Immaterial?
A number of UK open-ended real estate funds have, for the first time, suspended trading due to “material uncertainty” of the independent valuation of the properties in the fund. The idea is that when the standing independent valuer (SIV) flags these circumstances the fund suspends trading as the unit price, formed from the property valuations, would also be subject to material uncertainty. The corollary is that property funds are subject to price uncertainty but there is a point where that uncertainty is immaterial, given that they are not permanently suspended. Here, we take a look at immaterial uncertainty and ask whether it is, indeed, immaterial.
To get a gauge on this, we need to look at studies of valuation uncertainty. This is an important topic (not least because valuers can end up in court as a result of their valuations) and there has been annual research into the uncertainty surrounding property valuations in the UK for around twenty years. This research has been undertaken by RICS* and has taken the form of comparing sales prices to the prior (uninfluenced) valuation. Strictly speaking this does not measure uncertainty, rather it measures a series of price / valuation discrepancies (valuation imprecision) on a sample of properties that were actually sold (i.e. selected by the owner for sale often on the basis that price is likely to be above valuation), but it should give us a good indication of what might be deemed immaterial uncertainty.
If valuations are best estimates of a likely sales price and, if valuations are unbiased best estimates of a likely sales price (which they may not be, but that is another matter), there will be a range of estimated values around the, as yet, unobserved sales price. This range is not the result of valuers making a mistake (an “error”) but of imprecision in the estimate. Indeed the RICS studies show that for the UK, on average, only around 84% of valuations have been within plus or minus 20% of sales price (consistent with a standard deviation of around 15%). As stated, this is an average and it can be better for some sectors at some times e.g. shopping centres in 2010 when 100% of sales prices were within +/- 15% of the prior valuation, and worse for some sectors at some times e.g. west end offices in 2011 when just 61.4% of sales prices were within +/- 20% of the prior valuation.
These are the discrepancies that have been measured and there may have been much greater (or potentially less) variability than this where properties were put up for sale and not sold, or not put up for sale (and so not sold), but that can’t be measured. This is awkward of course as it is those properties which represent the vast bulk of properties in a portfolio. Nonetheless, these figures seem to indicate quite a wide spread, even a material one, but since such parameters can reasonably be expected and have been accepted, this would indeed be defined as immaterial.
It is one thing to look at immaterial uncertainty for individual assets and another to look at it for funds, since aggregating valuations to derive a fund price is not the same as aggregating prices. Whilst uncertainty at individual property level tends to cancel out through aggregation, it can be shown that the aggregation of 40, individual property valuations to a unit price for a fund, using 15% standard deviation for the individual property valuations’ uncertainty (consistent with RICS’s research cited above) still results in uncertainty of around +/- 3.3% at the aggregated, fund level**. Assuming no other assets or liabilities, such a fund priced per unit at 100 could reasonably sell all of the property assets for a unit price between 96.7 and 103.3.
Again, this is nothing to do with valuers making a mistake, it is just the potential result of aggregating uncertain individual property valuations to a unit price for a fund. This might result in losing, or making, a unit holder £330,000 for every £10m traded at a price of 100. Since property funds are not permanently suspended, it would follow that this type of potential discrepancy is viewed as immaterial, even though trading based on such “immaterial uncertainty” might, on average, wipe out one or two years of a unit holder’s capital return.
* RICS, (2019), “Valuation and sales price”
** Bowles, Tarbert and McAllister, (2001), “An assessment of the impact of valuation error on property investment performance measurement”, Journal of Property Investment and Finance, Volume 19, Issue 2, pp 139-157