When Distress Becomes Market
The real estate market is currently undergoing significant changes, with many institutions waiting for conviction in the market to deploy capital. Market unpredictability, higher interest rates and declining asset valuations have increased Investor uncertainty. Investors are looking to "buy the bottom" of asset valuations and achieve long-term returns, but what many perceive as distress may, in fact, represent the market's reality across various sectors. Sources consulted by the Alliance Global Advisors (Alliance) team reported that transactions are happening but at lower valuations, reflecting the current market. This blog delves into the nuances of what truly makes distressed assets, proper valuation practices and comparable sales in the current market.
We thank Brian Velky, Managing Director and Head of Real Estate Valuation Services of SitusAMC and Kurt Edwards, Head of Taxable Real Assets at UBS for their insightful contributions on this topic.
INTRODUCTION
Valuations in all real estate sectors have declined, causing Investors to hold off and accumulate dry powder for the right opportunity. The office sector led the decline, while the hospitality sector performed the strongest and has shown the least valuation declines. Investors’ current practice of awaiting lower valuations and higher conviction in decisions, often referred to as "buying the bottom," highlights Investors' anticipation of capitalizing on lower prices and achieving long-term returns. However, it's crucial to understand that when asset values decline across the board, this practice is unnecessary to achieve desired long-term returns. Consulting valuation experts and examining current market transactions reveal a more complex picture.
DEFINING DISTRESSED
Understanding what constitutes distressed assets is vital for Investors and Managers. Distressed sales are typically forced and leave the selling party with limited negotiating power:
Distress (aka Troubled/Special Servicing): This indicates direct knowledge of property-level distress, often known through announcements of bankruptcy, default, court administration or significant public issues such as tenant distress or liquidation. CMBS loans transferred to a special servicer also fall under this category.
Potential Distress (aka Potentially Troubled/Watchlist): This indicates possible future property-level financial trouble due to events such as delinquent loan payments, forbearance or slow lease-up/sell-out. CMBS loans placed on master servicer watchlists are included here.
Distressed Sale: This refers to a sale where the property or properties acquired were considered distressed, resolving a previously distressed situation.
Historically, distressed real estate required specialized approaches and strategies to return stability to the asset. These sales leave the seller with limited to no negotiating power, often with a distasteful result for the seller. Factors such as the duration of the remaining weighted average lease term (WALT) on the asset impact perceived valuations and what a buyer is willing to pay. Specifically in the office sector, many distressed sales transactions occur when seller financing is contemplated. Cap rates ruled the appraisal space in the past, but cash rates have become more impactful in valuation practices following economic events in the past five years. Understanding the historical contexts surrounding real estate valuation can provide valuable insights for understanding buyers and sellers in the current market.
VALUATIONS AND DISTRESSED ASSETS
Valuing distressed assets requires adherence to certain standards, such as the Uniform Standards of Professional Appraisal Practice (USPAP). According to USPAP, “Market Value means the most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, with both buyer and seller acting prudently and knowledgeably and assuming the price is not affected by undue stimulus.” This definition implies several conditions:
The buyer and seller are typically motivated
Both parties are well informed or well advised and acting in their best interest
A reasonable time is allowed for exposure to the open market
Payment is made in terms of cash in U.S. dollars or comparable financial arrangements
The price represents the regular consideration for the property sold, unaffected by special or creative financing or sale concessions
Industry organizations such as the National Council of Real Estate Investment Fiduciaries (NCREIF) and the Pension Real Estate Association (PREA) established reporting standards and committees to address valuation struggles. The NCREIF/PREA Reporting Standards, NCREIF Accounting & Valuation Committees and the PREA Reporting & Valuation Affinity Group are at the forefront of tackling these issues.
Industry organizations or appraisers may value an asset differently than buyers or sellers. For the past two years, bid-ask spreads on real estate assets have widened amid valuation declines. Currently, buyers and sellers either meet in the middle on values or the deal often falls through. This difference in perceived value and the seller not fully being “forced” to sell the asset or roll over in negotiations implies these deals are a fair representation of the current market.
DIVING DEEPER: ASSETS IN THE CURRENT MARKET
Appraising assets currently requires separating market value from special situations. Equity and debt valuation practices differ, and various industry forums, including those organized by NCREIF and PREA, are addressing these challenges. The PREA Valuations and Reporting Standards Committee is working diligently to improve the accuracy of valuation practices.
Market statistics reveal that a 30% decline in value in one quarter is considered distressed, but what about a 30% decline over five quarters? This highlights the importance of peak-to-trough analysis and understanding the timing element. Public REITs in the U.S. can serve as a leading indicator for directional movements in private pricing, particularly when premiums or discounts exceed 15%.
