Property prices tend to be cyclical in nature, shifting as the economy expands and contracts but the challenging environment in the retail market has recently seen the pricing of retail assets deviate from the price movements experienced in the industrial and, although to a lesser extent, office sectors. The recent but sudden drop in retail asset prices reflects a change in the risk and rental growth expectations of investors, and possible realisation that retail assets have been over-priced.
Existing property pricing research tends to be developed from the work of Fisher (1930)[1] and Gordon (1959)[2] where the risk premium attached to an investment, ultimately estimated as the difference between the expected and required rates of return, should appropriately reflect the risk tolerance of individual investors, and the investment community more generally, and adequately compensate investors for the risks they take on when investing in property. These risks should capture the asset’s susceptibility to illiquidity, void and default risks with the risk premium associated with prime commercial property being found to vary between 2%[3] and 3.5%[4][5]).
Evidence of misplacing in the office sector
An IPF study into fair value, examined the required and expected rates of return differential as a measure of mispricing in the office market between 2000 and 2014[6]. Here, they identified over-pricing between 2004 and 2008, when the expected return fell below the required rate of return. The office market then undertook a fundamental repricing of risk, restoring market prices to fair values in December 2008, and experienced a period of under-pricing until 2015. These periods of over- and under-pricing before and after the Great Financial Crisis where also identified by Jones, Cowe and Trevillion (2017)[7] when they estimated the risk premium in the office market.
Is mispricing evident in the retail sector?
Repeating this exercise for the risk premium for standard shops in the UK, we see in Figure 1 the time-varying risk premium fluctuating around a 1.8% long term average with a negative premium where expected returns fell below required rate of returns occurring in 2009 and again in 2020. Both triggered by a surge in market uncertainty, which in turn resulted in undervaluation.
Figure 1 suggests the over-pricing and recalibration of yields in the office market were mirrored in the retail market between 2005 and 2010 as expected returns failed to deliver the long term average premium and then again in 2018, before the start of Covid pandemic. Jones et al. (2017), describes the period before the Great Financial Crisis as a period of ‘irrational exuberance’ in the office market, followed by ‘irrational pessimism’ as an over-correction in pricing results in sharp movements in market values. Similar observations here in the retail market might also be because capital values were being driven by unreasonable expectations of rental growth by investors, as surmised by Jones et al. (2017), which the market eventually recognised and resulted in a price correction.
Possible causes of misplacing
Cyclical movements in property investment pricing are not new and are a normal part of the investment process but these periods of over and under-pricing suggest that the market is slow to accurately capture risk and return changes in the market. One possible explanation might be that direct property valuations are being influenced by investor sentiment effects (and possibly reinforced by large investors following the same forecasts) which are powering the severe market corrections whereas the expansion of oversea investment activity is further contributing to the exuberance in the market.
Another explanation offered by academic studies is that valuers are not using all-risks yields that accurately reflect individual property characteristics and local market conditions. Inappropriate risk pricing and the over-reliance on market average all-risk yields remain a potential cause of mispricing in the retail property, particularly during periods of thin market trading or when uncertainty over covenant strength, and default and void risks are unusually high. The result of this uncertainty is a nervousness about making large changes to yields in one go.
Recommended changes to valuation process might help
Recently, The Independent Review of Real Estate Investment Valuations, commissioned by the Standards and Regulation Board of RICS, made a series of recommendations to improve valuation practices. One of these recommendations being the call for growth-explicit discounted cash flow valuation models to become “the principal model applied in preparing property investment valuations” (Gray, 2021, p36[9]). The RICS has accepted all recommendations made by the independent review but as yet there are little details on how they will support the valuation profession to make greater use of the discounted cash flow model and analytical techniques to determine realistic required rates of return. It is likely the RICS will shy away from prescribing the use of a particular valuation model but they may encourage valuers to use as a cross checking tool.
We would go one step further, in light of the rise of turnover-linked rents and other lease changes that have occurred in the market, and suggest that the RICS Valuation Professional Group undertake a systematic exploration and evaluation of global best practice to find out how retail assets are valued in countries with similar lease structures, and possibly even identify the structural issues associated with relying on the limited number of datasets that most valuers and investors have access to. The retail valuation methods, data and risk assessment methods identified in this review should inform the revised guidance issued regarding the valuation of retail property.
– The REPAIR Team
[1] Fisher, I (1930), The Theory of Interest, New York: McMillan.
[2] Gordon, M J (1959) Dividends, earnings and stock prices, Review of Economics and Statistics (The MIT Press), 41(2), 99–105.
[3] Fraser, W D (1993) Principles of Property Investment and Pricing, 2nd edition, Macmillan, London.
[4] Blundell, G (2014) Risk premia, the reward for taking risk, Issue No 25, May 2014, Investment Property Focus, IPF, London.
[5] Baum, A (2015) Real Estate Investment: A Strategic Approach, 3rd edition, Routledge, London.
[6] Burston, B and Burrell, A (2015) What is fair value?, IPF Short Paper 24, Investment Property Forum, London.
[7] Jones, C, Cowe, S and Trevillion, E (2017) Property Boom and Banking Bust. The role of commercial lending in the bankruptcy of banks, Wiley-Blackwell.
[8] Estimated as rp = k – rfr + gm – d – dgm where rp is the risk premium, k is the expected investment yield estimated using MSCI net yields, , rfr is the nominal risk-free rate estimates as the 10-year nominal gross redemption yields from the Bank of England, gm is the expected rental growth estimated as the three year mean IPF rental growth forecast for shops and d is the rate of deprecation is fixed at 0.4%. based on IPF depreciation study.
[9] Gray, P J P (2021) Independent Review of Real Estate Investment Valuations, Review commissioned by the Standards and Regulation Board of RICS, December 2021, Wellcome Trust, London.