Real Estate Banking 2014 | 2015
Debate on a Sustainable Value
Or: What makes the Real Estate Market
in Germany less volatile?
by Jörg Quentin, pbb Deutsche Pfandbriefbank
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Global real estate markets are sometimes subject to considerable fluctuations. At the same time, real estate properties are very capital-intensive.
Combined, these two elements can stoke economic crises or even trigger
them when properties are – as is often the case – reported in the balance
sheet or valued as loan collateral at their market value. This is something that
the Bank of England, too, has noticed. One way out is to calculate a sustainable value when valuing real estate. This has been practiced in Germany for
well over 100 years with the concept known today as the mortgage lending
value (Beleihungswert). This article describes the four minimum requirements that an “international mortgage lending value” would have to meet
in order to cushion the impact of exaggerations in the market, with the negative consequences they bring for the economy as a whole.
These days, the media report almost weekly on how the banking landscape is being, and
will continue to be, more and more regulated. This is the result, on the one hand, of the asset
quality review by the European Central Bank, which is taking over responsibility for supervising Europe’s biggest banks. On the other hand, the supervisory authorities are still busy
reappraising the fallout of the recent financial crisis. This task includes, amongst other things,
developing and implementing measures designed to prevent a repetition of large-scale volatilities such as those seen in the wake of the crisis on the international real estate markets.
One of the triggers of the most recent crisis were the financial products that were created
to enable US households with a poor credit standing (“subprime”) to buy their own homes.
The quality criteria and therefore the risk management instruments for these financial products were ratings and property market values. The increasingly complex financial structures
of these products led to a situation in which the buyers could no longer tell what collateral
was actually behind these “securities”. Market values and, above all, the rating awarded
by the established rating agencies inspired confidence enough in what was believed to be
a capital market product that would remain safe in the long term. But as early as in 2005,
values dropped sharply in the US housing market, revealing the problem that these products
entailed. For the slump in value and the deterioration of the fundamentals of the US economy
were initially not reflected at all in the ratings. Investors continued to believe that the rating
signified that the structure of the product had been adequately examined and that the sustainability of their investment was therefore assured. As prices continued to plummet in the
housing market, the first bank failures occurred in 2007, followed by extreme rating downgrades. The banking world faced one of its worst confidence crises as a result. The ratings
of financial instruments alone, or ratings combined with market values, had failed as quality
criteria for the sustainability of an investment.
It is interesting to consider the consequences for the commercial real estate market,
which at that time was affected neither by falling prices nor by declining rents. The confidence crisis of 2007 almost brought interbank trading and with it the procurement of liquidity
in the financial market to a complete standstill. Banks had to hold on to their liquidity, which
meant they could no longer use it to grant loans. The availability of finance for commercial
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Real Estate Banking 2014 | 2015
Debate on a Sustainable Value
Or: What makes the Real Estate Market
in Germany less volatile?
properties deteriorated at once as a result. Although the crisis had not yet even reached the
commercial property market, the market’s response was swift and exaggerated. As early as
in 2009, market transactions on the commercial property markets in the US and the UK were
suspended altogether, while market values fell sharply in other markets. This procyclical behavior in commercial property markets fuelled the crisis further and accelerated the ongoing
economic downturn.
A pattern of this kind – one not restricted to the most recent crisis – is intensified by the
fact that banks chiefly provide finance on the basis of the market values as at a specific date.
When coupled with a loan-to-value (LTV) ratio, which in addition to rising market values usually increases in parallel during a boom phase, this procyclical effect is amplified substantially
by lending activity, which then becomes extremely extensive. Conversely, in times of crisis,
banks place additional restrictions on lending when market values are low in any case, and
only provide finance at very low LTV ratios. When the changes in value are shown in the balance sheet, the procyclical behavior is accelerated as it destroys capital disproportionately
quickly. As a result, an approaching crisis is additionally fuelled by the fact that the liquidity
that an economy urgently needs, particularly in this unstable phase, is then lacking.
It is therefore a mark of far-sightedness that the Executive Director for Financial Stability at the Bank of England should recognize valuations calculated as at a specific date as the
cause of the procyclicality of the commercial property markets, which in such a setting can
do greater damage to the economy as a whole than most other business sectors.
