What Goes Round Comes Round: or does it?The Valuation of Over-rented PropertiesERES 2011

Sarah SayceJudy Smith Fiona QuinnPhilip Parnell

presented by

Sarah Sayce1

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

3

Source: adapted from IPD 2010 annual indices

•2 property collapses

•20 years apart

•This swifter – deeper

•But superficially similar

Why This is Timely

4

•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?

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

spectrumWorse 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

End of lease

MR

Rent passing

Over-rent

Over-rent

Reversion- all risks yield implies growth at each future rent review into perpetuity

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

10

Adapted from Crosby and Goodchild, 1992

Tiered Top Slice-vertical split of top slice

13 years RR

MR

Rent passing

Over-rent

Over-rent

Market rent x capitalised at market yield x PV £1 at equated yield

MR capped for 3 years at e%

Tier 2 top slice at e% x PV at e%

Tier 3 top slice at e% x PV at e%

3 years RR

Tier 1 top slice at e%

8 years RR

Layered Top Slice-horizontal split of top slice

13 years RR

MR

Rent passing

Over-rent

Over-rent

Market rent x capitalised at market yield

x PV £1 at equated yield

MR x cap 3 years at e%

Layer 2 top slice at e%

Layer 3 top slice at e%

3 years RR

Layer 1 top slice at e%

8 years RR

Aftermath: call for Change• Complex • Issues around

assessing rental growth prospect

• Knowledge issue

13

Challenges around level of rental growth

Connected to lease length

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

16

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

A Pilot Study

• 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

Leading Valuation firms + 2 smaller firmsAll members of RICS Valuer Registration SchemeScenario presented of over-rented London City Office

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

• 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

Very consistent answers

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