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Property valuations and the
investment market
RICS, Moscow
Andrew Baum
Department of Land Economy
University of Cambridge
25 March 2014
Why are valuations needed?
• For sale and purchase
– transaction and due diligence support
• For bank lending
– loan to value ratios
• For balance sheets
– asset valuation
• For performance measurement
– manager track records and performance fees
Consistent valuation standards are important
• Valuations need to be
– accurate and unbiased
– professional and regulated
– consistent within and across borders
• RICS Valuation: Professional Standards (the 2014 Red Book) covers
the valuation of assets in the form of real estate (land, buildings and
interests therein). Fully compliant with International Valuation
Standards (IVS) 2013
Cross-border investing has boomed
Foreign Ownership of City Offices
60%
50%
40%
30%
Other/Unknown
International
Middle East
Europe
20%
10%
Japan
USA
Germany
0%
Source: University of Cambridge
Some places get more than their fair share of capital
• International capital flows are explained by a combination of
formal and informal barriers
• Formal barriers
– taxation, capital controls, limits on foreign owners
• Informal barriers
– legal and title risk
– liquidity risk/limits on exit
– currency, culture, transparency
• information asymmetry/market research
• valuation
JLL Transparency Index, 2012
Composite
Score
5 Sub-Indices
Performance
Measurement
Market
Fundamentals
Governance of
Listed Vehicles
Regulatory
and Legal
Transaction
Process
13 Transparency Topics
• Direct Property
Indices
• Listed Real
Estate Indices
• Unlisted Fund
Indices
• Valuations
• Market
Fundamentals
Data
• Offices, Retail,
Industrial, Hotels,
Residential
• Financial
Disclosure
• Corporate
Governance
• Regulation
• Land and
Property
Registration
• Eminent Domain
• Debt Regulation
83 individual questions and data-points for each market
• Sales
Transactions
• Occupier
Services
JLL Transparency Index 2012 - Europe
Western Europe
CEE
United Kingdom, Netherlands
France, Finland, Sweden, Switzerland
Highly Transparent
Germany, Denmark, Ireland
Spain, Belgium, Norway
Poland
Italy, Austria, Portugal
Czech Republic, Hungary
Greece
Turkey, Slovakia
Russia (Tier 1-2 Cities), Romania
Transparent
Croatia, Russia (Tier 3 Cities), Bulgaria
Ukraine, Slovenia
Semi Transparent
Serbia
Low Transparency
Kazakhstan
Belarus
Opaque
Source: Jones Lang LaSalle, LaSalle Investment Management
Cambridge research
• Remarkable surge in cross border flows over the last decade; sharp
differences among countries
• Each country should receive capital flows commensurate with the size of
its respective economy or, more accurately, the total size of its investible
real estate market
• Key finding: improving real estate market transparency appears to have
a stronger positive impact on cross-border flows than an increase in
historic and prospective returns
Transparency and investment activity are correlated
5.0
R2= 0.39
Ratio of Global Transaction Share
to Global GDP Share
4.5
4.0
Hong Kong
Singapore
3.5
UK
3.0
Above Average Share of
Global Volume Relative to GDP
Sweden
2.5
2.0
1.5
1.0
0.5
0.0
Norway
Taiwan
Australia
Netherlands
USA
Finland
Hungary
Japan
Switzerland
Below Average Share of
Global Volume Relative to GDP
1
Transparent
Macau
South Korea
Czech Republic
Germany
1.5
Ireland
Italy
2
Brazil
Russia
China
Portugal
2.5
Real Estate Transparency 2012
Croatia
3
Bulgaria
3.5
Vietnam
4
Opaque
Sources: Jones Lang LaSalle, LaSalle Investment Management
Are valuations accurate?
• International investment requires valuations which are
– accurate and unbiased
– professional and regulated
– consistent across borders
• Smoothing: valuations are conservative
• How close are valuations to sale prices? Is there evidence of bias?
• Is there evidence of client influence?
Smoothing
• Real estate is said to offer a reasonable return for low volatility, and
diversifies the portfolio
• But volatility is under-stated by valuations
– anchoring and valuer conservatism
– temporal averaging - when are year end valuations undertaken?
– lagging effects - the use of ageing comparables
Smoothed property values
220
200
180
160
Return
SD 10%
140
Return
SD 14%
120
100
81
82
83
84
85
86
87
Smoothed
88
89
90
Unsmoothed
91
92
93
94
95
96
97
Optimal portfolios, rising returns
UK stocks
UK property
UK gilts
70%
60%
50%
40%
30%
20%
10%
Observed
mean
0%
11.5%
13.0%
14.5%
Valuation uncertainty
“… the valuer and most informed users of the valuation
recognise that there will be a degree of uncertainty
associated attached to the figure provided.”
