Being in real estate right now is a little bit like walking in a blizzard. You may be able to see the ground just a few feet ahead, but it is impossible to make out your heading. Plus, by the time you actually get to where you are going, the landscape could look completely different. Even for those with the best sense of direction in normal conditions, the familiar and known can become foreign and strange. In the real estate world, being able to see the horizon is all about being able to understand market value. But in the blizzard we find ourselves in now, there is very little to go on since transactions for many building types are few and far between.
The traditional models for property valuation that the industry once relied on are filled with assumptions. Delayed retail reopenings, office lease renegotiations, multifamily eviction restrictions, all of these have made predicting rent rolls with any degree of certainty nearly impossible. All this is happening at a time when customer preferences are changing for where and how people want to work, live and shop. Common spaces and shared amenities, the things that have traditionally made properties more marketable and therefore valuable, are now sitting empty. The prestige of supertall buildings rely on the close quarters of vertical transportation. If this COVID-19 continues for an extended period of time, we will have to completely rethink how assets are positioned to make them the most valuable to their end user, the tenants.
In the meantime though, we must find our way through the storm. To do this many in the property industry have started looking to new types of data to help them find their way. Pauline Hale is a senior advisory manager at Altus Group, a provider of software (including the popular valuation program ARGUS), data, and advisory services. She gave me examples of some important alternative data that should be taken into consideration when calculating the value of a property, including public markets. “Although they don’t directly correlate due to issues like investment horizon, liquidity, and the fact that REIT shares represent the value of not only the real estate, but the operating company and liabilities, the public markets do give insight into directional and relative sector performance,” said Hale.
In addition to public markets, Hale also explained that “reverifying sales” can be a way to account for alternative data or simply a change in circumstance, which is exactly what has happened. “With very few market rate transactions in the market, one method of determining current market cap rates is to reverify sales,” Hale said, and what this means is “essentially interviewing parties to pre-shock transactions and asking how they would underwrite the identical deal under today’s market conditions.” Understanding the factors that make a difference in property valuation provides insight for future transactions. Applying different cap rates to model possible outcomes or changes in valuation can help owners be better prepared for the future. It can also help owners understand where best to direct funds for upgrades and improvements on existing properties if the different models indicate such a need.
Hale also suggests looking at some of the tangible data from the last few months as well: “Retracted sales, those that were canceled or repriced after the ‘Great Lockdown’ can also be studied to understand why they failed.” Possible reasons for failure could include “financing, liquidity, or performance,” said Hale, “and this information can be used to evaluate the potential impact to similar properties, sectors, and markets.” Examining a retracted sale in a particular city could help guide modeling for properties that are comparable within the same market. Looking at the most relevant and recent transactions within a specific market has always been a way to provide appraisal data for the sales comparison approach, but it could become a standard for other appraisal methods as well, now used as a way to provide further context for a potential deal.
Since the onset of COVID-19, the way we gather data and information has changed, too. A lack of overall transactions and, in many cases, people being unable to physically examine a property have led to more reliance on alternative data sources. “During the pandemic, webinars, phone interviews, and articles have temporarily replaced traditional data sources,” Hale said. While polls have always been commonly used to gauge market sentiment, they’re now a critical way to understand market trends.
Altus recently came out with their Market Reflections Poll which provides insight into market sentiment and its impact on value. In their May and June 2020 results, about 65 percent of respondents said that post COVID-19, they expect to see “a fundamental shift in office space demand from central business districts (CBDs) to suburban markets.” Out of the major CBD office markets in the U.S., 60 percent of respondents felt that New York City was most at risk. This kind of information indicates that the value added to a property by its location could look a lot different in the coming years.
Proximity to public transportation has typically been an enormous driver of value, but as suburban office markets grow, this factor may not be as important as it once was. According to Richard Green, Chair of the Department of Real Estate Development at University of Southern California, data like household formation and employment might be critical alternative data to review in a post pandemic market. “You can run regressions to look at market demand against employment. We can also look at the relationship between jobs and household formation,” said Green. “We might see people moving in together,” Green suggested. He continued, “Looking at household formation, we might see it decreasing in a downturn.” This type of data can be particularly useful when determining growth or decline for local markets.
While it can be challenging to pinpoint where to find sources for local market data, it’s the only way to ensure validity when modeling outcomes. As Hale explained, “During this pandemic, the effects are hyper-local, so information needs to be market and sector specific and sourced from local experts.” Because each state’s governor was left to decide how to handle COVID-19, and because of how little we know about this disease, its effects have varied dramatically throughout the nation. “Maybe most importantly, on a short-term horizon, is the degree of lockdown at the state, city, and local level,” Hale said.
Some states like New York and New Jersey are just now beginning to cautiously reopen and new cases of the virus have tapered off from their high, but in some parts of the South, new cases are on the rise causing the reopening process to be stalled or reversed. These local market fluctuations are creating opacity within markets due to the daily changes in reopening statuses and its resulting data. Markets where tourism is a large component of the economy are a good example of this. Places like Orlando will be affected much differently than clusters of knowledge workers like Austin.
In order to account for these fluctuations and ensure more accurate valuations, alternative data needs to be built into future modeling equations. Factors like public markets, alternative or retracted sales data, and local market information have to be used alongside property fundamentals when making cash flow assumptions and pricing parameters. Hale also recommends looking at both short-term and long-term projections, “short-term considerations like rent collections and lease-up timing can be factored into the early years of the cash flow projections, but the possibility of longer term impacts and potential structural changes need to be considered in discount and cap rates.”
One of the worst things to do in a blizzard is to stand still. The important thing is to make sure that any move you are making is towards your destination and not away from it. While many real estate firms might be waiting out the storm when it comes to new transactions, they should use this time to try to move their valuation techniques forward. Relying solely on historical data and traditional methods for valuation could result in inaccurate estimates and costly mistakes. Even in the worst conditions of visibility, we need to use any source of information we can to guide us. These same sources could be what helps guide us again when the next blizzard eventually hits. [Propmodo]