The purpose of this article is to develop a guiding framework which will help property owners and developers effectively to conduct and establish an 'Opinion of Market Value' during and after the COVID-19 pandemic and to provide guidance as to how the requirements of the valuation Standards may apply during this time and in related specific situations.
This framework is structured and based on directives issued by the Royal Institute of Chartered Surveyors "RICS" as a guidance in the form of a RICS' Valuation Practice Alert dated March 2020, Beyond COVID-19: Valuation approaches and evidence during the COVID-19 health crisis - issued by RICS during May 2020 and Appraisal Institute and additional input as recommended by the International Valuation Standards (IVS)'s technical board, in a recent letter issued during March 2020.
It should be noted that this article focuses on the 'Valuation Approach during COVID-19' and helps to understand the 'Market Value' and its characteristics. The article further highlights the types of uncertainties that may apply and the applicability of Basic Valuation Principles and sustainability of value.
A. Valuation Approach during COVID-19
COVID-19 is an unprecedented "black swan" event that has had a substantial impact on the world's economy and that is further expected to influence subdued demand, liquidity pressure and a prolonged credit crunch. The level of uncertainty in almost all of the global economies is unparalleled in history and is currently at an all-time high with the trajectory of the recovery difficult to forecast.
Real estate asset classes including office, retail and hospitality will witness structural shifts and will face severe disruption in the short and long-term. The residential sector will face challenges on account of an unsold stock overhang, low absorption/sales levels and drops in selling prices. However, long-term demand will remain unchanged, only delayed. In the meantime, it will create significant declines in market capitalization rates as a result of the unprecedented impact from their original estimates and valuations.
Discount and cap-rates using applied historical data may not reflect the current environment or outlook for the business going forward.
Given the immense uncertainty in the coming 6-24 months, assumptions should be applied cautiously to ensure that the risks involved during these uncertain times are properly reflected.
- Considering the current situation, it is important to document the nature of the selected instances (recently transacted or quoted price/rents) and how they align against the subject development.
- Comparable instances should only be used if it is available to a valuer on the date of valuation. Information derived from comparable market transactions will normally provide the best evidence of value. Such evidence should be recent, relevant and comprehensive and may be collected from a variety of sources.
- Consider alternative scenarios in your forecasting process and performing enhanced modeling.
- Value derivation through multiple approaches and/or methods should be reasonable and the process of reconciling the values into a single value assessment.
- Also, it is anticipated that there will be a substantial change in vacancy levels, declined absorption rates, and increased cap rates – thereby significantly affecting the final estimation of the property. Such input assumptions to be cautiously captured and recorded appropriately.
Considering the likely impact on the determination of value due to uncertainty during this COVID-19 crisis, we suggest that valuers report at a specific date and present the market conditions on a 'as is where is' basis. The only market assumptions and instances available for the valuation are likely to relate to the market before the event occurred and the impact of the event on prices will not be known until the market has stabilized, a point that is also emphasized by RICS.
B. Characteristics of Market Value
The International Valuation Standards defines "Market Value" as follows:
"It is an estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm's length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion." (International Valuation Standards 2017)
It is important to observe that the following elements are common to each of the foregoing definitions:
- Market value results when the parties are typically motivated, are generally well informed, and are acting in their best interest;
- Market value results when the property is exposed on the market for a reasonable length of time;
- Payment is in cash or its equivalent.
Quite often and during times of such uncertainty, the general characteristics of market value are absent from the transaction that occur. Buyers and Sellers might choose to transact before they have full information. Because of the sudden change, they might be extraordinarily motivated to buy or to sell. Sometimes, market activity will cease altogether during pandemic, prospective sellers may cancel plans to sell, prospective buyers may cancel plans to buy. A Valuer must be especially mindful of these characteristics of market value when in chaotic or unstable market.
C. Valuation Uncertainties
A Valuation is NOT a fact; it is an estimate of the most probable range of outcomes, based on the assumptions made in the valuation process and such estimation shall include any uncertainties.
Thus, the degree of uncertainties is based on their level of impact; the more uncertainty, the more cautions will need to be given to the inputs. The International Valuation Standards defines "Valuation Uncertainty" as follows:
The following are the type of uncertainties.
- Market disruption (uncertainty in the current and future market conditions);
- Input availability (uncertainty in the specific inputs & availability of market Informations);
- Choice of Valuation Method or Model.
