There’s no clear litmus test that lets real estate CFOs know when enough number-crunching has been performed during valuation exercises. But one thing for certain is that all would enjoy a smooth audit process. We spoke with CFOs, valuation experts and auditors themselves to ask about GPs’ common mistakes or challenges GPs run into. Their responses shed some useful light on how to satisfy auditors’ expectations – and as such, should help to avoid the lengthy back and forth communication often required these days before all the parties involved can feel comfortable with the final estimates.
1. Do more credit checks
One thing valuation experts and auditors like to argue is that property is really only worth the net present value of the cash flow it generates. Translation: GPs need to do more than just look at what the rental contract says cash flows will be. The world is an uncertain place, and auditors say GPs don’t always take that into enough consideration when working out a property value.
Accordingly real estate managers need to conduct more due diligence when assessing a tenant’s ability to pay on time and throughout the life of the rental agreement, says Robin Priest, a managing director within Alvarez & Marsal’s real estate advisory services team.
This means more than just the standard quantitative test of figuring out a tenant’s credit score, elaborates Philip Parnell, head of real estate management and valuation at Deloitte. Whether it’s a corporate renting an office block or a retailer letting space in a shopping mall, specific nuances exist around each renter’s ability to pay.
During valuation, real estate managers should then ask questions like: What sector does this tenant operate in? Is it thriving or suffering a downturn? What is their strategy? And perhaps above all else, who exactly is named on the lease? A fund manager may think he has some blue-chip tenant, when in fact the lease is written to a subsidiary of the company without recourse to the parent, warns Priest.
Other metrics like the makeup of a retailer’s consumer base, including class status and gender, can be used by real estate managers wanting to dig deep on a renter’s creditworthiness. One auditor says he wants to see fund managers assess whether or not a potential retailer’s store will be a success by using the retailer’s in-house research to work out whether or not it will have access to its core customer base when opening in a new location.
In conjunction with making predictions about an entity’s future success, auditors also like to see real estate managers performing sufficient homework on current performance. Auditors like GPs to obtain standard credit reports and rating assessments of their tenants. And even then auditors say they spot mistakes when too many assumptions are being made on the numbers crunched. To illustrate that point, Parnell uses the example of the global financial crisis, which saw companies and institutions with high credit scores crumble rapidly.
2. Don’t be too bullish on growth
As a corollary of not doing enough groundwork on where a property’s income is coming from, market sources say that fund managers can get too “bullish” with their rental growth assumptions.
Parnell says interpreting rental growth has always been difficult for fund managers, both when the market is on the way up and when it is on the way down. “There is a temptation that one can get caught in the moment of that particular market.”
One auditor recalls to pfm a client who was renovating a property just outside Paris as an example of aggressive assumptions. According to the auditor, his client made rental growth assumptions based on a prior investment made in Paris, but hadn’t thoroughly checked current rates, which were declining for similar buildings. The assumptions were also based on Paris, but the location of this building was outside the city hub, where demand for high-quality office space wasn’t as high.
Some sources say this over-optimism can come from creating a valuation from the top down. “There is a tendency for fund managers to use the buy-in IRR as a discount rate so the valuation becomes a self-fulfilling prophecy,” says Mark Collard, valuations partner at KPMG.
“Fund managers often say: ‘We bought in expecting an 18 percent IRR so that is the discount rate we are going to use’,” adds Collard. “That is fundamentally wrong from a basic valuation perspective. It needs to be a bottom-up discount rate, starting from scratch.”
3. Try not to overestimate your ‘value-add’
Overvaluing any value-add work done to a property is also an area that fund managers can trip up on, warn auditors.
Collard describes a scenario where a client owned a 50 floor office block in Manhattan. He says the client could never get the building more than 80 percent full at any one time. So in a bid to get higher occupancy rates, the owner decided to roll up his sleeves and refurbish the property, with an expected completion time of six years. However Collard says the owner wasn’t making the right adjustments in light of this new value-add project as the refurbishment got under way. Moreover rental growth wasn’t adjusted down when floors were unusable during refurbishment, among other things.
Parnell agrees that pricing value-add initiatives can be a struggle. He says fund managers need to challenge how much a purchaser would pay for the added work, and importantly, the extent to which a potential purchaser would be able to take on the risk of the initiative. Can a buyer accommodate the risk that the refurbishment doesn’t get completed in time, and so start paying for something that hasn’t been delivered?
4. Compare apples to apples
Real estate fund managers also face a pure information gathering challenge when comparing assets for valuation purposes.
“In all honesty, transaction activity has slowed dramatically; so a lot of the data points that were there in 2006 and 2007 are gone,” says Keenan Vyas, vice president at valuation experts Duff & Phelps. “The [data] pool isn’t as big as it was, so what ends up happening is fund managers rely on what is nearer or easier to get their hands on – [whereas] what they should do is take a more global view.”
Vyas says that fund managers fall into the habit of using past investments as comparable assets even when the property isn’t suitable. He stresses that fund managers need to appreciate more the specific risks and nuances contained in each market, sector or industry. And with respect to using comparables valued before the financial crisis, he emphasizes that “clearly things have changed in the last few years”.
“It’s about widening the sample,” says Vyas. “You might look at the best office development in Manchester, but there is nothing locally comparable to that particular asset. So trying to come up with what a proper yield would be in Manchester for that type of asset is inappropriate; you have to go to Leeds or Birmingham to come up with a relevant comparison.”