Opinions on the subject of real estate valuations can be as diverse as the various regimes themselves. Here, industry participants give their views on what continues to be a source of contention
Head of Property Fund Management
Mark Callender Head of Research
Why different valuation methods suit different fund structures
While Europe's property investment markets have become increasingly international over the last two decades, the idea of a single harmonised valuation standard for Europe is still little more than a distant fantasy. Most countries have kept their own valuation practice and cross-border investors typically arrange for their foreign properties to be valued in accordance with the standard in their home market, even if that involves paying valuers to visit assets in foreign markets where they have only limited experience.
Perhaps the best known difference in valuations standards is between Germany and the UK. In the UK, the RICS Red Book defines open market value as the best price that could reasonably be expected in today's market. Alternatively, the German Verkehrswert is defined as the average price that could be expected in normal market conditions. The German valuation standard therefore requires valuers to judge whether the current investment market is either operating smoothly or being distorted by abnormal factors, and it implicitly introduces the concept of a sustainable value.
The practical result of these differences in definition can be illustrated by comparing the IPD Germany capital value index based on local German valuations, with the corresponding CBRE index based on UK RICS standard valuations (source: CBRE European Valuation Monitor). According to the IPD index, capital values in Germany fell slowly, but steadily between end-2007 and end-2010, dropping by 5% on a cumulative basis. By comparison, according to the CBRE index, capital values in Germany fell sharply by 17% between end-2007 and end-2009, but then recovered by 1% in 2010.
Admittedly, the two indices are based on different sets of properties and the CBRE sample is much smaller than the IPD sample. Nevertheless, the comparison strongly suggests that, whether by accident or design, the German valuation standard smoothes out much more of the upswings and downswings in market prices than the UK valuation standard.
Turning to the rest of Europe, it is possible to get some impression of the extent to which local valuers mark to current market prices by looking at the historical volatility of the IPD indices (largely based on the investment portfolios of domestic investors, which have been valued according to local standards). The table ranks the 10 countries where IPD has a 10-year record, both according to the volatility in capital values and the volatility in economic output.
If we assume, other things being equal, that countries with more erratic economic growth will also have more volatile capital values and vice versa, then it appears that valuation smoothing is most pronounced in Germany and Switzerland and possibly also Denmark (the capital value ranking is significantly lower than the GDP ranking), while valuers in France, Norway and the UK make the most effort to mark to current market prices.
The Netherlands, Portugal, Spain and Sweden appear to sit somewhere in the middle of the valuation smoothing spectrum, although the rudimentary nature of the analysis means that these findings are very tentative - one obvious short-coming is that the analysis ignores variations in the length of leases in different countries).
When considering differences in national valuation standards it is important to understand that they are not simply due to a few eccentric decisions taken by whoever drafted the definition back in the mists of time. While national stereotypes are always dangerous, German valuations stem from an investment culture that views property primarily as an alternative to corporate bonds; puts as much emphasis on the income return as total returns; regards property transactions as very expensive and seeks to minimise turnover in portfolios; regards benchmarking fund managers over any period shorter than three years as frivolous.
More fundamentally, the German valuation standard reflects a belief that property is a physical asset and is therefore a store of value. A bondholder, or shareholder of an insolvent company will lose all of their investment, but a landlord can always re-let a unit if a tenant goes bankrupt.
Conversely, the UK valuation standard springs from a quite different property investment culture that focuses on total returns and therefore pays a lot of attention to short-term movements in capital values; where investors are confident that the high costs of trading will be more than offset by higher total returns on their new purchase and where fund managers are required by clients to benchmark their performance on a one, three and five-year basis.
At root, the UK valuation standard is founded on a belief that, because property is relatively illiquid compared with financial assets, it is a high-risk asset and that investors' first priority should be to play the market cycle, buying at the bottom and selling at the top.
So which valuation standard do we prefer? In our opinion, a lot depends on whether the fund is open or closed-ended. With regard to open-ended funds, we have a clear preference for French/UK style valuations, because it is much easier to price units and manage inflows and outflows of capital if valuations have been marked to current market prices.
That said, we do recognise that French/UK-style valuations are not perfect and that the premium and discounts that exist on portfolios at different points in the cycle mean that the gross (net of debt) acquisition/break-up price of a fund is rarely simply the sum of the capital values of the individual properties.
