; and the use of transactions in similar properties means that a lag is built into property valuations. Over the period 1996-2006, a period of rising prices, sale prices were around 3% higher than valuations. This suggests some lagging of valuations.
As a result, few analysts accept that appraisal-based indices reflect the true underlying performance of the property market. Such indices fail to capture the extent of market volatility and lag underlying performance. Why?
Real estate valuation is founded primarily on the use of comparable sales evidence. Similarity in property characteristics is paramount and the currency of the transaction may not be easy to control. Hence the evidence used to value a property as at 31 December 2007 may use evidence collected over the period July to December.
In a rising or falling market, this will again result in a lower variance of prices. As a result, valuations will be based upon the previous valuation plus or minus a perception of change, and the perceived changes, unless the subject of very reliable transaction evidence, will be conservative.
There may also be client influence. Fund managers may need a particular performance outcome to earn a bonus or carried interest, or to support a track record to win or retain fee-earning business.
There are circumstances in which clients and other stakeholders in the outcome may want to put pressure on the valuer to report a specific outcome. For example, in early 2006, some German open-ended funds with unit prices set by valuations were subject to very high withdrawals from investors. It has been suggested that investors did not trust the valuation-based price levels.
There were a number of factors leading to this perception. First, although the German concept of sustainable value was not used for these particular valuations, the valuations were undertaken by valuers comfortable with this smoothing concept of value.
Second, the stated objectives of the funds and a major marketing point were that these open-ended funds were designed to be much less volatile than other property funds. Given that valuations tend to lag price increases and falls, valuations in a bear market will not follow price reductions down as quickly as they occurred.
If this bear market continued for a long term, which was the case in Germany, valuations could become higher than prices.
It is not surprising therefore that investors would be nervous of this cocktail of moral hazards, with plenty of incentives for the funds to influence valuers, many of whom were comfortable with the positive smoothing concept. As the valuation process tends to smooth prices, some investors lost confidence in the valuation levels being reported.
Is the UK different? The UK is surely different. There is no evidence of client influence maintaining artificially high price levels.
However, there is a secondary market for units in unlisted funds. There is also a derivatives market, and a REIT market, not to mention a CMBS market. All offer pricing indicators to valuers of direct property. Yet they clearly do not feel able to use them. The result was patent over-pricing in a falling market in the second half of 2007.
Valuers claim a lack of comparable evidence, as there were few transactions. But evidence is all around in the capital markets and unlisted property vehicles. And why are there no transactions? Could it be that there is a lack of confidence in reported valuations, inhibiting sellers and buyers? Is it possible that valuation methods inhibit liquidity and prevent arbitrage and efficient markets? Yes.
It is time for a change in valuation practice. Stick your necks out, please, valuers, and use all of the available evidence. You may be pleased with the increase in respect you will have earned and the more efficient market which results.
This article derives in part from ‘Property Investment Appraisal' written by Andrew Baum and Neil Crosby. They teach at the University of Reading in the UK