Either valuers will deliver the future-performance appraisals for properties desired by lenders, or they will lose out permanently to other consultants. By Christopher Horler
It is the underlying worth of a property to the lender that is of paramount importance in the assessment of risk when considering a property as security for a loan. In simple terms, this is the robustness of the property during the term of the loan (and beyond) plus the risks attached to it.
The UK property finance market has evolved rapidly during the 1990s and cashflow lending is becoming more the norm, rather than the exception. Loan-to-value ratios are, thankfully, losing their pre-eminence as the banker’s first tool of analysis. The skill of the property finance banker today lies in analysing the property’s risks to determine if they are acceptable in return for the senior debt margin or equity return. Traditional valuations for loan security purposes have not kept pace with this trend and there is now a mismatch between the advice required by the banks and that provided by valuers.
Open market value (OMV) and estimated realisation price (ERP) are of scant interest to the property banker. These “values” confirm that the potential borrower may not be overpaying for the property or, in other words, the price was right at that specific moment. Instead, what is required is the valuer’s appraisal of the underlying worth of the property over the term of the loan from the lender’s point of view. With this information, an assessment of likely performance can be made and risks identified and factored in case the funder becomes an unwilling investor in the property at some future date.
However, it seems that the pulse of the mildest of valuers is raised whenever the word “worth” is mentioned, and requests are put in for appraisals of future trends, rather than snap-shot valuations. Value, price and worth have been the subject of long-running and esoteric debates. While the valuation industry wrestles with what these words mean, the ultimate users of their services have to put up with a less than perfect product.
There is little doubt that most of the larger valuation firms have the necessary skills to advise the lender, but there is a great reluctance to deliver. Appraisers continue to produce reports mostly containing a standard regurgitation of basic facts to support a spot-price figure. After all, does a banker really need to be told eight different routes to the Isle of Wight and their respective journey times?
Factual information often turns a report into a bookend, at the expense of advice and recommendations. Full cash flows are rarely included and, when they are, no analysis is proffered. Comment on market trends is all too frequently transposed from the latest in-house research document, often produced with an agency slant, with no attempt made to analyse the underlying dynamics of the subject property over the term of the loan and beyond, particularly with regard to any downsides.
Why is there a natural reluctance to provide banks with appraisals? Funds and institutions seem to be able to get advice and some of the better purchase reports address the future performance of the assets, often using scenario analysis. Many reasons are cited for the poor product that banks are often provided with and expected to accept. These range from professional indemnity issues, the fact that banks (apparently) do not ask the right questions, “we cannot crystal-ball gaze”, to the pure traditionalist approach – “this is how it has always been done and we are not changing”.
However, there will have to be change. Property globalisation, EMU, REITs and the wall of US money arriving on the European market will necessitate it. Forward-looking appraisals and calculations of worth must be provided.
The RBS Property Finance Group has been promoting the need for change for two years. Unfortunately it is still difficult to get the right product consistently. A war of attrition has been maintained, but any lapse on our part to keep the pressure on appraisers usually leads to the traditional valuation creeping back in.
This cycle can be broken, in theory at least, only if there is reciprocity between the banker and appraiser, breaking down the mystique of the respective professions. This process may well accelerate with the current interest in Europe from overseas institutions, which are well versed in cash-flow analysis and demand forward-looking appraisal advice from their property advisers.
Of course, it is right and proper for surveyors to debate and formulate definitions and valuation methodology but as lenders we need a specific product now and it cannot wait for consensus by committee.
Property appraisals must mirror the rapidly evolving property funding techniques. If this does not happen then accountants and management consultants will increasingly encroach on surveyors’ work.
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Tenant Quality Profile |
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|
Current Rent |
||
|
Grade A |
£50 |
0.0% |
|
Grade B |
£554,056 |
65.2% |
|
Grade C |
£217,950 |
25.7% |
|
Grade D |
£77,450 |
9.1% |
|
Gross rent |
£849,516 |
100.0% |
|
Vacant ground rent |
(£77,699) |
-9.1% |
|
Net rent |
£771,817 |
|
Expiry/Break Profile |
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|
Leases expired |
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During year 3 |
£0 |
0.0% |
||
|
During year 4 |
£2,500 |
0.3% |
||
|
During year 5 |
£96,500 |
11.4% |
£114,000 |
13.4% |
|
During year 6 |
£0 |
0.0% |
||
|
During year 7 |
£0 |
0.0% |
||
|
During year 8 |
£0 |
0.0% |
||
|
During year 9 |
£0 |
0.0% |
||
|
During year 10 |
£50,500 |
5.9% |
£50,500 |
5.9% |
|
During year 11 |
£510,816 |
60.1% |
||
|
During year 12 |
£15,500 |
1.8% |
||
|
During year 13 |
£0 |
0.0% |
||
|
During year 14 |
6,150 |
0.7% |
||
|
During year 15 |
£0 |
0.0% |
£532,466 |
62.7% |
|
During year 16 |
£0 |
0.0% |
||
|
During year 17 |
£0 |
0.0% |
||
|
During year 18 |
£0 |
0.0% |
||
|
During year 19 |
£0 |
0.0% |
||
|
During year 20 |
£0 |
0.0% |
£0 |
0.0% |
|
During year 21 |
£0 |
0.0% |
||
|
During year 22 |
£152,500 |
18.0% |
||
|
During year 23 |
£0 |
0.0% |
||
|
During year 24 |
£0 |
0.0% |
||
|
During year 25 |
£0 |
0.0% |
||
|
Beyond year 25 |
£50 |
0.0% |
||
|
Total |
£849,516 |
100.0% |
|
Why cash flow is king What can be learned from this example?
