ENDURING VALUE
Around the globe, falling property values are having a negative impact on the balance sheets of real estate companies. In this interview, the independent real estate writer, Walter Senk, discusses the causes and effects of recent developments, the value of real estate as a commodity with Wolfhard Fromwald, member of the CA Immo Management Board, and property valuation experts Professor Alfons Metzger and Georg Fichtinger.
- f.l.t.r. Walter Senk, Wolfhard Fromwald, Alfons Metzger, Georg Fichtinger.
Within one year, global market capitalisation has slumped by US$ 17 billion. The banking sector has ground to a halt and money markets around the world have been rocked by an unprecedented crisis in finance and confidence. This situation began with the flood of defaults on the American mortgage market as private borrowers, deep in debt, found themselves unable to cope with interest rates and meet the repayments on their home loans. Eighteen months on, the adverse trend has spread to virtually all categories of real estate all around the world: ultimately, it means adjusted numbers on the balance sheets of property companies.
Senk: The events we are seeing on real estate markets, with property prices falling around the world, did not come about overnight. Where do the roots of these developments lie?
Metzger: You have to look very carefully at the fundamentals. The foundations of the situation we see today were laid out 10 or 12 years ago in the course of globalisation. As investment activity spread around the world, the real estate market became a part of the financial market. At the same time, totally new valuation systems for real estate became established because people wanted similar systems that would allow them to value properties in the international context.
Senk: Isn’t that a good thing?
Metzger: Of course, in a globalised property market you must have parallel systems and methods. Unfortunately, though, international real estate investments relied on a method called DCF, or discounted cash flow, which is normally used for corporate valuations. Real estate was increasingly acquired as part of a package, investments were valued in the same way as corporate takeovers, and the result was a displacement of value. Individual valuations were still carried out in isolated cases, but portfolios tended to be assessed as single packages comprising many different properties, even though each property has its own background.
Senk: In other words, the method was misguided?
Metzger: I don’t think there’s anything wrong with the methodology, so long as it’s correctly applied. However, real estate is not a product like furniture or shoes, so a property portfolio cannot be assessed in the same way as a furniture or shoe factory. The cash flow for a property, by which I mean the net revenue that a property generates for me, is a key criterion. Despite this, the assessment also calls for consideration of factors such as net asset value, location, quality, tenant profile and the potential for opportunities and threats in the medium to long term.
Senk: How could a single trigger affect the entire economy?
Metzger: As the borders have come down, a world-wide financial circuit has emerged. If someone introduces poison into the system, nobody can tell where it came from or how toxic it might be.
Fichtinger: The effects are evident. Prices are falling in nearly every country and across all sectors – retail, industry and offices. We’ve been observing the pattern across the world since the third quarter of 2007, but around the end of 2008 the prices of commercial real estate in Austria started to drop particularly steeply.
Senk: Surely prices are falling so steeply because they had climbed so steeply beforehand?
Fichtinger: Prices had been rising steadily since 2001, and yields were coming down accordingly. A great many international investors came in when prices were too high. This pushed prices up even more. In some cases, we would value a property at X for a potential buyer, who would then offer significantly more because of pressure to invest and the favourable financing conditions. Real estate got more and more expensive, and the transactions made at the higher rates helped to raise the valuations for other properties.
Senk: CA Immo AG has always been highly conservative when it comes to investment. Why must the value of your portfolio also be revised downwards at this time?
Fromwald: We are not immune to developments on the international markets. Returns on real estate in all usage categories have risen exponentially, and market values have slumped at the same time. Despite all of the caution that we apply to valuation, the change was much more dramatic than we could have foreseen.
Can you clarify that with an example?
Fromwald: Yes, Bucharest is a very good example. At the end of 2007, the valuation for our properties in prime sites produced a gross yield, which we define as rental income in proportion to market value, of around 7 %. We regarded this as conservative, because at that time acquisitions were being made at yields of around 6 %. Because of falling prices, the comparable yield is now 8–8.5 %. We were overtaken by the market and the expectations of yield. Obviously we need to correct our values as well, but to be precise only halfway – from 7 % to 8 %, not from 6 %. Yield development has been much the same in the other countries of eastern Europe. There’s a similar trend in Austria and Germany, although not quite as pronounced. The pattern shifted very quickly in 2008. Property yields have risen by average of 100 base points across Europe just in the last 12 months, and this equates to an average price reduction of 15–20 %.
“The only positive aspect is the fact that revaluation losses do not represent an outflow of funds; our operational cash flow in 2008 remained satisfactory thanks to the income producing properties.”
Wolfhard Fromwald,
Management Board member of CA Immo since 1990
Metzger: Real estate has not lost its essential value. Shares can always lose value, but savings accounts can collapse too. I believe that an investment in real estate is still the most enduring investment available. Over the long term, it secures not only sound revenue, but also the original capital deployed. Just to make it absolutely clear, I’d like to say it again: when the property market and the capital market merged, there was a failure to consider real estate in isolation. Properties were bought and turned around, or sold at a profit, straight away – that’s what was driving prices. In the old days, you would buy and hold; as globalisation gained ground, the mantra changed to ‘buy and sell at a profit’. As a consequence, prices spiralled up and up, but the system lost sight of the potential for value.
