Tumbling capitalization rates create valuation trap

09-12-2004

In the residential property market, estate agents and valuers have a serious problem in estimating the market value of a house, says Rode CEO Erwin Rode.

The reason for this is the phenomenon of galloping prices that invariably means that the historic comparable sales on which an estimate of market value is based, are outdated the moment they become available to market players.

Rode quotes a recent case where the owner of a townhouse had his house valued by three top agents in the neighbourhood. The average estimate was R450.000, and they were within R10.000 of each other. So the owner put his townhouse on the market for this amount. Within two days he had sold the property for R500.000 — because the first prospective buyer offered more than the asking price!

In the commercial and industrial property market a similar scenario is unfolding. Market rentals haven't moved by much yet, but capitalization rates — the market's rating statistic — have dropped quite considerably over the past year, depending on property type and region.

Rode says that over the past year, regional centres' capitalization rates, for example, had dropped by nearly ½ a percentage point per quarter. In the current market, the implication is that if a property valuer were to use historic evidence without further adjustment, he or she is probably undervaluing the property.

The main factors driving this steep decline in physical-property yields are:

• Long-bond rates are dropping on the back of declining inflation expectations,
• Equities are — wrongly — still out of favour as an investment class, and
• More syndicators are entering the market because of the sharp decline in interest rates, and they are depressing capitalization rates as a result.

Thus, in the current fast-moving market, valuers should carefully consider time-adjusting all evidence relating to capitalization rates to arrive at a more accurate rate as at the valuation date.

“In the case of capitalization rates reported by Rode’s Report, we recommend that the smoothed trend over the past four quarters be extrapolated by one quarter. As for capitalization rates from other sources, this extrapolation might be for an even longer period,” Rode says.