Making better predictions in Real Estate valuations

Uneven volatility     |     The value of confidence     |     Reliable data with good insights     |     More informed decisions     |     Versatile applications offer various opportunities

Real Estate portfolios are facing increasing volatility. Managers and investors will need to become much more sophisticated in the way they predict the future.

The pandemic has put many of the traditional real estate market fundamentals under pressure. And nobody really knows what the long-term impact will be on the way people will live, work and play.

What is clear is that the influence of the pandemic on real estate markets has been uneven. The retail and hotel sectors have, from today’s perspective, been the most affected due to lockdowns and capacity restrictions. Many physical retailers and hotel operators are feeling the cash crunch; bankruptcies are on the rise; and many are struggling to pay rent.

The office sector, on the other hand, is currently fairly stable. But the sector also has an uncertain outlook as workers and employers become increasingly comfortable with ‘work from home’ models and more business interactions become digitized. Many businesses will undoubtedly start to think about adjusting their office footprints. Long term contracts remain in place, but there is growing uncertainty about how this trend will impact demand for office space once contracts are due for renewal.

Other sectors are expected to see an increase in market values as a result of the pandemic. Demand for some residential segments, for example, has boomed. The logistics sector has also enjoyed significant growth as a result of the digitization of commerce and uncertainty of transport chains during the pandemic.

The pandemic has also had an uneven impact on individual markets. Some countries are facing a deeper and longer climb back to growth than others. Even within the same country or region, long-term prospects will vary. Five-year outlook for commercial real estate in Hamburg (in the northern part of Germany) is now significantly different to that of commercial assets in the German capital city Berlin. Common assumptions can no longer be trusted.

Nobody wants uncertainty in real estate valuations, and it is not just landlords and REIT managers that are concerned. Banks and investment managers are also increasingly focused on understanding the impact of real estate volatility on their books of assets. For many, the implications could be significant. Consider, for example, how a few percentage points of change in valuations could affect the amount of capital reserves that may be required to be held by banks.

Regulators have been quick to notice the change in these potential risks. Many have started to actively nudge their constituents towards taking a more sophisticated and scientific approach to assessing the long-term valuations of their illiquid assets – real estate in particular. Standard abatements will no longer be sufficient for the regulators. They are looking for managers to have a much more detailed view of their assets’ longer-term risks.

Based on our market experience, most real estate managers and investors agree that the lack of precision in their forecasts remains one of their largest risks going forward. The problem is that they often struggle to achieve clarity as to what data they should be using to create their scenario plans and what relationships they should be inferring from that data.

In Germany, for example, there are almost 20 institutions and analysts that provide GDP growth forecasts; their predications can often vary significantly from the most optimistic to the most dire. Knowing which data sources to use and which are reliable is not easy. Creating systems to capture that data and integrate it into a decision-making tool is equally difficult.

Even once reliable indicators have been selected, managers will still need to accurately assess the meaning of the performance indicators for the longer-term sustainability of real estate valuations in a specific segment and geography. This requires a certain level of analytics and scenario planning capabilities, deep insight into local market nuances and an understanding of the interplay between data indicators and real-world outcomes.

When the right data and insights are combined, however, the results can be transformational for a real estate investors’ risk management and strategic planning capability. At KPMG in Germany, we have created a solution that is designed to allow landlords, investors, banks and asset managers to achieve a targeted view of an asset’s medium-term prospects.

We can, for example, create transparent ‘base’, ‘better case’ and ‘worst case’ forecasts for single-purpose usages like hotels and offices, as well as for large, multinational portfolios of assets across different sectors.

In each case, we can analyze the data on a market-by-market and sector-by-sector basis, understanding the nuances and interconnections in the data at each stage to develop transparent and broad-ranging forecasts. That enables our clients to make more informed and confident, forward-looking decisions about how they want to shape their real estate portfolios for the future.

Clearly, the need for a more sophisticated approach to creating valuation forecasts is not unique to Germany, and certainly not isolated to the real estate sector. It is true of virtually every market and every illiquid asset class.

Some markets may struggle more than others to curate reliable sources of data; others may face challenges interpreting the data for their specific asset class. But, ultimately, every investor, stakeholder and manager should encourage and strive for greater confidence in their valuation forecasts.

In our view this has the potential to lead to better management of assets and investments, better mitigation of short and long-term risks, and better long-term value creation for real estate asset owners and investors.