Fichtinger: I would agree that real estate became a commodity, but that has its positive side. Turning real estate into a commodity also makes the market more transparent. The market developed first, and property is another form of merchandise. That’s not a bad thing.
Fromwald: That’s right. Back in 1988, everyone in Austria was delighted when real estate was suddenly being traded for real, and a market had emerged. Unfortunately, trading in real estate soon became an end in itself as the retention periods got shorter and shorter. In most cases, the value increases achieved were not the result of active management, they stemmed from short-term speculation based on falling interest rates and excessive liquidity in the market. The situation we have now is the exact reverse. Transactions have all but dried up, so a key element for valuation is absent: comparable, effectively concluded transactions that substantiate values determined by a surveyor.
“Just because no transactions are taking place at the moment,
and real estate has got cheaper, does not mean that the value we possess is suddenly worthless.”
Professor Alfons Metzger, FRICS, CRE, owner of
Metzger Realitätengruppe and internationally
renowned property valuer
Metzger: Market transactions are important, but the lack of purchases and sales in response to the extraordinary events we’re now seeing within the economy does not mean that the value we possess is suddenly worthless. Transactions made in an emergency don’t provide a useful yardstick by which to assess the value of similar properties. What I mean is this: to a certain degree, fluctuations in value are a normal part of the property cycle, but extreme short-term movements are not normal, at least in central Europe, thanks to the legal frameworks, financing criteria and ownership structures. This is certainly very different from the conditions in the USA and on the British property market.
Fromwald: Calculation methods also tend to overlook asset value. Clearly, all properties have a value. Of course a house may not yield much of a profit, but it doesn’t lose its long-term value potential. Asset value has been cast aside, and needs to play a greater role. CA Immo AG has huge reserves of land in central areas of the main west German cities. These reserves might not be producing regular income at the moment, but they still have intrinsic value and, above all, high potential. In my view, the capital market pays too little attention to this value owing to short-term yield targets; it is massively underrated because of insufficient cash flow and potential development risk.
Fichtinger: All real estate has an asset value, calculated from the land value and the breakdown value of the building itself. If a commercial property is standing empty, you have to ask yourself why is it vacant? Is there a problem with the location, the utilisation or the quality? Does mean that I won’t be able to attract tenants, or the will rental revenue that I obtain be much lower than I’d expected? In this case, the net asset value – which can and must have no influence on valuation – is worth much more than the earning power.
Senk: How will the general market situation affect the value of real estate that makes up CA Immo’s assets?
Fromwald: We have had to adjust our real estate by around 7 % on average across the whole portfolio, which includes income producing properties as well as projects under construction. That’s typical for the sector in Europe. When you have total property assets of around € 4 billion, though, that produces a considerable revaluation loss. The only positive aspect is the fact that this loss doesn’t represent an outflow of funds; our operational net earnings in 2008 remained satisfactory thanks to the income producing properties. On the basis of actual rents for 2008, our income producing properties are yielding approximately 6.2 % on average.
Metzger: Anyone who invests in real estate knows that a return of five or six percent is going very good. As long as a reasonable financing structure is in place, long-term returns on equity of 6–8 % are possible, depending on the usage type and the region. Real estate is a solid investment with guaranteed value. It’s just that over recent years, certain activities have created unrealistic value potential. This has affected a lot of speculative investors in particular.
Senk: How often does CA Immo AG carry out valuations on its properties?
Fromwald: For some years, we have valued our properties in eastern Europe on a quarterly basis. This is because property prices increased very quickly there on account of rapid economic growth, strong demand and short supply. Returns were still in the range of 10–12 % until a few years ago, but this had halved on average by the end of 2007. We perform annual valuations in Austria and Germany because the shifts in value are less erratic and the markets are generally more stable.
Senk: As an investor, I would be interested to know how you measure the market value of a property?
Fichtinger: The real parameters are creditworthy tenants and sustainable rents, adjusted to the market wherever possible. Then you must consider the potential for opportunities and threats, location and future variables such as investment strategies and development options.
Metzger: Taking that a step further, you also need to think about political developments. A local political crisis can cause the value of property to hit rock bottom – at least temporarily.
“Prices had been rising steadily since 2001, and yields had come down accordingly. Partly encouraged by favourable financing, a great many international investors came in when prices were too high, and this pushed prices up even more.”
Georg Fichtinger, Senior Director (Head of Capital Markets)
in Austria for CB Richard Ellis, the world leader
in commercial real estate servicesSenk: What’s next for the property markets?
Fichtinger: In Austria, the pressure on prices will continue and returns will carry on rising. In this country, developments are not entirely dependent on the sector and utilisation.The trends for other European countries will vary. Some countries, such as the United Kingdom, have almost completed the correction process. In the UK there was a major correction at the end of 2007, followed by steady devaluation of one or two percent per month last year.
Fromwald: In the event that the general situation fails to stabilise or gets even worse than we are expecting, we can’t rule out further adjustments. On the whole, though, I’d rather be optimistic and suggest that we will hit the floor this year, with the upturn arriving by 2010 at the latest. From our perspective, it’s not only developments in eastern Europe that matter, but also what happens in Germany in particular – and the forecasts being issued by experts are all over the place.
Metzger: There’s no doubt we must watch the overall economic picture. As soon as economic growth and stability make a comeback, real estate will be a commodity that’s much in demand.