Commercial Real Estate Valuation in the Age of Coronavirus

For both real estate valuation professionals and intended users of valuations/appraisals of real estate, the COVID-19 pandemic will undoubtedly create challenges. Recalling turbulent economic periods experienced in the past, such as the 1980s national savings and loan crisis, 9-11 and the Great Recession, it is particularly important in this current moment to emphasize that a valuation or an appraisal establishes an opinion of value. Or, to put it another way: a recurrent refrain among real estate professionals is that the valuation of real estate should be viewed as an art, not a science. The goal is to provide an appraisal that is credible.

Accordingly, it is imperative to carefully consider the qualifications and experience of the valuation professional that is developing a given opinion of value. The art of appraising real estate often requires significant experience working with specific and relevant property types and markets. A valuation result may be overly conservative or optimistic if the professional responsible for its preparation lacks sound judgment and proven expertise. Especially in a declining market, these attributes are essential to properly evaluate current and anticipated risks.

Given the current state of the market and the complex circumstances impacting our economy, the following are some key considerations that investors should bear in mind when assessing an opinion of value.

Although there are three primary recognized methods to valuing real estate, including the Cost, Income and Sales approaches, an investor or lender of real estate would typically rely on the Income Approach. The Income Approach is based on the premise that a value indication for a property is derived by converting anticipated benefits into property value. Anticipated benefits include the present value of the property’s net income (from rent or other sources) and the anticipated net proceeds resulting from the property’s subsequent disposition following a holding period.

There are two Income Approach methods: 1) direct capitalization of the first year's net income by a capitalization rate (or cap rate) and 2) a discounted cash flow analysis based on the projected net income from an investment over a reasonable holding period. Utilizing the direct capitalization method is a more straightforward approach and particularly useful when a property is in a stabilized state.

On the other hand, performing a discounted cash flow analysis will require an appraiser to carefully consider detailed assumptions applied year over year during the entire analysis hold period. In a discounted cash flow analysis, a present value is calculated utilizing a “discount rate” that is established by examining investor yield requirements for similar types of investments. For example, assets like hotels and retail that currently may be suffering from low occupancy levels could require absorption and cash flow projections based on thoughtful analyses of current and forecasted market data and the subject property’s historical data. A direct capitalization method may still be valid for a property that is not stabilized, but considerable focus must be given to making any critical adjustments in anticipation of future market conditions, particularly when the current market climate is volatile.

It is vital that sufficient market support is incorporated into key valuation assumptions. This includes applying a good balance of cash flow and investment rate (capitalization and discount rate) assumptions, in order to avoid being either overly aggressive or conservative.

The cash flow generated by real estate is typically composed of the “return on” investment, or annual net cash flows during ownership, as well as the “return of” investment, or the reversionary value of real estate at the end of an investment holding period. Attention must be given to the risk inherent in the projected cash flows and anticipated residual value in selecting proper investment rates. In addition, the subject property’s historical data will need to be carefully examined for its applicability.

Valuation analyses and appraisal reports should include an acceptable level of qualitative analysis and attendant explanations of such analysis to enable the user to understand the appraiser’s thought process in developing the opinion of value. This is particularly important in a challenging market, when opinions tend to vary and the logic behind certain assumptions needs to be made transparent. Market data and support should be timely, relevant and comprehensive.

When evaluating comparable market transactions, it is important to examine not only the market condition and sales price, but also the condition of sale. As opposed to market price, market value should consider market exposure in an open market, marketing time, “motivated buyer” and “motivated seller” conditions and typical market financing — in times of crisis or uncertainty, property sale conditions can vary widely based on some of these factors. Accordingly, it is vital to distinguish between market and distressed sales.

In times of economic turbulence, it may be particularly important for an appraiser to develop alternative valuation scenarios. For example, in a scenario where a property is occupied by non-credit tenants or the entire property is occupied by a single credit tenant, it could be useful to value the building as unoccupied — often referred to as a “go dark” scenario. Other economic scenarios may be warranted depending on the needs of the valuation user.

Depending on the intended use of an appraisal, the projected cash flows can impact a deal analysis just as much as the fair market value. The projected cash flows may be evaluated to estimate important metrics such as debt yield (net cash flow divided by debt amount) and debt service coverage ratio (net operating income divided by debt service obligations), among others. These cash flow metrics during underwriting may impact deal structuring — including covenants, earnouts, holdbacks and cash flow sweeps, as some examples. Therefore, attention should be paid to cash flows, as well as concluded value, during the development process.

As defined in the Uniform Standards of Professional Appraisal Practice (USPAP), the generally recognized ethical and performance standards for the appraisal profession in the United States, an appraisal is the act or process of developing an opinion of value. Given that it is an opinion and not an exact science, users of a value opinion will seek analyses that are well-developed and reported.

Especially during uncertain times, it is imperative for the valuation industry to provide investors, lenders and other users with detailed market and analytical support, transparent and clear logic and sound judgement. While conducting property valuations during such time periods is certainly more challenging, it is also an opportunity for valuation experts to highlight their knowledge and skills.