Global Financial Crisis Impacts on Property Valuation Thinking - Literature review Example

GLOBAL FINANCIAL CRISIS IMPACTS ON PROPERTY (REAL ESTATE) VALUATION THINKING by: Presented to: Course/ Class: University: City and state: Due date: Introduction The objective of this piece of writing is to discuss the impact of Global Financial Crisis on real estate valuation thinking. First, the paper will bring to light background to the crisis. This will entail a detailed discussion on global financial crisis in terms of causes and its relationship with real estate. Specifically, the paper will examine the Discounted Cash Flow and the influence of global financial crisis on this valuation approach. Apparently, Discounted Cash flow model estimates cash flows and discount rates. Cash inflows comprise of rents and lease payments. To assess cash inflow, past trends in rent and forces of demand and supply for space i.e. vacancy rate are considered. On the other hand, cash outflows are expenses on real estate ranging from property taxes to utility expenses. Additionally, growth rate and terminal value are obtained to facilitate calculation of DCF. The paper will finally scrutinise the impact of financial crisis on real estate valuation. Background to the crisis At the heart of Global Financial Crisis was deterioration in asset prices, failures of banking and other financial institutions because of insolvency and liquidity. This was caused by collapsed credit market due to defaults by US sub-prime mortgage market borrowers that spilled over to Australia and other countries in the world. On the contrary, Lyndall (2010) posits that Australian Banking industry was less exposed to the crisis mainly because of efficient regulatory system and minimum contact with U.S subprime products. Even so, Australia experienced liquidity and refinancing problems in 2008 as foreign banks took back their funds with a view of addressing financial problems in their home countries. Besides, Brown (2008) mentioned an aspect of increased cost of funds that accompanied Australia’s reliance on offshore funding. Predatory lending practice as well contributed to the financial crisis. In this case, lenders were enticed into borrowing unsustainable loans from banks due to low lending rates. The effect of this action was loan default and consequent decline in the value of homes and housing market. Diminishing prices of real estate and other assets were initially caused by asset price bubbles. A bubble is said to occur when the price of asset rise beyond the present value of expected income. In the second quarter of 2005 the prices of homes appreciated drastically. This rise intensified in 2007 making the prices of home expensive. As people continue to sell their property, prices eventually fell in line with property market cycle. Economist (2008) held a view that Global Financial Crisis was caused by mispricing of risk where banking system was encouraged and given incentives by central banks of leading economies to participate in extreme risk business of excessive borrowing and lending in several asset categories. Concisely, the crisis was initially caused by the demand to buy real estate, which then prompted financial institutions to participate in lending practices that were susceptible to property market cycles. This culminated into complicated outcome on global market economies and the collapse of several banking and corporate establishments. Along the chain of reaction, liquidity reduced and global recessionary pressures were created. This had substantial impact on valuations especially in the determination of yields and discount rates. In a literature by Folkestone (2011), GFC led to the withdrawal of debt, which severely affected the capital-intensive real estate. Folkestone (p. 2) asserts that by 2008, debt market had been frozen while cost of debt rose substantially. This meant that potential purchasers of real estate were not able to borrow funds for investment in the sector. In the same line, values for non-residential real estate plummeted. AUS$42 billion stimulus plan coupled with the introduction of First Home Owners Boost bolstered real estate during 2009/2010 (Murphy, 2011). This response was in form of National Building Economic Stimulus Plan. DCF valuation approach In summary, Discounted Cash Flow model is given by the following: DCF = CF1/(1+r)1 + CF2/(1+r)2 + CF3/(1+r)3 ...