THE CHALLENGES faced by valuers are universal across asset classes and geographies, with the possible exemption of “deep” investment markets where there is considerable transaction activity, e.g. London, Paris, etc. Unfortunately, the biggest problem valuers face is a lack of “market signals” (comparable sales) which would allow them to undertake more accurate valuations.
Let us consider a simple way of valuing income producing property (and shares for that matter). The dividend discount model (DDM) is a method of valuing an asset based on the theory that an asset is worth the discounted sum of all of its future dividend/rent payments. In other words, it is used to value assets based on the net present value of the future dividends/rent. The equation most widely used is called the Gordon growth model. Because the model simplistically assumes a constant growth rate, it is generally only used for assets with stable income streams (e.g. commercial properties on long leases) with low to moderate growth rates.
Gordon’s growth model states that Y (the yield, i.e. rent divided by price) is equal to Rf (the risk free rate of return from an investment), plus Rp (the risk premium needed to undertake an investment alternative investment that will be “riskier”), minus G (the growth rate in the income from the dividends), i.e. Y=Rf+Rp-G.
Yields are just prices, or rather a multiplier to get the price of an asset (Rent/Yield=Price). If the income from a given property is 100 and the yield is 5% then its price is 2,000. If the yield rises to 6% then its price is 1,666. So the issue is really why prices fluctuated so much over the past five years. Basically prices dropped a lot in a period of market turmoil and then recovered. Why? Well, the economy was crashing, prices of most assets were falling. Why should real estate be different?
The appropriate Rf rate is causing a lot of head scratching at the moment. It should be noted that until recently Rf was mainly given to be the interest rate on five or ten-year government bonds, as these were deemed to be the safest possible investment. Clearly this is no longer the case, which in turn is part of the problem. Lots of hedge funds think that yields of UK/US (and some European) government bonds are far too low (i.e. overpriced) and are claiming that there is a government conspiracy to keep them low. They have basically bet against them staying so low and are losing money. Commentators like Paul Krugman state that current bond rates are pretty consistent with what economic theory (IS-LM) would predict in the current macro-economic climate – it’s Japan in the 1990s all over again. Smarter people than me know a lot more than I do about this.
The real estate risk premium (the Rp) must have gone up over the past five years. Assuming that in 2007 real estate had bubble components, then, as the bubble burst, a more rational real estate risk premium would emerge (i.e. the risk premium was too low in 2006-07). But also the real estate risk premium may go up (compared to what it SHOULD have been in 2006-07) as tenant default is more likely, voids (as leases end etc.) may be longer.
However, there is a basic simple issue here – if government bond yields fall, then yields of assets that have bond-like components should also fall. Calling it artificial is basically saying that the bond market is mispriced – it may be and it may not be. I don’t know. Financial assets are prone to mispricing. If the prices of real estate assets are theoretically based on the prices of assets that are prone to mispricing, then we, valuers, will also misprice.
The other thing that is missing is also ‘G’ – expected income growth has also fallen dramatically. It is also a component of yield, but no one knows what growth to expect in a market as uncertain as now.
So where have I got to… Bonds (yields) can be mispriced. Textbook derivations of property yields include bond yields as a component (it is implicit that they are correct). No-one ever told us what to do when there was possible bond mispricing – i.e. it is based on the assumption that bond prices are efficient. But why should they be? Nothing else traded in financial markets is.
The main thing that people are struggling with because of the Rf rate, is estimating a target rate of return. The underlying foundation (bond yields) is not perceived as reliable – so the answer to everything is basically to “find a plausible way to make the yield add up to 6% or 7%”.
There you have it. Valuers can’t value and now you know why.
Managing Partner | Real Estate Advisory