Risk-free rate paradox
We live in interesting times. The property market is once again sending us signals from which we should draw conclusions for the daily property valuation practice. Unfortunately, as far as I see, this is not happening.
For many years I have been questioning the use of the so-called additive method for determining yields for valuations by means of income approach, in favour of observing transactions occurring in the market. There are already enough of these transactions each year to be able to observe yields and draw conclusions from them for the purposes of a specific valuation. Unfortunately, those who contest this approach are coming up with reasons to prefer a mechanical summation of often made-up risk premiums. The most common excuses are those relating to difficult access to data or the fact that the reported largest investment transactions, for which yields are known, relate to properties located in largest cities and not in the smaller towns where the subject property is located. International valuation practice has for decades provided a solution to this in the form of the so-called „hierarchy” of yields. For its application, to adjust the yield from a large city for the purpose of valuing property in a small town, with all its peculiarities, however, it is necessary to know the market and the mechanisms governing yields. We know of course, that the level of the yield reflects the level of risk of investing in a property. But, do valuers know what influences the level of that risk? Unfortunately, according to my observations, they not always do. But then again, how are they supposed to know this if they do not make such market observations by facilitating their task by mechanicall applying the additive method.
However, the current market situation is causing the world of such ‘valuation mechanics’ to collapse somewhat. Well, the interest rate commonly regarded in Poland as the risk-free rate on 10-year treasury bonds already exceeds 7%. Meanwhile, commercial real estate transactions, especially for warehouses, are still recorded at rates close to 5%.
What is this all about? Could it be that suddenly real estate has become less risky than the mythical risk-free investment? Why do investors, instead of buying government bonds and sitting around with their hands in their pockets, waiting for the interest to be paid, take the risk and invest in real estate?
Such questions are being asked more and more frequently, also by banks. “Mechanics” find them difficult to answer, because they have probably never had to think about it before. Up to now they added a few more or less clever risk premiums to bond rate and had a yield, even if it was out of line with the market. And here, all of a sudden, it appears that they would have to start ….subtracting?
This is the damage done to the valuers’ community by pahragraph 12 of the Regulation on valuation and preparation of the valuation report, allowing determination of discount rates based on the capital market and the famous additive method. And the manifestations of this damage I see every day, e.g. in the form of a rate of 2.93% (what precision) in the valuation of a hospital in a small town or 6% in a valuation in the early 2000s of an outpatient clinic in a locality of 5,000 inhabitants. In both cases, the valuation errors ran into millions. And it was enough to open even one report on the investment real estate market to find out that even prime yields were much higher back then. But they say “you can’t argue with maths”.
However, before the ‘mechanics’ abandon the income approach in favour of a comparative approach (which in the case of commercial real estate very rarely ends well and rather only accidentally), it is worth considering why current yields for real estate are lower than so-called risk-free rates.
This question is probably being asked all over the world at the moment, and it is not at all easy to answer. However, this is not rocket science too and one might be tempted to list at least a few reasons for this situation. However, it is important to remember that the list of reasons is not closed. They may vary from market to market or market segment to segment, but they can also change over time.
One of the reasons for observing real estate yields in the market that are lower than bond yields is investors’ expectation that property income will increase in the future, a privilege not afforded by bonds. Paradoxically, this is facilitated by inflation (if only through the indexation of rents), which has a downward effect on yields, although it should also lead to higher discount rates in explicit cash flows. This second issue, however, concerns not so much the market as much as the valuation methodology and valuer’s practice.
Secondly, perhaps investors also expect real estate capital values themselves to increase in the future. This is another reason why the decompression of yields in the Polish property market lags far behind the actions of the Monetary Policy Council in terms of interest rates and the ministry’s valuation of Treasury bonds.
The more basic mechanisms of the market should not be forgotten either. The supply of good investment products in the property market is limited. Many would like to buy but have nothing to buy because the construction process takes a long time, especially in a situation of high uncertainty related to rising construction costs, the cautiousness of construction companies and the difficulty of obtaining financing. Meanwhile, as we know, limited supply with high demand raises prices, which, with an assumed, albeit temporarily fixed income, translates into lower rates of return (Capitalisation Rate=Income/Price).
It is also worth asking a more iconoclastic question. Have not Polish government bonds, even the 10-year bonds, recently moved away from the mythical risk-free investment? Although the idea of the existence of such an investment has been somewhat theoretical, because with every investment there is some risk involved, lately, with regard to bonds, this risk seems to be somewhat greater. Furthermore, it should also not be forgotten that in the global markets investors are no longer condemned only to Polish government bonds. They may be able to find instruments abroad that are closer to the idea of freedom from risk than Polish government bonds. So maybe real estate yields are being compared to the wrong benchmark?
By contrast, there is no doubt that there can be many opinions on the reasons for the yield ‘paradox’, and it is likely that further arguments will emerge as a result of the ongoing disscussion. Valuers are left to observe the market and reflect it as closely as possible in their valuations. However, the main lesson to be learned, so far, is the unreliability of the additive method as a tool for determining the level of property yields or rather the unreliability of the mechanical way of applying it, which is dominant in Polish practice.
Automated translation from Polish