Valuation in an uncertain World Part 3 
Tim Millard, Head of the JLL Advisory Group Russia&CIS, highlights some issues in arriving at an opinion of property value when market conditions are, at best, uncertain or, at worst, non-existent end explores how they may be dealt with.
When I wrote the first blog on this topic I thought that it would be a one off. It now seems that it needs to be a recurring theme! My experience of carrying out market valuations of property over the past few years in Russia has highlighted a number of issues in arriving at an opinion of value when market conditions are, at best, uncertain or, at worst, non-existent! This, then, is a more technical post exploring some of these issues and how they may be dealt with.
Independent valuations are of heightened importance in such circumstances. They provide reassurance and backing to investors, banks and stakeholders and allow the continued operation of the markets at all levels in the capital stack. However, it can be very difficult to arrive at robust findings and to defend them to parties who, quite often and perfectly legitimately, have vey different interests. Although there may be a temptation to work from the worst-case scenario, this is rarely helpful in my opinion. Much better to try and understand all of the forces that are at play.
Be warned – this is not one of my 2 page numbers dealing with issues in a concise and entertaining fashion…for those that venture further there is quite a lot of technical analysis which necessarily requires quite a lot of details (and length!) although I will try and keep everything in laymen’s terms. For those of you who want the short version, please skip to the section headed: “If you read nothing else” at the end of the blog.
So, let’s start form here…Market Value is usually defined as: “The estimated amount for which an asset or liability should exchange on the valuation date 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” (e.g. International Valuation Standards (IVS) 104, paragraph 30.1). This raises quite a few issues in a dislocated market:
1. Firstly, though, it should be clarified that it is an “estimated amount”. I.e. a valuation in a report will always be an opinion formed by a valuer based on the facts attributable to any specific property and their understanding and interpretation of the market. It is perfectly legitimate, and indeed healthy, for different valuers to have different opinions, not least because there are in theory a number of allowable valuation approaches and methodologies (well perhaps not, but more on that later). One would hope and expect that the difference in opinions would, in most cases, not be significant or material. However, in dislocated markets or those lacking transparency it is not uncommon to see wide variations. This can cause many problems, not least if any valuer is reluctant to accept the legitimate opinion of their brethren.
2. Starting from the end of the definition and working backwards – “without compulsion” means each party is motivated to undertake the transaction and is not being forced to (IVS 104, paragraph 30.2(i)). It is often the case that “a willing seller” will be just that when the best price reasonably obtainable in the market provides a fair return. However – in a market that is severely dislocated this may be significantly different from what “a willing buyer” is prepared to offer, or indeed accept, as the most advantageous price reasonably obtainable by the buyer (IVS 104, paragraph 30.2(a)). Where the best bid available in the market from willing buyers is not enough to induce willing sellers to trade what is the market value? When the bid - offer spread is so wide that there are no genuine transactions taking place without compulsion where does the correct market value lie?
3. To take this analysis a little further – some would say that the market value is the bid a willing buyer would make, and therefore that is the level at which a transaction could take place. However, if it is a bid that no willing seller acting prudently and without compulsion would accept, then by definition it is not market value.
4. An approach which equates Market Value to either end of the range would have real world consequences. As one example, taking the willing buyer bid level as a proxy for Market Value could quite easily result in valuations so low that they push a large number of properties into technical default of loan-to-value ratios. This could either result in borrowers having to pay down loans to correct the default, requiring new financing which may be scarce, expensive or not available, or in a lot of properties coming to the market further depressing prices when demand is low and triggering a downward spiral.
5. Conversely, using the willing seller’s offer price as a proxy for Market Value would send a signal that the market is unaffordable, dissuading new entrants from coming to the market. Banks and investors would also have little or no faith in the valuation levels effectively killing all activity.
6. Valuers of all stripes have a responsibility to understand the potential effects of these different approaches.
So, how should we approach arriving at an opinion of Market Value when faced with what seem like unsurmountable challenges?
IVS 104 Paragraph 30.6 states – “The data available and the circumstances relating to the market for the asset being valued must determine which valuation method or methods are most relevant and appropriate. If based on appropriately analysed market-derived data, each approach or method should provide an indication of Market Value” (The emphasis is included in IVS 104)
It is not an optimistic start that even if you do everything correctly you “should” get an “indication of Market Value”. However – where market data is limited, either due to a lack of transparency or lack of activity, the importance of selecting the appropriate and relevant method or methods is exaggerated.
So, what does the toolbox of available valuation methods look like. And what are some of the challenges and consequences associated with employing each in our challenging market situation?
IVS 105 is helpfully titled “Valuation Approaches and Methods.” It will surely be no surprise to any of my readers that this includes the Market Approach, the Income Approach and the Cost Approach. There are also details of certain of the most commonly used methods within each approach, without striving to be exhaustive.
