Patrick O’Connell Blog: What’s in store for Property in 2023 ?

At the time of inditing this blog, it is end February 2023 in the midst of South Africa’s summer – 35 months on from when Covid 19 hit the South African and Global shores and wreaked havoc in many economies worldwide; emerging and established economies were not spared the effects of the C-19 Lockdowns. Let’s have a look at where we are now and what is anticipated to unfold in the short to medium term.

As a recap, C-19 came, created chaos and went – however this has not quite stopped it from still creating damage across all world economies.

When C-19 hit, I made the statement that this was a Black Swan and that we would not see another Black Swan again soon, but rather Black Goslings for the medium term – this is the environment we are presently in.

Post C-19 and its varying lockdown periods, in SA we experienced the hasty return of a consumer with “brass in pocket” and there was a resurgence of retail spending. The Retail Sector started to report sales numbers trending nicely to pre-Covid levels; the Office Sector saw green shoots appearing within the “new way of working” sphere; the Industrial Sector continued on its way, with limited effect from the C-19 Pandemic together with the upshot of online retail and the subsequent demand for logistics warehousing. On the Residential front, interest rates were low and the buy-to-let market experienced increased vacancies as Lessees opted to purchase property based on the affordability of a mortgage bond due to a low interest rate environment. Happy Days ……. Not!! The black goslings had been hatched.

Roll on the start of 2022 and Russia decided to have a fight with the Ukraine. Not long after this, markets began to rally, and the Oil Price started its upward trajectory. In SA, the impact was immediately felt in petrol prices at the pumps and soon we began to experience increases in our Inflation Rate, much like the rest of the world. Oil was not the only culprit here, with China being offline with continued C-19 restrictions, worldwide supply chain disruptions continued, and we reached one of those macro-economic stages where demand exceeded supply; a run on prices followed, further impacting local and global inflation rates negatively. During this phase, the All-Property sector trundled along with some green shoots here and there, but not enough to create fireworks. There were some improvements to Vacancy Rates during 2022, Cap Rates were not too dramatically affected, and we saw positive, albeit rather small, rental reversions taking place; residential stock traded well. Then another black gosling hatched.

Enter the ANC elective conference in December 2022 and the onset of a severely damaged Eskom with consequential heightened black-outs, together with an increasing inflation rate and increasing interest rates – a witch’s brew of the poorest quality. Business confidence waned pending the outcome of the governing party elective conference whilst the Eskom conundrum impacted it negatively even further. This political and economic instability did not do us any favours at all; however, across the ocean things were not much better. Europe, the UK and the USA also experienced heightened inflation rates and consequently also increased interest rates to levels last seen decades ago; those far cleverer than me started forecasting a worldwide recessionary environment for 2023.

Eventually China started to come out of their C-19 lockdowns with a much-anticipated improvement in the ever-present supply chain disruptions environment. Subsequent to this, those in the know have been forecasting that the opening up of the China economy may very well soften the impact of a worldwide recession – this waits to be seen. In SA at the commencement of the 2023 calendar year we were greeted with yet another increase in our Repo Rate, however this time only a 25 basis points increase – a move I strongly believe will see us levelling out at the top of our inflation and interest rate run. The next gosling is hatched.

There are numerous negative reports coming out regarding the 2023 calendar year given the ongoing Russia/Ukraine scrap, high inflation, high interest rates and the ever-present woes of Eskom. In addition, our ongoing political and economic instability are still front and foremost in the mind of Business confidence, which is still coming in low. What is the outlook for us and the SA All-Property Sector for 2023 then?

So now we have a number of black goslings swimming around and creating a challenging environment for South Africa and the world at large. I do believe that we are at the top of our interest rate hiking cycle; we shall see our inflation rate remaining stubbornly high for the short term linked with a sustained high interest rate environment, and Consumers stretched to their limits financially. The Eskom woes will see businesses experience difficult financial performance on the back of higher input costs thereby squeezing margin, which we are already experiencing.

