IPF-sponsored report A Vision for Real Estate Finance in the UK, published in October, is a well argued, succinct document that makes seven draft recommendations. The Bank of England is giving attention to the fourth, that “regulatory capital requirements for CRE lending should be linked to a property’s long-term, sustainable loan-to-value ratio, rather than current appraised LTV”, as a way to mitigate the pro-cyclical effects of the unconstrained use of spot pricing (market valuations).
The question is whether adoption of long-term sustainable value (LTSV) assessments will help lenders, regulators and central banks to modulate property markets to limit the scale of cycles. A number of issues must be addressed if this model can be made to work. Firstly, the concept must have only one agreed definition. As LTSV is a calculation of worth, I recommend including the word ‘worth’ rather than ‘value’, as the latter is synonymous with achievable price. In its response to the report, The International Valuation Stand-ards Council says LTSV is a misnomer, as “an average of a series of values over time is not itself a ‘value’, neither is it ‘sustainable’, which implies that the figure could be of enduring relevance”.
It may be useful to look at Germany’s definition of mortgage lending value, if only to reject it. In Germany, MLV is required to be below the lowest level of normal market fluctuations. It cannot be considered as a ‘value’, but as a risk assessment tool to support the pfandbrief bond market. As worth calculations are likely to be even more subjective than market value/price assessments, it is vital to have a single methodology for their calculation. The 1997 IPF/RICS information paper Calculation of Investment Worth concluded that the discounted cashflow approach was the only one appropriate for calculating investment worth/value.
Crosby’s and Hughes’ 2011 paper The basis of valuations for secured commercial property lending in the UK stated that investment value is “a rational concept and approach” albeit subject to “significant valuation variance”. Having said that, it is a regularly used value concept and the methodology is generally understood by clients and valuers. The use of an agreed and generally understood long-term sustainable worth concept will not (and should not) cause market value assessments to be abandoned. All loans should be assessed against the property’s realisable value, not only at the outset, but regularly during the loan’s life.
The report anticipates that whatever value concept is adopted, it should be applied to each loan on a bank’s book as a way to calculate capital adequacy. But I am concerned that this will not in itself be sufficient or even necessary. In calculating worth at the level of a single property, it will be hard to take account of the economic, demographic, financial, physical and technological changes that could have big impacts on market value over time. The use of investment worth/value calculation methodologies involving forecasting future trends is well established, particularly at sector and regional level. Real estate consultants and fund managers have developed sophisticated techniques to assess worth versus price. For example, DTZ’s Fair Value assessment is very useful in determining whether markets are over heated.
A beefed-up version of the report’s second recommendation, that a group of industry experts plus others with broader macro-economic experience should advise regulators on market trends and inflection points, could be all that is needed. By adopting Fair Value modelling the regulator will be forewarned of the build-up of market stress leading to over or underpricing. This will be the trigger for pre-emptive action to call for counter-cyclical adjustments in capital requirements. It could be useful then to ask for long-term worth calculations for all bank loans in a national database (recommendation one) with LTV ratios above a certain level. But all this will only work if the process is embedded in regulation – and if regulators have the courage to act in advance.
Robert Peto is chairman of DTZ Investment Management and a past president of the RICS. The views expressed here are his own.