+ CFn/(1+r)n It is obvious from the model that inputs should be estimated. Briefly, the above DCF valuation model first requires the determination of relevant time-period i.e. 5-10 years (Jebaraj, 2012). Secondly, reasonable forecast of future cash flows, CF1 …n is established. This necessitates inclusion of revenues, direct and indirect costs, capital expenditure, and cash items. Aside from giving a clear definition of item that is being valued, discount rate ought to be agreed on. When determining discount rate, time value of money and uncertainty of future cash flows are taken into account. If project earnings were highly uncertain, then discount rate would be greater. Similarly, if investors were exposed to high risks, a higher rate of return would be applied. The cost of debt and cost of equity are calculated and included in the discount rate. Both cost of debt and equity makes use of risk free rate. It is imperative to note that lower rate of returns is deployed in the calculation of cost of debt simply because debt holders are less exposed to risk. Risk premium is incorporated to take care of risk of lending to a company instead of government. Conversely, cost of debt is obtained through capital asset pricing model that integrates equity risk premium, country risk premium, and small company risk premium, i.e. E(R) = Rf + β (Rm- Rf) (Damodaran, 2012). A number of issues arise from the use of discounted cash flow as a valuation approach. First, the model assumes that marginal investor is diversified whereas in real sense, real estate investors do not favour diversification. In such a case, total beta is adjusted to reflect both market risk and extent of non-diversification. Secondly, DCF assumes that all assets are liquid. In truth, liquidity in the scenario of real estate is less compared with financial assets. What is more, buyers and sellers in real estate are less while transactions are infrequent and expensive. This problem can be handled by valuing real estate as if they were liquid then factoring in liquidity discount. Thirdly, the approach is influenced by changes in tax rates and depreciation methods. The immobility of real estate means that an individual cannot take advantage of tax difference in another locality. Finally, DCF faces the problem of high costs and risk of obtaining information. Impact of GFC on DCF valuation In a research by Black (2010), GFC had the greatest impact on cost of debt. The impact on cost of debt is perceptible in the changes in the debt risk premium otherwise termed as spread. Changes witnessed in risk-free rate and responses made by government ultimately affect cost of debt. However, recent development such as Basel III Accord and the Cooper Review affected the Australian Bond Market by aiding in controlling spreads (Bloomberg, 2011). In wake of Global Financial Crisis, determination of applicable discount rate was greatly hampered. Since global financial crisis was marked by intense volatility and uncertainty, construction of discounted cash flow model necessitated rigorous analysis with a view of obtaining an accurate revenue growth and profitability forecast. One of the impacts of financial crisis on the calculation of discount rate revolves around risk-free rate, a major component of cost of capital (Cubis, 2009). Reserve Bank of Australia (2010) brought to light the downgraded credit wrapped securities for this reason, it became difficult to believe that a truly risk-free rate exists. Securities often play the role of proxy for the risk-free rate but following monetary inflation in some countries and complete default in other nations, the concept of risk-free rate is doubtable. Market-risk premium and beta are also considered in the calculation of discount rate. Given the circumstances of global financial crisis, markets were highly volatile thus; premium on government bond yield can vary immensely over a short period (Adair, 2009). In the same way, betas of a company may diverge. These changes are difficult to predict whereas a valuer is obliged to obtain these values. According to API enews (2009), Global financial crisis rapidly and negatively influenced property market across Australia and the entire world. In the mid 2009 for example, some banks were willing to lend their funds hence markets started to correct, which meant that transactions were carried out at new prices. However, valuation of assets in a scenario where prices are correcting while sales are forced or distressed is difficult. It is therefore vital to evaluate the concept of market value in the current highly volatile market. In an argument by Chris Thorne, the chairperson of the International Valuation Standards Board, a valuer has to be well versed with the market and how it operates (International Valuation Standards Council, 2011). He asserts that when transactions are limited as a result of financial crisis, a person has to understand mindset of potential buyers and sellers in addition to economic drivers of the market. Succinctly, knowledge is required on why a property is not making sales and the price level that buyers will be willing to buy property. Valuation process calls for presence