From a property perspective, I anticipate the following for the 2023 FY:

• I expect rental reversions to come sharply back into the spotlight this year as tenants grapple with increased Cost of Occupancy ratios, as a direct consequence of the Eskom woes which will compel Landlords to invest large financial sums to keep the lights on for their tenants.
• The high cost of utilities will remain front and foremost in the minds of commercial property asset managers as Operating Costs grow at a rate higher than what income streams are anticipated to grow at.
• Retailers will see Gross Profit margins coming under pressure as a consequence of a financially stretched Consumer. Whilst we did see good numbers presented in terms of Trading Density upticks for the period Q4:2022, the real effect to consumers will be felt through the first 2 quarters of 2023 where I anticipate the gains made to claw back somewhat.
• The office sector will continue its subdued performance for the 2023 period as there is still so much available vacant space which has to be filled – supply exceeds demand.
• The industrial sector is still positioned to perform well – this will significantly be underpinned by higher demand for high-tech logistics and distribution facilities. This could even be the Jewel in the Crown of the commercial property sector were it not for our infrastructure deficiencies in South Africa.

In summary then, with the number of Black Goslings still swimmingly well, we will experience a tougher 2023 where I expect the commercial property sector to manage along somewhat subdued, but certainly not losing any asset value ground.

Patrick O’Connell
CEO – Spectrum Valuations & Asset Solutions.

To Office or not to Office

Will the Office Sector recover to pre-pandemic levels or is it doomed to be the thorn in the jeweled crown for years to come? Walk with me as I unpack this further.

We have recently entered the world beyond Covid-19 where all regulations and restrictions have been removed. It goes without saying that this is indeed a tremendous milestone and one which we have been waiting for since end March 2020.

Further to the above, it has also been well documented that the property sector has been significantly affected by the Black Swan that was Covid-19; I would however like to remind you that black swans are not as commonly found in the world, as was the arrival of C-19, and that it was only a black swan. At the onset of Covid-19 I was involved in many online meetings with a multitude of people and organizations who were seeking inputs and opinions on what would happen to the property sector as a consequence of the C-19 lockdowns and “new ways” of doing business. My view then, as it still is today, is that things will return to what they were prior to Covid reaching our shores.

There are numerous media reports of the Office Sector being lackluster in color compared to its Industrial and Retail Sector cousins; this is well the case presently however there are signs of greenshoots appearing.

The culture of Work From Home – WFH – is just not that ingrained in our society as it may be in first world economies, given how South Africa lags behind the rest of the world. Added to this, there are societal issues which prevent a significant shift to a WFH culture which is not entirely endemic to South Africa alone; here I am talking about the great digital divide, safety, security and abuse – either physical or substance.

These are real issues which cannot be ignored nor denied and which do affect a significantly large part of our population.

Most importantly though for me when it comes to the conundrum of “To Office or Not To Office” is the matter of company culture, collaborative working and the interaction amongst office staff, with the latter ranking high on Maslow’s Hierarchy of Needs in the workplace. The WFH phenomenon will not do much when it comes to company culture; a company with a good culture delivers well above the average in terms of services and customer satisfaction. Company Culture is certainly not developed through isolated workstyles and exclusively interacting via a telephone or online meetings, it is just not possible. Similarly, the case made for Gen Y, or Millennials, does have some merit; however, consider for a moment that a substantially big part of this generation’s world is social media together with physical interaction with their friends. Given this, where a company has a great culture and has refined their workplace to accommodate the Millennials, it is my view that they too will be attracted to the workplace environment, not of old, but spruced up, dynamic and fun.

So, my view therefore, with the above as context, is that there will be a return to the office environment and with the greenshoots currently revealing themselves, there is a good possibility that this will be sooner than later.

A Blog by Patrick O’Connell,
CEO of Spectrum Valuations & Asset Solutions

Capitalisation Rates and Discount Rates explained

In the world of commercial property valuation, it is

1. rental income streams,
2. annualized property expenses,
3. vacancies,
4. capitalization rates and
5. discount rates which all impact the Value of a property.

