The latest IPD Monthly Index shows UK commercial property capital values declined by 14.2% in the calendar year 2022. Income was something of a saviour of total return though. This was not a great result for the investors, but it is understandable if looked at through the eyes of the other two major asset classes. The UK FTSE All Share delivered a total return of 0.2 %, whilst the UK Government Bond index delivered a calendar year total return of -25.1 %.
The headline property figures hide some dramatic in-year movements. The last few months of 2022 saw the fastest ever decline in capital values for commercial property. Valuers have long been regarded as being behind the curve of the market, so a move like this is very interesting. The RICS Red Book encourages the use of comparable evidence for valuation purposes, so it has been inevitable that valuations were backward looking. It is not a surprise then that listed property sector investors laugh in the face of the property valuation industry by opening and closing discounts to NAV at certain points in the cycle. That should just not be.
The dramatic downward adjustment in values has been explained in some circles as ‘the Pereira Gray effect’. Probably not the outcome he had in mind at the time of writing his report for the RICS on Commercial Property Investment Valuations and how the RICS might improve confidence in them!
The report has caused consternation in some circles I hear, and there is some valuation industry ‘push back’ on the rotation recommendation especially, despite the RICS having accepted all the recommendations at the time. Tricky for the RICS when firms of valuers pay their fees. Another criticism is that the report ‘re-writes the Red Book by the back door’ by recommending the use of discounted cash flow as a valuation methodology for regulated valuations. This seemed quite a bold call as it was bound to upset the old guard, but given what has happened to valuations recently, the rationale and its consequences are worth exploring.
“Others argue that there was nothing wrong with traditional valuation methodology and it had the great advantage of smoothing valuations out over time”
Prices are set by market participants looking forward, so the report argued that valuations, which should estimate those prices, should use the same underlying methodology, thereby keeping valuations ‘current’. Others argue that there was nothing wrong with traditional valuation methodology and it had the great advantage of smoothing valuations out over time (giving property its place in the strategic asset allocation mix). No prizes for guessing which of these is a dinosaur’s perspective.
The report has been around for a year, and the dramatic changes in valuations have come some 9 months later. This might be valuation industry inertia, but the lag is likely a coincidence. Truss and Kwarteng were the real instigators of such rapid change.
For assets to be attractive to investors, one must understand the basis of their valuation. For too long property has been eschewed for its different valuation protocols when compared with equities and bonds. As the property valuation industry catches up with the times, quite quickly it seems, the asset should become more attractive to those more used to investing elsewhere. The transition phase might be uncomfortable though, not least for the RICS who are not yet up with the times themselves. Near term, valuations may well fall further, but where there is disruption, there is usually opportunity.
Over time, those pesky discounts to NAV in the listed sector should reduce, and buyers will likely return. In example, UK Commercial Property REIT (typically the first to report) announced an NAV fall of over 20%, but its share price went up on the day. Same with SEGRO last week. Such a notion challenges the talk these days of a stagnant listed sector and private property funds being the preferred investor vehicle.
As valuation methodologies converge, the returns from listed real estate companies should look more like the returns from underlying property holdings in the future. We might then see the good portfolios and management teams rewarded with more capital and higher ratings. That’s as it should be.
This could put pressure on the open-ended property funds to justify their existence again. And rightly so. Might they see listing as an elegant route out of their structural problems? BlackRock and M&G are financially sophisticated and ‘gated’, so watch them first. Apparently, there’s over £15 billion across this subsector. All this activity could end up being rather positive for the whole property industry.
Who would have thought that Truss and Kwarteng would have accelerated a change recommended a year ago and quite likely, put property onto a more even footing with the other asset classes? Good news indeed if the valuers can keep up with the changes.
