Prices, then, have not come down to a point where more transactions will take place, because not enough transactions have occurred to show that the market has in fact repriced.
This conundrum is one convention of the valuation trade that has some investors and fund managers tearing out their hair. Everyone knows, they argue, that values have dropped. Denial of the repricing everyone knows has taken place serves only to draw out the period of stagnation before there can be a recovery.
"The reality is that values have dropped, but people havent come to terms with it"
Alan Patterson, Axa Reim
"The reality is that values have dropped, but people havent come to terms with it," says Alan Patterson, head of European research and strategy at Axa Real Estate Investment Management in London. "The property market may be in denial but that doesnt mean everyone is. Non-direct property is giving a better signal of where value is than the property market itself."
Others, like Patterson, believe valuers should be looking at so-called indirect evidence as an indication of property values rather than sticking with transaction data. Valuers should be heeding share and Reit prices as well as property derivatives levels, and using this indirect evidence to inform their valuations.
"There has been a 35% drop in property derivatives property pricing levels, but valuers say its not evidence," says Patterson. "The quoted property market is trading at a discount to net-asset-value because NAV is expected to drop. This is indirect evidence of where other people think the market is going."
Guesswork or science
The nature of valuation makes it an inexact science and in straitened times it becomes virtual guesswork. Even in the UK, valuations will lag behind the market reality and tend to smooth the peaks and troughs. No one denies that a valuers job is difficult. In past market downturns, valuers have been blamed for overvaluing at the peak and undervaluing as the market corrects.
This time around, valuers, particularly in the UK, are being criticised by those who believe that they have dropped values too much, as well as from those who believe values ought to decrease even more. The UK IPD index, which is valuation based, has dropped 20% in the past 12 months, indicating a much quicker and more precipitous decline in values than witnessed in previous market downturns. Valuers point to this decrease as validation of their practices.
"Certain UK valuers are getting a hard time, but if you look at the rapidity and scale of the market movement compared with other European countries, that would suggest the system here mainly is working," says Nick Croft, partner, real estate advisory at PricewaterhouseCoopers in London.
In the UK, valuers are not wholly reliant on transactional data to determine value, but it still plays a big part in what they do. Unlike a decade ago, valuers at the big property services companies such as CB Richard Ellis, Jones Lang LaSalle and Knight Frank now work closely with their in-house capital markets teams and other parts of their businesses in an effort to gather pricing evidence. This kind of practice has allowed them to drop values despite a lack of transactions taking place.
"We have come a long way from the early 1990s when property really wasnt compared with other asset classes," says Andrew Renshaw, head of valuation at Jones Lang LaSalle in London. "Valuers were criticized for not having a wider understanding of markets. I dont think thats the case now."
In the past, valuers would look at a limited amount of so-called evidence to draw conclusions on a propertys value. Primarily they would use sales data as well as information about rents and yields to perform a comparative analysis of similar properties to come up with a value. That has started to change. Valuers realize that just because there have been a limited number of transactions, that is not a reason to say values havent changed. Especially in the UK, valuers have become cannier about looking farther afield for evidence.
Most have proprietary databases enabling them to keep close track of properties. That includes sales data as well as bid histories on properties that have not sold. Looking at properties that have not sold is one way valuers are gauging market sentiment and figuring out where buyers expectations are. Still, given the paucity of evidence, valuation these days is largely guesswork and concern is mounting that values are lagging too much and compounding market illiquidity.
Given the outlook for the global economy, some real estate experts expect values to decline. In the UK some believe values have a further 10% to 15% to drop and wonder why valuers do not just go ahead and go to that level especially as thats what indicators of market sentiment such as property derivatives, property shares, unit trusts and Reit prices are showing. The answer is, even though valuers have changed, many aspects of their trade have stayed the same.
"Valuers are valuing to the market at present but because there is a perception that valuations need to fall further, valuers are seen to be behind," says Harry Morten, partner at Knight Frank in London. "It is our job to value to what we believe the values are at a certain time, not to where we think theyre going to fall."
The UK is lucky enough to have the most active and liquid property derivatives markets, miles ahead of the US and any continental European market. So why not use it? Valuers are relying on market sentiment bid histories, for example more than ever as part of their practice, but still resist so-called indirect evidence such as property derivatives as an indicator. One reason given is that valuers, while up to speed with capital markets generally, are relatively unfamiliar with derivatives. Another is that derivatives are forward-looking, an indicator of potential future value, which goes against what valuers are trying to achieve.
"To say we should be using the derivatives market as a benchmark for our valuations would be wrong, because it is a projection what is going to happen in the future," says Morten. "I wouldnt support the idea of using evidence from the derivatives market as a valid method of valuation if you are trying to assess market value at the current time."
Mortens view is echoed by many in the property valuation profession. One of the biggest stumbling blocks to adopting property derivatives as part of the valuation process is that valuers see the instruments as too different from physical property in terms of how they are priced and how they trade. They are not a proxy for physical property.
"It is unwise to use pricing on swaps or futures as a benchmark from which to value assets," says Paul Robinson, an executive director at CB Richard Ellis, in London. "The reason being that property derivatives are, in part, a forecast of the market and they are not fungible with the underlying so you cannot do a risk-neutral pricing, because you cannot replicate the index by buying the underlying."
Valuers acknowledge that the derivatives market could be seen as a signal of value and the two markets are interrelated but argue that they are not perfect surrogates for one another. They point to how pricing changes on the derivatives market and sentiment can move it in any direction very quickly as another reason why these instruments are difficult to use as valuation evidence.