Let us start by seeing if there any approaches that can be eliminated.
The Cost Approach
The cost approach is included in para 60 of IVS105 and includes the following:
60.2 The cost approach should be applied and afforded significant weight under the following circumstances:
(a) participants would be able to recreate an asset with substantially the same utility as the subject asset, without regulatory or legal restrictions, and the asset could be recreated quickly enough that a participant would not be willing to pay a significant premium for the ability to use the subject asset immediately,
(b) the asset is not directly income-generating and the unique nature of the asset makes using an income or market approach unfeasible, and / or
(c) The basis of value being used is fundamentally based on replacement cost, such as replacement value
The cost approach is therefore appropriate in only a very limited number of specific circumstances and certainly, due to paragraph (b) above, it is never appropriate for investment properties.
The Market Approach
The market approach is included in paragraph 20 of IVS 105 which includes, inter alia, the following:
20.2 The market approach should be applied and afforded significant weight under the following circumstances:
(a) the subject asset has recently been sold in a transaction appropriate for consideration under the basis of value,
(b) the subject asset or substantially similar assets are actively publicly traded, and/or
(c) there are frequent and/or recent observable transactions in substantially similar assets
I would contend that, as the basis of this blog is that there are no, or very few, reliable data available in the market, the Market Approach is not appropriate or relevant under these circumstances. So…
The Income Approach
The applicability is covered by paragraph 40 of IVS 105 and includes the following:
40.2 The income approach should be applied and afforded significant weight under the following circumstances:
(a) the income producing ability of the asset is the critical element affecting value from a participant perspective, and/or
(b) reasonable projections of the amount and timing of future income are available for the subject asset, but there are few, if any, relevant market comparables. (emphasis is mine)
This will apply for almost all investment properties that are being valued in low volume and / or low transparency markets.
So, under almost all circumstances we should be using the Income Approach.
Let us then consult paragraph 50.1 of IVS 105 which deals with Income Approach Methods
50.1 Although there are many ways to implement the income approach, methods under the income approach are effectively based on discounting future amounts of cashflow to present value…
So essentially the only choice is to use the discounted cashflow method (DCF), fickle mistress though she may be.
So far so good. We have identified that in low volume and / or low transparency markets we are limited to use the Income Approach and specifically the DCF methodology. This is where it gets interesting, at least for those of you have persevered this far it is likely to get interesting! There are 6 essential steps in any DCF (see para 50.4 of IVS 105):
a) Choose the most appropriate type of cash flow,
b) Determine the most appropriate explicit period,
c) Prepare cash flow forecasts for that period,
d) Determine whether a terminal value is appropriate,
e) Determine the appropriate discount rate,
f) Apply the discount rate to the forecasted cashflow.
So – simple then. No! Not at all. There are very many factors that go into a cashflow and all of them have a more or less significant impact on the outcome. Understanding the relative sensitivities and managing them is key to applying the method accurately – and also an understanding that DCFs can be unpredictable and often require careful interpretation. The result of a DCF analysis should not be treated as gospel – it cannot be taken on faith!
As you will by now expect there are specific issues around every element of developing a DCF. Below is my commentary, taking account of, and building on, IVS105 paragraph 50:
Type of cash flow: The valuer should use the type of cash flow that is most relevant to the property being analysed – that means that the cashflow should reflect the basis of analysis of market participants. I.e. what do the players in the market look at when analysing investments.
So, the cashflow can be pre or post tax, nominal or real and in any currency. However, in my opinion, in an environment where inflation can change rapidly and is difficult to predict a nominal cashflow is more robust.
Furthermore, in markets where corporate structuring is extensively used, both onshore and offshore, it is preferable to use pre-tax cashflows for property valuations as the effective tax rate can vary greatly on the type of specific corporate structure employed. As it is specific it cannot be applied to the universe of willing buyers.
Forecast period : The shorter a cash flow period, the more likely it is to be (reasonably) accurate. The longer it is, the more variables that come into play. However, it is important that the period allows for an asset to become stabilised, i.e. to reach a level of income in line with market rents. Otherwise the terminal value (see below) is likely to be derived from a NOI that is not sustainable and the valuation opinion will therefore not be robust.
The approach to forecast period should not be dogmatic but should be tailored to the individual circumstances of each subject asset. A property which is rack rented will probably benefit from a direct capitalisation. Where there is long dated income which differs from market rental values it is likely to be necessary to extend the period of analysis beyond the reversion of any over or under rented leases.
