Material Valuation Uncertainty In Abnormal Times


By Gavin Anderson

Covid-19 has created a sharp economic recession and unprecedented market conditions for commercial real estate. Every sub-market has been impacted, to some extent, by the seismic contraction of our economy in the 2nd quarter of this year, which is likely to be a feature going forward, with major uncertainty about the full economic impact, even after the pandemic is over.

The retail, leisure, motor trade and hospitality sectors have been particularly hard hit by the lockdown, although retail was already struggling before the Covid-19 outbreak, with structural issues resulting in numerous business closures and administrations over the past few years. Whilst the supply of office space is expected to be lower, due to the lockdown and the resultant interruption of construction supply chains, demand from firms & organisations for office space is also expected to weaken, as office moves are reappraised or scrapped altogether. With ongoing social distancing requirements, this may be mitigated to an extent, as firms may need larger offices to accommodate the same number of staff. The industrial sector has performed well recently and is expected to remain resilient following lockdown.

What will be the impact on commercial real estate after the lockdown is over?

The retail sector is likely to continue to struggle, with high debt and low margin retailers most vulnerable, along with those retailers with no online offer or a weak online presence. The motor sales industry has also taken a battering, with April’s new car sales down by 97% on the same month last year, according to the Society for Motor Manufacturers & Traders, with obvious implications for the remainder of 2020.

The leisure and hospitality sectors are expected to be the last to recover and once such premises are allowed to re-open, it is anticipated that some restrictions on capacity will be introduced. Restrictions on the capacity of premises will almost certainly have an adverse impact on the profitability, and potentially the commercial viability, of many businesses in the leisure and hospitality sector. A decline in business & leisure travel and entertainment is also expected after the lockdown is over, which will adversely impact both the hotel and hospitality sectors, although some businesses may benefit from an increase in domestic spending, with travel abroad and foreign holidays likely to be constrained.

Longer term, demand for office accommodation may well weaken, with more home-working and video conferencing reducing the need for office space, notwithstanding a likely requirement for desks to be further apart for safe distancing of staff. Business Centre models that share office space are most at risk, because of worries about the spread of infection by “hot-desking” and desks being close together.

As previously mentioned, the industrial sector currently appears to be the most robust sector of the market, given the healthy demand that exists from online retailers for logistics distribution space. Post Covid-19 & post Brexit, we could also potentially see an increase in reliance on local manufacturing and distribution, increasing demand for modern, strategically located, industrial space. The medium term prospects for this sector do appear encouraging.

What does this all mean for commercial property values?

The value of any property asset is essentially a function of supply and demand dynamics. In the medium to long term, markets will adapt to economic conditions, with prices and values adjusting accordingly. However, the recovery profiles of each sector will vary from market to market. Inevitably, there will be re-pricing of assets at some point and property valuers should be aware of this. However, valuations should always reflect the current market and not influence the market.

This is a time when clients need and rely on valuers’ expertise in interpreting markets. The lack of empirical evidence currently available, due to the ongoing hiatus, makes the valuer’s job extremely challenging at the present time. Market evidence pre-dating the Covid-19 outbreak may not be representative of the market now, or even for some time after lockdown completely ends. However, as the RICS Red Book makes clear, a lack of comparable evidence available in an inactive market should not prevent property valuations being undertaken.

The skill, expertise and judgement of the valuer assumes a much greater importance, in difficult market conditions.

Valuers must be knowledgeable of the commercial sectors of their market and fully aware of the supply & demand dynamics for the type of property being valued. Valuers will require to make a judgement to adjust evidence pre-Covid-19, to reflect differences in that particular market since the outbreak and the relevance of that evidence now. In making valuation judgements, valuers should reflect current market conditions, including sentiment (both positive and negative), by interacting with as many market participants as possible, when researching their evidence and should also consider other economic data points, local market factors, wider sector performance data and all other relevant indicators. Valuations cannot, however, be downgraded without reasoning and the property market does not always follow other indicators, so preparing valuations on the back of general economic trends must be done so with this in mind.

By their very nature, real estate markets are imperfect and generally characterised by a lack of comprehensive information. However, with the volume of transactions currently so low, valuations currently require as much judgement as fact. It is, therefore, more important than ever that the valuer clearly outlines the valuation approach and reasoning in their valuation. The valuer’s rationale must be clearly communicated in the narrative of their report, so that the client understands how the relevant market is functioning (or not) and how Covid-19 has impacted on demand, supply and ultimately property values.

The disruption to markets, caused by Covid-19, means that we are in “unchartered territories” to some extent, as the full economic impact is unknown at this stage. In turn, we are currently in a period of “material uncertainty”. During these abnormal times, valuers should make a clear disclosure about “material uncertainty” in their valuation reports, as it is essential to ensure that the client understands that unusual market conditions result in less certain valuation figures. It is important to remember that valuations will always have a degree of tolerance, but this is even more pertinent in the current circumstances.

Disclosure of “material uncertainty” is not a disclaimer, however, as the client needs to have confidence that the valuation produced is reliable. Whilst valuation is a matter of opinion, rather than a precise science, the process of identifying, analysing, adjusting and applying comparable evidence will always be fundamental to producing a sound valuation, which is reflective of the market and can stand scrutiny from the client.

In conclusion, valuations post Covid-19 will definitely be more challenging. They will remain so until such times as markets resume and start to function again, with a meaningful volume of transactions concluding, creating clear evidence on which valuers can more robustly rely.

Meantime, there is no substitute to a valuer’s detailed local market & sectorial knowledge.

Written by Gavin Anderson BSc MRICS, Associate at DM Hall in Glasgow.

Gavin has more than 30 years’ experience as a Valuer and Agent in the commercial property market and has experienced working through 2 previous recessions in the early 1990’s and after the financial crash in 2008.