Are property valuers too conservative?

04-05-2005

The fact that many listed property firms are currently trading at a premium relative to their net asset values (NAVs) has recently been cited as evidence that professional property valuers are too conservative in their valuations.

This is not necessarily so, says Erwin Rode, CEO of Rode & Associates property economists and valuers. While he agrees in principle that it is possible that some valuers are too conservative, given the current flux in the market, he says that the fact that many funds’ NAVs stand at a discount to their market capitalization, does not demonstrate that valuers are undervaluing the underlying property of listed funds.

Rode explains that valuers generally use recent — but nonetheless historic — market information when valuing non-residential property. When valuing an office block, for example, a valuer would consider recent sales of comparable buildings and extract from these sales important information such as the rentals achieved, operating costs incurred, vacancies, and the capitalization rates at which the transactions took place. This information is then used in calculating the value of the subject office block. It therefore stands to reason that when any of these critical factors are fast changing, a valuer should be on his or her toes, and not blindly apply historical information.

“The unquenchable thirst for residential and, increasingly, non-residential property, over the last few years has made valuers’ job a bit more challenging. In such a fast-changing environment, where tomorrow’s price is already achieved today, valuers cannot blindly use historic sales information without possibly extrapolating the trends of the crucial value drivers,” Rode says.

He stresses that the NAV of a fund is the sum of the underlying individual properties’ market values (assuming they will be sold individually); and then goes on to argue that the following differences between NAV and listed-market capitalization should be considered:

• Depending on when in the financial year of a counter the comparison is made, the NAV reflects the market values of the underlying properties as at a date that might be anything from three months to eighteen months old. In a fast-moving market this time difference could be responsible for a highly significant difference.
• Investors are prepared to pay more for a given cash flow when the risk is lower. Hence, a fund, consisting of a multitude of individual properties’ cash flows, will trade at a premium to the sum of the individual properties market values (diversification improves the rating). This premium, expressed as an income yield, might be 100 basis points. Put differently, all things being equal, a fund could trade at an income yield that is 1 percentage point lower than the sum of the individual underlying properties’ income yields.
• Investors are also prepared to pay more for better tradability, also known as higher liquidity. This liquidity premium might deduct yet another 100 basis points from the listed fund’s income yield relative to the sum of the income yields of the underlying properties.

“Until now, we have compared the trailing income yields rather than capitalization rates of individual, directly-held properties with the trailing income yields of listed funds. If we were to make the comparison with the capitalization rates of directly-held properties, further incomparabilities would creep in because capitalization rates are forward yields.”

Interest-rate decline caused market shift

Rode emphasises that he is not implying that the income yields of listed funds are still irrelevant to valuers of directly-held properties, as used to be the case. “There has been a shift in the non-residential market over the past year or so, and the reason is a web of circumstances that have as a common denominator the sharp decline in interest rates.”

The income yields of listed property funds followed long interest rates on the down path, and the cost of financial gearing concomitantly declined as well, thus boosting listed values in two ways. Through this mechanism, directly-held properties’ prices and listed funds’ prices started to converge — for the first time in probably decades — and this fact, more than anything else, made the listed funds dominant players in the property investment market, according to research for Rode & Associates quarterly publication Rode’s Report.

“Dominant players set prices, of course, and in this way, the effect of declining interest rates has indirectly started to play an important role in setting the prices of individual, directly-held properties, not just listed funds’ rating,” says Rode. This especially applies to trophy investments like shopping centres. The chain of cause and effect works more or less as follows: long-bond yields determine the income yields of listed funds and the cost of finance. These two combined determine the maximum price at which listed funds would acquire individual properties, given their policy — rightly or wrongly — that they would not contemplate acquiring a property where the net short-term effect would be a dilution of earnings.

“Hence, by buying a directly-held property, a listed fund immediately adds value by adding liquidity. Moreover, the property is now part of a diversified portfolio.” It is this value-add that is largely responsible for the difference between NAV and market capitalization, concludes Rode. “Thus, a market capitalization premium to NAV of about 30% seems justified,” says Rode.