Evaluating property in South Africa
There is more often than not a discrepancy between property valuations from various institutions and developers. So just how should property be effectively valued in South Africa? The inaugural Property Professional Property Platform asks some industry leaders what their thoughts are on the matter.
By Michelle Funke
Everyone seems to get to different figures when valuating property. Property Professional wanted to find out how and why, and what the future holds. Ewald Kellerman, head of sales at FNB Home Loans, Zain Sayed, regional manager of FNB Commercial Property Finance for Gauteng South West and East, Timothy Akinnusi, head of sales and client value management at Nedbank Home Loans as well as Mike Walters, divisional and asset manager at Renprop sat around the table discussing how we can, or perhaps should, effectively value property in South Africa.
The measurement methods
While everyone took the fifth when it came to discussing municipalities and their property evaluations, it is clear that the residential and commercial property sectors use completely different evaluation methods.
Walters says that from a commercial perspective, the valuation exercise is a lot easier. “There are essentially two ways in which commercial property can be valued: firstly based on the income that the property produces or the known cap rates for the area, which are published by Rode. The calculation is a simple percentage of nett income that the property can produce while there is a lease in place. Factors that influence the cap rate are location, the age and condition of the building, the terms of the lease, and the type of tenant. The second way in which commercial property is valuated comes into play with vacant buildings, where generally a rate per square metre is used which will fluctuate depending on age, design, and whether or not the property is already built. This rate is negotiated and agreed at the time of sale.”
Kellerman says that on the residential side there are number of different challenges compared to the commercial side as residential property is not driven by the same commercial factors. “A typical residential buyer will place value on a property based on its features that meet their requirements,” he says. “A modern kitchen, for example, would win over one buyer, while the fact that the property is close to a certain school may win over another. Specific investment value that is placed on a certain property by a person with unique requirements can mean that the property will sell for more than what open market would pay for it. This is where a lot of anomalies come in to residential property values.”
Kellerman goes on to say that with residential property valuations, there is a lot of irrationality as it’s usually a personal decision. “In the residential market, a comparable sales approach is typically used to determine the value of a property, and is based on property sales in the area, adjusted for time, difference in characteristics and other market conditions in the area. This method has its own anomalies as it can drive irrationality and help the market gets ahead of itself easily. The gap between value and income stream from buy-to-let properties in the residential sector is quite big generally, as is the gap between replacement value and market value. The residential market is strongly driven by sentiment – what buyers are willing to pay for properties.”
Top value influencers
When it comes to commercial property, the cliché of location, location, location holds true, says Sayed, followed closely by the term of lease and the type of tenant and then the condition of the building.
Akinnusi points out that residential property values are based on the same criteria, except where the term of the lease is important from a commercial perspective, amenities close to the property, accessibility and town planning take precedence in the residential sphere. “Accessibility and amenities are what really give residential property its real intrinsic value – it’s not just the bricks and mortar with which the house is built, but rather what the surrounding suburb can offer such as schools, shopping centres and the like.”
Kellerman takes a step back, and looks at specific market drivers like debt levels, which have a huge influence on the market. “When financial institutions had a greater appetite for lending, it was a massive driver for residential sales in the boom years.” He also points to external economic factors, particularly around inflation and interest rates, and lastly, from an economics perspective, is supply and demand.
Walters says the state of the economy and GDP play a massive role in the value of property, as does the political climate, the unemployment rate, individual levels of disposable income and the government’s ability to deliver, or not, on existing and new infrastructural projects.
The valuation challenges
While commercial property valuations don’t seem to have the complex issues surrounding them like the residential side of things, Sayed says that one of the biggest challenges in commercial property finance is trying to explain the difference between market value and replacement value. “Market value is based on the willing buyer and willing seller principle, whereas replacement value is linked to costs of rebuilding the building. There are anomalies here, like a building in Sandton, for example, might have higher market value than replacement value, whereas a building in the Johannesburg CBD will have a market value that is a lot lower than the replacement value.”
According to Walters, there are fundamental challenges with the way in which banks value new residential property projects which does not sit well with developers. “Most of the time the valuers that the banks appoint are not as close to the market as the developers are, so they are often unaware of the needs/demand in a particular sector,” he says. While historical data plays a role, he says it is not the only basis on which a new project should be valued. In addition the method used and the use of external valuers can be seen as an easy way out for the banks, especially when the valuer does not find value.