These are the essences of commercial property valuation where all of these elements together reflect risk, security and confidence in the asset being valued.

Items listed 1 to 3 above form the basis of determining Nett Annualised Rental Income which is then Capitalised at an appropriate rate to determine Present Value of an asset or property.

Capitalisation Rates and Discount Rates are two different concepts and are made up of similar, but also different elements. The basic differences between a Cap Rate and a Discount Rate is that the former capitalises a net annualized income stream into present value, whereas the latter discounts a number of future income streams into present value.

Contrary to some views in the economy, there is no mathematical build-up of a Capitalisation Rate, these are determined from the yields against which properties transact at. By way of example, if a property has a net annualised rental income of R 100K and it transacts at a value of R 1m, then the net annualized income is yielding 10% return on the deal. In valuation practice, Valuers will research multiple comparable sales to establish a Yield Rate range upon which to base the selection of a capitalisation rate which is to be applied to the property being valued. So, if market research indicates yield rates in a tight range of 8.5% to 9.5%, the Valuer will select a cap rate based on the strength of the property, type and length of covenant in place, quality of offering, nodal strengths together with Macro influences. In essence then, Cap Rates are derived from arms-length sales yield transactions.

Discount Rates are another story, to an extent. Traditional textbooks will say that a Discount Rate is made up of Cap Rate plus Lease Escalation Rate; in practice, this is Cap Rate plus smoothed market growth, not lease escalation. An alternative approach to the establishment of a discount rate is termed the build-up approach.

The build-up approach is based on the following elements:

• Prevailing Long Bond rate which matches the income stream, eg. 10 year cashflow, R186 which has an investment horizon of 10 years or close to it – say 9.25%
• Less: Income Contingency – risk based on annualized income receipt vs monthly income receipt – Standard is -0.25%
• Add: Property Risk – Standard is 1.5%.
• Add: Regional Factor – Standard is 1.5%.
• Add: Sector Factor – Standard is 1%
• Add: Tenant Risk Factor – Standard is 1%

Given the above, by way of calculation, this amounts to a Discount Rate of 14%. As a cross check, we consider the Cap Rate plus smoothed market growth: Cap 9.5% + smoothed market growth 4.5% = Discount Rate of 14%. The textbook method is not applicable any longer because it would penalize the value unnecessarily, eg. Cap Rate 9.5% + lease escalation 6.5% = 16%.

In the calculation of Discount Rates, the largely non-variable number is the long bond rate, whilst the Valuer is able to manipulate the other 5 variables in the matrix depending on the strength of the property, type and length of covenant/s in place, quality of offering, nodal strengths together with Macro influences.

What is detailed herein may look straight forward at a glance, however this is indeed far from the case. Property Valuation entails a strong comprehension of mathematics, in-depth knowledge of local and international economies, in-depth knowledge of the business performances of tenants in occupation and a good “feel” for property, to mention but a few. This is why the Valuation Profession is well equipped and educated in undertaking this type of work.

Chat with us, at Spectrum Valuations & Asset Solutions we have the teams to solution your property investment decisions.

Changing Commercial Valuation Methodology – A Case for Green Building

Green Building in South Africa is fast-becoming the norm of the New Build Commercial Property Development with all kinds of tax incentives and presumably lowered operating expenditure for the owner / landlord. The case for approaching a Property Valuation of this kind (in the case for a Green Certified Building) is argued by many to follow the traditional Income Capitalisation Method of Valuation, with the effects of Green Building being absorbed either by achievable rental (in the instance where the value add effects the Indoor Environment Quality for the occupants, and they will presumably pay a slight premium on the space, within market parameters), or the value add may be absorbed in the lower Operating Expenditure Ratio output of the building; this thought, strengthens the notion that no change in Valuation Methodology is necessary.

