Real Estate Valuations in a Falling Market: Understanding What the Numbers Really Mean

Chris Dempsey: Head of Transaction Execution, Corval Avenue and qualified valuer

In periods of market volatility, such as the current decline across the broader residential property market, scrutiny on valuations intensifies.  Valuations provide important information to lenders and investors alike, but remain widely misunderstood  within real estate finance. People frequently assume that a valuation represents an objective truth about what a property is worth, however, the market value definition, “the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion”  suggests a more subjective basis.  A valuation is a professional opinion of value at a specific point in time, based on the information available to the valuer, usually within a defined selling period.  That distinction is critically important when markets and sentiment are moving quickly.

In residential property valuations, including development, valuers rely on a direct comparison methodology that primarily considers recently settled sales of comparable properties. That in itself  means a valuation is inherently backwards looking. When markets are stable, this methodology generally works well.  However, in a falling market such as we are now seeing, buyers often become cautious and step out of the market and sellers are reluctant to accept lower prices unless they are under pressure to sell immediately.  This bid-ask spread  widens  and  transaction volumes fall.

Ironically, this reduction in sales activity can make valuations appear more stable than the market itself. With little current evidence available, valuers are often forced to rely on comparable sales that occurred three, six or even twelve months earlier and exercise more subjectivity where comparable sales values indicate a broader market value range. Valuations therefore lag. On paper, values  appear relatively unchanged, justifiable by settled sales evidence, even though market sentiment has deteriorated significantly.

Experienced valuers recognise this issue and will commonly include commentary regarding market uncertainty, reduced transaction volumes and softening conditions. Those comments and disclaimers  are important and often provide valuable insight into heightened risks that may not be immediately visible in the headline valuation figure. Rarely, will  valuers attempt to quantify precisely how much value may yet be lost. For the same reason in rapidly rising markets, valuers will often appear to be conservative, although a contract of sale provides a level of additional support to market value.. Their professional indemnity insurers generally expect valuations to remain grounded in observable evidence rather than make market predictions.

This creates a challenge for lenders and investors. A valuation used to establish a loan-to-value ratio (LVR) today may bear little resemblance to the value of the underlying security when the loan ultimately matures in 12-36 months.

Understanding how different asset classes behave during downturns is equally important.

Land almost always moves first and furthest in a falling market. The reason lies in the way development sites are valued. A development site’s value is not determined directly by the land itself. Rather, it is calculated as the residual value remaining after deducting all development costs from the anticipated value of the completed project.

The equation is relatively simple:

Because land is the residual component, it absorbs changes occurring elsewhere in the feasibility model. If apartment sale prices decline, construction costs rise, finance becomes more expensive or developers require larger profit margins to compensate for risk, the impact falls disproportionately on land values.

As a result, the hierarchy of price declines in a downturn often starts with development land.

The first assets to experience substantial valuation pressure are Englobo land (large undeveloped parcels of land that have not yet been subdivided or fully serviced for development). These sites typically carry the greatest planning, infrastructure and execution risk, making them highly sensitive to market changes.

Next come DA-approved sites, followed by subdivision projects and residential land estates. After that, off-the-plan apartments often experience significant pressure.  Whilst delivery risk is gone as the project is complete, settlement risk remains as purchasers may struggle to obtain finance at settlement or may simply walk away if valuations come in below contract prices.

Completed houses and duplexes / townhouses, are generally the last segment to move. They benefit from a broader buyer pool, immediate utility and a larger body of comparable sales evidence.

This creates an interesting irony where media headlines focus on house price movements as the primary measure of market strength or weakness. Yet for a development lender, the key risks usually lie much further up the development chain, where changes in land values, construction costs, finance costs and project feasibility can have a far greater impact on ultimate loan performance.

This is why experienced commercial real estate lenders add value beyond simply commissioning a third party valuation. Firms such as Corval Avenue have experienced staff and independent credit committees that interrogate valuation reports rather than accepting them at face value. They also know how to assess broader project fundamentals including capital structure, construction capability, delivery risk and product strategy. These factors often determine whether a development succeeds or fails and can be just as important as the valuation itself when assessing risk in a falling market.

Ultimately, valuations remain an essential tool, but they are only one piece of the puzzle. In periods of market stress, understanding their limitations can be just as important as understanding the headline number.