Regulatory pressures for unlisted funds to use fair value accounting are increasing. Graham Barnes and Paul Robinson discuss the implications
Many investors in unlisted indirect real estate funds have historically carried their positions at net asset value (NAV). This has been justified by consistency with direct real estate, the ability to ‘touch’ NAV at fund maturity, and the absence, in an illiquid asset class, of another systematic basis.
NAV is the assets less the liabilities dependent, at a detailed level, on the accounting policies adopted. There have been attempts to standardise accounting treatments, such as guidance from the European Association for Non-Listed Real Estate Vehicles (INREV), but these have not been universally adopted.
The demand for increasing liquidity in fund investments has highlighted that NAV is not the same as market value. Additionally, regulatory developments, including IFRS accounting standards and the Solvency II Directive, are encouraging the adoption of a ‘fair value’ accounting basis.
Fair value is defined under IFRS 13 as the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. Fair value is based on the market value, not the entity value, using assumptions of market participants under prevailing market conditions. Neither the intention to hold an asset nor the ‘I would not sell at that price’ argument is relevant.
Is NAV suitable for valuing in a fair-value context? Property investors understand that identical buildings with differing tenancy structures will have different fair values. Most indirect property funds revalue their assets using an approach compatible with fair value. Some accounting approaches seek to adjust for the market value of liabilities including derivatives and fixed-rate debt. Further adjustments are made for items including tax, fee recognition and set-up costs. However, some items are not addressed, such as fee structures, distribution policies, and the margin on private debt. These all have an impact on returns and hence the price that a investor might pay.
We consider that there is a more important consideration in determining whether NAV is an appropriate measure of fair value. Even the most sophisticated measure of NAV essentially marks to market each of the assets and liabilities independently. But investors do not own the assets and liabilities separately; instead, they own a financial instrument that entitles them to distributions of income and a realisation of the capital value from a sale or the winding up of the fund.
Investors are exposed to the risks and volatility of these net cash flows. NAV does not seek to price the cash flows at a discount rate appropriate to the risk to them; therefore, NAV is only equivalent to fair value by chance. This is borne out by the increasing volume of market data from PropertyMatch, where funds consistently trade away from NAV with a spread of trading prices (highest premium plus largest discount) of 60%.
A small position in a large, ungeared, open-ended core fund generates similar cash flows to owning and managing the underlying property. NAV might be a good approximation of fair value. Fair value may actually be in excess of NAV because neither the diversification of the fund portfolio nor the more liquid nature of the structure is factored in. The counter argument is that, given that in an open-ended structure a purchaser can buy at NAV, fair value cannot exceed that accessible price.
The direction of the market will also affect fair value relative to NAV. Property valuations inherently lag the market as these are historic measurements. Therefore, fair value should typically lead the trend in NAV as investors appreciate where the spot market is and anticipate the evolution of property valuations.
It is widely accepted that leverage increases risk. The NAV of a 50%-geared property fund is twice as sensitive as an ungeared fund to a change in the value of the underlying property. This relative sensitivity changes as the valuation moves. For example, while at 50% loan-to-value (LTV) the geared NAV is twice as sensitive, at 85% it is 6.7 times as sensitive.
How can fair value be best defined? The starting point for fair value is a market price for an identical or similar asset. For unlisted property funds these might be provided by data from PropertyMatch. But how can fair value be estimated where there is no observable price?
Theoretically, market price will be the present value of expected future cash flows discounted at a rate that reflects the risk. The concept of applying different discount rates to future cash flows of differing degrees of certainty is well understood.
At a fund level there are a range of risk factors that indicate whether the discount factor should be higher or lower. Over and above the property considerations, these include liquidity, size, gearing, transparency, distribution, diversification, quality of management, strategy and cost structures.
Comparisons are often drawn between property yields and gilts. This extends to property and credit, with (real) BBB credit regularly cited as a benchmark for institutional-quality property. But these relate to property and not fund interests.
Listed real estate equities share many of the characteristics of unlisted funds and we would expect the prospects for real estate as a whole and the discount factor, effectively a premium over risk-free returns, to have the most significant impact on pricing. If one accepts that real estate has similarities with BBB credit, then moderately geared equity might be expected to have analogies with high yield credit.
This is supported by the figure that shows the EPRA index plotted against the Xover index, an index of high-yield credit spreads. Statistically, the weekly correlation between EPRA and Xover over the last three years is 0.7, which can be interpreted as showing that around half of the short-term price movements of listed real estate can be attributed to changes in general risk pricing.
While to date the industry has generally used NAV as a valuation basis, we consider that – unless used to value interests in a truly open-ended structure allowing one to ‘touch’ NAV – this is both conceptually flawed and incompatible with the concept of fair value.
Investors are increasingly requiring liquidity, and they understand that this is not necessarily available at NAV.
Regulatory pressure to adopt fair value accounting is increasing in the form of IFRS 9 and IFRS 13, and also Solvency II.
Published current secondary market prices for individual funds are a sensible measure of fair value. But where these are not available, a more analytical approach is required, reflecting proper analysis of the individual fund vehicle, an awareness and appreciation of current secondary market evidence and the ability to factor in evidence from wider markets. Are you ready?
Graham Barnes is senior director and Paul Robinson is executive director in the real estate finance team at CBRE