From a banking perspective, Kellerman says that when it comes to valuations, the purpose is to use the valuation as a prudency check during the loan approval process. “The bank looks at it from a security perspective and so has to take the resalability of the property into account.”
Walters says that even so, the way in which the banks value properties is a huge challenge – both for the institutions themselves and for the purchaser. He says that valuations are generally conducted by external or independent parties who only look at historical sales figures and price growth. “Due to the fact that they look at historical figures, it is extremely difficult from a development point of view – no matter whether you are looking at an urban city environment or a country town environment – as the statistics can skew the figures to such an extent that developers are disadvantaged by the method that is used. The historical figure evaluation method lacks a broad approach that we would like to see. Valuers and banks are not at the coal face of the property market, and should therefore rather look at the developer and their track record to see the potential for the development over the historical area data.”
While Kellerman agrees that on the residential side there is a historical bias, he says that financial institutions work on scientific information – the nature of which is not forward looking. “While it is a good idea to look at the credibility of the developer, many banks have burnt their fingers with many developers, so we need to protect the assets and money we invest. We are not in a position to take an uncalculated risk – if growth in an area’s property market cannot be proven, it is difficult to commit finance and show that we have lent money prudently. There are a couple of factors involved, and while I think a developer’s credentials can be relevant, there has to be caution around the risks. There have been many developments or inexperienced investors over the past few years that have received financial backing in situations where the potential for growth has not been realised.”
Sayed adds that while commercial property does not seem to have a valuation problem as there is generally a consensus between all parties on the value most of the time, when it comes to residential property, post 2009 almost all financial institutions took a big loss and have therefore limited their lending capacities towards residential developments. “But Mike has a point; there is perhaps room for developers to be backed financially based on their track record. However, one should bear in mind that unlike commercial property, leases are shorter in the residential sector and there is still a long-term loan on the property that needs to be serviced. It becomes more challenging in the residential sector as financial institutions have to look at other important factors that can influence the property value such as the market demand, growth of area and other factors.”
On the commercial property front, while getting to a value that everyone can agree on is not really an issue, government’s delivery on infrastructure is. So much so that there seems to be a move for development further up Africa as there is a willingness from the governments to co-operate with developers through offering a smoother process in terms of land rights, access to services such as power, zoning and the like. “South Africa is losing potential investment as there seem to be better returns developments up Africa. While there are challenges in every market, South Africa’s service delivery seems to be getting worse,” says Walters.
Time to change the way property is valued?
Kellerman says that the comparable sales approach or the scientific approach has been a viable one for banks in the past. “A home loan is a highly geared asset as we can lend up to 100% on residential properties, and when we have to call in an asset, which is a very unfortunate part of our business, our losses are just as leveraged so we end up losing a lot. Generally in the market, the losses are between 20% and 30% when a loan goes into default, which are massive loss rates considering the low margins of home loan finance. This makes it a very risky business in a very competitive environment and because of that, the valuation methodology needs to be sharpened. We are quite far away from replacing the traditional valuation methods; however there is a space for more innovative methods or improvement on the current methods, particularly around the process of conducting valuation and not so much the methodology.”
There is a general agreement around the table that going forward, the commercial property valuation model is successful and will stay much the same.
According to Sayed, the only factor that might influence commercial property value in the next couple of years is the interest rate. “We are at the bottom of the cycle, and if the rates increase, it could slow down the values of commercial property, but other than that, this market is expected to stay on its current path.”
When it comes to valuating residential property, Akinnusi feels there is data lacking. “Valuation is a very critical part of the process. Over reliance on finance is only going to stop when people start saving up for a deposit and when sustainable jobs are created. And that will only happen when the economy begins to strengthen. In the mean time, those who are leveraged to the hilt will fall hard with any interest rate hikes.”
For Kellerman, the biggest gap between banks and developers is lack of information. “From a banking perspective there are many risk factors as we sit with the asset for 20 years after a developer has handed over the key. However, there is a lot of room for improvement to bridge the gap between industry players. Perhaps banks are overly conservative to a degree, but smaller companies are a lot more agile and are better able to respond to changing market conditions. The fundamentals of property valuation will stay the same, but there is a huge gap in the valuation process and technological information relating to it and hopefully necessity will breed co-operation between the various entities.”
It is evident that while the current valuation methods used by financial institutions serve the purpose for determining finance feasibility to a degree, they fall short of foresight and lack a certain understanding or comprehension of market potential. If this knowledge gap or lack of information and communication between banks and developers is bridged, it could unlock a whole lot more potential for development in South Africa.