Valuation in crisis – Art versus Science – The Science View

The Science View on Valuation

Estimating Property Values in Times of Significant Uncertainty

In times of Covid-19 pandemic, property market or fair values are harder than ever to estimate. Valuers desperately trying to find enough ‘evidence’, but property is an illiquid asset by definition and as such, transactional evidence disappears during periods of market unrest.

So, what can property valuers do in times of market uncertainty?

The International Valuation Standards Council (IVSC), whose standards have been adopted by the ‘RICS Red Book’, issued a letter in March 2020 with the title ‘Dealing with valuation uncertainty at times of market unrest’[1]. Their advice was mainly based on three points:

  • If the valuer can’t carry out an inspection due to government restrictions, clearly state it and agree this with the client.
  • If the valuer considers that it is not possible to provide a valuation on a restricted basis, the instruction should be declined.
  • Valuers should not apply pre-crisis criteria to their valuations as this approach is based on the potentially erroneous assumption that values will return to their pre-crisis levels and there is no way of predicting that this assumption in fact correct.

 As a valuer, we are confounded not able to use past evidence to assert value or forecasting future values. Valuations have a ‘value date’ and values should reflect the ‘estimated amount for which a property should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction’.

So, what kind of evidence should I use in order to carry out a property valuation?

The simple answer now is: No one knows!  However, we can use historical evidence to shed some light on how we should estimate property values at this point in time. We can absolutely argue that the past is not an indication of the present or future, however we can try to infer some relationships and see if they still work to these days.

We will start with the bonds (fixed income) market to try to find any meaningful relationship with the property markets.

  1. Historic property yields and gilt yields

The research paper ‘Implication for Property Yields of Rising Bond Yields’ published by IPF in 2014 finds that the index-linked yield gap, i.e. the difference between the UK all-property equivalent yield (EY) and index-linked gilts, is a useful benchmark because both include inflation expectations.

The graph below was taken from that research:

Graphfig 4.1graph fig 4.2

Source: ‘Implications for Property Yields of Rising Bond Yields’, IPF, 2014

From this, we can say that historically property EY move more or less together with gilt yields (less so with the 10-year gilt yield, more so with the 10-year index-linked gilt yield). Note how the EY moves in the same direction and roughly at the same time as the index-linked bond yield. This would infer a strong positive correlation, which is also noted in the research paper.

Historically the difference between EY and index-linked gilt yield, the ‘Yield Gap’ had been around 4% to 6% pre-global financial crisis in 2008. As the new norm of intensive quantitative easing of compressed debt yields and higher perceived risk of the property markets which were at centre of the what was called ‘toxic assets’, this yield has widened and was estimated at around 7.5% at the time of the paper (2014).

  1. Is the property risk premium the same today as it has been over the past ten years?

From our graph below, the property risk premium, or the yield gap to index-linked gilts, as we are referring to it here, has been fairly stable over the past ten years ranging from 7% to 9%.

Graph 20 yr benchmark

Legend: green: property equivalent yield; blue: index-linked gilts yield

Source: Bank of England database, Capital Economics, Cambridge Finance
The question now is, will it change? Or more formally, will we see a ‘structural change’ in the yield gap?

Not very likely. What we are currently seeing in the UK at least is that some sub-sectors, for example high-street retail, shopping centres, leisure, pubs, hotels and offices are more exposed to default risk than ever before, but other sub-sectors such as supermarkets and logistics are seeing demand overstrip their own supply capacity. All in all, the pandemic effect is not the same across all the property sub-sectors and as such the risk premium  should fluctuate within historical band; some sub-sectors at the higher end of the premium expectrum whereas other at the lower end.

  1. Can you give me an example?

Say the subject property you are estimating the market value for had the following EY over the past 5 years and valuation dates were for 31 December each year, in percentage (%):

  • 2015: 7.2
  • 2016: 7.0
  • 2017: 8.0
  • 2018: 7.7
  • 2019: 7.5

The average index-linked yield for the years below were (all negative):

  • 2015: -1.1
  • 2016: -2.0
  • 2017: -1.8
  • 2018: -1.6
  • 2019: -1.9

The yield gaps were therefore (EY – gilt yield):

  • 2015: 8.3
  • 2016: 9.0
  • 2017: 9.8
  • 2018: 9.3
  • 2019: 9.4

What we can say it that for this property, over the past 5 years, the risk premium in comparison with the index-linked gilt has been around 9%, ranging from 8.3% to 9.8%. We should therefore expect that this property should trade within this yield gap band.

But what about during market unrest?

In this case, we can use the EY of 2017 as the Brexit vote could be seen as a period of crisis.

  • The index-linked yield as of 16 April 2020 closed at -2.24%
  • Assuming the EY for the property is at the high end of the risk premium take a yield gap of say 9.8%
  • Working backwards this gives an EY of 7.75% (9.8%-2.24%)

Therefore yields should have hardly moved as a result of interest rate reduction by the Bank of England and its quantitative easing policy.

  1. If yields haven’t moved much, does it mean that property prices are the same as it was before?

Not necessarily, and the reason for that is because there has been a move on the occupancy side of the valuation equaltion: the estimated rental value have gone down as cities shut down, resulting in longer than expected vacancies, tenant defaults and much higher probability that tenants will not be able to pay rents. Valuers should be on the look out of how the new wave of rent holidays, rent reductions, vacancies, non payments and imminent defaults will impact the property cash flow now and consequently, how they will be translated into the valuation estimate.

Maria Wiedner MRICS CFA MPhil

CEO Cambridge Finance

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