Despite this information, executing strategies in private markets remains challenging due to bid/ask gaps at the asset level. Secondary markets and entity-level transactions offer paths to access truly distressed assets, indirectly aligning interest between the buyer and seller, but many of these deals come with their complexities as Investors and Managers navigate these unique transactions.
Reference the recent Alliance Blog, which elaborates on the research we conducted on the rising popularity of entity-level investing amid the current market conditions: Exploring the Rise of Entity-Level Investing in Real Estate
WHY ARE DEALS FALLING THROUGH?
To provide further insight into valuation struggles, it is essential to account for the ancillary details often included in a real estate transaction. Considering details such as seller financing workouts, in many scenarios, the transaction would not classify as a “distressed sale,” given that the buyer and seller negotiated the deal and aligned interests, leaving both parties satisfied.
In cases where deals fail, service providers often hear, “I agree with all these metrics; I just don’t agree with the value,” from the buyer or seller. This can be attributed to the party not accounting for factors outside the typical valuation process when considering, “What will someone pay for this asset, realistically?”
The notion of the "Perfect Wave" does not exist in real estate. Dollar averaging into the market may be the best strategy, given the long-term returns historically associated with real estate. Investors should not wait for valuations to “bottom out” before making thoughtful and strategic investment decisions, including capital commitments. With most deals falling through due to a failure to agree on the bid/ask spread, Investors and Managers must take the current market as it is and realize that transactions reflect the changing market. Further evidencing this is the recent data from MSCI Real Assets showing the velocity of distressed transactions slowing (see chart below showing net change in distressed deals).
Chart Source: MSCI Real Assets
Blackstone has highlighted the importance of market timing, and PREA forecasts suggest depreciation for 2024, followed by appreciation in 2025. Starting dollar averaging into the market in 2024 could be a viable approach.
ASKING THE EXPERTS: BEST PRACTICES IN VALUATIONS AND COMPARABLE ASSETS
The Alliance team connected with Brian Velky and the team at SitusAMC to dive deeper into what valuations look like currently and the best practices employed in the space:
What are some of the best practices/key considerations that must be employed when appraising asset values in the current market?
Brian Velky answered, “When gathering sales information, make certain the sales information is applied consistently with how it was extracted from the market – the details matter, particularly today. A couple of examples we have observed in the current market include:
Multifamily: Is the cap rate associated with sales being quoted based on actual in-place NOI but then applied for purposes of valuation to a more aggressive forward proforma NOI?
Industrial: Is the cap rate associated with sales being justified based on a below-market rate deal with short WALT being applied to a below-market rate deal with long WALT?
Investor return expectations differ based on those variables, so a key consideration is to apply assumptions that differentiate those risk profiles.
In the current market, consideration must be given not only to valuation metrics and conclusions in a given period, but to understand and analyze across multiple periods (i.e., year-over-year, peak-to-current, pre-pandemic to now, etc.). This ensures appropriate application of changes and trends at a macro and micro level.”
What makes an acceptable comparable asset in the market currently?
“Any sale that meets the definition of “Market Value,” which generally reflects a competitively marketed property; buyer and seller each acting prudently, knowledgeably and in their own best interest; and the sale is not affected by undue stimulus.”
Rarely is a comparable asset an apples-to-apples comparison, and Mr. Velky states that appraisers will make adjustments to comparable sales under unique circumstances:
“For example, the presence of seller financing has been prevalent given the higher cost of debt in this environment. Sales exhibiting the influence of seller financing can (and should) be adjusted for the impact of the positive financing to arrive at a market cap rate, etc.”
Currently, what are the most significant issues with assessing asset values?
Velky provided, “In the history of the ODCE index, the biggest one-year trailing decline took place between 4Q08 and 3Q09, which is the period following the Lehman bankruptcy. This represented a period where there really was limited transaction activity. Compare that to today, where the NPI Index (a relatively small view of the total CRE market) has had over $44 billion in total transaction activity since 3Q22 (post peak). Based on these factors, it is clear that transaction activity should not serve as the limiting factor in providing a reasonable fair value representative of current market activity and conditions.
In addition, there is a misperception that similar funds follow an identical valuation process, whereby frequency, scope, diligence of execution and management involvement are all assumed to be the same. However, there are varying levels of independence as well as processes that may be more or less comprehensive.”
Is there a significantly higher level of distress in the current market, and is it really distress?
“At this point in the cycle (two years), it would be difficult to point to distress for any specific property type, particularly as it pertains to anything except office. However, even within the office sector, you can look at some of the “best-of-the-best” sales that are taking place. These clearly do not reflect distress and are trading at cap rates ranging between 6.50% and 7.00%. This provides strong evidence that the cap rates of lesser-quality office properties should at least be higher than these observed sales.”