- Material Uncertainty
Market Disruption: Market Uncertainty comes about when a market, as at the valuation date, is disrupted by current or very recent events such as current COVID-19 outbreak, sudden economic or political crises and change in policy or regulations etc. Market uncertainty is not measurable as the uncertainty arises from the inability to observe and reconcile the impact of the event(s) on market prices as at the valuation date.
Input Availability:A lack of relevant input data will cause valuation uncertainty. This may be due to market disruption as described above but may also be due to the assets being unique or because the market for the asset is normally illiquid. Where there is a lack of relevant market data, there may be a need to extrapolate inputs from directly observable prices for similar assets, or to rely on unobservable inputs. These uncertain input assumptions will translate into an uncertainty with the resultant figure, the valuation.
Choice of Valuation Method or Model: For many asset types, more than one method or model may be commonly used to estimate value. However, those methods or models may not always produce the same outcome and therefore the selection of the most appropriate method may itself be a source of valuation uncertainty
Material Uncertainty: It is important to emphasize that a lack of comparable data should not prevent a valuation being undertaken but the skills, expertise and judgement of the valuer become more important in difficult market conditions. The valuer must look further afield and across a wider range of indicators when transactional evidence of directly comparable real estate is lacking. In such circumstances, it may be necessary to consider more indirect evidence: for example, local or national economic data that can indicate trends to give guidance towards, rather than direct evidence of, value.
However, among the four uncertainties as mentioned above – the Choice of Valuation Method becomes crucial when considering the level of uncertainty.
D. Applicability of Basic Valuation Principles
Any Valuer must be approached using recognized methodology, considering basic valuation principles, regardless of whether market conditions are at their most chaotic. Applying established approaches to solving valuation problems will help to simplify even the most complex assignments. Valuation during uncertain times requires special attention to the fundamental Valuation Principles of supply and demand, anticipation, change, balance, substitution, contribution, and externalities.
- 1. Supply & Demand: In Valuation Analysis context, the principle of supply and demand states that the Value determination is directly proportionate with demand and inversely proportionate with supply.
- 2. Anticipation: The future receivables anticipated from the property would be adjusted for the outgoing expenses to derive cash flows and/or cash flows for the disposal period. The same is then discounted at an appropriate discounting rate linked with cost of capital or risk adjusted rate to arrive at the value of the property in present value (pv) terms.
- 3. Change: The principle of change (Growth, stability, decline, or restoration etc.) due to market forces may affect the Value of a Property. Market forces are usually in a state of flux, and they influence the rate of & return and helps in deciding the exit time.
- 4. Balance: It is directly related to returns. It states that value is created & maintained only when the necessary real estate activities are in equilibrium.
- 5. Substitution: Substitution effect is purely a reflection of frugality in consumer behavior. This is the primary principle upon which the cost and sales comparison approaches are based. Thus, it underlies all the evaluation approaches like Cost Approach, Income Approach & Direct Comparison Approach.
- 6. Contribution: The principle of contribution states that the worth of an improvement is what it adds (or contributes) to the market value of the entire property, not what it cost to add the improvement.
- 7. Externalities: A variety of external factors are beyond the control, such as Government regulations, Changing Policies, economic conditions, social forces, can substantially affect value.
E. Sustainability of Value
Sustainability of value over time will be reflected in the current market value, but after a disaster there is much more uncertainty which makes buyers and sellers to be more cautious. Changes in market conditions may cause changes in market value to occur more rapidly than usual. So, it is best to communicate to the client about the relative reliability of the value opinion. Also, it is good to point out in the appraisal report that the data upon which it is based is limited in quantity or quality and that this affects the reliability of the conclusions.
Both buyers and sellers are currently undergoing tremendous uncertainty and it is likely to affect valuations, deal flow, deal terms, and deal structure. Valuation uncertainty should be distinguished from uncertainty risk. The possibility that the estimated value may differ from the price in an actual transaction deemed to be taking place simultaneously means that the value may be higher or lower than that price. Thus, clear understanding on uncertainty is crucial and is of utmost importance not only for valuers, but also for the stakeholders involved.
Given the present market instability and the level of valuation uncertainty noted, we recommend that Clients review their valuation at regular intervals to assess the impact level and take informed decisions on the investments made.
Meraqi's independent Valuations Team along with two of our overseas-based RICS valuers are available to assess the value of your portfolio during these challenging times.