FEATURE: The art of valuation

As private equity real estate fund managers prepare their year-end valuation reports, how are GPs facing the challenge of marking to a rapidly declining property market? PERE magazine February 2009 issue

Determining the value of a real estate asset should be simple. It is merely the price two willing parties – the buyer and seller – perceive to be as correct at the time of a transaction. Easy.

Easy, that is, unless you happen to be invested in a market where little to no transactions are taking place, where the spread between seller and buyer expectations is getting wider and where valuations are expected to decline even further as fundamentals continue to weaken.

All real estate sectors, in all countries, have weakened during the past four months. Now as private equity real estate managers sift through the wreckage that was the final quarter of 2008, many are facing the prospect of write-downs on existing investments and the need to re-evaluate strategies for certain assets and even portfolios.

Art, not science

Valuing properties though is not a science. Indeed, arriving at a valuation can often be more of an art form. In deriving valuations, fund managers and appraisers will undoubtedly look to comparable real estate transactions, present and future income streams and replacement costs.

Few professional investors will admit to being swayed to the emotions of real estate. Why should they after all, an investment is about business. But as everyone knows the three most stressful experiences in life involve death, divorce and moving home. Some commercial real estate owners are today acting no differently from emotional homeowners when it comes to valuing their assets in a declining market.

As one GP says, it's like the parent whose child can do no wrong. Teachers who inform the parents dear Johnny isn't performing very well are often blamed for Johnny's failures instead. “Some owners are just being too optimistic,” he added.

The problem with valuations, as told by numerous market participants interviewed in the course of researching this article, is that although appraisers use the standard cost, income and sales comparison approaches in assessing the value of a property, there is no global standard relating to the assumptions used, who should do the valuation and how often.

Little black and white, lots of grey

International accounting rules have tried to address some of these issues (see p. 31 for the debate surrounding this issue) by requiring assets and liabilities to be updated at each reporting period. However even these accounting standards have plenty of grey areas. Typically, private equity real estate funds will conduct third party evaluations of their entire portfolios on an annual basis and internal reviews each quarter where an individual asset has witnessed a material change in pricing. It is not a hard and fast rule though.

Of the fund managers PERE spoke with, some hold external valuations every quarter, some value half the portfolio twice a year on a rolling basis, some do internal valuations every six months and others have third-party appraisals of a third of their portfolios each year. Real estate valuations are often as diverse as the underlying assets, with valuation methods varying as much between different countries as they do between different property sectors.

In the UK (and to some extent continental Europe), the valuations process is seen as more transparent, with the appraisal industry regulated by the Royal Chartered Institute of Surveyors (RICS), a professional body encompassing all the building and property-related professions. The further away from the UK you travel, the less “efficient” that process is percieved as becoming, according to some professionals PERE spoke with.

Whether you agree with that analysis or not, most agree repricing in the UK is “ahead of the curve”, not least in comparison to the US.

According to the property data company IPD, UK commercial property returns in 2008 look set to surpass the landmark losses recorded in 1990 with all property total returns falling -18.2 percent in the 11 months to November 2008, compared to -16.2 percent almost 18 years ago. In November alone, total returns and capital values for all sectors of the British commercial property market fell by a record -5.1 percent and -5.7 percent respectively, the largest monthly declines ever recorded by IPD.

In the US, the National Council of Real Estate Investment Fiduciaries (NCREIF) monthly property index recorded total and capital returns as falling by just -0.17 percent and -1.42 percent respectively in the three months to September last year. NCREIF's index of real estate funds, the NCREIF/Townsend Group real estate fund index, however does highlight the pain being felt by opportunistic real estate vehicles, with total and capital (time weighted) returns of -12.3 percent and -12.4 percent being recorded respectively in the three months to September 2008. Closed-end value added funds recorded total and capital returns of -3.1 percent and -3.9 percent respectively for the same period.

Learning from history

During the RTC crisis of the 1990s, the US saw property prices fall by roughly a third across all sectors, with some sectors, such as office, seeing peak to trough declines of up to 55 percent, according to one real estate secondaries veteran. Today, a handful of real estate investment professionals told PERE they expected commercial real estate valuations to fall by as much as half their peak.

The same is true in the UK. According to the RICS, commercial property markets in the UK are expected to see peak to trough declines comparable to the downturns of the two recessions of the 1970s and 1990s. Capital values, the organisation say, are expected to fall a further 16 percent in 2009, on top of declines of around 25 percent since the start of the credit crunch in June 2007. The office sector could be one of the hardest hit, with values falling – peak to trough – by up to 60 percent.

