Impact and change in cash flow assumptions, property-level discount rates and terminal capitalization rates
The impacts of COVID-19 on the global and national economy are far-reaching and well documented. In this environment, the valuation of real estate, a highly subjective endeavor in normal times, is made more arduous by the absence of real-time data — a direct impact of the near shutdown of the real estate leasing and transaction markets for most sectors beginning in March.
The data that does exist provides mixed signals — the National Council of Real Estate Investment Fiduciaries (NCREIF) Index, which tracks core property values reported by institutional funds, reported a quarterly increase of 0.71% as of 31 March 2020; however, as of that date, US equity REIT share prices declined by 24.20% since December 2019, implying that stock market investors, at least, believe that the real estate underlying these shares had lost value. These conditions raise some important questions for accounting and finance professionals tasked with providing thoughtful and well-supported valuations to their investors and other stakeholders on a current basis, among them:
- How does the market view the impacts of COVID on real estate values?
- How should cash flow assumptions be changed to reflect the short- and long-term impact of the virus on individual property as well as on the macroeconomy?
- How should property-level discount rates and terminal capitalization rates be impacted? Or should they be changed at all?
In an effort to answer these questions and gain other insights into how real estate market participants are thinking about COVID-19 and real estate valuation, EY professionals conducted a survey of over 200 professionals active in the US real estate markets. The survey was conducted in late April/early May and included representatives from private equity funds and public REITS, as well as brokers, asset managers and lenders. Our survey asked participants 18 questions about their expectations regarding value trends, transaction activity, discount and capitalization rate changes, and other questions about the duration and impact of the COVID-19-induced market turmoil.
Real estate has lower liquidity and less volatility than equity investments. The stock market is an immediate and real-time representation of market sentiment; real estate market values tend to move more slowly due to the presence of long-term leases, 10-year-plus investment horizons and the higher cost and longer time frame required to ultimately sell an asset. This is why market values do not adjust as quickly as REIT prices, which are down as much as 60% from late February to the middle of May. However, this metric does provide a perspective on investor expectations and cannot be ignored when considering property-level valuations.
We asked our survey participants about their plans for acquisition and disposition activity going forward. Respondents generally expect to curb dispositions of real estate as a result of COVID-19; however, a significantly smaller percentage expect to curtail acquisitions. This suggests a coming disconnect in the market between buyers and sellers that will likely lead to limited transaction activity for the remainder of 2020 in many property sectors.
Regarding discounted cash flow valuation assumptions, our survey participants indicated a reference for adjustments to cash flow items as opposed to discount rate and terminal capitalization rates, in order to model the impact of COVID-19 on property values. A majority of participants indicated that they intend to make top-line revenue adjustments, which could include lowering near-term tenant renewal probability, slowing the pace of speculative leasing and modeling rent concessions and deferrals. Only 26% of respondents indicated that they plan to adjust the discount rate applied to their cash flow forecasts and only 22% plan to increase terminal capitalization rates.
Of course, there is not a generic, one-size-fits-all valuation adjustment for COVID-19. The pandemic has had radically different impacts on the various property sectors and even within sectors, the effect can vary considerably. As such, the following commentary is presented, based on market observations as of March 31, 2020, by asset class with regard to COVID-19 valuation implications.