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The real estate rules have changed

How to rethink real estate valuation and transactions

RFP
City view from window It’s now more challenging than ever before to establish truly accurate property values. The immediate and long-term business impacts of COVID-19 mean that the real estate market currently offers some discounted opportunities and some risky pitfalls – and the difference comes down to the right valuation.

As Propmodo recently reported, “In the real estate world, being able to see the horizon is all about being able to understand market value. The traditional models for property valuation that the industry once relied on are filled with assumptions.” Grant Thornton Corporate Value Consulting Managing Director Don Davidson added “And each and every assumption has to be viewed in conjunction with how it affects every other assumption. So, these are definitely unique times and things can change quickly as new information becomes available.”

“Each individual property and each individual market and submarket is facing its own unique issues that have to be addressed,” Davidson said. With some states reversing course on their reopening plans, nobody can predict when or if some businesses will return to normal. And hopes of a V-shaped recovery have faded.

“Those of us who have been around for a while have seen numerous market disruptions like the financial crisis of ’07 - ’08 or regional disasters such as hurricanes, floods and wildfires. But COVID-19 is something very different, and something we’ve never seen before,” Davidson said.

“There’s no playbook for the scenario we are living in now. Real estate valuation has always been both an art and a science. But in this environment, especially with the lack of solid real-time market data, the valuation process requires a much deeper, more thoughtful analysis of each and every valuation assumption at the individual property level,” Davidson said. Now, Davidson said he has daily communications and surveys with local real estate brokers, leasing agents, bankers, private equity, real estate investment trusts (REITs) and internal real estate experts, advisors and auditors. This provides a continual analysis and reassessment of assumptions, and how these assumptions apply to each specific property and value.

The biggest concerns Right now, real estate valuation needs to consider a list of difficult questions and concerns, like “What will the impact of work from home be over the long term? Has the crisis affected the credit ratings of individual tenants? How much will operating expenses increase, to assure the safety of employees and customers?” There will be major disputes over property assessments and taxes as local governments are in dire need of revenues. Valuation experts who are accustomed to basing their decisions on abundant market data and metrics are finding that they have almost no current market evidence, or that metrics are inconsistent or inconclusive.

But more than market turbulence, the biggest worry in real estate is cash flow.

In a recent Grant Thornton webinar on real estate valuation, more than 200 attendees weighed in to indicate that uncertainty around market assumptions and cash flow are their top concerns.

Chart: what is your greatest concern

“Liquidity and cash flow might seem obvious at first, but it’s becoming even more important,” said Grant Thornton Diligence Partner John Cristiano. “We’re certainly seeing a tightening from the banking side. Everybody wants to grow their way out of it and get back to a normal economy, but we’re seeing signs of tightening from capital sources and it’s something to be aware of as you look at opportunities.”

While there might not be an easy solution for market instability and restricted cash flow, real estate investors can gain a competitive advantage by adopting innovative approaches.

The best approaches “Of course, there’s not a one-size-fits-all valuation adjustment for COVID-19,” Davidson said. “The pandemic has had radically different impacts based on location, property sectors and even subsectors, and those impacts can vary widely.” But, amid the uncertainty, there are still approaches that can give investors more accurate bearings in a turbulent market – and help loosen the cash flow restrictions.

Study different data
Typically, valuation professionals want to look through proven sources for current and past data, separating the real trends from the anomalies. “What people did before was rely on history to indicate how a property or business would perform in the future. And now it’s harder to do that,” Cristiano said.

“A lot of what we were doing was taking out the extraordinary,” Cristiano said. “And now, we’re facing a situation that’s completely extraordinary.”

Now, valuation professionals are looking at different sources of data to understand the broader range of impacts that can lead to changes. They are studying management companies, development companies, brokerages, real estate tax service companies and other services, while also considering the assets involved as appropriate. “It gets more and more important to do your diligence and understand the pieces here,” Cristiano said.

Consider new data
If you don’t have enough solid and relevant data to analyze, you need to know how and when to consider new data sources.

Grant Thornton Corporate Value Consulting Director Alan Kaplan recalled one retail client with several leases that had various levels of risk. “On the back side of our cash flow, we looked at the factors moving forward. We looked at the market rents. We looked at what we thought was going to happen to discount rates. We used some other tools in our toolbox to get to where we could make a forecast. Because the data was lagging, we also had to spend a little more time surveying actual players in the market – buyers, sellers, tenants, landlords and others – to find out what they were thinking and how they thought they were going to deal with the situation.”