(RICS, 1997, p. 26)
“All valuations are estimates and carry with them
a degree of uncertainty. The range of uncertainty
may vary in different market conditions and for different
types of property” (RICS, 1997, p. 26)
Do public markets lead?
Derivative margin is divided by 10
20
REIT
Fund
Derivative
IPD monthly
0
-20
-40
-60
-80
-100
Higher volatility, but no evidence of different turning points
Source: Merrill Lynch, Bloomberg October 2007
Sale prices are more volatile than valuations
Sale prices are more volatile than valuations...
10.0%
8.0%
6.0%
% Difference
4.0%
2.0%
0.0%
-2.0%
2004
2005
2006
2007
2008
2009
2010
2011
-4.0%
-6.0%
-8.0%
France
Germany
Netherlands
UK
-10.0%
...but some countries are more volatile than others
Source IPD
Client influence: the principal/agent problem
Fund managers
Valuers
• Reduce fees – or pass them on
• Maximise performance
• Achieve performance fee
• Maximise fees
• Increase market share
• Increase client satisfaction
Who appoints the valuer? The investor or his agent?
Are valuers rotated?
Client influence
• Portfolio valuations are often submitted in draft and sometimes
subject to ‘negotiation’
• The process invariably includes a client meeting to review draft
figures - end of year valuations can be particularly difficult
• Two main effects - improvement and biasing
• Evidence of ‘shock’ to valuations when new valuers and/or
managers are appointed
Consistent across borders
• Are markets different?
– UK v Germany
• Do valuers apply different standards?
– UK and German valuations of the same market sector
Capital value change, 1996-2011
Consistent across borders?
15
10
% Year on Year
5
0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
-5
-10
-15
Germany
UK
-20
-25
-30
Source: IPD
Central London office capital growth 2000-2009
Consistent across borders?
30
20
% pa
10
0
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
-10
UK valuers
-20
German valuers
-30
Source: IPD
Central London office capital growth, 2000-2009
German valuers
UK valuers
Average
0.37% pa
1.20% pa
Standard deviation
3.67%
13.54%
Consistent across borders?
Source: IPD
Issues – property appraisal methods
• Market price - observed exchange price
• Market value - estimate of most likely selling price
• theoretically, one figure but practically a point on a distribution of possible values
• usually comparable based
• Germany v UK
• Investment worth - how much should an investor pay for the property?
• can be different for each individual or group, also a point in a distribution
• usually explicit cash flow (DCF)
• Discount rate
• Cash flow
Fair value, market value
• In accounting and economics, fair value is a rational and unbiased
estimate of the potential market price of a good, service, or asset
• Market value is the estimated amount for which an asset should
exchange on the date of valuation between a willing buyer and a
willing seller in an arm's length transaction after proper marketing
wherein the parties had each acted knowledgeably, prudently and
without compulsion
• Must be based on comparable evidence
Problems with fair/market value
• No market, no evidence
• Temporary distress (Brixton, 2009), temporary bubbles
• Bank balance sheets?
Is market value always best?
• A Vision for Real Estate Finance in the UK – from the Real Estate
Finance Group – highlights that poor commercial real estate
valuation and lending can invariably “cause or prolong” a financial
crisis
• “The recent crisis has been no exception. The natural consequence
of the 45 per cent collapse in UK commercial property prices
between mid-2007 and early 2009 has been a pro-cyclical
evaporation of financing capacity”
Sustainable or mortgage lending value - definition
• The mortgage lending value is the prudently calculated value of a
property. It represents the value which throughout the entire life of
the loan can probably be achieved for a property that is sold on the
free market – irrespective of temporary (for example, economicallyinduced) value fluctuations in the respective property market. This
requirement serves to eliminate speculative influences
• But how volatile is real estate as an asset class?
Investment worth
• The value of the property to a particular owner, investor or class of
investor, for identified investment objectives. This subjective
concept relates specific property to a specified investor, group of
investors, or entity with identifiable investment objectives and/or
criteria.
• Must be DCF and cash flow based
• Can clearly indicate under-pricing or over-pricing in the market
Conclusion
• We need internationally consistent valuation approaches
– accurate and unbiased
– professional and regulated
– consistent across borders
• But we need three bases
– market/fair value (UK/US) – performance, transaction advice
– sustainable/mortgage value (Germany) – balance sheet, bank lending
– investment worth (DCF) – consulting advice, bank lending?
References
• Baum, A and Hartzell, D (2012): Global Property
Investment - Strategies, Structures, Decisions,
Wiley Blackwell, 2012
• Crosby, N. and Hughes, C. (2011): The basis of
valuations for secured commercial property
lending in the UK, Journal of European Real Estate
Research, Vol. 4(3): 225 - 242
• Crosby, N. Lizieri, C. and McAllister, P. (2010):
Means, Motive and Opportunity? Disentangling
Client Influence on Performance Measurement
Appraisals, Journal of Property Research 27(2):
181-201
• www.ipd.com