Real Estate Valuation

From Open Risk Manual

Definition

Real Estate Valuation methodology as per the AQR Manual

For real estate that has not been re-valued according to market value principles in the last 12 months, real estate should be valued consistently with the principles of the European Standards EVS-2012 (Blue Book) – and other international standards, such as the Royal Institute of Chartered Surveyors (RICS) guidelines. More specifically, real estate valuation should be on the basis of market value. Market value is defined as the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion. All valuations should be in EUR. Risk premia should reflect the fact valuation is in EUR i.e. discount rates used in hope value calculations should reflect local market risk premia.

Valuations on the basis of depreciated replacement cost are not allowed – in situations where this approach may have been applied an alternative approach is described below. Valuation on the basis of net income attributable to the property (e.g. net income for a factory rather than the rental income) is also not allowed - in situations where this approach may have been applied, the appropriate provisioning level should be assessed using a going concern cash flow based approach (see Chapter on credit file review).

Where an NCA considers that the valuation approach used as a standard in the country is more conservative than implied by a RICS/EVS market valuation, then the prevailing valuation approach should be applied. Before allowing local approaches the NCA will need to demonstrate to the ECB’s satisfaction in written form that the local approach is conservative in all relevant cases. For the avoidance of doubt, mortgage lending value may only be used in cases where it is explicitly less than market value.

Valuations will be carried out on a ‘desk’ basis without the benefit of internal inspection, but taking into account the specific location and external attributes of the property. Where relevant this may involve automated valuation approaches for residential and small ticket commercial (i.e. <€1MM valuation) properties. Quality of the location, construction and allocation of areas should be taken into account. In some cases a drive by inspection may be indicated at the discretion of the NCA bank team.

NCA’s will be asked to work with third party appraisers to provide transparency around key assumptions (yield, valuation per unit area, discount rates for hope value etc) for the markets relevant to the significant banks under their supervision. This should take the form of a presentation to the ECB during early March 2014 covering the following topics for the home market as well non-SSM markets where the significant bank of the NCA have material selected real estate portfolios:

  • If relevant, justification of the use of local valuation methods over RICS/EVS market value (i.e. demonstrating conservatism);
  • Benchmark rental yield assumptions by relevant dimensions (property type [i.e. office, retail etc], region, quality of property) (see Section 5.6.1.1);
  • Benchmark valuation per unit area by relevant dimensions (property type [i.e. Urban land without planning, Agri, office, retail etc], region, quality of property) (see Section 5.6.1.2); and
  • Discount rates and time horizons to be applied for hope value by relevant dimensions (see Section 5.6.1.3).
  • Other relevant factors for consideration in the file review (e.g. time to liquidation)


The ECB will provide feedback on these assumptions to ensure alignment across regions. This may involve challenging third parties to justify assumptions vis-à-vis other similar markets.

5.6.1 Decision Tree For Deciding Valuation Approach

The decision tree below describes how market values should be assessed for the purposes of the AQR:

The minimum information required to perform a valuation must be available, but not all data points are required in each case (e.g. actual rental income is required for tenanted property but not for vacant property or land). If the minimum required information cannot be provided, the valuation is 0.

For the avoidance of doubt, granular property price indices are not available for many small regions. In these circumstances the most appropriate index may be used to update recent external (and where relevant internal) valuations. A haircut of 20% (as per the decision tree above for situations where there are no comparables) is not required.

5.6.1.1 Comparable Based Valuation Based On Net Effective Rent

Valuation based on net effective rent is to be used when there is a long term rental agreement in place (i.e. >5 years) and/or the current rental agreement is judged to be consistent with market terms by the appraiser.

The valuation based on net effective rent relies on two key parameters:

  • The yield
  • The net effective rent


The valuation is then simply the net effective rent divided by the yield. The following aspects will be taken into account:

  • For mixed properties, the valuation may be done on the basis of a ‘sum of the parts’ reflecting the difference in the rent and yield for each part;
  • For leasehold properties, the valuation must be adjusted to reflect the value of the Freehold (i.e. the value of the freehold must be deducted to arrive at the value of the leasehold property).

