How can you carry out valuations in the current circumstances? James Fox explores how the ‘material uncertainty’ clause issued by the Royal Institution of Chartered Surveyors (RICS) has affected the way real estate valuations can determine the fair value of commercial property.
One of the biggest questions facing the real estate sector today is how to undertake valuations in the current economically uncertain climate. Back in March, the RICS issued the material uncertainty clause. While it has long been recognised that market disruption can increase the level of uncertainty attached to a valuation, it’s worth noting that the material uncertainty clause has only been issued by RICS a handful of times in its 150-year history.
The clause itself means that the real estate market is uncertain, not the valuations of the properties themselves. The key point to remember is that, when there are either very few or no transactions being undertaken, it becomes increasingly difficult to obtain any comparable evidence. As a result, the actual valuations themselves are difficult to ascertain and analyse. One of the impacts of the coronavirus is that far greater scrutiny will be attached to all valuation reports published from now on.
What does the material uncertainty clause mean for real estate valuations?
The resultant effect of the RICS issuing the material uncertainty clause is that all valuations carried out by RICS members, irrespective of geographical location or asset type, must carry this further qualification (or reservation) until the RICS feels it is appropriate to rescind the clause. However, it’s important to recognise that just because the material uncertainty clause is now included, it doesn’t necessarily mean the valuation of the property is any less reliable. Even though this caveat will now be included in every single valuation report for the foreseeable future, the onus is still on the valuer to obtain further reliability where possible.
For the purposes of this article, it’s worth highlighting that we are discussing standard institutional investment valuations only. While that may appear obvious, a large number of valuations are undertaken in the absence of a market such as the Depreciated Replacement Cost (DRC) method, which is a cost-based method of arriving at valuations never exposed to the open market, and Existing Use Value (EUV), which determines the value of land and buildings sold in its current form. Both of these methods are primarily used for infrastructure-type assets or public sector buildings, eg educational establishments or social housing.
Director’s valuations will face far greater scrutiny under the material uncertainty clause
Paragraph 16.7 of FRS 102 requires investment properties to be measured at “fair value” at each reporting date, and that when the valuation is undertaken in-house in the current climate, this will be subject to greater scrutiny by auditors as in-house valuers will not have access to the same quantity of data as independent valuers, simply because they are not undertaking such valuations on a day to day basis. This is known as the director's valuation.
Of course, an independent valuer has a much greater quantity of data at their disposal, whereas a director’s valuation conducted for audit purposes is likely to be based on far more limited information. This means that the recipients of these valuations will be placing far greater scrutiny on director’s valuations going forward. Gone are the days when the valuation number presented by a director can be accepted ‘as read’.
Office real estate valuations
Whether offices are physically occupied or not is somewhat irrelevant to the valuation. Instead, the value is determined primarily by whether the occupant is capable of paying rent. Even in cases where a rent holiday has been given, it can still be treated in the same format as a ‘rent-free’ period for valuation purposes, for example as a tenant’s incentive for renewing or taking out a new lease. Even though the valuation of the office may go down slightly because a rent holiday has been permitted, the valuation itself can still be deemed reasonably reliable.
The industrial sector: ecommerce coming into its own
Industrial sector properties are mainly still occupied, as with offices, but even where a rental holiday has been permitted, this can still be treated as a rent-free period for valuation purposes. However, with this sector, it’s worth talking about growth prospects. As we get used to coping with the changes that coronavirus has caused in the market and the resultant acceleration in historical trends, logistics will play a huge role. The biggest change within the industrial sector is likely to be within ‘last-mile delivery’, when goods are moved from a transport hub to their final destination, which is projected to grow significantly as a result of the global lockdown.
Leisure real estate valuations are harder to calculate
Leisure properties are valued on a different formula, based on a profits method, otherwise known as the ‘reasonably efficient operator model’. This model states valuers must make adjustments based on the business competency of the operator of the property. But in today’s climate, with all restaurants, pubs and hotels closed for business, the concept of a reasonably efficient operator no longer exists. Even those businesses that are still open, such as takeaways, are not operating to their full capacity.
Such properties can still be assessed, but with far greater reservation, making it therefore more difficult. Valuers may choose to look back at the previous two or three years of accounts and assess their projecting profiles going forward. However, greater risk is attached, and this risk should be reflected in any valuation report.
The retail sector is the most challenging in real estate valuation terms
Retail is inevitably the most difficult to value during the current lockdown, and this is exacerbated by the diversity of properties that make up the sector and, in some cases, are dependent on each other. Supermarkets, for example, are still open, operating and paying rent, meaning that valuations should be relatively straightforward. But looking at the rest of the high street, each occupier has to be assessed closely on its own individual merits, and the covenant strength of each retailer will have to be reviewed carefully.
This is particularly relevant when it comes to shopping centres. In most cases, the occupiers invariably pay rent on a turnover basis. So, if the shop is closed, or the shopping centre itself is closed, the retailer is not achieving any turnover and, therefore, not paying any rent. In those cases where rent is not being received, it is extremely difficult to assess accurately the value of the shopping centre.
Alternatives – shared spaces will be worst affected
While the alternatives property sector has become increasingly mainstream in recent years, there are individual sub-sectors within this asset class, such as student accommodation and care homes, which are projected to grow exponentially while co-working environments are likely to be adversely impacted. WeWork is probably the highest-profile example of a shared working space and is likely to be severely impacted, due to a lack of investor sentiment as a result of coronavirus and more long-term need for social-distancing measures. And so, these varied growth profiles within the alternatives space are, in-turn, likely to be subject to greater scrutiny. Again, much will depend on individual covenant strength to assess the reliability of each particular valuation.
Different economic scenarios will affect real estate valuations
It’s generally accepted that the UK will enter a recessionary period as a result of the coronavirus and lockdown. Recently, the Office of Budget Responsibility speculated that the UK economy faces a 35% drop in GDP in the second quarter of this year if the lockdown remains in place throughout. The International Monetary Fund has also projected that major global economies will see growth falling sharply from +3% to -3% for 2020 as a whole.
The question now is how long this recession will last. Economists had previously expected the global economy to experience a ‘V’-shaped recession (quickly in and quickly out). However, this has now been revised to more likely be ‘U’-shaped (quickly in, but with a staggered recovery).
Our view is that we can expect to experience a ‘W’-shaped recession for the UK. This would entail quickly in and quickly out, but with a recovery in a staggered form, leaving us adversely affected by other international-based economies – particularly the USA. This would mean that, towards the end of this year, we would go back into recession and then hopefully slowly see positive growth re-emerge in early 2021.
To discuss any of these points or talk through any challenges you are experiencing, contact James Fox.
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