Publications

ADDRESS to the ANNUAL GENERAL MEETING
of the International Valuation Standards Committee
on 1 October 2001 • Bangkok/Thailand

RAYMOND TROTZ
Director, HypoVereinsbank AG, Munich/Germany
Board Member IVSC
Delegate of the Association of the German Mortgage Banks

Mr. President,
Ladies and Gentlemen,

Sawatdii krap, a warm welcome,

First of all I would like to express my very great pleasure at being given the opportunity to talk to you today about

“The significance of real estate valuation to the financial sector —
with the emphasis on calculating the mortgage lending value or —
a value at risk approach.”

PICTURE 1
Ladies and Gentlemen, when it comes to highlighting risks managed by the financial industry in real estate transactions, I believe it is essential to look at the environment, in other words

• the real estate market itself and
• its significance in comparison with other industries.

Although it is not that easy, even for expert specialists, to come up with even reasonably reliable figures on these two aspects, the following figures should give us something to go on:

As you can see from PICTURE 2, the real estate investment volume p.a. (in new and existing properties) is

• in Europe around 900 billion Euro,
• in the USA around 800 billion Euro and
• in Asia around 700 billion Euro (very rough estimate).

In addition to that are to be considered transfers of existing properties (huge transfers of existing properties with unknowned figures). The volume of other investments, i.e. in plant and so on, is

• in Europe around 800 billion Euro,
• in the USA around 900 billion Euro and
• in Asia around 700 billion Euro (very rough estimate).

It is clear from this that the real estate sector is the largest industries in the world, or to put it another way:
more than every second dollar, euro or yen is spent on real estate.

Ladies and Gentlemen, as real estate valuation for the financial industry is the focus of this address, I would now like to look at those aspects of the real estate sector that are chiefly the reserve of the financial industry.

I would like to point out at this juncture that it is a difficult undertaking, as we have to distinguish between:

• real estate investments that are directly influenced by the financial industry, and
• large areas in which the financial industry only participates indirectly, such as the mergers & acquisitions business, bound up with lending to companies by banks, when the sizeable real estate portfolios that are part of the company’s balance sheet assets are an indirect aspect of the loan transactions, or in the privatisation of government enterprises, such as the railways, the post office or airports, which just as frequently encompass large real estate holdings.

How can we define the business of the financial industry in concrete terms?

The obvious aspects to mention are:

• the banks with their extensive real estate lending business, including their real estate products, such as open- and closed-end funds as well as
• the investment activities of institutional investors (insurance companies, pension funds, property companies etc.)

Basically, it is safe to assume that around 2/3 of the real estate investment value is directly or indirectly within the sphere of influence of the financial industry, i.e. that a projected annual volume of around 1,600 billion euro is “affected” worldwide. So this is the real estate market involved when we talk about the financial sector.

Ladies and Gentlemen, this now poses the question, what percentage of this market passes through the “hands” of real estate valuers? That is to say,

• when making valuations for the purposes of buying and selling real estate
• for the purposes of annual balance sheet valuations
• for risk assessment purposes within the sphere of real estate financing
• etc. …

If we assume that, of the market share that is within the sphere of influence of the financial industry, in turn 2/3 passes through the hands of specialists whose task it is to determine the value of this real estate, the global direct and indirect real estate volume to be valued each year in the financial sector might be in the region of 1,000 billion euro.

Ladies and Gentlemen, this is roughly the market we are dealing with when we talk about the market for real estate valuation for the financial industry.

If, say, 10% of these valuations were incorrect owing to

• poorer valuation standards
• lack of market knowledge or
• poor training in real estate valuation

the “damage” to the economy would be in the region of around 100 billion euro year on year.

This is roughly equivalent to the gross annual earnings of 3.0 million German or French workers or, in terms of real estate, approximately the value of around 400,000 detached family homes at 250,000 euro — each year!

So it is worthwhile to aim for the best standards for real estate valuation and qualified training measures for real estate specialists!

In the next part of my address I will consider, from the lenders point of view, the real estate valuation standards that enable the financial sector to make the property and market risks transparent and to assess these risks as accurately as possible. I will concentrate initially on the principal objectives of valuation within the context of real estate financing:
PICTURE 3

1. To obtain knowledge of the current, fair market value of a property, i.e. the market value, as well as an insight into how that value is likely to develop in the foreseeable future, i.e. cash flow and forecast, which are linked directly to market events.
   