Yield

The yield should be determined based on similar transactions in the market reflecting the specifics of the asset including:

  • Risks associated with the rental agreement – in particular credit quality of the tenant;
  • Characteristics of the surrounding area, and the availability of communications and facilities which affect value;
  • Characteristics of the property; Dimensions and areas of the land and buildings;
  • Construction of any buildings and their approximate age;
  • Uses of the land and buildings;
  • The apparent state of repair and condition;
  • Environmental factors, such as abnormal ground conditions, historic mining or quarrying, coastal erosion, flood risks, proximity of high-voltage electrical equipment;
  • Contamination, e.g. potentially hazardous or harmful substances in the ground or structures on it;
  • Hazardous materials, such as potentially harmful material present in a building or on land; and
  • Any physical restrictions on further development, if appropriate.


The level of detail required for yield ranges is shown below:

Approach to determining net effective rent

The approach to determining net effective rent must adjust for rent free and incentive periods and rental growth using a DCF approach. Net effective rent should be determined based on the total length of the agreement, not the remaining length. Any additional proceeds from over rental should also be taken into account. The approach is illustrated using the example below. Where the current rental agreement is judged to be inconsistent with market terms by the appraiser, this will be reflected in the valuation

5.6.1.2 Comparable Based Valuation Based On Unit Of Area

For vacant properties or properties with short term rental agreements that are out of line with market rents, the asset will be valued based on comparable transactions normalised for area. The valuation based on unit area relies on two key parameters:

  • The area of the property
  • The valuation per unit of area


The valuation is then simply the valuation per unit area multiplied by the area.

For mixed properties, the valuation may be done on the basis of a ‘sum of the parts’ reflecting the difference in the valuation per unit area of different parts of the property. For leasehold properties, the valuation must be adjusted to reflect the value of the Freehold (i.e. the value of the freehold must be deducted to arrive at the value of the leasehold property). Only the property size with potential value is aimed - therefore, property size can be assimilated to the usable size.

The valuation per unit area should be determined based on similar transactions reflecting the specifics of the asset including similar factors to those described in the section on Yield.


5.6.1.3 Valuation Reflecting Hope Value

As discussed above, no hope value will be attributed to land without planning or in situations of ‘change of use’.

For land with planning or ongoing developments, hope value may be ascribed based on a DCF analysis of the expected future cash flows, provided that a reasonable expectation of demand for the development can be demonstrated. If this is not the case, the property should be valued on the basis of comparable land transactions.

The DCF valuation involves projecting the cash flows from sales following development of the land (net of construction costs and any required infrastructure e.g. roads, utilities etc). The cash flows are projected in a conservative manner reflecting realistic time to develop and appropriately considering the likely future demand for the development. A simplified illustrative example is shown below:


The discount rate used for the DCF analysis should be based on the market experience of the appraiser. Each NCA in Europe will be asked to propose a set of discount rates (across the dimensions below) for all relevant countries for the AQR of the relevant banks for that NCA following input from third party experts during early March 2014. The parameters will be verified by the ECB in March 2014 before valuations begin:


As an indication, benchmarks for discount rates as a guide are provided below:


5.6.1.4 Valuation Without Comparables

Given the scope of the exercise, it is not perceived feasible to produce valuations on the basis of depreciated replacement cost at a reasonable level of accuracy and conservatism. As a result, if a property has no immediate comparables and no net income can be attributed to the property (i.e. a situation where a going concern cash flow based provisioning would be appropriate) then the appraiser is asked to apply the closest available comparable with an additional discount of 20% reflecting the inherent illiquidity of the property. The 20% are a benchmark to be used unless there is a strong reason for a higher discount.

5.6.2 Structure Of Report

The appraiser will be required to populate a table with a line on each property valued covering the following topics

  • Debtor ID
  • Collateral ID
  • The subject of the valuation;
  • The interest to be valued;
  • The type of asset and how it is used, or classified, by the counterparty;
  • The valuation date;
  • Method used (comparable, hope value DCF, income)
  • Total net effective rent (if available)
  • Average yield applied (if relevant)
  • Average valuation per m2
  • Property area
  • (If hope value attributed) type of development, completed value, and time to completion
  • (If net effective rent method) discount rate applied
  • Disclosure of any material involvement, or a statement that there has not been any previous material involvement;
  • The identity of the appraiser responsible for the valuation
  • Any assumptions, special assumptions, reservations, special instructions or departures;
  • A statement of the valuation approach and reasoning;
  • The opinions of value in figures and words;