Does a falling tree make a noise if there is no one around to hear it?

Or in real estate terms, do real estate values decrease when there are no transaction evidence to support it?

The falling tree question is a classic philosophical thought experiment that has been debated for centuries. There are two main schools of thought on this issue. The first school of thought is that the falling tree does make a noise, as the noise would occur regardless of whether anyone is there to hear it or not. The second school of thought says that sound is a subjective experience that requires a listener. Without a listener, there can be no sound.

Ultimately, the answer to this question depends on one’s definition of “noise.” If we define noise as a physical phenomenon, then the falling tree would create noise even if there is no one around to hear it. However, if we define noise as a subjective experience that requires a listener, then the falling tree would not create noise if there is no one around to hear it.

Real estate prices are determined by the interaction between demand and supply. Demand is substantially driven by demographics, employment and spending characteristics, the state of the economy, and the availability of financing (equity and debt). The recent collapse of banks in the USA and Europe, as well as the knock-on effect on other financial institutions, e.g. regional banks, REITs, etc, has led to a repricing of risk across the board. This is demonstrated by the higher cost of credit default swaps, higher bond rates issued by banks and others, higher lending rates by banks, etc. As debt is being repriced across the board, equity is following suit. Given the change in risk and the wider range of available opportunities, investors demand higher returns from potential investments.

With investors seeking higher returns and sellers having no indication where pricing is at (thus anchoring to prior valuations and price points) we are slowly entering a period of price discovery, i.e. the process by which the market determines the fair value of a financial asset through the interaction of buyers and sellers. I refer to this period as “playing chicken”, a situation in which two parties engage in a contest of nerve, each refusing to back down or yield in the face of a challenge or threat.

Public markets have already repriced the value of real estate. In the USA, the REIT (Real Estate Investment Trust) sector started strong in 2023 with an +11.77% total return in January, but quickly gave up the majority of those gains in February with a disappointing -6.18% return in February. March will be even worse.

Let’s speak about NAV (Net Asset Value) for a moment. NAV is a measure of the value of a company, calculated by subtracting the total liabilities from the total value of its assets. In the case of a REIT this would be calculated by subtracting the total liabilities from the total value of its real estate assets. In the USA the average REIT NAV discount widened from -14.31% to -19.63% during February. The median NAV discount also widened from -13.35% to -17.59%. There fluctuations in departures from NAV are caused by changes in investor sentiment. That is, when investors become pessimistic about REITs, the value of REIT shares is pushed below the underlying value of their real estate. Another way to think about this is that public markets believe that the value of the real estate owned by REITs is lower by 17.59% compared to what they have it at their books valued at.

Whilst the market “has spoken” and liquidity in the system is slowly drying up, we have not seen any significant number of transactions at such new pricing. This is not dissimilar to what happened in the UK in 2008 during the great financial crisis; when the financial crisis hit and property values began to decline, many investors began to withdraw their money from these funds, leading to a liquidity crisis. As more investors tried to sell their shares, the funds were unable to meet redemption requests, as they had invested in assets that were difficult to sell quickly. Valuers were caught of guard and they started repricing properties downwards, even though there was no market evidence to support such price points. After a few turbulent weeks, the RICS (Royal Institution of Chartered Surveyors) provided guidance to valuers, which basically guided them to keep prices “steady” in the absence of market-based evidence.

Those of you who are planning to sell or buy, you are entering a period of chicken.

Those who own assets can continue to believe what they want to believe the value of their property is, as no one will know what it is until the outcome of the game of chicken becomes known.

I am getting my popcorn ready to watch the show.