Real estate does not exist in a bubble. As capital allocation is not constrained, Real estate as an investment asset class must compare favourably with other classes of investment. For real estate to compare favourably, it must have a return on investment similar and comparable to other asset classes such as government bonds and company shares; and it must be priced appropriately with consideration given to relevant macroeconomic indices in the given jurisdiction.

In Nigeria, with inflation at c. 11% (and rising) as at August 2018, Monetary Policy Rate / Base Rate at 14%; Treasury Bills yield between 10% to 12.6%; FGN bonds yield between 12.8% and 14.69%; and Nigerian Government Eurobonds yielding 7% to 8%, it is exceedingly difficult (if not impossible) for real estate assets yielding between ‘say’ c. 5% and c. 10% to attract investment from retail or institutional investors especially given the alternative investment classes – primarily government securities.

[The justification for investment in real estate (yielding between ‘say’ c. 5% and c. 10%) is capital growth, primarily through rent reviews/rent uplifts during the period of investment as opposed to yield compression. Capital growth would aid to give a total return (over the investment period) which could compare favourably with other investment asset classes.]

Given the above yield differential, it seems to be the case that there exists a structural fault in real estate returns and pricing relative to macroeconomic indices in Nigeria.

To attempt to understand the issue of real estate pricing and, perhaps, the relative lack of institutional investment (other than regulatory limitations such as Regulation on Investment of Pension Fund Assets – April 2017) in Nigerian real estate as an asset class, one must consider the concepts of price, value and worth and view this triumvirate from a real estate perspective.

Price, value and worth

Price is the amount of money or the consideration that has to be paid to acquire a given product. As long as the amount of money paid for a product represents its value, the price is also a measure of value. As said by Warren Buffet, “Price is what you pay; value is what you get.” It follows, therefore, that price should not be too dissimilar from value – certainly, one should be within a reasonable margin of the other. After all, a purchaser does not want to pay a price that far exceeds value nor would a seller want to receive a price far lower than value.

Theoretically, a market price is the amount at which one transacts on an asset while market value is the true underlying value of an asset. The difference between price and value is usually as a result of inefficient markets i.e. lack of information, or situations where prevailing market prices are not reflective of true underlying market value. For a market price to equal market value, the market must be efficient from an information perspective and rational expectations must prevail. One could conclude that price would hardly equal value as markets are not efficient and rational.

From a real estate perspective, open market value (OMV) or value, according to International Valuation Standards is “the estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arms-length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently, and without compulsion.” Open Market Value determination or property valuation based on yield implies that the value of an asset is the net annual income from the asset multiplied by the inverse of the yield (where yield is the annualised return from the asset expressed as a percentage). Therefore, an asset with a yield of ‘say’ 5% would have its net annual rental income multiplied by 20 while an asset with a yield of ‘say’ 9% would have its annual income multiplied by 11.11 to determine its open market value. As well as yield, property valuation is also based on comparable evidence from the market.

In finance, the value of an asset could be considered to be the lump sum payment made (today) for the benefit of the future cash flow accruing from the asset. This is essentially the DCF method of valuation.

Given that price is the amount that one transacts on an asset, and it can be established as a matter of fact from market evidence, it follows that price would be equal to value as described above once a transaction completes. This gives objectivity and acceptance to both price and value.

Worth, whilst used, unfortunately, interchangeably with price and/or value, should not be mistaken for price or value. Worth is a subjective view of price or value, and it is the price or value to a particular entity or individual as opposed to the market.

For example, an asset (‘say’ office premises) next to a manufacturing plant could be worth more to the owners of the manufacturing plant due to its proximity to the plant. The same asset would not be worth so much to any other tenant or potential owner. In this example, the worth to the owners of the manufacturing plant exceeds the value of the asset in the market.

Similarly, due to the legal, planning and construction challenges faced by a residential developer, residential units developed on a (perhaps inherited) parcel of land could be considered to be worth a lot more than a willing buyer would pay. The worth ascribed to the asset should not be determined to be the value of the asset. With the price, value and worth broadly understood, consideration should be given to capital and cost of capital used to acquire real estate.

Cost of capital

All capital, debt or equity, has a cost, with debt generally considered cheaper than equity. In any (investment) market, debt (and cost of debt) is a vital element, which serves to, inter alia, improve return on (equity) investment.