   
2. However, we must also recognize the prudence threshold, up to which the loan loss risk can be deemed so slight that it is not relevant to the borrower’s personal ability to repay the loan: i.e. in Germany the calculation of the mortgage lending value in accordance with §12 HBG [German Mortgage bank act]. In Europe this is increasingly referred to as the European Mortgage Lending Value. This calculation is focuses on properties as security of the loan, and not on the true value of the property. Because while the market value is a value on a reference date with multiple functions and, consequently, is only valid for a short period, the mortgage lending value is an independent value with a clear function, namely the extension of a loan on a property for a long period [15, 20 years or more] and the associated safeguarding of the value of the agreed mortgages. The lending value is a loan collateral value that is sustainable in the long term: this is a “value-at-risk approach”.
   
   A higher risk-transparency is achieved by complying relationship “loan to value” not only to market value but also to the mortgage lending value.

Ladies and Gentlemen, in the case of products such as the CMBS — Commercial Mortgage Backed Securities — too, we encounter this approach in principle, both in the case of so-called true sales transactions and of synthetic securitisation. In other words, here too the sustainability of valuations performed by the banks must be reviewed. For example, in a CMBS transaction roughly 70% of the experts’ reports prepared with regard to the assets to be securitised are recorded and, if necessary, the values they state are adjusted if the (rating) agency believes that the values are not sustainable and valid in the long term.

With which valuation method can we arrive a lasting value? More on this question later.

Ladies and Gentlemen, as stated, the significance of real estate valuation to the financial industry is indisputable and the necessity of the best valuation standards for the respective purpose, as well as the highest level of expertise in the performance of the valuations, is a matter of particular concern to me.

But, which individual risks need to be made transparent within the context of real estate valuation?

To give a rough idea, the risks can be summarised in the following six risk groups:
PICTURE 4

1. the market risk, which must take into account aspects such as volatility, market cycle, the behaviour of market participants, the supply and demand situation and the attractiveness of regional markets,
2. the location risk, which looks into the microeconomic/macroeconomic situation, how the property will appreciate in value in that particular location, attractiveness to companies wishing to locate in the area etc.,
3. the property risk, which relates to tenant creditworthiness, the cashflow risk, the contaminated site risk, suitability for third-party use,
4. the partner risk, which sheds light on the professionalism and soundness of the property developer, of the property management etc.
5. the tax and legal risk, which deals for example with rental agreements, tax regulations etc. and
6. from the bank’s point of view : the financing risk.

If the valuation of the real estate is spot-on, and of the highest standard, and if the right methodology is applied, these risks can be made transparent using the following tools:

• detailed investment analyses,
• valuations,
• evaluations of economic efficiency,
• market research analyses and
• competition analyses.

Ladies and Gentlemen, making a risk transparent means: making risks recognisable at an early stage, so that specialists from the field of real estate financing can promptly take countermeasures in the event of impending losses or alternatively, employ the right financial tools - which takes us into another field in terms of the significance of real estate valuation for the financial industry, namely the forthcoming new capital adequacy regulations under Basel II. Put briefly, these regulations ultimately mean that banks must underlay loans they issue with equity capital (at least 8%).

Essentially, the Basel II reforms are intended to make this capital adequacy more dependent than in the past on economic risk and to take into account more recent developments on the financial markets as well as in institutional risk management. Past experience has proved that debts that are secured by mortgages (claims secured against real property), such as real estate, will in future still only require an allowance of 50% in the so-called standard approach. We must await the outcome of the ongoing debate to find out whether, within the so-called IRB approach (IRB= internal rating based), it is possible to privilege risk weighting the requirements even further. However, in order to do this, market and property-specific factors will have to be presented in a transparent and detailed form - otherwise there will hardly be any scope to further ease the capital adequacy requirements.

As you can see, in future the valuation of real estate will increasingly involve establishing or applying the value-at-risk approach.

