Archive | Pan Pacific Congress

Securitisation and discount to NTA under spotlight

Tie two addresses to the valuers’ Pan Pacific Congress together and you have two related steps in the changing shape of real estate investment. One was about securitising it, the other about the place of intangibles such as management contracts.

Woody Hanson (right), president of the US Appraisal Institute, said the most significant capital market effect on real estate investment was the turning of a privately owned asset base into a publicly owned one.

The two most recognisable forms in the US are the reits (real estate investment trusts) and commercial mortgage-backed securities (CMBS), with an umbrella reit the latest form to start taking shape.

“Between 1979 and 1998, equity reits had a total annual return of 14.4%, outpacing the return on direct property investments, which stood at 8.72%. Over 300 reits are publicly traded today, with total assets of $US130 billion dollars.”

The mortgage-backed securities industry is a more recent creation. After the savings and loans’ collapse and bailout in the 80s, the Resolution Trust Corp was charged with liquidating thousands of mortgages held by failed financial institutions. Among the obstacles facing this new agency were “the lack of any standard underwriting or due diligence criteria, as well as a lack of historical performance data on portfolio types and locations.

“This led to development of new risk-rating criteria, along with other due-diligence standards. As portfolio data and information formats were developed, appropriate software was also created. By the late 90s a global demand for commercial mortgage-backed securities had been generated. The CMBS market has grown from $20 million in 1994 to nearly $200 billion in 1999.”

Mr Hanson said these capital markets had led to a much more stable and efficient system based on markets rather than on banks. “CMBS and reits have changed the real estate valuation needs of issuers and investors. Commercial real estate investors are increasingly seeking information that provides detailed market analysis and insight into future revenue projections. Because securitisation offers less risk to investors, less weight is placed on historical value.

“Ratings agencies now play a key role in the securitisation process. Investment-grade CMBS are generally priced based on the rating assigned by the rating agency. The rating agencies are less concerned with the value conclusion than with the market data found in an appraisal, for example operating statements, rent estimates, tenant improvement allowances, leasing commissions.

“That data is used in an analysis that focuses on debt service coverage and loan-to-value ratios. In this context, value is determined by a cashflow analysis applied to a capitalisation rate based on property type, not from the appraisal report.”

All this greater market appraisal has meant that the expansionary phase of the US real estate market this time round has run three to five years longer than it ordinarily would have, he said.

Because of the demand for faster delivery of securities reports, and presentation of them in a more efficient manner, the Appraisal Institute is creating a commercial database for its members which is due to come into play in the first quarter of 2001.

“It seeks to provide transactional data from appraisers that can be accessed, queried and downloaded via the internet by customers who virtually span the globe.”

Mr Hanson said the institute was working with Britain’s Royal Institution of Chartered Surveyors and Australia’s valuers to create a single cohesive set of standards for valuers worldwide.

“This effort is being led by the International Valuation Standards Committee and will be unveiled this July during Valuation 2000.”

For the physical property industry, Mr Hanson said there would be more disciplined capital flows and construction patterns “thanks to the power of the public police, those 26-year-old analysts on Wall Street.

“Real estate is rapidly becoming a commodity. When Wall Street thinks of office, they think of square feet and a performance is derived out of that. Wall Street has imposed discipline on Main Street.”

Mr Hanson sees other changes coming, too, among them the advent of flat fees through the internet. He also expects the internationalisation of standard appraisal to raise the profile of a business he has been a partner in since last August, Integra Realty Resources. Because local firms can join the group but remain independent, he says it is already challenging the position of the big international agencies which operate through branches.

Role of intangible assets in listed trust valuations

Local Ernst & Young real estate group principal Gary Cheyne (left) presented a paper on valuing intellectual property and intangible assets, aimed at getting a true business value measure, but stopped short of its application in the property industry.

In a separate interview, Mr Cheyne said the value of intangible assets was an important factor in valuing listed property trusts and companies.

The common benchmark was to set the unit or share price against tangible asset value. But he said there was an inverse relationship between the size of a trust and its capitalisation rate.