"To say that kind of movement should be echoed in the physical market, which has none of the liquidity features of the derivatives market, is naive in the extreme," says Ian Cullen, co-founding director at IPD.
Real features of the two markets mean they cannot perfectly track one another. To trade a few hundred thousand pounds on the swap market takes seconds, while the average lot size in the direct market is £50 million. That includes a lot of small things one small purchase attracts stamp duty and due diligence that takes two to three months to complete.
"Property is a lumpy, heterogeneous and low liquidity market and should not be expected to behave in an identical fashion to the derivatives market"
Ian Cullen, IPD
Some market watchers hinted that valuers might be taking a peek at property derivatives even if only to see where the market sentiment is heading. No one, though, is using derivatives or even share prices as a formal part of their valuation analysis.
"Property derivatives could be useful as an indicator, certainly a measurement of trend," says CBREs Robinson. "You could argue that the value of an asset is the cost of hedging out the market risk. Its valuable but youd have to be careful about how you interpret property derivatives pricing. Not all valuers are that up to speed with property derivatives. Misinterpreting them could have consequences."
Even if derivatives might have some use in valuation, they are considered too new and perhaps too complex to make up part of the process. It is valuers resistance to using evidence from outside the direct property market that will make derivatives acceptance a long process. Their instinct is for using direct evidence in the form of sales, rental and yield data.
"My view is that valuers have to change. They have to use all the indirect evidence and try to come to a view," says Neil Crosby, professor in the School of Real Estate and Planning at the University of Reading. "In the absence of any evidence at all, youre more likely to anchor on a past price if youve got no evidence of things falling apart from total sentiment. Theres got to be some evidence for them to grasp even if it does come from indirect markets."
Although that change might take place, there is frustration in some quarters that indirect evidence is still viewed askance by valuers.
Relying on sentiment
"Strictly speaking they shouldnt look at indirect evidence, but they relied heavily on sentiment last year," notes Axas Patterson. "If people think property derivatives are overstating the fall in the market, then they should be piling in and shorting the derivatives market."
Resisting moving values downwards has fuelled some of the criticism being heaped on valuers. Their obstinacy gives the impression that they are indecisive and far from certain in their valuations. Some valuers believe that because the market is so difficult to gauge, they should be putting caveats into valuations indicating that prices are volatile, meaning likely to go lower. This kind of hesitation leaves valuers open to accusations of caving in to client pressure to keep valuations as high as possible.
"Some valuers are saying they need caveats on valuations," says John Rhodes, head of investment valuation at AtisReal in London. "They dont have confidence in their numbers but, at the same time, they dont have the confidence to drop values. Clients certainly dont want values to drop, because it causes problems with bank lending and unit pricing."
Historical sector performance
Three-month total returns
CBRE is one property services company that says it had put caveats on all its valuations as a result of the lack of transactional evidence and market volatility. Other valuers are using caveats to warn investors how unusual market circumstances are informing valuations. This practice of adding caveats is permitted by the UKs Royal Institution of Chartered Surveyors, which has codified valuation methods in its Red Book of standards.
This sense of uncertainty has contributed to stagnation in the market. While everyone knows prices are bound to drop, sellers are sticking to their guns and trying to get top price for their properties. Even if valuers and vendors are not officially looking at future pricing, the emergence of a practice called chipping indicates that buyers certainly are.
Wary about the fact that property prices are set to fall further, buyers have adopted the attitude: why pay todays price for a property that will be worth less tomorrow? So when it comes to time to exchange contracts, buyers have tried and in some cases succeeded in chipping away at the sale price. Even as buyers take this approach to the market, valuers are not budging.
"Theres an element of forward pricing, because buyers assume the markets going to fall away and the assumption is it has a bit further to go," says Jones Lang LaSalles Renshaw. "We have to be careful not to get ahead of ourselves. Quite clearly there are definitions we have to follow for market valuations."
That property values in the UK are set to fall further is not being disputed. Most valuers agree the market has further to go on the downside. The extent of the drop will become clear when banks begin to force the pace of the market and more distressed sales come through.
With valuers standing firm behind their assessments and practices, some critics grudgingly admit there has been a vast improvement in how these market practitioners have reacted. However, many still blame valuers, at least in part, for contributing to the stand-off between buyers and sellers. Valuers are used to this kind of criticism.
"The alternative of reaching the market peak in 2007 and stagnating there would also have resulted in reduced liquidity," says PwCs Croft. "While the speed of the downward correction has certainly been unexpected and painful, it should, in time, pave the way for a new deal environment."
As to whether dropping values a further 10% to 15% would have been the right action to take, valuers remain sceptical.
"Yes, it would have been useful [if property prices had dropped further] but who is to establish when is the bottom?" says Knight Franks Morten. "If values had fallen 30%, would that have helped the market? I think it would have marginally if it were established that was the bottom. However, it is very difficult to assess when youve reached the bottom of the market."
Those on both sides of the argument of whether or not valuers should be using indirect evidence more extensively seem to agree that valuation is more art than science and that, as a rule, UK valuers outperform their peers. UK best practices for valuation might indeed lead the global property markets but that does not mean there is no room for improvement."Its not as simple as saying take the indirect market and push it through to the direct and thats where the value is," says Crosby. "Still, the idea that you have to rely solely on direct value evidence is wrong. They should be looking at any soft evidence above the hard transaction they can get to reach a view."