Consider though, the fact that a Green Building is normally comprised of an intricate set of specialised Plant & Machinery, which have various impacts on the building performance and environment at large. The valuer would be wise to therefore give some thought on the effective lifespan of the Plant & Machinery components. We know that currently, the valuation of Plant & Machinery, is currently not recognized by the South African Council of the Property Valuation Profession (SACPVP); it is a long-accepted norm that the valuer ignores the effect of Plant & Machinery in the standardized Income Capitalisation Method of Valuation (especially in the case of the Commercial Property).

The case for Green Building however, has the added complication that the Green Building Features and Initiatives (GBFIs – as the term was coined at the University of Cape Town) are normally made up of highly specialised Plant and items of machinery which contribute in their existence to the output of the Green Building. The question therefore surfaces: Can the valuer continue to disregard Plant & Machinery in the valuation approach?

From the earlier argument by some, that the effects of Green Building can either be absorbed in rental achievable or by lowering the operating expenditure, is mathematically incorrect. The reason for this is simple: The Income Capitalisation Method of Valuation assumes a 50 Year cashflow / perpetual annuity. It is therefore assumed that both the Gross and Net Income are kept at a standard stream, with a consistent Expense Ratio over the 50 Year Scenario. However, in the case for Green Building, it is incorrect to assume that specialised Plant and Machinery can achieve this same 50 Year lifespan. In practice, we know that these are moving parts, which need interval maintenance and service plans which purport to a strong degree of variability in the holding period and effective lifespan of these assets. In other words, during the assumed 50 Year effective lifespan, there will be considerable fluctuation in the Expense Ratio of the Green Building.

To expand on the point further, the valuation report of a Green Building should perhaps look something like a 50 Year Discounted Cashflow where the Valuer has modelled a strong degree of research into the Plant & Machinery component to model the expected variability of the Expense Ratio in conjunction with the market-related rental achievable on the Gross Lettable Area of the building itself. Further to this, the valuer would be able to map out, by means of the Net Present Value and Internal Rate of Return calculation, different scenarios of the Holding Period (in intervals of say 5, 10 or 15 years). In graphing the change of the Net Present Value, the valuer will then be able to report on the Optimum Holding Period and the subsequent Holding Period Returns.

In the case for Mortgage Lending, this approach allows for the Financial Institution to minimize their risk of the client defaulting by tailoring the loan term to fall within parameters of favourable return. Why should a bank sign a client up for a 10 Year loan, if Year 9 (by investigation) purports to a complete replacement of the specialised plant installed, minimizing Net Profit for the Landlord, adding to the risk of default in meeting the mortgage payments. Instead, the bank now has the ability to have informed, calculated decisions on the optimum term of the loan.

Some argue however, that the Discounted Cashflow method brings with it a large degree of assumptions in the calculation inputs, but the opposite can also be argued; the lack of assumptions in the Income Capitalisation Method of Valuation and how this disproportionately distorts expected cashflows. An assumption is not something the valuer should shy away from, as a good amount of market research will enforce the calculated assumption to apply in any event. This is necessary where the underlying asset is built up from components which have differing expected lifespans, which cannot be standardized.

Therefore, the valuer will play an integral role in the future of Green Building Valuation and the subsequent valuation of Plant & Machinery installed in these buildings. This also means that regulatory bodies such as the SACPVP will need to inform themselves on the relevance of Plant & Machinery Valuations and provide an accreditation in this regard to ensure that the same high standard of Immovable Property Valuation is adopted for this new channel in the industry.

In valuation circles, the joke is often to say that the best way to conduct a Plant & Machinery Valuation is to not do it in the first place. However, the valuation of such types of Asset Classes are integral and useful in a changing industry. More on this topic to follow in my next edition.