It does not take clairvoyant powers to predict that regulations coupled with valuations as
at a specific date will not succeed in calming the commercial property markets. In future as
in the past, competitive pressures and a market environment with low interest rates will cause
market values to rise more quickly and banks to expand lending volumes when margins
contract. That is why it is important to show market participants what sustainable value –
disregarding economic crises and boom phases – they ought to use as the basis for assessing
the risk associated with the real estate collateral and, therefore, as the basis for the amount
of the loan.
This approach has been practiced in Germany for decades. In order to smooth out cyclical
property market fluctuations in valuation, not only the value as at a specific date is calculated
but also a mortgage lending value (MLV). The MLV indicates what a property is worth notwithstanding the market cycle and the features specific to a certain property, and serves as
the basis for determining the amount that can be funded through Pfandbriefe. The Pfandbrief,
incidentally, was the only instrument through which real estate loans could still be funded on
the capital market during the confidence crisis following the Lehman crash in 2009. The decisive factor was that the value of the Pfandbrief was not additionally burdened by the market
value as at a specific date. Rather, proof of the sustainability of the property value strengthened investors’ confidence in the product. In other words, the lower risk was reflected in the
pricing of the Pfandbrief as a refinancing instrument and in its marketability. Thus, the property risk appraisal that is based on a sustainable MLV and, therefore, the setting of lending
margins that take adequate account of the risk explain the significantly lower degree of volatility in the German real estate market.
The sustainable MLV is currently proving itself with regard to the capital requirements as well.
The Credit Requirements Regulation (CRR) also provides for the possibility to report collateral
at its MLV. This likewise exposes the bank’s statement of its own capital to considerably less
volatility. Banks that opt for this approach have an additional advantage in that applying this
sustainable value for their capital backing requires less time and effort, and thus entails lower
costs, in connection with the necessary regular monitoring and review of the value of the real
estate collateral.
A third important factor that would help calm the markets would be for real estate companies to report a sustainable value in their balance sheets. In this way, the nature of the real
estate as a long-term asset with cash flows that are secured through lease agreements and that
often far exceed the duration of an economic crisis would be reflected in the company’s annual
result. This would go a long way toward decoupling the profit and loss accounts of property
market participants from market cycles. The Institute of Public Auditors in Germany (Institut
der deutschen Wirtschaft, IDW) has advocated this idea for almost ten years now. Under its
auditing instruction 9.522.1, the IDW recommends taking just such a sustainable approach
when valuing real estate collateral.
Last but not least, a contribution to reducing volatility in the commercial real estate market
would be to couple the LTV covenant not to a market value as at a specific date but to a significantly more stable value, such as the MLV. The 2009 crisis in particular showed in dramatic
terms how many borrowers suddenly found themselves facing an event of default as a result
only of the extremely negative market fluctuations – even though neither the cash flow nor the
physical state of the underlying collateral had worsened. This event of default forced the lending real estate credit banks, which themselves had to struggle to procure liquidity at that time,
to demand additional capital from the borrower or even to institute enforcement proceedings.
As a result of these experiences, real estate investors have grown less and less prepared to
agree to this market value-based LTV covenant, as they cannot in any way influence it. On the
other hand, banks must keep an eye not only on the stability of the cash flow but also on any
possible loss in the value of their collateral. In this context, too, a sustainable value would help
mitigate market fluctuations.
If the Bank of England is currently searching for a way to slow down procyclical tendencies in the British real estate market, it is only logical that consideration should be given to
the MLV, all the more as the recommendation of the MLV was presented to the British public
by real estate market players at an investment property forum of the real estate industry in
October 2013.1)
A Vision for Real Estate Finance in the UK (Draft recommendations By A Cross-Industry Real Estate Finance Group),
Real Estate Finance Group and Investment Property Forum, Oktober 2013
1)
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Real Estate Banking 2014 | 2015
Debate on a Sustainable Value
Or: What makes the Real Estate Market
in Germany less volatile?
What Minimum Rules Must a Sustainable Value Follow?