By contrast, the arguments for which valuation standard to apply to closed-ended funds are more finely balanced. On the one hand, mark-to-market valuations are favoured by Solvency II, and the pressure from regulators to adopt French/UK-style valuations is likely to grow.
On the other hand, investors in closed-ended funds are mainly concerned with the eventual return on their cash and the final destination is vastly more important than the journey. German/Swiss-style valuations may be more attractive to investors in closed-ended funds, because they screen out a lot of the noise generated by short-term volatility in market prices.
International Valuation Standards Council (IVSC)
Time to consider a dedicated valuation standard
Valuation is pretty important for the proper functioning of investment property markets. At least financial regulators seem to think so, as many jurisdictions require regular valuations of real property held in collective investment schemes. The International Accounting Standards Board (IASB) also seems to agree that the current value of investment property is something shareholders might find useful in company accounts, and in the US the Financial Accounting Standards Board (FASB) are picking up on the idea with the zeal of the newly converted.
And last but not least, many industry groups such as the European Public Real Estate Association (EPRA) and the European Association for Investors in Non-listed Real Estate Vehicles (INREV) issue best practice guidelines that identify regular independent valuations as a cornerstone of sound reporting and governance.
Accordingly, valuation ought to be well understood and consistently practiced. Unfortunately this seems to be far from the case. In 2009, JP Morgan undertook a survey in Europe of listed and unlisted property companies and funds and buy-side investors. This showed that only 16.7% of investors had high or very high confidence in reported valuations in the sector, with more than double this number (37.5%) having low or very low confidence in valuations.
It is true that the survey was conducted following 18 months of almost unprecedented volatility in the markets, conditions that not only made it more difficult for valuers to provide accurate valuations but the very fact that values were moving so rapidly undoubtedly contributed to investors' scepticism. However, one of the most startling findings was the scale of the differences in confidence levels between different countries, with 67% of investors having a high or very high confidence in the valuations provided in the highest rated country but only 1% in the lowest rated.
Since the market volatility between 2007 and 2009 affected all the countries covered in the survey to a greater or lesser extent, the extreme range of investor confidence indicated that there must have been some very significant differences in the perception of valuation quality across borders. The survey also found that nearly 80% of investors considered that improved comparability of valuation practices and disclosure would make a big difference in their investment decisions.
The inconsistencies between countries that so greatly weighed on investor confidence were not solely related to valuation practices; across Europe there are significant differences in the amount and availability of market data, and in the culture of disclosure by corporate entities. Markets in some countries are also considerably more active than others.
However, there is still much that needs to be done to improve the consistency of approach and comparability of valuations and not just in Europe, because I am sure that the results would not have been very different had JP Morgan undertaken its survey in another continent.
The rapid drop in values across most sectors in 2008 certainly exposed limited understanding of key valuation concepts by some in the sector. Many times I read or was told by owners of investment property that because the definition of market value (or, in the case of IFRS accounts, fair value) assumes a willing seller, the prices in the market were not actually market value because they were not willing to sell at that price!
Likewise there were people who thought that any sale in a falling market must be a forced sale and therefore could be disregarded in establishing market value. This resulted in some reported values being based solely on historic, pre-crash data. Others fondly believed that using a discounted cash flow rather than a rent-and-yield method would automatically produce a higher value. In some countries there was a belief that the job of the valuer was to produce a value that smoothed the volatility of actual market prices.
The International Valuation Standards Council (IVSC) exists to bring about consistency in the understanding and development of valuation practices. Prior to a restructuring of the organisation in 2008, its sole output was the International Valuation Standards (IVS). These have become well established in the real property markets.
For example, the aforementioned best practice guidelines issued by EPRA and INREV both commend the use of IVS, and they are also supported and adopted by many of the major professional institutes involved in real estate. The IVS has just undergone a major review and a completely new set of standards were published in July 2011.
However, is there more that the IVSC can do to improve the confidence of investors in real estate?
The standards themselves identify and promote the use of generally accepted principles and definitions. They also set out procedures designed to ensure that valuations are conducted and reported in a way that enables them to be understood by those who rely on them.
However, although there is a standard for valuing investment property under construction (which was produced in 2009 in response to evidence of confusion on how to implement a change in the requirements in IAS 40 to carry such assets at fair value rather than cost), there is no standard for investment property per se. There is a standard for the valuation of real property interests, but this is generic and does not specifically address issues that are particular to investment property.
