The Complex Art of Valuing Commercial Real Estate During a Pandemic and Cyclical Downturns

The valuation of commercial real estate is not easy. Valuation is an opinion, not a fact. Valuation has long been called an "art," not a "science." Commercial real estate is not homogeneous and is an illiquid asset traded in an inefficient market. These inherent characteristics of real property valuation make it challenging to argue, prove, and defend any opinion of value.

For example, two identical adjacent buildings could have vastly different property values based solely on the underlying facts that determine the cash flow of each property, even before taking into account other factors such as the strength of the capital markets, the credit quality of the tenants, or the strategic investment plan of that pool of buyers. The simple supply and demand of the real estate market adds complications that lend real estate conclusions to subjectivity and uncertainty. Try to take those concepts into account and add to them a vast pool of real estate data, characteristics, facts, and assumptions: Even a non-real estate professional can relate to the difficulty and faults in valuation.

Now imagine all those hurdles in a market downturn, such as we have experienced during the current pandemic. Estimating real estate values becomes even more challenging partly due to reduced liquidity, a slowing leasing market, and a dearth of comparable sale transactions. Appraisers in market declines are forced to rely more on investor sentiment, capital sources, and discussions with real estate brokers, triangulating this anecdotal evidence with the available market data in order to produce a credible opinion of value. These needed discussions add to the time necessary to complete appraisals, inserting another layer of difficulty, given that this type of market reconnaissance is often dependent on market participant relationships. In addition, appraisers are increasingly under thinner and thinner margins in the fees they are able to bill for their services. Undoubtedly, third-party market data is a source for providing supply-and-demand information. Still, that data is often backward-looking with limited forecasts often based on algorithms not explicitly connected to that market's trends. Relying solely on these sources will often complicate the valuation of forward-looking cashflows, creating yet another obstacle.

Understanding the Lag Problem

An issue that has haunted direct real estate institutional investments has been the historical lag in real estate values compared to broader markets or real estate investment trusts (REITs), publicly traded real estate. The comparison of privately and publicly traded real estate companies could fuel many future articles. Still, excluding the fact that REITs are traded on a real-time market, with some corporate tax differences, the real value of the underlying assets should show similarities. Unfortunately, lags found in direct real estate investing, often attributed to a delay in data, can skew those comparisons. For example, appraisers need timely and comparable sale transactions to help determine property value. As liquidity and capital flow slow significantly during a recession, appraisers experience an absence of completed transactions upon which to base their values. This gap in information makes the "art" aspect of real estate valuation even more difficult and subjective.

Now that you understand some of the reasoning behind the lag when comparing private direct real estate investment values to others, it's essential to recognize the results. Looking at a snapshot of The Great Recession, the S&P 500 and Equity REIT price index reached their peaks before the peaks shown by direct real estate investment as represented by the National Council of Real Estate Investment Fiduciaries (NCREIF) leveraged price benchmark. This pattern can be seen in many previous recessions and other volatile market movement periods.

As exhibited below, both publicly-traded indicators are at the forefront of the National Bureau of Economic Research's (NBR) declaration that the economy had fallen into a recession as of the third quarter of 2007. According to indexed values based on 2005 equaling 100, the National Association of Real Estate Investment Trusts (NAREIT) equity values are first to peak, a quarter ahead of the S&P 500. More importantly, both the S&P 500 and NAREIT results peaked three and four quarters ahead, respectively, before the smooth appraisal-based NCREIF index. Historically, this is the quarterly lag that many professionals view as an imperfection in determining direct real estate values.

It isn't just the peaks, but the lags in the troughs as well. In our recession example, you can see how the NCREIF index again is about four quarters behind both publicly traded benchmarks. So does it balance out? Is it correct? Those questions can be answered in different ways from a variety of viewpoints and investment preferences. However, responsible valuation managers and appraisers must respect their fiduciary responsibility to these funds and their investors. To do that, they need to provide the most accurate values based on current market conditions in a timely fashion with the available data and resources.

Valuation During the Pandemic

Halfway through the second quarter of 2020 and after over four months of dealing with some form of shelter-in-place throughout the U.S., commercial real estate is preparing itself for substantial value changes through the rest of 2020. Unemployment filings have reached historic highs, and all commercial real estate holdings are paying the price in one form or another—especially the hotel and retail sector. In the case of directly-invested institutional real estate, these funds will be dealing with these consequences when they mark their assets to market.

