The
impacts from COVID-19 are yet to be seen in a property market context as
transactions generally follow a due diligence process and are less
liquid than the public market of the stock exchange. In terms of
valuations, we are seeing valuers starting to utilise disclaimers
highlighting ‘valuation uncertainty’. Valuers draw upon previous transactions
to form opinions of value and these have now occurred in a different
market environment to what we are currently experiencing.
Whilst
the consequences of travel bans, isolation, consumer uncertainty, supply
chain disruption, stock disruption and job loss are still evolving, we set
out below our considerations on the impact the pandemic may have on the
property market and valuations throughout 2020.
What happens to value?
To
appreciate what may happen to value, it is worth remembering the definition of
value which contemplates a willing buyer and a willing seller and what
they are prepared to transact the property for, at the effective date.
What
these parties will consider in their disposal / purchase decisions are the
various assumptions that feed into valuation analysis, of importance:
- Rental and cashflow
- Yields and discount rates
- Vacancy and prolonged impacts
What happens to rental income?
The
government’s reaction to COVID-19 pandemic has been to enforce strict social
distancing policies forcing businesses to close, with some property owners
being faced with the inability for tenants to continue to pay rent in some
cases. This has further been supported by the government encouraging
landlords and tenants to ‘talk to each other’ about rent relief.
While rent payment is the tenant’s legal obligation, loss of rent and
tenant fall over can be anticipated, noting some retailers have publicly
announced they will not be paying rent1 .
We
suggest an analysis of tenants can be undertaken to establish a revised
cashflow for a property, taking into consideration history of tenant
arrears, business models of tenants in terms of whether they provide
discretionary or essential services, their trading performance since
the impact of COVID-19 and their share price, if listed. In terms of
retail, turnover rents are likely to dissipate except for the likes of
supermarkets. Analysts may consider factoring in periods of loss of
income, abatements, deferred rents, increased incentives, tenant fall over and
extended periods of vacancy. Vacancy levels of 10-20% could be witnessed
as small businesses and retailers already under pressure prior to the
impact of COVID-19 fold.
What will cap rates do?
A
question a valuer always gets asked! With the above cashflow implications in
mind, and having performed some analysis and discussed with clients,
worldwide colleagues and auditors, we consider property will be affected
on a case by case basis. Prime assets are likely to remain sought after
given their more secure cashflows with stronger tenant covenants to banks,
government tenants and large corporates with locked in leases and minimal
near term capex requirements.
Secondary
grade assets of late have had almost divergent yields to prime stock. However
if an asset’s tenancy profile is deemed to present cashflow and / or
vacancy risk, a softening of cap rates is likely to occur. Similarly this
will occur for retail assets, which had already started to be seen, prior
to any influence from COVID-19. This will likely particularly apply to those
heavily exposed to tenants aimed at discretionary spending. The reletting
and vacancy risk will be certainly priced into an investment decision.
What we
can expect to see is a greater disparity of yields between prime and secondary
stock. This was evident 5-10 years ago where there was 200-300bp
difference in yields. That gap narrowed in 2018/19 and there was almost no
difference between asset classes due to high demand and the lack of
available stock with investors chasing return.
Tourism
and education assets are likely to have already experienced the immediate
impacts of travel bans and will face a long recovery period. These assets
may initially be viewed by some as having more of a cashflow crisis than a
significant change in cap rates, however the uncertainty of the duration
of the crisis will likely mean risk is priced in and inevitably a rerating of
these assets will occur.
Land and
development assets are likely to exhibit the most significant value
volatility. Unemployment levels and lack of consumer confidence may see
these assets to be the most dramatically discounted, akin to the post GFC
environment.
Volatility
in commercial property markets tends to be less observed as owners (other
than distressed owners) tend to hold and liquidity naturally reduces
during recessionary times.
Owners of
prime assets, especially those in Australia, have modest gearing and so
transactions that do occur will tend to relate to poorer quality assets
and this can further skew data available within poor market conditions. It
is likely that banks will be more careful about their lending decisions,
which means cashed up purchasers are more likely to be present in the market
who will demand a higher return on equity.
Time will
tell whether there are a number of ‘forced sales’, noting that if this type of
transaction regularly occurs, these transactions can tend to become the
market expectation for pricing.
What will the long term impacts be?
Following
the GFC, a flight to quality was observed in the demand for property assets.
The COVID-19 crisis could result in structural changes to how the real
estate market evaluates tenants in terms of risk, noting that occupiers
providing essential services diversify risk under these circumstances and
tenants offering essential services may be considered to offer a
robust covenant.
Assets
with a diversified income, including government and essential services tenants,
and a broader spread of tenant type are likely to be sought after. We
may see the change of use of some more secondary assets to a higher and better
use.
Other
decisions around property may include sale and leaseback arrangements becoming
more prevalent as businesses seek to improve cashflow, their balance sheet
and reinvest capital in their businesses.
Assets
with direct exposure to offshore visitors such as tourism will likely reveal,
at least for the medium term, structural repricing. In terms of
occupier demand, tenants may not necessarily demand lower rents, but will look
to be more efficient with their space requirements. Tenants are likely to
realize efficiencies in terms of space requirements following adapting to
working from home and similar arrangements. A reduction of floor space may
occur as tenants who have evolved to utilize digital technology over this
hibernation period, look to reduce nonessential spaces that were previously
utilised for group gatherings and functions. We may see renegotiating and
restructuring of leases and an emphasis on a healthy and hygienic
environment in the office sector.
