It’s now become a truism to say that Covid-19 has deeply affected every industry in South Africa. And while some of these effects were felt immediately in sectors like travel, tourism and hospitality, the effects on other areas of the economy – like the property market – are still unfolding. We know that rental collections have been under pressure, that REITS are being conservative in issuing dividends (if they’re being issued at all) and that “fair” property valuations have become increasingly difficult to make in this volatile environment. So the question is, where do you start? Jason Glass, Audit Partner at BDO, unpacks the issues.
First off, most valuers will lead with the disaclaimer that their valuations are uncertain and unpredictable right now, especially during a black-swan event like Covid-19. Valuers typically draw on historical transactions for their opinion based on things like tenancy data, cash flows, expected yields, location, conditions and property size. But now they must account for more pessimistic scenarios and potential future events like:
- estimates for tenant insolvencies
- reduced sales activity
- stricter lending criteria or higher margins for banks
- rebates and rental deferments that impact cash flow
- variations to lease contracts with more flexibility and reversions to market rentals in shorter spaces of time.
Valuation service providers will need to be more savvy in this area, adopting more sophisticated tools than before.
WHAT HAPPENS TO VALUE?
To appreciate what may happen to value, it is worth reminding ourselves of the definition of value which contemplates a willing buyer and a willing seller and the value at which they are prepared to transact for a property, at an effective date. Because there are a limited number of transactions right now, it is increasingly difficult to determine capitalisation rates (cap rates). You can model cash flows and arrive at a price, but there are no current transaction precedents to help determine if that modelling is correct. Smaller deals are also much easier to price right now: a R1 billion shopping centre, for example, will have few (if any) buyers given the current retail pressures, but smaller neighbourhood retail centres are selling.
Time will tell whether there are any ‘forced sales’ happening. If these happen regularly, it can influence the market expectation for pricing.
RENTAL AND CASHFLOW
Government’s reaction to the Covid-19 pandemic has been to enforce strict social distancing policies, forcing businesses to close or operate under limited and restrictive conditions. Consequently, some property owners have been unable to collect rental from their tenants. Landlord and tenants have been encouraged to keep an open dialogue going about rental relief and/or deferrals. While rent payment is a tenant’s legal obligation, loss of rent and tenant failures will typically erode rental income and destroy cash flows.
To established revised cashflows for a property, we suggest analysing:
- the mix of tenants
- any history of tenant arrears
- tenant business models and whether they would be considered “essential” under lockdown regulations
- tenant trading performance since lockdown began
- the impact of Covid-19 on their share price if applicable
- their trading performance.
In terms of retail tenants, turnover rents are likely to dissipate except for the likes of supermarkets, pharmacies and other providers of essential consumer goods. Analysts may consider factoring in periods of loss of income, abatements, deferred rents, increased incentives, tenant failure and extended periods of vacancy. We may witness vacancy levels of 10-20% as small businesses and retailers were already under pressure before Covid-19 hit. Following on from this, we are likely to see landlords come under pressure to renegotiate leases.
Some of the trends that may emerge include the following:
- Rental reversions
- Market reviews built into lease contracts every two years as opposed to the traditional five years
- An allowance for turnover clauses to be used to determine base rental in the event of future Covid-19-like pandemics that result in shutdowns
- Greater lease flexibility in favour of tenants, including introducing generous lease breaks; as demand for more short term leasing grows, landlords will need to be ready to respond
- Historical lease escalations of between 8-10% are a thing of the past and tenants will look to lock in escalations at much lower levels
- Landlords requiring larger security deposits/guarantees/suretyships
- The introduction of further lease conditions in an attempt to protect landlords.
CAP RATES VS DISCOUNTED CASHFLOWS (DCF)
With the above cashflow implications in mind, and having performed some analysis and discussed with clients, worldwide colleagues and auditors, we consider property will be affected on a case by case basis. Prime assets are likely to remain desirable given their more secure cashflows with stronger tenant covenants from banks, government tenants and large corporates with locked in leases and minimal near term capex requirements.
However, if an asset’s tenancy profile shows a present cashflow and/or vacancy risk, there will likely be a softening of cap rates as well as a discounting of cashflows to provide for these risks. Properties with large exposure to retail tenants, which were already experiencing sluggish growth prior to any influence from Covid-19, are also likely to see an increase in cap rates. This will inevitably also apply to landlords heavily exposed to tenants aimed at luxury and discretionary spending. The re-letting and vacancy risk will certainly be priced into an investment decision.
There may be a re-emergence of a DCF valuation technique within the real estate sector. Many regions around the world do not standardise their portfolio and investment valuations around the DCF methodology but that may need to be reconsidered. The expected standard 10-year hold period itself may also need to be reconsidered, since real estate investments aren’t as steady and predictable as they used to be. The modern real estate market may be forced to evolve differently and more frequently, primarily due to tenants and residents adopting new technologies and innovations, which in turn alters their expectations of where they live, work, and play. This type of flux is extremely difficult to predict over a 10-year or more timeframe, potentially discrediting portfolio valuations based on assumptive data extending that far into the future. Applying a cap rate indefinitely to cashflows may be a thing of the past given the fast changing landscape we are in.
