A lot depends on accurate valuations of underlying real estate assets, not least the trillions of dollars worth of global asset-backed investments. Steve Williams looks at the current state of the global valuation profession and what needs to change
What's it worth? This vexing question continues to haunt investment decision-makers across world markets. Depending on the answer, assets gain or lose value, debt is called or extended, stimulus packages succeed or fail, and the trading values of listed funds teeter.
In 2007, the world learned painful lessons about asset values and the market's inability to accurately track them. Over-inflated tranches of under-documented US sub-prime residential mortgages exposed global valuation errors of unprecedented magnitude.
As the world's stock markets plummeted, questions began to be asked not only about credit rating, but about a global valuation profession caught in the headlights of the catastrophic domino effect.
Why, many asked, did residential property values in the US cause huge tranches of global assets to become suddenly worthless? Could the global valuation profession not have provided early warnings about the unsustainable rise in the property values unpinning the trades in global collateralised assets?
There is a simple reason why the questioned remained unanswered. There was no global valuation profession - or at least not one equipped to interpret the market intelligence available at that time, into a foretaste of what was about to happen.
But in the harsh spotlight of many a post-crash inquest, the matter of valuation could not be allowed to rest. National and international valuation organisations were quick to address the issue via re-evaluation of methodologies used in the appraisal of assets as loan collateral, the measurement of loan portfolio performance, and the evaluation of compliance for IASB financial reporting.
Looking ahead, it was also obvious that work would be needed on such timely topics as asset values for liquidity buffers under the Basel II banking guidelines, and the on the implications of owned real estate (as opposed to leasehold interests) under Europe's proposed Solvency II regulations.
The rise of national and global standardsIntrospection was not a new exercise for
the appraisal profession. In previous recessions, notably the economic dog days of the 1930s, appraisal organisations had banded together not only to provide members with broader networking and educational opportunities but to codify methodologies, set standards of ethics and competence, and generally distance themselves from perceptions of client-pressure. It was no coincidence that this soul-searching took place predominantly in UK, Europe, and North America. These were the markets where collateralised lending first took root.
The UK, which had allowed valuation to be a self-governing rather than a government-legislated profession, happened to be the headquarters for the established (and now globally influential) Royal Institution of Chartered Surveyors (RICS). Over many decades, RICS evolved the valuation standards that, in 1974, came together between the covers of the first Red Book of Standards. Most recently, RICS has launched a new framework of global regulation with which its worldwide valuation membership must comply.
In the US, a number of appraisal organisations that had been formed in the inter-war Great Depression era got together in 1989, under federal pressure, to form the Appraisal Foundation (TAF). Authorised by the US Congress to set state-administered standards of competence and ethics as well as overseeing minimum qualifications based on education/examination processes, the TAF represented a united response to US Savings and Loan crisis of the late 1980s.
One of the original member organisations, the 80-year old, Chicago-based Appraisal Institute (AI) has recently broken away from TAF. Adding to its highly respected education and credentialing function (it grants MAI and SRA designations), it too is expanding its global reach.
In Germany, the financial industry has mandated that valuations for mortgages (the Pfandbrief model) can only be carried out by valuers holding the HypZert certification. Since 1996, HypZert has set the required compliance standards for Germany's 1000-plus qualified mortgage valuers. The methodology they use complies with a concept known mortgage lending value (MLV).
While open to criticism as overly formulaic and conservative, the MLV concept has been credited with cushioning the German financial system from the worst ravages of market distress that hit so many other European economies - notably the UK - in 2008.
In an international context, the need for higher competencies and stricter professional ethics was exposed in the post-Enron era by the US's Sarbanes-Oxley Act of July 2002. This gave new momentum to the ‘International Valuation Standards (IVS) and Guidance Notes', a valuation code that had been in existence since the early 1980s but lacked the momentum to be widely adopted.
Today the IVS Council, reformed in 2009 after a process of systemic reforms, is becoming a widely adopted global methodology for listed companies' financial reporting, as well as a general default standard in countries where indigenous valuation standards do not exist. However, unlike the RICS, TAF, the AI and Hypzert, the IVSC does not educate or credential valuers, nor does it provide an enforcement mechanism.
Other recognised sets of codified valuation standards include: TeGova's ‘Blue Book' in Europe; the ‘Professional Practice Guides' of the Australian Property Institute (API) and the Property Institute of New Zealand (PINZ); Japan's ‘Real Estate Appraisal Standards', and China's ‘National Standards for Real Estate Appraisal'.
Despite persistently wide differences in global business cultures, these sets of standards contain many elements of commonality. The underlying economic principle that the interaction of supply and demand sets price, for example, remains fundamental to any jurisdiction.
Value in exchange is based on the ancient but simple valuation premise of two parties coming together in an open market to strike the best deal. The only difference today is that the valuation process is simplified, speeded and hopefully made more accurate by computer-assisted valuation models and web-based databases. With rapid access to up-to-the-minute transaction data, increasingly transparent price discovery enables a trained valuer to support his or her conclusions with compelling, real-time, market evidence.
The only drawback is that to be successful, the process requires plentiful buyer-seller interaction. Over the past four years, trading volumes in most developed markets were thin. As a result, the 2008-2009 period - the very years when sound valuation advice was most needed - marked a low point on the valuation accuracy curve as measured by Investment Property Databank (IPD) in its annual accuracy survey.
