Mark-to-market valuation promises a snapshot of worth, but the German approach has time on its side. Shayla Walmsley reports.

TS Eliot, the Anglo-American poet, wanted to expunge from the English language such words as hippopotamus that are derived from both Latin and Greek. Some combinations, so he argued, just do not work.

Now try this one: the current debate over mark-to-market valuation, as favoured in the UK and reflected in the RICS Red Book, versus German ‘sustainable value' has an obvious solution: combine them. Simple enough? If only.

Yhe two main European approaches measure different things. Simon Mallinson, director of European research for Invesco Real Estate and co-chair of the global investment performance standards (GIPS) real estate working group, speaks of the difference between a volatile trader approach, which looks at buying and selling, and an investment approach.

The preference for one or the other goes beyond parochial bias. According to Robin Goodchild, international director at LaSalle Investment Management, investors are asking valuers to carry out two contradictory tasks.

"The instructions valuers are given when valuing for a loan should be different from valuation for annual reporting purposes," he says.

Splitting the function would also avoid a potential conflict of interest between loan-to-value and unit price. "The manager wants the correct price but at the same time valuation could mean the fund is in breach of a loan covenant," he says.

There are other, less nationally determined, fault-lines. The affiliation of the valuer, a sense of ‘specialness' vis-à-vis other asset classes, and frequency have all come in for scrutiny.

Although there has been some convergence between the UK RICS approach and the US approach, the difference there is over who does the valuing. In the US, it is not uncommon for costly in-house teams to conduct annual valuations of portfolios, with robust processes for ensuring independence. European investors, in the main, opt for third-party valuations.

René Gudat, of the Leibniz University of Hannover, claims it would be a mistake to see European valuers as somehow more independent then US in-house teams, dismissing the putative independence of valuers hired to conduct annual reviews of open-ended funds. "Indeed they are not independent," he says. "They only do what the fund manager wants them to do."

That is not necessarily a bad thing, according to Frank Rackensperger, real estate portfolio manager at the Feri Family Trust. "In general, I'd say there is no right or wrong way. It's a question of what the client needs," he says. "But if a client can live with negative returns over a period, from a valuation perspective, the RICS approach is more efficient."

What the client needs touches on a second issue: the frequency of valuation. Rackensperger says he has come across German investors that do not make valuations on direct property holdings at all. "They have the book value on the balance sheet. As they see it, they'd purchased the assets in the 1980s and values have gone up since then. So even if the property is in poor condition, they're relying on the value of the land increasing. It was a simple buy-and-hold strategy," he says.

One suggestion is that more frequent valuations would make them more reflective of ‘true value' - and of the market. The idea of more valuations has its champions, among them corporate heads of treasury and chief financial officers of insurance companies who have to present those numbers to the board, as well as other stakeholders.

"I would favour more overt disclosure of information and more frequent valuation," says Mark Gerold, RICS valuation faculty chairman and head of valuation at BNP Paribas Real Estate. "Even if you're holding property for investment purposes, it makes sense to do it frequently. The benefit of frequent valuations is that a pension fund is constantly updating information on its assets - where the value is, and what the rental values are. So they're getting updated information on what is funding the fund. Some will be underperforming or outperforming. And you need to take that into account."

There are clearly downsides. Stephen Ryan, senior investment consultant at Mercer, argues for a "break-even point" at which the value added is lower than the cost of valuation.

There is also a risk that frequent valuations may dilute value for investors, even if they increase market transparency. Jenny Buck, head of indirect property investment at Schroders, believes that, during the crisis, where assets were valued monthly or quarterly, loan-to-value breaches were triggered earlier than they would have been otherwise. This meant higher margins on interest and "less time to sort things out".
"Valuations came under stress when the market was rising or falling rapidly," she says. "Market extremis tends to put the pressure on."

Yet in principle Buck supports the contribution of frequent valuation to market transparency. "In an open-ended fund you need frequent valuations to make sure investors going in and out of the fund are treated fairly in terms of price differences," Buck says. "Regular valuations also let investors know whether they're going in the right direction.

In addition, especially experienced investors are sceptical of attempts to confine the debate over valuation to approaches taken for directly held real estate. "To call it suspicion of valuations is a bit strong but they are questioning what we can learn from adjacent asset classes such as REITs and derivatives," says Ryan.

Although, at least in the short term, REITs tell you more about equities than they do about the property market, they give advance warning of the property market, he argues - and you have the same rents reflected in both.

"Surveyors are less likely to look at adjacent asset classes, while property consultants would find lessons to be learnt across the market," says Ryan.

