What Goes Round Comes Round: or does
it?
The Valuation of
Over-rented Properties
ERES 2011
Sarah Sayce
Judy Smith
Fiona Quinn
Philip Parnell
presented by
Sarah Sayce
1
Agenda
•
•
•
•
An introduction: the Scenario of the 1990s
The Current Market Scenario
Exploring Current Practice: a pilot study
Implications for valuation techniques: A
discussion of the Issues
• Conclusions
2
Why This is Timely
Property Total Returns
•2 property collapses
30
•20 years apart
20
10
•This swifter – deeper
%0
•But superficially similar
-10
-20
-30
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008
Years
Income
Capital value
Source: adapted from IPD 2010 annual indices
3
Why This is Timely
•2 property collapses
•20 years apart
•This swifter – deeper
•But superficially similar
Do they raise the same valuation issues?
Did we learn nothing last time round?
4
What Happened in the early 1990s
• The Market:
• Rental values collapsed in the wake of over-supply and
economic downturn and high interest rates
• Capital values collapsed
• Commercial property rents secured on covenant not value
• Estimated 85% City of London Offices over-rented
• Yields moved sharply up
• Property priced as no growth investment
• Tenants trapped in long leases:
• Mainly 25 year terms
• Upward only rent reviews – no get outs
• Ongoing liability (privity of contract)
Valuations called in to question....
5
What Happened in the early 1990s
• Valuers and their methods were called into question as:
• Secured loans failed and valuations exposed
• Market assumptions of implied growth questioned
• Institutions questioned the medium of property as an
appropriate investment vehicle..
• Failure to recognise real estate as part of the investment
spectrum
Worse still
• Valuers were found to have been negligent through a string of
high profile negligence cases
6
What Happened in the 1990s- the
Response in Practice
• Yields were adjusted and a simple initial yield
approach adopted to place risk within the cap rate
• The Term and Reversion approach exposed as
inappropriate and inaccurate
7
Problem- Double counting
Rent
passing
Over-rent
Over-rent
MR
Reversion- all risks yield implies growth at each
future rent review into perpetuity
End
of
lease
What Happened in the 1990s- the
Academic Response
“more explicit techniques highlight a number of areas which are
either overlooked or over-simplified in traditional techniques,
particularly regarding the timing and level of the projected
cashflows”
(Adams and Booth, 1996)
•
•
•
•
Comparability was viewed as inappropriate
Risk lay in cash flow rather than physical asset
Call for greater sophistication
Encouragement to adopt ‘short-cut’ DCF which could
accommodate risks to the cash flow as explicit assumptions
made about future rental growth
9
What Happened in the 1990s- the
Academic Response
• Tiered top slice
• Required specific
assumptions about the
future movement of
rental growth
• Required market yield
and money-based rate
• Placed risk where is
really lay – more logically
• 2 versions proposed
Adapted from Crosby and Goodchild, 1992
10
Tiered Top Slice-vertical split of top slice
Rent
passing
Tier 1
top slice
at e%
Tier 2 top slice at
e% x PV at e%
Tier 3 top slice at
e% x PV at e%
Over-rent
Over-rent
MR
MR
capped
for 3
years at
e%
3 years
RR
Market rent x capitalised at market yield x
PV £1 at equated yield
8 years
RR
13
years
RR
Layered Top Slice-horizontal split of top
slice
Rent
passing
Layer 3 top slice at e%
Layer
2 top slice at e%
Over-rent
Layer 1 top
slice at e%
Over-rent
MR
MR x
cap 3
years at
e%
3 years
RR
Market rent x capitalised at market yield
x PV £1 at equated yield
8 years
RR
13 years
RR
Aftermath: call for Change
• Complex
• Issues around
assessing rental
growth prospect
• Knowledge issue
Challenges around
level of rental
growth
Connected to lease
length
13
Structures in place to improve
Valuations
• Valuer Guidance
• Increased scope of ‘Red Book’
• Guidance of differentiation MV and Worth
• Tightening of reporting requirements
• Requirements to rotate valuers
• Valuing under conditions of Uncertainty (GN5) issued
2003; reviewed 2008;