It is time, as one GP states, for fund managers to go “kiss your bricks”. Aggressive asset management is vital, adds Spencer Garfield, managing director of New York-based Hudson Realty Capital. “You have to let the market speak to you, rather than you speak to the market.”

Hudson, which makes debt and equity investments in mid-market value-added real estate opportunities, says today's real estate markets have seen valuations become increasingly difficult – and increasingly important. It is just one of many firms to have increased the number of staff marking assets in an effort to stay ahead of a rapidly changing market.

Garfield says that as part of its (now longer) valuation process, the firm has also changed many assumptions, including increasing the hold periods of assets, and underwriting properties with higher capitalisation rates, higher discount rates and lower occupancies. “The worst thing you want to do in a market that we are seeing today is to tell your investors an asset is worth X and then a short-time later tell them it's worth X minus a certain amount,” adds Garfield.

Valuations, he notes, are never exact – especially in a volatile market. “Some factors will make you go back and re-evaluate.”

Sign of the times

With economic and real estate fundamentals expected to worsen further in 2009, there are plenty of factors ahead to make all fund managers fairly pessimistic when valuing their assets. In November, the International Monetary Fund predicted world activity would grow by 2.2 percent in 2009, down by 75 basis points on projections just one month previously. In developed economies, output is forecast to contract in 2009, the first time since the Second World War.

As the industry celebrated a new year, headlines were filled with news of mounting job losses, rising vacancies, falling rents and increasing levels of bankruptcy and repossession. “Real estate values are affected by everything around them,” says Peter Slatin, editorial director of data provider Real Capital Analytics. “Real estate valuations cannot be assigned in isolation. Nothing should ever be taken for granted in an economic downturn.”

And few GPs are taking anything for granted. Instead of focusing on capital values, as some fund managers did during the height of the market, GPs are now concentrating ferociously on the operational side of their investments, the bread and butter of real estate: rent.

“If your portfolio shows a loss you can live with that, it's when you start losing tenants, that's the real pain, that's real cash flowing out of your pocket because it hurts both sides of the equation – the actual income and the valuation of your real estate asset,” says Zelick Altman, managing director of LaSalle Investment Management Canada.

LaSalle appraised its entire portfolio on 30 September 2008, owing to market volatility and to make sure “investors have a realistic view of what a property is worth. Investors, and GPs, don't want surprises,” adds Altman.

Rising cap rates

One thing that won't be a surprise to the industry in 2009, though, is cap rate expansion.

Maria Clarke, managing director and chief investment officer, of the Washington Fund, sponsored by Hart Realty Advisers, says commercial real estate was the last place investors attempted to hide from the global economic downturn. “There's no hiding anymore. We are being much more conservative than we were even a year ago.”

Traditionally, fund managers would use some rent growth assumptions when assessing assets. Today, the Washington Fund, along with many others, is assuming zero rent growth in its valuations. Residual cap rates, Clarke adds, are now also 50 basis points higher upon entering a deal, and 100 basis points on exit.

It's a scenario backed by Gary Koster, national director of Ernst & Young's real estate investment funds group. A straw poll of GPs conducted by the group at the end of September 2008, revealed that half of fund managers believed cap rates for US commercial properties would rise by up to 50 basis points during 2009. Almost four out of 10 of those questioned said they would rise by more than 50 basis points, while 17 percent said they would remain unchanged.

In Europe, cap rates have already risen from an average of 5.72 percent in 2007 to 6.28 percent in 2008, according to Real Capital Analytics, while in Asia, cap rates are also expected to rise across the five property group. The PricewaterhouseCooper/ Urban Land Institute Emerging Trends in Real Estate Asia Pacific 2009 report predicts cap rates in the Asian industrial sector rising by 39 basis points to 7.57 percent. Office, retail, multifamily and hotels are expected to see cap rate increases of 24, 21, 18 and 15 basis points, respectively, by the end of 2009. Do an all-equity opportunistic deal and your cap rate will be an automatic 20 percent.


According to Koster, most GPs are doing a “good job” of disclosing valuation assumptions. However, as he notes, there is a certain level of discomfort on all sides. “No one ever wants to report something to an investor that turns out not to be true. In this environment, where there are absolutely no value-confirming events, GPs will feel uncomfortable and for good reason. In 25 years, I've never seen this type of market.”

As private equity real estate fund managers prepare year-end reports, some question whether there is enough motivation among over-leveraged GPs to aggressively mark down portfolios, especially if it could impact on an asset's loan covenants – and their ability to fundraise in coming years.

“There are some tough decisions to be made by some people,” says one real estate veteran. “Do you lose the assets and impact your fund performance, or do you try to protect something that you consider to have value? Valuations got scarily high during 2006 and 2007 – the chickens are now coming home to roost.”