As points of contention these fade beside the big debate: not who, or when, but how.
The UK method has in its favour the fact that evaluations are more accurate - at least in good times. "From a valuation perspective, the RICS method is more efficient because it better reflects the current market status," says Rackensperger. "With smoothing, it takes longer for negative valuation to be incorporated. The UK market anticipated the recession because, in pricing terms, it has a more efficient valuation method."

So the problem is not that the RICS approach is less accurate - which is not true - it is that it suits investors less well. German firms are often oriented towards rental income rather than price. "Returns of funds using the German valuation methodology and those funds using international valuation approaches should be equal over the long term, but volatility won't be," he says. "Appraisal smoothing makes for more stability even if over a 10-year period, even if you have the same performance."

Marian Berneburg, real estate portfolio manager at Ärzteversorgung Westfalen-Lippe (AVWL), says the pension scheme's pro-‘sustainable value' approach comes from the experience of watching mark-to-market investments suffer in 2009 only to rebound strongly in 2010. The approach introduced volatility under the balance sheet.

"Under the German approach that doesn't happen and strong peaks are - at least partially - cut off," he says. "The intention of the German approach is to reflect fundamental, inherent value rather than to a establish a market price. In theory, you can perform an aggregate analysis but this contradicts the idea of mark-to-market, which is to ask: what's the going market price today? Inherent value is not about selling now." He adds: "From a personal perspective, I see the virtues of mark-to-market. But it doesn't work when the market fails."

Yet other pension funds were not spooked by volatile pricing. Mallinson points out that pension fund allocations to real estate have not declined, even though, because of the denominator effect, real estate shot up from 5% to between 10-12%. "There has not been a huge flight away from real estate in a bid to rebalance portfolios," he says. "I think pension funds have acted fairly robustly."

The strongest argument against the UK approach is that it did not work when the market was in freefall. When the market falls rapidly, valuations are "not that meaningful", says Peter Denton, London-based managing director of WestImmo. "It would have been better to say: ‘We can't value this.' The bounceback was short and quick. There was no fundamental change in sentiment but the absence of transactions converted into a pessimism of valuation. Now you have comparables, we've moved back into a normal discussion - are values too high? Is the market hot? - and it's based on real transactions, that is, on what people are willing to pay."

Yet Denton acknowledges that no other method would have proved any more effective in measuring a market in flux.

"We have to be grown up about it and recognise there is no such thing as a market value," he says. "Only when people are brave enough to put their money where their mouths are will you know what the value is. Otherwise we're trying to apply rules to a situation where the rules don't apply."

Mark-to-market might not suit volatility-conscious investors, but it does better reflect the property market, at least when it is relatively stable. Gerold draws a distinction between ‘obscure' and ‘overt' datasets that form the basis of most valuations. Valuers can work with either - "wherever the data are available or where there is something to measure against" - but where there is less availability of information, the speed of correction was not as evident as it has been in the UK.

"When the market was overheated in 2007-08, the prices defied logic," he says. "But valuers had to value them according to the market. If you have one or two transactions like that, you could say it's a special purchaser or that the investor has been ill-advised. But when the whole market is doing it, the valuer can only point out in a note that it isn't in accordance with the long-term trend."

So would a ‘global' standard - some combination of the UK and German approaches - be any more reflective of the market? Recent clarification of some of the terms, such as ‘fair value', used within GIPS, was not an attempt to set a new valuation standard but to allow investors to measure real estate in one market against another, across different jurisdictions.

Mallinson is optimistic about the possibility of a global standard - if only because an agreed standard is better than the alternative. "The standard in 10 years will be a hybrid of the two," he says. "There will be a long-term component but there will also be volatility for short-term traders. We're slowly moving towards it - but very slowly. There are national interests involved."

Likewise, Gerold believes the inclusion of those long-term trends in valuations will augment market value rather than attempt to replace the (favoured) mark-to-market approach.

Nor is there any shortage of compromise solutions. AVWL CEO Andreas Kretschmer suggests a variation based on ‘normal' and ‘exceptional' markets: take mark-to-market evaluation as the standard under normal circumstances, but in case of market failure or unusually high market price volatility, allow for the option temporarily to switch to a more stability-focused approach to evaluating real estate.

The fact that all of these solutions involve some form of compromise points to a paradox in valuation. A theoretically perfect model would be no more reflective of the market than any of the existing approaches. What that means is that you have to recognise the need for clear standards, as offered by the RICS Red Book, to operate along the lines of equivalent data and common definitions, but at the same time to acknowledge that being evidence-based does not make valuation a science. In short, this is educated guesswork.

"Valuation is a bit of an art," says Buck. "It's 90% of the time what the asset would trade at. But investors have to understand that, even though it's based on a number of elements, it's only the valuer's best opinion."