“The covid crisis has certainly impacted valuations a few different ways,” says Kjelstrom. First, property inspections became very difficult, if not impossible, during the coronavirus lockdowns. Second, “similar to the global financial crisis, transaction volume is significantly reduced and that makes the valuation process much more research intensive and reliant on anecdotal commentary.”
Indeed, global commercial real estate transaction volumes plummeted 57 percent year-on-year to $109 billion during the second quarter as a result of coronavirus-related lockdown measures and border controls – the lowest quarterly total since 2010, according to broker CBRE.
Even when there is high transaction volume, appraisers could still supplement research with conversations with market participants. “But when there are no transactions, the reliance on conversations increases exponentially and you should be having a lot more conversations as a result,” Kjelstrom notes. During the first quarter, for example, Chatham Financial spoke with more than 60 managers in the valuation process – more than double the number during Q4 2019.
Meanwhile, Richard Kalvoda, head of the advisory practice at Altus Group, which advises real estate firms on valuation management, says his team has tripled the time spent on market outreach. As a form of “alternative research,” the firm adopted a strategy it calls “refried sales” in conversations with market participants.
As Kalvoda explains: “Since there aren’t new sales, we’ve gone back and looked at transactions that occurred in the six to 12 months before covid and went back to buyers and sellers on those transactions and said, ‘based on that property you bought, or the property you sold, in the same situation but with covid, how would you have changed your assumptions?’” Additionally, Altus is looking at ways to replace the physical inspection process, such as video calling with a manager for virtual walk-throughs of assets.
Given the current market uncertainty, the valuation process – which looks at both cashflow and pricing – now requires appraisers to drill more deeply into property data. “At the fund level, for instance, property type and geographic allocations don’t tell the whole story anymore,” says Kjelstrom. “The further breakdown into subtypes, into markets, tenant exposure, the credit quality of tenants, are all really important right now.”
A wide range of reasonableness
He adds: “In an environment like this, for many properties, there’s actually a wide range for reasonableness for valuation conclusions right now. What’s important is for investors to understand where within that range of reasonableness their assets being valued.”
Similarly, Velky likens valuation to a bell curve. “If there’s a highly efficient transaction market, your bell curve becomes significantly narrower,” he remarks. “In an uncertain environment, you have a wider bell curve – it’s all around the most probable price.”
He acknowledges the third-party appraisers SitusAMC hires can have thoughts and opinions on valuations very different from another. “The key question we should be asking ourselves is whether these opinions are reasonable and well supported in light of the information available,” Velky says. Ultimately, “we’re trying to be consistent in the values being assigned, creating credibility – especially in a time of uncertainty.”
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However, he expects pricing assets in certain property sectors will become less challenging over the coming quarters: “There’s going to be greater transparency from the transaction market by year-end for industrial and, potentially, multifamily. Office will take longer to play out and retail even longer, due to structural changes impacting these sectors.”
Kalvoda, however, says he has not yet seen wide dispersion in valuations or underlying valuation assumptions. “Where we see most of the variations in the assumptions is the retail and hospitality sectors. If you think of how a sector is impacted as much and as quickly as hospitality and retail is now, you have to make an assumption,” he observes. “That is where you’re going to make bigger change assumptions and where you are going to see more variation. In the other sectors, we aren’t seeing much variation.”
Potential anomalies in valuations, moreover, can be detected through technology. Altus reviews more than 8,000 valuations every quarter and aggregates and benchmarks about 400 data points from each of those reviews, according to Kalvoda. That data is visualized in a scatter plot, or bubble chart, where a property’s valuation assumptions can be measured against similar assets that quarter, he explains. “If it’s not in that curve, in that cluster where everybody else is on those assumptions, it raises a flag,” he says. “Can we explain why that value is much higher on a per-square-foot basis, versus everybody else?”
One of the biggest ongoing valuation challenges is the lack of standardized data – the legacy of an industry that historically comprised individual owners which saw opacity as a competitive advantage, says Kalvoda. That is changing, however, as real estate becomes more institutionalized and the demand for transparency and consistency increases, he says.
For Kjelstrom, the most significant challenge facing the valuation industry is appraisal lag, or the tendency for appraisers to rely on previously closed transactions, where pricing was likely negotiated and finalized months before closing and may not necessarily reflect current market conditions. While this was a challenge for the industry pre-covid, it has become more heightened in the crisis, he adds.
He says access can also be an issue for appraisers, as it is largely dependent on individual appraiser’s relationships in institutional real estate. “It is an uphill battle for appraisers to get access. They oftentimes will in their research not get return calls and do their best to dig into a transaction without direct insight into what actually happened, when managers have that information typically at their fingertips,” Kjelstrom says.