Understanding market performance is essential for any investor in commercial real estate. Accurate and timely pricing data is of high value, especially during periods of uncertainty. Representing market trends with a transaction-based index is challenging in times such as the current period, however, when fewer transactions are occurring. The judgment applied by valuation professionals can help provide clarity in these times.
Readings on performance
In periods of low liquidity, transaction-price indexes take some time to adjust. Such indexes can struggle to show true market trends when liquidity is low and transaction data is scarce. Currently, the price-expectations gap between buyers and sellers for office markets in the U.K. and Netherlands is at levels last seen during the global financial crisis (GFC) and, absent this alignment on pricing, fewer transactions take place.
An alternative for investors is to look at other sources of pricing information. Public markets are often used as a leading indicator of private markets. A disadvantage is that outside of the largest countries there are no country-specific indexes of public real estate. In addition, REITs make use of leverage and public indexes incorporate general stock-market volatility. (Liquid real-estate indexes aim to solve for the impacts of leverage and volatility but are available for only a handful of markets.)
Valuations are normally not seen as an optimal alternative. Appraisers need transaction evidence to update valuations, so naturally valuations tend to lag the transaction market. This pattern has been shown over many years and for many countries, but there are circumstances in this market downturn where the relationship is reversed.
Valuations in the lead
In some countries, the valuation-based indexes for offices have posted sharp declines since the second quarter of 2022. The Netherlands and U.K. are examples of countries where transaction data has been scarce, but where appraisers have revalued assets aggressively. By contrast, in Australia, for instance, valuations have moved slowly. Elsewhere, such as the U.S., office transaction activity has been sufficient to estimate transaction-based price indexes.
The valuation-based index for the Netherlands has posted a cumulative downturn of 24.2%, and the U.K. has shown a 25.0% decline measured from Q2 of 2022 to Q4 of 2023. In the exhibits below, we compare these large declines with the transaction-based indexes running through Q1 of 2024. In the Netherlands, the transaction-based index has declined only 13.0% since the peak, while the U.K. transaction-based index has posted a 21.8% drop.
It is clear in the Netherlands that valuations are leading in the current downturn. The declines shown in the valuation-based index have happened faster and more severely than declines observed in the transaction market; this is in contrast to the GFC when valuations were lagging transaction-market movements. This time is different — the valuation-based index can be used as an alternative when the transaction market comes to a standstill.
Valuation indexes led in this downturn
For the U.K., we see the more traditional relationship where the valuation index slightly lags the transaction-based index, in this case by one to two quarters. However, this relationship, while true as of Q1 of 2024, varies over time because the transaction-based indexes are not frozen — they revise as new historical data is incorporated.
And so, looking at the U.K. picture at various points over the last year and a half, a different pattern emerges. In the exhibit below, we show the cumulative decline since June of 2022 for U.K. offices. The transaction-based index revises downward every quarter as more deal information emerges. A similar pattern is seen for the Netherlands: Over time, more transaction data comes in that revises the transaction index downward.
UK office indexes at points in history
A valuable third view
Knowing that there is value to be found in the valuations, especially in times of low liquidity, we can enhance the transaction-based index with valuation-index information to create an index that has the strengths of both. This enhanced index gets informed by valuations at times when transaction evidence is scarce. Utilizing our Bayesian repeat-sales models, we incorporate the valuation return of the previous period as structure for the transaction-based index.
In the exhibits below, we show the enhanced index for the Netherlands and U.K. In the Netherlands, we currently see a strong decline in the enhanced index, driven by lower valuations. The total decline in the enhanced index since the peak is 21.8% versus the 13.0% decline in the transaction-based index. In the U.K. we see a similar impact, as the enhanced index declines significantly. More importantly for the U.K., the enhanced index also would have shown strong declines in 2023, when the transaction-based index was still behind.
Introducing an enhanced index
In the chart below, we again show the cumulative decline for U.K. offices since Q2 of 2022, now adding the enhanced index. Taking the second quarter of 2023 as an example, we already see a 14.3% decline in the enhanced index versus the 6.9% shown at the time by the transaction-based index.
Enhanced index at points in history
The case for appraisers
Appraisers provide real value in the current price-discovery process and valuation-based indexes have led the transaction-based indexes in the Netherlands and U.K. during the present slowdown. Accurate market returns are essential for investors in a downturn and in some countries enhancing a transaction-based index with valuation information provides investors with another useful illumination of the current state of the market.