Property valuations and the investment market RICS, Moscow Andrew Baum Department of Land Economy University of Cambridge 25 March 2014

Why are valuations needed? For sale and purchase –transaction and due diligence support For bank lending –loan to value ratios For balance sheets –asset valuation For performance measurement –manager track records and performance fees

Consistent valuation standards are important Valuations need to be –accurate and unbiased –professional and regulated –consistent within and across borders RICS Valuation: Professional Standards (the 2014 Red Book) covers the valuation of assets in the form of real estate (land, buildings and interests therein). Fully compliant with International Valuation Standards (IVS) 2013

Cross-border investing has boomed Source: University of Cambridge

Some places get more than their fair share of capital International capital flows are explained by a combination of formal and informal barriers Formal barriers –taxation, capital controls, limits on foreign owners Informal barriers –legal and title risk –liquidity risk/limits on exit –currency, culture, transparency information asymmetry/market research valuation

JLL Transparency Index, 2012 Direct Property Indices Listed Real Estate Indices Unlisted Fund Indices Valuations Market Fundamentals Data Offices, Retail, Industrial, Hotels, Residential Financial Disclosure Corporate Governance Regulation Land and Property Registration Eminent Domain Debt Regulation Sales Transactions Occupier Services 5 Sub-Indices 13 Transparency Topics 83 individual questions and data-points for each market Composite Score Performance Measurement Market Fundamentals Transaction Process Governance of Listed Vehicles Regulatory and Legal

JLL Transparency Index Europe Source: Jones Lang LaSalle, LaSalle Investment Management United Kingdom, Netherlands France, Finland, Sweden, Switzerland Germany, Denmark, Ireland Spain, Belgium, Norway Italy, Austria, Portugal Greece Highly Transparent Transparent Semi Transparent Low Transparency Opaque Poland Czech Republic, Hungary Turkey, Slovakia Russia (Tier 1-2 Cities), Romania Croatia, Russia (Tier 3 Cities), Bulgaria Ukraine, Slovenia Serbia Kazakhstan Belarus Western Europe CEE

Remarkable surge in cross border flows over the last decade; sharp differences among countries Each country should receive capital flows commensurate with the size of its respective economy or, more accurately, the total size of its investible real estate market Key finding: improving real estate market transparency appears to have a stronger positive impact on cross-border flows than an increase in historic and prospective returns Cambridge research

Transparency and investment activity are correlated Sources: Jones Lang LaSalle, LaSalle Investment Management Below Average Share of Global Volume Relative to GDP R 2 = 0.39 Australia Vietnam UK Italy Norway Hong Kong Sweden Bulgaria South Korea Macau Hungary Netherlands Switzerland Croatia Czech Republic Finland USA Germany Taiwan Portugal Ireland Singapore Russia China Brazil Japan

Are valuations accurate? International investment requires valuations which are –accurate and unbiased –professional and regulated –consistent across borders Smoothing: valuations are conservative How close are valuations to sale prices? Is there evidence of bias? Is there evidence of client influence?

Smoothing Real estate is said to offer a reasonable return for low volatility, and diversifies the portfolio But volatility is under-stated by valuations –anchoring and valuer conservatism –temporal averaging - when are year end valuations undertaken? –lagging effects - the use of ageing comparables

Smoothed property values Return SD 10% Return SD 14%

Optimal portfolios, rising returns Observed mean

Valuation uncertainty “… the valuer and most informed users of the valuation recognise that there will be a degree of uncertainty associated attached to the figure provided.” (RICS, 1997, p. 26) “All valuations are estimates and carry with them a degree of uncertainty. The range of uncertainty may vary in different market conditions and for different types of property” (RICS, 1997, p. 26)

Source: Merrill Lynch, Bloomberg October 2007 Do public markets lead? Derivative margin is divided by 10 Higher volatility, but no evidence of different turning points

Sale prices are more volatile than valuations

Sale prices are more volatile than valuations... Source IPD -10.0% -8.0% -6.0% -4.0% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% % Difference FranceGermanyNetherlandsUK...but some countries are more volatile than others

Client influence: the principal/agent problem Fund managers Reduce fees – or pass them on Maximise performance Achieve performance fee Valuers Maximise fees Increase market share Increase client satisfaction Who appoints the valuer? The investor or his agent? Are valuers rotated?

Client influence Portfolio valuations are often submitted in draft and sometimes subject to ‘negotiation’ The process invariably includes a client meeting to review draft figures - end of year valuations can be particularly difficult Two main effects - improvement and biasing Evidence of ‘shock’ to valuations when new valuers and/or managers are appointed

Consistent across borders Are markets different? –UK v Germany Do valuers apply different standards? –UK and German valuations of the same market sector

Capital value change,

Central London office capital growth % pa UK valuers German valuers Consistent across borders? Source: IPD

Central London office capital growth, Average Standard deviation German valuers0.37% pa3.67% UK valuers1.20% pa13.54% Consistent across borders? Source: IPD

Issues – property appraisal methods Market price - observed exchange price Market value - estimate of most likely selling price theoretically, one figure but practically a point on a distribution of possible values usually comparable based Germany v UK Investment worth - how much should an investor pay for the property? can be different for each individual or group, also a point in a distribution usually explicit cash flow (DCF) Discount rate Cash flow

Fair value, market value In accounting and economics, fair value is a rational and unbiased estimate of the potential market price of a good, service, or asset Market value is the estimated amount for which an asset should exchange on the date of valuation between a willing buyer and a willing seller in an arm's length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently and without compulsion Must be based on comparable evidence

Problems with fair/market value No market, no evidence Temporary distress (Brixton, 2009), temporary bubbles Bank balance sheets?

Is market value always best? A Vision for Real Estate Finance in the UK – from the Real Estate Finance Group – highlights that poor commercial real estate valuation and lending can invariably “cause or prolong” a financial crisis “The recent crisis has been no exception. The natural consequence of the 45 per cent collapse in UK commercial property prices between mid-2007 and early 2009 has been a pro-cyclical evaporation of financing capacity”

Sustainable or mortgage lending value - definition The mortgage lending value is the prudently calculated value of a property. It represents the value which throughout the entire life of the loan can probably be achieved for a property that is sold on the free market – irrespective of temporary (for example, economically- induced) value fluctuations in the respective property market. This requirement serves to eliminate speculative influences But how volatile is real estate as an asset class?

Investment worth The value of the property to a particular owner, investor or class of investor, for identified investment objectives. This subjective concept relates specific property to a specified investor, group of investors, or entity with identifiable investment objectives and/or criteria. Must be DCF and cash flow based Can clearly indicate under-pricing or over-pricing in the market

Conclusion We need internationally consistent valuation approaches –accurate and unbiased –professional and regulated –consistent across borders But we need three bases –market/fair value (UK/US) – performance, transaction advice –sustainable/mortgage value (Germany) – balance sheet, bank lending –investment worth (DCF) – consulting advice, bank lending?

References Baum, A and Hartzell, D (2012): Global Property Investment - Strategies, Structures, Decisions, Wiley Blackwell, 2012 Crosby, N. and Hughes, C. (2011): The basis of valuations for secured commercial property lending in the UK, Journal of European Real Estate Research, Vol. 4(3): Crosby, N. Lizieri, C. and McAllister, P. (2010): Means, Motive and Opportunity? Disentangling Client Influence on Performance Measurement Appraisals, Journal of Property Research 27(2):