Beware Conflicted Values
The global economic indicators are flashing amber warnings in many markets as the near decade long bull run in equities has come to an abrupt halt and the support given to asset prices through unprecedently low interest rates and central bank purchases winds down. Coupled with the increasing politicisation of trade between the major global economies it is not surprising that many investors are being cautious or negative. Slowing markets create valuation challenges, and, with it, greater scrutiny of valuers.
A good example can be found in the UK retail sector, where a number of commentators have been accusing valuers responsible for the regular valuations of real estate funds of failing to adequately reflect the woes facing many retail chains. Critics believe that the fact that retail values in the IPD Index have fallen by only a few percentage points over the past twelve months, whereas the share prices of the major REITs invested in retail property have fallen by a far greater amount over the same period, indicates that valuers are not facing up to reality. Some argue this is due to a systemic problem because the majority of the major funds are valued by a handful of firms who also provide brokerage and other consulting services to the same coterie of funds, which compromises their independence.
Accusations that the relationship between valuer and fund is compromised by other work that the valuer’s firm may do for the fund are not dissimilar to those levelled against the Big 4 accounting firms in relation to their auditing role. Yes, it is vital that the potential for conflict is acknowledged and appropriate safeguards in place to avoid, or at least significantly minimise, the impact this may have on the duty of independence and objectivity owed to the client and any affected third parties. However, nowadays most firms have rigorous checks and safeguards in place, and indeed are obliged to do so by their professional bodies, such as RICS, who will hold those who transgress to account. The bigger the firm the greater the potential for conflicts arising but, by the same token, the resources it can deploy to first identify and then avoid such conflicts are also greater. And beyond the avoidance of conflicts, most will have in place other internal review and audit procedures aimed at ensuring their valuations are as objective and relevant as possible.
Those who advocate complete isolation of those who provide valuations relied on by investors from other work for the same client, or even in the same sector, need to be careful what they wish for. For a valuer to be effective they have to be in touch with the market in real time, not just analysing past transaction data that has made its way into the public realm. Only by being closely involved with clients who are active in the market, or with colleagues who are, can a valuer appreciate all the nuances that lie behind day to day decisions to buy or sell and the prices to accept. I would question the motives of someone who preferred their valuer not to know too much about the market.
This tension between independence on the one hand and relevant knowledge and experience on the other lies at the heart of much professional activity and is why avoiding conflicts of interest and other ethical considerations are a prerequisite of membership of professional bodies. Put another way, being a professional requires you to have not only technical skill and knowledge but an obligation to use that skill and knowledge for the public good. The simple fact that there are a limited number of professional advisers with the competence and capacity to serve a specialised market is not of itself a reason to suspect that any advice they provide is tainted by other considerations.
The suggestion that a firm’s involvement in a market beyond providing valuations leads to pressure not to mark valuations down also needs examination. Who would gain from this? REITs and funds subject to public scrutiny could not, as NAVs are closely analysed and dissected. Any perceived advantage would soon be undone and could lead to a greater negative reaction. Neither would the firms, as their other clients will include buyers and sellers in that market, neither of whom would be served by conscious distortion of the values at which deals could actually take place.
The evidence presented for alleged current over valuation, that share prices have fallen by a much greater percentage than the falls in the reported NAVs, also misses the point. There are a number of reasons why a correlation between the two should not be assumed, which include:
An interest in property, particular a large commercial property, is illiquid and transactions are expensive. By comparison, shares in REITs or funds are far more liquid with modest transaction costs. Consequently, the price of property is more likely to be affected long term considerations than the price of shares into which investors can easily dip in and out based on the perceived short term prospects of the entity in question.
While the illiquidity of real estate is one of the attractions of indirect investment through a fund, it also means that when markets are difficult redemptions may put short term pressure on cash flow and necessitate the sale of assets at sub optimal prices. This leverages the negative effect on share prices of an underlying fall in real estate values.
The downside risk of a building becoming vacant or even obsolete does not compare with the risk to shareholders of a company becoming insolvent which amplifies the effect of declining property values on the share price of the entity that owns them.
The importance of recognising and avoiding threats to the objectivity of valuers should not be dismissed, especially where investors are relying on those figures. Vigilance is required to ensure that high professional standards are maintained. However, I do feel some of the current criticism is wide of the mark.
Looking back to 2008/09, the last time there was a sustained fall in the value of most investment property, the valuers contributing to the IPD Index were not shy about marking down values significantly, particularly in the months following the crash of Lehmans. Indeed, there is a strong argument that the walking down of values to the point where buyers re-emerged was instrumental in the UK investment property market recovering more quickly than some of its counterparts overseas where both REITs and valuers held on to 2007 values on the grounds that there had been no transactions to justify a reduction. This is a further indication that there is no shared interest between a fund and its valuation adviser in denying the market by keeping values high.
So while the current criticism is a reminder to the major valuation firms that they can never become complacent about the avoidance of conflicts of interest, a case has not been made to prove that the dominance of the fund valuation market by multidisciplinary real estate advisors is leading to inappropriate valuation. Indeed, the alternative that can be imagined would probably have even greater problems.