DISRUPTING THE TRADITIONAL PROPERTY CYCLE
Furthermore the traditional property cycle of between 17 to 19 years will be disrupted and could be of little relevance in the future. We can expect to see a greater disparity of yields between prime and secondary properties and different property classes. The heightened tenancy and cashflow risks coupled with a weak economy may see cap rates increasing anywhere between 100-300bp depending on the property class, situation, the quality of tenants, the duration of leases and condition of the property. It is also important to be aware of the substantially lower interest rate environment (and as a result the lower costs of borrowing for property investors) can make current property opportunities more attractive especially when geared with loans.
While it has become difficult to value properties, those with strong leases are actually seeing yield compression given the drop in interest rates. The approximate 3% drop rates should not be ignored because this would lower the risk profile on properties underpinned by contractually long leases with good cashflows, and purchasers seem willing to pay 8.5-9% cap rates for long term leases with strong tenancy profiles.
Tourism and education assets are likely to have already experienced the greatest immediate impact of travel bans and will face a long recovery period. Although these assets seem to have more of a cashflow crisis than a cap-rate change, the uncertainty about the duration of this crisis should mean that risk is priced in and inevitably a rerating of these assets may occur.
Land and development assets are likely to experience significant value volatility. Unemployment levels and a lack of consumer confidence may result in these assets being the most dramatically discounted. Volatility in commercial property markets tends to be less observed, as owners (other than distressed owners) tend to hold these properties especially when used by their owners in conducting their manufacturing and trading operations, other than when their businesses require capital injections. Liquidity naturally reduces during recessionary times.
It is also likely that banks will be more stringent in applying cashflow and other factors in their lending decisions. We will more liquid purchasers in the market who will demand a higher return on equity.
HOW VALUERS WILL APPROACH COVID-19
Valuers are required to report at a specific date and reflect market conditions at that time. At the moment, valuers only have enough historical metrics about the market before Covid-19 hit. So, they must rely on all information available to them when submitting their assessments. Valuers can, with caution, reflect on, for example, historical evidence that suggests how property markets might move under differing economic, monetary and fiscal conditions.
Expect valuers completing valuations during the COVID-19 crisis to:
- caveat their advice, referencing issues outlined above
- reference the high valuation uncertainty, and that there is more downside than upside
- value estimation error
- reserve the right to reconsider their advice as events unfold and if these events are likely to have a material impact on value. This might extend to valuers recommending that they review their advice prior to the next financial reporting date and as market evidence occurs.
- limit the use of their advice to specific events and time periods.
More regular valuation reporting will likely be needed to keep advice up to date. This would come with additional cost consequences. Valuers will have to estimate appropriate discounts and/or capitalisation rates to apply to their analyses. When markets are stressed, valuers will need to consider issues such as the need for liquidity premiums and whether it is appropriate to consider additional risk premiums to account for the greater degree of uncertainty in estimating cash flows. Care will need to be taken in deciding on the appropriate level of additional risk premium and significant judgement will be required. We would recommend that the reasoning for any additional premium or discount is fully documented within valuation reports to provide transparency.
Considering the likely impact on the major assumptions of value, we expect:
- a softening of capitalisation rates across most asset classes
- a change in valuation techniques being applied to property portfolios and the emergence of a DCF type valuation methodology because of structural changes to lease agreements
- ‘value add’ properties climbing higher up the risk curve, emphasising well-leased properties to secure tenants with fixed growth such as prime assets, where capital will continue to seek diverse and secure cashflows
- a short-term effect on cashflows from discretionary type tenants
- a pricing in for risk of vacancy and letting up allowances
- the recovery time for tourism and retail assets will depend on the duration of the crisis; the longer it continues, the longer the recovery time will likely be
- additional valuation disclaimers and using evidence available to them at the time they should ensure to articulate fully their assumptions and opinions as well as greater limitations on the use of their reports. Valuers should be open to having transparent dialogues with clients and their auditors as this crisis evolves. Their advice may require more regular updating, since emerging transaction data throughout the crisis period will reveal how the market is responding.
Watch out for capex and service delivery. Government continues to underperform in its service delivery to business. Prospective property investors should watch out for additional capex that may need to be factored into a property acquisition. The inability for the vast majority of municipalities in this country to obtain clean audits, indicates that the level of service delivery will continue to drop significantly, thereby forcing landlords to inject further capex into their properties such as generators, boreholes, solar and waste management thereby reducing the returns accordingly.
Based on all my observations, I would expect to see a general decline in the valuations of most properties and that it may take several years for the pre-Covid values to return. There are many property investors who rely upon investment properties to produce an income they depend on. The disruption to their cash flows may cause them to have to realise their properties and there could be a resultant surplus of properties for sale which will only sell at reduced prices to investors looking for above average returns on their investments. Forced sales will also depress valuations.
Landlords can only sustain impaired cash flows for a limited period of time before they have to sell. Those in the worst situation are the landlords whose mortgage interest payments consume the greatest portion of their cashflows. For the moment, the banks have assisted them with interest rate reductions and deferment of mortgage instalments during the pandemic. Only time will tell whether such reductions continue indefinitely and how sensitive their positions are if interest rates rise.
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