Neil Crosby examines how the banks may need to rethink their valuation principles if future busts and bubbles are to be avoided
Property valuations contribute to the bank lending process in two main ways. First they are an integral part of capital adequacy systems. Second they are used to assess individual loans, both at the initial lending decision and at various times within the loan period. The two valuation bases of market value (MV) and mortgage lending value (MLV) which are included in the European capital adequacy regulations are prominent in valuation standards. The MV definition is:
"The estimated amount for which an asset should exchange on the date of valuation between a willing buyer and a willing seller in an arm's length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently and without compulsion."
This is an exchange price concept with no shelf life beyond the date of valuation and requires the valuer to determine the exchange price of the asset on the date of valuation assuming that the property has been on the market for an appropriate time enabling it to be marketed fully and to realise the best price reasonably obtainable. It is perceived generally to be both observable and objective in that it can be related to actual transactions taking place in a market and the valuer is therefore a scorekeeper and not a market maker. The Red Book, mandatory on our UK valuers, suggests that it is the normal basis.
MV has its critics for the bank lending role in a cyclical market where asset price bubbles and busts are present. Despite a major increase in property prices in the run up to the fall in 2007, banks continued to lend at high loan-to-value (LTV) ratios, further fuelling the bubble.
To solve the problem caused by adherence to exchange values, some commentators advocate the use of MLV as a means of smoothing out the peaks and troughs of MV. MLV is a sustainable through time value concept rather than a market based exchange price concept at a single point in time.
‘The mortgage lending value shall mean the value of the property as determined by the valuer making a prudent assessment of the future marketability of the property by taking into account long-term sustainable aspects of the property, the normal and local market conditions, the current use and alternative appropriate uses of the property. Speculative elements should not be taken into account in the assessment of MLV. MLV shall be documented in a transparent and clear manner.' (EMF, 2006 as set out in RICS Red Book.)
The basis is elucidated further in the German Pfandbrief Act, which not only sets out the principles but also the approach to be taken in producing such a valuation, stating that the ‘value on which the lending is based (mortgage lending value) is the value of the property which based on experience may throughout the life of the lending be expected to be generated in the event of sale, unattached by temporary, eg, economically induced, fluctuations in value on the relevant property market and excluding speculative elements.' (Pfandbrief Act, 2006, Section 16, Para 1 and 2.)
It may have laudable aims but it has been heavily criticised as having no real meaning or conceptual base, so implementation must be by a set of rules.
There is one other major basis of valuation set out in both international and UK national standards called investment value (IV). This definition can be interpreted at both the market and the individual property level and is a value in use concept. It has not hitherto been suggested for use within the bank lending process and is normally undertaken by prospective buyers and sellers when acquiring or disposing of property.
IVis: ‘The value of the property to a particular owner, investor or class of investor, for identified investment objectives. This subjective concept relates specific property to a specified investor, group of investors, or entity with identifiable investment objectives and/or criteria.' (IVS, 2007.)
Would investment value help the bank lending process?
What would have been the effect of having bank lending valuations carried out by IV techniques over the last cycle? Figure 2 is a simple modelling of MV and IV over the three sectors of the UK property market from February 2005 to February 2009.
MV is constructed from the rental value capitalised at the equivalent yield. The rental value is taken as #1 pa as at February 2005 and increased by the rental value growth rate for the sector for the year as recorded in the IPD annual index. The rental value is capitalised at the equivalent yield/market yield, again as recorded by IPD at the previous year end. The combination of yields drifting downwards and rental value growth means that capital values rose significantly to peak in 2007, before falling significantly in 2007/08 and more so in 2008/09.
The IV of the segments is based on a simple five-year cash flow using the Investment Property Forum consensus rental value forecasts of each sector for February - hence the notional annual valuation date. The exit yield is based on an equilibrium equivalent yield taking the average over the period 1981 (the date IPD first started measuring property performance in the UK) to the end of the year before the valuation (2001 for February 2002 valuation, etc). The target rate was taken from the annual survey of target rates by DTZ within their Money into Property series (DTZ, annual)*. All inputs were available at the time of the valuation so no hindsight is involved.
The difference in valuations set out in Figure 2 suggest that all three segments are overpriced by at least 30% by the beginning of 2007. This overpricing was, therefore observable by applying the most simple of analyses therefore it has to be assumed that the market was well aware of the situation - but obviously not aware of the precise timing of the expected downturn.
A rational appraisal of the prospective benefits of a purchase indicates a much smoother set of values. As forecasts and target rates change through time, the IV obviously fluctuates but not to the extent that MV has over the past few years. IVs rose during 2005 and 2006 but only by around 6% compared to around 30% for market values. During 2008 they fell by nearly 10%, but were dwarfed by the near 30% fall in market values. It indicates the level of mis-pricing of the market during the period and the significant readjustment that has taken place is merely back to a more rational pricing level. It therefore fulfils in a defensible economic rationale the objectives of the sustainable value without the disadvantages of application of the latter.
The information behind a cash flow approach gives a wealth of information about risks such as future lease events and yield relativities regardless of the valuation figure produced. Should the bankers start asking better questions of their valuers and if the bankers do not ask the right question is it time property advisers started advising them what the right questions are? There are cost implications, but this model could be applied at a segment level and used to determine sensible loan to market value ratios across segments rather than for individual properties.
Of course, there may be another explanation for the current problem in commercial property lending. The above discussion suggests that the current crisis has come about because lenders, attempting to construct sustainable loan books, have been asking the wrong questions concerning the ability of the property security to underpin any loan problems.
A more cynical assumption is that the lending industry knows exactly what questions to ask but other issues are driving the lending cycle, mostly based on short-term gain.
*Using a bond rate plus 3% risk premium as an alternative target rate does not impact significantly on the shape of the IV