The appraiser in this case did not communicate the risks to the bank. It probably never occurred to him that he should. And under the Red Book the valuation was compliant. In summary, the appraiser should have highlighted the cash-flow issue in this transaction, and commented upon whether pro-active management would sustain the robustness of the asset. This is one of many examples that one could cite. What is needed is real property advice and analysis rather than description and a number. Appraisers need to think very hard about what they are doing. Jargon and mystique have no place in the modern appraisal process – appraisers and bankers need to work together towards a new appraisal product. Looking to the future and appraising a property’s potential performance will become a major part of a valuation surveyor’s work. REITs, equity participation and special purpose vehicles will all need appraisal advice regarding the potential of the property and likely residual values. Rating agencies will look for advice for stress-testing property-backed vehicles. Quite clearly, the “caveat surveyors” are not likely to fare well in this type of market, nor should they. Instead, the surveyor who is prepared to give an opinion on underlying worth and not hide behind dictionary definitions and committees will prosper. Equally he should not fear litigation for offering sound advice. Only this way will accountants and management consultants continue to take second place to the chartered surveyor who is truly qualified and able to give this advice. |
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Give real property advice! Consider how “banker’s worth” is treated in this example, using our in-house modelling system. This case study looks at a transaction that went ahead on the basis of a traditional valuation report. When analysed by RBS Property Finance Group, it was found to be far from a simple senior debt loan. The robustness of the asset was found to be very much dependent on the borrower’s property management skills – the main risk. Base facts
From a traditional lending perspective, this looks a dead cert. However, when the cash flow is analysed a wholly different story emerges. |
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Table 1 shows the income profile by tenant quality using an in-house grading system. Grade A is government and institutional grade, Grade D is poor income. It can be seen that the majority of income is Grade B. Grade A – a total of £50 – is from the substation! Furthermore, the property is leasehold with a ground rent of 9% of gross income based on incomes receivable – the nuances of which will not necessarily be understood by a non-property professional. Looking at the expiry/break profile in Table 2 the real story starts to emerge. By year 11 nearly 80% of the core, contracted income has expired – c£500k of income being subject to a block date expiry. Chart 3 shows the income by grade and the potential liabilities looming in year 11 based on contractual income. Chart 4 shows debt capacity from the loan’s inception looking forward. It illustrates, assuming the current contracted rent, how much grade B income will be mopped up in servicing the ground rent and interest liability post year 11. The above points are especially relevant when you consider that the proposed term of the loan was 10 years – imagine what an alternative funder would think if confronted with a property with only one year until the vast majority of the income expired. Refinancing might prove difficult. As Chart 5 shows, taking all rental surpluses by year 10 the debt will be amortised to £1m. However, after that date – assuming no reletting – the bank is faced with deficit financing: an ageing asset with ever-increasing obsolescence costing the bank c£3m in lost interest by year 20. Readers may consider that this is a very pessimistic approach. It assumes that the borrower does absolutely nothing with the property and the bank ends up with a dead asset. But, funnily enough, this is not unknown. However, this scenario is far removed from the original valuation advice received upon which the bank advanced funds. But it is a real risk, which the banker needs to factor into his assessment of the transaction so as to ensure the correct remuneration and financing structure to accommodate it. Let us add a little commercialism by assuming that the property is relet at the same rent and the interest rate remains static. It can be seen from Chart 6 that, based on these assumptions, the loan interest payments are negligible by year 20, ie the bank could get out of the loan, relying on a de minimis residual value of the asset by year 20. Look at Chart 7, the net income by grade with different assumptions. By assuming a six-month void after lease expiry but before reletting and an interest regime of 10% Libor a totally different scenario emerges – a large provision for the bank! What is obvious from this exercise is that the cash flow suffers a major stress point in year 11. |