In those years, too, inaccuracy was exacerbated by a fast-moving, multimedia world of 24-hour rolling news and e-messaging that served to disseminate more bad news than good to real estate investors. Thus a sovereign debt default in Europe, political upheaval in a Middle Eastern oil state, tighter credit, or the threat of stricter rules for synthetic vehicle trading, have the potential to suddenly slow cross-border capital flows.
A question of value
There is no doubt that the years from 2007 to 2009 - characterised by high volatility - were difficult for a valuation profession stung by criticism of its inability to predict the investment risk inherent in the preceding years. It is perhaps not surprising therefore that a number of learned papers suggesting ways for the profession to meet its challenges, were published.
A number of these contained repeated themes that are worth noting. Michael Brett's ‘Valuation Standards for the Global Market', and Gilbertson and Preston's ‘A Vision for Valuation' were both pre-recession papers published in the RICS ‘Leading Edge Series'. While Brett applauded the profession's efforts to buttress its ethical codes and commission what he called the "prescient and timely" IVS, Gilbertson and Preston suggested that further reform was needed to keep pace with fast-moving global financial markets.
Had the valuation profession heeded their recommendations for adapting more quickly to the globalising of the financial markets, it might already have assembled a more effective arsenal of weaponry to confront the economic downfall that was to come. As things turned out, two years later at the low-point of the recession, most valuation organisations found themselves distilling guidance to members desperate for advice about the almost impossible task of finding market evidence to support valuations in slow, volatile and uncertain markets.
On the other side of the world, Kerry Vandell of the Center for Real Estate at the University of California-Irvine sought answers in a study of appraisal organisations' reactions to previous market downturns. In a paper presented to the World Valuation Congress in Kuala Lumpur*, he concluded that a mature valuation profession relevant to what he called our "new world economic order" could only exist through a unification of the world's valuation skills. He saw little merit in what he called the profession's "Balkanized approach", calling instead for a global, inter-disciplinary approach that would "synthesize global valuation methodologies".
Former IVSC chair Joe Vella, speaking to the International Business School in Rheingau, Germany, took a similar line. "Valuers can no longer present themselves as a fractured profession", he said. "The market place requires a unified, highly qualified, and multidisciplinary profession; one that trains and acclimates its experts in a transparent world where finance and property are bedfellows and where data is rapidly accessed and openly shared."
Mark Gerold, chair of the RICS global valuation board agrees. "The most valuable aspect of our services as valuers," he explains, "is the analysis and interpretation of the market". He adds: "To maintain client respect and compete with other professions in the financial market place, valuers must package their knowledge and wisdom into a broader array of advisory services."
Sir David Clementi, president of the UK's Investment Property Forum (IPF) agrees. "The long-term challenge for valuers," he believes, "is to understand the changing nature of property as an asset class and the implications of accurate valuations for property funds".
Additional ‘how-to' advice is found in the late-2009 report ‘Issues in Property Investment Valuation' prepared by the University of Reading for the IPF.
Outlining a litany challenges confronting current valuation methodology, the paper's number one issue was the need for a valuation process that recognises how vehicle structure impacts value in the contemporary investment market. It follows, therefore, that the second issue is the need to routinely supplement comparative market evidence with cash flow-based methodologies.
The Reading paper reinforces the message that valuers must keep pace with the property finance revolution. In the world of securitised, cross-border real estate, finance and the property professionals need to engage together in a full and open knowledge transfer.
The Reading report's final two issues highlight the devastating market implications of non-impartial valuations. In the world of global property investing, where stakes and risks are high, independence is essential to a credible, third-party valuation process.
The paper points to a body of anecdotal evidence and academic research suggesting that the valuation process is too often skewed by the involvement of clients in everything from their selection of valuers to the direct interference of clients anxious to meet performance goals. While performance-related compensation remains an accepted part of the funds market, it should not, the report stresses, be allowed to contaminate independent, third-party opinions.
Finally, the report draws attention to the need for the valuation profession to embrace the application of sophisticated analytical methods and advanced statistical modelling techniques. In this respect, it specifically urges valuation organisations not to allow institutional constraints to stifle innovation.
These papers reflect a profession that has not been idle in the self-examination process but needs to implement changes in the way it interacts globally with the financial markets it serves. The recommendations expressed seem to fall, in summary, into the following three prerequisites for a globally relevant valuation profession:
• A recognition of the close link between accurate valuations and global financial stability;
• An innovative collaborative strategy for introducing into the valuation system, exactly the same risk-evaluation tools that are used daily by investment decision-makers in layering global debt stacks within an ever-expanding array of investment vehicles;
• A recognition of the need for a collective organisational approach whereby standards merge, inter-disciplinary, cross-border educational exchanges become more frequent, and the bases for a recognised cross-border credential that enable holders to offer consistently reliable opinions of value are agreed.
The reward for the highly-trained global valuer will be the ability to compete with fellow financial professionals for levels of compensation commensurate with high-paid peers working in the world of global finance. Such recognition would enable the valuation profession to compete in what recruiters call the "war for talent" and attract into the profession the brightest college graduates - in itself a significant stimulus for a valuation profession searching for global veracity. In the end, it's a question of value.
Steve Williams is a past president of RICS and director - global business development - at Real Capital Analytics
*Journal of Property Investment and Finance, Vol. 25, No. 5, 2007