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Investment

„Valuation is as much an art form as it is a science”

The challenges of valuating retail properties.

By Dirk K. Wollweber

Dirk K. Wollweber is in-house lawyer and managing partner at TREC Real Estate Consulting GmbH in Düsseldorf, Germany. Image: TREC

I am supposed to write an expert opinion about “The Challenges of Valuating Retail Properties”, right in middle of the year-end business season, generally retail’s most positive yet stressful advent and pre-Christmas period. No pressure!

Furthermore, I am not really an expert for traditional “valuation” despite my Chartered Surveyors’ membership, I am more of a practitioner with superficial academic knowledge.

But I am about to get a cup of tea and try it anyway, even though it will, for the above-mentioned reasons, most likely turn out to be more of an experience report instead of a scientific paper.

In my experience, valuating retail properties (and shopping centers in particular) with the traditional gross rental method takes far more than assessing property rates, sustainable leasing fees, and operating costs.

Even though I was working predominantly with it when I was a young acquisition guy at a German investment company more than 15 years ago when I had my first professional encounter with a shopping center.

Traditional “operator-run properties”

At that time, I believed that rental income and tenant mix are the key factors for the (commercial) success of such retail properties. But during my due diligence investigation for the acquisition of a shopping center project in a medium-sized German city, I realized how important leasing, center management and joint advertising contracts were, besides the blue book. Additional key factors were utility bills and utility cost forecasts as well as the tax construction of operating facilities.

At that time, I did not yet question why shopping centers and hotels were called operator-run properties. This is something I learned when I started working for one of those developers and operators of shopping centers. I had to learn from scratch how such a center actually works, how one develops, builds, leases, manages, and ultimately sells it.

Here I learned a lot about retail in general, about absorption quotas, turnover ratios, purchase power, market shares, etc. I was also taught a lot of new things. For example, that center management is not just a cleaning job, that some center managers are almost more important than mayors in their municipalities, and that tenants do not necessarily move into a shopping center voluntarily. I also learned how important the quality of leasing contracts is for a center’s performance and therefore for its commercial success since they regulate the legally-compliant cost-splitting of ancillary and personnel costs. Let alone all the possible tax-related traps for foreign investors with a foreign investment vehicle.

But first and foremost, I learned how important it is to take a closer look at submarkets. Germany in particular has a wide variety of economic regions and location factors due to its decentralized and federal structure. This is why, for example, even a small center with limited retail space can be sustainably successful in a mid-sized town in an economically strong region with weak competitors.

Occupancy cost ratios

I realized how complex yet one-dimensional my learnings were up to that point when I collaborated with an opportunistic financial investor from the Anglo-Saxon world. After the initial defense automatisms were dismantled and followed by the mutual reduction of prejudices and utilization of synergy effects, the dimension of the financial world and the techniques of cash-flow modeling showed man an entirely new approach to shopping centers as properties and assets.

From this point onwards, I calculated OCRs (occupancy cost ratios), worked intensively with benchmarks and comparables, and learned for the first time how to make “real” discounted cash flow calculations, which, by the way, have become today’s standard for the valuation of larger retail properties. They let us to anticipate the center’s future over the next five to ten years. But even here one has to make assumptions, and that’s when it gets difficult. Because if they are not correct the entire dynamic cash flow based valuation is pointless.

And that is the real challenge nowadays when it comes to the valuation of large retail properties, with these extremely short cycles in the retail sector and constant changes (e.g. changing consumer behavior caused by the permanent change of demographic and socio-economic structures). Questions upon questions and no crystal ball in sight.

Is a three or five-year lease contract an opportunity or a risk in comparison with a traditional ten-year contract? What will the space requirements of retailers from certain industries be in a few years, for example in the consumer electronics or fashion sector? How will online and offline sectors develop? How do I assess ERVs (estimated rental values) when contracts have expired? Do I still believe in retail and consumer spending, which has been stable in Europe and Germany for years? Which costs do I have to budget for architectural adaptions, tenant rotation, and a potentially necessary expansion of my service offer to adapt my property to the constant changes?

Difficult to anticipate

Even so-called experts have a hard time making binding statements. That poses the question how informative can a valuation be that claims to anticipate all that for the next ten years? But I trust experienced colleagues who do nothing but exactly these valuations professionally; there may well be different scenarios, maybe supported by sensitivities and risk analyses like the Monte Carlo Simulation, which help to show all possible outcomes and better assess the corresponding risks. That would be the real science.

If one wants to truly understand larger retail properties and valuate them holistically, one also has to include the market’s and the competition’s factors, current developments and trends in retail and consumer spending as well as of the property and its management and, last but not least, the quality of the operator into the valuation or the respective investment and profitability calculations.

That is to say that one should no longer approach the valuation and assessment of retail properties with purely business management-related principles, isolated from the outside world, but take off one’s “blinders” and dare to take a look beyond the horizon… That would be the real art form.

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