In the
industrial market, occupiers involved in key supply chain activity will be more
highly sought after, whereas businesses reliant on offshore demand will be
less sought after.
Retail is
likely to face a challenging recovery period as confidence needs to rebuild
amongst households. Job losses, job security and uncertainty may cause
more people to save or pay down debt which will further increase the
period of recovery. Some retailers may use the hibernation period as an
opportunity to permanently shut down underperforming stores
and restructure their operations following having to adapt to an online
platform. It will be interesting to see how food and beverage retailers
recover from social distancing and the impact their struggle has on retail
assets as they have represented a large proportion of lettable area
within centres.
Overall a
challenging reletting market is likely to occur coupled with expectations of
incentives. We may see new clauses drafted by the legal profession to
cover similar events providing more flexibility for the tenants in times
of significant uncertainty.
How are valuers going to approach COVID-19?
Valuers
are required to report at a specific date and reflect market conditions at that
time. Events such as COVID-19 create valuation uncertainty, because the
only inputs and metrics available for the valuation are likely to relate
to the market before the event occurred and the impact of the event on
prices will not be known until the market has stabilized.
Currently,
there is no way of confirming the movement through transaction data as yet
and valuers will need to rely on all information available to them when
they complete and submit their market value assessments. Valuers can
reflect, for example, historical evidence that suggests how property
markets might move under differing economic, monetary and
fiscal conditions.
Expect
valuers completing valuations during the COVID-19 crisis to:
- caveat their advice, referencing some of the issues outlined above
- reference the high valuation uncertainty, and that there is more downside than upside value estimation error
- reserve the right to reconsider their advice as events unfold and if these events are likely to have a material impact on value. This might extend to valuers recommending that they review their advice prior to the next financial reporting date and as market evidence occurs. More regular valuation reporting will likely be needed to keep advice up to date.
Valuers
will have to estimate the appropriate discount and/or capitalisation rate to
apply for their analysis. When markets are stressed, valuers will need to
consider issues such as the need for liquidity premiums and whether it is
appropriate to consider additional risk premiums to account for the
greater degree of uncertainty in estimating cash flows. Care will need to be
taken in deciding on the appropriate level of additional risk premia and
significant judgement will be required. We would recommend that the
reasoning for any additional premia is documented within valuation reports
to provide transparency.
The
Australian Property Institute suggested that its members utilise the following
disclaimer:
The outbreak of the Novel Coronavirus (COVID-19)
was declared as a ‘Global Pandemic’ by the World Health Organisation on 11
March 2020. We have seen global financial markets and travel restrictions
and recommendations being implemented by many countries, including
Australia. The real estate market is being impacted by the
uncertainty that the COVID-19 outbreak has caused. Market conditions are
changing daily at present.
As at the date of valuation we consider that there
is a significant market uncertainty. This valuation is current at the date
of valuation only. The value assessed herein may change significantly and
unexpectedly over a relatively short period of time (including as a result
of factors that the Valuer could not reasonably have been aware of as at
the date of valuation). We do not accept responsibility or liability for
any losses arising from such subsequent changes in value. Given the
valuation uncertainty noted, we recommend that the user(s) of this report
review this valuation periodically.
Meanwhile,
The Royal Institute of Chartered Surveyors (RICS), which provides global
guidance to valuers, suggests on their website (as at 29 March 2020) that
its members consider advising their clients that they:
“… attach less weight to previous market evidence
for comparison purposes, to inform opinions of value. Indeed, the current
response to COVID-19 means that we are faced with an unprecedented set of
circumstances on which to base a judgement.”; and
report their valuations “on the basis of ‘material
valuation uncertainty’ as per VPS 3 and VPGA 10 of the RICS Red Book
Global. Consequently, less certainty – and a higher degree of caution –
should be attached to [our] valuation than would normally be the case.
Given the unknown future impact that COVID-19 might have on the real
estate market, we recommend that you keep the valuation of [this property]
under frequent review.”
Notwithstanding
the above, valuers will need to advance their thinking on how they
structure their valuation reports to ensure they communicate their
opinions and assumptions in a way that assists their clients with
evaluating the valuation advice and presenting it in a meaningful way
to their stakeholders.
In Conclusion
Considering
the likely impacts on the major assumptions of value, we suggest a softening
of capitalisation rates is likely to occur across most asset classes.
We see
‘value add’ properties climbing higher up the risk curve with an emphasis
placed on well leased property to secure tenants with fixed growth, such
as prime assets, where capital will continue to seek diverse and secure
cashflows. Australia has traditionally been favored for its transparent
market and strong governance and will likely continue to attract offshore
capital.
A short
term effect on cashflow from discretionary type tenants and those businesses
which can be called non-essential services may eventuate. Pricing in for
risk of vacancy and letting up allowances is likely to occur.
The
recovery time for tourism and retail assets will depend on the duration of the
crisis. The longer it goes on, the longer the recovery time will likely
be, as unemployment and uncertainty perpetuate and households move to
saving and paying down debt.
Valuers
will include new disclaimers and utilise evidence available to them at the time
and should ensure to articulate fully their assumptions and opinions.
Valuers should be open to having transparent dialogues with clients and
their auditors as this crisis evolves. Their advice may require more regular
updating, noting as more transactions occur throughout the crisis these
will reveal how the market is responding.
-PWC
