How investors are facing up to private real estate’s valuation challenge

Higher capex is increasingly required to make real estate investments work, forcing investors to reassess how they determine value and what qualities warrant extra spend.

The goalposts have been moved when it comes to valuing real estate assets. Higher capex is required to meet mounting service requirements and tenant demands, but bigger spend has not necessarily translated into better returns.

While it is common practice to outsource property valuations to third parties, the actual decision rests on the shoulders of the investment team. Laurent Lavergne, global head of asset management and development, real assets at AXA IM Alts, and his colleagues look at various metrics, but also at the tenants’ taste: what will they pay more for?

“It is easier to attract a broader band of potential tenants to flexible, energy-efficient, high-quality buildings in the right locations – while it is fair to say, traditionally older assets may only attract a narrow pool of potential tenants,” says Lavergne. “So you are not in the same position to create market tension there.”

“There is always a judgment call to make,” he adds. Judgment calls require investors to step back and look at overall trends. When looking purely at the financials, however, other metrics have become more valuable to investors.

Cashflows are particularly important for some. At Atrato Group, the investment manager’s chief investment officer Steven Noble says there has always been a focus on investment over cap rate, as it can give the best insight into the value of an asset over the long term. He and his team use two sources for calculations: “The first is the lease: the value of this is informed by the credit quality of the underlying tenant. The second is the reversion value of the property at the end of the lease.

“One gets discounted against credit quality; the other is about pure property fundamentals.”

As for the issue of credit quality, Noble points to supermarket tenants in the portfolio. These companies have high credit ratings, which can provide a better view of how their lease cashflow information will inform his valuations.

Elsewhere, other firms are paying more attention to cashflow metrics. Simon Martindale, fund director at investment manager Mayfair Capital, says he and his team are becoming more “forensic” about cashflow analysis for assets. The reason is the higher cost associated with refurbishments and renovations. “We now try to reflect the actual build costs that have been incurred on similar schemes – and apply these to our assumptions – rather than rely on build cost indices,” he says. “It can be quite a big difference sometimes, especially with current inflation on raw materials such as steel.”

Importance of data

Like any decision, those around valuations require information. While noting that big data is key, Atrato’s Noble highlights nuances in typical real estate investment decisions. “In the old days, if you bought a retail store on a 20-year lease then you were fine and geography didn’t really matter,” he recalls. “However, in today’s digital world you need to be more careful. Big data can inform this decision and inform your view of the asset’s catchment area, what is impacting its success, how many competitors are nearby, etc.”

“Carbon-reduction capex costs now must be factored into values”

Basil Demeroutis
FORE Partnership

More consultancies and research firms are launching into the sector to satisfy this demand for analysis. But big data’s worth is not uniform, according to Lavergne.

“Big data can be quite powerful when you are applying to it mass-market, residential assets, but it is more challenging for office spaces, which are much less regular by nature and where specificities of each asset have significant impact,” says Lavergne. “I’m not sure, as of today, using big data will give you as much insight there when compared to the deep understanding of our development experts.”

This analysis struggles to deliver insights on another metric that investors increasingly need to know about: energy efficiency.

Cultural (and regulatory) shifts have led more and more companies to set net-zero targets. Tenants are passing these concerns onto developers and landlords, which now need greater insight into the energy efficiency of their assets and the cost of the journey to net zero.

“Tenants are willing to pay more for sustainable real estate, particularly in the office sector,” says Lee Bruce, head of fund valuation, real assets, at CBRE. “There is growing evidence of a green premium being achieved across the occupational markets for best-in-class green buildings, and investors will seek to lever this.”

Carbon calculus

Getting this data is not as easy as for other real estate metrics, largely because of the relatively new nature of ESG and how this has changed building design. Paying for green refurbishments is no longer something investors can ignore, according to Basil Demeroutis, managing partner of investment firm FORE Partnership. He says these costs eventually do need to be covered, which is why their calculation is crucial to valuations.

“Carbon-reduction capex costs now must be factored into values, a direct write-off to values and reflecting the reality of what needs to happen to transition to a low-carbon future,” says Demeroutis. “There is growing market data to demonstrate that these higher capex costs are more than compensated for in terms of higher returns.”

A challenge for investors is that data around assets’ energy efficiency is lacking. In the UK, Energy Performance Certificates (EPCs) are the closest many investors have to informing these decisions, but Mayfair’s Martindale warns against using them as they are based on unreliable assumptions.

“The difference between the EPC and the actual energy consumption of a building can be quite significant,” says Martindale. “We recently bought an office in [the English town of] Solihull with an EPC of C, which estimated it was being used for 45 hours a week. When we got hold of the energy consumption from the tenants, we found out it was being used for double the amount of time.”

This meant the office building’s net-zero target was five times higher than what was being indicated by the EPC.

Martindale and his team are talking to more research organizations that specifically analyze energy efficiency. He expects the wider industry will do so, too: “Many landlords have made net-zero target commitments based on capex assumptions from EPCs. It will be interesting to see whether we see wholesale amendments to these targets as greater data transparency becomes available.”

Suffice it to say, asset valuation is not the straightforward task it once was.