Contact us for more information

Nathan Theron

Beware of Over-Capitalization of Farm Land

• As a professional Valuer for many years I have frequently encountered unhappy farm owners, because the money they have “invested” in structural improvements are not fully reflected in the market value of our reports.
• On the other hand one should respect the fact that it is logical to deem money spent on improvements to contribute towards increasing the market value, but on the other hand one has to understand that not all improvements contribute towards the main use of a farm.
• What is important is to understand market value is determined by the perceived contribution, in the mind of the potential buyer, the features of a farm makes towards the main purpose of the farm.
• State of the art horse stables, built at very high costs on a 300ha citrus farm will have very little impact on the value of the farm if the potential core of buyers are mostly interested in the quality of the orchards and the allocated water rights.
• Farm buyers consider the agricultural potential of the farm and will have very little consideration for aspects such as tennis courts, built in saunas, gymnasiums and indoor swimming pools.

My conclusion is; if you consider structural improvements on your farm, with the view of improving market value, make sure it is something that has a direct impact on the productivity of the operations. Any improvements not directly related to the main agricultural activities could be considered irretrievable expenses.

Deon Van Onselen
Professional Valuer – Spectrum Valuations & Asset Solutions

Our Promise

At Spectrum Valuations & Asset Solutions, we boast of a whole range of valuation related and asset creating services across our national footprint.

Our collective expertise and ability to deliver a world class service is something we believe that sets us apart. We value our staff and we truly believe that we are the employer of choice in the Industry.

Our valuers are consistently striving for Professional status, and the qualification statistics of these special people amaze us every year.

For some time now, we have been debating exactly as to why our clientele buy from us. At the same time we constantly engage with our clients to understand what we can do differently in order to increase our value offering to them.

It is becoming more and more evident that we don’t sell valuation related services, although these appear to be our offerings. We, in fact sell risk mitigation services and the ability for our clientele to make better commercial decisions in their business and their dealings with their clients.

We have thus found it important to embrace and consolidate elements such as service excellence, expert knowledge, professionalism and ethical behavior into our Culture and Values.

We remain committed to serving all our valuable clients, now and in time to come.

Specialised valuations: entering a world of Asset Optimisation anywhere in South Africa

Merger: Entering a world of Asset Optimisation

The merger results in a new name you can still trust: Spectrum Valuations and Asset Solutions. Dedicated Focus where the market will see Spectrum Valuations and Asset Solutions broadening their scope of services to cater for a far larger market. A market where you are assured the stakeholders carry your investment interest’s top of mind for Asset Optimisation.

Now with the largest national footprint and service offering, the merger has boosted the company’s market share to arguably the largest in the country. Boasting the most experienced experts in the industry with access to high level information and consulting.

The mission of these combined entities is to help people and organisations to realise their true asset potential throughout South Africa.

Specialised valuations anywhere in South Africa, with the backing of influential shareholders and a strong BEEE ownership, fits the Spectrum Valuations and Asset Solutions overall future vision and growth strategy, which has been well constructed to move from a 2 pillar approach to a 4 pillar approach, encompassing:

1. Property
2. Moveable assets
3. Consulting services
4. Specialised Services

The new offering formulates a 360 degree approach for every customer needing Consulting Services and Specialised Services.

Spectrum Valuations and Asset Solutions now ensures its customers additional peace of mind, in that they have the best people for any asset valuation and superior consulting services. The high standard of quality control which ensures every customer receives:

1. Superior Risk mitigation
2. Excellent turnaround times

Moreover, our customers can now take advantage of and benefit from the following dedicated planned offering:

1. Wherever you are, with our consolidated national footprint
   • One service
   • One price
   • One experience
2. Access to information on consulting
3. Speed and accuracy

Moving forward from the exciting merger of 2 of the largest, most specialised industry experts, our customers will see an integrated asset management policy of these 2 entities.

This integration ensures full optimisation and growth of the largest national footprint in the industry. This positions Spectrum Valuations and Asset Solutions as the market leader in Asset Optimisation, which ties into the overall Mission and Vision of the company and speaks to the core values of professionalism, integrity, excellence and reliability in all that we do.

