Just like the measured weight of an object differs in water versus on land, asset valuations, or measurements, are too affected by their own environmental variables. For example, it’s a reasonable assumption that an asset valued in a booming market is going to generate a different result than if valued during a downturn. For that reason, we’re better prepared in any valuation analysis if we first examine the environmental variables affecting the assets being valued. For real estate investment trusts (“REITs”), the main environmental variables are the economy in general, and the real estate marketplace in particular.
If the economy has interwoven layers of smaller economic marketplaces, then the country’s real estate market is arguably the most unique. What makes it so unique? For starters, land does not expire or get worn out like other capital assets, it is immovable, and can be used for many diverse purposes – from residential to mining. And, more importantly, real estate is illiquid and generally highly leveraged.
As to examining the environmental variables, we can talk about where the market is trending, whether it’s a buyers’ or sellers’ market, or even discuss economic factors like supply and demand. To get a more in-depth, long-term perspective, however, we might look at where the current real estate market falls within the conceptual real estate cycle.
Taking into consideration the usefulness of examining both short-term and long-term market forces, a practical definition of the real estate cycle may incorporate both terms: trend and cycle. In the context of real estate, a good way to define trend is as a unidirectional movement eking out minor, measurable growth or decline – gentle price increases or decreases, supported by minor supply or demand movements in the market. On the other hand, the term cycle implies something more predictable and predetermined, something long-term and conspicuous, like the cycle of birth, growth, and death: uncontrollable, and sometimes extreme, shifts of state.
A real estate cycle may be loosely defined as the act of cycling through two extremes of boom (an over-valued market) and bust (an under-valued market) which, within the extremes, exist minor periodic trends in one direction or the other. On this point, recent history has shown that the gradual movement upward from bust to boom is more prolonged and full of minor directional changes, whereas the boom to bust shift is short and overwhelmingly downward trending. If you are curious to see an example of this process in action, take a look at a chart showing the lead up to the 2008 financial crisis in either the US real estate or stock market.
As mentioned above, the Canadian real estate market is the economic landscape in which our current valuation analysis takes place, and it is also the landscape in which REITs regularly set out to value their real estate assets. This connection is far more important than it initially appears when you consider that REITs value their real estate assets at fair market value (“FMV”) – the value at which the current market is willing to pay – using capitalization rates as set by the forces of supply and demand in the marketplace within which they operate. Furthermore, the current market value of the REIT on the stock exchange typically tracks, dollar for dollar, its net asset value (assets less liabilities).
This brings us to the billion dollar question. Given that capitalization rates, along with interest rates, are at historical lows, how accurate are REITs’ current self-assessed valuations? Are REITs presently valuing their assets too high due to a general real estate boom fuelled by slack lending practices and accommodative monetary policy, or is demand for prime real estate simply outstripping supply in the marketplace?
Let’s begin to answer this question by first surveying the economic landscape.