Since 2008, the IVSC is no longer solely charged with developing and maintaining standards. It has a wider brief to promote the development of the global valuation profession. This includes developing guidance and technical information to assist valuation practitioners in identifying best practice, thereby reducing diversity in the way the standards are applied in different countries.
The IVSC is currently considering a project to examine valuations in this sector in greater detail and to consider the case for a dedicated standard for investment property with associated technical guidance. However, for it to decide whether such a project should be undertaken and if so, what are the major issues it should address, feedback is needed from the investment property market itself. Unless the IVSC can be confident that it can produce something that is an improvement on what exists at present and that reflects the needs of the industry there would be little purpose in proceeding.
Readers are therefore encouraged to let the IVSC know what they think it can do to help build confidence in the valuations that are so critical to the credibility of real estate investment.
Director Pan-European Valuations
The challenges facing cross-border investors
With the increasingly global nature of the property investment market, one important consideration for investors should be the valuation methodology used in any given market together with the definitions and assumptions made therein.
The RICS Red Book has certainly become more globally dominant over the past few years and it is rare, certainly among International banks in Europe, to be asked to perform a valuation against another standard.
In terms of valuation methodology, discounted cash flow (DCF) approaches, which involve period-by-period estimations of income and expenditure and are growth explicit, are prevalent in continental European markets. While this goes some way to establishing a standardised approach, the cash flow term adopted varies from market to market - five, 10 or 20 years being the more popular - and clearly the inputs and assumptions differ widely.
So it is still dangerous for investors to employ the same approach on a cross-border basis, as one must reflect local market prac tice to understand not only the value but also the risks and potential returns.
Despite previous expectation that DCF approaches would become the norm in virtually all markets, it is clear that things have not changed in Europe's largest property investment market, the UK. Traditional methodology, applying growth implicit yields to the current income stream and appropriate market rents, is almost exclusively used by valuers and investors alike.
A big factor is, of course, the market transparency, which allows for relatively straightforward acquisition of comparable transactional information. A clear criticism of DCF techniques is that it is extremely hard for valuers to defend or support a particular discount rate, other than through reference to investor target returns.
In France, the chartre de l'expertise encourages the use of more than one approach, the two most popular being DCF and "traditional" - although comparison of capital value rates per square metre is commonplace in many French markets. Therefore, many valuation reports include two methods of calculation.
In Germany, one of the challenges for the standardisation of methodology is still the use of the Verkehrswert definition in calculating market value (MV). It is important, however, not to confuse this with the calculation of mortgage lending value (MLV) in accordance with the Beleihungswert regulations.
The market value calculation - an opinion of the amount at which a property should exchange in an arm's length transaction at a specific date - should, in general, accord with the MV if it had been calculated in accordance with the Red Book. This date is an important factor as the MV is a ‘snapshot'. In a fast-moving market, values can change considerably even over a short period of time (However, the Verkehrswert approach asks the valuer to take into consideration the land value together with the capitalised value of the building).
The latter, MLV, is an opinion of the sustainable long-term value with valuers asked to adopt sustainable rents and yields, and consider the remaining economic life of the building - therefore disregarding to a certain extent whichever boom or bust cycle may be being experienced at that time. German banks, due to reliance on the pfandbrief market, continue to consider the MLV and we, as valuers, are increasingly asked to provide formal opinions of both MV and MLV in multi-jurisdictions.
The biggest issue for cross-border investors in my view is not so much the methodology but the need to consider different regimes for each and every market. Factors such as leasing practices, recoverability of costs under such leases, ability for rents to be increased (or decreased), treatment of purchasers' costs all influence not only the value but the returns to investors.
Even the different use of terms, such as net or gross yield, cap rates and cold multipliers, can lead to difficulties.
For example, while the majority of commercial leases in the UK are drawn on a full repairing and insuring basis and with limited non-recoverable costs for landlords, in Germany the typical dach und fach lease structure usually results in non-recoverable costs of, say, 5-12% of the annual rent. In Sweden, some leases are drawn on a "warm" basis (Varmhyra) and landlords can end up with non-recoverable costs of up to 40%.
Clearly, it is crucial for any investor to be able to accurately project net operating income within their underwriting and this is where it is particularly important for cross-border investors to take into account an international perspective (to be able to compare market to market), together with considering dynamics at a local level.