These are exciting times for the South African market and our customers are assured that our planned future growth will create dedicated quality control as well as accuracy and speed of delivery for an unsurpassed market offering, with the continued aim of assisting our customers, people and businesses alike in realising their true asset potential.

Spectrum Valuations and Asset Solutions looks forward to the journey with our customers following the merger.
Should you have any questions regarding our service offering please contact info@specval.co.za

Patrick O’Connell
CEO – Spectrum Valuations & Asset Solutions.

Are you spending too much?

Over capitalisation is used in property field to indicate when a property’s total capital costs plus land exceeds the market value it can achieve.

But what does this really mean, and what are the implications on the different parties involved in property transaction by this. The following short explanation is almost relevant on any kind of property.

In layman’s words over capitalisation is when a property owner spends excessive capital on the property including the land cost, and in the process exceeds market value by far.

Reason for capital loss is not due to poor performing markets, but the large capital spend on the property in an area that does not justify this.

Over capitalised properties are normally marketed at too high prices due to emotional connection and hence take forever to be sold at a much lower than anticipated price. The owner therefore makes a loss on his capital investment.

Buying an over capitalised property has its own risks as you are never really sure when the market will catch up with this and you might end up also not making any future profit on your investment.

This comes back to the old saying: “rather buy the smallest house in an established affluent neighbourhood, compared to buying the biggest house in an inferior neighbourhood”.

Bank Valuator VS Property Valuer

There appears to be a misconception surrounding property Values in South Africa. There is no such thing as a Bank Evaluator, Valuator or Bank Appraiser. We are property Valuers who are registered with the South African Council for Property Valuers Profession. Property Valuers who either work in the private sector or are employed in Financial Institutions are all members of SACPVP and fall within the requirements and ethical constraints of the statutory body. The Valuers are either in training and referred to as Candidate Valuers working with a mentor or they are qualified as Professional Valuers and Professional Associate Valuers.

To qualify as a Valuer requires a minimum of 3 years of study, attending a week long intensive workschool before a minimum of 2 years work experience and thereafter applying to the SACPVP board to sit and write the entrance board exam.

The 2nd misconception within the South African property market is that there is a difference between Bank Valuation and market valuations. Valuations are performed predominately at market value no matter whether performed by a Bank or for a Bank. Other Valuation requests are at times required by the client, such as replacement cost or insurance Valuations, but they are predominantly requests for market valuations.

The purchase of a property may well be the largest single investment that the average person makes. It is therefore important to understand why the valuation is required, and why the services of an independent and objective Property Valuer is required.

Competency VS Responsibility

We have recently come across a few scenarios where large tenders have been awarded on what we believe could largely have been based on cost.

At the same time, after analyzing what is required in the brief or scope of work, it is somewhat difficult, at times, to comprehend how on earth this project will be delivered at that cost to the client.

I know of a particular tender awarded in the scenario described, above. One can only assume that the contractor in question was either

1. Unable to deliver; or
2. Had misunderstood the scope of works required entirely.

On the other hand, we all want to land that one life changing big deal. And the reality is that not all of us are competent enough to deliver once that deal has been clinched.

I have read some interesting literature on the aspect of selling yourself or your organisations ability “as if” you are able to deliver. In my opinion, there is nothing wrong with this approach if you are confident enough to understand what is required to deliver and you are structured enough to do what is necessary. In many cases you would need to be backed by a network of contacts and infrastructure which will assist you.

And one would only hope that pricing, in this scenario, will reflect the effort and quality of the finished product.

On the converse, should you honestly believe that there is a remote chance that you may not be able to deliver, it is my sincere belief that you have a responsibility and duty of care to recognize any limitations you may have and stay away from the specific tendering process.

The consequences of not being honest with yourself and /or your potential client may be dire.

Pricing on its own has its own integrity value too. And an unusually low price could reflect on the expected quality of the product to be delivered. Differentiating factors such as service excellence experience and quality could negate the need to price low in the hope of winning that tender.

Eric Wright
CEO