In broad terms, the start point for the cost of debt is to determine the risk-free rate, which is the rate at which sovereign entities i.e. governments borrow, then add a risk premium for borrower risk and investment risk. In Nigeria, the Nigerian Naira risk-free rate would be the yield on Treasury Bills (10% to 12.6%), or for long-term borrowing, the yield on 5-year or 10-year bonds (12.8% to 14.69%) whilst the United States Dollar risk-free rate would be Nigerian Government Eurobonds (7% to 8%). Borrower risk and investment risk could be upwards of 2% depending on a host of considerations. Assuming a total (borrower and investment) risk premium of c. 2% or 3%, then the cost of long-term debt should be no less than c. 15% or 16% in Nigerian Naira and c. 9% or 10% in the United States Dollar.

Considering central government securities (treasury bills, bonds) are considered risk-free and other investment asset classes are priced (with a risk premium) relative to the risk-free rate, then no asset class should be priced or yield a (total) return lower than the risk-free rate…unless the investment is seen and accepted to be more secure or less risky than sovereign/government securities. Real estate investment is certainly not considered to be more secure / less risky than government securities even with a very good quality tenant in occupation on a long lease.

In addition, to the extent that debt (priced as explained above) is utilised in the acquisition of real estate investment, then the real estate investment must have a total return in excess of the cost of debt i.e. a yield in excess of c. 15% or 16% in Nigerian Naira and in excess of c. 9% or 10% in United States Dollars to service the debt, and capital growth to compensate for the risk of investment.

Otherwise, the investment total return would not suffice to service the interest on the debt never mind amortise the debt and compensate investor.

Note: It is possible, and there could be significant value in buying an asset at an initial yield lower than the cost of debt if the purchaser believes that a reversionary yield in excess of the initial yield can be achieved. The reason for this is likely to be that a rent review is imminent or the asset has a high vacancy. The value in a transaction of this nature would be the purchaser’s ability to maximise annual rent at rent review or minimise vacancy within the asset in the shortest possible time or both. In any event, the purchaser’s key initial objective would be to achieve reversionary yield (in excess of the cost of debt) as soon as practically possible.

Back to value

Only when real estate yields (initial and reversionary) are in the range suggested above would real estate as an investment asset class be attractive to retail and institutional investors when compared against other investment asset classes.

When considered from this perspective, the logical conclusion is that real estate assets, with initial yields of c. 5% to c. 9% (i.e. multiples of c. 11 to 20) on Nigerian Naira net annual income, are significantly over-valued especially in the absence of real capital growth and reversionary yield to support an attractive total return (which is not based on yield compression).

With real estate yields as explained and determined above, multiples on Nigerian Naira net annual income from real estate should be in the range of 6.90 (c. 14.5% yield) to 6.25 (16% yield) in the absence of real capital growth to derive a total return in excess of cost of debt. The yield could reduce slightly in a market with a deep tenant pool (therefore low vacancy rates) and stable currency. For completeness, real capital growth is based, largely, on increases in rental income over and above prevailing inflation during the hold period of the investment. An asset bought and sold at the same yield but with the benefit of rental income growth over and above prevailing inflation would have the benefit of capital growth and would be likely to derive a positive total return.

The above suggests that real estate asset with a net income of ‘say’ NGN 5 million per annum currently valued and priced at c. NGN 83.33 million based on a yield of 6% is significantly over-valued and should, perhaps, be more appropriately valued and priced at c. NGN 35.5 million based on a yield of 14.5% especially if a rent review is not imminent and real capital growth is not certain.

Over-valuation is one of the reasons real estate financiers are often asked by agnostic investors: ‘why invest in real estate for a yield of x% (without certainty of real capital growth) when an investment in government securities can be made for a yield of 1.5x% or 2x%?

Whilst it could be argued that any difference between price and value of an asset is down to demand and supply and market inefficiency, price, we know, would equal value at transaction completion. The issue of worth, and trying to equate worth to value or price, should not occur nor should it be permitted in any market.

For prudent and competent real estate pricing, consideration should be given to whether an investor / a purchaser would be willing to acquire an asset that yields a total return that is far less than the cost of capital and if, indeed, the cost of capital has been considered, determined and understood.

Should an investor or purchaser be willing to accept a total return less than the cost of capital, then, it seems value creation is not the objective of investment and, perhaps, the source of the capital ought to be questioned.

In order to create value within the real estate industry in Nigeria, it is incumbent on all participants in the sector to consider international best practices in real estate asset valuation and pricing and ensure that over-valuation / unjustifiable pricing (based on worth) is avoided.

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