Cash flow : Start with the facts. Use actual leases to populate the cashflow as far as possible. When looking at reversions, on the termination of current leases, market practice should be taken account of – but also the stage of the economic and property cycle. Where rents are below the long term trend, applying the current market levels at reversion will result in an under valuation, and vice versa. Valuers need to take account of broader trends in occupational and investment markets and be prepared to make forecasts about the future direction and pace of travel of market metrics. If the cyclical nature of property markets is not properly accounted for then results will be perverse. An unusual amount of judgement is required from valuers when forming opinions of value in low volume markets, as indeed they are in very active markets which can be frothy at the top of a cycle. In such circumstances the ability to make judgements, beyond analysis by rote, should be particularly prized.
Terminal Value: Assessing the terminal value correctly is of vital importance and one of the most important factors in arriving at a reasonable opinion of value. IVS 105 includes a number of helpful provisions in this regard, all of which should be taken into account. For example:
50.21(e) for cyclical assets the terminal value should consider the cyclical nature and should not be performed in a way that assumes peak or trough levels of cash flows in perpetuity
50.26 When a market approach / exit value is used, valuers should comply with the requirements in the market approach and market approach methods section of this standard…valuers should consider the expected market conditions at the end of the explicit forecast period and make adjustments accordingly (emphasis mine)
So, the assessment of exit value should take account of the market and how the market will evolve over the period of the analysis. An alternative is provided by sections 50.21 and 50.23 of IVS 105:
50.21 The terminal value should consider:
(a) whether the asset is deteriorating / finite-lived in nature or indefinite lived, as this will influence the method used to calculate a terminal value…
50.23 Gordon Growth Model / Constant Growth Model – the constant growth model assumes that the asset grows (or declines) at a constant rate into perpetuity (emphasis mine).
As all properties have a finite life, and as all property markets are cyclical, the constant growth model cannot be used, and the valuer is beholden to make forecasts as to the exit value of the asset.
There is some further commentary on the Gordon Growth Model below, for those of you for whom it is of interest.
Discount Rate: The discount rate is obviously an important element of any DCF, although often it is not the most sensitive factor included in the analysis. IVS 105 (paragraph 50.30) makes it clear that the valuer can use any reasonable method for developing a discount rate. Due to the flexibility afforded, valuers should show similar flexibility in interpreting the approach of there peers. Provided the analysis is reasonable then it is acceptable. IVS 105 also includes the following:
50.31 In developing a discount rate, a valuer should consider:
(a) the risk associated with the projections made in the cash flow used,
(b) the type of asset being valued…
(c) the rates implicit in transactions in the market,
(d) the geographical location of the asset…
(e) the life / term of the asset and the consistency of inputs…
(f) the type of cashflow being used, and
(g) the bases of value being applied. For most bases of value the discount rate should be developed from the perspective of a participant
This last point is key – as the discount rate should be developed based on the attitudes of particpants who are active in the market and extra weight should be given to their attitudes and approaches.
At this point I need to say a few words about the Gordon Growth Model. At a certain point, I know not from whence, a practice as sprung up, in certain circles, of applying the Gordon Growth Model to property valuations in Russia. In my view there is no justification for this for the following reasons:
Constant growth: the model assumes that there is constant growth – in the income, not just in one input to it. This will never be the case in a property cashflow. Take for example index linked rental increases. These are usually linked to an index such as CPI – these will never be constant.
Perpetuity : Gordon is for cashflows that go on for ever, with constant growth. No property is indefinite lived
Terminal Value: In any event Gordon is a method for calculating terminal value – it is correctly applied by subtracting the constant growth from the discount rate to get the exit cap rate. It is not a way for calculating a discount rate. However, such a dogmatic approach ignores the broader property market trends and their cyclical nature – valuation cannot operate in a vacuum that ignores what is happening in the market.
So, a plea - can we please, please stop thinking that the Gordon Growth model can in any way be applicable to property valuations, anywhere! It was not designed for this purpose.
If you read nothing else: In using the (essentially proscribed) discounted cashflow: be pragmatic, be conservative but not overly so. Understand the attitudes of participants in the market. Be prepared to make predictions about future market conditions (both rental rates and capitalisation rates), but based on experience and broader economic conditions, not fantasy. Use pre-tax, nominal cashflows. Be robust in developing your discount rate and justify it based on the attitudes of market participants. Keep the forecast period as short as possible, but long enough to allow the market to stabilise, understand there is not an answer for everything and embrace that fact, accept that valuation is as much art as science and respect the opinion of others. Consign the Gordon Growth Model to the dustbin of property valuations where it belongs.
Valuers almost invariably act in good faith. When you sign a report, you are staking a lot that you believe in your own opinion – it really should take a lot for others to challenge the responsibility that entails.
1 Starting with a disclaimer – this blog represents my personal view only
2 Much of this blog will concern how to apply International Valuation Standards under limited market conditions