Considerations for Year-End Real Estate Investment Valuations

Fund managers and others who estimate the fair value of their real estate investments will find the process particularly challenging this year. During the last twelve months we have experienced an extraordinary increase in the cost of real estate capital, equity and debt capital illiquidity, slowing rent growth, and inflationary pressure on operating and capital expenses. These dynamics make estimating property values difficult, particularly due to the lack of transactions to serve as comparable sales.

The Impact of Market Trends on Property Valuation

There is a general view by real estate market analysts that real estate values have declined since the beginning of 2023. However, each commercial and multifamily property is unique in is location, tenancy, physical attributes and amenities, and competitiveness in its market. Each market and property type has experienced different trends in supply and demand, and the pace of rent and occupancy growth or decline. Accordingly, no single set of standards or metrics can be applied to all properties in a fund’s portfolio. Fund managers must support the critical assumptions used in their valuation analyses based on local market and property specific data.

The users of financial reports containing fair market values of property investments will be focused on the trend in valuations over the past two years, during which the real estate cycle for many markets and property types turned negative. The market has also experienced growing distress due to the impact of higher interest rates on mortgage indebtedness. Users will also be focused on the terms of the debt secured by those investments, especially the timing of loan maturities and interest rate hedge expirations, as well as compliance with loan covenants.

Information to Support Asset Valuation Estimates

As a leading practice, fund managers should consider the following in support of their year-end asset valuation estimates:

• Recent (non-distressed) comparable sales that could be used to benchmark valuation and any appropriate adjustments or discounts to those benchmarks given property-specific attributes.
• A change in the asset’s investment strategy, including hold period, due to changing market conditions and whether that has impacted the asset’s valuation.
• Market and analytical data used to derive current and terminal capitalization rates appropriate for the asset in its market.
• Trends in leasing, including current year and anticipated changes in rental rates and required concessions and tenant improvements.
• Current year and anticipated changes in vacancy.
• The impact of inflation on operating expenses.
• Whether inflation and supply chain issues have impacted the budget or the timing of construction or redevelopment projects.
• The availability and rising cost of maintaining the same level of hazard insurance.

The capital used to acquire and operate real estate is an integral part of an investment’s strategy and performance, and therefore its valuation. Fund managers should also take into consideration known and anticipated capital requirements, and the cost of that capital, when estimating value, including:

• Any additional capital required to refinance debt that will mature in the next year and the potentially higher on-going debt service.
• Any additional capital required to cure a loan covenant breach, such as a debt service coverage ratio breach that occurred because of higher interest rates.
• The cost of purchasing an interest cap or other hedging instrument for existing floating rate debt.
• The assumed terms of any required loan extensions or modifications.
• The cost of any gap capital, including bridge loans, mezzanine loans, preferred equity, or direct equity, and any potential dilution of interest in the investment.
• The added debt service cost of converting a construction or bridge loan to permanent financing.

Adapting Valuation Approaches in Dynamic Property Markets

Given the uncertainty in the property markets, the estimation and presentation of investment valuations requires more support for key assumptions than in a more robust transactional environment where data is readily available. Down cycles highlight the unique performance attributes among properties and there are many investments that are no longer performing in accordance with their original strategies. The approach to property and investment valuation estimates must reflect these current market conditions.