“Is it a reflection of property? Maybe in part, but it’s probably also a reflection of the bigger trusts being able to attract the better people. What you’re seeing, in effect, is the valuation of human capital, the processes, the innovation and the ability to reflect in a better way the value of that intellectual capital.

“Human resource is the organisational assets. It’s also made up of brand and stakeholder relationships.”

Mr Cheyne’s point takes on importance in the debate over discounting, which happens to be more common than stock price premiums among New Zealand property listings. The property industry has argued that the sharemarket is wrongly valuing stocks by pricing at a discount to NTA.

Mr Cheyne’s finger points at the high value of management and its contracts, where there is a premium, and conversely at poor management where there is an apparent discount to NTA. In this assessment, physical property and property equities analysts might agree on tangible asset backing but the corporate value would be distinguished by the separate analysis of management intangibles.

Valuers conference

The NZ Institute of Valuers is three-quarters of the way towards its hope of getting 350 participants in the Pan Pacific Congress to be held in Auckland from 2-5 April, about half of the 260 so far enrolled coming from overseas.

The conference, at the Sheraton Hotel, will open strongly with a keynote address by ASB Bank managing director Ralph Norris, outspoken recently in his demands on government direction. Mr Norris played a significant role in boosting the bank’s position as a computerised and internet leader (before e-commerce was invented), and an important role again in the success of the business leaders’ session which ran alongside last year’s Apec conference.

He will speak on the future business environment, followed by Ove Arup’s NZ managing principal, Fulbrook, on the impact this environment will have on property.

The conference will be held under the auspices of the NZIV, although that organisation formally joined forces with the Property & Land Economy Institute at the start of this year. Organisation of the conference was well under way before the merger.

Valuers challenged on their future

Valuers must identify the long-run demand for their profession’s services and set entry standards accordingly or risk being merely time-paid artisans, keynote speaker Christopher Jonas told the Pan Pacific valuers’ congress in Auckland today.

Mr Jonas is a past president of Britain’s surveyors’ institute. Five years ago he set up his own boutique practice, where he consults on real estate strategy, independent directorships, private equity investment in non-property businesses, and unpaid work for the public good.

In his address he ran through the consequences of various points — the entry basis, fee structures, definitions of valuation and the huge impact he believes electronic commerce will have on property.

An important factor, he found, was that merchant banks had discovered property was respectable. “Now each one has a dedicated property team and, more often than not, a discretionary property investment fund. Banks are winning an increasing share of the large deals market.

“They and the deal-driven large commercial property firms are leaving the professionals to collect the time-based valuation or structural survey fees.

“Thus I see an increasing divide between very well paid deal makers for large profitable transactions and the journeyman professional, forced back to carrying out the more basic, almost artisan, functions.”

Mr Jonas said that as this developed, “no bright young graduate who can get into a Goldman Sachs will want to join even the best exclusively professional firms.”

On the issue of definition, Mr Jonas believes there should be one, not an ever-increasing list bound to cause confusion. He said valuers worked in total contrast to the old truism of buying from the frightened and selling to the greedy, by sticking to the c concept of open market value, “the notion that a certain price is the right one for both parties.”

By this method, freezing the moment of valuation, “he gives us no insight on where the value has come from, or the scope for the value moving in the future — and if so, in which direction.”

Mr Jonas says valuers need to apply more research to the relationship of property risk and return to the capital markets, and how property markets link to their surrounding economy.

But he believes e-commerce will give valuers their greatest fright, because it will bring huge shifts in occupier demand. He likes the prospect for warehouses (and this is apparent in Auckland, too, with strong growth in that sector).

“I would expect shopping streets to be the biggest losers as trade is siphoned away, with many units reverting to leisure, showroom or even residential uses.”

The enigma is the downtown office sector. “It is hard to see many wanting to work from home permanently, but there is similarly little need for office workers to travel into the major city centres just to do a job that can be done anywhere… One thing appears clear already. E-business is going to put pressure on the overheads of doing business the traditional way. Head offices will be in the firing line.”