Ladies and Gentlemen, for the final point in my address, I would like to talk about a quite concrete, proven value-at-risk approach to real estate valuation that has been employed in Europe for almost 100 years. The aims of this approach can be described as follows:
PICTURE 5

• a prudent assessment of the future marketability of the property,
• identify and eliminate speculative elements,
• reflect the normal and the local market conditions,
• be primarily based on long term (sustainable) aspects,
• taking into account of the current use and, if possible, of alternative appropriate uses,
• be based on transparent and clearly stated valuation methods and
• be carried out by valuers with an appropriate level of competence

In Germany we call this value the mortgage lending value, in Europe the European Mortgage Lending Value, which by the way has been included in the revised version of the International Valuation Standards 2001 (IVS 2001) as a “non-market value.”

Ladies and Gentlemen, this can be illustrated as follows:
PICTURE 6 [diagram: difference between market value/mortgage lending value]

In other words, as already mentioned, the market value is a value on a reference date with multiple functions and, as such, has only short-term validity. The mortgage lending value, however, is an independent value with a clear function, namely lending on a property for a long period [15, 20 years or more] and the associated safeguarding (covered by sustainable value) of the value of the agreed mortgages (claims secured against real property). The main parameters for the mortgage lending value can be summarised as follows:
PICTURE 7

1. In Germany, the value is always established on the basis of real value (cost approach) and income approach (“dual pillar principle”), with both values being calculated independently of each other (control function). Depending on the type of property, the mortgage lending value will as a rule be derived through cost- or the income approach.
   
2. When calculating the building cost as part of the real value, for reasons of prudence deductions should be made from the building cost (“reduced building cost”).
   
3. The incidental construction costs (fees and charges) for property may only be taking into account up to an appropriate maximum level.
   
4. Only sustainable, net rents may be incorporated in the calculation for the income value. Here is the current, local market level the basis. Admission income over a limited period (over-rent) may not be taken into account when calculating the mortgage lending value.
   
5. The management costs (including running costs) to be borne by the lessor must be taken into account on an individual basis and deducted from the net rent, as the full cashflow from the property is thus no longer available to the borrower to service the loan.
   
   However, the idea that an appropriate allowance should, if possible, be made for all future risks that may potentially reduce the sustained earnings is of crucial significance when calculating the mortgage lending value. With this in mind, it is justified and advisable to determine a minimum management costs figure based on the net rent — a minimum of 15% in Germany for instance. If the actual costs are in excess of 15%, a higher percentage must be applied.
   
   In addition, a so-called revitalisation risk must also be taken into account.
   
   This risk depends in particular on the property type, the location of the property, the building’s structure and the fittings of the property, its condition and the level of the starting rent.
   
   As a rule, the revitalisation risk will be greater
      - the more contemporary the fittings and design have to be,
      - the older the property is,
      - the more exposed and the more central the property is,
      - the higher the rents are.
   
   Some examples of properties with a high and very high risk are leisure buildings, sanatoriums, clinics and hotels with especially high management demands.
   
6. As a rule, the capitalisation of net income must be within certain ranges in terms of capitalisation rates. For the purposes of calculating mortgage lending value, this interest rate, in contrast to the calculation of market value, is not based on the current short-term market situation. Rather, it has to be derived from the long-term market trends.
   
   In Germany therefore, it is usual when calculating the income value for the mortgage lending value not to apply capitalisation interest rates of less than 5% for properties used for residential purposes and of less than 6% for commercial properties. These approaches have proved to be sustainable in Germany, and therefore stable in value in the long term for properties calculated on the income approach.
   
   When the capitalisation interest rate is set individually, this must be done on the basis of the regional market circumstances, based on an examination of the property specific criteria, location and demand criteria and suitability for use by third parties. The greater the earnings and selling risk of the property, the higher the chosen capitalisation interest must be. Long-term market trends are central to this decision.
   
7. When assessing a property’s long-term earning capacity, the valuers must establish whether the property is suited to various functions and is sufficiently useable.
   
8. The main property-related lending risks must be taken into account when making the loan decision.
   
9. Responsibility for calculating the mortgage lending value must only be given to experts or suitable employees, who have the necessary qualifications in the sector as well as sufficient experience and whom the bank knows to be reliable.
   
