Benchmark valuation data is great, but not always readily available or relevant to your market. Because investors, brokers, lenders, appraisers, servicers, receivers, lawyers and the courts consistently need to understand the current value of an asset, it is important for all real estate professionals to know how to provide valuations that do not rely solely on historical data.
Establishing the correct value for an asset to be sold, or space to be leased is the most important aspect of any transaction. The key to understanding an asset’s value is the relationship between the asset type, its geography, and the current commercial real estate cycle.
But in creating valuations that are reliable in a time of unprecedented uncertainty, commercial real estate professionals must not dwell in the past. We are in an economic recession coupled with a public health crisis like the United States and the world has not seen in at least a century.
Part of producing the best possible forecasts is understanding what the next economic cycle may look like. Here, it’s a bit of alphabet soup. We have four general options, each with distinct implications for commercial real estate:
- V-Shaped Recession: A short, single drop with economic activity picking up relatively quickly.
- W-Shaped Recession: A double-dip recession that includes a second contraction after an initial recovery.
- U-Shaped Recession: An extended period of economic strife with unemployment and inflation becoming long-term considerations before a marketed recovery.
- L-Shaped Recession: An economic shock that leads to a long, slow, but steady recovery (with the Japanese recession of the early ’90s as an example).
In creating valuations that are reliable in a time of unprecedented uncertainty, CRE professionals must not dwell in the past.
In understanding how to develop reliable valuations in the age of coronavirus, here are five assumptions that are key to establishing current and future worth for real estate assets of all types.
Premise 1: Certain properties are inherently difficult to analyze. In a robust market, substantial data from comparable sales can help determine benchmark numbers for cap rates, discount rates, and sale prices per square foot. But such information isn’t available in secondary and tertiary markets or for properties valued below $2.5 million simply because there are fewer of them.
Premise 2: Historical data is no longer valid as an indicator of future performance. COVID-19 has made a lot of information worthless. Our current situation cannot be compared to a bullish or bear market that we’d expect to see in anything resembling normal times. The sheer disruption to the commercial real estate market requires professionals to ignore a lot of what happened before 2020. The downturn has been abrupt and not inherently based in economic issues. Even six months after the initial shock of COVID-19, still greater uncertainty remains about the final fallout of the effects of the pandemic on commercial real estate. For the foreseeable future, it is best to rely on forward-looking analytics and current market status rather than attempting to extrapolate future events from past activities.
Premise 3: Asset type and locations are important. It’s not that geography was never an important factor in determining a real estate asset’s worth. It’s just that a global pandemic has made location type and location that much more essential. While New York and Seattle were initial hotspots for the virus, other regions have experienced outbreaks in the summer and early fall. Additionally, interest in suburban markets has ticked up as people avoid densely populated urban areas. This trend could lead to a shift in overall consumer behavior in the years to come. Understanding this variability is crucial to predicting a real estate property’s value in the future.
Similarly, the asset class plays an important factor, as market sectors have had wildly different experiences amid lockdowns and quarantines. Retail is a perfect example, where a bifurcated market has led to convenience stores and grocers seeing strong sales while nonessential storefronts and restaurants are trying to scrape by.
Premise 4: Future performance impacts present value. The best valuations are determined by examining current and forward-looking analytics. Understanding what an asset is worth today (the acquisition cap rate) must also incorporate how it will perform in the future (the discount rate). Estimating the performance of an income-producing property over time moving into the future and then applying an appropriate discount rate to those estimates will give the valuation greater credence. This model will also allow for the use in probabilities in determining future cash flows. For example, calculations can be based on varying vacancy and credit loss numbers. Then, by applying a probability to each outcome, you can determine a value based on a weighted average.
Premise 5: The future is uncertain. There is no such thing as a real estate asset with a single value. All predictive values represent a range. COVID-19 has required everyone to set and reset expectations – sometimes on a daily or even hourly basis. Many people in early March, for instance, expected the pandemic to be a temporary disruption to normal life. Offices and stores were closing, but the timelines of shutdowns were extended as the full impact of the public health and economic crises were realized by experts and everyday people alike.
For real estate, an asset needs to be valued in a range. If a vaccine becomes available tomorrow, that development would greatly impact the value of a hotel property. But if travel remains difficult for years to come, the predictive value of that asset is very different.
We are in unprecedented times, but commercial real estate will rebound, and the industry will be an important player in the U.S.’s recovery. COVID-19 will make valuations more difficult to create, but understanding what goes into the creation of reliable estimations is essential for commercial real estate professionals to serve their clients and themselves in the road ahead.
Editor’s note: This article was adapted from the CCIM Institute course, “Creating Reliable Valuations.” In addition to discussing premises underlying estimations of worth, it covers the impact of COVID-19 on property types and markets, while examining long-term economic consequences on income-producing property yields. For more information, visit www.ccim.com/education.