Perils of Unreasonable CRE Valuation Expectations
Since 2009, unconventional monetary policy by the largest central banks have kept rates very low and in some cases negative which has led to inflated commercial real estate (CRE) investment valuations. As the cost of capital remains artificially low and ROI high, investor demand for safety and yields resulted in real estate as a preferred asset class. But the degree to which future performance expectations can be realized in light of emerging macro trends is questionable.
Asset valuation and project feasibility models often incorporate net present value (NPV) and internal rate of return (IRR/MIRR) / yield to maturity (YTM) calculations to analyze the profitability of a projected investment. In doing so, an appropriate discount rate is applied to the formula to determine if the project is feasible. But determining an appropriate discount rate is not a trivial exercise. Inaccuracies of even a few points can make a big difference in value estimates. Discounted cash flow (DCF) analysis using weighted average cost of capital (WACC) to incorporate the blended cost of equity and the after tax cost of debt is also subject to material errors as the use of traditional models such as capital asset pricing model (CAPM) to measure the cost of equity is reliant upon the accurate assignment of a true risk free rate, which in today’s environment, is the subject of debate. Current methods utilize a heuristic approach with shorter duration treasury maturities to reduce modeling risks. Further, many investors and asset managers expectations for returns above the risk free rate (equity market risk premium) assume that the current spreads over the risk free rate can be maintained in any rate environment, which is unrealistic and reminiscent of the high valuations given to the .com companies before the .com market crash.
The risks associated with current valuation models in an uncertain rate and liquidity environment and where investors are certain to expect higher returns if market liquidity risks grow, will affect asset values measurably if conditions materialize where higher returns are unachievable. As has been the case for many years, follow the Fed!
By Les Sweetow, Published on January 2, 2017
Head of Client Strategy and Research at Inland Real Estate Brokerage and Consulting, Inc.