The task of finding rules that are, as far as possible, uniform worldwide poses a special
challenge given that property markets function differently at the national level and that they
sometimes have different initial parameters for real estate valuation. In Germany, the rules for
a sustainable value, the mortgage lending value, are set forth in the Regulation on the Determination of the Mortgage Lending Value (BelWertV), which makes the valuation procedure
uniform and transparent. However, these rules are based on a specifically German valuation
methodology and take into account, above all, the national characteristics of the real estate
market. International rules for a sustainable property value would have to comply with the
following four main prerequisites.
1. Valuation Based Only on Long-term Elements
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The core principle in determining a sustainable value lies in taking only long-term elements
into account in order to safeguard the future marketability of the property during different
market cycles. The individual parameters that are used for the valuation procedure have to be
chosen such that they produce a sustainable value within the underlying valuation model. The
valuation parameters are derived by comparing current average values with the longest-running time series available, from which sustainable rents, costs or comparable prices can then
be obtained. It is crucial to evaluate time series given the volatility of the parameter “interest
rate” (yield, cap rate, etc.). In order to enhance the safety aspect, notably in markets that are
highly volatile or in which there is insufficient long-term market information, an appropriate
measure may be to limit individual valuation parameters. These limitations should be based
on available time series or on market experience and geared to the national markets. Moreover, features particular to the national markets should also be taken into consideration.
One such example would be to impose a limit on the capitalization rate. Whereas the
BelWertV stipulates minimum capitalization for business premises of 6%, a level that may
be undercut by 0.5 percentage points if the property is of an especially high quality and in a
very good location, this is not appropriate for properties in A1 locations in a metropolis like
Paris or London. Evaluations of long-term time series, e.g. for Bond Street in London, have
shown that a capitalization rate of more than 5% was never achieved in any market phase.
A 5% capitalization rate would surely be sufficient for such purposes, even by a conservative
interpretation of these data.
What is more, the sustainable value could be assured using an independent second
method. To be sure that a value that is based on income is sustainable from a long-term
perspective, the investment costs could be set against it for control purposes. As long as
the income-based value is not significantly higher than the investment costs, it may be
assumed that a normal level of investment will be carried out in this type of property in
future, too, and that a competitive market will not arise which will quickly become bloated
and then lead to an equally rapid slump in rents and, therefore, in property values.
Prime Office Market Yields: Year 2000 - 2014
12
11
10
9
Yields in %
8
Paris: La Défense
Frankfurt: City
Munich: City
Amsterdam
Warsaw
Madrid: Town Centre
London: City
7
6
5
4
3
2
1
2014 Q2
2013 Q4
2013 Q2
2012 Q4
2012 Q2
2011 Q4
2011 Q2
2010 Q4
2010 Q2
2009 Q4
2009 Q2
2008 Q4
2008 Q2
2007 Q4
2007 Q2
2006 Q4
2006 Q2
2005 Q4
2005 Q2
2004 Q4
2004 Q2
2003 Q4
2003 Q2
2002 Q4
2002 Q2
2001 Q4
2001 Q2
2000 Q4
0
Source: PMA Property Market Analysis LLP
2. Eliminating Value Elements that Are Temporary, Speculative or Apply Only to a
Small Circle of Users
A temporary element such as overrent, which decreases over the term of the lease and thus
over the useful life of the property, must not be taken into account in a sustainable value. If
it were, the collateral would constantly lose value over time, so that there would be no stable
value for the balance sheet or on which to base the financing.
Similarly, expectations – even if it is foreseeable that they will be met – must not play a part
in the sustainable value. The classical example here concerns possible reserve building rights.
Although the possibility may exist under a development plan or vicinity development plan to
add a story to the property to be valued, a building permit has not yet been given. In this case,
the buyer’s expectation that the building permit will be granted is priced into the market value.
However, it does not exist for the actual, present collateral and so cannot be taken into account.
Another vital aspect concerns the usability of a property by third parties. The valuation must
reflect the fact that the property is suitable for use by a third party or for a different type of use.
It is important, therefore, that all the elements that refer only to the current user or owner are
eliminated from the valuation. For instance, special fixtures and fittings are often installed for
large office tenants, who pay for them with higher rents. This, in turn, results in an increase in
the market value of the property. Additional installations of this kind cannot be taken into consideration where an average user of such a property is concerned, as an average user would not
pay a higher rate for them. They must therefore be disregarded for the purpose of determining
the sustainable value. With regard to the owner, when calculating the sustainable value the
operating expenses often have to be geared to an average real estate operator rather than to the
current one. Both these measures are intended to ensure that the determined value of the collateral continues to hold good after a property passes to a new owner or user.