of willing buyer and seller. In the context of Global Financial Crisis, a seller may not be willing to sell property at low prices. This means that the only sellers in a market facing deteriorating prices are forced sellers. The prices, in consequence, do not reflect the willingness of buyer and seller. Under this situation of rapidly changing prices, there is a risk of under or over valuation. In an article by Macdonald (2012), inaccurate forecast regarding Perth’s property market were made simply because of unforeseen economic downturn. Initially, it had been forecasted that median Perth house prices would increase but it actually declined. This demonstrates the inability to draw forecast after the unprecedented global financial crisis and following a fall in consumer sentiment. Noting that the concept of market value requires exposure of a property to the market for a substantial period before valuing, this might not be possible with fixed assets that usually do not face public exchange. Assumption is therefore made that the asset was exposed to the public for a reasonable time. Conclusion To comprehend the impact of Global Financial Crisis on real estate valuation, the paper began by assessing the historical and institution context of the crisis. This section entailed an assessment of causes of GFC. In an attempt to bring to surface the influence of GFC on real estate valuation, various components of Discounted Cash Flow model were examined. One of the visible impacts of financial crisis is in the calculation of discount rate. To obtain discount rate, risk-free rate is used. This is an issue for the reason that using Australian Bonds as proxies faces the risk of being upgraded or downgraded because of sovereign debt crisis. It affirmed that risk-free rate might not exist. Other issues that emerged in valuation of real estate during financial crisis were market-risk premium and beta, market information especially in real estate, inflation, and willingness of both buyers and sellers. Reference List Adair, A, Jim. B, Haran, M. Greg, L. Stanley, M. 2009, The Global Financial Crisis: Impact on Property Markets in the UK and Ireland, viewed 13 September 2012, http://realestateinitiative.ulster.ac.uk/files/The%20Global%20Financial%20Crisis- Impact%20on%20Property%20Markets%20in%20the%20UK%20and%20Ireland .pdf. API enews 2009, Valuation Uncertainty in Troubled Property Markets, viewed 13 September 2012. Black, S, Brassil, A & Hack, M 2010, 'The Impact of the Financial Crisis on the Bond Market', RBA Bulletin, June, pp 55–62. Bloomberg 2011, Basel Ruling Slashes Size of Kangaroo Bond Sales by 50%: Australian Credit, viewed 14 September, 2012, http://www.bloomberg.com/news/2011-05-15/basel-ruling-slashes-size-of- kangaroo-bond-sales-by-50-australia-credit.html. Brown, C & Davis, K 2008, Spring/Summer, The Sub-Prime Crisis Down Under, Journal of Applied Finance, vol. 18, no. 1, pp. 16-28. Cubis, J 2009, Investment Valuation in a Time of Global Financial Crisis, viewed 13 September 2012, http://www.aseanvaluers.org/PDF/Investment%20Valuation%20in%20a%20time %20of%20global%20financial%20crisis.pdf. Damodaran, A 2012, Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, John Wiley & Sons, New York. Economist 2008, “When Fortune Frowned – Special Report on The Global Financial Crisis” The Economist, 9 October, n.p, http://www.economist.com/node/12373696. Folkestone 2011, White Paper: Australian Real Estate Outlook, viewed 13 September 2012, http://www.folkestone.com.au/assets/Uploads/Research- Report/Folkestone-White-PaperFinal.pdf. International Valuation Standards Council, IVSC 2011, The Discounted Cash Flow (DCF) Method –Real Property and Business Valuations, viewed 13 September 2012, http://www.ivsc.org/pubs/exp_drafts/1101_dcf_method.pdf. Jebaraj, BS, Athi, N & Marathamuthu, MS 2012, “Fair Value Accounting and the Global Financial Crisis: The Malaysian Experience”, Jamar, vol. 10, no. 1, pp. 53-68. Lyndall, B 2010, Housing supply in Australia: the impact of the availability of development finance. In Proceedings of 2010 International Conference on Construction and Real Estate Management, China Architecture & Building Press, Queensland University of Technology, Brisbane, Queensland, pp. 386-391. Macdonald, K 2012, “Property experts blame the GFC for dud forecasts”, West Australian Newspapers, 4 August, n.p, viewed 13 September 2012, http://au.news.yahoo.com/thewest/a/-/breaking/14456028/property-experts- blame-the-gfc-for-dud-forecasts/. Murphy, L 2011,'The Global Financial Crisis and the Australian and New Zealand housing markets'.', Journal of Housing and the Built Environment, vol. 26, no. 3, pp 335-351. Reserve Bank of Australia 2010, Bulletin: The Impact of the Financial Crisis on the Bond Market, June Quarter, p. 61. Read More