CONCLUSION
The current state of real estate valuations presents a complex landscape where perceived distress may not always align with market realities. Investors and Managers can navigate these challenges by understanding the definitions and nuances of distressed assets, adhering to valuation standards and making strategic investment decisions. Even if assets are returned to the lender, the owner is still making a conscious decision to do so and is not entirely distressed at the time of the “sale.” The historical performance of real estate suggests that thoughtful and strategic investments in well-positioned assets (or assets that can be stabilized through other methods) will yield positive results over time. Investors must be thorough in their diligence and find deals in the market that will align with their interests over the long term. The critical takeaway for real estate Investors is to focus on long-term returns and not be deterred by short-term market fluctuations.
Alliance Blog Addendum
Commercial Real Estate Appraisal Best Practices: A Global Comparison
Understanding the accuracy of property valuations is fundamental for investors, consultants and investment managers alike. Values serve as the foundation for making informed investment decisions about buying, selling or managing properties. However, the best practices for appraisal methods and techniques vary across different regions of the world, and appraisal practices differ vastly for Core and Non-Core fund holdings. Debt mark-to-market requirements also vary by region.
Differences in Appraisal Practices: United States vs. Europe vs. Asia
Appraisal practices for commercial real estate differ significantly across the United States, Europe and Asia due to varying market conditions, regulatory environments and valuation methodologies. One of the main differences between these regions is the reliance on market comparables in the U.S. versus discounted cash flow (DCF) in Europe. The U.S. market's depth and data availability make the market comparable approach more practical, while Europe's focus on long-term investment horizons aligns well with the DCF method. In Asia, the hybrid approach reflects the diverse economic environments and varying levels of market maturity across the continent.
United States
In the U.S., appraisals primarily rely on the “market comparable approach”. This method involves comparing the subject property with recent sales of similar properties, adjusting for differences in factors like location, size and condition. This approach is widely used due to the high availability of transaction data and the transparency of the market. The U.S. also incorporates other valuation methods, such as the income approach and the cost approach, but market comparables remain dominant, especially for properties in active markets.
Further, due to the enhanced liquidity features, U.S. Core open-ended funds utilize a more stringent process for establishing quarterly valuations in which both equity and debt are marked-to-market with more frequency. Separate Account appraisal practices vary widely based on investor preferences. Due to the illiquid nature of Non-Core fund vehicles and the value-creation ongoing throughout the fund life, Non-Core funds often have less frequent appraisals.
We are living with the palpable downside to using the “market comparable approach” today. During periods of uncertainty, when transaction volume is stagnant, it becomes more difficult for buyers and sellers to ascertain values – and for investors to understand the true value of their portfolio. As our blog indicates, distressed transactions often do not “count” towards market comparables.
Europe
European commercial real estate appraisals often focus on the “discounted cash flow method.” This approach involves projecting the property's future cash flows over a specific holding period and then discounting these cash flows to their present value using an appropriate discount rate. The DCF method is favored in Europe due to its ability to capture the long-term value of properties, which is particularly important in markets with less frequent transactions or where properties are held as long-term investments.
Asia
In Asia, appraisal practices can vary widely by country but tend to blend elements of both the U.S. and European approaches. For instance, in more developed markets like Japan and Singapore, there is a strong emphasis on the income approach, similar to the DCF method used in Europe. However, in markets with more active trading, such as Hong Kong, the market comparable approach is also prevalent. Additionally, the regulatory landscape in Asia often requires more conservative valuation practices due to the influence of government policies and less market transparency compared to the West.
For further reading, you can explore more detailed reports and market analyses from Deloitte, PwC, and other industry leaders [oai_citation:1,Real Estate Appraisal Market Research and Insights 2030](https://exactitudeconsultancy.com/reports/34092/real-estate-appraisal-market/) [oai_citation:2,2024 commercial real estate outlook | Deloitte Insights](https://www2.deloitte.com/us/en/insights/industry/financial-services/commercial-real-estate-outlook.html) [oai_citation:3,Emerging Trends in Real Estate®: Europe 2024 | PwC](https://www.pwc.com/gx/en/industries/financial-services/real-estate/emerging-trends-real-estate/europe-2024.html).
ABOUT ALLIANCE GLOBAL ADVISORS
Alliance Global Advisors is a women-owned consulting firm focused on empowering the institutional investment community to elevate best practices. Advising clients with over $870 billion in assets under management, Alliance partners with organizations to provide an independent perspective and innovative approach to critical strategic initiatives. Our partnerships allow senior management teams to focus on what matters most: diligently managing client capital, creating value and delivering exceptional returns in a performance-driven market.
Disclaimer: This blog was originally published in August 2024 and will be updated periodically to reflect changes in the industry. The content may contain or cite personal and/or professional opinions that differ from the views of Alliance Global Advisors.