10. When calculating the mortgage lending value, the expert must make an assessment of the general marketability of the property (letting and using potential).

Such, in general terms, are the main parameters for the mortgage lending value.

To sum up, the described procedure and the fundamental principles discussed serve to detect the risks inherent in the property in order that the bank can make appropriate allowance for these in, for example, its risk control or pricing when granting (normally long-term) loans.

Ladies and Gentlemen, the following comments on the “German Pfandbrief” should be seen in close association with the mortgage lending value. The “German Pfandbrief” is a fixed-income security, just like the bond.

How do these two securities differ and what role does the mortgage lending value play?
PICTURE 8

In the case of an uncovered bond, the issuer is liable with its creditworthiness. The “German Pfandbrief” is also a bond, but a so-called covered bond. This means that the “German Pfandbrief” is covered by first-rate land title securities, which in turn are based on a prudently calculated mortgage lending value: to be precise, only 60% of the calculated mortgage lending value may be used to refinance the “German Pfandbrief”. In this respect, the “German Pfandbrief” offers the (mortgage) bondholder much greater security.

In practice, for example, this means that mortgage bonds issued by my bank, the HVB, are rated triple A, and the uncovered bonds AA-. Even this extremely slight difference can translate into 2-3 basis points in interest charges. This difference can grow to around 10 basis points if a first-class industrial company is the issuer. It can be correspondingly higher in the case of second or third-class companies.

In addition to security in the form of mortgages — as already mentioned — together with priority rights in bankruptcy proceedings, a sound calculation of the mortgage lending value is essential in order to attain a triple A rating.

PICTURE 9
Ladies and Gentlemen, at this point I would like to refer to a study published in April 2000 on the subject of “Asset Prices and Banking Stability”, in which the European Central Bank arrives at the conclusion that the intensified competition amongst banks in the real estate sector has resulted in differing lending practices. In various countries, for instance, there has been an increase in the loan to value ratios, without any relaxation of other mortgage lending criteria.

One important finding of this study is that the use of a market value to determine the value of the loan collateral in conjunction with a high loan to value ratio for mortgage lenders can represent an extremely high risk in the event of a fall in prices.

For the above reasons, this prudent approach is reflected in the new capital adequacy regulations in Basel II, as I mentioned earlier. This mortgage lending value approach had already previously been incorporated into the regulations on the European solvency ratio directive.

Ladies and Gentlemen, to sum up:
PICTURE 10 & PICTURE 11

• There is scarcely an industry that has less knowledge of its overall market than the real estate industry. In other words a much greater degree of transparency is called for in this industry, even though certain countries, such as the USA or Great Britain, already have a relatively high level of transparency.
• The “service market” for real estate valuation, about which I have spoken today both in general terms and from the point of view of the financial industry, is a powerful market: hence the great significance of real estate valuation.
• There is the highest level of expertise amongst experts who, for many years and sometimes using very polished methods, have been arriving unerringly — and
• Today I have presented to you a particular valuation methodology, which until now has been used mainly in Europe: the mortgage lending value or value at risk approach. It is an approach that should attracted growing interest outside Europe, too, and has been included in the International Valuation Standards as a “non-market value”.
• Against the backdrop of these comments, I welcome and support the activities of the IVSC aimed at harmonising valuation standards, so that in future we will increasingly arrive at “global standards”. Global standards prepared by a large group of experts, from many parts of the world, with all the knowledge and experience of national valuation standards that have proved their worth over many years and are now being debated here — at the IVSC — and evolving into global standards.

Ladies and Gentlemen, high-quality real estate valuation — whether it be the calculation of a market value or of a mortgage lending value — demands that the necessary knowledge is passed on to real estate appraisers through ongoing training, because in the end the best methods are of no use if the people using these methods do not have the relevant training and qualifications. The expertise of the valuers is a subject to which I have devoted a great deal of time in recent years, and about which I would be more than happy to speak to you again on another occasion.

Thank you for your attention!

For further informations:
Raymond Trotz
Director, HypoVereinsbank AG, Munich/Germany
Tel. ++49 89 378 22 529
Fax: ++ 49 89 378 22 174
e-mail: heidi.storner@hypovereinsbank.de
website: http://www.hypverband.de