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Ah, 2019, you wily rascal you. You strung us along with your record-breaking rental growth and transaction volume. The people I met in 2019 were either giddy with celebration of another year of strong performance, or eyeing the situation with utter skepticism, asking “what’s the catch?” I found myself speaking at several MRI and industry conferences around the world, discussing both the lucrative exploits of real estate investors as well as the likely timing, severity, and characteristics of the next downturn.
We of course considered the cyclical nature of the real estate cycle – the transition from recovery to expansion to hyper supply to recession – and predicted that this cycle, like the last one that came to an abrupt end during the 2008 global financial crisis, would likely be a short cycle…though, with a much milder downturn that, for many, would be barely an inconvenience.
Oh, but how wrong we were. Enter 2020 – 2019’s evil cousin. If I had stood up at those conferences and said “Adjust your investment valuations, my friends, and hold onto your cash, because your real estate investments, regardless of asset class or location, are going to see sharp declines in KPIs due to a global pandemic in Q1,” I’m sure I would have been booted out of the building with no buffet lunch to show for it. I might as well have been saying that aliens in giant spaceships will hover over each major city on the 4th of July and destroy all the real estate in a 10-mile radius with green lasers!
But here we are, and whilst the real estate industry dedicates a lot of attention to managing receivables and their financial run rate, there is much to consider in terms of property valuations and the cap rates that are on the rise. Sure, transaction volume has nosedived, with the exception of distressed assets that the PE community are lapping up, so perhaps folks are willing to ignore the near-term volatility. But what about the longer-term effects of this pandemic on how our valuation market chooses to function in the future? Let’s look at a few possibilities:
1. A renaissance for discounted cashflows?
Many regions of the world do not standardize their portfolio and investment valuations around the DCF methodology, and perhaps that will need to change. The consideration of NOI and NCF over a prolonged hold period means you can reduce the impact of any cashflow volatility that occurs within that timeframe, or even offset it by applying a stabilization factor at different points in time to negate anomalies.
On the other hand, the standard 10-year hold period itself may need to change, since the once-lauded steadiness and predictability of real estate investment is now a debatable concept. The modern real estate market is forced to evolve more frequently, primarily due to tenants and residents adopting new technologies and innovations, which in turn alters their expectations of where they live, work, and play. This type of flux is extremely difficult to predict over a 10-year timeframe, thus potentially discrediting any portfolio valuation based on assumptive data that extends that far into the future.
So how do you address this dilemma? One option is to leverage reliable software. For example, MRI Valuations has the means to navigate this issue and accommodate any eventuality. In one tool, property and portfolio valuations can be generated using multiple valuation methodologies – DCF, Equivalent DCF, Capitalization, Cost, Hardcore, Term & Reversion, and more – and the results can be compared to one another on a rolling monthly basis. The hold period for a DCF calculation can also be adjusted to any number of years, or automatically tapered to the end of your forecast timeframe as you roll from one period to the next.
2. An evolving dataset to manage the big picture
The current pandemic has also proven that cashflow and tenancy data alone are insufficient to determine a property’s true value. Other data points, and qualitative data in particular, are becoming more and more pertinent, such as sales and footfall in retail, automated communications and facilities in conventional residential, environmental metrics across the board, and so on.
This was already a changing landscape ahead of COVID-19, but appraisers now have the additional challenge of limited access to the physical site due to social distancing. Those responsible for collecting and reviewing all this information will rely more and more on third-party data providers and virtual/augmented reality to visualize the site from afar.
Services like MRI’s Data Management Services that make data collection, normalization, and aggregation a quick and simple proposition – regardless of data source and format – are emerging as essential services for most medium to large-scale real estate businesses. Asset/portfolio management tools like MRI Investment Central and MRI Analytix that empower users to visualize this data, including custom attributes, begin to deliver even greater value and ROI.
3. Not just an appraisal…an advisory service
Pre-COVID, third-party investment valuation service providers were primarily responsible for delivering a current appraisal based on tenancy data and cashflows. Today’s job description is greatly expanded. In addition to managing many more data points, which in many cases are client-specific, the market will likely look to these seasoned professionals to provide more than just today’s value – they could assume the responsibility of an advisory service to help maximize value over time and weather the storms ahead.
This means performing sensitivity analyses; shocking a portfolio with pessimistic hypotheticals, such as tenant insolvency, reduced sales activity, government restrictions that impact cash flow, stricter lending criteria or higher margins, market rent and inflation fluctuations, and more. MRI Asset Modeling and Fund Modeling solutions build on the fundamentals for producing a property or portfolio valuation by layering on scenario modeling capabilities to deliver valuations, returns, yields and other metrics based on any number of potential futures. We will likely see valuation service providers being asked to become more and more savvy in this area, thus adopting more sophisticated tools than before.
Does 2020 have more curve balls up its sleeve? All predictions aside, the best path forward for real estate firms is to create business agility through flexible tools and processes. New challenges may have long-lasting effects on the approach to real estate valuations in a post-COVID-19 market.