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Real Estate Banking 2014 | 2015
Debate on a Sustainable Value
Or: What makes the Real Estate Market
in Germany less volatile?
3. Complete Transparency of the Valuation Procedure
First and foremost, complete transparency needs a framework of rules which defines the
valuation process. A third party must be able with the help of these rules to check the MLV.
This means that all the valuation parameters that have been chosen must be set forth, and
readily understandable reasons given. Simple calculation templates and extracts from real
estate market reports or market databases are therefore not nearly sufficient. It is essential that the parameters chosen and, above all, the proof of the sustainability are explained.
Additionally, an on-site inspection has to be made of the property being valued, placing the
emphasis on long-term aspects. It must be clear for any third party which parameter applies to
the particular risk associated with the property itself or with the sub-market. For the German
method of determining the MLV, it has proven indispensable for transparency that the valuer
is able to draw on comparative data that reflect practices specific to the German market.
Thus, the German method refers to the remaining useful life, the land value and the yield
defined especially for Germany ("Liegenschaftszins") as key elements in the valuation process,
as transparent and extensive comparable data exist for these parameters. Thus, the determination of the MLV must be based on the method that is customarily used at the national level,
and for which transparent and comparable market parameters are available.
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4. The Valuers’ Independence and Professional Qualifications
Even when unambiguous and strict rules exist with regard to transparency and methodology
to ensure the sustainability of the value calculated, the valuation hinges crucially on the person who carries it out – the valuer. For this reason, a set of rules must also clearly stipulate
the valuer’s qualifications and, above all, his or her independence. Only then can it be assured
that the calculation of the MLV is not influenced by third parties, as otherwise its function as
an objective initial value facilitating a long-term, sustainable appraisal would be lost.
Today, Europe-wide standards are in place which define qualification criteria for real estate
valuers. The globally recognized RICS as well as TEGoVA, which represents the interests of
European valuers’ associations, have set up minimum requirements for the qualifications of
valuers. HypZert, the only institution thus far to specialize in the valuation of real estate for
financial purposes, has established a presence throughout Europe. Because its quality standards are embedded in the global ISO system of standards, it is assured that HypZert as a
monitoring body is likewise subject to stringent international criteria. In addition to the valuer’s professional qualifications and the fact that ongoing training measures are monitored, the
valuer’s long-standing experience is essential.
The independence of the valuer depends on strict rules stipulating that the valuer’s interests and those of one of the parties concerned must be separated. In Germany, it has been
shown that these rules can be observed if the position held by a valuer working within the
lending bank is similar to that of internal auditor. Clear-cut regulations concerning the post
of a bank’s in-house valuer lead to a very strong position that allows the valuer to engage in
real estate valuation free from business and other constraints. The high regard in which this
system is held, not least, by the German supervisory authorities testifies to the success of
these rules.
Yet the model chosen – whether that of internal or external valuer – is not decisive. It absolutely must be assured in both models that hard and fast rules are in place which allow the
valuer to work completely independently not only of the loan acquisition and decision-making
process but also of the brokering, sale or letting of properties.
Conclusion
The sustainable value is a value in its own right which cannot be derived from any other
value, including the market value. This means that the expertise of a real estate specialist is
absolutely essential in determining it – a specialist who has to examine the property and the
relevant sub-market thoroughly, has many years’ experience in real estate and is versed in the
methodology of sustainable valuation. Only if these basic rules are observed when defining a
sustainable value can such a value fulfill its function as a consistent and sustainable collateral
value through the various market cycles, thereby weakening the effects of exaggerations in
market activity. Real estate finance practices have increasingly come to resemble Anglo-Saxon
procedures, increasing dependence on the market value as at a specific date. As a result,
fluctuations in the commercial property market have grown in Germany, too, in recent years.
Against the backdrop of the most recent crisis and the negative impact that highly volatile
commercial property markets have on the economy as a whole, the focus in future again needs
to be placed more on real estate as an investment. Real estate is and will remain a stable, longterm investment product, for which reason it should – unlike the volatile stock markets, for
instance – be judged accordingly, which is to say from a long-term perspective.
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