Investment managers should address these changes now due to the longest-running period of U.S. expansion ending as of February 2020, when the NBR declared that a recession had begun. Despite a record-setting business cycle, lasting a total of 128 months, the NBR announced this recession outside the standard definition of two consecutive negative quarters of GDP change, by declaring it with only a one-quarter drop.

According to the 2020 first-quarter closing NCREIF NPI leveraged price returns, the index was down 1.23 percent, with hotels leading the way by falling 10.7 percent and retail dropping 5.8 percent. Still, comparing the index to real-time results, the S&P declined over 20 percent, and Equity REIT prices, according to NAREIT, were down 24.1 percent—with hotel REIT prices crashing over 52 percent. Looking at this from an institutional direct real estate standpoint, a decrease of 20 percent to 30 percent in REIT market property values should imply a change in their underlying assets as well. Yet, values were not adjusted significantly during 1Q 2020. Granted, those are massive spreads in returns for only one quarter, but we are dealing with unprecedented times. The private equity industry anticipates substantial second-quarter writedowns, although broader markets have regained much of the loss, and even some REIT sectors should post a more robust quarter. The dislocation of the market is real, and it does not relieve the appraiser or valuation management consultant of their responsibility to mark values to market.

The Need for Responsible Valuation

Under any scenario, appraisers still have a duty to provide an opinion of value based on the market for an asset as of a particular date. We find, however, many appraisers "punting" on real estate values by putting in extraordinary conditions and disclaimers to relieve them of the responsibility of providing as accurate a value as possible. This article revolves mainly around institutional real estate funds with a quarterly valuation process. However, institutions originating loans do not wait until the close of a quarter for a value. So why are the two done so differently?

Maybe because institutionally owned real estate is a longer-term hold for investors in which values are typically marked every quarter with trades that happen on a quarterly basis. Even so, there are daily funds that are priced daily and offer constant liquidity to their investors. Consider institutions holding real estate loans on their balance sheets. These loans are valued as an entity daily, and accuracy is critical in enforcing appropriate loan covenants based on proper values. The value of the loan is dependent upon the value of the underlying asset.

To us, it's simple. The values should be the same for the underlying real estate, no matter who the owner or lender is and how the property is held financially. We believe this is the underlying problem in the inefficiency of the valuation process for commercial real estate. With advancements in technology over the past decade and an abundance of available data, the industry is ripe for changes to more accurately and swiftly produce accurate values for reporting purposes.

Often considered an alternative asset class, the pension world has continued to increase allocations to commercial real estate. Flattening and smoothing real estate values, instead of identifying market downturns due to credit losses, pricing, and volatility may create a denominator effect. This effect can often set a plan’s allocations requirements out of balance. These results often lead to another implication of lags in value increases or decreases.  

Based on the preceding discussion, accurate valuations are necessary to report correct returns to investors, but according to the Pension Real Estate Association Survey of Industry Conditions in the Wake of COVID-19, the pension fund players have their doubts. Of those surveyed, 67 percent believe appraised values may contain material uncertainties, and 23.9 percent believe that appraised values may be a somewhat less accurate estimate of the true value currently under the normal circumstances—results you don't want to hear as an appraiser or as an investor in real estate.

The Need for Progressive Change in Valuation

As the world deals with a historic time of change, the "art" of valuation needs to follow suit. The real estate industry needs to find answers to remove the valuation cloud on direct real estate property values. Dealing with volatile market changes appropriately and avoiding lagging results are just two issues that need to be addressed. These changes will help stop the discredit that has haunted the appraisal industry as a whole. Daily pricing for real estate funds is a step in the right direction, and some funds do an excellent job marking their assets to market with this format. Also, these funds provide valuable real estate options for investors to trade upon daily. This process, however, requires a collaborative, proactive approach on the part of the appraisers and valuation teams. Technology has come a long way in assisting in easing some of the administrative burdens and enhancing accuracy and efficiency for daily valued funds. But the point remains clear to us that the value of a commercial real estate asset should not vary based on who holds the keys to the castle.

Stephanie Dubicki is a senior managing director with Ankura in Houston, Texas. Charles DiRocco is a managing director with Ankura in Washington, D.C.

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