With rising COVID-19 infection rates, renewed lockdowns and the sharpest contraction in the U.S. economy since World War II, commercial real estate owners and investors are keeping close watch on the factors impacting property values. The challenges are daunting for most major asset classes, but no one has a precise view of the size and scale of the impact, or how long the disruption might last.
“We try to be as realistic as possible with valuations,” said SitusAMC Director Meredith Young, who works on valuations for a portfolio of 700 assets which require quarterly review. “It doesn’t seem that there are sure bets anymore. Things assumed previously – like a tenant’s ability to pay or maintain occupancy at a center is changing at a rapid pace. Everything is very fluid.”
Given the uncertainty and market volatility, what factors should owners and investors consider to get a handle on values? The following are good places to start:
Fundamental Versus Technical Value
The industry has seen a significant disconnect between public and private real estate values, with values on publicly traded real estate investment trusts (REITs) falling more than 18 percent between March 20 and June 20, as measured by to the FTSE Nareit Equity REITs Index (FNRE). But quarterly fluctuations in public market values are often not reflective of underlying asset values, and therefore not particularly meaningful to the private market, Young noted.
“Short-term, the public markets are not a great proxy for intrinsic real estate values,” Young said. “In the private market we are practicing fundamental valuation, which involves a lot of data sources and frequent, careful analysis of property performance, supply, demand, leases and ultimately a cash flow. The public market is trading based on technical value, which uses price and volume and considers the patterns and trends of what a stock might do. It can be tied to sentiment; the motivation of buyers and sellers in the public market is not known and doesn’t reflect reflect the motivations of buyers and sellers in the private market.” Over time, Young expects public and private values to converge.
A Focus on Collections and Occupancies
Investors, owners, asset managers and appraisers are getting up close and personal with tenants to understand exactly how they make money and how the pandemic is affecting their incomes, and ultimately, property values. On the multifamily side, more than 30 million Americans are collecting unemployment, and more than half of U.S. households have experienced a loss of employment income as of July 21. Meanwhile, the next round of federal stimulus is still up for debate at this writing.
On the retail side, consumer spending is down nearly 7 percent from pre-pandemic levels, accelerating bankruptcy filings among restaurants, department stores and service firms, from California Pizza Kitchen to Nieman Marcus to Hair Cuttery. More than 72,000 businesses that were open in March have closed permanently, according to a recent analysis by the review site Yelp, with tourist destinations such as Las Vegas particularly hard-hit. Professional services such as attorneys, accountants, physicians and educational tutors have fared better, a plus for the office sector.
“In the near-term, we are making adjustments for greater collection shortfalls,” Young noted. “For example, a better-performing grocery-anchored retail center may see collections at 90 percent, which is great comparatively, but it’s not the 98 percent we were projecting before the pandemic.”
Meanwhile, rent growth is likely to be on pause for some time as owners work to maximize occupancies, Young said. “Static vacancy is a significant consideration,” Young said. “If a property had only been operating at 90 percent occupancy but the valuation assumed it would rise to 97 or 98 percent, you need to think about whether there’s something structural that should be considered. Maybe 90 percent is your new stabilized occupancy on certain properties.” On the multifamily side, “landlords are not trying to push rents, they want to maintain occupancy.”
Rising Property Expenses
Net operating income will undoubtedly be impacted by rising costs. New hygiene and safety protocols, more frequent cleaning, retrofits of HVAC systems to prevent airborne virus transmission, reconfiguration of office amenity spaces to promote physical distancing, and technology investments such as touchless elevator call systems will demand higher operating and capital expenses. In addition, as online commerce accelerates, industrial properties could see higher capex costs for technology investments, revamped factory layouts that accommodate more space per worker, and even more dock doors for distribution.
Moreover, owners and investors are likely to see higher property taxes, as state and local governments suffer precipitous declines in revenue. U.S. cities and municipalities are anticipating $360 billion in lost revenue between 2020 and 2022, according to the National League of Cities. “In many cases, real estate taxes are passed through to tenants,” Young said. “The question is, what is the effective rent, inclusive of pass-through expenses, and if effective rents are increasing significantly, will we see downward pressure on base rents?”
Finally, appraisers are rethinking how heightened risk impacts valuations. “To the extent we are making adjustments in net operating income and cash flow over the holding period, it’s important to remember how the risk profile has changed from one period to the next,” Young explained. “If there is significant income growth assumed in your valuation, maybe the rates you are using need to reflect the additional risk. The implied growth and overall risk embedded in your valuation is an important grounding principle when investors think about changing cash flows and investment rates.”
SitusAMC has been involved in commercial real estate valuation since 1931, and our experience and knowledge has guided owners through decades of volatility. Clearly, public markets tend to reflect turmoil in the broader landscape, and trade based on sentiment. Given the massive uncertainty caused by COVID-19, owners and investors would be wise to focus on a fundamental analysis of property performance, grounded in cash flow and supply and demand, rather than cap and discount rates. Over a longer-term, measures of real estate performance by private and public market indices eventually converge. Once nations solve the health-care crisis, economic recovery will follow, and in a low interest-rate environment, commercial real estate is likely to outperform on a risk-adjusted basis.