Commercial property valuation: Coping with an uncertain market

Lots of uncertainty, especially for office properties

The current state of US commercial real estate valuation might be summed up in a single word: uncertain.

Periods of valuation uncertainty have happened before, according to the speakers at Altus Group's recent online panel discussion, “Current State of US CRE Valuations”, but with shifting fundamentals in parts of the market (especially office), there are some new wrinkles this time around.

In recent months, there has been a sharp drop in the sales volume for commercial assets, which in more robust times provided an ample flow of data to support valuations. By the time 2022 came to a close, it was clear that higher interest rates and the possibility of a recession significantly slowed CRE sales volumes for virtually every property type and in most markets.

Even the most attractive property types, industrial and multi-family, saw sizable drops in sales volume: 22% in 2022 year-over-year for industrial and 27% for multi-family, with most of the drop coming toward the end of the year, according to our Altus Market Insights data.

But for other kinds of properties, valuation uncertainty is more than just a matter of low sales volume. Office assets in particular face a future of uncertain fundamentals because the impact of remote work and office space utilization still isn't clear three years after the pandemic stress-tested the economy and forced a mass adoption of remote work.

“Where there's the most uncertainty is office, by far, because it's not just a pricing question, but also a fundamentals question,” said Altus Group President of Analytics for the Americas Richard Kalvoda, who moderated the event.

“Back-to-the-office is not fully successful yet,” Altus Group Executive Vice President of US Advisory Robby Tandjung said. “Physical occupancy is still about 50% to 55%. The biggest question mark is, what will the revenue look like when leases roll over?”

Complicating the picture for office valuation is the wide variation between types of office, as well as the differences between markets across the country. Life science space, for example, is in high demand, and generally has a stronger outlook, while space suitable to tech companies – a popular sector only a few years ago – is suffering from the contraction in tech employment.

“It's certainly not a one size fits all,” Deloitte Advisory Real Estate Principal Nathan Florio said, referring to the office market. “Between top-notch product and second tier, Class B product, there's a different feeling in the market for those for those assets.”

Commercial property valuations expected to keep declining

During the panel discussion, Altus Group conducted a poll to assess the audience’s expectations for commercial property valuations. Specifically, the poll asked whether the audience anticipated property values to keep declining and which property type would be most affected.

More than two-thirds, or 68% of respondents, expect to see values decline further by 5% to 15%.

By contrast, only about a fifth (21%) of the respondents said that the bottom is near, anticipating less than a 5% decline. A less optimistic but smaller percentage – just over 10% – said that the market isn't even close to a bottom and anticipate more than a 15% drop in commercial real estate valuations ahead.

Besides office assets, which have without question the most value uncertainty in the current economic climate, a slight majority of the respondents, 54%, said that retail has the most value uncertainty. Next were apartments at 21% and then industrial at 17%.

More frequent communication is the key to commercial property valuations right now

Even in a more active transaction environment, the panelists reminded the audience that the valuation process isn't just a matter of looking at recent comparable sales or asset cash flow and calling it a day. The valuation process is comprehensive and therefore isn’t reliant on any one valuation method. Assessing the market, the asset, and gathering information from market participants, are all critical steps included in the process.

Communication between transaction participants is also more important than ever, even as the pace of transactions has slowed down or stalled out completely.

“There's always discussions with brokers, lenders and leasing agents during the normal appraisal process,” Kalvoda said. “But in times like this, there's much more frequent conversations, that are much more detailed, about what's happening in the market. You don't have an actual transaction occurring, which requires more communication among the industry.”

“In markets where there's much more uncertainty, we reach out to a lot more folks on the investment side, or in brokerage, or to other market participants, to understand where the market is going,” said National Property Valuation Advisors Managing Principal, David Walden.

At the same time, the valuation process also means analyzing market fundamentals, taking into account such factors as tenancy, market leasing assumptions, leasing pipeline reports, operating expenses, capital expenditures, and – when available -- pricing data.

“It really doesn't matter whether it's a quarterly or an annual evaluation, the methodologies are the same,” Walden said. “The presentation might be a bit different, but at the end of the day, it's really about looking top-to-bottom or bottom-to-top on the asset. It's about looking at all the different inputs at a very granular level.”

Looking at the deals that didn't go through is also important. The bid-ask spread in transactions that didn't happen is a data point “we look hard at,” Walden said.

In commercial property valuation, it is also useful to consult prior period sales. “We can interview the buyer and seller of a previous transaction and find out how they might underwrite it in today's market,” Tandjung said.

“Overall, there's definitely a lot more work now -- when there aren't a lot of transactions -- than when there were,” Tandjung said. Understanding macrotrends, operating challenges and leasing are all part of the mix for valuation due diligence in 2023.