Behringer Harvard Europe
Why there is no need for a uniform global approach
The differences in valuation approaches on the international level have been a regular source of disagreement between real estate surveyors and valuers. Basically, any valuation will take one or more of the following key approaches: the DCF method; the comparative method of valuation, and the depreciated replacement cost method. That said, the approaches are subject to weighting differences, internationally speaking.
The Anglo-American approach is less standardised, and places more emphasis on the valuer's personal assessment - for example, when using the DCF method. Yet the greater market transparency permits the valuer to access extensive and detailed market data. In Germany, by contrast, specifically the data of the valuation committees play a larger role. However, due to the sometimes incomprehensive market data, German valuers will often work with standardised premiums or discounts, among other things.
As far as I can see, though, these methods will all deliver comparable results. So the quarrel over methodology and questions such as whether we need a global valuation standard are missing the point. Real estate is a local business and this makes regional valuation differences by all means legitimate.
Neither do different valuation approaches present a fundamental challenge to cross-border investments. Here, as elsewhere, it is safe to say: If you wish to invest abroad, you have to familiarise yourself with regional market peculiarities anyway. This includes possible valuation specifics.
So is everything ship-shape as long as the difference in approach delivers the same sort of results? Sad to say, it is not. In my opinion, there are two areas of concern.
The first area relates to the considerable influence of short-term market trends. Valuations are inherently static, and will present an appraisal snapshot of a certain point in time.
Irrespective of the valuation method used, the valuation practice is to a large extent influenced by the historic law of supply and demand: if the transaction market environment is calm, with few assets changing hands, the inactivity itself tends to negatively impact property valuations.
Especially in the Anglo-Saxon world, this phenomenon is explained by a lack of comparable transactions. The absence of representative cases that lend themselves to a comparison will boost the weight of outliers and individual cases where an owner may have been forced to sell or to accept a discounted price; or the valuer argues that, due to the lack of transactions price, expectations from sellers are too high.
The approach favoured in the German-speaking countries places more emphasis on the data provided by valuation committees, which may seem to downplay the gravity of a possible lack of comparable transactions of recent date. Ultimately, though, the approaches will produce similar effects: the multipliers applied to cash flow, used to establish the outcome of the valuation, will be lower in times of slow transaction activity.
What are the ramifications thereof? It could cause a disconnective tension between declining values that are posted in the books during slow market cycles, even if the definitive underlying qualities of the property's actual cash flow remain unchanged.
Depending on the market, this trend is more or less clearly defined. I have, for instance, observed a pronounced penchant for steep devaluations on slow transaction markets in eastern Europe. In some cases, properties are posted in the books with a 30% discount, even though the asset fundamentals are unchanged and show an impeccable cash flow.
It should be added that data available for valuation purposes (also depending on the valuation method) do not have the same degree of transparency everywhere. So once the market action tips the other way, and the number of transactions increases or decreases, it will impact valuations with a definitive time lag.
In many markets, transaction data are submitted quarterly. There are also markets, however, where you have to wait six months before the data are made available or indeed are not polled for sub-markets at all (not wishing to pass judgement; I am simply stating a fact). Valuations therefore lag behind the actual market action, and this is more the case the less transparent the respective market is.
This brings us to the other principal area of concern: The aforementioned disconnective tension and the time-lag problem can have enormous ramifications for current real estate financing. Whenever particular loan terms stipulate a recurrent market valuation to establish the loan-to-value (LTV) ratio, the valuation practice can turn into a snare for the owner. As previously suggested, the value of a property may be discounted in response to a new valuation, despite a sound operative development.
We are aware of cases where properties with a strong tenant base, remaining lease terms of more than 15 years and positive rental growth were marked down because they happened to be in a slow transaction environment. There was no intention on the part of the owner to sell - and why would there be? The property, was acquired as a core investment, was developing just fine.
Depending on the way LTV covenants are structured, however, the financing bank may reduce the loan volume or force the owner to contribute additional equity. This can also quickly consume any extra revenues a property may have earned due to rent increases.
Here is my conclusion: The valuation debate should not be conducted among the valuers in different countries. Despite different approaches, the findings show essentially the same high quality. It is in the nature of real estate markets to manifest minor regional differences - and there is no need for a uniform global approach.
Rather, the valuation debate should be conducted with the underwriting banks. Here, we need to see a unified and reliable awareness of the fact that a given property can principally be solid as a rock even if valuations tell a different story.