The UK’s Property Industry Alliance has proposed three different possible metrics to measure long-term value to help lenders handle the commercial real estate cycle.
The three methodologies were unveiled for the first time at the Commercial Real Estate Finance Council Europe (CREFC Europe) conference in London on 11 May.
Their development arises from the Vision for Real Estate Finance in the UK report which was published three years ago in response to encouragement from the Bank of England for the industry to look at how real estate debt markets should be regulated in the wake of the last crash.
Peter Cosmetatos, CREFC Europe’s chief executive, said the proposal that lenders adopt a long-term value metric had the 'explicit support' of the Bank of England.
'This is all about trying to tackle the tendency of people to go with the cycle rather than to manage it, and to provide the tools for lending institutions and regulators to do that,' he said.
The three metrics unveiled yesterday are: Adjusted market value (AMV), Investment Value (IV) and Mortgage Lending Value (MLV).
The presentation showed that the AMV method had predicted all recent crashes. AMV is not a valuation per se, but works by deriving a long-term value trend adjusted for inflation and comparing it to current IPD (see chart).
Charles Cardozo of Radley Associates which produced the metric said: 'When the market as measured by the IPD index gets a long way above the long-term trend that we’ve used, it is generally predictive of the significant falls within the next 5 years.'
The current level shows the market at 11% above trend. Cosmetatos said that the research had established that at the All Property level an AMV overvaluation of 20% or more indicates 'very high likelihood of a fall in values of at least 35% in the next five years'.
At present, it is only in certain subsectors, including London City offices, that significant overvaluation is suggested, but the research did not establish a reliable link between overvaluation and the likelihood of a major fall in values at the subsector level.
Of the other two methodologies, MLV is broadly the method used by German pfandbrief banks to value their real estate loans while IV is a discounted cashflow method, based on predictions of future rental streams for assets, which was developed by Neil Crosby of Reading University.
Cardozo said more work would be done on the IV method, which predicted the 2007-08 crash but not the severe correction of1989/90 . He said if long-term rental growth values were substituted for forecasts, then it did predict the events of 1989/90.
The chairman of the PIA long-term value working group, Rupert Clarke, said the main purpose of long-term value methodology is to try and give lenders some indicators as to when we are getting to the end of a cycle, and no one should assume that because loan-to-value ratios have stayed more conservative in this cycle than the last, that will always be the case.
'I have a clear view that if you as a lender are competing for business at the end of a big cycle, and you hit the end of that cycle still competing for business, you will lose all the profits you made in the whole of the cycle. So it is extremely important to know when the end of that cycle is about to come and what you are going to do about it when you get there.'
Cosmetatos said 'AMV has been the most effective, based on the back testing we have done at market level'. But he added that more work would be done on the IV approach and on how these tools might work at the sub-sector level.
'And alongside this we are in the process of engaging with lenders and regulators, getting their input as to how they might use these methodologies in the way they carry out their day-to-day business.
'The Bank of England is on this working group and they’re taking a very close interest in it. So there is a reasonable chance that they would be using it in the way that they supervise the debt markets.'
The full, 150-page report and a 30-page summary is expected to be published in about a month’s time.
