Valuation uncertainty and property risk
20 March 2009
A familiar question to valuers in current market conditions is likely to be: how can you value property in market conditions where no debt or buyers are available, and where the only transaction evidence is from forced sales?
Investment inactivity caused by property market uncertainty, and wider financial market volatility, means there is little transaction evidence on which to base values. Prices achieved in recent years have been driven by freely available debt and tremendous investor demand. The freezing up of the debt markets and weakening confidence have seen the property markets decline rapidly with greatly diminished trading activity. The lack of comparable deal activity means greater reliance on the valuer's market judgement. In this environment, clients are naturally holding valuations up to greater scrutiny, meaning valuers need to be more explicit with their clients about the reasoning and the thought processes on which their advice is given.
Despite these difficulties, valuers are still faced with the requirement to provide an opinion of Market Value to a wide variety of clients with differing concerns. Investment managers of long term funds like to see stability and will resist falls in values - many in the market are even questioning the validity of the Market Value definition in these current uncertain conditions. Other clients such as refinancing banks focusing on sensible underwriting or receivers and administrators needing to turn assets into cash will be more accepting of a valuer's judgement on the market correction.
Some users of valuations may say that this reliance on valuer judgement invalidates the results (particularly if they don't like the results). However, valuation can not rely completely on comparable evidence. Making a judgment about investor sentiment is important when valuing in all markets, whether rising, stable or falling. In a rising market this is arguably easier as there is lots of bidding activity to demonstrate investor sentiment. In the present market, this is not the case and it is even more important for valuers to study investor and vendor behaviour closely in building their valuation case.
So what market activity is taking place? Most investors are not looking to buy at the moment unless attractive opportunities can be found. Many are holding back on the expectation of further market falls. With property and financial market risk at high levels and very limited debt, purchasers are simply seeking higher returns for higher risk and are prepared to wait for it. The cost of their equity has therefore risen and buyers see vendors who are not willing to trade at their level as unrealistic about current pricing.
What about the sellers? Some observers argue that any vendors prepared to sell in the current market must be forced sellers and so prices achieved are not true reflections of Market Value and therefore should be disregarded as evidence. On closer analysis, while many investors currently selling are certainly motivated by external pressures, such as from their lenders or equity investors, many are not truly forced sales. The RICS Red Book offers guidance on this in PS 2.3(5) 'Forced sale arises where there is pressure on a particular vendor to sell at a specific time, for example, because of the need to raise money or extinguish a liability by a given date... the time constraint is not merely a preference of the vendor'. The most important factor in concluding whether a sale is forced is therefore whether a vendor gives a reasonable period of time or a fixed date to effect a sale. Valuers must therefore consider fully the context of such transactions, especially the vendor's motivation and time allowed for marketing.
As well as analysing the limited completed transactions, valuers should observe the sales processes of comparable properties offered to the market but which may not have sold. In conditions like this, the valuer can gauge a great deal about market pricing by observing the level and depth of bidding activity and whether price reduces throughout the sales process as vendor and purchaser expectations come closer. It is therefore especially important for valuers to have a full dialogue with investment agents and clients who are trading properties. This 'soft' evidence will assist the valuer in establishing where current market pricing lies in the absence of completed transactions.
Fundamental property risks are often overlooked in a rising market but when conditions change these negative attributes will begin to impact pricing as the market's sensitivity to risk increases. Investors' definition of a prime location tends to widen in bull markets but will narrow in a bear market, short leases and vacancy are no longer viewed as asset management opportunities but become risks which will attract discounts in pricing. Valuers need to identify such issues and to discuss their impact openly with clients.
The RICS Valuation Standards Guidance Note 5 provides guidance to valuers in relation to valuation uncertainty. A recent information bulletin issued by a working party of the RICS International Valuation Faculty Board - 'Valuation Uncertainty and Market Instability' provides further notes on the application of GN 5 in the light of the continued market uncertainty. This paper stresses the importance of the valuer identifying and explaining the reason for and extent of valuation uncertainty. The paper also encourages valuers to have a dialogue with clients to establish any special assumptions and to comment on the degree of subjectivity in the valuation figure. A reminder is given to consider the provision of forward looking advice and for certain assets, such as development properties a sensitivity/risk analysis. Importantly, the paper emphasises that it is not acceptable to have a standard caveat to deal with valuation uncertainty but that valuers' emphasis should be to provide considered and authoritative professional advice.
Valuers are facing a very difficult task in reaching their conclusions and in conveying these to their clients at the present time. It is therefore more important than ever to:
- Be clear about the basis of valuation and any assumptions.
- Establish the full background to relevant market transactions so that they can be interpreted correctly.
- Review and analyse the soft market evidence to inform valuer judgement fully.
- Identify the key attributes and risks of the property and explain how these impact value.
- Explain the context of current valuation uncertainty having regard to GN 5 and recent advice in 'Valuation Uncertainty and Market Instability'.
Dermot Charleson, Director, Pan European Valuation