The key is to look at a broad range of data and factors together, including a local perspective. “A lot of times, people will get focused on one component,” Kaplan said. “So, they’ll do a great study on a capitalization rate or a discount rate by itself, then separately they look at the market rent by itself and they look at growth rates by themselves. But we find that especially today, you really have to look at the set of data. And every industry, property type and location has its own set of metrics, its own uncertainties. So, we think you need to be a little bit careful before you apply a national discount rate or a national vacancy rate across the board.”

Analyze management’s input
One critical source of information can be input from management. In the past, this input might not have been as telling as an examination of broader trends. But now, a property’s value can fluctuate more quickly and independently.

“We’re spending a lot more time understanding what management’s telling us, understanding what the models are saying, and looking to see how realistic that is,” Cristiano said. While broad data analysis and synergies across multiple forecasters can be important, this is also an important time to consult the individual factors that will shift property value.

“It becomes very important to understand the underlying issues facing the tenants. You have to really look upstream and downstream when you’re thinking about these businesses and these investments,” Cristiano said.

Reconfirm financing
Like everything else, financing can be more turbulent right now. “We certainly have a few situations where you get to the last minute and then someone gets cold feet on the financing side and it causes delays – it could even crater a deal,” Cristiano said.

To ensure a deal’s success, it can be important to model different leverage, or factor in more equity. “It’s just a reality of where we are, and you have to weigh the delay of waiting to see where things land against the chance of getting a deal now — if you think you’re getting in at an opportune price and you’re willing to take those risks. But we’ve seen more situations where you need to put up more of your own capital as borrowers try to tighten things up,” Cristiano said.

The other issue can be the effect of long-term financing availability. “These issues certainly impact the ongoing financials, such as ongoing costs – and maybe that’s a short, medium or long-term issue. Certainly, it’s part of the new round of questions that we include in our scope,” Cristiano said.

Examine the post deal
When the future value of a property is more difficult to determine, it becomes important to map out how various factors will shift after the deal.

“Previous results are not going to be a good proxy here,” Cristiano said. “So, it’s more and more dependent on what the post-deal looks like, from a diligence perspective.” Tenant turnover, physical changes, financing changes, external delays and other possibilities factor into your risk model to help project likely value.

It becomes even more important to look at your model and do some rigorous stress testing, with different scenarios. “When you’re looking forward, that’s really what you’re trying to do. You can come up with that clean number to launch from, but what are you launching into? Saying that it’s going to look like it did before is probably not the way to do it,” Cristiano said.

Manage REIT cash distributions
Cash flow can be especially important for REITs, since they are legally required to distribute 90% of their profits as dividends to shareholders each year. “But, if you’re in a REIT structure, there are a couple levers that you can pull,” said Grant Thornton Tax Partner Lorie White.

If REITs do not have enough cash to distribute in the current taxable year, they could make an 858a distribution in the next tax year and pull back those dividends, from a tax perspective, to cover current year taxable income. That said, if a REIT doesn’t distribute the 85% of its taxable income in a current tax year, it will still have a 4% excise tax.

Some public company REITs have elected to defer some of their distributions. But, for their annual REIT distribution testing, they need to be careful to monitor whether their taxable income and GAAP income are different and ensure they meet distribution requirements. Some public REITs are also considering options like distributing stock instead of cash.

The full range of factors Right now, there are many perspectives on how to establish real estate value because the traditional rules have changed.

Traditional valuations were built on a mix of known risks and unknown risks. “But the third risk level that we’re really seeing right now is the uncertainty in the market,” Kaplan said. “And it’s defined a little bit differently – it’s not an ‘unknown risk.’ It’s obvious there are impacts on the market. We can read the news every day. But, as we move into more uncertain times and there are more unknowns, even if you’re accounting for that cash flow, you may have to start increasing the rates to fully reckon with the marketplace and understand the risks that buyers are going to be facing.”

Ultimately, the best approach is to consider a full range of factors with an evolving balance – and those factors will keep changing.

“We’re in a time now where things are very local – yet some of those things may provide extra risk and turn out to be very bad information,” Kaplan said. Some locations will fare better than others, and many will be influenced by current and future changes in property use, improved technology and other emerging trends.

The current range of factors that feed into a valuation has expanded beyond the traditional rules, but these factors will continue to evolve and shift in different ways for each industry, property type and location. Increasingly, the only path to a clear answer is a comprehensive and dynamic analysis.

Contacts:

John CristianoJohn Cristiano
Partner, Diligence
T +1 212 542 9790


Don DavidsonDon Davidson
Managing Director, Corporate Value Consulting
T +1 832 476 3626


Lorraine WhiteLorraine White
Tax Partner
T +1 215 814 1728


Alan KaplanAlan Kaplan
Director, Corporate Value Consulting
T +1 215 656 3040