• Valuing certainty (GN1, 2011) – call to be explicit and
transparent; use of Sensitivity Analysis where high
volatility
• Wider use of DCF use advocated (RICS, 2010; IVSC, 2011)
14
Structures in place to improve
Valuations
• Discussions regarding ‘Mark to Market v Mark
to Model’ (RICS 2008)
• Tracking valuation accuracy reveals greater
consistency
• Valuers “quick to grasp the nettle” (French
2010)
15
Same but different
•
•
•
•
Same
Collapse in confidence
Rental and capital
values fall
Financial market
issues
Significant number of
over-rented
properties
Different
• Low interest rates
• Shorter leases (average 6
years)
• Break clauses
• Risk adverse investors
• Privity of Contract abolished
• Easier assignments
• Greater understanding of
worth
Therefore market issues are different- but still need for explicit exploration
of rental growth and understanding of required returns and risk profiling
There is a clear case for explicit valuations
16
A Pilot Study
Leading Valuation firms + 2 smaller firms
All members of RICS Valuer Registration Scheme
Scenario presented of over-rented London City Office
• In relation to scenario:
– How you would deal with the over-rent?
– growth implicit or growth explicit approach- and
specifically what method?
– How would you establish the nature and quantum of
risk and factor it in?
17
A Pilot Study
• More generally, what is Impact on valuations of:
–Historically low interest rate
–Finance cost and availability
–Changed Lease structure
18
Findings: General Approach
Very consistent answers
•
•
•
•
•
•
An implicit approach still prevails
One valuer – Term and Reversion
Core and top-slice – very much like 20 years ago
2 simply take 1 cap rate (initial yield)
But build in for voids at lease end (majority view);
Adjust yield for risk of voids (minority view)
19
Findings: Use of Explicit Approach
• DCF still a minority game
• But – some using DCF as a ‘check’ against traditional
– Where they did the period ranged from 5 – 9 years to build
in for voids
• DCF more likely “Where purchaser likely to be a fund as
recognition that fund managers use explicit methods”
20
Findings: Approach to Risk
•
•
•
•
•
•
Tenant covenant viewed as the chief risk
Build in for Voids
Build in for voids + rent free period
Analyse against covenant strength (majority)
Take a view on market at lease expiry
No indication of application of sensitivity analysis
21
Findings: Placing the Valuation in the
Wider Context
• The changed interest rate environment is not perceived as
relevant – simply rely on market comparable evidence
• only one valuer commented that there would be need to look
at wider money market if few comparables
• Another interest rates are only one factor in market pricing”
• No account of lending market or availability of finance –
assumption now that market is equity driven
22
Findings: Placing the Valuation in the
Lease Context
• The issue of changes to privity etc not raised
• Lease length and void risk – majority would build in voids
explicitly as assume tenant would leave – minority simply
build in as part of risk profile
• No valuer assumed that tenant would re-negotiate back to
Market Rent – or considered the early surrender scenario
23
Conclusion
• Very little changed in market practice over 20 years
• Hardcore (core and top-slice) is growth implicit – this was
difficult to justify before – arguably still the case – despite
different market conditions
• Taking voids into account explicitly is not compatible with
hardcore - so implies a move back to Term and Reversion..
• Using DCF as a back up check - progress?
• The changes to leases structure reduces the issue in valuation
terms as over-rents will not persist
24
Conclusion
• The lack of relating of valuations to the
wider financial markets is perhaps
concerning given that the property is
compared to other asset classes
• The lack of change of methodology
does present risks
• Transparency and rigour are key
• Initial yield and traditional simply too
doesn’t work in times of economic
uncertainty
• Time to dust off those textbooks –or
extend the survey?
25