Learn to cannibalise yourself or be beaten, Norris warns

Entrenched businesses don’t usually make it in the new environment. We talk about globalisation, but there is a strong future for smaller businesses winning niche opportunities. Intermediaries are on their way out, and partnering is a key ingredient of the new environment.

These are some of the points made by ASB Bank chief executive and Business Roundtable chairman Ralph Norris today as he looked at the forces changing the course of business, at the Pan Pacific valuers’ congress in Auckland.

Perhaps the most important of all these changes is this element: “The new entrant’s greatest competitive advantage is the unwillingness of the incumbent to fight on a deconstructed definition of the business and cannibalise itself.”

In the information revolution, “the focus of wealth creation is moving from machines to individual skill, knowledge and innovation.

“Any business that has not worked out the risks and benefits that this information revolution will bring to their business, is probably already on the way out of business and will become the equivalent of history’s blacksmiths and cowpers.

“The difficulty with these shifts is that the entrenched businesses usually do not make the transition into the new environment. They do not see the changes happening early enough, when they do see it they pass it off as a fad or a niche sector which will have limited appeal, and rely upon their current strength of incumbency to justify the status quo.”

Mr Norris said finance and insurance industry mergers would continue as scale and new technology force the creation of larger and larger businesses, to remain competitive. The midscale manufacturer’s day had passed, while focused niche players were enhancing their positions.

Small business was better positioned than large local or medium-sized businesses in the new environment. He said they should focus on niche opportunities with high levels of intensity in customer relationships, a tailored versus a custom approach.

Sector domination by monopolies, through scale and momentum, was under attack not because of the successful business model that had created the super-profits, but because the rules had been changed, mainly through the use of technology and information. This would bring the demise of the intermediary.

Mr Norris said this began 30 years ago when the banks’ large corporate customers accessed capital markets directly. “One company was so successful in its own right it has established one of the world’s largest finance businesses, GE Capital.”

Computer company founder Michael Dell beat the opposition by using catalogue, phone and fax to sell directly, eliminating most of the finished goods inventory. One research firm estimated this translated into a 6% cut in Dell’s costs, before the dealer margin was taken into account.

The book “Blown to Bits,” by Philip Evans and Thomas Wurster, describes the collapse in sales of Encyclopaedia Britannica after a 200-year climb to domination. One lesson in the book is that, “even if the executives of established businesses fully grasp the impact of new technologies, and even if they can reason their way beyond their corporate myths and assumptions, they still face a massive competitive disadvantage arising precisely because they are incumbents.

“Incumbents are saddled with legacy assets — not just clunky mainframe systems, but sales and distribution systems, bricks and mortar, brands and core competencies. Competing in the face of the new economics of information requires cannibalising those assets, perhaps even destroying them.

“Incumbents hesitate to do that, especially as long as the business has positive margins. Rather, they do complex calculations and get bogged down in internal political debates. Insurgents have no such inhibitions.”

Mr Norris said there used to be a tradeoff between richness, through one-to-one selling, and reach, through catalogue and direct mail. The internet provided the facility to offer significant richness coupled with reach. Mr Norris said the seller’s knowledge advantage over the buyer’s was fast disappearing.

The “Blown to Bits” authors termed this process deconstruction — the dismantling and reformulation of traditional business structures.

Mr Norris put it this way: “It results from two forces: the separation of economics of information from the economics of things and the blowup (within the economics of information) of the tradeoff between richness and reach.

“Traditional business structures include value chains, supply chains, organisations and consumer franchises. When the tradeoff between richness and reach s blown up, there is no longer a need for the components of these businesses to be integrated.

“The new economics of information blows all these structures to bits. The pieces will then recombine into new business structures based on the separate economics of information and things.”

He said the new entrant’s greatest competitive advantage was the incumbent’s unwillingness to fight on the new basis and cannibalise itself. To stay alive, companies would have to ensure best practice was followed in all aspects of their business.

If not, “outsource the process and continue to question your business model, where would a new entrant attack and by what means.”

Mr Norris said the intense competition for customer ownership among telcos, banks and retailers, among others, was spreading across network boundaries of the past. Banks could find telcos or retailers becoming their strongest competitors, rather than other banks.

Mr Norris related his overview directly to property through the insatiable demand for IT and e-commerce, which is creating a worldwide skills shortage. He said the US was issuing 90,000 work visas a year, specifically for people with IT skills, to address vacancies estimated at 500,000.

International competition for the best skills was strong, which meant that a country such as New Zealand had to ensure more people were educated in IT, and the economic environment made them want to stay.

“Overall these new economic forces will have a tremendous effect on the pattern of work. The use of teleworking, the reducing need for cbd space, connectivity and communications will make location largely irrelevant. The efficiency and speed within the supply chain will, as it is already doing, reduce inventory, speed delivery to the end consumer, resulting in less warehousing and manufacturing real estate.”

Japanese parked surpluses, pushed up prices

Points made by Hong Kong real estate boss CY Leung last week are so blindingly obvious, but it seems they need to be made quite often.

Mr Leung, whose firm is part of the DTZ Debenham Tie Leung group with which Auckland firm Bayleys is associated, gave the valuers’ Pan Pacific Congress an international perspective, chiefly about the 1997 Asian meltdown.

He began by saying the Japanese were the first major cross-border investors in Asia because they wanted to park their colossal trade surpluses, and bank loans were an important part of that parking exercise. By 1997 the Japanese banks had $US250 billion on loan through Asia, much of it on real estate.

“The injection of loan funds into real estate markets pushed prices up, sometimes against fundamental factors. Increasing prices of real estate induced more loans into real estate. The all-too-familiar cycle was set in motion.”

Japanese and German banks had 40% of the Hong Kong project finance market at that time, worth $US24 billion, equal to the outstanding loans on 120,000 units, or 12% of Hong Kong’s housing stock. Come crisis time, and those Japanese banks began calling in their mortgages. They were able to do so on many loans on only seven days’ notice.

Around Asia, Mr Leung said, much of the lending was done without proper safeguards, very often on the basis of personal or political relationships and not the viability of the project. He recalled an address he gave to Thai bankers in 1992, when he noted that “basic ground rules such as asset valuation guidance notes were yet to be formulated.
Valuations became more of a form and a ritual than a safeguard against anomalies.”

Loans were denominated in US dollars, on the understanding that the valuation in local currency would not change on redemption. This relationship ended with the 1997 crisis, leaving greatly overvalued assets created on easy loan money.

Mr Leung said the importance of current cost accounting was not recognised in Japan until early 1998, so corporations carried real estate assets on their books at historical cost or valuation.

The foreign vulture funds arrived to invest, but Mr Leung said few had done so. Currency risk remains one of their concerns, and many of these investors have not differentiated between currency systems or the currencies of strong and weak economies.

“The Hong Kong peg system is still talked about in the same breath as the link-rates system elsewhere.”

Two other concerns have kept these investors out: the expectation gap and title risk. “Many international investors have an IRR expectation of about 15% to provide the necessary incentive over and above the 10% IRR available in, for example, the US.

“However none of the low-risk markets in Asia Pacific such as Hong Kong and Singapore offers this level of return. Markets in Asia that do offer such high returns are considered risky and unpalatable.

“Furthermore, future capital appreciation on which Asian investors heavily rely, is generally not featured as prominently in the cashflow analysis of international investors from outside this region.”

On title risk, Mr Leung said many international investors walked away from seemingly attractive propositions because they could not be satisfied on title, lease agreements or building contracts. “International investors who jumped at opportunities in Asia, taking the reliable legal and title frameworks in their home markets for granted, are already counting the costs of title risks.”

Mr Leung did not stretch beyond the meltdown, but his point on parked trade surpluses should raise awareness on investment from similarly inflexible surpluses such as national superannuation funds.

Singapore is steadily expanding its investment overseas as it hunts for new avenues for its pension investments, and Australia is starting in the same direction.